The Generalist

Denninger’s House

One of the virtues of being a generalist is the ease with which one can often detect a con. While the specialist examines the bark of a single tree, the generalist sees the forest for the trees. The generalist’s overall knowledge of surrounding area often gives him vital clues, even before any specialized investigation begins. For that very reason the con man often attempts to envelop his intended victim in a specialized and intimidating language where the victim will no longer be able to identify contradictions on his own. Once the victim’s reasoning is crippled, there will be no choice but to rely on the opinions of the “experts”.

Enter Mr. Karl Denninger, a financial writer who has written several articles that attempt to undermine the case for “hard” money. In Sound Banking A Capitalist Imperative Mr. Denninger invokes the specialized field of accounting hoping to convince the reader that fractional reserve banking is not fraudulent and creates no new money. To the generalist, who can already place “fractional reserve banking” in its proper historical geopolitical context sans accounting, Denninger’s assertion is preposterous on its face.

Nevertheless, there remains good reason to proceed with a full investigation of Denninger’s “accounting” claim. If the generalist is able to decode the specialist language, he will not only deepen his own understanding but he will also be able to more easily communicate his argument to others. Let us put aside Mr. Denninger’s complex and incorrect accounting example for the moment and start from the beginning, with a much simpler example, a pawn shop with one item pawned in exchange for a 20 dollar loan:

Pawn Shop
Liabilities Assets
Ring $20 $20 Loan

Liabilities and Assets balance because the ring is in possession of the pawn shop. The balance sheet indicates that there has been no fraud or theft because liabilities and assets balance to zero. Indeed this is the philosophy and very reason for the existence of the accounting field. “Accounting” for things is merely the objective operation of ensuring that nothing has been lost or stolen, assets and liabilities must balance out. Despite the taxman’s best efforts to corrupt the accounting field with a myriad of endless depreciation schedules, accounting will never be able to determine wealth or value. Measuring wealth will always depend upon an individual’s particular context and situation. Accounting can certainly be a useful tool for clarifying and presenting data but it will never be able to objectively decide a hierarchy of values — that always requires the individual. The science of accounting will never replace the art of business.

Now that we understand the purpose of accounting and why the numbers are supposed to balance out, let’s attempt the same accounting example with a bank:

Liabilities Assets
Depositor’s Cash ($200,000) $180,000 Collateralized Loan
$20,000 Reserve (cash)

Again the numbers seem to balance out. Could Denninger be right?! But what happens once we try to physically verify where the entries are? Everything is verified except of course the depositor’s cash which is nowhere to be found! It appears only as an electronic blip worth as much as the numbers in front of you now.

Classical accounting fraud – the reason for audits

In the pawn shop example, if you discovered that the ring was missing from the shop’s inventory you would realize the pawn shop accounting numbers that seemed to balance out as electronic blips were actually a fraud. The same accounting logic that applies to pawn shops must apply to banks as well. Classical accounting fraud involves having false entries that do not correspond to physical reality, the numbers still seem to balance out, however one of the entries is a lie.

The auditing process – verifying each accounting entry is similar to verifying each syllogism of a mathematical proof. Only if each link in the chain of reasoning is correct can one proceed to validate the bottom line. In our example, our auditor discovers that not only is the Depositor’s Cash line a fraud but the $20,000 of reserve labeled as a bank asset mysteriously has the same identification numbers as some of the missing cash originally deposited by the bank’s customer!

How it is even worse than that because of the reserve multiplier

If the depositor hired an investigator to trace where the rest of the cash went he would find it residing in other banks as their cash reserves. If this bank was the only one in town the balance sheet might eventually look like this:

Liabilities Assets
Original Cash Deposit ($200,000) $180,000 Collateralized Loan to buy house from John
John’s Cash Deposit ($180,000) $162,000 Collateralized Loan to buy house from Mary
Mary’s Cash Deposit ($162,000) $145,800 Collateralized Loan to buy house from Joe
$54,200 Reserve (same ID as original Depositor’s cash)

Obviously this process could continue until all $200,000 of the original depositor’s cash is listed as Bank Reserves. The overall deposits for customers would total 2 million dollars. Each of the deposit entries has no physical cash and is manifested only as an electronic bank credit. Nevertheless, Denninger concludes that his definitions are correct:

Ok, having settled on definitions, we will now turn to the fundamental reality of fractional reserve banking. Many people claim that banks “create money” or “print money.” This is not true; a bank recycles money, that is, it increases the velocity of a given amount of money in circulation, but an ordinary bank (not a Central Bank) never creates new money.

The sheer absurdity of Denninger’s claim is now exposed – regular banks must create new money out of electronic blips or they must commit fraud. Only because the electronic blips presented by banks are considered to have unique and magical properties is criminal prosecution avoided – namely that the electronic blips of banks are the creation of entirely new money.

Cash (paper) and Bank Credit (electronic blips in banks only) is the modern analogy to the gold and paper receipts of the past. Banks create credit and by doing so expand the money supply, nothing less than a euphemism for legalized counterfeiting. The accounting example above also explains why every electronic blip of bank credit (money creation) leaves a legacy of debt on the other side of the ledger. Is it any wonder why so much debt exists in the World today?

In another article Mish “Hard Money” Goes Off The Rails Mr. Denninger takes a completely different tack in trying to undermine the excellent case for hard money made by Mike Shedlock. This time Mr. Denninger attempts to provide a metaphysical justification for expanding the money supply as both natural and inevitable:

I walk into the forest (grow) and cut down trees (mine) which I then process into lumber (manufacture.) I dig up some iron ore (mine) and turn it into steel nails (manufacture.) With these two items I now construct a house (manufacture.) That house (and all the products that I used to make it) are in fact money. They were the product of mining, growing, and/or manufacturing. Each of these acts is in fact the creation of money.

Yet who decides to create the money from the house?! If Mr. Denninger constructs his own $500,000 house can I print myself $500,000 dollars (or even easier just enter the amount electronically into my bank account)? Can I then proceed to buy the house with my newly minted money? Can Mr. Denninger who built it? Apparently neither of us, somebody else has that privilege. A naive person might say “society”, those who suspect something is wrong would probably say “government”, while those who are in the know will tell you “the private banking cartel” of course!

In any case, Denninger’s concrete example is ultimately founded upon his own flawed definition of money, a definition that has conveniently confused the terms “money” and “wealth”:

Money: The product of either growing something, mining something or manufacturing something. “Money” is actual wealth, and comes into being only through creation. Ultimately, all money is traced to the only “free lunch” that exists in this solar system, that is, the power of The Sun, although in many cases (e.g. mining) the activity is in fact discovery of previously-created wealth (by the actions of The Sun) levered through human endeavor.

“Wealth” depends not only upon the individual person’s own definition but upon their particular location in time! “Money”, on the other hand, has an objective definition that can be easily quantified and agreed upon. Everyone agrees on how much “money” is needed to make 100 dollars, not everyone agrees on how much “wealth” they would personally ascribe to it. Should your organs be considered a new addition to society’s money supply?

Indeed, there is no way for banks to objectively grow money based upon “wealth” creation. Nor is there any reason to do so. Despite this fact banks create new money everyday with the most common excuse given to the public being the need to “stabilize” prices. Promoting themselves as defender of “stability”, they will never warn you that the “stability” they offer is the stability of a feudal system. For only a feudal lord seeks to “stabilize” prices – workers seek either an increase of their own wages or a decrease of their cost of living. Under a stable, fixed money regime the quality and quantity of goods is allowed to increase relative to the fixed quantity of money. The counterfeiter who instead “stabilizes” prices by destabilizing the quantity of money hinders the market process from producing an ever increasing prosperity. The ideal that people intuitively seek has never been stable prices but stable money.

All prices transmit important information to market participants and only when the quantity of money remains absolutely fixed in quantity is the price information of supply and demand transmitted “noise free”. The phenomena of boom and bust would disappear. Only with all counterfeiters removed, can the market operate as efficiently as possible.

Historical quest for the perfect money and cons perpetrated to profit from it

The desire to establish a fixed quantity of money has historically led to commodities such as gold and silver serving as money because such metals are the only commodities that can approach the abstract ideal of a stable money — readily fixed in quantity (new mines add little to the overall pre-existing quantity), easily portable, and difficult to counterfeit. Not surpisingly, Mr. Denninger also rails against such a fixed money supply based upon metal:

Mish and others like him are wrong because they have their premise incorrect. This incorrect base premise leads to shrill calls for that which will not work (hard currency) and in fact has a thousand-year plus history of not working to stop depressions and other serious economic imbalances.

Yet despite over a thousand years of history none of these people ever examine their premise to discover why these so-called “fixes” never, ever work. They instead wave their arms and try to come up with all sorts of other “explanations” for things like the Panic of 1873 and the Depression beginning in 1929 instead of examining the foundation of their premise and recognizing it’s infirmity.

Mr. Denninger’s superficial and deceptive historical commentary is an immense disservice to his fellow man and only exposes his own ignorance of the banking conditions that preceded the panics of 1873 and 1929. He assumes the rather naive notion that rulers have ever allowed a “hard currency” to exist without manipulation. Even old roman gold coins were diluted by the emperors. The gold gave the coins their appeal to the general public, the diluting copper gave the emperor his pound of flesh. As the coins became more diluted, prices rose. Every economic bust was the result of financial manipulation because every economic bust was preceded by the introduction of a legalized counterfeit. The consequent result is as inevitable as the series of events that follow a man jumping off the ground.

Perhaps the most concise definition of money is the best one: Money is the unique commodity that all sellers in a particular market agree to accept. Thus, the terms “money” and “market” become inextricably linked; the “market” being a group of sellers all of whom accept a common currency called “money”. Honey might be the currency of the beehive, while money is the currency of the rush hour commute. Using this simple paradigm, it becomes clear that there exists markets of all kinds each using their own currency. The obvious fact that certain proprietors are not interested or willing to sell their assets for a particular “money” should immediately dispel the illusion that “money can represent all wealth”.

Money serves a particular function no different than a nut or a bolt and like any tool has an optimal use. Unfortunately that use has been perverted to serve someone other than the ignorant public. If a central bank creates 100 billion dollars in a year, private banks can create one trillion dollars a year – conservatively speaking because the fractional reserve ratio only applies to checking accounts. A trillion dollars a year can change cultures, corrupt academic institutions and scientists, brainwash the public, create new religions and buy politicians. Perhaps it explains why the little mafias the world over have never been able to successfully engage in counterfeiting, perhaps it also explains why some people persist in the magical belief that banks can and should be doing something that nobody else can – turn electronic blips into money. To support his own belief in money creation, Mr. Denninger confuses “money” with “wealth” and in the process elevates money to life itself. He claims that hard money advocates engage in idolatry, while he himself requires money to be everything under the Sun.


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