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The Price is Right?

August 2nd, 2009

In my discussion of the efficient markets hypothesis, I’ve asserted at various times that if (strong or semi-strong) EMH holds, then the market price of an asset “the best possible estimate of the value of the asset” or, more simply, the “right” price. Quite a few commenters asked me to spell out what this means, and there was some useful discussion. This really is the central issue in evaluating the EMH, so I want both to get it right and to express myself as clearly as possible for non-specialist readers. There’s a draft over the fold. I await your brickbats and (hopefully) bouquets.

The EMH implies that the prices generated by stockmarkets and other asset markets are the best possible estimate of the ‘right’ price for the assets concerned. But what does it mean to say ‘The Price is Right’?

From the point of view of an investor, the value of an asset is determined by the flow of income it generates over the period for which it is held and the disposal value (if any) at the end of the period. This stream of payments can be converted into a current value by a discounting procedure (the opposite of working out a future value using compound interest): the problem is to choose the ‘right’ risk adjusted discount rate.

Given efficient markets, economic analysis suggests that the discount rate should be determined by the socially efficient allocation of the aggregate risk for the economy as a whole among individual consumers. This gives rise to a model of the determination of the prices of capital assets called (perhaps unsurprisingly) the Capital Asset Pricing Model, or CAPM. Economists who want to stress the point that the asset prices are ultimately determined by the preferences of consumers sometimes make this explicit and refer to CCAPM, the Consumption-based Capital Asset Pricing Model. The difficulties of CCAPM will be discussed in Chapter …, but for the moment it is sufficient to note that the model depends critically on the efficient markets hypothesis.

If a stock price is indeed the best possible estimate of the risk-adjusted value of future dividends and resale values, then individual investors (at least those without inside information according to the semi-strong EMH) can do no better than to buy a portfolio of stocks and other asset prices that matches their risk preferences, without worrying about attempting to make their own estimates of the value of individual assets. In this sense, the price is right for them.

But there is a stronger, and more important sense in which the EMH implies that market asset prices are the right prices. Given any possible set of investments, market participants can estimate the value of those investments by considering the likely immediate impact on the stock prices of the companies concerned, or the likely return in an Initial Public Offering (IPO). Capital markets will fund the subset of investments with the highest market value. If there are no relevant market failures outside capital markets, the EMH says that these will also be the most socially valuable investments.

The qualification about market failures requires some clarification. Suppose a company is considering an investment that will be highly profitable but environmentally damaging. Then stock markets will value the company on the basis of the profits, and will fund the investment, even though it may be less socially valuable than an alternative, more environmentally friendly choice. In this case, the financial market price is not the ‘right’ price.

But, an EMH advocate will say, the answer is not to try and change financial markets, for example by promoting socially responsible investments. Rather the correct response is to address the market failure directly by imposing tighter environmental regulations. In fact, a sufficiently strong EMH advocate will argue, even the prospect of such regulations will depress the value of the company, and this will lead markets to kill socially damaging projects even before governments have got around to responding to them. Given the EMH, all is for the best in the best of all possible worlds (provided “possible” is defined carefully enough).

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  1. Alan
    August 2nd, 2009 at 14:27 | #1

    Professor Quiggin,

    As a new arrival to your blog, let me start by saying that I find your posts very insightful and informative; I look forward to your upcoming book.
    Not to be too wonkish, but there are some issues related to your post you might wish to further discuss:

    * strictly speaking, the discount rate used is determined by the covariance between an investor’s marginal utility and the asset’s payoff – perhaps this is what you mean by “socially efficient allocation of the aggregate risk for the economy as a whole among individual consumers”, but social efficiency (in a welfare sense) and utility maximisation need not be the same concepts.

    Thus, models like CAPM, C-CAPM are really empirical implementations of this model (i.e. the CAPM uses returns on a “market portfolio” to proxy for investors’ marginal utility). Seen in this light, the CAPM and CCAPM are really special versions of this basic model.


  2. jquiggin
    August 2nd, 2009 at 14:36 | #2

    Alan, your point is valid, and I will try to convey it to my readers without being too wonky, if I can manage it.

  3. Ernestine Gross
    August 2nd, 2009 at 18:05 | #3

    JQ, IMHO you are doing an excellent job in describing how the CAPM and the dogma of ‘efficient markets” (in the sense of the market is always right) has been ‘sold’ but this narrative does not correspond to the primary source literature.

    For example, the CAPM is a charactrisation of an equilibrium of a model of a competitive private ownership exchange economy with complete markets (assets and their payoffs are given, there is no government and there is no money other than a numeraire and the state space of the payoffs of the assets is spanned by the securities in the market). There are strong assumptions about preferences (strictly risk averse) and about price expectations (‘not too divergent’, ie in a closed cone). These assumptions are more restrictive then in an otherwise comparable model for commodities.

    The Fama efficient capital market hypothesis is not an assumption in the CAPM. Alternatively put. Suppose one wants to link Fama’s strong form efficient capital market hypothesis (‘prices fully reflect all available relevant information’) then one would identify ‘all available relevant information’ as the set of assumptions from which the CAPM is derived (in the logic of mathematics). But what is the purpose of such an exercise? I can’t see a useful purpose because one can go directly to the assumptons and compare those with observables.

  4. Ernestine Gross
    August 2nd, 2009 at 18:12 | #4

    Further, the useful insight from the CAPM (and Markowitz’s portfolio theory) is that if investors are educated sufficiently to realise that negatively correlated pay-offs can reduce the fluctuation of returns on a portfolio then the cost of capital (on average) is reduced. Surely, a similar idea is underlying Keynesian type macro-economic demand management (‘stalisation policies’)

  5. Ernestine Gross
    August 2nd, 2009 at 20:29 | #5

    JQ, this is my final comment on this thread (promise!)

    The Fama efficient capital market hypothesis methodology uses the absence of profits, conditional on an information set, as the criterion for efficiency. My 1986 point about the non-testability of the semi-strong form hypothesis was that the test results do not allow one to distinguish between the information set in question being ‘fully reflected’ in the prices (ie ‘efficient’) or not at all.

    If one were to accept the no-profit criterion as meaningful then one would accept the argument that if you have something ‘relevant’ to say then you should use it to make a profit and if you can’t make a profit then it is ‘irrelevant’. I do recall several instances where exactly this argument was used against some of your statements on this blog site. This is the argument which is compatible with the belief that one can draw inferences about a person’s abilities or effort or knowledge from his or her wealth alone. This is what is wrong with the ECMH and it is totally inconsistent with the fundamental research question of theoretical research even in the area of competitive private ownership economies. This is no longer neo-classical economics, this is dogma or financial capitalism or whatever you wish to call it. (I hope this is sufficient to convince you that it is not a good idea to mix up the CAPM (or portfolio theory) with the Fama ECMH).

    Assuming you will allow me to be a little bit cynical, why, I ask, do applied finance researchers use the rate of return of a government security from a country considered to have little political risk or ‘country risk’ as a proxy for the risk free rate of return in the CAPM reduced form equation when there is no government sector in the underlying theoretical model?

  6. Alice
    August 2nd, 2009 at 21:05 | #6

    @Ernestine Gross
    re comment
    ” why, I ask, do applied finance researchers use the rate of return of a government security from a country considered to have little political risk or ‘country risk’ as a proxy for the risk free rate of return in the CAPM reduced form equation when there is no government sector in the underlying theoretical model?”

    This is a damn good question. Where is the markets risk free return in the absence of governments and what provides this in a model with no government??

    (well perhaps we know the answer to that after the recent bailouts…and perhaps bailouts are the risk free return judging by Goldmans comeback). Nice that you can rely on inputs from an entity that doesnt exist in the model.

  7. Ernestine Gross
    August 2nd, 2009 at 21:18 | #7

    Alice, the ‘risk free rate of return’ exists in the CAPM framework (ie theoretically) if there are two securities whose payoffs are perfectly negatively correlated. Your comment reminds of another difficulty arising from mixing up the axiomatic approach to economic theory (eg the Debreu model) and positivism (eg M. Friedman); there is a blurring of theoretical results with reality as experienced in daily life at a particular historical epoch and in a particular location.

  8. William Wild
    August 2nd, 2009 at 21:36 | #8


    To keep it grounded it is worth saying that no-one in bank lending or project finance actually uses the CAPM as designed, even though it should be universal if it is applicable. Do you have evidence of an industry where the CAPM really is used as the decision-making tool, in the way it is designed? People happily calculate discounted cash flows, but that is not the same, and in any event its often just cover for a decision that they have decided to make on other grounds anyway.


  9. Alice
    August 2nd, 2009 at 21:54 | #9

    @Ernestine Gross
    Then Ernestine – if two securities payoffs are perfectly negativeky correlated – isnt the risk free rate = no gain, no loss, therefore zero return. Under my tuition in finance (a long time ago) the risk free rate was equivalent to the RBAs cash rate which is rarely zero.

  10. Ikonoclast
    August 2nd, 2009 at 22:39 | #10

    Maybe too technical for the intelligent lay person (if I am intelligent enough to be a guide) but I guess anyone with an accounting, commerce or economics BA will understand it and maybe the undergrads from 2nd year onwards too. Is that the target audience? It’s too technical for the general public I think.

    Someone like me would have to be given an example of the discounting procedure so that I understood it. In a box within the text perhaps. A clear explanation of the CAPM would be required also (but I note that a chapter is to be devoted to that elsewhere).

    I have a feeling that you are not going to win much general public readership with this book but maybe you are aiming at the accounting, commerce and economics audience noted above. I think this latter set may be the right audience anyway. This argument has to be won in academia, incorporated into undergrad and postgrad courses and thence used to train up a new cohort of professionals who are NOT neoclassical economists. Then you have to get that cohort into Treasury and Finance and finally (hopefully) even into the corporations and market. It’s a ten or twenty year plan.

    People like me are convinced that neoclassical economics is a crock because we see the warped priorities and economic carnage where the neoclassical “economic rationalist” tread hits the ground and tears up ordinary life and the general environment. The empirical outcomes are refutation enough. From the ground it’s clear that it’s a dogma based theory which ignores reality. It’s clear also that it’s often about speculation and wealth transfer rather than about productive investment.

    (As an aside, I avoid the phrase “wealth creation”. It sounds too much like a shonky “physicist” talking about a perpetual motion machine. It has the same connotation of something being created out of nothing.)

  11. sdfc
    August 2nd, 2009 at 22:43 | #11

    Alice, the proxy for the risk free rate when applied in DCF calculations is the government bond rate. The cash rate is an overnight rate and so is inappropriate for longer time horizons.

  12. William Wild
    August 2nd, 2009 at 23:34 | #12


    I’m not sure the argument has to be won in academia, because I’m not convinced that people in the real world actually used any of these models anyway. In 20 yrs of banking I’ve never seen anyone use a theoretical model properly (or, usually, at all) for decision-making. Its all common sense and horse trading.

    Financial players/institutions argue that markets should be unregulated not because they believe in any theory that it is efficient, and that it is for the good of the nation, but because regulation might reduce their opportunities to make supra-normal profits. Look how hard the banking lobby in the US and the UK is working now. In fact the last thing you, as a private financier, actually want is the competition theoretically inherent in unregulated/efficient (choose your adjective) markets. There is a pretty good argument that theory was only ever cover to allow politicians to justify the deregulation/light regulation of markets that the institutions wanted, and that academia only gave this unwarranted validation.


  13. Martin
    August 3rd, 2009 at 01:20 | #13

    Never understood this ‘true price’ thing, at least since I gave up on the labour theory of value. After the event, one can (if one has the data) take the cash flows generated by an asset and derive retrospectively a ‘cash value’ as at a previous date. But that reflects the situation over the life of the asset and includes the effect of events after the date at which we are valuing the asset.

    I do not see any meaningful sense of the ‘true value’ of an asset at the present time. Or can someone explain it to me?

  14. Freelander
    August 3rd, 2009 at 05:05 | #14

    It is important to remember that the price involves the evaluation of the income flow which is a sequence of random variables with their distributions conditional on the information at any particular point in time, using the risk adjusted (or risk neutral) discount factors which are also random variables (again conditional on the information at any particular point in time)… at least in the rational model. The varioius models, like CAPM, involve simplifications but the principles are still the same. I am glad that everyone else manages to correctly carry out these evaluations because it lets me free ride given that I am unable to do the evaluations myself.

  15. Kevin Cox
    August 3rd, 2009 at 07:06 | #15

    If the EMH held for capital markets then we would not get random highs and lows in market prices. We would see the price of any stock stabilising around its “true price”. That is we would get small random fluctuations around its true price but we would not get long periods where there is a trend for a stock to rise then a trend for a stock to fall. There is no need to look for reasons if the EMH hypothesis holds. Empirical observation of looking at the graphs of stock prices tells us it doesn’t. That is, if the market was efficient then the graph would look more like a set of steps.

    It is pretty obvious why the market is inefficient because it is not what most people think of as a market. A market is a place where when supply cannot meet demand then the price rises AND supply increases to meet demand. When supply is greater than demand then the price falls AND supply drops.

    In share markets when supply cannot meet demand the price rises and supply decreases not increases. Why does it decrease? Because people hold onto stocks that start to rise because they are not thinking about the true price but are thinking about what price it will go to before they will sell. Some would say that rising stock prices will cause other stocks to come into the market and that increases supply. While this might be true in the long term it is not true in the short term.

    If you want to have an efficient market in capital then the time frames for the increase and decrease in supply and demand have to more closely match the rate at which prices can change. Capital markets as constructed are classic positive feedback systems that give random highs and lows.

    BTW there is a way for stock markets to break away from the positive feedback effect. If companies purchased their own stock when prices fell and sold more shares when the prices rose where their decision to buy and sell are based on their (or someone else’s) estimate of the true price – e.g. the published estimated profits. This would increase and decrease supply in face of changing demand.

  16. Alan
    August 3rd, 2009 at 09:04 | #16

    Professor Quiggin

    Related to some of the comments made by others above, you may wish to highlight some of these points:

    * Financial economists have known since Grossman & Stiglitz’s 1980 seminal AEA paper, “On the Impossibility of Informationally Efficient Markets” that the EMH is unlikely to hold. Furthermore, behavioural finance is a burgeoning research area, in which there are models which significantly depart from the EMH;

    * The problem appears – in my opinion – to be that these views have not been injected into the policy-making sphere (while Greenspan was a classic embodiment of an “EMH believer”, I think this belief was held – albeit perhaps to a lesser degree – by other policymakers), as well as into the broader economics literature (e.g. most economic models – DSGE or otherwise – continue to use assumptions of market efficiency and, in particular, market completeness);

    The July 18 issue of the Economist (amongst other sources) touches on these points.


  17. Ikonoclast
    August 3rd, 2009 at 09:10 | #17

    William Wild, I feel the argument has to be won in academic circles and promoted through a new cohort of economists into the Departments of Treasury and Finance. The mandarins there and the government of the day (whom they advise) need a robust and validated theory with which they can resist the siren calls of the cavaliers of finance in the market place.

    It’s the old story. Bulldust baffles brains but it doesn’t baffle brains operating within the discipline of empirically tested and coherent theory. I think Micheal Pusey’s book “Economic Rationalism in Canberra” stands validated in every respect. As do the economic theories of Steve Keen and the social-democratic-economic perspectives of JQ.

  18. Alice
    August 3rd, 2009 at 10:56 | #18

    Ta sdfc – it was a while ago and the two must have got mixed up in memory banks not having needed to do one of those calcs since (thank goodness). No finance bod here.

  19. TerjeP (say tay-a)
    August 3rd, 2009 at 13:55 | #19

    I think Kevin Cox is pretty spot on in his comments above*. I’d go further and say that currency markets exhibit the same sorts of random feedback processes and it was maddness to move to floating fiat currencies in the 1970s. The governments of the world ought to get their houses in order in this regard and relink to gold so that value is coupled to a real market. This pricing of currency issue should be a far more significant policy priority than any concern about the pricing of stocks. Especially given the governments monopoly status and general neglect.

    Given John Quiggins views regarding “the right price” I’m surprised he still prefers an emission trading scheme (ETS) over a carbon tax. A carbon tax entails a democratic decision about the price we should pay to mitigate a collective problem. Whilst an ETS in it’s pure form demands a solution at whatever price the market decides on. A situation that provides a far less certainty investment environment for incumbant energy producers and alternate producers.

    * Kevin suggests a remedy which I’m not convinced by. Companies have alternate uses for cash and buying their own undervalued stock may not be the wisest of options. It may make sense to buy somebody elses even more undervalued stock. And companies often want the market value of their stock to be regarded as an independent price. I can imagine also some conflicts of interest in any price setting activity prior to a new capital raising. Of course if a company has stock that is overvalued it probably has an incentive straight up to do some capital raising (ie selling stock and increasing supply).

  20. Kevin Cox
    August 3rd, 2009 at 19:33 | #20


    Companies put out predictions. Companies that “stand by” their predictions are the ones that are likely to be the favourites with the market. If your stock is undervalued in your opinion then it is in your interests to buy and if you buy then it means that you are standing by your predictions.

    Companies that “do the right thing” and can be trusted with respect to their predictions will gain the support of the market. As the prices rise then the company again will show its good faith by selling more stock instead of leaving supply limited and giving some shareholders short term profits. Of course gamblers will not like this approach and the company may face resistance from existing shareholders – but in my opinion it is the “right” thing to do and we need more of doing the right thing.

    Money a company raises that they do not need can be used to purchase stock if there is a run on the stock – however, if there is a run on the stock then the company is in a good position to defend the price.

    The issue is one of trust and of being a “fair” trader. We all prosper if we can trust each other. Of course companies can cheat and take advantage of the system but perpetrators will only get away with it once if the system is open and transparent.

    However, what happens will only be seen once a few companies try it out. It would be fascinating to see what would happen if say BHP or Rio Tinto took up the idea.

    Over the past year I have been proposing a system that will turn the money markets into true markets. I will put up the proposal again – but it is based on the same idea of turning money markets into a “true” market where prices are able to act as the control mechanism to match supply with demand.

  21. August 4th, 2009 at 22:23 | #21

    Kevin – Please draw my attention to it when and where you put it up again.

  22. Kevin Cox
    August 5th, 2009 at 05:44 | #22

    TerjeP I am writing it as an article for online opinion but here is the essential idea.

    Credit money is created through loans. That is banks are allowed to “increase the money supply” by creating a loan. It is argued that this is not creating money because credit money is money that will “go away” when the loan is repaid and if it is not repaid it comes from the bank reserves.

    This argument is a bookkeepers argument it is not a system argument. Credit money is indistinguishable from fiat money because when it is in the system no one can tell the difference.

    So we have a system where when we take out a loan from a bank we increase the money supply.

    So let us now see how the system as a feedback system operates.

    Let us assume that there is an increase in the demand for money. The demand for money means that more loans are taken out. More loans being taken out increases the money supply. The increase in the money supply increases the demand for money because interest has to be paid so more loans are taken out.

    If this were not bad enough when we increase the supply of money we increase the ability of organisations to take on more loans because there is more money in the system which can be used to back loans (the deriratives market amongst others). So the increase in demand causes more loans which causes more money.

    Price in this scenario is irrelevant. It does not act as a control mechanism. Supply of money just keeps increasing until the system collapses under its own weight.

    There is NO true market in money because of the way we increase the money supply.

    The real issue is that money has become divorced from the reason for its existence. It exists to facilitate exchange of disparate goods and as a method of representing assets (which is really the same thing). That is money is a measure that enables us to compare the value of different goods and services.

    It gets its value not from itself but because through a loan it represents an asset and in effect we pay rent on the asset through interest.

    So when we create extra money – be it fiat money or credit money – we should make sure that there are assets available to support the money if we want to charge interest on the money. If we don’t then the system will inevitably go through these cycles of the creation of too many loans then too few as it tries to readjust itself.

    There is no market with prices that can control the system and no amount of regulation or fiddling will help until we create a true market in money.

    Our objective is to have a continuously growing economy because that enables us all to “have more” so the objective is to have a market that controls the growth in money supply. Credit money does not work because it cannot work because the system properties cause a continual increase in credit (not because of the greed of bankers).

    I have made two general suggestions on how to solve the problem. The first is the simple creation of fiat money that is given to the population but where it must be invested in ways to reduce greenhouse gas concentrations or other community goods and services that have difficulty getting loans because the external values of the investment (community) are high relative to the individual returns on the investments.

    The second is the one that I think is easier to sell and will be easier to implement as it is a “small” variation on the existing system. It is to have a new banking product where loans are given with zero interest and where bad loans (those that do not get repaid) are allowed to be written off by the banks not taken from their reserves.

    The second is preferrable because the government can direct where investment can go without getting involved in the details of the investment and we have in place systems where investors have control over where money is invested and look for the highest returns on their zero interest loans.

    Either zero interest loans or giving away new money will increase the money supply and we can do it in a way that guarantees that assets of value will be created.

    It also means that we no longer have to use credit money as the mechanism to increase the money supply. This means we will no longer need credit money. Loans can be given using fiat money. In other words banks will only lend money if it is on deposit in the bank except if it is for a zero interest loan that is guaranteed to create an asset.

    We will now have a true money market. Banks will get deposits and will loan money for projects that are not eligible for zero interest loans. This will still be the vast majority of loans as zero interest loans are only for the increase in the money supply which will now match the growth rate of the economy plus the replacement rate of assets.

    As the interest rate goes up so the supply of money can be increased through issuing more zero interest loans. By restricting the total value of zero interest loans we can ensure that inflation will be kept at zero.

    The particular areas where zero interest loans should be given can be determined by the value of the right to a zero interest loan. For example I would propose that everyone in the population be issued with the right to zero interest loans for investment in ways of reducing ghg in inverse proportion to their per head home consumption of electricity. The value of this right will reflect the return to the individual and while the return to the individual is low then there is a need for these loans.

    btw zero interest loans can be very profitable for the bank as they can ask for more money back than they create and with no risk because they are guaranteed by the government.

  23. William Wild
    August 5th, 2009 at 15:49 | #23

    If you believe banks create money, then I’d be grateful to know exactly where in the lending process this occurs, either as new physical currency being printed or the balance in a payments system account increasing spontaneously without an offsetting reduction in another account.

  24. Kevin Cox
    August 5th, 2009 at 18:10 | #24


    Banks create credit money and have always done this since the days of early gold merchants. They discovered they could have more promissory notes than gold in the gold vault. Today banks are allowed to use money rather than promissory notes.

    I go to a bank for a loan and it puts money in my account balanced against the mortgage against an asset I own or a lien on my future wages. The money that appears in my account does not come from other deposits. That is the money is balanced against the loan account. The fact that money “goes away” when the loan is repaid is irrelevant to the fact that money appears in my account.

    Where do you think the money that appears in my bank account comes from and don’t say it is not money as everyone who has a loan believes they received some genuine money for the mortgage.

  25. William Wild
    August 5th, 2009 at 19:00 | #25

    Kevin, forget about banks as magical money creating machines. The only difference between a bank and any other company is that the bank can take deposits from the public without prospectus. Company raises $2 in equity and borrows $10. Company lends $10. Leverage is just leverage, not new money.

    If we could just create money there would have been no money/interbank markets crisis last year, no bank would care about the ratio of its loans to deposits, and we wouldn’t all need to be sourcing funding from the central banks or issuing against government guarantees.

  26. Kevin Cox
    August 6th, 2009 at 05:16 | #26

    WW I have heard this argument a dozen times and from the point of view of a “static” double entry bookkeeping world it makes perfect sense. But there are other ways of viewing the economic world than the double entry book-keeping model.

    What I and most economic and accounting “outsiders” see is a system where the total money supply increases. This money has come from somewhere. The existing system makes money to be the same as loans. If we need money in the system then we create loans.

    We need to break this link and treat money as a separate entity from loans. Even so called fiat money is created through a double entry bookkeeping involving the government issuing bonds.

    However, to “satisfy” those who think no matter how it is done we must have loans to create money we can use zero interest loans with a variable period of repayment to achieve the same result as creating money independently of loans and it will still fit within the bookkeeping model. That is, we only increase the money supply by building value creating entities that – over time – produce more value as measured by money than they consume.

    In my view of an economy I see “factories” of value. That is, individuals or organisations (entities) that both consume value and generate value. Value happens to be measured by money.

    When you imagine an economy in these terms then a lot of things suddenly become “obvious”. One of these is that we should not have entities that produce something of value (money that earns interest) without there being a way to justify the value put on the product (money).

    Some people seem to interpret what I am saying to be a disbanding of loans or of making them difficult to create. Others interpret it as being a wholesale “printing of money” without control. The opposites are in fact the case. The system being proposed will make it easier to get loans and the creation (and destruction) of money will stabilise to match the increase in value production of an expanding economy.

    Do take the time to think through what is proposed and break away from the static book-keeping model. Think instead of the economy as a growing organism where the different parts of the organism exchange and measure value using money. The organism part also exchanges other information using measures other than money – but that is another story.

  27. William Wild
    August 6th, 2009 at 06:41 | #27

    Kevin, sorry but I’m not an accountant or an economist. I have no model. I arrange bank loans for a living, and I don’t for a moment think that loans are money. Money supply is an economic concept, it has no reality in the actual world. Once you lend it, your money is gone and the borrower now has it. You have a loan, which is nothing more than a promise, but it is not money and you don’t get your money back unless and until you get repaid. But if you don’t have money in the first place then you can’t lend it. It really is that simple. The money just goes around in circles except to the extent it is created or destroyed by the state. Its not book-keeping, just reality. I think everyone makes it all far too difficult to understand by using concepts that have no meaning and can’t be quantified. And there is no use in talking about what should or should not happen, because it has “value”. Value means nothing in finance. People determine the flow of money and they will do what they want subject only to incentive and enforcement.

  28. Kevin Cox
    August 6th, 2009 at 20:10 | #28


    In Australia authorised deposit taking institutions do not have to have funds on deposit before they lend funds for loans They are permitted to create what some call credit money. When the borrower repays the money then the banks “destroy” the money as the repayments do not go into anyone’s account. This does not seem to create money because what is created is later destroyed but the total money supply has increased on average of 11% per year for the last 30 years so something is going on. It is estimated that 97% of money in existence will later be destroyed when or if the loans are repaid.

  29. August 6th, 2009 at 20:44 | #29

    Kevin Cox – sad to see you peddling snake oil.

  30. William Wild
    August 6th, 2009 at 22:21 | #30

    Kevin, not sure what I can say but you’re not talking about banking as I am aware of it. Where in the banking regulations is this provided for? Where in the payments system does it occur? And if it is true, why do we have to worry about the source and cost of funding our loans? In your system there would be no place for Libor or BBR. I suspect you are taking about M1, but that is purely an economists concept and is not real.

  31. Kevin Cox
    August 7th, 2009 at 03:52 | #31

    WW banks are allowed to create credit provided they have certain amount of reserves and provided they keep within the limits of credit creation permitted by the fractional reserve regulations. I agree with all of this and do not dispute it.

    I am saying that we can have another banking product that has zero interest and is secured by a zero interest deposit and against future earnings and that this product will have certain implications. It is when I try to explain the implications and why these will be “good” that the message gets confused.

  32. Kevin Cox
    August 7th, 2009 at 04:21 | #32


    Forget my attempts at explanations on why zero interest loans will be a good thing and just tell me if the following is true.

    Can a bank offer a banking product with the following characteristics

    It is secured against a zero interest deposit of 10% of the loan and lien on future earnings.
    The loan pays zero interest but has a repayment schedule of 150% paid from the earnings generated from the loan investment

    Secondly if this loan defaults can the government allow the bank to cancel the loan and leave the bank reserves as they are.

    If the loan defaults is the government “out of pocket” – that is does the government have to transfer money anywhere or can the loan writeoff be a “book entry” on the part of the bank?

  33. William Wild
    August 7th, 2009 at 06:20 | #33

    Kevin, first I hope I’m not being too dogmatic in my comments. I do enjoy talking about this stuff and don’t want to appear dismissive. Second, I think you need to be very careful when you talk about credit creation and fractional reserve regulations as if they are something special. All they mean is that the central bank/regulator, in return for allowing a bank to take deposits (for which the government is, in political reality, an implicit guarantor), imposes some constraints on its balance sheet. Very crudely, a certain percentage of the bank’s assets have to be cash on deposit with the central bank (liquid assets), and its liabilities cannot exceed a certain proportion of its assets (leverage or capital ratio). That does not make a bank fundamentally different from any other firm. If it was so minded, the government could impose such constraints on any firm. Credit creation is simple lending. When I lend money to my friend I am creating credit by this definition.

    Now if you want to propose a new loan product then it has to be one that makes commercial sense for the bank to do, fundamentally that its expected return exceeds its expected costs. A loan has to cover its cost of funding (roughly, cost of deposits plus cost of equity) plus a share of the provision for portfolio credit loss. Now if the loan has very good security then the credit loss provision will be reduced, that is all security does, but the other costs still remain. So if the banks funds 95% of its loans with deposits, that cost it Libor, and 5% with equity, on which its shareholders want a return of 20%, then the loan has to have an interest rate of Libor plus 1% plus the credit loss provision. This is vastly simplified but is good enough for our discussion.

    Can you explain your proposal within this framework?

  34. Kevin Cox
    August 8th, 2009 at 08:08 | #34


    You are very constrained in your comments and quite correct in what you say and you don’t call me a “snake oil saleman”:)

    I know the product I want. Zero interest loans repaid through earnings on investments. Now I have to figure out a way to make it fit within the current system so that it is acceptable to banks and governments and is “easy” to do. It will be of great assistance if you think the following will work and if not what I need to do to fix it.

    Here are my current thoughts.

    If the fractional reserve requirements are 10% then it means – in effect – that a bank can have credit outstanding of 9 times the amount on deposit. That sets a limit on credit creation. As well the bank has to have on its balance sheet mortgages and other securities to more than match the amount of credit outstanding.

    The bank does not have to get the money from somewhere else if it goes through the process of credit money generation as follows. A depositor puts in 10, the bank loans the depositor 9 which the depositor puts back into the bank. The bank loans 8.1 back to the depositor etc. That is the 10 dollars of unencumbered money backs the loan of 90 dollars now in the depositors account.

    So let the bank offer a product that is a zero interest loan for 9 times a deposit of zero interest money. That is the person gets a loan but the money does not earn any interest while in the person’s bank account. This will satisfy the fractional reserve part of the equation. – it is the capital adequacy that is at issue because the zero interest loan has not yet been spent and there is no asset to back the loan. The government could – if it wished – not require these loans to be considered as liabilities to the bank. That is, because these are “special loans” then in effect the government will say that the government will cover any loss and so the liability need not appear on the banks balance sheet.

    This will be a great deal for the banks because they will give out loans and if the loans default then they keep the deposit and they can make the terms of the loan that the repayments can be more than the initial outlay but paid from the earnings on the assets. Banks do not have to worry about the reason for the loans as long as they are for investments in areas specified by the government.

    How about the government? Well a defaulting loan simply means the money supply has increased and the government does not have to pay anyone anything – except note that there has been an increase in the money supply without an asset backing it.

    If however, a majority of the loans work out OK then the extra assets created from those loans will cover the losses from the defaulting loans. The system can be designed to keep track of the total value of the assets created versus the money invested to ensure that this criteria is met.

    What about the investor taking out the loan? Well a way of getting 9 times a zero interest deposit as credit that you can invest in a productive asset and that is repaid from the profits of the investment will be very attractive and everyone will want these loans.

    For this to work we need to do the following

    The loans must be spent on building new productive assets. We cannot have people using the money to buy existing assets because that does not increase the assets in society.
    The loans must be repaid immediately if the assets are sold.
    There will be an enormous demand for these loans and consequently there could be many unsatisfactory investment proposals that do not stack up if there were too many loans granted.
    There has to be effective compliance procedures.
    Investors have to have a choice in where they invest their loans – otherwise the system will be inefficient.

    So assuming we have the mechanics of the loans worked out the issues are the control of the expenditure, ensuring compliance and working out who gets the loans because it really is the allocation of “future wealth” and as such is a political decision.

    It is these aspects that I have been working on and designing and know how to build.

    Let me go over again the community issue of the funding of renewable energy and of funding investments in ways to reduce energy consumption as an example.

    There is an investment market place with these products already. Companies, community organisations, not for profits all want to build things like solar thermal power stations or put up windmills. There are many products on the market that are heavily subsidised by governments such as solar panels or solar hot water systems. The government is providing funds for insulation. The government is trying to introduce an emissions trading system to increase the price of energy so as to encourage investment in renewables. So we know there is a societal need to encourage this investment market.

    Zero interest loans to invest in these things would be a simpler more cost effective way of encouraging investment than the plethora of methods in existence.

    How about getting people to take out loans? Well everyone will want them and it will be a matter of limiting the loans and so the right to a loan will be a tradeable commodity.
    The simplest thing is to give the right to a loan to everyone who wants one and to allow the loans to be tradeable. A better method is to give them out on the basis of the inverse of the amount of mains energy consumed in a household on a per head basis as this gives a Reward for non consumption.

    Compliance is the big issue.

    Loans can only be used in a market place where suppliers specify what their products are and how they will reduce greenhouse gas. Only products that reduce or save a certain amount of ghg per dollar spent will be permitted in the market. Sellers will specify their claims for their products. If buyers find these claims are not met then sellers will not only have to stop offering their products but they will be banned from selling any other products in this market place and any others that might arise.

    Similarly if buyers are found to collude with sellers then they will be forever banned from receiving the right to loans.

    Systems to ensure compliance using some of these ideas exist already in EBay and Amazon and PayPal.

    Such systems can keep track of exactly how each person spends the loans they take out and can ensure that when the assets are sold the loans are immediately repaid.

    Given all this what are some of the likely outcomes.

    First it will cost the government very little. There will have to be a supervisory role watching over the organisations that run the systems but little else. Someone will also have to decide how many loans to allow and decide on the method of allocation.

    Energy costs will drop because there will be no financial costs associated with renewable investments. The cost of solar thermal power will be 1 cent at the “factory gate” without finance costs and it can be sold for 6 cents per kwh.

    Because we will have a lot of people with loans and because we will have a lot of suppliers there will be a genuine free market place and so loans will go to the most economically efficient suppliers.
    The right to have a loan will be tradeable and its value will determine whether zero interest loans are needed or not to encourage this community investment.

    The government decides how much fiscal stimulus is needed by allocating the rights to that amount of loans but they do not have to “get it right”. If too many loans are issued to a particular area then the value of the right to a loan will drop – not cause general inflation. The government simply monitors the reductions in ghg and the expenditures and the rates of inflation and adjusts accordingly.

    Note that Australia can do this without the government going into debt, without borrowing money from overseas, and without having to get agreements from anyone. My calculations indicate that $30 billion in loans for the next ten years will give us zero net emissions, with lower energy prices. Note also it gives the way for the government to compensate those parts of the economy that will be affected by the closure of mines and fossil burning energy plants. The government gives them the right to take out some large loans to build renewable capacity if they promise to close down their mines and their polluting energy plants.


    The system works because money is directed towards investment NOT consumption. Investment produces more money than is invested hence is a non zero game and everyone can win. Because the loans are invested through a market place we will get the most economically efficient distribution of funds for this “purpose”.

    The approach can be applied to any area of investment but we only need to apply it to those areas where the community (through the government) decides needs some stimulus because the community benefits are high in comparison to the benefits to the individual investor.

  35. Ernestine Gross
    August 9th, 2009 at 09:56 | #35

    “I know the product I want. Zero interest loans repaid through earnings on investments”

    Issue equity.

  36. Kevin Cox
    August 10th, 2009 at 06:37 | #36


    Exactly right. What I am proposing is a way to get the increase in the money supply into equity in new assets rather than the current system where the increase in the money supply goes into increasing the price of existing assets.

  37. Kevin Cox
    August 10th, 2009 at 08:44 | #37


    To explain a little further. Say I am investor wanting to build a new asset. To get loan money to build the new asset I have to mortgage another asset to get the loan. In effect to get a loan I have to give title to another asset and rent it back or “pay interest” on the loan. I can now do different things with the money like build another asset but what I do with the money is of no interest to the lender.

    The incentives are the wrong way around. The provider of money, is only interested in my ability to repay the loan and not at all interested in what I am going to invest in. Of course that is a good deal for the provider of money but not a “good” deal for me as I do not have an asset to pay the interest until the asset starts to generate income. What this means is that money suppliers want to loan money to those who control existing assets.

    The existing system encourages increases in the price of existing assets because the higher the price of existing assets the more loans can be made and does not encourage the creation of new assets because new assets are likely to decrease the value of old assets particularly if the new assets are more productive. (Telstra’s copper wires are a classic example)

    The other method of finance – equity finance – for any company is very much more expensive than debt financing and is normally much greater price than the risk involved. If you have no assets or you are an individual or a startup then it is simply not available.

    In other words the existing system charges more for the creation of new assets and it is not available in “small quantities”.

    What I am proposing is a system of equity financing through loans to build new productive assets and done in a way that everyone in society can participate and not just those who already have existing assets.

    An example of the idea are the micro loans for people to invest in productive enterprises. Some banks in Australia are experimenting with micro loans. The proposal I am suggesting is an “industrial strength” system in which the government can participate and that can be used for such areas as financing ways of reducing ghg emissions. If widely adopted it removes the need for using price incentives like carbon trading, taxes, or emissions permits to encourage investment.

  38. August 10th, 2009 at 18:14 | #38

    Kevin, you do not need to mortgage asset A to secure a loan to invest in asset B. We will happily lend you money to invest in asset B with security only over asset B if we think that the cashflows from asset B will repay the loan. In fact it would be extremely rare to take security over an unrelated asset instead, and it would be more common to make a loan without security at all. The security held by the bank doesn’t appear on the balance sheet anywhere. Balance sheet is loans assets = deposit liabilities + (equity) capital.

    The only other observation I would make is that there is a strict conservation of risk in financing. Any risk of an investment has to be borne by someone, somewhere. You can’t make it disappear by structuring around it. You can turn the risk into a cost, but then the cost has to be borne by someone. No way around it. So when you say equity financing is expensive that must be because it is bearing risk. You can’t just call it loans and have that risk disappear.

  39. Kevin Cox
    August 10th, 2009 at 21:02 | #39


    There are ways to handle the book-keeping problem. One way is for the government to allow the bank to write off bad loans and be allowed to reduce the deposit liabilities it has. This “in effect” increases the fiat money supply in the system.

    The other way is for the government – if the loan goes bad – to “print money” and put it into the bank. This is called the government guarantee and we have this in place already.

    In effect the government bears the risk – but what is the risk?

    We know – for example – that the cost of producing renewable energy from solar thermal power plants is currently 1 cent per kwh in running costs. We know we can sell this power for 6 cents per kwh. The risk of there being no demand for energy is zero. This means that the risk of these investments not paying back their money is pretty well zero in the absence of fraud and theft. It is going to be very unlikely that the government will be forced to “print money”.

    The risk to the government is that the money supply will expand too rapidly if there are too many bad loans. If this happens then the government simply limits the number of zero interest loans it is prepared to guarantee.

    There is no need for banks to charge interest on loans that create new productive assets. It is not done because – until recently – we have not had the technology to control, track, monitor and enforce compliance of the expenditure of monies in the way I envisage.

    Of course you can’t have people using loans to build assets, sell them and not pay off the loan. You have to have in place the agreement that if an asset which you built with your loan is sold then then loan must be immediately paid back.

    There is a lot of bookkeeping and “intrusion” into the way loans are spent but that is something that we can do today with ease and security. That is we build compliance into the system operation and if people bypass the system checks we tell them they cannot participate in the market place as a buyer or seller.

    On the question of getting loans. My company has zero tangible assets, but it has major listed companies as clients, with a strong order book, and with “break even” in the next few months. I have no hope of obtaining a loan to be spent on expansion and I have to either get very expensive equity – which in our case we estimate the rate of return is a minimum of 40% – or simply expanding slowly. I have decided to expand slowly with a small amount of equity but that is not a good option for society because it means that an enterprise that will bring social and economic benefits to society is not going to expand as rapidly as it could.

    I have just been talking to a person with a similar highly prospective product that we will use who is going to become a Singapore resident and take his business to Singapore because he cannot get expansion money at what he considers reasonable rates and so is going to Singapore where he will get government loans at low interest rates.

    A company in which I have shares was unable to obtain loans or equity finance in Australia at “reasonable rates” (less than 40% IRR) and so has obtained finance from an Arab bank where the bank gets its return when the company is sold or lists and it puts a limit on the amount of return. In effect it gets equity but with a limit on the upside of 20% IRR. This company has contracts with the world’s largest companies but requires a lot of development capital to fulfil the orders.

    I can go on and describe many other similar stories. If you have an innovation in Australia then to get it you have to pay way over the odds for funding out of all proportion to the actual risk. The problem is the way banks measure risk. They measure it by how much money they can get if there is a sale of the assets over which they have a lien. Innovation means in many cases that there is no established market for your product at the time you need a loan. It is a “law of innovation” that your initial products are expensive and that as you increase volume you decrease your costs (in our case) by about 50% every time we double capacity.

    Giving zero interest loans for investment in new productive assets where the loans are guaranteed by the government allowing the money supply to increase if the loan goes bad is a much better way of growing the economy through investment than our current approach which favours investments in existing assets which in turn tend to inflate in value.

    In effect what I am describing is a system where “the community” bears the risk of failed ventures that are producing assets that the community as whole wants (like broadband networks, renewable energy plants, schools, hospitals, public transport etc).

    I am not advocating the replacement of normal lending or changing the banking system. What I am saying is that if we are going to increase the total money supply by x dollars we do it by investing x dollars at zero interest in new productive assets rather than investing the x dollars bidding up the price of Sydney harbourside housing.

    What I am advocating is cheaper money for new productive assets rather than the current approach which gives cheaper money to purchase old assets.

  40. August 11th, 2009 at 01:33 | #40

    Kevin, I’m still not following why actual flows of money are a book-keeping problem. I’ve done a post on my own blog about fractional reserve banking which might show you where I am coming from. Will. http://williamwild.blogspot.com/2009/08/fractional-reserve-nonsense.html

  41. Kevin Cox
    August 11th, 2009 at 19:15 | #41


    I am not saying that the current system is “wrong” or “incorrect” in any way. I understand how fractional reserve banking work. What I want to do is to tweak the existing system to favour investment in the construction of new assets against investment in the purchase of old assets. I want people who build new assets to get a better deal in terms of financing than those who simply buy existing assets. The reason for this is that we progress by developing more productive ways of doing things and we stagnate when we do not continually strive for better ways of doing things.

    Think of money as being something different from a loan. That is, we do not have to have a loan to have money. What if we did not have fractional reserve banking? In other words we had a system where before a loan was given the person giving the loan HAD to have money in an account somewhere. Such a system would work provided there was enough money to cover all the loans needed. If there was too little money in the system then interest rates would rise because there was not enough money. If there was too much money available then we would need to get rid of some money.

    Our issue now becomes one of having to create some extra money (and occasionally to destroy some money) to keep interest rates at an appropriate level.

    The answer that we have devised is fractional reserve banking where banks can create extra money – until the loan is paid off – that is backed by existing assets or guaranteed future income. So extra money is introduced into the system by creating (albeit temporarily) some new money and we get rid of the extra money when we have no further need for it.

    This all seems good BUT the trouble is that we count money as an asset when it comes to creating new credit money. In fact this is the way the system is meant to work. A bank can only lend a fraction of the money on deposit – but it does not matter where the money comes from. This would not be a problem if the money represented a productive asset BUT the money already represents an existing asset and so it should not (from a systems view) be able to be used to create more temporary money. The reason is that some asset somewhere has to earn enough income to pay the interest on the loan used to create it.

    The fact is that the total amount of money in all the bank accounts in the world is far greater than the value of all the “productive” assets that earn money.

    So how to solve the problem of creating too many loans backed by too few assets?

    There are many ways and I have been suggesting a few and I think the latest one of zero interest loans that must be used to create a new asset is the best so far. You may be able to come up with another method? The system I propose leaves the current system intact because we cannot change such a system quickly without immense disruptions. It achieves its aims slowly through slowly introducing this new form of loan that favours the creation of new assets.

    We give the creation of new assets an advantage when it comes to getting a loan. If you want a loan and the reason for wanting the loan is to create a new asset then you get your money for zero interest. You may or may not be required to pay the money back. If there is not enough money in the system then you can be forgiven your loan. If there is extra money in the system then you are taxed more on your earnings and the government destroys the money.

    We know we have too much money in the system when the interest rates for ordinary loans drops too low. My guess is that the interest rate should be about the productivity rate plus inflation. When there is too much money in the system then we get rid of the money as is happening now with the GFC. Banks are tightening up on their lending so they are in effect not replacing money quickly enough to keep the economy moving. In such cases the government allows more zero interest loans.

    I now think, after trying to explain it to you, the best way to address the bookkeeping issue is for zero interest loans made by banks under the restrictions imposed on the loans not to be included as a bank liability. That is, because the bank issues zero interest loans and the money they give people for this purpose earns no interest until it is spent then there is no need to “put it on the books” at all. It goes on a separate set of zero interest loans books. This can be done by the issuer of the currency.

    Remember the objective – with which you may disagree – is to favour new loans that will be used to create new assets versus loans against old assets that may be used for any purpose including consumption.

    Of course we need methods to ensure people comply with the new regime and do invest their money and that is why I talk about special market places where the market place enforces the rules of asset creation.

    Hopefully this explains what I am on about a bit better.

  42. August 11th, 2009 at 21:08 | #42

    Kevin, I’m not sure we’ll get to the stage of understanding each other, so I’m going to sign off on this now. Best of luck with the idea. Cheers, Will.

  43. Kevin Cox
    August 13th, 2009 at 04:21 | #43

    William, thanks for listening. In trying to explain to you I think I have finally nailed it. You can find the new explanation at http://stableproductivemoney.wordpress.com/2009/08/13/taking-the-interest-out-of-loans/ and I will try to get the article into online opinion. I have also figured out a strategy to get the idea introduced so watch out for zero interest loans.

  44. Graeme Bird
    August 14th, 2009 at 07:39 | #44

    John I would say that our markets are grossly inefficient. Here I’m not considering any externalities but I just mean in terms of straight resource allocation and share pricing. Its good that you seem to be conducting this review and I’m sure that a lot of good would come out of it.

    Forgetting externalities for the moment. I would say that good share pricing leads to superior resource allocation. Since if shares are priced higher than their book value and some reasonable estimate of the firms net present value (divided by the number of shares)…… and if this firm believes that it has valuable projects to explore..;.. then it follows that the management are doing the right thing by the shareholder by having a share issue, ((((giving the first options to the long-term shareholders in proportion of their shareholding)))) Since though they will be watering down the equity it is a case of swapping expensive shares for relatively cheaper cash. And the converse is true. Where the company may release resources via share buybacks if the share is underprices, via dividends if the share is overpriced but few good opportunities present themselves and so forth.

    So to me efficient share pricing is critical. And perfect or near perfect share pricing would harmonize the interests of the company management (or at least reduce agency problems) the shareholders and the wider community.

    But this is not what we have now. In fact I would say that the sharemarket is now so powerfully inefficient that its almost impossible to say in the case of many companies if they are net destroyers of wealth or are they showering benefits on society at large.

    If I may be so bold as to give you a tip, I think you ought to hold off jumping to the behavioural side of things. And prior to making that leap I think it would be fruitfull to set yourself the task of all the various ways our sharemarket is powerfully inefficient even ignoring any behavioural issues.

    Certainly I can talk at great length about these subjects. But failing you consulting my opinion on these things I would suggest not to leap to the behavioural or Pigouvian side of things lest you miss out on the real fruitful issues of why the market would under current policy be totally erratic and inefficient no matter if humans were all totally rational and no behavioural quirks need apply for consideration in this matter.


    Terje Kevin Cox wasn’t peddling snake oil. Its three years now and you refuse to learn the basics of monetary economics. Banks do indeed create new money supply via using debt to pyramid upon cash. I’ve explained it to you before. Where is the learning deficiency coming from? This is straight basic economics. And its simply not open to your gainsaying.

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