The financial crisis: real causes and real solutions

Hopefully it’s becoming increasingly clear to people, in light on the latest market developments (i.e. Euro-zone bailouts and now a “post-AAA” USA), that the responses to the 2007 financial crisis did not constitute a solution, merely a postponement of global finances “day of reckoning”. I’ll discuss why I think that without fundamental reforms there will indeed be such a “day of reckoning” and why these reforms are needed, not another set of bailouts. Some of my specific comments refer to the UK situation (as that’s where I live), but my underlying arguments should apply equally well to economies like the US.

The short answer is that you cannot fix a problem caused by debt with more debt; you cannot borrow your way out of a debt. The proposition is incontrovertible, but the extent to which it damns all responses to the financial crisis thus far is rarely appreciated, even (or perhaps especially!) by the so-called experts. The key consideration missing from all mainstream analysis of the situation is the fact that pretty much the entire money supply is created as bank credit (a euphemism for debt) incurred when businesses or consumers take on bank loans. If you are somewhat incredulous of this fact and want independent confirmation, you can find corroborating statements from industry insiders, as well as much additional information, here. What does issuing virtually the entire money supply as a debt imply? It makes global financial meltdown pretty much inevitable, as I will now explain.

The “boom and bust” Gordon Brown famously promised us “no return to” is a consequence of the means by which money is supplied to our economy. Banks issue “credit” to consumers which then circulates in the economy and stimulates production. One firm investing and hence providing jobs, producing things, distributing purchasing power amongst consumers contributes to improved prospects for returns on investments by other firms. So bank loans, like buses at bus stops, tend to arrive together. This is the “boom” phase of what economist call “the business cycle”.

However, after a little while the firms want to start repaying their loans. Just as when bank loans are issued bank deposits are created, when they are repaid bank deposits are destroyed. This means there will be all of a sudden less money circulating in the economy for other firms wanting to pay down the principal or service the interest charges on their debts. Again like buses, this repaying of loans tends to happen together (often governments will provoke it by adjusting interest rates to assuage monetarist economist’s concerns that the economy is “overheating”). Crucially, note that while the money supply will increase or decrease, depending on whether more loans are being issued or repaid, individual debts owed by firms remain fixed.

So, what if as a result of several firms repaying their debts the overall money supply contracts? Firms with debts still on their balance sheets are now potentially in trouble, since the money available to pay these remaining debts has contracted, while the debts themselves have not. As a result, some firms are unable to make interest payments on their debts and will go bankrupt. Jobs disappear, so less money is being distributed as salaries and the problem gets worse. A domino effect ensues whereby each struggling firm going under worsens the investment climate of the economy, so that soon other firms are taken down with it. This is the “bust” phase. Our economy is a little like a children’s game of “musical chairs”; as long as the music is playing (loans are issued, the money supply is expanding) firms are okay, but when the music stops (loans are repaid, the money supply begins to contract), some firms will lose the game, since there are not enough chairs available for everyone (not enough money is readily available to repay all the loans).

What all this implies is that our system of “debt-money” is both dynamically unstable and pro-cyclical. Firstly, it is tremendously prone to destabilising positive feedbacks. If the money supply expands a little this will lead to a more favourable investment climate tending to make it expand even more. If it contracts a little, this will lead to a less favourable investment climate, tending to contract it even more, since contraction will result in some firms going bankrupt making it even harder for the “survivors” to find the money to service their debts. This is the opposite situation to what is desired for the economy, a stable self-correcting money supply. Governments can try in vain to correct for perturbations and re-stabilize the system by adjusting interest rates, but this is a little like trying to balance a basketball on the head of a pin – the slightest nudge one way or the other causes the economy to fall off.

The only way to get out of a recession within the current monetary system is a bizarre “hair of the dog” style stimulus; more money must be supplied to service existing debts, but the only way the system has of putting more money into circulation is to issue even more debts! The current recession is escaped, but only by loading the system down with ever more debt, ensuring that each subsequent recession will be more serious than the last one.

Where are we today? Thanks to compound interest on the debt-money stock, we find ourselves in the absurd situation that the total amount of debt in the UK economy is larger than the total amount of money! See the graph below (taken from this report) of UK total personal debt (red) vs total money supply (green):

This graph above tells us two things:

1 – If we pooled all the money in our wallets and our bank accounts then used it to pay the nation’s debts, we would still owe the banks several hundred billion pounds and
2 – If we actually did this, there would be absolutely no money in circulation, not one penny with which to pay our remaining debts or indeed perform any economic functions (recall that when a debt is repaid a bank deposit a.k.a “money” gets destroyed).

Add to this the fact that there is a second massive debt to pay, a UK national debt of around one trillion pounds (which is actually not so bad compared to a lot of countries, Japan for example), and you see that it is quite impossible to pay our debts or indeed even stop them growing relative to the money supply, due to the way our monetary systems work. Any talk of “living within our means” is manifest nonsense, since debt is not a choice for the economy as a whole. Money is put into circulation as bank loans; in other words if we want to have money we must also have debt! If you are “in the black” then others must be “in the red”, since the money in your savings account must have originated as somebody else’s bank credit, accompanied by an equivalent debt.

At some point then, debts will become so endemic, grow so large relative to the money supply, that the money to service interest on them can no longer be transacted frantically enough. (is this the real reason we chase the mirage of perpetual GDP growth?) The entire economy will then begin to collapse, in a process Ben Dyson of Positive Money UK terms “the death spiral”. This is the point we may well have reached today, and if so further bailouts will be absolutely no help, since they simply add even more debt to a system already about to collapse under the burden of its current debts. Looked at in this way, the fact that the current crisis has manifested as a property based asset inflation bubble is largely incidental. The real causes were more the mathematics of compound interest on debt-money than any repealed Glass-Stegall acts or toxic Mortgage-Backed Securities, which have merely added some extra straws to an already over-burdened camel.

So, what can we do instead? We can end the process of creating money out of bank loans, by making banks operate the way most people think they already do; as financial intermediaries, transacting already existing money but not creating any new money. This could be done via a straightforward banking reform; you decide if you want your money to be kept safe and accessible (with no risks to or returns upon your money), or to be lent out and temporarily inaccessible (with some associated risks to and returns upon your money). In contrast, the current banking system tries to pretend that your money can be kept both accessible and risk free and simultaneously lent out (with risks) to investors ; a sleight of hand the governor of the Bank of England Mervyn King referred to in a recent speech as “financial alchemy”.

Instead of banks creating money for private profit and charging UK taxpayers interest on the entire national money supply (usury is an entirely appropriate term for this in my opinion), money could be created by an independent monetary policy committee, which will assess how much money needs to be created to provide for the needs of the economy rather than for the bonuses of bankers. The examples of possible reforms I mention above are my attempt to summarise those of a submission to the Independent Commission on Banking (ICB), co-authored by Positive Money, the New Economics Foundation and Prof. Richard Werner of the University of Southampton’s School of Management.

If you want to find out more details about how “our” current system “works”, how it could be reformed such that the financial crisis is actually addressed rather than either ignored or exacerbated, or get involved in moving these proposals forwards, visit the Positive Money website and please consider signing their petition and promoting their campaign.


~ by freedomthistime on August 10, 2011.

2 Responses to “The financial crisis: real causes and real solutions”

  1. Sounds good but how does one get from here to there?

    Establishing how much money the economy needs is one thing. But how does one establish the shares of the supply. A employer of thousands wouold presumbaly get a lot, a pensioner would presumably get little or nothing. How does one deal with savers who have hoarded their money supply?

    • Hi Cullum,

      I wrote this a while back and I’m learning more and developing my understanding of these things all the time. I suppose how we get from “here” [a privatised money supply] to “there” [some public accountability] is massive public education leading to massive public pressure. I tend to see the sorts of reforms Positive Money proposes as just a first step though, not an end point. What you say about sharing the money supply fairly is true enough – I would like to see the democratic management of the economy as well as formal political democracy. I think the latter is largely meaningless without the former. As John Dewey put it:

      “As long as politics is the shadow cast on society by big business, the attenuation of the shadow will not change the substance.”

      Beyond that, I increasingly think it will be necessary for us to completely rethink what an economy is and what money is. I think capitalism (or whatever label you want to give today’s social/political/economic system) is founded upon a set of cultural assumptions that, if not radically challenged, are going to trash the planet’s ecology and kill most, if not all, of the 7 billion people alive today over the coming decades. I hope I am wrong, but that is what I honestly think.

      So, we need to imagine alternatives. As far as completely rethinking what an economy is goes, I recommend the book Parecon: Life After Capitalism by Michael Albert. As far as completely rethinking what money is goes, I recommend the book: Debt: The First 5000 Years by David Graeber. If we decide we want radical alternatives and reach some consensus on what these might look like, how will we get them? By collectively recognizing that oppression relies upon the tacit consent of the oppressed. 1% of the people cannot stand over 99% of the people with a baton or a gun 24/7 – this monstrous system only endures while that 99% continues to police itself.

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