The desire to point the finger is understandable. Crooked mortgage brokers, greedy investment bankers, dozy regulators, slack credit-ratings agencies, and now rapacious hedge-funds are all in the frame. But I argue that the real answer is none of the above. We must all take responsibility for what has happened. Let me explain what I mean by this uncomfortable statement.
The financial system for which we are jointly responsible is completely unsustainable. All the money in our economy was created and printed by our central bank until we gave commercial banks a licence to create money. The central bank that creates the money in our economy doesn’t just give money to our economy, it lends money to the government – plus interest. If the central bank creates all the money, who pays the interest?
This is the foundation of the flawed system that has come close to collapse a number of times. However, government intervention has kept the crisis at bay on each occasion.
Fractional reserve banking & moral hazard
When we put our money with a commercial bank, the bank pays us a small amount of interest on our deposit and then uses our money to lend out at a higher interest rate leaving only a fraction of the money in reserve. This is known as a ‘fractional reserve system.’ It is all based on confidence. If depositors lose confidence in the bank and demand their money back at the same time, a bank run occurs, as we saw with Northern Rock.
The banks’ practice of keeping only a fraction of deposits on hand has an important cumulative effect. Essentially, it permits the banking system to ‘create’ money. Central banks play the role of ‘lender of last resort’ in this system. If the commercial banks get into difficulties, the central bank – the Federal Reserve in America and the Bank of England here – is there to lend support.
While the central banks’ role undoubtedly inspires confidence, it also creates what economists call a ‘moral hazard’ problem. The idea is that having a safety net can actually encourage the sort of reckless behaviour that leads to accidents. Because commercial bankers know that the central bank is on hand to pick up the pieces, they take bigger risks. If those risks pay off, they reap the benefits. If they don’t, the central bank – and the country’s taxpayers – pick up the tab. It’s a case of ‘heads I win, tails I don’t lose.’
The situation isn’t helped by the incentives that commercial and investment banks offer their staff. They receive commissions and bonuses based on the volume of business that they generate. When lending conditions are loose and interest rates are low, this encourages them to make hay while the sun shines. They innovate to find ways around restrictions and a lot of money is lent irresponsibly. In the process, many earn enough to set themselves up for life, at the expense of collective stability.
The process of fractional-reserve banking has a cumulative effect of money creation. When a loan is funded with central bank money, new commercial bank money is created. As a loan is paid back, the commercial bank money disappears from existence. Money comes into a bank, a fraction is held on deposit and this is spent and re-deposited into a bank, which is lend out further subject to the fractional reserve ratios. Eventually, the money in existence has multiplied itself many times over, creating fictitious currency that has no real value.
In the days of the gold standard, the value of our economy used to be limited to the amount of gold we had, now it is linked to the amount of debt we can create. The end result of such a process is sub-prime lending, or lending to a lot of people who can’t really afford it at high rates.
In an economy where 5 per cent of our money is created by government and 95 per cent by commercial banks, we have reached a situation where simultaneously families are in debt through mortgages and credit cards, corporations are in debt through equity and bank loans, small businesses are in debt through venture capital and bank loans and the government is in enormous debt through government bonds.
We are all to blame
When the banks need to borrow money they go to the money market. When everybody needs to borrow at the same time, the money market dries up. The public look to the government to rescue us. As politicians never look beyond the next election, they are more than happy to do so.
Reform will only come about when we get rid of the fake money we have created and cut our coat according to our cloth. But what politician would dare communicate such a message?
We have all benefited from false prosperity and collaborated with the system behind it. Unless we all willing to contribute to a solution, repeated and worsening credit crunches will become a fact of life.
simon@benedix.co.uk
