19. The financial system

Ch 19

Capitalism’s weapon of mass destruction – the world casino

This chapter is about the financial system.  My definition of this includes activities which involve the movement and manipulation of money.  So, mainly, it includes the banking sector and the stock markets.

A short description of money

We need to start with a few paragraphs on money.  This is because money, while superficially straightforward, is not actually as simple as it seems.

Money seems to have arisen with the early major civilisations, often as a means for governments to manage the problems of social complexity – particularly taxes, soldiers, and food[i].

Earlier social groups tended, as far as can be worked out, to operate through the sharing of goods and services, and some form of “gift economy”, in which status was acquired through one’s level of giving.  This created mutual obligations, which might not be formally recorded (the pure gift economy, an informal structure of mutual obligations), or might be marked – essentially as debts – by giving in return decorative or other objects which became marks of status and “wealth” – essentially early forms of money.

As societies grew larger and more complex, and “trade” of one sort or another developed over distances, more formal recording of debts became the norm, and portable tokens became necessary, which eventually transmuted into currencies which were negotiable over distances among trading societies.

Modern economics explains money as having arisen to replace barter.  But no-one has even found any evidence of barter economies which existed before debt- or money- economies, except as very arms-length – indeed often hostile – transactions between separate groups.  The original meaning of the expression “truck and barter” or its equivalent in other European languages was “to trick, or take advantage of, others”.

Money actually allows us to distance ourselves from the full meaning of any transaction which uses it.  Convenience replaces social obligation.  By paying my $3 for a kilogram of apples at the local supermarket, I can pretend that I, the final consumer, having “completed an exchange”, have formed no social relationship or mutual obligation with my chain of supply – the poor farmer, near-starvation-waged picker, and slightly better paid trucker, handlers, and check-out staff; the grossly overpaid executives and owners of the transport and supermarket companies; and the environmental impacts of the actions of all the above.  Money is a means of distancing myself from the community and actions on which I depend.  But it is very convenient.

Money is normally described as having three main properties or uses.  In this chapter, we’re most interested in the first two uses.

First, money is a medium of exchange – in other words, instead of bartering (I’ll swap you a cow for a rifle and 100 rounds), we use money as an intermediary (having sold my cow for $200, I’ll pay you $200 for a rifle and 100 rounds).  Money is much more efficient than bartering, mainly because you don’t need to have an exact match of needs between buyer and seller (what if the seller didn’t want a cow?).   But a key underlying issue is how the money is created and guaranteed – ie how both buyer and seller learn to trust that the $200 is a fair, and negotiable, representation of their transaction.

Second, money is used as a store of value.  Things you own (such as land, buildings, machinery, seeds, or cows) are direct stores of value – they are real assets.  Money, as a promise of assets (I have $200, so I have the capacity to buy a cow or a rifle and ammunition), is an indirect store of value.  A key underlying issue is how that indirect value fluctuates over time, as those who have suffered under high or hyper-inflation are well aware.

And thirdly, money is used as a unit of account.  That is, it is used as a common measure of the value of transactions undertaken, and the value of assets held and liabilities owed.  So, it is a common language to help understand the status of ourselves and of organisations.  A key underlying issue for this use of money is the difficulty of ascribing monetary value to many things (such as Nature), and, consequent on this, the risk of commodifying those things (that is, ignoring their unique and often irreplaceable values by using such a simple and incomplete measure), as discussed in chapter 17.

How money is created – banks as bubble-blowers

All sorts of things have been used as money over time.  Decorative objects (shells, bangles, trinkets), types of metal deemed “precious” (eg, gold, silver, copper, either raw or as coinage), pieces of paper (currency, IOUs), and most recently, digitised records (electronically accessible modern bank accounts).  But the underlying question for all these forms of money has been who creates it, and how trust is built in it.

Gold has no particular intrinsic value other than durability which makes it useful as money.  It is malleable and attractive, and some find it very desirable, whether raw or worked.  And it has been both a direct medium of exchange and a store of value for centuries.  Because of some sort of societal trust in it.

Having been used as physical currency, it then became the basis of the “gold standard”, where paper currencies were “backed” by the amount of gold held (in Fort Knox and elsewhere).  These days, the gold standard has been abandoned, and it is mainly regarded as just another commodity, but many consider it a very good one for storing value.

Paper currencies were developed by commercial banks and then taken over by central banks.  They represent a trusted form of IOU – the government will accept them in payment of taxes, and the central bank guarantees the bank notes for you, and will enforce their legitimacy through the courts if necessary.  The amount of paper currency available is controlled by the central banks, only marginally affected by forgers.

But the most important form of money for our purposes is the general IOU.  Another name for this is “debt”.  This can be issued by anyone, at any time, but commercial banks are the only entities which are legally entitled to issue debt as money.  And they have become primary, and destabilising, issuers of these IOUs.

They are destabilising because, with the growth of IOUs as the main form of money, money has lost any relationship it previously might have had to the real wealth underlying it.  Attempts by central banks to control the amounts of money issued have by and large failed, as described below.  Indeed, instead of being a store of value, money has become a creator of artificial value.

House mortgages are a simple, but important example.  Banks will lend up to a given proportion (let’s say 80%) of the market value for house purchases.  The fact that the market today puts $100,000 higher value on the house than it did say a year ago doesn’t matter to the bank, beyond the fact that it sets up an opportunity to profit from creating more money by lending it out.  The bank simply issues $80,000 more debt.  It has created an additional $80,000 in money, which then goes into circulation to buy other assets or consumables.

But the house itself has not generated any more value to underpin this.  All that underpins it is the hope that the buyer of the house will be able to repay the bank, either through their future income or a higher house price on future sale.

This is called “speculation”.  Another word for it is gambling.  And it has led to many financial crises in the past.  Substitute “tulips” for houses and you have the great tulip bubble of 17th century Holland.

Governments and central banks have responded to these instabilities by trying to limit the amount that banks could lend. Until recently this was related to the levels of deposits or reserves banks had, and they could issue debt up to say 10 times their level of deposits.  This was called “fractional reserve banking”.

The regulated limits have become more and more complicated as the years have gone on, and the relationship between deposits and lending capacity have eroded.  The most universal of them now in place – more or less – is “Basel 2”, which sets requirements of between about 9% and 14% (depending on how you count them) on the ratio of bank capital to loans.  But, the way the rules work and are applied, there is no longer any effective limit on how much banks can lend, as long as they can find willing borrowers.

The amount of debt money issued has skyrocketed in recent years – see for instance this graph of the amount of money created by English banks over the last 45 years[ii].  The “cash” is the banknotes issued by the UK central bank.  97% of the money in the UK has been created by the banks – and most of that in the last decade.

Ch 19 illus 1

Guess what all this extra money it has been spent on? Yes, you’re right – on houses.  Mainly existing houses, not new ones.  Oh, yes, and on “financial sector business”, which means “other forms of speculation”, such as stocks and shares.  Here’s how the money has been spent[iii]:

Ch 19 illus 2

As at mid-2015, there were housing bubbles in major cities throughout the world.  They will burst at some point in the near future, once again destabilising the financial system and the real economy.

So, by creating money in an irresponsible manner, to fuel bubble markets, banks are fuelling instability.

The last time this sort of thing happened was only 9 years ago.  The Global Financial Crisis was also brought about by lending on housing.  But while this didn’t necessarily create a housing bubble on its own, it certainly helped it burst.  In the case of the Global Financial Crisis, the issue was caused by irresponsible lending, to people whom the banks knew would be unable to service their loans, for amounts sometimes in excess of the current (possibly inflated) values of the houses.

These loans were then onsold as high quality debt, via instruments such as MBSs (mortgage backed securities) and CDOs (collateralised debt obligations).   “Derivative” instruments such as these, designed to hedge against risk or, more usually, to extract marginal financial gains, have grown in the last few decades till they dwarf even the inflated “real money” sector.  What they really are is a betting system, pure and simple, but largely incomprehensible to all but a few, most of whom gain (or lose) large amounts from it, in all cases at the expense of the real economy.  If you are in any doubt about whether the financial system is basically a casino, just look up the meaning of “shorting”, and follow through on a few examples of how it has worked[iv],  or maybe just watch the movie, “The Big Short”.

This is what “financialisation of the economy” means – the extraction of wealth from the real economy by creation and growth of new financial processes and instruments.  The derivative markets are a house of cards built on top of the house of cards of “real” money (IOUs and cash).

So, as people found it difficult to service their loans, and made losses on resale as the bubble burst, the whole multi-storeyed house of cards crashed down.

This sent the world into a recession which continues.  One of the reasons it continues is that, following the crisis, the banks became very cautious about lending more money (notice how the graphs above flatten out after 2008).  When the central banks pumped more money into the system through the banks, by such means as “quantitative easing”, the banks simply took the new money onto their balance sheets rather than onlending it to stimulate production and consumption.

Since banks are the major providers of money, the health and activity of the real economy is dependent on their moodswings.  Having created the crisis by lending too much, the banks compounded it by lending too little.  But you’ll be pleased to know they remained profitable, and were able to continue paying bonuses.

This explosion of debt has been worldwide, and largely driven by changes in the regulation of the American banking system.  Gradual attrition of the provisions of the “Glass-Steagall” Act (passed in 1933 to keep commercial and investment banking separate, and thus reduce the risks of “retail” banks indulging in speculative behaviour), and other deregulatory acts, have taken most of the reins off the banking system.  And only marginal improvements have been made since the Global Financial Crisis – the banks continue on their merry way, at the expense of others.

Over the last 40 years, the amount of money in the world has increased by about 11.5% per annum – or 75-80 times in total[v].  No-one pretends that the world’s wealth has increased 80-fold in that time – some estimates even say it is reducing.  But money is now completely unrelated to the wealth it helps to exchange, and has become not a store of value, but fuel on an inflationary and destructive bonfire of speculation.

Even governments have joined the party – New Zealand’s national (ie government) accounts include $NZ180 billion in derivatives, on annual government spending of $NZ80 billion, and primary debt of $NZ120 billion.  The New Zealand Treasury even labels the government’s balance sheet as an “investment portfolio”[vi].

Conservative institutions are starting to notice there is something wrong. A recent study by the Bank of International Settlements (the “central bank for the central banks”) concluded that, beyond a certain point, rapid growth of the finance sector is bad for the real economy[vii]. And even more recently, a study by the OECD concluded that “too much finance (used mainly for housing or speculation) was crowding out more productive uses of money”[viii].

Creating winners and losers – banks as “functional thieves”

Banks probably initially developed as enablers of the first two functions of money.  They would hold your money for you safely till you needed it for another transaction. This was a very noble and useful function, taking our worries away.  And, of course, the banks had to earn something from doing this, to pay themselves for their time and effort in keeping our money for us.  Who could argue against a fee for the safety of a bank vault?  Or indeed against the banks’ investment of your money while they had it, to generate some income, as long as it was at their risk?

But, banks also very quickly turned into creators of money, as described above.  And they found an interesting way to create profit for themselves, which leads to the unstoppably increasing mountain of debt being created in our modern economy.

They charged interest on the IOUs.  And then kept it.  Having lent us the extra $80,000 for the house, they asked for repayment of not just the whole amount, but an additional 3/6/15% per annum.  After we had repaid the $80,000 steadily at say 6% interest over five years, the bank would have about $92,000.

But where did this extra $12,000 come from?  It had not been created by issue of the original IOU.  The only possible source would be the issue of other IOUs.  But these would always be less in sum than the total amount owed, because they represented only the original capital amounts.

This system puts us, as earners or borrowers, on a perpetual, and accelerating, treadmill of earning and debt.  If the treadmill stops at any point, there must be losers – there is not enough money in circulation for all debts (including interest) to be paid, so some cannot pay.

They lose the assets they pledged for the original loan, through repossession or foreclosure.  Or, if they are poor countries, they enter a never-ending treadmill of debt obligation, as interest on their unpaid debt compounds.  One estimate of poor country debt repayment is that in the 1990s, the poor world was spending $13 on debt repayment for every dollar received in foreign aid or grants, and that this ratio has now more or less doubled, to 25:1[ix].

This is how the “business cycle” of boom and bust works, most recently illustrated by the Global Financial Crisis.  Our monetary system is designed so that we either work fast and harder perpetually, to keep up with the ever-increasing interest payments on ever-increasing debt, or (and inevitably) at various times the system will grind to a halt, and many will be seriously financially damaged and thrown into poverty.

Can you guess who the winners are?  You’re right, the inevitable winners are the bankers, and with them those who understood the system enough to profit from its rises and falls, and its booms and busts.

Charging interest on debt is a recent phenomenon.  All the major churches forbade it for many centuries, and Islamic banking still forbids it unless the lender takes what is effectively partnership risk in the enterprise for which the money is lent.  In some systems, the debt itself was also forgiven after a time, by debt “jubilees”.  These were seen as a way for the wealthy to redistribute some of their wealth in a socially beneficial manner.

“Usury” was originally the term for charging any interest on a debt.  It has subsequently come to mean charging exorbitant interest, but the original meaning is the most telling.

Let’s look at the house purchase example from the bank’s side.  The bank has taken the trouble to make a book entry “Debit loans $80,000, Credit Jane Doe $80,000”.  For this, it earns $12,000.  This is usury of the worst kind.  Nice work if you can get it.

On Jane Doe’s side, she’s still got the same old house, plus the gamble that she’ll recover some, or all, or even more, of what she has paid, by passing the same problem and gamble onto the next owner.

Of course, if I have a deposit at the bank, they’ll give me 2/5/14% for it.  And the bank will only make a small amount of money (1% or so) out of onlending that deposit.  But that’s not what the bank mostly does – it mostly creates loans more or less at will, and charges interest on them.  This is why banks make obscene profits.

McKinsey estimated that the global banking industry earned a record $1 trillion in 2014, representing a very comfortable 9.5% return on equity for the third consecutive year[x].  In Australasia, the “big four” banks earned $Aus28.8 billion after tax, at 14.7% on equity[xi].

The banks are able to do this because, as an industry, they have a lot of control over this system.  They are intermediaries in an economy which thinks it really needs money to function.  And they are able to indulge in what I call “functional theft”.

Functional theft is made possible by the need to specialise.  As society becomes more complex, we split tasks up, and each become partial contributors to the creation or distribution of wealth.  Sometimes we are parts of a chain of production, sometimes we are brokers of supply and demand (eg banks, real estate agents).  In either case, we have become functionally necessary to the completion of the transaction – to final production or to sale/exchange.

“Functional theft” arises from using that position to profit unreasonably.  Banks are without doubt the biggest criminals in this regard, through both their legal and their illegal behaviour.  By charging unreasonable fees on transactions, by creating money and then charging interest on it, and by manipulating the system to their own advantage at will – not a year goes by now without a major corruption scandal involving banks and billions of dollars of dishonestly obtained money.

And yet apparently banks are essential to the world economy, and some of them are even “too big to fail”.  This is because they have created a giant Ponzi scheme, and a world financial system which is ridden by a requirement for ever-increasing debt.  When it next collapses, they will undoubtedly be bailed out again, and, again it will be at the expense of taxpayers and the rest of the world.

I talk about the financial system as a “casino”, partly because the banks are often taking risks in their lending such high amounts, partly because they create new products whose rules no-one understands with the express purpose of separating the rest of us from our money, and partly because the biggest bet the banks take is that they WILL be bailed out.  By us.  And they will be, because the real gamblers are running the casino, so they’re taking a pretty safe bet.

A word about stock markets

The stock markets are another important part of the world’s financial system.  The original purpose of stock markets was to raise capital for enterprises – a worthy function.  However, as soon as they were used to trade stocks for indeterminate prices, they became casinos.  A gamble on whether stocks will earn you some money, and which stocks will give you a preferable return.

As I write this, the Shanghai stockmarket is undergoing a “significant correction” (its stocks have lost 30% of the 80% in value they gained over the last year).  What does this mean?  Partly, it means that repayment of the money banks have created to enable people to buy stocks has just got a lot more risky.  Partly, it means that people who came in late and bought stocks “on margin” (ie by only putting up a little of their value) are going to have to borrow more money to cover their losses (good news here – there’s a friendly bank just down the road – maybe…).

Stock markets operate now with automated, split second trading, aiming to take gains as quickly as possible and move on.  This has in turn motivated many corporations to concentrate more and more on short-term profit than long-term value building.  Prices rise and fall on quarterly statements, and on fractional variances from profit forecasts which are always, in an open market economy, subject to uncontrollable variance.  So, while democracy seems doomed to short-term thinking because of election cycles, the economic sector (well, many investors, at least) has chosen to think short-term in the pursuit of profits.

What this means in total is that money is being made and lost with no reference at all to any concept of underlying wealth – the stock markets are, once initial capital has been raised, simply giant casinos.  Warren Buffett is one of the world’s best gamblers – he just does his card-counting better than most, and he’s had some luck.

Stock markets in which prices represented actual underlying value would be like goods with prices representing actual underlying costs – a jolly good thing.  Prices would fluctuate in relation to the published profitability of the enterprise, not on the basis of often wild guesses as to what future profitability might be.  Then those who have chosen to invest in stocks would be part of a reasonable and fair system of wealth maintenance.

And, to be fair to Warren Buffett, his “card-counting” has consisted of concentrating on the underlying soundness and stability of the companies he invests in, not by gambling on the latest hot property.  Although I must point out that the lemming-like instincts of stock market participants mean that, as people follow Buffett’s lead, they increase the irrational element in the prices of stocks which he holds.

Stock market bubbles and crashes recur, time and time again.  From the South Seas Bubble of the early 18th century through the Wall Street crashes of 1929 and many other dates, stock markets crash.  People make money out of this, people lose money out of it, but it is severely and unnecessarily disruptive of the real economy and of people’s lives.  Who would wish another Great Depression on the United States or the world?  Our current great recession was not caused by a stock market crash, but another one soon will be.

Wikipedia lists 49 crashes or “bear markets” (severe drops in a share market) since 1643 – that’s one large “correction” every eight years or so for the last 370 years. 21 of these have been since 1980 – one every 2 years or so.  And yet we persist with this bizarre set of institutional arrangements.  Because somebody is going to win some money from them.  While somebody else loses.

The moneychangers are now in charge of the temple

And they are no longer just moneychangers, they are moneymakers (literally).  The bankers create IOUs which extract wealth from the real economy, to their own benefit.  And they are not only destabilising economies, they are destabilising whole societies.

The great European project for peace has now been taken over by the moneymakers.  The European Community formed between 1957 and 1967 as a bold attempt to ensure that the conditions in Europe which led to the second world would not be repeated.  It was an experiment in unity and comradeship.

But with the introduction of a common currency in 1999, and hence common monetary policy, the moneymakers were allowed into the temple.  They have taken only 15 years to bring large sections of (mostly Southern) Europe to their knees, on the basis of neoliberal economic policies.  The austerity programmes and limits on government deficits (routinely sideslipped by the northern countries as it suited them, but used to castigate the southern countries) gave the poorer countries little room to cope with their internal economic and social problems as they arose.  Ireland, Spain, Portugal, Greece and Italy have all suffered at one time or another from the straitjacket of the Eurozone.

The current situation of Greece is appalling.  Yes, there was deep corruption and widespread tax avoidance in Greece, Greece was and is deep in debt, and the wealthy in Greece will probably sidestep the worst effects of their current situation.  But having been under the pump for years, Greece has now been subjected to even more punitive measures, because it elected an anti-austerity government.  Creditors are being protected at the expense of democracy, and of social and economic sanity.

Greece now has the highest unemployment rate in the European Union, at 26% (higher even than Spain), of whom a staggering 74% are long-term unemployed[xii], and the highest youth unemployment rate, at 50%[xiii].  These are the levels of unemployment which preceded, and contributed to, the formation of the German Third Reich in the 1930s.  And they are caused by similar actions – punitive behaviour from what are essentially occupying nations, on behalf of the banking system’s financial interests.

The system is designed so that there is no escape from an ever-increasing mountain of debt, caused by the charging of interest which requires further debt to be generated to pay it, or suffer large losses of wealth.

The need for mutual responsibility in financial systems…

In New Zealand we have people who take their trucks from door to door in poorer suburbs between paydays lending people money at inflated interest rates to buy goods at inflated prices.  They are true “usurers”.  The banks lending to countries and to people who are unable to service their loans are no better than this.  And they operate a system which inevitable leads to there being losers.

If moneylenders are irresponsible enough to lend to those who cannot service or repay their loans, then they should bear some of the costs of their own lack of responsibility.

This type of irresponsible behaviour, by the way, needs to be contrasted with the provision of investment and venture capital, which is money advanced that is put at true risk in uncertain ventures.  In this case, mutual responsibility would be expressed through honest information on the risk and possible returns of the venture by the would-be “borrower”, and full acceptance of that risk on the part of the “lender”.   Just like agreeing to the rules of a poker game.

…and the need for a new system in total

There are some who argue that the financial system is the sole reason for the explosion in consumption we have seen in the affluent world over the last 30-40 years, and which is now doing serious damage to the planet, and to humanity’s future.  That the ability of the banks to issue unlimited debt at interest has created the recent spiral of increasing debt and hyperconsumption.

I would argue that it is a major instrument, but that the banks are only a part (an important part, but only a part) of a capitalist system which has gone out of control.  The behaviours of capitalism as described in chapters 17 and 18 have clearly led directly to degradation of the planet, social alienation and poverty.  They would have occurred whether or not banks had unlimited power to issue debt at interest.

Though it is likely they would have occurred at a slower rate.  So, while the banks might not be solely responsible for our current state, they are at the very least a major contributor to its accelerating nature.

Whether banks are wholly or only partly to blame, it is quite clear that we need to abandon our current monetary system for one which works for society rather than against it.  A system which does not inevitably create winners and losers on a perpetual debt death-spiral, but which supports the easy and fair exchange of goods and services, and which is not subject to interference which compromises its use as a store of value, if it is to be used for this purpose.

Such systems do exist, at least in prototype, and will be discussed in chapter 29.

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[i] This and the next two paragraphs are basically drawn from “Debt: The First 5,000 Years”, by David Graeber

[ii] Positive Economics, http://positivemoney.org/how-money-works/how-much-money-have-banks-created/

[iii] Positive Economics, http://positivemoney.org/how-money-works/how-much-money-have-banks-created/

[iv] See for example “Shorters line up with OPEC to kill off US shale oil”, Australian Business Spectator, 9 Dec 2015, or the movie “The Big Short”, which is actually about how a small number of speculators made huge fortunes out of betting on the Global Financial Crisis

[v]  See http://positivemoney.org/how-money-works/how-much-money-have-banks-created/

[vi] See “Trading Places”, ppC4-5, The Press, Christchurch New Zealand, 6 Feb 2016

[vii] “Why does financial sector growth crowd out real economy growth?”, Cechetti and Kharroubi, Feb 2015

[viii] See “Banks’ economic value in spotlight”, Dominion Post, 20/06/2015, page C8

[ix] See “Rethinking Money”, Bernard Lietaer and Jacqui Dunne, 2013

[x] “2015 Global Banking Annual Review”, McKinsey and Co, reported in “Banks better move it to stand still”, Miranda Maxwell, Business Spectator, 11/11/2015

[xi] ‘Major Australian Banks: Full Year Results 2014”, KPMG, November 2014

[xii] http://www.telegraph.co.uk/finance/economics/11554873/Why-theres-little-hope-for-Greeces-unemployed.html

[xiii] http://www.statista.com/statistics/266228/youth-unemployment-rate-in-eu-countries/