Monday, January 26, 2009

Reflections on the Banking Bailouts

I have been giving some thought to the massive banking bailouts, and I am increasingly concerned about what it going on, and the justifications for the bailouts - the idea that we must 'save the financial system'. The more I think about this, the more curious the expression becomes. In fact, the more I think about it, the more I find the expression to be disturbing. It is being thrown around like confetti by politicians and being repeated by the media. My problem is this. Which financial system are we discussing?

If we actually think about financial systems, the requirements of a 'financial system' are surprisingly simple. Here is what is needed:
  1. A unit of exchange which holds its value, and which is widely accepted and trusted (money)
  2. Institutions where any surplus of money acquired can be safely stored (security of money)
  3. An institutional structure that allows for individuals to use their surplus of money to fund the activities of others, thereby risking their surplus for a greater amount of money in return at some time/times in the future (investment).
Much more could be said on point 3, which is purposefully simplistic. I have kept it that simple, because, however we actually look at the situation, this is pretty well a summary of what is required in a capitalist financial system. If anyone can see any other purpose for the financial system, I would welcome their thoughts.

Returning to the bailouts of the banks, this activity is apparently 'saving the financial system'. My puzzle is this; what is actually being rescued?

Now, before I go any further, I must confess to a very serious error in many of my previous posts. Like many others I have been saying that the government is bailing out the banks, and this is completely wrong. The government is not bailing out the banks, YOU are. I would like to be 100% clear on this. I must emphasise this point because every newspaper article, every columnist, every commentator keeps on talking about the government bailing out the banks, and I have also been guilty of expressing this fallacy.

The reality is that the government only has the value resultant from the efforts of individuals in wealth creation activities as a means to fund the bailouts of the banks. In literal terms, when you go into work today, a considerable part of the value of your labour and efforts are being transferred to the banks. As such, part of the value of your labour is literally being given to the banks. The banks are returning absolutely nothing to you for the value of your labour, and this is why it is a gift. For example, the banks are giving the government shares, but shares in something that is insolvent is giving nothing (see note 2). The government is expropriating a percentage of the value of your labour to give to the banks.

In addition to a part of the value of your labour and efforts today being transferred to the banks, a considerable amount of your future labour is being given to the banks. With every day that passes, the government is literally giving larger and larger amounts of the value of your future labour away, by using that promise of future value to give more money to the banks. This means that, in the future, the value of your labour is no longer all your own, but has been given to others in a binding legal contract. Such has always been the way of government (to expropriate a part of the value of your labour) but now it is doing so in order to give it to the banks.

This is, of itself, a rather disturbing idea. However, as we are now in the business (in the US and UK) of 'quantitative easing' the situation is even more disturbing. For regular readers, apologies for repeating this again, but quantitative easing is unconstrained increases in the supply of money, or money printing. When new money is created, it has no value of itself, but transfers the value from the existing money supply onto the new money, and the new money goes towards government uses. For every newly printed unit of currency, there is a removal of value from every other existing unit of currency. This is a form of taxation and it is a tax on every asset, and every unit of currency held by every individual and organisation. These savings and assets represent the stored value of your past labour. This money is going to be used to support the banks, and will effectively be given to the banks.

What we have is a situation in which part of the value of YOUR labour from the past, present, and future labour is being given to the banks. The banks are offering absolutely nothing in return for the value of your labour that is being transferred to them.

I am hoping that this is now completely clear in your thoughts. The government is not bailing out the banks, your labour - past, present and future - is being given to the banks with absolutely no exchange in return. You are all currently presenting a gift to the banks. The government is telling us all that gifting ever greater parts of the value of your labour is good for us all, and that we should be appreciative of the governments efforts to force us to present these ever increasing gifts to the banks. In this point of view, giving money to the banks is 'good', because we will all benefit from 'saving the financial system'.

It is to be hoped that they have a very, very good reason to be doing this.

At this point we can return to the question of what, exactly, the government might be 'saving', when they say that they are saving the financial system with the value of your labour. It is here that the situation becomes very opaque indeed. If we go back to the first bailouts, the nationalisation of Northern Rock in the UK for example, we were told that it was nationalised to prevent a run on the bank. Later bailouts were being made for exactly the same reasons. In amongst all of the chatter, talks of CDOs, and all of the other complex products that constitute finance, there is a very simple point at the heart of the crisis.

Banks have taken the money from depositors and have 'lost' that money such that they are unable to return either the original deposit or any interest. I will clarify this point, as it is very important. When I say that the banks have lost the money, it conjures up an idea of the money just vanishing.

The money has not vanished, it has been transferred. Money does not vanish, it is transferred from place to place, person to person. It is necessary to remember that the only way that money can be destroyed is by central banks, and the central banks have over the last few years been creating money, not destroying money. There is, of course, the possibility of the destruction of physical bank notes, but I do not think anyone is suggesting that people in Citibank were taking $US and putting a fire under them (though they might as well have done so). As such, the money is not being destroyed, is not vanishing, but is being transferred.

The question is this; where is it being transferred to?

If we think about, for example, the Royal Bank of Scotland (RBS) - it has apparently 'lost' a large amount of money and is therefore insolvent without ongoing gifts from you. It has taken large amounts of deposits from individuals and businesses, and has put that money to work in a very bad way, such that it has lost that money. This means that they have transferred the deposits to others in the expectation of that money being returned with interest, but the person they have transferred it to is unable to return it. This is a loss to the bank, and therefore a loss to the depositors, but we must remember that someone, somewhere was in receipt of that depositor money. It was not destroyed, did not vanish, but was instead transferred.

Let's imagine that the money was used for a person to buy a house. When the individual purchased their new home, RBS provided the finance in the form of a mortgage. When RBS provided the finance, they are transferring some of the money of their depositors to the seller of the house. As such, the money has not vanished, it has been transferred. The former seller now has the money, and will according to their own personal circumstances utilise this money in some way. If we fast forward into the future on this transaction, we can imagine a situation in which the borrower loses his job and stops paying the mortgage, such that RBS is forced to repossess (foreclose for US readers), and sell the property. When they sell the property, after all of their expenses, they do not recover the full value of their original loan, making this a bad investment by RBS. It has just 'lost' some of the depositor's money.

However, as we can see from the above, it has not literally 'lost' the money, it has been transferred. The money is still there, but it is in the hands of the original house owner (assuming he has not spent the money). The money is still there, but the depositors no longer have any claim on the money.

In the case of RBS, it has not only been taking deposits from ordinary people and companies to make investments but has been borrowing on its own account to make investments. We need to careful here, as this borrowing is still based in deposits somewhere. When a bank borrows on the wholesale market, it is borrowing from another bank's depositors, even if indirectly, or through complex instruments. It does not matter how it gets into the hands of RBS, the origin of the money is from the stored value of the labour of individuals, otherwise known as savings.

It is here that we come to the big problem. We know that, one way or another, RBS has taken large sums of money either directly or indirectly from lots of depositors. It has then invested that money very poorly. The money, at every stage, is not literally lost, but it being transferred to somewhere. RBS has committed that it will return money to depositors at a certain rate of interest. They promised to return to the depositors more money than they were given, but no longer even have the full amount of the original deposits which have been transferred somewhere else. When depositors are asking for the return of their money, RBS simply does not have enough money to repay their depositors. This is in part because some of the depositors money is tied up in investments which, if they were sold now, would not return the original sum paid for them, some of the money is tied up in investments that are not immediately accessible, and so forth.

Above all else, their investments have been losing money - but remember that this is not a case of the money vanishing or being destroyed. Someone, somewhere actually has possession of that money.

Here is the important point. None of the money has been destroyed, it has all at some stage been transferred. The question is; where to?

For the moment, I would like to leave this question to one side, and return to what is happening to the money that is being gifted to banks like RBS. We know for a fact that as fast as we are gifting the money to these banks, it is being used for something - such that they are constantly asking the government to arrange that we gift them ever more of the value of our labour. We know where some of that gifting goes. For example, when a person who has deposited their money in RBS goes to a cash machine (ATM), and withdraws £50, that money is available to the depositor because of our gift to the bank. If a UK company writes a cheque for office supplies, then the money will be transferred from RBS to another bank using the gifted money.

However, as we are all aware, ever greater amounts of the value of our labour is being gifted to various banks. When we consider the massive scale of the bailouts, this amount of money is more than can possibly be used for these kinds of day-to-day claims on money deposited with the bank. We are looking at sums of money that are way, way beyond these requirements. However, as fast as we are gifting money, it is disappearing, meaning it is being transferred to somewhere.

The question here is again; where to?

Here is where the situation becomes very disturbing. We now know that, across the Western world (see note 1), that broadly speaking the banks are in a very similar situation. They nearly all seem to require that we gift them lots of the value of our labour. If we are all doing this across the Western world, then we know that we are not transferring the money between Western banks, or at least some of the banks would suddenly become very solvent and have lots of money. This is not happening.

As such, the only answer is that the transfers must be going to non-Western depositors, however that might be indirectly achieved. The question then becomes who, and where?

Whatever has happened, none of the money has been lost, it has been transferred. We are seeing ever greater amounts of the value of our labour being gifted to the banks, but we are not seeing that gift appear within the Western banking system. It is being transferred somewhere else. It is being transferred to our creditors, such as the oil states and China. It is being transferred to repay their lending to us.

It is here that we can start to see the central problem. At this moment in time, our governments are transferring ever larger amounts of money taken from the value of our labour, suggesting that they are doing so in order to protect the 'financial system'. It is at this point that we have to ask which part of the financial system they are actually protecting.

The stereotypical picture that we are offered to justify the protection of the banks is the picture of lines of people outside of the banks trying to gain access to their deposits. We can almost hear the cries of outrage at the idea of the 85 year old lady who loses her life savings in a banking collapse. This is supposed to be the financial system that we are protecting, helping to ensure that the little old lady does not lose her savings.

However, in order to protect that little old ladies' savings (or the deposits of companies or whatever variation of this theme), why has it been necessary for so much to be gifted to the banks? Surely, if there were a bank run, the value of the assets of the bank could have been sold, and the government could then have had the option of using its expropriation of the value of our labour to compensate those who lost deposits. It is here that we can see that something is very wrong in the picture. We know that many of the depositors must be from non-Western countries or the money pouring into the banks would appear somewhere in the Western banking system. They are not just protecting depositors in the country, but all overseas depositors too.

In other words, the value of our labour that is being expropriated by the government and being gifted to the banks is largely being used to pay overseas depositors - the Asian countries, the oil states, not depositors within our own countries. Money is pouring out of the Western world. This is why, when so much money is being dropped into the banks it seems to disappear as fast as it is dropped in. When the banks are announcing losses, they are not actually 'losing' the money, they are transferring the money to a new place. That place is not within the Western world - or someone somewhere would be recovering from the crisis.

The problem is this. What we are actually witnessing is our own insolvency. We are having to service the debts that we owe to all of the creditor countries, and we just do not have the means to service these obligations. As fast as we are gifting the value of our labour to the banks, the banks are then using that gift to repay our external creditors, but it is just not enough. The government is having to expropriate ever greater value of our labour to keep the repayments going.

The next big question in this is to ask whether the value of our labour is actually enough to repay what we collectively owe. We have seen ever greater transfers of money out of our countries, as we now know that that is where the money has been transferred to. Each unit of money transferred out is a promise that we will make a repayment equivalent to x units of our labour value in the future. Money is a means of exchange for goods and services, and provision of goods and services are resultant from labour.

Much of the money that is now being repaid was used to fund consumption. This has come in many forms, consumption by individuals and consumption by government. I have many times repeated that borrowing for consumption now means a future contraction. It has been one of the themes in this blog. The simple fact is that we have been borrowing for consumption, and we are now actually at the point where that consumption is being paid for. With interest. However, as fast as we transfer the money that we owe back to the creditor countries, we are making promises to provide ever more labour, as that is what the money we give promises. The money is a future contract on our labour (even a commodity requires labour for extraction and movement etc.).

The reason why governments are expropriating our labour in such quantity is not to protect domestic depositors, but to protect overseas depositors. The financial system that they are trying to save is a system in which we can maintain our borrowing for consumption, which is not actually the purpose of the financial system at all. Only through the expropriation of ever greater value of our labour can they continue to service the debt, and it is only if they continue to service the debt that we can still continue the system of borrowing to consume. Overall, we are still in the position of borrowing ever more money, and we are now borrowing it in ever greater quantity.

The trouble is that this is just taking us ever deeper into insolvency. We are, with every day that goes by, simply consuming more than we can produce, and the longer this consumption continues, the worse the situation is becoming. I have long argued that we must finally accept that we tighten our belts, and deal with the fact that we are much poorer than we think.

The really terrible part of this is that large sections of the media have actually accepted that the government is bailing out the banks. This is simply not true. What the government is actually doing is very, very rapidly impoverishing us so that we can continue to consume -for a short while longer- more than we can produce. They are doing so by promising and expropriating ever greater amounts of the value of our present, past and future labour.

As I sit here writing this, I can not but help but wonder about whether any of those responsible for these ongoing bailouts have any idea whatsoever of what they are actually doing. They stride around bombastically proclaiming that they are 'saving us', saving the financial system, when the reality is that they are deluding themselves, and every single one of us.

In practical terms, this is what this means; you will be working to pay back the investment made by, for example, a Chinese individual who has deposited their savings in a Chinese bank. Deposits like this is what is currently funding much of the economy. This funding of current spending will, in the end, need to be returned to that depositor with interest. If we take away the cumulative deposits of all of these overseas savers, we are left with a much smaller and poorer economy. The stored value of their labour is quite literally being used by us so that we can consume more than we produce. This is the answer to the cigarette lighter problem I wrote about a long time ago.

How long can we and our governments sustain this process of, on the one hand, spending ever more borrowed money on consumption, and on the other committing ever more of your value of labour into supporting the borrowing and consumption? We are just digging our own hole ever deeper because, unless there is a miracle on the horizon, there is simply no way that we are ever going to produce more than we are consuming. If we keep on borrowing to consume the future contraction will just get ever larger, and ever more devastating.

Yes, if governments can keep on propping up the banks with ever more borrowing to pay off the previous borrowing, this process might, just might, go on a little longer. However, in doing so they just wreak more havoc with the future.

The reality is that our creditors are seeing that this can not be sustained. They are seeing us for what we are. We are like the individual using a credit card to pay off our bank loan and mortgage, and all the while selling our furniture to try to make ends meet. All the while we are doing this, we are still shopping and spending more than we earn. It is madness.......

I have read so much justification for the bailouts. I see it everywhere, in the newspapers, and even in the latest edition of the Economist. They all make it sound so plausible, that the banking system must be saved. What none of them are talking about is that you are gifting your future, present and past wealth so that we can continue to consume that we can pretend that we are the kings of the world for that little bit longer...I very rarely put things so bluntly, but it is pathetic. They are 'saving' the banks in an effort to keep the credit lines open, to convince our creditors that we are not bust.

My answer to the question of what part of the financial system we are saving is quite clear. The financial system that is being saved is the financial system that allows us to consume more than we produce at an ever increasing cost to the future. It is a very different financial system to the one which I detailed at the start of the post. A financial system is not there for us to collectively impoverish ourselves, but that is the financial system we are trying to save.

My answer to the crisis is very simple - better now than later. Let the financial system collapse. It is in any case worthless.

Note 1: I use the Western world very loosely here, and it also includes surplus countries such as Germany. I am therefore being a little too simplistic, but hope I will be forgiven for a compromise to aid the overall clarity.

Note 2: I am a business which is losing money, with greater liabilities than assets. I come to you and say that I will give you a share in my business if you give me a large sum of money. You look at my books, and find that I have assets worth £1000, and liabilities of £2000. I lose £100 a week on operations and my losses are increasing fast. There is no significant forthcoming circumstance I can point to which might indicate a change of this situation. If I give the shares to you, are they actually worth anything? In such a case, the only reason someone might give the sum of money would be if they were mad, or as an act of charity - a gift.

Note 3: I think this post might sound a little odd. I hope it makes sense.

Note 4: I think that I will have to deal with the issue of Fractional Reserve Banking (FRB), which I wanted to avoid for this post. I have already had a comment on the subject, so I think now is the time to deal with it.

I will explain the principle in brief. If lots of people deposit lots of money into a bank, they make an assumption that not everybody will want their money returned at the same time. As such, they are happy to lend out a portion of the money that they get. This means that, if I deposit £100, they feel comfortable to lend a proportion of that money (e.g. keep 20% and lend 80%) in the belief that they can service all of the demands for return of deposits that will actually occur. As such if I deposit £100 they will only keep, for example, £20 available for cash and will then invest the rest. In simple terms, the level of the reserve is set to give a safe margin against an expectation of the maximum demand for return of deposits over x period of time.

A bank run is when everyone starts asking for a return of their deposit at the same time and, because the bank only holds a fraction of the deposits as immediately available to return as cash, they can not return all of the deposits.

However, the system gets a little bit weird when we think of a bank using my £100 deposit to invest it/deposit it with another bank. That bank then has an £80 deposit from the original bank, but only needs to keep £16 in reserve, leaving £64 which they can then lend. If we think about this, my deposit has allowed lending of £80 + £64, which means that they are lending more than I have deposited (£80 is lent from the original bank, and £64 from the second bank). If we add up the two sums of money available for lending, then we appear to have created money. This is the standard picture of FRB, that money is created from nothing, but I will illustrate further.

When I enter into bank A and deposit £100, the bank effectively writes me an IOU for the £100. The bank then takes my money and lends £80 to bank B, who writes an IOU to bank A for £80. That bank then lends £64 to a consumer, who writes an IOU to bank B. Whilst it may appear if we look at it in some respects that we are creating money, as more money has been lent than deposited, I think that this is an exaggeration of what is actually happening. In the end, the amount of credit that reaches the end user of the credit has not expanded in the way that those who are anti-FRB seem to imply. Whilst each bank appears to be creating money, the reality is that the more banks that touch the money, the less money there is available to be lent into the economy outside of the banking system.

If you look at the table such as the one shown in Wikipedia, it is accurate but it is deceptive as each transfer from bank to bank actually diminishes the amount of credit available to end users outside of the banking system. Each time a bank touches the money, the availability of credit outside of the banking system actually reduces. In other words you can increase the money supply within the banking system itself, but the more that my deposit is used for intra-bank loans, the less of my original deposit is available outside of the system.

If we look at my £100 deposit, as soon as Bank A lends it to Bank B, only £64 is available to lend outside of the banking system. On the other hand, if Bank A lends the money directly to a consumer or business, they have £80 to lend.

Now I will freely confess that this appears to go against much of the thinking about FRB, and that there are many very clever people who theorise about this. However, as hard as I look, I can only find a situation in which the more that my deposit is loaned within the banking system, the less money that is available in the economy outside of the banking system. As such, if you take the example given in Wikipedia, it appears that money is being created, but the reality is that available credit outside of the banking system is destroyed.

In this situation, it appears to me that if banks stop lending to each other, then the deposits that are held by the banks will make available more credit external to the banking system. I am more than happy to have somebody correct me on this, as this is just the result of my own thinking on the subject, and maybe I am missing something/ or misunderstanding something. It is one of the few areas in my own thoughts about economics where I have nagging doubts. I only have doubts on the basis that so many people seem to imply that FRB creates money available in the wider economy, but I find that this is not the case. In fact, I find that the more money that is created in the banking system the less the availability of money in the economy.

Perhaps I just have it wrong? Comments welcomed (please note that I am not talking about central banks lending into the banking system here which has a different starting point altogether, and where money and credit can both be created).


  1. I just thought I would write a quick note as the £GB has strengthened slightly. I have mentioned before, during the early stages of the crisis, daily movements are not as important as trends. Watch for further weakening and a continued downward trend.

  2. Cynicus,

    As a non-economist myself, I have been trying to get myself up to speed on a number of these issues over the last few months and have found your blog invaluable in this regard.

    Having had no background (or real interest) I have found this quite tough-going at time but have managed to cover alot of ground thanks to your explanations and genius analogies.

    Thank you so much for all your effort.

  3. Cynicus,

    thank you so much for your clear explanations to this crisis we're in at the moment.

    To me it seems China is going to be the winner overall.

  4. What about fractional reserve banking? I thought that money is actually disappearing, rather than being transferred, due to deleveraging.

  5. This comment has been removed by the author.

  6. Mark, you've done it again: you have cut through the myths being peddled through the media and straight to the heart of the matter. If we assume that our days of borrowing from overseas to fund excessive consumption are over (we are now being seen for what we are), are you suggesting that we should simply let the overseas depositors lose their money? They took a risk and lost?

  7. Hi Cynicus

    Thank you for another insightful post.

    Caroline Baum at Bloomberg has a piece out which touches on the madness of the current policies:

    'The government wants to ensure that consumers, whose spending accounts for about 70 percent of gross domestic product, can borrow and spend. This makes as little sense as using easy money and housing incentives to cure the effects of easy money and over-investment in housing.

    “What policy makers on both sides of the Atlantic desire is to sustain household leverage and consumption at any price, when the only exit from the credit crisis involves a return to thrift by the overleveraged,” writes David Roche, president of Independent Strategy, a London consulting firm, in a Jan. 22 Wall Street Journal op-ed. “That cannot be achieved painlessly.”

    And yet the federal government is seeking ways to make mortgage and other credit cheaper and more readily available, going further into debt in the process. Institutions deemed too big to fail, such as mortgage-finance giants Fannie Mae and Freddie Mac, were recruited in that effort. (That was after they were told to curb the growth of their portfolios and before they became wards of the state.)


    These are short-sighted, short-term solutions being orchestrated at the expense of the economy’s long-term health, and I suspect most economists know it. (Politicians are a different story. Their knowledge of economics is generally confined to the area of trade: providing favors in return for campaign contributions.)

    President Barack Obama’s crack economics team, including Larry Summers and Christina Romer, and Fed officials from Ben Bernanke on down have to understand that the problem of too much leverage can’t be fixed with more borrowing; that a misallocation of capital to housing can’t be cured with incentives to buy more homes; that consumers (and the nation) can’t spend their way to prosperity.

    At least I hope they do.'

    Is not the cruxial problem that the ruling 'economic' elite are Neoclassical economists who through their ideology have wrecked the economy but in their madness think they can solve the problem by utilising the same solutions that caused the Crash? It is truly insane.

  8. Let the banks crash?

    My thoughts are that the consequences would be grave with civil unrest/war a certainty.

    If there is the possibility, no matter how small, of a long term readjustment even though it requires incredible sums of "bridging loans/grants" then I think it's worth it.

    I think it's also worth remembering that huge political and money interests will dominate - I'd like to see you comment on this in future posts because your economic theory is very sound, but I would say that you ignore many political factors both seen and unseen. The real movers and shakers, anonymous to our media, are who will have the final say. This might sound contrived but I believe it is so and that is why I believe the UK and the US banking systems will not be allowed to fail.

    We must remember that many of these countries from whom the money is disappearing are armed to the teeth in comparison to the others. Who knows, their survival may depend on selling arms to countries with money!

    My Twitter Page

  9. “It is to be hoped that they have a very, very good reason to be doing this.”
    In the US its a regular occurrence that prominent business figures move into the government and then back into private corporations. We can see this epitomized by Dick Cheney, or perhaps of more relevance to this blog Henry Paulson. Its highly plausible that these individuals - and others like them - have used their positions in office to further select private interests in the knowledge that after their stint ‘serving the public’ they will be rewarded with lucrative directorships etc. In the UK Blair’s record earned him among other things a consultant/advisory role with JP Morgan (he’s also reputed to be the preferred candidate for the first EU President!). Where will Brown’s reward land him for his service to the banking world?

    “The really terrible part of this is that large sections of the media have actually accepted that the government is bailing out the banks.”
    Swathes of the media are little more than government pundits who whilst may at times criticise the government – necessary to ensure their own credibility – never stray too far and essentially justify the government’s actions.

    “I can not but help but wonder about whether any of those responsible for these ongoing bailouts have any idea whatsoever of what they are actually doing.”
    I appreciate this is an economic blog so discussions on motive may not be that relevant. But I find it intriguing you regularly conclude that the people in power are fools as opposed to having an alternative agenda that furthers select interests. Corruption pervades all governments; in some it’s just less apparent.

  10. According to the FT, Britain remains the world’s sixth largest manufacturing power. Where is the evidence for the supposed gross disparity between the UK's production and consumption that is one of the fundamental premises of your argument?

  11. Cynicus,

    I do not believe that you are entirely correct. The Chinese have controlled the exchange rate and kept RMB low to boost exports. However, unless they adopt the USD they have basically worked for free.

    For this reason the China has made a massive error and will suffer worst. The US has no export market because everything was imported for free or extremely low cost. The US ecomomy will soon manufacture again (along with the UK) and this recession will not be the end of things. It may be long and deep but at the end the US economy will remain the most powerful.

    If China had allowed RMB to move naturally, they would have been be an economic superpower. Maybe freedom and economic power cannot be seperated.

  12. A very nice article, but If I followed your points about Fractional Reserve Banking correctly I think an error is being made.

    Your argument that each time the banks touch a deposit the amount available to loan diminishes seems to be missing a point.

    If the original bank has £100.00 and makes £80.00 available for loans. Then invests the £80.00 in another bank who make their own 80% available for loans there *is* money being created from nowhere.

    The fact that each bank is making a smaller amount available does not detract from the fact the each and every one is reusing a 'part' of the original capital.

    If all the banks recognised the fact that there was only one original deposit due to some "audit trail" they could follow back, then it would be possible to hold a deposit without making loans available from it (because another bank had already done so.) This would create a situation where, although multiple banks might move the money around, it could only be used for loans once.

    I believe this is a common sense approach, however difficult to achieve.

    If I had a million pounds, and used it as collateral to borrow money. Then gave the same million pounds to my friend who also used it as collateral to borrow, we would be acting in a fraudulent way. Because I should have informed my lenders that I no longer had access to the capital. I'd moved it elsewhere.

    Im no banker, so perhaps its me that has misunderstood your points.
    But it seems to me that one unit of £100.00 should only be used once for loans. Complex financial instruments serve to hide the true nature of an ability to pay.

  13. Re: Note 4

    I will start with a note that I am not an economist.

    As I understand it, the apparent expansion of the money supply comes from this process, assuming like you did 20% reserve rate:

    1. £100 is deposited
    2. £80 is borrowed, and possibly spent, but this doesn't matter, because in any case the money must end up in someone's possession
    3. That someone then takes this money and deposits it, possibly even in the same bank.
    4. The bank now counts those £80 as reserve assets twice, allowing it further lending.

    From what I read in some cases the same depositors money was counted as assets as much as fifty times.

    This all more or less works when the money created by multiple counting is balanced by equal amounts of debt, which in this case counts as contra-money. Unless of course financial institutions start using derivatives to transform debt from contra-money into money, which was what triggered current crisis.

    What I think the bailout people are doing is trying to replace "bad money", that is money backed with bad debt, which is rapidly being annihilated, by good money, taken from taxpayers. I do not believe this is going to work, for reasons you outline in your blog: there is just not enough "good money" in the economy anymore.

  14. Here is further comment you may find interesting:-

    A Less than Sterling Analysis

    The British Pound Sterling has suffered more from the financial crisis and recession than any other major currency. From its high point of just over 2.1100 in November 2007 to its Friday close at 1.3812 the Sterling has lost 35% of its worth against the US Dollar. It has sustained similar losses against the Yen, 51%, the Euro 44%, and the Swiss Franc 36%.

    In comparison the Euro has declined only 19% against the Dollar, 32.1% versus the Japanese Yen, and 11% against the Swiss Franc; the Australian Dollar has lost 33% against the US dollar, and 46% against the Yen; the Canadian Dollar has fallen 26% against the American Dollar and 43% against the Yen but gained 9% against the Euro; and the Swiss Franc has dropped 20% against the US Dollar and 27% against the Yen while gaining the above 11% against the Euro. With the exception of the Yen crosses which were the beneficiary of the funding based carry trade and whose destruction in a welter of deleveraging, repatriation and capital flight is a story apart from the general market, the Sterling has forfeited more value than any other industrial world currency.

    The immediate economic and interest rate prospects can account for a large part of the market disenchantment with the Pound. But there are also secondary concerns, the British sovereign debt outlook, the health of the banking system, the pending election and even the trading history of the Pound, which although not as quantifiable as interest rates or GDP add considerably to a Sterling trader's worries. Unfortunately for the British public and the government not one major criterion is positive for the Pound.

    The Bank of England (BOE) has been more forthcoming about the condition of the economy and more aggressive in reducing rates to meet circumstances than its counterpart across the channel, the European Central Bank (ECB). But it has lagged far behind the American Federal Reserve. Though the current BOE 1.5% repo rate may be an historic low across more years of existence than any other central bank, it is very likely that rates will move even lower in the immediate future. The BOE does not have the anti-inflation mandate of the ECB or the institutional credibility of the Bundesbank. Mervyn King the BOE Governor may warn the market of the dangers of ultra low rates but in the end he will take the bank down the same path as the US Federal Reserve. Aside from other considerations the British economy will have suffered from the delay.

    Gross National Product in the United Kingdom plunged 1.5% in the last three months of 2008. It was the largest economic contraction since 1980. The British housing market has experienced a credit fueled real estate boom like the US and is mired in oversupply, falling prices and bankrupt mortgage lenders. Unemployment is at 6.1% the highest since 1997, claims jumped 77,900 in December and consumer spending and confidence are sinking. Industrial and manufacturing outputs were down 6.9% and 7.4% respectively on the year in November.

    The British banking system is not as diverse as that of the United States and is centered on a few large institutions. The Royal Bank of Scotland is one of those key institutions and the government now has a 70% stake in ownership. While wholesale nationalization of the banking sector is not contemplated nor spoken of by the government, as more banks come to depend on government rescue funds the result is a nationalized industry, in fact if not in declaration. Financial services accounts for a large part of the British economy. A government controlled banking industry will be neither as profitable nor as expansionist when the recession finally ends as it would have been under private stewardship. The difference for the British economy will be fewer jobs in a less productive financial sector for years to come.

    Standard and Poor’s reaffirmed the British AAA rating on January 13th but the longer term prospects are still questionable. The government has assumed many of the liquidity problems of the banking system. In so doing the government has vastly expanded its debt and risk burdens. If markets continue to fall analysts and the rating agencies will posit more bank recapitalizations and more private sector debt on the government books. Spain, Portugal and Greece have already had their ratings reduced and they have the benefit of belonging to the united European currency. In the newly stringent rating agencies, concern for British debt rations will weigh far more heavily than consideration for government funding costs or British chagrin.

    Gordon Brown's Labour Party is trailing badly in the polls. The deciding factor in the US election may have been the state of the US economy and the financial market blowup in September and October. Prior to that intensification of the financial crisis the two candidates, Barack Obama and John McCain, were essentially tied. The lesson will not have been lost on Mr. Brown. Nothing determines an election in a democracy like the state of the domestic economy. Market suspicion has to be that the Brown government will do whatever it can to prop up the economy before the election, including lower rates, massive fiscal stimulus spending, and quantitative easing when rates have reached a nadir. Nothing that will help the Labour cause and the economy will support the Pound. Every measure can be justified by the need to rescue the economy from recession or worse. If the Pound is sacrificed in the attempt so be it.

    Finally, trading historians will remember George Soros and the European Exchange Rate Mechanism (ERM). In the fall of 1992 Mr. Soros bet that the Conservative Government of John Major would be unable to maintain the Pound within the trading band of the ERM. The currency markets believed Mr. Soros and joined in the most famous currency raid in history. The Sterling was forced out of the ERM and the Conservative Administration’s reputation for fiscal competence was shattered. Today there is no ERM and no central bank trying to hold back the weight of the currency markets. But currency traders still hunt in packs and they are stalking the Pound Sterling.

  15. That's the answer I was looking for! I felt stupid for asking where had the money gone and where was it going now. I knew there had to be a winner somewhere with all this money flowing away.
    If the banks fail, will they not ask for all assets back immediately and leave mortgagers stuck having to sell their houses in a market where everyone will have to sell?
    Is that what we are trying to avoid?
    (I'm not a homeowner)

  16. maybe you could put up an email address so that you could be sent email non related to a particular topic but relevant to the whole website?

  17. Forgive me, CE, but I understand the FRB correctly, you got it wrong.

    I was watching yesterday the first 55 minutes of a 1996 video, “The Money Masters” available on Gooogle Video
    and also reviewed in Wikipedia. It seems very interesting but I had no time to watch in full, yet. Perhaps others would like to comment on it?

    Anyway, in the part I saw the author claims that the reserve ratio in American banks is 10 allowing, for example, to lend $1000 out of a $100 reserve. Yes, $1000 out of thin air. So, if you deposit those $100, the author says, the bank will then lend $1000 at - say - an interest of 8%, making a gain of $80. Out of your $100.

    In the Wikipedia entry to which you referred, after the borrowing-between-the-banks part (that I find very confusing), look at the “Money multiplier” section. You’ll see the formula that “calculates the maximum amount of money that an initial deposit can be expanded to with a given reserve ratio”.
    For a reserve ratio of 20 per cent the multiplier value obtained is 5. “This number is multiplied by the initial deposit to show the maximum amount of money it can be expanded to”.
    So if you have $100 in a bank with has a reserve ratio of 20, the result is 100 x 5 = 500.
    For a bank with 10 per cent reserve ratio, that money should be expanded to $1000, as the graphic demonstrates, so the video is right. Quite shocking, isn’t it?

    Keep on with the good work, I always enjoying reading your blog.

    Phil (from now on, Phil in Cyprus)

  18. Yes I too was thinking that the money being pumped into the bank was being 'destroyed' as it unravelled all the 'created' money that the banks are sitting on that is going bad. Nonetheless some at least is going abroad surely (like the recent horror story about a massive international run prompting the 1st bailout in Oct 08) and some is going to pay fat salaries, and some is going straight back to the goverment (perhaps helping to pay for subsequent bank bailouts?). But either way it is a drain on us through 'sharing' the value of our currency...

  19. Maybe the UK government just wants to let its current relience on debt (as a way of funding the country) continue, because it has accepted that the takeover by China and other eastern countries in terms of world power and wealth is inevitable and that in the short term it may as well make life as easy as possible for itself and its population.

  20. An irish Newspaper gives specific on the process CE describes in relation to the recent nationalistion of Anglo Irish Bank
    It now emerges . . . that Anglo Irish Bank has 300,000 retail depositors, of whom only 72,000 are Irish. In other words, the guarantee scheme has guaranteed 230,000 foreign retail depositors. The number of corporate depositors is 12,000, of whom only 3,500 are Irish.

    Why did the state guarantee the deposits of 8,500 foreign corporate depositors? Why were we not told at the time of the guarantee last September 30 that 228,000 foreign depositors in Anglo Irish were being guaranteed, as were 8,500 foreign corporate depositors?

    What was done on September 30 may turn out to be not merely a blunder, but a catastrophe. We have committed ourselves to guaranteeing the 228,000 foreign retail depositors and 8,500 foreign corporate depositors in Anglo Irish Bank, and it would surprise nobody if that undertaking cost us in the region of €10 to €20 billion, given the scale of the loans that Anglo Irish forked out to developers.

    But who are we way to complain? Have we not been sucking up the fruit of human labour in "emerging markets" for years?

  21. A couple of replies:

    Lemming: The short answer is 'yes'. As you will know from my previous posts I think that, as soon as a person makes an investment, they must accept risk. The investors have risked and lost. However, the other side of that coin is that (as discussed in my banking reform post)a more explicit statement of risk is needed.

    Death to Bubble Addicts: Thanks for the quote. It is interesting to see that the realisation is starting to spread. Unforunately not fast enough....

    Chris: The problem here is not a matter of letting the crash happen, but that it will happen. Better now and we address the problems before we dig the hole any deeper. Believe me, I am aware of the risks of upheaval, and suggest now is better to minimise them (though six months or a year ago would have been better still...)

    Jonny: I agree that there is always corruption in government and that the banking industry has too much influence. However, I think foolishness is at the heart of it. For example, the collapse of Lehman illustrates that this has hurt the banks as well.

    Yes, government is too close to the banks, and they listen to the advice of bankers too much. Also, too many politicians end up working for the banks and so on.

    However, the banks were fools to get into the mess they are in, and the government is even more foolish to listen to their advice. That the banks are using their influence to encourage this action is no surprise...

    As such, yes, corruption is in there, but the roots of the crisis lie in foolishness. I do not think, for example, that Gordon Brown would ever have acted as he did if he could have forseen this outcome.

    raphaeladeas: The simplest way to check this is to look at our merchandise trade balance, which can be found here:

    Acrobat_747: I have discussed this in previous posts. Yes, the Chinese are between a rock and a hard place. Either they keep providing goods for the US in exchange for very little, or they risk their own economy. If you look through some of my previous posts you will see this discussed in detail.

    Steve Tierney: **If** my understanding is correct, the deposit may be lent and re-lent within the banking system, but only once outside of it. I am not worried about within system re-lending, as this becomes ephemeral, and does not impact on the broader economy.

    However, the more I have read on this subject, the more opaque it seems, so I have pause to be confident in general.

    Having said that, I am increasingly seeing the problem as being a question of what is counted as a reserve. As such, expect a further and more detailed post in the future....

    Ramarren and anonymous on FRB: Thanks for the comments and links.

    I watched all 3+ hours of the video, and checked on some of the assertions and found them wanting e.g. ownership of the fed by International Bankers. See here:

    I find FRB an interesting subject and am still digging around on the subject. There seem to be many arguments about how it operates in practice. As per my reply to Steve, I will probably write a dedicated post on this later after digging around a bit further.

    Anonymous (posting on the £GB): I think this illustrates that we have both underlying reasons for a fall, as well as a major shift in sentiment towards a fall. A fall looks very likely....

    JohnPaul: If the banks fail, they still can not ask for an asset such as a house to be returned. Provided the person makes the payments, maintains the property to a reasonable level it is not possible to foreclose.

    In the event a bank falls, the mortgages held by the bank will be sold onto another institution, with the same contractual terms.

    Anonymous ref an email address: I would like to add an email facility, but would be concerned that it would just end up being spammed. However, it sounds like you have a broader concern than the subject of this post, so please feel free to address it in the general comments.

    Pocmloc: I think that is quite a good summary of the situation. I have mentioned the money-go-round in some previous posts. Bailout money going into bonds, going to bailouts...All of these factors sit neatly together. You may also want to take a look at Lord Sidcups comment.

    Lord Sidcup: Thank you for a very helpful link. My post was based purely on logic (and I hope reason), so it is very helpful to get some good solid facts behind the subject.

    Although your quote is for Ireland, there is no reason to believe that the UK banks would be any different, except perhaps to have an even greater proportion of overseas depositors.

    General: For the other comments, it is always very encouraging to have positive feeback, so thank you for taking the time to write.

    As a final note, I occasionally see that people discuss my blog on various forums. I have seen a forum recently where one commentator speculated that I was a marxist. A very puzzling notion indeed....

  22. A Marxist? Hmmm...

    It did occur to me though, as I watched a Peter Schiff video on youtube, that the fiercely pro-free market commentators have one similarity with Marxists: their conviction that things could be/have been different if only human beings just behaved differently.

    Schiff et al rightly condemn polticians for distorting market processes. But when did politicians ever not try to aggrandise themselves on the back of a market boom or bust? Could a society ever be conceived when the majority didn't need a bunch of ego-tripping half-wits governing them?

    It's as utopian as any Marxist to believe that the free market can operate untrammelled by human/political interference. A lot of free market remedies being bandied about sound robust but are, in terms of their likelihood, completely flimsy - they have no precedent in human experience.

    I guess this is the nature of the crisis we are in - it holds a mirror to the intractable reality of our core nature. Not pretty.

  23. I'm glad to see that I'm not the only one confused by FRB. Irrespective of the details, it would be nice to know the idea behind it. As far as I can tell, it is used because it is a self-regulating method for injecting the correct amount of money into the economy 'on demand'. The "fractional reserve" aspect sounds like a minor detail: I'm sure I read somewhere that in the UK the required reserve ratio is effectively 0% and it is simply up to the issuing bank to ensure its own solvency.

    But who decided that FRB should be the officially-sanctioned way of issuing money? And why is it not a matter of debate in the same way that banks' other 'financial instruments' are?

    Now that interest rates are almost 0%, the phrase "pushing on a piece of string" is often used to describe central banks' efforts to control the economy. Presumably, in amplifier terminology, the system is 'Class A' i.e. it always has to be forward biased to achieve control, hence the necessity to maintain positive inflation, and a positive interest rate and that the amount of money should always be tending to zero i.e. disappearing as loans are repaid. But is this system 'neutral'? Does it have any perverse side-effects which distort the operation of the free markets?

  24. FT - 28/1/09:

    Hi Cynicus,

    Looks like this is the week when the Mainstream Media started to come out of denial:

    Why I fear the west’s luck has run out
    By Luke Johnson

    Over the months I have told my colleagues at Channel 4 and the Royal Society of Arts that this is not just a financial hiccup, or something happening to the City and Wall Street.

    We need to make programmes, do research and deliver lectures about this moment – because this downturn is very bad indeed. It will sear itself into a generation’s memory and scar lives. It may well be the worst slump most of us have ever experienced. It surely needs to be recorded and discussed, while solutions are sought – and in the meantime we have to struggle through it.

    For at least a year I have been as restrained and positive as I felt I could be. I am past all that now. It is time for some blunt talk, I fear.

    It is clear that as a society we must learn something painful and radical – how to live within our means – because the credit just is not there any more. The easy money is all gone, and there will be no more for a long time.

    Previous assumptions simply do not apply. Homeowners should forget about houses going up in value – all that is history. They are places to live in. So cut back on your outgoings. Pay rises are off the agenda. Wholesale pay cuts may yet become common. Put some cash aside if you possibly can; you might lose your job. I fear most citizens’ plans for the future must be put on hold. This is not something happening to other people – we are all in trouble.

    ‘Prepare for a wrenching, unstoppable redistribution of wealth – and I am not talking about domestic taxes’

    Business must adjust to the idea that this stagnation could last for many years. The age of free money from mad lenders is finished. The growth game is over. Whole swathes of industry are on life support. The banks are in desperate straits. If their management cannot see that, then they are even more incompetent than they are portrayed.

    Indeed, too many of us still fail to see just how severe conditions are, and how horrible things are likely to get. This is not a correction, a brief hiatus until the upward march once more resumes. At some point, the Japanese, Chinese and Saudi buyers of US and European government bonds will see just what miserable value they offer. Then governments may have to stop all the runaway state spending and bail-outs, and even put up interest rates.

    Plenty of observers, including me, have criticised the media for being too gloomy. I am now beginning to believe that they have not been gloomy enough, if they want to reflect the true consequences of our profligacy and past conceit.

    After all, who wants to face up to the bleak reality that confronts us? The experts say we will not suffer a repeat of the 1930s slump. Indeed, we have to contend with fresh issues. Like the fact that there are 1.5bn recent additions to the capitalist workforce in China and India – hard-working, increasingly well-educated people, all keen to better themselves. Meanwhile, modern logistics and communications mean trade and production can take place almost anywhere if it makes economic sense.

    So why should industrious Asians earn a tiny fraction of what citizens in the west earn? Especially when they have so much of the cash and productive resources, while we have deficits, high costs and poor demographics.

    Prepare for a wrenching, unstoppable redistribution of wealth – and I am not talking about domestic taxes. For too long it has been more profitable in the west to finance consumption rather than production. That cannot continue. I am afraid that the west’s credibility – and luck – has run out.

    This vast reordering of our economic system has only just begun. We shall have to cancel all the self-indulgence of endless welfare spending and cultivate rather more of a work ethic and a sense of self-sufficiency. Expectations must be modified and attitudes altered profoundly. Expect years of negligible growth, permanent high unemployment, declining property prices, higher taxes, crumbling currencies and falling living standards.

    We shall look back on the last decade and think: we never realised what we had until it was gone.

  25. I'm not convinced that we are "much poorer than we think". Your cigarette lighter argument shows that exchanges rates are out of line with purchasing power parity, but that is unrelated to how poor we are. In china, the minimum monthly wage is in urban areas somewhere about 800 RMB a month{B120D814-3C01-468A-9C11-B7596BCE1A35}
    This ignores the rural population. But the rural population do not count towards the increase in global labour. Thus in china, on the minimum wage I can buy (according to your figures) 1150 lighters.

    In the uk the monthly median wage is about 2075 pounds (, and the relation between the minimum and median wage is about .45 in the uk (
    Thus in the UK, someone on the minimum wage will earn about 900 pounds a month. Lighters are .59 pounds (
    So I could buy 1500 lighters.

    So, the difference in what labour buys between the UK and China is not so great, especially since I suspect they work longer per month in China than the UK. Our cheap labour is worth about the same. For more expensive labour, the UK can pay more as it is more efficient, re infrastructure, rule of law, etc.

    So whilst the world economy is in big trouble, and things are going to change, I'm not convinced the man is the western street is suddenly going to be poorer. He may have to change job, and move to an industry that produces more value, but what his labour will buy him should stay the same.

  26. Hi Cynicus,

    I agree that the hole is deep but I don't believe that a crash is a certainty. It's probable but by no means certain. A correction is inevitable but I don't think that a correction the size of a crash is guaranteed. I don't think that anyone can say that, no matter how logical their argument - life has a way of doing the unexpected, even if a person is contrarian - much like we are.

    I would still love to hear your thoughts on the politics. You've touched on China but I'd love to hear your thoughts on the global picture. Obviously, your forte lies in economics, however I still believe the politics has a huge influence and that the logic of long term economics does not necessarily always prevail - this is one reason why I believe a crash is not inevitable. The idea of efficient markets has been shown many times to be flawed and big players have a huge say in what happens - just look at what J Pierpoint Morgan did in 1929 for example.

    btw I did a quick google search and found a few solutions for a contact form without giving out your email addy:

    My Twitter Page

  27. Superb opus! I agree with most of what you say. However, most of the money that was lost actually didn't exist at all - see Paul Grignon's video "Money as Debt" at for a great explanation.

    It was also interesting to hear in the media this week about a renewed popularity in regions setting up their own local currencies (particularly successful in Lewis).

    All the best with your great blog.

  28. Aantonikl:

    Thank you for an excellent and very well thought out response to the 'Cigarette Lighter Problem.'

    For other readers, the original post can be found here:

    Your point about the rural population in China is interesting, but we have an equivalent in the long term unemployed. The difference perhaps is that one group is self-sufficient, the other is not. In fact the latter group in the UK could be described as the minimimum wage?

    Your analysis reminds me of something I read recently on measuring salary in terms of Mars bars purchasing power - which showed that there was very little real change in the salary of new graduate starting salary at ICI from (I think) 1950 and now.i.e. you can buy roughly the same number of Mars bars now as then with the salary.

    Essentially the Mars bar comparison highlights that the measure of inflation is very dubious.

    However, returning to your excellent analysis. I am not sure that you have followed it through to the logical conclusion.

    You correctly identify that exchange rates are out of line with PPP. In this case I could change £1 and buy several lighters if I took that money into a Chinese shop.

    This has been one of the consistent arguments of this blog. Exchange rates are going to have to shift.

    You suggest that is that there is not much difference in the value created by our cheap labour and that of China, so we will not be poorer in the future. However, it is evident from your own argument that our purchasing power is being significantly subsidised by China (and I would add - many others).

    The imbalance in the exchange rates means that we have not been paying the full value for the goods that we purchase. We have had our purchasing subsidised by China.

    If we take away that subsidy (exchange rate corrects), then our purchasing power will diminish significantly. This, by any reasonable definition, means that we will be poorer. At its most simple, the lighter we bought for 59p will go up in price.

    One point of contention. You use the price from a major UK supermarket for a comparison. However, in my comparison I used a New Zealand dairy (corner shop/convenience store) and an equivalent sized shop in China.

    I do not remember/know what a lighter would cost in a supermarket in China (e.g. there was a Walmart near where I lived in China), but would guess that the price would be considerably lower than that which you used.

    Another point of contention is your assertion that:

    'For more expensive labour, the UK can pay more as it is more efficient, re infrastructure, rule of law, etc.'

    I think that you are making some very bold assertions here. For example, infrastructure in China (in the cities, but also increasingly so in the countryside) is surprisingly good, whether transport, power, or telecoms. Clean water still leaves a lot to be desired, but that is about it.

    Your other example is lack of rule of law, which is true, but the lack of rule of law in China has advantages. For example, they can use our intellectual property without paying for it. The absence of law is also a positive in that regulation is less, and often can be ignored, such that costs of regulatory compliance are lower, and so forth.

    The cost of this lack of law is uncertainty and corruption, and lack of incentive to develop intellectual property (IP). However, as soon as the balance is to the advantage to China to enforce IP rights, you can be sure that the rule of law will (as if by magic) be enforced.

    I think overall you are making some assumptions in your proposed advantages, at least in the examples you cite. If you were to visit a Chinese city/live in China, you may be very surprised, and the same might be said of many of the towns, in particular in the most developed provinces (e.g. Guangdong).

    Finally, there is the most fundamental problem. If we accept that our economy has been supported by borrowing, one of the central themes of this blog, then the problem becomes worrying.

    In particular, borrowed money circulates through the economy, pushing up activity, pushing up employment, and so forth. All of this offers a higher standard of living for everyone (in the short term)and this reflects in the cost of everything.

    As such, every part of the economy appears to have greater wealth than really is the case. For example, the borrowed money is supporting higher wages through higher employment levels.

    As such, if you think about it, just taking the case of wages as an example of a factor, those higher wages impact upon the selling price of that lighter. Many people are involved in finally putting that lighter on the shelf, though their overall % contribution to the price will not be that large.

    However, this is just one factor, but another might be the cost of real estate, and so forth...the cumulative impact of the higher costs finally ends up in the lighter.

    Returning to wages, the cost of the lighter is higher to support the higher wages, and the higher wages are partly resultant from the artificial boom in the economy. The artificial boom is the result of borrowing.

    What we have, therefore, is a situation where a part of the price of the lighter originates in borrowed money. As a purchaser, I am also in part spending borrowed money, even if I am buying it from my wages, for the same reason as I have just explained for the cost of the lighter. In other words, part of the transaction is financed by economy wide borrowing.

    This is difficult to grasp, I know, but when I buy a lighter with cash (not borrowing), I am in reality using partly borrowed money to purchase the lighter, and the price of the lighter is higher than it should be because of borrowed money.

    However, thank you for an excellent and well thought out comment. At some point I may copy your comment and this reply to the original post.

    I will welcome a response to my reply. In particular if you feel that you still disagree with my assertion that we are poorer than we think.

  29. @Lemming
    I like your analogy. To me, the whole situation goes like that. We had an amplifier design on paper and we put it in a breadboard. It worked and every nation got the same breadboard.

    The problem now is that they are all hooked up in the same power supply that cannot hold them, while our economists believe that the problem is noise and try to eliminate it.

  30. Cynicus, In your response to JohnPaul you wrote "If the banks fail, they still can not ask for an asset such as a house to be returned. Provided the person makes the payments, maintains the property to a reasonable level it is not possible to foreclose."

    A few weeks ago, I saw a press report (in Metro, but I'm afraid I can't find the link) that this ain't necessarily so. It was said that a bank is within its rights to withdraw the loan in certain circumstances (of which the bank itself is the judge), and can foreclose if the borrower is unable to make immediate repayment. If true, this would be nasty.

    Meanwhile, thanks for the post. I look forward to the resolution of what FRB actually is. I'm confused about that because a) I've always been told that banks do in effect create money when they make a loan but b) I've also been told that retail banks make their money simply by borrowing short and lending long.

  31. Chris,

    I don't think the word 'correction' is appropriate in describing what Cynicus says needs to happen. A correction occurs due to the over/under-valuation of somthing, not when a whole system is broken and cannot be fixed easily. What Cynicus is saying is that rather than let the Earthquake keep building, lets have it now - that way it will register lower on the richter scale than if it happens at some other point in the future.

    However... Earthquakes are purely physical, and we are not, so even though there is a sense of inevitability about all of this, we as intelligent beings are tinkering with the insides of the machine that our civilisation has built and are doing our best to apply the power of reason to our very difficult to fix problems.

    I share the same fears as everyone else should about the effects of letting the system fail, either now or in the future, but whatever 'damage limitation' humanitarian sticking plasters are applied to the problem, we will still pay the bill eventually, just as we shall with climate change.

    As human beings, our ideal should be to make as graceful a descent as we can while the earthquake rumbles. I believe social projects that reinforce communities and promote sustainable solutions for future generations are a good way of contributing something positive now towards that ideal of a graceful descent... Its also a nice way of paying off some of the bill...

  32. Cynicus,

    I am not sure that collapsing banks and the ensuing turmoil demonstrates that it was foolishness that created this mess. There is the interesting claim that Lehman went bust because JP Morgan froze $17 billion of Lehman’s money on the Friday before it went into bankruptcy.
    The collapse of Lehman did provide a shock to the financial system, but its fallout allowed activities to go ahead that may not otherwise have been acceptable, whilst the break up of banks such as Lehman merely provided opportunities for other banks to profit – a reorganization and redistribution of assets. Overall banks only win as the losses are absorbed by the tax payer.

    Furthermore given we agree the banks are too close to government, can banks really be said to be acting foolishly if ultimately they knew they could act in any way they wanted only to be supported courtesy of the tax payer? You could equally argue that it demonstrated their sheer arrogance as they knew they could act with impunity.

    One other point from a previous post: how did you come by your assertion that we are within 3 months of the plunge? I am not disagreeing, I am just interested in why you think we are so close and not 6 or 9 months? What do you think the key signs will be? Do you still believe Ireland will go first or has the situation worsened for the UK?


  33. That was an incredibly in depth look at the financial system (well, as in depth as I want to go right now). I remember reading a story that China has a large stockpile of cash. I think all they need to do is wait until the western world collapses

  34. Mark, interesting article that's right up your street:

  35. These articles better explain my comments and I believe are well worth reading:

  36. Good audio link related to motives:

  37. The BBC mentioned the amount of money lent by banks in recent years compared to around 10 years ago. They suggested this extra money was from foreign investors. I can't find the report anywhere on their website.

    I did find this that gives a similar view of the amount of money being lent Wherever that money came from is where it is flowing back to now.

    Isn't this the same thing that led to the 1930s depression? Loads of money being freely available and then suddenly withdrawn and debts ordered to be paid.

  38. Hi Cynicus, while I agree with much of what you write, I believe that the essence is much much more simple. A nice graph in The Guardian "Global recession - where did all the money go?" ( this well. It shows world wide estimated values, in dollars, of 0.845tn for gold reserves, 3.9tn for cash, 39tn for the things banks and governments traditionally do (ie invest and lend), and a whopping 290tn money bubble created by the financial industry. My conclusion is that the credit crunch is nothing more than the bubble having burst, as this 290tn was and is nothing more than an endless and increasingly complex pile of IOU's (derivatives, hedge funds etc) written by financial institutions to each other... In short, it's 290tn of fictitious money.

    The UK and the US, and to a much lesser extent some European and other governments, have tried to keep this artificial money balloon going by pumping some of our 'real' money into it... to no avail, because in total they've put in only 1.9tn, a drop in an 290tn ocean--though a lot of 'real money.' Basically it's our good money thrown into a bottomless pit and if the governments carry on like this, we will go down with it... it would make a few people and institutions very very rich, and bankrupt everyone else. The only alternative, as far as I see, is to identify what is 'real' or at least money with some relation to reality, say the 39tn, and let the rest collapse, ie virtually all this fictitious money will disappear. Many financial institutions will go bankrupt, but at least we can create a new economy built on money values that have some relationship to reality.


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