If we actually think about financial systems, the requirements of a 'financial system' are surprisingly simple. Here is what is needed:
- A unit of exchange which holds its value, and which is widely accepted and trusted (money)
- Institutions where any surplus of money acquired can be safely stored (security of money)
- 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).
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 now....so 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).