Why Things Are Going to Get Worse - And Why We Should Be Glad. Michael Roscoe
means that when a central bank creates money by crediting (lending to) commercial banks, it has no way of knowing what multiple of that money will eventually find its way into actual circulation. The reserve ratio acts as a limit to money creation, but the complexity of the system makes it a very crude and unreliable tool.
The effect of all this ‘leveraging’ (the process of multiplying money by creating credit out of thin air) is not very different from the ancient practice of debasing gold coins with copper to make the sovereign’s gold supplies last longer. Both processes, unless backed up by a corresponding increase in real economic output, have the effect of devaluing the currency.
Not so efficient
I made the point earlier that the gold standard provided a fixed link between money and real economic wealth, and that such a link would have prevented the formation of the credit bubble, which in turn would have prevented today’s economic problems from developing. But, even without a gold standard, if the banks had been forced to hold higher reserves it would not have been possible for them to lend so much money, so this also would have reduced the likelihood of such a financial crisis.
This lax regulation has its origins in the City of London in the late 1950s. The foreign-exchange department of the Bank of England, which was self-governing but had to agree to increasing controls on trades in pounds sterling, began trading in dollars internationally, to avoid such regulation. The British government, which had close ties to the City, chose to let the Bank do so, and counted this market for international deposits and loans (which became known as the Eurodollar market) as ‘offshore’.
Thus developed an unregulated but quite legal trade, theoretically based offshore but actually using banks located in the City of London. It wasn’t long before these banks started opening branches in real offshore territories, in particular the Bahamas and the Cayman Islands. In 1963, the US government tried to limit the flow of dollars overseas by introducing a tax on the interest from foreign securities, but the unintended result was to send US banks flocking to London’s offshore accounts, where they could avoid tax altogether. The US asked Britain to tighten regulation on these offshore banks, but the Bank of England resisted such measures and, when US banking interests also exerted influence on politicians, the matter was quietly dropped.
A bigger change came with London’s ‘Big Bang’ of 1986, which wasn’t really deregulation so much as the discarding of a system based on honor and trust (as well as restrictive practices), in which investment bankers were partners who shared the risks as well as the rewards. The new ‘anything-goes’ culture that followed this change was actually more regulated (because the honor-based system didn’t need much regulation) but in such a way as to leave huge loopholes, which were quickly exploited by the new wizards of finance.
The Big Bang was an essential step in Britain’s transformation from fading industrial power to global financial center; from producer of wealth to magnet for wealth produced elsewhere. The City’s square mile, and its outgrowth in Canary Wharf, part of London’s redundant docklands, became the focus of international currency dealing, bond and derivatives trading, insurance and other financial services. Once the busiest port in the world, handling 50,000 ships per year at its 19th-century peak, trade now goes through 500 banks instead. Unfortunately, for the majority at least, this is the wrong kind of trade.
Banking is supposed to be a service to industry, a means of providing funds for investment in the real economy. Real investment involves the expansion and modernization of industry; the construction of new factories, farms, infrastructure, housebuilding: the process of economic development and the creation of jobs. Real investment has nothing to do with speculating on exchange rates or profiting from other people’s wealth to make personal fortunes that don’t contribute to the real economy.
Bankers try to justify these activities by claiming they provide more funds for industry at lower rates, using the ‘efficiency of the markets’ argument, but there hasn’t been a shortage of funds for sound industrial investment for decades, as my next two charts show, and as wealth keeps accumulating faster than the economy can grow (as I explain in Chapter 8), there isn’t likely to be.
Figure 26
The only thing in short supply is real work, yet the financial sector is responsible for killing jobs by encouraging corporations to become more productive and more ‘efficient’, so they can make more profit for the owners and banks at the expense of everyone else (investment banks being major shareholders), and also by ensuring that as little tax as possible is paid on these profits and inflated earnings.
Two types of debt
As I said earlier, money can be lent for productive or non-productive purposes. When a commercial bank lends money for genuine business expansion, the debt is eventually paid off with the resulting boost in real earnings. This is productive debt; it boosts the economy. But lending for purposes other than business expansion results in non-productive debt, and this is predominantly the type of lending undertaken by investment banks and other financial traders and investors. Non-productive debt creation is by definition a zero-sum game; because no wealth is created this way, any gains must involve losses elsewhere. This means that any asset growth boosted purely by unproductive credit is inherently unsustainable, as we have seen with stockmarket and house-price bubbles.
Figure 27
As the ratio of real industrial investment to financial investment declines – as the latter grows much larger in relation to the former, as shown in Figure 26 (for the UK) and Figure 27 (for the US) – then the ability of the economy to service the debts declines with it. This has been happening since the 1980s; the financial sector generally has been attempting to profit from rising asset prices rather than from real investment in industry. But in the long run, this is impossible, because the rising asset prices represent rising debts, which in the end will have to be paid, in the process bringing down the asset prices, as happened in Japan in the 1980s (more of this in Chapter 13).
The profits made from such unproductive investments are ‘unearned’, as was recognized by the economist-philosopher John Stuart Mill in 1848, when he criticized the rentier income of landlords, who ‘grow rich even in their sleep’. There is no real work involved, and consequently there is no value added to the economy; quite the reverse, in fact.
The central-bank obsession with controlling inflation, or indeed deflation, through interest rates, ignores the point that it is this attempt by banks to profit from unproductive lending that causes the growth in unsustainable debt, which in turn threatens to bring about serious inflation. Governments and central banks should have been limiting unproductive lending and debt creation, as they did before bank deregulation, rather than holding down interest rates and encouraging more borrowing, most of which results in the wrong kind of debt. As the two charts show, the growth of unproductive debt is a recent phenomenon.
So how did banks get into this business of wrecking the economy through unsustainable debt creation?
Financial times
With all the negative publicity concerning the financial sector since the crash of 2008 – the infamous bankers’ bonuses, excessive rates of pay generally, the fixing of lending rates and so on (criticism that was entirely justified, to the point that several top bankers have been forced to resign and few have tried to defend their practices) – it would be easy to forget the vital role that banks play in the economy. Businesses need loans to invest in capital – in factories and machinery and anything else that requires large sums of cash – just as people need mortgages to buy houses and loans to buy cars. So banking is an essential business, and also one of the oldest.
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