People are inherently conservative and will not look to alternative economic and monetary policies unless forced to do so by personal distress or pity for the plight of others. Cynical though it might be, the present subprime crisis as it spreads from the United States of America will give enhanced opportunity to those who are committed to monetary reform.
Meaningful monetary reform can be implemented only by political means. Economic and monetary policy proposals must be based upon fact in the manner of science – rather than articles of faith in the way applying to religion. Historically, the ridiculing of monetary reform proposals by establishment economists has always been of sufficient influence to deny the public credibility required if monetary reform is to be instituted by a democratically elected government.
The credibility of monetary reform proposals cannot be established until the undue political influence of establishment economists is successfully challenged. The morality of the present financial system must also be given much greater attention. The present financial system has progressively developed morally unacceptable features.
Although differing in form, a monetary problem has always been the catalyst for a series of economic crises that have afflicted the developing world for the last three hundred years. The architects of the present credit crunch debacle are known as financial economists and as such have been granted the status of modern day economic high priests as Nobel Prize winners. In historical order, economic high priest status has been enjoyed by Adam Smith (the invisible hand), David Ricardo (laissez-faire), John Maynard Keynes (selective government intervention) and Milton Friedman (monetarism). In each instance, governments have applied policies based on the particular article of faith each espoused.
None of the other core economic articles of faith will withstand the test of fact as universal truths. The fact of socio-economic evolution has to be considered.
Abandonment of a particular policy and the associated rejection of the underpinning economic article of faith have occurred only as the consequence of severe economic malfunction. Of greatest immediate concern is that the features and background of the 1930’s Great Depression differ in form to that of the present yet to be fully felt subprime crisis. Since the Second World War the economy and associated monetary system have both rapidly evolved and in a social sense the financial for the worse.
Monetarism – the core contention of which is that inflation can be controlled only by high interest – remains the core article of faith underpinning present government policy. Those promoting monetary reform must successfully challenge this particular article of faith by proving that it has validity in certain circumstances but not those at present applying. . Both directly and indirectly interest must be including in prices as a cost. For some forty years, the growing extent of this compounding cost has entrenched inflation – rather than eliminating it.
Fractional Reserve Banking
The Great Depression was caused by a breakdown in the fractional reserve system of banking that was invented in the 17th century in Europe (Sweden) and became common to every industrializing nation. The present subprime crisis relates to investment banks that function more like what most of us know as savings banks.
In 17th century Europe, the availability of gold and silver coin was insufficient to allow industrialization to proceed. Particularly in Great Britain, ever more money was required to fund the industrial revolution and the associated production and consumption of consumer goods. On a free market, relying simply on available coin would have made the interest earned from money lending much more profitable than investing in powered machinery and thus stymied growth. To be doubly sure that this did not happen, usury laws were enforced in ways that made the acceptance of the notes printed by individual banks and then their cheque money virtually compulsory. Somewhat ironically, New Zealand’s lagging productivity of today can be directly traced to monetarist policies that have resulted in it becoming much more profitable to invest in money lending and speculation than the accumulation of real and more efficient and relevant industrial capital.
The fractional reserve bank had to maintain the pretence that the money it had created and issued was as good as gold. The promise was given that such money would be converted into specie upon demand. Periodic runs on the banks to convert their notes into gold or silver coin could not be met and the word bankrupt came into common use. Depression resulted. In boom times the fractional reserve banks created too much money and in depression not enough. It was a time when Adam Smith’s call to allow the profit motive (“the invisible hand of the market”) to do its work in guiding the production of consumer goods was both relevant and appropriate. The prior mercantile era was stiflingly restrictive with monopolies granted by the crown.
Adam Smith (1766) had argued that nothing need to be done about the availability of money because if the banks wanted more reserves then the price of gold would rise with additional mining meeting the demand. He said that bank failure was more the result of bad investment decisions than inherent fault within the system. His successor as the economic high priest of the day, David Ricardo, in 1817 expounded the laissez-faire article of faith that any government interference with market forces could only do harm.
The defects inherent in the fractional reserve system of banking reached crisis point in the early 1930’s with the Great Depression. Governments were forced to ignore the advice of establishment economists and instituted Reserve Banks who provided governments with credit (created money) to fund social investment in mainly housing and roads. In particularly Germany, the Nazi state acted as guarantor to the manufacturers of armaments as they looked to fractional reserve commercial banks to provide them with the money to meet the orders from the government for weapons of war. The approach had precedent in the armaments race that Germany initiated in the 1890’s that culminated in the First World War. In this regard, the economists of day in promoting laissez-faire policies virtually forced governments to adopt armament policies that are today known as “Keynesian militarism”. Some politically acceptable means had to be found to ease the problem of the chronic depression that afflicted mainly Europe in the last quarter of the 19th century. At the time, the United States was an exporter of gold – suggesting that local banks could create money for investment purposes whilst maintaining a prudent ratio.
Belatedly, in February 1936 the British economist JM Keynes published a book that provided justification for what by then had become widespread government intervention in the economy. The core article of faith he enunciated was that income equals the value of current output and that depression was caused by the insufficient investment of savings. The particular article of faith was unsupported by fact and prefaced by “provided it is agreed”. The contention was accepted by governments around the world and endured until rejected and replaced by the monetarist article of faith first espoused in 1963 by Prof. Milton Friedman. CH Douglas of Social Credit fame in the 1920’s had provided an alternative explanation to depression by suggesting that the payment of money into accounts in overdraft meant extinguishment of the said money resulting in a gap between income and prices.
Bretton Woods
The internationally attended Bretton Woods conference of 1944 laid the foundation for a new worldwide financial system. The Americans dominated the conference with their proposals as much designed to facilitate the exercise of American imperial power than address the problem of periodic depression. It was agreed that each nation would accept that the American dollar was “as good as gold” as a bank reserve. Although unintended at the time, the “reform” instigated resulted in the fractional reserve banks evolving and over a period of some fifty years becoming more investment banks.
The fractional reserve bank was more the creator of money whilst the modern investment bank is more like a savings bank. The imposition of monetarist inspired credit squeezes on the fractional reserve banks from the late 1960’s facilitated the transformation.
Under the gold standard, the prudent ratio of bank created money to reserves was to the order of 6:1. This continued to apply even when Reserve Banks were formed with the commercial banks obliged to sell to it their gold reserves and accept in payment what was called high powered money with the ratio principle still applying. Reserve banks were charged with settling overseas accounts in gold or a reserve currency readily convertible into gold. Of central importance at Bretton Woods was that when settling balance of payments deficits between countries the American dollar – rather than gold – would be unquestionably accepted in payment. Of course, America was exempt from any discipline in regard to a trading deficit and could simply create money in payment and did so but as a debt. Today, the debt is to be measured in billions. Much of the debt is in the form of interest bearing US treasury bills of which Japanese and now Chinese banks are the major holders as securities. The Americans had agreed to a ratio of 4:1 at Bretton Woods when creating internationally acceptable money but from 1971 this condition was ignored.
Since 1971, billions of American dollars have been made available to the world banking system because of massive and ongoing United States current account deficits. As a consequence, the ratio requirement that restricted national banks in their creation of local money has become largely irrelevant. Progressively, a bank of issue has been able to extend the same amount of credit (create money) at a progressively lower ratio. Government policy (credit squeezes) has forced the banks more to extend credit with borrowed money than by reference to a reserve ratio. There has been a veritable glut of American dollars available to borrow.
Modern runs are more against a national currency than bank reserves as such. To the extent that the American dollar has reduced reserve status the greater the risk of a run against it into, say, Euros. This risk at present is very real because of an ongoing devaluation of the greenback. It is reported that small Chinese and European traders are today refusing to accept US dollars in payment from tourists.
Holding a steadily devaluing currency is bad business and a run against the American dollar can have devastating consequences. American access to oil is just one. The present Iraqi war was instigated as much because Hussein declared that he would nullify the agreement stating that all payments for oil are made with American dollars. He wanted choice with Euros in mind.
Investment Banks
Although monetary problems have always been at the heart of depression and the associated social and economic distress – the specific cause has been subject to constant change in tandem with the ongoing evolution of the associated economic and monetary system. Today, trillions of American dollars worth of debt securities have been packaged in a multitude of extremely complex forms of which derivatives, insurance and hedge funds are the better known. The said securities are bought and sold on the open world market in the never-ending pursuit of speculative profits. Investment banks are the biggest creators, buyers and sellers of such securities. Any run against the American dollar will dramatically reduce the market value of these securities.
Today’s failing investment banks are those who have miscalculated and find that their outgoings of interest payments to their creditors exceed interest income with an associated dramatic fall in the capital value of their securities. Their creditors are mainly ordinary people who have invested their savings at interest in bank securities. Many have invested in the shares of failing banks.
The present credit crunch in America is the result of their investment banks suffering losses to the order of billions of dollars. Some relief is providing by the Federal Reserve creating billions of dollars of money and lending this at low interest to the major banks in crisis. Such is a palliative only and does not address the underlying problem. Further, it should be noted that such intervention is in direct contradiction of the tenets of free market economics.
People are close to rioting because the American government has required the Federal Reserve to created billions of dollars to bail out the major investment banks in trouble but has done very little to help the thousands facing foreclosure. Many have been forced to live in tents with the empty houses repossessed by the banks vandalized.
Any blame for the social and economic distress triggered by the subprime crisis in America has been directed more at politicians. Political naivety might be an issue, but responsibility for what has happened must be placed fairly and squarely on a new breed of financial economists with their continuing religious-like commitment to dangerously unrealistic economic articles of faith. Further, the morality of what is at issue has to be of growing concern.
Financial Economics
The financial and social stress most evident in America today is the direct result of more than a decade’s political support of the article of faith that underpins what is called financial economics – the most prominent architects of such (Markowitz, Miller, Merton & Scholes) have been granted high priest status as Nobel Prize winners. An extremely influential and powerful devotee is the economist Alan Greenspan who was chairman of the Board of Governors of the Federal Reserve of the United States from 1987-2006.
The basic tenet of financial economics is that if the market is sufficiently large then risk when lending can be virtually eliminated. Computer models (the Gaussian Bell-shaped Curve) based on the historic record of risk were constructed that showed the interest rate to be charged by banks to virtually eliminate the risk of loss from house mortgages.
With government disregard, American banks gleefully accepted the advice and funded housing mortgages in the trillions with no proper assessment of the ability of the borrower to service the loan. High commission fees were paid to those who could con people into buying properties they could ill afford. The purchasers were assured that the required mortgage money was unquestionably available. Some banks even provided loans on the basis of interest payments only. Leverage was encouraged by revaluing property with money from an increased mortgage providing the small deposit required for further purchases and mortgage commitment.
Today, within all the states threatened by the subprime crisis, the return on rental property has become significantly less than the interest to be paid on the mortgage granted over the said property. This type of investment has been prompted more by capital gain than rental income. In New Zealand today capital gain has largely evaporated, rents are rapidly rising and families that once could afford a house have been forced to downsize to a room. The same is also happening with student accommodation.
Over the last seven years the strength of demand for property in the worldwide housing boom has steadily increased prices. The incentive of capital gain has also enticed people to buy and build houses in size and for a price way beyond their means. After all, capital gain on houses has exceeded any other form of investment and most particularly that in the production of consumer goods. In an economic sense, houses produce nothing but simply provide for the basic human need of adequate shelter. The morality of all of this must be given very serious attention.
A modern subprime mortgage is one in which no assessment has been made regarding the ability to even fully pay interest – let alone repayment of the mortgage.
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Once a security held by a bank becomes suspect its capital value plummets with a run on its available cash as people clamour to cash up their savings. Apart from selling a security for cash on the open market, the only way an investment bank can obtain cash to satisfy its panicking creditors are foreclosure. Either solution involves massive losses of capital on a falling market with failure becoming endemic.
Americas more astute banks bundled up mortgages they held into packages and sold these on the world’s security markets. Sales to mainly banks around the world were facilitated as much because of the American dollar retaining the reserve status granted at Bretton Woods. The extent of doubtful subprime mortgages in each packet was not revealed and for that matter not even known. According to the financial economists this was not necessary with A plus rating more or less automatically granted.