by Greg Buck
Following up the recent series on China, credit, and why it matters, I think a primer on money would be in order for a lot of readers. Unfortunately, most people have an antiquated idea of what money is and how it works, and this makes it very difficult to understand the danger of too much credit.
Most people still cling to the notion that money is a “lubricant”, facilitating transactions in an economy, and that it is a “store of value” because it can be saved and then spent later. Well, money is these things, but the problem is that it is so much more than this. The most important of these is that “money is a claim on resources”. This is why it’s so important to make sure that the amount of money out there does not get ahead of the real world out there. The tail should not wag the dog.
Back in the day, money was saved by stashing it in the bank, and the bank put that idle money to work by lending it out, at interest. The interest paid to the depositor was compensation for the risk taken in lending their money. Banks could, within limits, lend more money than they had on deposit, because it was highly unlikely that all depositors would demand their money back at once. This “lending more than what you have” is known as fractional reserve lending, and it was permitted subject to very tight controls on banks, for obvious reasons. One of the most obvious restrictions was that banks were not allowed to gamble with their customers’ deposits! “Banking” banks and “investment” banks were kept separate, and any taxpayer-backed deposit taking institution was tightly regulated, precisely so that they could not take deposits from the public, gamble with them, lose them, and then turn around and demand a bailout.
Up until the 1970s, the US dollar was backed by gold. What this means is that dollars could be exchanged for physical gold. This is very important to understand, because it placed a limit on how many dollars could be printed. To fund the Vietnam War the US printed a hell of a lot of dollars, and after the war a lot of those dollars were exchanged for gold. Holders of dollars wanted gold, not paper. Then Nixon “closed the gold window” and the US defaulted on its debt by ceasing to pay the gold promised in return for those dollars. Simultaneously, and in order to prevent the expected stampede out of the “newly worthless” dollar, the US created the “petrodollar”, doing a deal with Saudi Arabia whereby the Saudis agreed to insist that all payments for oil be made in dollars, and in return, the US became the Saudi’s biggest ally. So, the world’s reserve currency was created, and its name was the US dollar.
Bingo! The gold standard was gone, and the world’s banks were no longer limited to issuing new money backed by anything. The shackles were off. They could create as much “credit” as they damn well liked.
Over the coming decades, the lobbyists and politicians went to work, and we soon arrived at a place where money is created “ex-nihilo”, literally out of thin air. Banks lend money into creation. They don’t on-lend existing deposits, or even multiples of existing deposits. They lend out of “nothing”. Lending out of “nothing” is synonymous with “creating infinite credit”, and it has two very big drawbacks.
The first we saw in 2008. Allowing banks to extend unlimited credit eventually led to a credit crisis, because the amount of credit out there was way beyond what could possibly be paid back. The response of governments and central banks was to drop interest rates to the floor, so that the existing outstanding credit became less onerous and could over time be paid back. Phew. But as I stated in an earlier article, money is fungible. It heads off and finds an unexpected home, and it does not stay in the bathtub. Instead of using the headroom provided by lower rates to pay down loans… you guessed it… people simply took the opportunity to take on bigger loans, aided and abetted by the cheering banks and politicians. Yay. House prices are going up! And share prices. And bond prices. And antiques, old cars, art, and bitcoin. Yipee. We’re all wealthier. Really? All that happened is that we and the politicians were not forced to address the ballooning debts, and banks were rescued from the folly of their extension of unlimited credit.
So where does this leave us today, ten years after the GFC? Massively increased debt and sky high asset prices, with interest rates still pinned to the floor. In other words, the problem which caused the GFC has simply been made bigger, and there’s no headroom of lower interest rates ahead.
The second is the claim on resources. “Financialised” assets like stocks or bonds, investment property, retirement accounts etc, are “worth” more when their “price” goes up because they can be exchanged for more “stuff” in the real world. But we live in a finite world. We desperately need to live “sustainably”. We definitely do not need to be consuming more and more and more. We need the exact opposite of sky high asset prices fueled by cheap money created with a tap on a keyboard. Why do we believe fool politicians and central bankers telling us that we are better off when the “money” value of “things” goes up?
How did we come to tolerate a system in which people who do not have “money”, created out of thin air, starve, and how did we come to believe that all of the claims behind “money”, created out of thin air, can possibly be honoured without the world as we know it being wiped out?