Understanding the Credit crunch
Since the Northern Rock crisis erupted it has become evident that the both the country and the world are facing a major economic crisis. With major banks collapsing, and other pillars of the commercial world seeking bailouts, we are facing a recession if not something worse.
The recession will have the same cause as every recession for the past two hundred years. To quote the famous economist Milton Friedman: 'I know of no recession that has not been preceded by a reduction in the money supply, nor of any reduction in the money supply that has not been followed by a recession.'
Debt-based money
In a nutshell the cause of the 'credit crunch' that is now facing the world is the high levels of debt being borne by large numbers of individuals. There is so much debt that increasing numbers of loans are defaulting, but the world's economy depends upon people borrowing. The solution now presented by the world's leading central banks to a problem caused by excessive borrowing is to encourage people to borrow more!
Contrary to popular assumption, there does not exist a large permanent medium exchange or stock of money. The permanent stock of money is very small. In Britain it amounts to only 3% of the total money supply, with similar proportions prevailing throughout the other major economies of the world. This permanent money stock, called 'M0' by economists, consists of notes and coins, which are brought into circulation by the Bank of England, contributing a 'profit' to HM Treasury of over one billion pounds sterling each year.
The remaining 97% of the money supply, called 'M4' by economists, is brought into existence by the lending practices of the 'High St' clearing banks. All this money is based on debt. It only exists when someone borrows from a bank, and it disappears when a loan is repaid.
New loans for old
Within an economy, there is a continual stream of people taking out new loans. What is important however, is that the amount of new loans that are taken out exceeds the amount of old loans being paid off, because the new money that is created as new loans has to match the repayment of BOTH the principal and interest of the old loans. This matching of more new money borrowed to old money paid off is achieved by a combination of inflation and expanding the market for bank loans.
In times past, banks never lent money to people on low incomes. Indeed, before the banking revolution of the 1980s, lending to any individuals was only a small part of their business. Before this time, most home mortgages were provided by building societies which, not being part of the bank clearing system, could not create new money as credit. This actually meant that house prices where limited by the amount of the deposits held by the general population. Since the banks taken the lion's share of the home mortgage market, house prices have rocketed.
Structured Investment Vehicles
With the increasing need to expand the circle of borrowers, banks have inevitably begun lending to people who are less and less likely to be reliable payers – the sub-prime market. These are high risk investments, but often with higher interest rates potentially offering higher returns, and clever people working for banks for large salaries have come up with ingenious ways of selling on these high-risk debts in a raft of Structured Investment Vehicles (SIVs).
Anyone who has wanted to buy dollars over recent years - still the the world's major currency - and does not want a pile of grubby bank-notes, but wants a nice, 'sophisticated' investment portfolio will be offered an SIV. For a top-rated SIV, it will have nothing but loans to secure 'blue-chip' companies, or so the theory is. However, the clever 'financial engineers' in the leading American banks, who want to off-load their more riskier investments, are quite adept at slipping in some high-risk, sub-prime toxic sludge into the mixture. So adept are they, that for much of this toxic sludge no one knows where it is and who is going to lose out when the loans default.
Increasing numbers of loans will default because increasing numbers of people are in debt. Even with historically low interest rates, defaults will rise. This is not the consequence of some arcane economic theory, but a simple matter of basic arithmetic, understandable to any child who has ever played 'musical chairs'. More money is needed to pay off a loan than is created by that loan, so people have to compete against each other just as children have to compete in musical chairs. Even though ever more is created (in itself causing the problems of inflation), the amount of total debts continues to rise faster than the money supply available to pay those debts.
This is bad news for lots of ordinary people, but it is also bad news for many banks themselves.
Bank credit
When a bank creates new money in the form of a new loan to a customer, it basically hopes to offset that loan against the new deposits that it receives drawn against other banks. Banks do not lend out existing deposits to new loan applicants because their current deposits are already earmarked against previously made loans. All the clearing banks make loans which leave them liable to claims against them from other banks into whom their new credit money is paid, and they themselves receive deposits which are effectively their claims against the other banks.
These various claims are balanced out through the bank clearing system. It is the bank clearing system that enables banks collectively to create the 97% of the British money supply that is based on debt.
When a bank lends out much more in loans than it receives in deposits, it has to arrange to borrow the difference from those banks who (inevitably) will have received more deposits than loans. In Britain, this is is done through the London Inter Bank Offered Rate (LIBOR), the interest rate at which the banks lend to each other. Normally, banks are happy to lend to each other as the business is easy to conduct and very secure.
The Northern Rock's business plan depended heavily upon LIBOR. It offered very cheap mortgages, which many people across the country sought out, even without a local NR branch. These cheap mortgages could be offered because the NR did not have a large and costly branch network. Lacking such, it did not attract many depositors so it covered its loans through LIBOR.
The trouble for the Rock grew when many SIVs began to fail. Banks became worried by their own exposure to these high-risk investments, as no one could be quite sure where all the toxic sludge was, but perhaps more worried about the exposure of the other banks. So to reduce their own risks, those more credit-worthy banks stopped lending to the more exposed and the Northern Rock found itself short of funds.
As banks do not lend existing deposits, but create new money when they lend, every time a bank makes a loan it leaves itself at risk at being unable to cover that loan either with new deposits from customers or with a LIBOR loan from the other banks. In a world of increasing uncertainty, banks have become more cagey about lending, and have increased their interest rates both to each other and their customers when they do, to cover the perceived increased risk.
A shrinking money supply
If the banks stop lending to each other (and businesses and the public), the money supply will decline. With less money in circulation to be earnt as business incomes and wages, more people will default on their loans, causing even less money to circulate, so that more businesses will collapse, unemployment will rise, and so into a downward spiral. There will be a recession. Hence the need to encourage more people to keep raising their level of borrowing.
The current credit crunch is not the first in economic history. Similar events have occurred over at least the past two hundred years, but many of the circumstances of today's situation are unprecedented. For example the level of debt money in the economy is higher than ever before. In the 1930s, it amounted to about 50% of the money supply, so 50% was not debt-based and unaffected by any credit squeeze. Now the debt-free element is down to 3%.
Levels of personal debt are higher than ever before, both in real terms and as a proportion of total UK debt. In times past a higher level of the debt burden was borne directly by Government and only indirectly by individuals as taxpayers. Few people worry about their share of the National Debt, whereas even far smaller amounts of personal debt can be damaging to family well-being.
The complexity of the global money markets, hiding and disguising the toxic sludge in the system is a new phenomenon, so it may be many years before the banking system becomes confident enough to resume the high levels of lending of recent years, and it is worth noting that for much of the industrialised world, the Great Depression only came to an end with the re-armament of the Second World War.
Academic economics
Conventional economic thinking, which accepts debt-based money as the only way to run an economy, requires an economy to be permanently balanced between an inflationary boom and a deflationary recession, although it is also possible to have the worst of both worlds in the form of an inflationary recession or stagnation (stagflation). What is not possible with a debt-based money supply is an economy that is neither recessionary nor inflationary. It is a simple matter of mathematics, the amount of money created as principal can never match the same amount of principal plus interest.
Such a finely balanced and inevitably problematic way of running an economy sets up a mystique over economic matters. Economists are consulted by politicians and journalists and their pronouncements are treated like holy writ. This is strange, given the lamentable state of the world.
In a world of enormous actual or potential wealth, even without wrecking the environment, the peoples of the world should be enjoying peace and plenty, and should have done so for at least the last one hundred years thanks to modern technology. Instead, through the entirely artificial process of creating shortages of money - an entirely artificial and arbitrary concept - abundance of real wealth has been turned into shortages and privations.
When economists talk glibly of the business-cycle is easy to assume that this is a natural phenomenon on a par with the natural laws of the world and as irrevocable as gravity or the speed of light. This is not so. The business-cycle, booms and busts, recessions and recoveries, are but a consequence of our entirely artificial debt-based money supply. A productive economy, physically able to provide all the things that its people require and many of the things that they desire could function quite adequately without inflation, recessions, house-price booms, unemployment or the large-scale debt that are the features and necessities of a debt-based money supply.
Reform required
Only by replacing a debt-based money supply with a debt-free money supply can long-term sustainability be ensured, for the economy, for the planet and for the people of the world. The Money Reform Party exists to educate the British people and their politicians about the nature and origin of the money supply and campaigns against the creation of the money supply by the commercial banks. Since the Northern Rock crisis erupted it has become evident that the both the country and the world are facing a major economic crisis. With major banks collapsing, and other pillars of the commercial world seeking bailouts, we are facing a recession if not something worse.
The recession will have the same cause as every recession for the past two hundred years. To quote the famous economist Milton Friedman: 'I know of no recession that has not been preceded by a reduction in the money supply, nor of any reduction in the money supply that has not been followed by a recession.'
Doom, Gloom and Very Funny Money
Written by the musican Neil Innes, from the Bonzo Dog Doo Dah Band, this is an explanation of the history of money, up until the late 80's, early 90's. It is a funny overview and I think it helps get the point across. The book's out of print. Luckily though the whole thing is online here: Doom, Gloom and Very Funny Money by Neil Innes
