Getting to the root of all evil

The problem with the financial world today is that they’re just not making money like they used, especially the hard-currency US dollar type essential for greasing global trade and productive investment. There are two main reasons why, but that simple fact alone leads to the predicament the world is in — an existential financial and generational standoff between the young, the poor and the indebted billions on the one hand and the wealthiest five percent of the world’s population on the other.

Financiers of all persuasions around the world are certainly trying to create more money, but it is just not possible to do so at the same blistering pace seen over the past forty-five years, or critically, not of the same quality and where it is most needed.

Money has a multiplier effect in an economy as it is spent. You pay the plumber or the hairdresser who then spends the money in the supermarket or in a restaurant where it is used to buy stock and fresh produce, allowing the farmer to pay for his tractor and the manufacturer to purchase raw materials and pay wages to employees, enabling them to extend the spending cycle. But in order for growth and increased prosperity, new money is required, trillions of dollars of it every single year. Without freshly minted money the velocity of spending decelerates and modern economies shrivel up and die.

US money supply grew at an average of 8.5 per cent from 1975 to 2008, but since then it has plummeted to a growth rate of just 1.5 percent, with the same pattern repeated across OECD countries.

The slow rate of money creation  afflicting the world is like a 100 meter relay runner being forced to take the baton at a jogging pace instead of a near-sprint, slowing the time around the track from one athlete to the next so that the race is lost. In an economy, it happens when people start delaying or even cancelling some purchasing decisions because of cashflow uncertainty, and it results in companies only paying creditors sixty or ninety days in the future, instead of the usual thirty days. This deceleration is hard to discern at first because billions of transactions  representing trillions of dollars still ping through the copper wires and fibre optic cables wrapped around the world every day. But there’s evidence of mounting uncertainty about the steady flow of money in the system, and it’s discouraging spending and the regular payments of non-essential bills.

This is the underlying reason why commodity prices crashed to 17-year lows early in 2016, global stock indices fell into a bear markets, the US economy has struggled through the weakest post-recession recovery on record, China’s economic growth is slowing and negative interest rate policies are being tried in desperation to prevent Europe and Japan from sliding into depression.

Money was created at a maniacal pace in the first seven years of this century, lifting living standards all around the world until it all spun out of control. China then took up running with the global growth baton with an unprecedented infrastructure spending spurt from 2009 — one only possible in a country where normal investment parameters didn’t matter. But now the quality of the money created in some sectors of the global economy to supply China’s once insatiable appetite for commodities is so poor it’s being destroyed. That’s what happens when a borrower can’t repay their loan.

The thing about money is that while we spend it every day and most know it affects just about every aspect of their lives, few people really understand what it is, how it is created and who controls it.

“…Money today is a type of IOU, but one that is special because everyone in the economy trusts that it will be accepted by other people in exchange for goods and services.  It is because money is a form of IOU that banknotes still have the ‘promise to pay’ inscription: but money today is fiat or ‘paper’ money that is not convertible to any other asset (such as gold or other commodities).  In addition to currency, bank deposits and central bank reserves are the main types of money in the modern economy. Each one represents an IOU from one sector of the economy to another. Most of the money circulating in the economy is in the form of bank deposits which…”

The Bank of  England, established in 1694

Most people think they just earn it for doing paid work every day. Many think they really, really earn and deserve every single penny of their millions or billions — and the lazy poor only have themselves to blame — without considering for a second from whence their paper wealth ultimately came, or what underpins it, which suits those that control it — among the biggest earners of them all — just fine.

“Let me issue and control a nation’s money and I care not who writes the laws.” Mayer Amschel Rothschild (1744-1812), founder of the House of Rothschild.

But ignorance of the root of money is understandable. For decades, there was little need to think about how money worked in an economy, except in obscure academic circles, because it just seemed to “happen” in a wonderful, spontaneous, self-fulfilling, exponential process. Sure there were ups and down, and you couldn’t spend it recklessly, but for most people in the Western world, money increased at a steady pace, taking all hard-working economic participants along for the ride.

“Money doesn’t grow on trees you know,” fathers often tell their children, but in reality, for some it’s been much easier than that since 1971. Over the last few decades, the only difficulty for those in control of creating it was ensuring it was repaid with interest, as well as learning how to pump it out in vast quantities without causing too much inflation that would prompt central banks to raise the cost of borrowing, threatening those that had over-extended with too much debt.

“The study of money, above all other fields in economics, is one in which complexity is used to disguise truth or to evade truth, not to reveal it. The process by which banks create money is so simple the mind is repelled. With something so important, a deeper mystery seems only decent.” John Kenneth Galbraith, former professor of economics at Harvard.

The simple answer is after a few strokes of a private banker’s keyboard to make a loan, knowing the central bank will always be there to fund the loans extended at an ever cheaper interest rate if too many customers struggle to make their repayments. According to double-entry accounting standards, the lending bank marks a debit in its loan account, credits the customer account and voilà! Money comes into existence.

Yet, as hard as it is to believe, even some Nobel economic laureates and by far the majority of all economists in the world didn’t really know how money was actually created until recently. Following some academic argy-bargy in 2014 between two schools of economic thought — the mainstream neoclassical economists and the new-age post-Keynesians — the risks for major policy mistakes from the misinformation became so serious officials at the Bank of England ** seemed compelled to publish a research report clarifying and explaining just how money came into existence. The BOE confirmed the post-Keynesian view most vocally argued by Kingston University Professor Steve Keen. Prof Keen has pioneered rate-of-change analysis to understand debt-dynamics. He was also one of just 12 economists in the world credited with forecasting the global financial crisis with sound economic analysis.

“In the modern economy, most money takes the form of bank deposits. But how those bank deposits are created is often misunderstood. The principal way in which they are created is through commercial banks making loans: whenever a bank makes a loan, it creates a deposit in the borrower’s bank account, thereby creating new money. As ‘Money creation in the modern economy’ explains, though, banks cannot create money in this way without limit: how much banks lend will rest on the profitable lending opportunities available to them which will, crucially, depend on the interest rate set by the Bank of England.  In this way, monetary policy acts as the ultimate limit on money creation… This description of how money is created differs from the story found in some economics textbooks.” The Bank of England quarterly bulletin (emphasis added)

If the borrowing customer immediately withdraws the loan money to pay for something and no other customer deposits money with the bank, leaving the bank “short” of cash to balance at the end of the day, the bank treasurer either has to borrow the funds overnight from another bank, or if money-markets are tight, go to the lender of last resort, the central bank emergency-lending window where borrowing rates used to be punitive but now cost next to nothing.

Of course each day major commercial banks around the world process millions of transactions with money flowing in and out of accounts, but essentially if the they lend and create a lot of money, and the sum of all those transactions leaves them short at the central bank clearing account, they need to borrow funds elsewhere to ensure they are square at the end of the day. The bank’s books must balance overnight, and that balancing works throughout the banking system, to try and ensure there is no fraud.

So banks are certainly not limited to lending out customer deposits as most people think. But  given all the so-called financial “innovations” bankers claim credit for, it is remarkable that after centuries of banking the simple money-creation process has only recently been officially clarified, even if some economists still argue about finer details of the process.

The ignorance is also remarkable given how global debt has exploded over the past few decades.

Total world debt has soared exponentially to over $200 trillion — based on data from McKinsey & Co in 2014 and other sources — up more than $57 trillion, or 40 percent, in the past six years.

About $26 trillion of debt-money was created in China as it compressed a generation’s worth of lending into just six years. Other emerging market economies and world governments aided by record low central bank lending rates and unorthodox monetary policies accounted for the rest.

“On the liabilities side of the household balance sheet, average (world) debt rose by 81% between 2000 and 2007. Debt per adult has been fairly constant since then, averaging about USD 9,000 and has trended mildly downwards when expressed as a proportion of household net worth,” Credit Suisse analysts said in their 2015 Global Wealth report.

The reason why most economists — the majority in the world belong to the neoclassical school   and don’t even consider the implications of debt in their economic modelling — are unconcerned about global debt problems is because of the accounting identity which essentially says a loan creates a corresponding deposit, and so “one man’s debt is another man’s asset”.  In their ideal world, the banking system is always perfectly balanced.

However, it used to be that your debt was your bank’s asset, but in a world of increasingly complex finance operated with little hindrance across national borders, your mortgage debt might amount to an asset of a pension fund in Norway or Japan. Or even worse, if you are late on your repayments, it might be owed to a distressed-debt specialist hedge fund — known as “vulture funds” — domiciled in the Cayman Islands with no scruples whatsoever about foreclosing on your debt and kicking you out of your house.

As debt levels have soared, so have the number of millionaires and billionaires.  A Knight Frank wealth report says the global population of ultra-high-net worth individuals (UHNWIs) has grown by sixty percent over the past ten years and there are now 187,500 UHNWIs with $30 million or more in net assets, excluding their principal residence, around the world. But that number dipped by three percent in 2015.

All this means is that the world is awash with cash and debt-based financial instruments that comprise the bulk of an estimated $250 trillion in private net-wealth.

Clearly there is no shortage of private wealth, but how it is split and what underpins it is the risk. According to Credit Suisse, most wealth is still predominantly concentrated in Europe and the United States.

“However, the growth of wealth in emerging markets has been most impressive, including a fivefold rise in China since the beginning of the century. The fact that financial assets accounted for most of the wealth growth in China highlights the relevance of financial markets in the creation of wealth, but also points to short-term vulnerabilities of wealth to financial shocks.” Credit Suisse 2015 Global Wealth report

Global wealth is contingent on a high percentage of the debt being repaid, firstly by the relatively poor billions facing rising costs of living and low wage growth, secondly by cash-strapped governments crimped by falling tax revenues and thirdly by companies that used debt raised in corporate-bond markets for share buybacks instead of productive, job-creating investments.

Compounding the uncertainty of that grand lending bargain, an unhealthy portion of the loans were indiscriminately dispensed by the world bankers and financiers over the past fifteen years — the most dodgy being US, Irish, Spanish and Chinese housing loans, and via risky “junk bonds” to finance energy, mining and start-up tech companies.

So for financial well-being to be maintained in the world, almost all of it needs to be repaid or much more needs to be created than gets destroyed by borrowers defaulting.

But the virtuous cycle of global money is running out of new, credit-worthy participants around the world willing and able to enter into a Faustian debt-bargain to keep money flowing through the world’s banking systems to support wage and company earnings growth so that existing loans can be repaid.

“… There are two main private sources of money: you can either spend money you already have, or you can borrow from a bank. When you borrow from a bank, you increase your spending power without reducing anybody else’s: the bank records a new asset on one side of its ledger (the debt you now owe to the bank) and a new liability (the additional amount of money in your deposit account). When you spend that borrowed money, it becomes income for someone else. So total expenditure and income in our economy is the sum of the turnover of existing money, plus the change in private debt.” Prof Steve Keen

All four of the world’s biggest economic blocs — the US, Europe, Japan and China — have sprinted hard since the world started rebuilding after World War II, but they’re all out of breath, without another runner to hand the baton to.

Debt is future consumption, but the future from debt has arrived all too quickly. Money feeds on itself. Money makes more money possible —until it exponentially explodes to the point where the liability side of the global balance sheet forms a dense deflationary black hole from which it is hard to reignite growth to reach escape velocity.

As Prof Galbraith said, grass-roots, “fiat” credit-money creation is a simple process, but bankers have resorted to mind-boggling complexity to perpetuate the process and disguise the risks. Understanding the ebb and flows, the swirling currents, the occasional floods and, most importantly, the severe droughts of money, are extremely important for conserving fragile financial wealth.

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