By Neville Bennett While it is obvious that the credit crunch was a crisis about the availability of money, no one seems to be talking about how the crisis affecting bank capital impacts upon money and the real economy. I want to review money creation though leveraged lending and stress again that it is a source of instability which needs more attention. At present the debate is about other kinds of regulation and the insanity of monstrous bonuses. Instability Larry Summers, the former Republican Democrat Treasury Secretary, reminded us that the recent crisis resulted from financial instability and "hundreds of thousands of middle class families who had nothing to do with the financial sector losing their jobs".
Moreover, the crisis was "disturbingly familiar". He ticked off: the Latin America debt crisis of the early 80's , the 1987 stock market crash, the Savings and Loan debacle of the late 1980's, the Mexican crash of 1994, the Asian financial crisis of 1997, the Dotcom bubble, collapse of LTCM 2000, Enron collapse, and the present crisis. The Obama-Summers-Geithner proposed solution will raise capital requirements, eliminate the present system whereby institutions choose who regulates them, impose stronger standards, establish resolution authority to ensure no institution is too big to fail, and improve consumer protection. But it many not be enough. Some gains The global political and monetary authorities have acted quickly to halt the crisis. To stop panic, most governments have guaranteed deposits, rescued many collapsing institutions, made massive liquidity injections, pump-primed the economy with infrastructure investments, and (often) introduced zero interest rates (ZIRP). The authorities have acted now without deciding how they will repay their outlays. Zero interest rate policies are risky. Keynes warned of possible liquidity traps when increasing liquidity will not stimulate the economy. Economists were skeptical about this theory until Japan fell into it in the 1990's. All Japan's efforts failed to stimulate growth: the most visible consequence was to incur massive state debt. Another risk of ZIRP is that private losses have been replaced with more public debt. That debt is now so high that ZIRP is ensconced because states could not service their debt at higher rates. Japan could not service its debt, which is double GDP, without a fiscal crisis, massive capital inflows and increased deflation. ZIRP encourages a search for yield. The dollar and sterling have joined the yen in a global carry trade: investors search out niches where yields are higher. This will bring more bubbles, more demand for gold, and more reckless leverage (possibly on margin in the futures markets). US low interest rates are holding the world to ransom. It is a brave country that raises rates when there is a flood of cheap dollars waiting to pounce on carry- trade opportunities. States are unwilling to start paying down their debt and this is increasing distortions. Ballooning Debt New Zealand is borrowing hundreds of millions of dollars weekly to provide government services. According to Treasury, net sovereign debt was NZ$15.5 b in 2009, but it will almost double next year to $27.3 b, and double again 2010-2012 to $51.9b, and then grow to $62b in 2013. This is an almost fourfold growth in 4 years, and this is the middle projection of the forecast: it could be worse. As it is, New Zealand will be issuing $54 b of bonds between 2008 and 2013. The UK is in a deep debt hole. According to the Centre of Policy Studies "The Hidden Bombshell", (a new book) the state's net liabilities are â‚¤2,200 b, three times official figures, and equivalent to â‚¤85,600 per household. The Confederation of British Industry uses the books data to demand the Government slash the budget to boost investor confidence. Households not guilty Spencer Dale (Bank of England Chief Economist) has corrected some misapprehensions about current realities. He denies the accepted view that current problems are a payback for past excesses, especially the idea that households were seduced by easy credit and rising assets, leading to a debt-fueled spending boom. There was no consumer boom! Consumer spending in the UK recently had the same increase as average over 40 years! Nor did household expenditure increase its share of national income. That destroys one myth. It is true that household debt, as a proportion of income, increased from 100% to 165% over 1997-2007, but there was a matching increase in finanancial assets. Debt increased by one trillion pounds but assets increased by â‚¤750 billion. Older households trading down were winners; younger households either buying in or trading -up, accumulated massive debt. The money borrowed by the young ended up in older households' bank accounts. The debt of one part of the population was matched by saving in another. There was no change in aggregate wealth. Asset prices have fallen (houses by 15%) but the debt remains. Moreover, the crisis has caused households to spend less. Employment has fallen. Consumption has fallen sharply for 5 quarters for the first time since 1955, when records began. Spencer Dale's paper is significant because the consumer emerges as blameless for the crisis: I therefore assume it was the behaviour of the banks that was responsible. Let us look at money creation. Money creation Money is essentially the net debts of the banking systems (including deposits). It increases when banks increase their balance sheet by making loans. In the past banks were restrained by regulatory capital ratios. But they escaped this constraint in the 1990's as securitisation allowed banks to sell the risks of their mortgage holdings. This reduced the capital needed to advance mortgages. Securitisation led to leverage, profits and a strong incentive to print money. Capital adequacy addressed only the bank's asset risks: but securitisation allowed banks to transfer the risk, so new mortgage lending boomed. House prices advanced due to easy mortgage finance and ever increasing house prices led to even more money creation. The 2007-2008 crash stopped the music and lending dried up. The lesson is banks must be held to capital ratio regulations and not avoid them by securitisation or other scheme that the banks dream up. The present reforms do not address this problem. ____________ * Neville Bennett was a long-time Senior Lecturer in History at the University of Canterbury, where he taught since 1971. His focus is economic history and markets. He is also a columnist for the NBR where a version of this item first appeared. firstname.lastname@example.org www.bennetteconomics.com