This essay looks at the relationship of politics, money, interest rates and credit. These are macro financial considerations that are deliberated on and decided way above the heads of most of us. But unless we have some decent understanding of what is going on then we will be managed just as much as the money is. We need to know what is going on and how money works at this level. At the macro level, the money in the economy is a like a container of cash, there is a certain amount in there which is used to finance all the economy activity. That cash pays wages and salaries, it buys groceries and services, it finances houses and cars, and it pays for capital works building programs. All transactions large and small.
Now there are two dynamics going on here, one is the velocity of money and the other is quantity of money. In order to get the available money to do all the things that it needs to do, and also that there is a desire for it to do, we need to have enough cash in the hands of people that things can be done. The essential quandary is that there is never enough money to do everything that is necessary and desirable. But we can do several things that can improve the situation. We can increase the velocity of money and we can also just create more of it.
Velocity of money in its basic concept is easy enough. If I have a dollar and I spend it today and the person I give it to spends it tomorrow and the next day it changes hands again, etc, then we have a money velocity of a dollar a day. If we increase the velocity at which money changes hands and so it passes through two sets of hands per day then the effect is the same as doubling the amount of money in circulation. This effect however is very vulnerable to fluctuations, any reduction in public confidence will mean people are much more reluctant to spend the cash they have if they are not assured that their income is secure. The slowdown in spending creates a self-reinforcing feedback loop where the first action provokes even more of a slowdown in spending.
This can dramatically hobble an economy and the GDP, it is one of the economic dynamics that Central Banks are particularly wary of and therefore have contingency plans to deal with as quickly as possible. Their first response is the “Open Mouth” approach, they will essentially employ the big lie, saying things aren’t so bad, things are actually improving and that the long term trends are looking positive. They appreciate that consumer confidence is a critical part of the velocity of money and that if they can cheerlead the public debate then hopefully they can nip in the bud any over reactions due to fear. Under normal circumstances that is probably fair enough and even legitimate.
But if there is a genuine shock to the economy underway, where just trying to talk up the economy and the mood by being Happy-Clappy and positive isn’t going to cut it, more will need to be done. At that point Reserve Banks fall back on some of their other tools. If the velocity of money keeps falling, then in order to keep the economy and the money system rolling along at normal levels it becomes necessary to inject cash into the system in sufficient quantities to make up the shortfall. They have several standard ways of doing this, one is government stimulus spending and another is to lower the official interest(cash) rate.
This is where things start to get tricky, because for every action there is going to be reactions and consequences. Pouring money into the economy in very large quantities, has very real and serious costs. Government borrowing will run up a very large debt very quickly and will encumber future generations with big repayment and interest costs. Really, it is just kicking the can down the road with the hope that later things will have turned around and we will be saved by providence, I call that “swing and hope”. Alternatively governments can just straight print more money to do the job, but that invariably leads to inflation, a-la Milton Friedman. We don’t really need or want to follow the lead of Weimar Germany or Zimbabwe. There are other costs to consider too. Increased Government spending inherently means that government ends up as a larger share of the economy, and if it gets big enough you end up with the equivalent of communism and the State owns and runs everything.
Also, the spending choices are going to be politically influenced, that is just inevitable, and history demonstrates that invariably poor quality choices are made. Consider some of the boondoggles that have occurred in Japan and the United States with their government stimulus programs. This is where we got the expression “a bridge to nowhere”. The degree to which cronyism and sector self-interest can overwhelm rationality is stunning. This form of economic miss-investment can actually do serious harm to an economic recovery. We end up promoting things we don’t want done and strengthening sectors of the economy that should have been left to contract. In other words we end up back where we started, not having learnt anything, having wasted time, money, opportunity, and prolonged the agony for the most vulnerable sectors of our society to boot. This is where we most blatantly see who the favoured elites and powerbrokers are, they are the ones who continue to prosper while everyone else is on Struggle Street.
Leaving aside the ethics and morality of politics and money for the moment though, we have now come to the most interesting aspect of the whole concept of the basket of cash and the velocity of money. The most significant modern trend in money and finance has been the substitution of credit for capital. Historically, the way finance works is that you became rich by spending less money than you earn. That creates a surplus of cash which is amalgamated either in stock markets or in Banks and then lent out or invested in productive enterprises that created further wealth and prosperity. The whole system was dependant and limited by the amount of accumulated savings, the system could not grow faster than the available supply of money.
And then we got “innovative” financing, starting with fractional reserve lending, we have been concocting innovative financial scams schemes ever since.
Fractional reserves are an interesting and clever concept; if a hundred people each deposit a hundred dollars, then the bank ends up with $10,000, which is available to be lent out to borrowers. Or rather, most of it can be lent out ($9,500 say), a small fraction must be retained as a reserve in order that any depositor who may wish to withdraw their money can do so. Historically we can project what sort of percentage of customers will wish to withdraw their money over a certain period and so figuring those averages gives us an appropriate margin for how much cash to keep on hand and not lend out. These margins and calculations are subject to Reserve Bank regulation and oversight and are part of a system the banking industry as a whole uses to stabilise and smooth fluctuations in the national finances. It maximises the capital available to be lent, while managing day to day cash-flow. If that was all there was to it then there wouldn’t really be any significant issues.
But the system has grown and evolved, it has mutated and manipulated in lots of directions that have not been sufficiently supervised, anticipated or understood, certainly not by the man in the street. Finance has become a reserve of a high priesthood that is so shrouded in mystery and voodoo that it is effectively out of control, the “Temple of complexity”. Financial innovation has continued to the point where we have an economy where much of the money in circulation is no longer capitol and savings, but debt. An economy can be pushed along twice as fast if in addition to the money that people have saved being invested in the economy, we can also invest fictitious capital, money that is lent and borrowed but which has effectively been conjured out of thin air. It is one thing to take money that has been saved by one person and lend it to another, there is no nett change in the money supply, but if we can get innovative then anything is possible. When money becomes subject to innovation like this, the difference between Real money and Credit blurs into invisibility and gets spent in the economy exactly the same. Right up until the point where it has to be paid back, then suddenly it is all a very different story.
If the flow of money through the economy can be boosted by adding IOU’s on top of the basic pool of currency in circulation, then so much more activity can be undertaken. A lot of thought has gone into the theory of the supply of money vs the productive capacity of an economy, but it is by no means a straightforward calculus, Doctoral Theses are written on the subject. In spite of that, the reality of this relationship is that it is more often a result of chance, politics and expediency than science. Political imperatives are for growth by pretty much any means. As long as everything’s growing then everyone’s happy, right? However, the longer that growth continues, the more the increased levels become the new norm and expected. Anything less becomes politically dangerous and unacceptable, the rules and systems will get reworked to extend that dynamic, systemic risk becomes endemic. But the danger with so much of the economy running on borrowed money, on debt, is that any slowdown in the velocity of money means an equal reduction in cash-flow and the ability to service debts, from there it is a cascading reaction of defaults and bankruptcies.
The systemic risk is a consequence of interest rates being artificially held too low for too long – or in other words: exactly what the major Central Banks around the world have been doing. By holding rates low and stable for so long, they have been able to flood money(lending) out into the economy and let the economy roar away. People have borrowed up to the maximum they can manage and have spent it on whatever took their fancy. That has inspired bubble economics and rampant price inflation, way beyond realistic and sustainable levels, in whole sectors of the economy, most notably in housing and Real-Estate. But consider for a moment what the consequences of a doubling of interest rates would be. People who have borrowed to the limit of their ability to service at a low interest rate loan and now finding the rate has doubled, are going to have to deleverage in a hurry.
Deleveraging means reverting to not owing 4, 6 or even 10 times more in debt than you have as capital, principal or as a deposit. Critically moreover, it all depends on the market for your asset not freezing up or prices declining precipitously. If that happens then your asset (your house for instance) is no longer worth what you paid for it and likely not even what you owe on it. That is the recipe for a very sad situation, particularly if the economy as a whole is running on extreme and excessive debt. One sinister effect of falling prices and deflation is that, opposite to the way inflation works, existing debts become larger relative to incomes. How many people have crushing mortgages, as well as a car loan and max’ed out credit cards? How many corporations have borrowed to excess, and how much commercial real estate is overblown and over leveraged? If the velocity of money slows down long term, then practically all that debt becomes unserviceable and ultimately must default.
And now comes the interesting stage when we find out where all the money originates from in the first place as the losses start to flow back through the system. There are going to be some very nasty surprises in here, because a lot of this money isn’t really money at all, but it is definitely a debt. Here’s how that works, Bank “A” loans some money out to a hedge fund, which loans the money out to a business, which uses it as collateral for a deal, which is part of a bundled security, which is sold back to the bank again and is then used to originate another round of loans and borrowings. The crude name for this is a circle-jerk. By the time dozens of actors have sliced, diced and circulated all these loans and financial instruments around and around, we have loans on loans on loans which all depend on complete honesty of all the parties involved to have truthfully stated and accounted for the underlying securities, assets, cash flows, insurance provisions and liabilities.
Leaving aside the possibility that market conditions might have changed so dramatically as to render any calculus for repossession and recovery of loans utterly unreliable, the real problem is that the money we have been using is fictitious. It spends like real money and it creates a debt obligation like real money, but was never real. At some point a loan on a loan on a loan, ad infinitum, is mathematically impossible to recover. A default at any point in the chain means that everything further along the chain collapses when there is no capacity to cover the losses. The assets to back the loan do not exist, there is only more debt. Proper oversight and regulation should in theory completely prevent such a situation from arising in the first place, but the realities are that Regulators have been captured by the money and the politics. While there was big profits to be made(and it was very big), a blind eye was turned. “Financial Innovation” took the path of least resistance and highest returns and that unfortunately means it all eventually segued into a scam. When financial systems extend to the point that mathematically it is impossible that it can ever be resolved properly then it is a Ponzi scheme.
We now are possessed of a fraudulent financial system. We owe money that can’t possibly be repaid and our governments are trying to prop up the system by borrowing or printing ever more money to reinflating bubbles and attempt to hold interest rates near zero. You can’t solve a debt problem with more debt, nor can you hold interest rates at zero forever. Following the great Depression in the 1930’s measures were implemented to prevent certain commercial and political practices. These were eminently sensible and practical rules, and while there were people alive who remembered the past, they worked for a while too. Except they prevented the gamblers from playing the system they way they wanted to, and in the end the political system was subverted to align things the way the gamblers wanted. It is corruption pure and simple and we will all be paying the price for a long time. The scammers got rich and we got fleeced.
There needs to be changes to the economic rules and recourse needs to be pursued against the phoney profits, but most of all, in the end, it is the political system that is the problem. It is an invidious situation, money and politics go together like a horse and cart, corruption and politics is the norm not the exception. Everything we learnt from the great Depression looks like it is going to have to be re-learnt all over again. The measures that were put in place to restrain speculation, reckless lending and borrowing, and feckless spending have been circumvented and ignored. Regulations have simply not been enforced and legislation has been manipulated to facilitate looting. In the convergence of politics and money there exists the genesis of corruption, unfortunately it has always been so. It is not that we haven’t had some valiant attempts over the years to ensure the virtue of our systems of government, it’s just that they have all eventually failed.
However, that is not a reason not to attempt to change things where we have problems, or to not strive to create a better system. Optimism, blind or not, is probably our only real asset and must ultimately carry us if we are to succeed. It is a big ask, looking to transform politics, money and bureaucracies. Overturning the moneylenders tables in the temples wont solve the problem, we need better systems. I think it is possible, at the very least we do actually know what not to do and the very best start would be to not repeat the mistakes of the past.
Here are a few simplistic, but true nonetheless, principles to work with:
The process of politics cannot be allowed to be captured by moneyed interest. Man is a rationalising animal, not a rational animal, and there will always be reasons and excuses for politicians to favour their friends with money. The instant that starts it is the slippery slope to perdition. Whatever it takes, however it works, money must be removed from the political process. Ergo, election systems that run on “campaign contributions” have got to go. Probably that means elections and democracy as we know it. Not that it can’t be democratic, but it can’t be the current system that bribes the electorate, buys elections and propagandises the political debate. The media particularly must not be captured by moneyed interests.
Governments cannot be allowed to set interest rates, whatever the temptations to do so. There is zero evidence politicians or bureaucrats have any clue what interest rates “should” be. They only ever know what they would like then to be and that is certainly a recipe for disaster. More-so, in that the inevitable attempts to “correct” for the consequences of their actions only make the situation worse. Additionally, the economic sectors with the most to gain from a particular economic policy and interest rate will be whispering in the ear of the politicians to swing things to their advantage. It doesn’t even need to be corruption, it can just be the squeaky hinge effect and the voice you hear most often, if it is plausible enough then actions will get taken without fully understanding the consequences. The only solution to that is to take interest rates out of the control of everyone and let a genuinely free market set the rates. That actually is technically achievable, the trick is to stop the political and financial manipulation.
Credit and debt must never again become the out of control monster it currently is. Managing credit isn’t really that difficult, main-street banks and credit unions have been doing it for decades and the system works. Right up until the financial innovators got to work and the system ended up bowing down to the temple-of-complexity. Yes, the general public needs to be a lot better educated about money, but when an averagely bright person can’t follow what is happening within a complex financial deal then guaranteed there is some sort of scam afoot. By the time we get to CDO’s, MBS’s, Derivatives and the like, the system is well past crooked or redemption. It needs to be slashed and burned in order to let some new honest growth come through. The big financial corporations need to be broken up, assuming they actually survive the consequences of their follies. Left to stay afloat without any bailouts from the public, I doubt they would. It would not be the disaster they predict either, except for them, and frankly my dear I don’t give a damn. The great thing about money is that it will flow like water to where it is needed if it is allowed to do so. The chokehold of the financial robber barons must be broken, we will never breath free otherwise.
The volume and velocity of cash in our society is critical to our economic wellbeing, it influences interest rates, prices, production and prosperity. Therefore this must be as open and transparent as possible. We can’t have bureaucracies, politics, corporates or ideologies capturing the system again. Now that really is a big ask, but not impossible. First and foremost is transparency. An educated and interested public is necessary as well as accurate information. What that specifically means needs to be formulated and defined. If the current system is going to break down under its own failings, then we need to have a replacement ready to step into place, otherwise the same old actors and factors will take up where they left off.
I will follow up on these themes further in subsequent posts.