Debt

So, we’re all fairly sure that the current economic crisis is something to do with the banks lending money to people who couldn’t finance their debts. We’re reasonably sure of this because we’re quite certain that the American Sub-Prime mortgage market was where the problems started and that if they’d not lent money to those people then we’d all be fine now and would be enjoying the same level of economic growth as before. How true is all this ‘knowledge’ though?

Money is debt. The available pool of cash with which to do things comes from each of our promises to finance our debts. The money you paid for your house with almost certainly doesn’t physically exist anywhere. Unless you’re in the minute minority of people who paid for their house from their earnings, then you got out a mortgage, the majority of which would have been created ex-nihilo. It exists as a string of 1s and 0s on a computer. As you pay/paid your mortgage off most of the money you gave back disappeared. It had never truly existed in the first place. The only money which didn’t disappear was the interest and the reserve deposit equivalent. That is the amount they have which they can lend from. The ‘real’ money that allows them to make fake money out of nothing more than your promise to repay. Their reserve ratio could be as high as 24:1, they could be able to loan out 25 times the real money they have.

Okay, so the bank can lend out more money than it actually has, but this fake money it creates is destroyed as it’s repaid, leaving only the real money and the interest. At a reserve ratio of 9:1 (as I understand it, a fairly low, reasonably common rate) they can collect interest on a £10,000 loan while only having £1,111.12 of real money. The interest on that £10,000 loan is theirs to keep and they only need to recover £1,111.12 to get their initial investment back, the rest of the £10k will be destroyed once repaid anyway. Of course, that £10,000 loan will be deposited somewhere once the loan’s been used for whatever it was intended for. The £10,000 loan, once deposited, can be then used to make a further loan of £9,000. That £9,000 loan can then be used to make a further loan of £8,100, and so on until we’re approaching £100,000 of loans (and the interest payments on those loans) for a £1,111.12 initial deposit. If there were only one loan made then the bank could only collect on the £10,000 initial loan. However, with dozens of smaller loans after the initial large loan the bank can collect on £100,000. Lending to lots of people wanting smaller quantities makes the bank a lot of money from nothing.

So the banks can make the huge loans that large businesses want, then use those to make medium loans that medium businesses want, then use those to make loans that small businesses want, then use those to make loans that consumers want. All of the loans made with the same initial deposit by the central bank. And the interest collected on all of the loans can then be used to make more loans and collect more interest.

Of course, no bank would get the deposits from their own loan from every stage of this process, but since the banking system is a closed system, it effectively means that, since each bank gets some deposits from every other bank’s loans, it works out to the same thing in the end.

So, the total amount of money in the system and the total amount of interest the banks can ‘earn’ is entirely dependent on the demand for debt. If you can find a way to give money to everyone demanding debt in such a way that you can get your money back in some way, with some interest, then you will. Capitalist greed demands that we do everything possible to get that extra penny of profit. It doesn’t matter if your business model is that you lend money to people to buy houses, knowing they will probably be unable to pay, because you’re gambling that their house will be worth enough to cover that by the time you come to repossess it, you will do it, collect your profit and sleep sound at night. Ethical considerations are not part of a capitalist system.

That’s a lot of explaining to essentially say that the sub-prime market was good for the economy, until the housing market started to shrink instead of grow. Once houses were starting to lose value rather than gain it the system stopped working, the gamble turned sour. Our long, sustained growth period was thanks in no small part to the extra money generated by the sub-prime market. It’s just sad that the means we chose to fend off a small deflationary period will have the effect of causing a massive deflationary period. Cest la vie.

Growth isn’t sustainable. I’ve said it many times within the course of writing entries for this blog, but I feel the need to say it once again. Growth is not sustainable. No level of growth is sustainable. No level of depletion is sustainable. It’s logically obvious that both of these statements are necessarily true. Yet, our culture doesn’t accept that logic. It says that either the conclusion is wrong or that some form of technology will appear to allow us to defeat the conclusion. The amazing tech fix.

We have been lulled into believing in the tech fix because it’s worked for so long now that we can’t perceive a time when human innovation will not provide us with new and innovative ways to continue killing the planet. We even imagine such a situation – where we can’t think of a new way to continue business as usual – as horrific. It would be terrible if we had to deal with the Earth as a partner and not as a slave! Tech fixes have been possible because of easy access to cheap energy. If peak oil strips us of our easy access to cheap energy, will the tech fixes be possible? Probably not if we’ve not done wide scale, serious investment in the alternatives prior to the peak. If, as some people argue, the world has already peaked, then we’re too late. Time to ride the roller coaster.

Crunchy Crunchy

I’ve just read David Waddell’s very wise words over on his blog about whether debt is good, bad or ugly. He makes a lot of very sensible points about micro scale economics. In his example of Bob and his new sofas, for example, he’s entirely right that if Bob saved, rather than got his sofa on credit every time, he’d be able to buy more sofas in the long run. Bob doesn’t do this and the economy doesn’t encourage him to because of the very nature of our entire society. The short term is more important than the long term. Governments look no further than the next election. Businesses look no further than the next profit report. Individuals look no further than the next pay slip. There are exceptions to those rules, but generally people live pay slip to pay slip, saving and then spending their savings, putting a tiny amount into a pension and then regretting it in the long run. Businesses may have what they call a ‘long term plan’, but they’re usually only very sketchy beyond 5 years, and 5 years isn’t the long term. Governments are seen as over-stepping their legitimacy if they make too many policy decisions which run for more than their term in office. Etc, etc, etc.

Also, Waddell seems to ignore the fact that our currency is now debt. It’s not linked to anything more tangible than the debt we owe to the banks. If we stop borrowing or they stop lending then we’re in serious problems (hey… spooky). Because we can no longer be paid on demand the sum of £5 in gold, and instead are paid the sum of £5 in £s, we now need banks to keep providing easy to obtain debt and consumers to keep taking out more debt than they can easily finance. Bob may be better off if he figures out that saving will enable him to get more, or more expensive, sofas in the future, but for that to work as Bob intends it to work there needs to be enough other people who don’t realise it so the system keeps working and Bob’s money is still worth enough to buy him a sofa by the time he wants one.

He also overlooks the fact that the interest paid on loans made by the banks becomes available for re-lending. So a sea of consumers taking out loans is a good thing for lending as it generates interest which the banks can then lend out to more customers. Since the banks are able to lend many times what they actually have in reserves, and since the interest is theirs to keep, they can get a lot of money for lending from lending money.

It’s a brilliantly subtle system while it’s working. People believe the money they trade for goods and services is a unit of value. They believe it is worth something, because of that belief it is. If that belief disappears then the money they trade actually has no value at all. They can’t trade in the money at a bank for a thing which has value as a tradeable item such as gold, they can only trade in the money for different money. If they don’t accept the value of that money, where does that leave them? It’s in their best interests that they accept that the 1s and 0s in the bank’s computer which represents their wealth has value as they have no other recourse if they don’t. Belief is what holds the entire economic system together. That and the legal system deems it to be acceptable if someone will only offer to repay a debt they owe to you in the legal currency of the country you’re in, whether or not you believe in that currency’s value any more.

Waddell has a good point when it comes to the three phenomena of self-certification, 6 x mortgages and over 100% mortgages. However, once one accepts that money is debt (rather than value) and that the banks hoover up the money supply through interest payments, it becomes obvious why such things started to happen. The system needs larger and larger debts to finance the interest payments on the debt already in circulation.

There is a finite limit on what credit-worthy people can finance and are willing to finance. So they introduce self-certification to allow those who aren’t credit worthy to get into debt. Since this debt is secured against their house, which is going up in value, it doesn’t matter if they finance the debt or default, the bank makes money, the interest gets paid and the loan has created the money it needed to create for the system to work.

The banks lend money to everyone, even those who on paper can’t pay it back, and that fuels further increases in property prices, which helps the banks out because the defaulters’ homes are worth repossessing. Now, the increase in price starts to mean that people who should be able to finance a house can’t. So the bank increases the amount they will lend, because more people buying houses is good for them, both in interest payments and in house price inflation for future repossessions.

When you’re moving house there is almost always something you want to change about the house you’re moving to. Some small or not so small detail which is wrong. Now, if you’re having to give the vast majority of your pay to the bank so they’ll give you a 70 or 80% mortgage then you can’t make that change right away and may never get around to it. Many such changes will increase the value of the home, such as an extension. The bank wants your house to be worth as much as possible and so starts giving out 100% mortgages, so you can spend that 20% you’d saved on your extensions and remodelling. Lovely. However, word gets around that the banks are now giving 100% mortgages, so people stop saving that 20% and just want their house. The banks still want the house to increase in value by the addition of extentions and remodelling, so they up the percent they will loan to the borrower in the hopes that the excess will be used to increase the value of their home or buy some other retrieveable goods. If the mortgage is financed the bank gets its share. If not then its gets its share by repossession. This works so long as the price of houses is going up.

The reality is so stupid that it seems almost impossible that it would be allowed to continue. A bank shouldn’t be allowed to loan out almost $100,000 on a starting capital of only $1111.12 (part two of Money As Debt), but in effect they can. They can have $1111.12 and collect interest on almost $100,000.

The current credit crunch (God I hate that it got called that) was obviously going to happen. The system makes it inevitable. If we have the fossil fuel energy reserves left to claw our way out of the huge hole we’re in then it will happen again, unless we change the way banks and loans operate. We wont change a thing though because we like the illusion of prosperity that the system creates. We like to buy things today that we can’t afford until next year/decade. We like to have businesses able to operate despite losing £75 million in one financial year. We like these things and these things are what the system provides. There is so little real incentive to change the system that it wont be changed. I can even imagine post-crash societies which still operate this type of credit system. We’re short term animals. We like the benefits today and don’t care if it hurts tomorrow. We like it even more when the benefits are today and the pain might not be felt until after we die (see the way we treat the environment, the problems looming with peak oil and the lack of action, etc).