Monopoly money in real life (aka: "Banks")

My last blog discussed the nature of money and concurrently the "ownership" and rights to create money.  When money is created by banks and private institutions and is able to be used as a commodity, it becomes a transient and elusive.  Without the control of it's supply by a real national bank (no, not a central bank) it operates in patterns that destabilise the economy it serves (a view that is supported by the paper referenced in my last blog).  

The current method that private institutions create money is by fractional reserve banking (FRB).  This method of money creation can be described as "optimistic" at best, and more glibly, it is little more than the idea of handing out Monopoly money but for real life purchases.  FRB is basically creating money out of thin air (or electrons anyway - all this banking is done electronically now).  It is essentially wonga.com but on a global scale.  You take out a loan (from a central bank or another private institution) then spend ten times the money that you were given, and hope that in the meantime no one calls you up looking for the other 9/10ths of the money until you have made some profit from it.  Another way to imagine it is the same way that multiple credit cards and 0% balance transfers can be used to juggle debt - but the banks do this with trillions.  Feel free to look this up, it's on wikipedia. 

FRB, the housing bubble and associated mortgage backed financial instruments are the tools that made the current form of recession possible.  I won't go into detail about these  here as they are better discussed in another blog.  What I did want to explore is some proof to my last blog's assertions - a real life example of the "destabilising effect" that Monopoly money have.  

I recently came across an article in The Atlantic that had some fascinating data about the collective worth of the Eurozone banks.  I submit it as an example of the above problems with  money creation since it throws up some appalling conclusions that should not happen in a well run and believable world.

Lets us assume that common sense dictated what happens in the world.  If we were to imagine then, the worth of the banking sector of the Eurozone, we would imagine something pretty substantial.  After all, the Eurozone is one of the largest economic blocs in the world.  If were to continue this thought experiment and compare the Eurozone's to other financial markets around the world, we would assume that intuition would give us some sensible ideas as to how they would stack up.  So when the article asks, would you believe that the Eurozone's financial sector is smaller than Australia's, most of us would say; "No, I don't believe it."

What?  Really?!

Well, there it is.  I am actually quite stunned by all this.  I find it terrible and obvious that this roller-coaster-like image of global finances is largely caused by the "virtual" Monopoly money that is ubiquitous in our economies.  It is even more terrible to understand that this small graph is a representation of the actual economic turbulence that is making life miserable for millions of people in around the world.  

I don't like recessions.  I don't like banks acting like gambling addicts.  I don't like rich institutions having access to powers that they cannot use responsibly, and I definitely don't like to see graphs like this one.  A graph that shows the result of this recklessness in crazy, reality-bending clarity.

Who's money is it anyway?

Some of you may be aware that there has been a bit of commotion in the world economy in the last few years.  It has largely been downplayed by the people responsible.  As for the rest of us, it has ended up with us feeling poor and probably unable to buy a house, no matter how small, squalid or secluded it is.  OK, so even if you have been living under a rock, since you can't afford rent or to buy a house, you will know of the recent financial problems.  A number of terms have been used, interchangeably or relating to specific aspects to the problem; credit crunch, recession, global economic downturn and even Great Recession - mirroring the name of the Great Depression in the 1930s.  

The last name became somewhat poignant since I  came across a fascinating research paper by Jaromir Benes and Michael Kumhof.  Titled "The Chicago Plan Revisited" it is available through the IMF website as a free to view PDF.  They explore the causes of the recent problem - the fact that we still have no idea what money is and who should give it out; the state or private institutions.  I say that we have no idea what money is - we really don't.  People intuitively understand the way money is used in every day life - I give the newsagent £1 and he gives me some Haribo.  

But, what money actually is and how it is defined has proven illusive for the entire of human history.  These underlying issues have been found to have caused financial instability in ancient economies as far back as 5000 years ago in Mesopotamia (the place we bombed for most of the 2000's).  So much for people learning from their mistakes.  Currently money is a commodity that can be bought as debt from central banks by private banks and can then be traded in of itself or for other commodities.  An alternative model is that money is a pure exchange medium that is controlled and priced solely by the state for the benefit of the economy.  

What does a "pure exchange" medium, controlled by the state, actually mean?  It means that money is created by the state for the purpose of exchange of tangible goods and assets.  It means that banks can no longer generate profits by exploiting loopholes in the calculations of global stock markets.  It means that your money will never "evaporate" from banks as the money in circulation would be linked to state backing.  It means that banks can no longer bet on the economy the way a gambling addict bets on horses because they no longer have the ability to generate "vitrual" money endogenously using fractional reserve banking.  Fractional reserve banking is another way of saying that a bank lends out 10 times more money that it actually has so that it can maximise its profits at the risk of catastrophic cash-flow shortage.  Basically writing cheques that will bounce - and hoping they don't get cashed in too soon to avoid them bouncing.

This would have profound implications for the way that banks operate.  By effectively taking control of the money supply away from private banks the "Chicago Model" envisages that the boom-bust cycle would be eliminated.  It would also eliminate the naked profiteering and consolidation of wealth that occurs in these cycles - as happened in the 1930s crisis.  Great, sounds brilliant - so why has it not happened yet?  Well, it turns out such a system has been used before, many time.  It became so ingrained in the ancient societies around Mesopotamia that it was included in their religions.  Aristotle even wrote about the subject in Ethics; “Money exists not by nature but by law".

The benefits of a system where the state controls the money supply can be seen in the history of the UK.  Before the introduction of the Free Coinage Act (allowing private institutions to create money supply) the incidence of boom-bust cycles was unprecedented.  Since its passing, however, it is estimated that there has not been longer than 25 years - a generation - between these upheavals.  

Sadly, since such a system is not conducive to the wealthy getting wealthier, in countries where it has been the status quo, there has usually been the concerted push from the plutocracy to move away from it.  Even though the authors of the paper go to length to model the benefits of this system and even propose a plan for transition from the current system, it would be optimistic to presume that there would be a change.  While there are ongoing problems in the  world economy, one thing that is the same is the self-interest of banks with much to lose.  Power as great as the ability to create money, is hard to let go of.

Link to the paper: http://www.imf.org/external/pubs/ft/wp/2012/wp12202.pdf

Jaromir Benes and Michael Kumhof, The Chicago Plan Revisited