Why Are We Captive To Wall Street?


The  other day a colleague told me that his chooks are still laying eggs. They don’t care about the financial markets, they just get on with chook business as usual.

There’s a key question hiding in this remark that ordinary people with average levels of financial understanding are asking themselves. Why can’t we just get on with our daily business as usual? Why are the stupidities of some Wall Street cowboys threatening to bring the world’s routine daily business to a halt?

Certainly the answer involves greed, some naughty CEOs, a lot of stupid people who bought impenetrable junk mortgage packages, deregulation, people who gambled with lots of other people’s money, irrational exuberance, fear, panic and all the rest of the diagnoses being tossed around. But those factors still don’t explain why the whole innocently bystanding world is suddenly threatened with a depression.

Hardly anybody is talking about the big magnifying destabiliser at the core of our economic system. Whatever trend is happening, it will magnify it. Worse, it will ensure that trends in so-called investment markets will spill over into daily business, so if the investment markets crash, Main Street burns too.

The magnifier is called fractional reserve banking. Banks must have in their “reserve” funds at least, say, 10 per cent of the amount that they have loaned
out. That’s to cover the needs of people who want to withdraw their deposits in the course of normal business. That sounds sensible, but the flip side of it is that banks can loan out ten times as much money as they have.

How can banks loan out more money than they have? By creating new money out of nothing. That’s right, Virginia, out of nothing. That’s where most of our money comes from.

When times are good the fractional reserve magnifier can cause the amount of money in circulation to keep expanding under its own impetus. For example, loans to buy houses can generate more deposits, more loans and more money to bid up the price of houses, and you get a housing-price bubble. Sound familiar?

The big danger in the fractional reserve system is that if a bank’s loans go bad it may have to dip into its reserves to cover losses, and that means trouble. For every dollar of reserves it uses, it has to reduce its loans by $10. That’s the magnifier at work. It means other borrowers may suffer. It also means there will be a sudden drop in the amount of money in circulation, and that’s the part that may hurt you and me.

If levels of debt have outrun the ability of the real, productive economy to generate wealth, then any bad loan may trigger a chain reaction. The failure of
a big loan may cascade into the failure of many more. If enough loans go bad a bank may fail. Because banks rely on huge loans from each other to stay solvent, if one bank fails, other banks are put at risk. The conflagration spreads.

In the Great Depression the financial markets collapsed, the money supply shrank and prices fell (that’s deflation – if you want to really scare an economist, sneak up behind him or her and whisper “Deflation..”). As prices fell, anyone who had money hoarded it, so even less was in circulation and the plunge steepened. Confidence collapsed, businesses failed, all the other destabilisers in our pathological economic system switched into reverse and brought everything crashing down with them.

A sensible economic system would have mechanisms that acted against fear, stupidity and bad luck. In other words the system would be designed to be
stable in presence of our human foibles, instead of magnifying their effects.

I suspect most economists don’t understand this concept. Engineers and physicists understand that dynamical systems are destabilised by positive feedbacks and stabilised by negative feedbacks, but the neoclassical theory is about equilibrium. It cultivates a static view of the world. Economists don’t seem to have such dynamical concepts in their mental armoury.

In 1932 a small town in Austria issued a different kind of money. You had to put a four-cent stamp on each dollar every month for it to keep its value. In effect its value steadily shrank. Sounds crazy, but it circulated 12 times faster than the national currency because of course no-one wanted to be holding much at the end of the month. People even paid their local taxes ahead of schedule.

Because it circulated rapidly, the shrinking money facilitated a lot of exchange, and that was what people desperately needed in the depth of the Depression. Worldwide, there was plenty of work to be done, and plenty of people wanting to do the work. What they lacked was enough reliable currency to facilitate the exchanges involved. After a year the town lifted itself out of depression and was attracting a lot of attention, until the Austrian central bank outlawed the shrinking money.

For some reason economists regard this as a very disreputable subject. They don’t want to hear about it, they don’t want to look at it, they don’t want to be seen anywhere near it. It’s true there were some rabble-rousing campaigners for monetary reform in the 1930s, but I suspect economists are just afraid of what they might see if they look. They might find some of their most cherished beliefs challenged.

A great virtue of such shrinking money is that its supply is stable and independent of the investment process. It doesn’t depend on the fractional reserve
multiplier to supply money, nor risk the collapse of the money supply if investments fail.

You might be thinking investment would not be possible in such a system because no-one would ever save. But saving can be achieved by buying things of real present value. When you want to invest you can convert those things back into money as you need it to build your factory or whatever.

In its mythical form, capitalism is supposed to invest surplus wealth in new wealth-generating enterprises, but our present system doesn’t run on savings,
it runs on borrowings. Increasingly the borrowings are not from other peoples’ savings, but from the future, because that’s what you’re doing when you create new money. That’s why we’re drowning in debt.

Instead of saving from the past and giving a gift to the future (that’s us and our children), we borrow from the future, incur great risks, and threaten our
children with ruin. A savings-based system avoids the instability of borrowing from the future. Funds that are used at present to pay off debt would flow into savings instead.

Under such a system you could still borrow from the future (as you do when you use unsecured credit with your credit card), but such borrowing should be tightly controlled, restricted to situations where it’s really needed (such as poor countries) and carefully insured by asset-rich insurance companies.

Perhaps the chooks aren’t so stupid. They get on with the business of producing real wealth (eggs) instead of playing clever and deceitful games with pieces of paper and blips in computers.

Geoff Davies

Dr. Geoff Davies is a scientist, author and commentator. He has been exploring economics for the past fifteen years or so. He is a retired Senior Fellow (now a Visiting Fellow) in geophysics at the Australian National University. He blogs at http://betternature.wordpress.com/, and at http://sacktheeconomists.com. He is the author of Economia: New economic systems to Empower People and Support the Living World (ABC Books, Sydney, 2004), the eBook The Nature of the Beast: How economists mistook wild horses for a rocking chair (self published, 2012), and the eBook Sack the Economists and Disband Their Departments (BWM Books, 2013).