What caused the financial collapse?

Here are four causes of the financial crisis not based on conventional economic wisdom:  the way in which we our economy creates money, the using up of the most accessible energy and mineral resources, the greed of most of us and imprudent or fraudulent banking practices which allow bankers to make excessive profits.

For a more conventional explanation see this article in The Economist.

We all use money and many people are very good at “making” money but very few understand its function and how it is created.  As gold and other items have traditionally been used as money we treat it as a commodity with some value of its own.  But money is a tool to facilitate the exchange of goods and services.  It is a token of purchasing power.  It is important that we have just the right amount of money to use otherwise we have inflation (too much money for the transactions we want) or deflation (not enough).

The money we use results from fractional reserve banking in which banks are required to keep a percentage of their deposits as reserves.  How this works is explained in the essay “LETS go to market: Dealing with the crisis” on this weblog.  It is complex but I find it  easy to understand.

Our money supply is based on loans made by banks and upon which they charge interest. For this system to work there must be a continuously increasing supply of money which sort of works so long as the economy is growing.  However, even a slowdown can cause problems because we need the right amount of money for the number of economic transactions.   I think this is a Ponzi scheme and therefore it is bound to collapse.  Periodic financial crises are built into the way we create money.  This is one of the causes of the current crisis.  When the U.S. mortgage bubble burst the money supply and the financial system collapsed.

There are two sides to the economic equation.  One side deals with the financial and the other with the physical goods that provide us with food, shelter, clothing. transportation and toys.

Since the industrial revolution we have been living in unprecedented increasing prosperity.  However there is some evidence that since the 1970s the growth of this prosperity has been slowing down and maybe even declining.  My theory to explain this is that we have used up the most easily accessible of the energy and mineral resources and it now takes more energy to recover what is left.  To use jargon, the marginal costs have increased.  This is bound to affect standards of living as more effort must be applied to resource extraction and less to other things.  This is background to the financial crisis.

Wall Street bankers are the kings of greed who got their riches partly be being in the right place at the right time.  They also make good scapegoats.

A scapegoat is somebody you blame for the consequences of your own weaknesses.  Most if not all of us have some greed and this was a factor in the financial crisis.  Before and since the crisis many people wanted the most they could get.  This includes the savers and investors who wanted the greatest returns to the poorer people who wanted housing they couldn’t afford.  Every time I go to the ATM machine or actually enter the bank I am reminded the financial industry is still appealing to the greed of its customers.

The final cause of the financial crisis is that bankers are smart enough to realize they can increase their margins and make huge profits by mismatching the terms of deposits and loans.  At the best this is imprudent.  It could even be fraud.

Bankers are financial intermediaries in that they collect deposits and make them into loans.  The difference in interest rates provide a margin which covers their expenses and provides some profits.  Prudent banking requires that the terms of the deposits and loans match.  Thus if a banker makes a loan for ten years then he should have on hand ten-year term deposits of the same amount.  Breaking this rule can be very dangerous and very profitable.

The reason for breaking the rule is that the longer the loan the greater the risk and therefore the higher the interest rate which will be charged on the loan and which must be paid to get deposits committed for the same time. A banker who finances a long-term loan with short-term deposits can increase his margin.  Prior to the financial crisis the banks were financing long-term mortgage loans with short-term deposits, some of the deposits were committed just for one day at a time.  This worked well when the economy was going well but when it became apparent there were problems the depositors became worried about their money and refused to roll them over.  As banks are required to only keep a fraction of their deposits on hand there was a limited number of depositors who could be refunded.

I think this should be considered fraud against the depositors or in this case the taxpayers who covered the losses.  It was necessary for the government to step in  because we would have lost even more of our money supply and that would have been disastrous.  The question which probably should not be asked: are bankers continuing to mismatch deposits and loans?

So there you have it, my list of four factors which contributed to the crisis.  All of these will be challenging to change.  Some ideas for change are in my essay “LETS go to market: Dealing with the economic crisis.”

 

If you liked this post your are invited to comment, press the like button and/or click  one of the share buttons. If you disagree you are invited to say why in a comment.  While I like the idea of sharing this platform, my personality is such that I don’t reply to many comments.

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