The next economic crisis: financial or real?

A few people are prepping themselves for the next economic crisis and speculating about what will cause it.  This blogger thinks there are several possible causes.  It is about 99.99 per cent certain there will be another crisis.

Even if somebody does make an accurate prediction it will probably do no good because there are so many vested interests there will be no consensus about the cause and about what to do to prevent it.  However, for some of us there is some fun in trying to think out economic problems and we might be able to improve our understanding of economics.  So, here goes.

The possibilities are for the cause to be within the financial system or for the cause to be within the physical or real side of the economy.  As the two are interconnected it may be difficult to determine just what is happening.

Problems within the financial system relate to money. Either there is too much money or not enough.  Ideally the available money supply needs to be just right for the quantity of goods and services exchanged and as this varies it needs to be flexible.  When there is too much money available there is potential for inflation and this is a problem for people with invested savings as they lose some of their purchasing power.  Deflation is a problem for lenders as the money they have loaned out will have less purchasing power when it is returned, if it is returned.

The really serious problem comes when there is not enough money as this curtails economic activity.  Most of the money supply is based on loans made by the financial industry and involves a multiplier.  When the industry has to write off a large quantity of loans, as with the recent subprime housing crisis, the money supply goes down, again with a multiplier effect.  Without money the exchange of goods and services becomes difficult and lots of people lose their jobs. Big time suffering.

Currently it appears there is lots of money floating around the economy.  Lots of firms are reported to have piles of cash on hand and are probably unable to see investment opportunities.

On the real side of the economy, many people assume there are lots of energy and mineral resources available and therefore no physical restraints on the exchange of goods and services.   This may not be true.

A common argument is that as resources are consumed higher prices will bring on a greater supply which happened with oil and lots of minerals.  The problem is that they also require more energy to extract which reduces the energy available for other activities and at some point the value of the energy exceeds the value of the resources.  This blogger figures there are lots of energy and mineral resources available on the earth’s crust,  but the cost of getting them makes them useless.  This could be changed by technology and the decreasing cost of solar energy will make the high cost of oil irrelevant.

Children, workings in a vegetable garden.

However there may be some economic  disruptions in the transition.  How much oil infrastructure will have to be written of and what would that do to the money supply? Also there are all the other minerals for which there are no clear cheap substitutes.

This guy fears the greatest threat to our economic well-being is from resource restrictions on the physical side of the economy.  An even greater threat is that too many people will not see the problem because they analyse problems only in financial terms and will be looking for solutions on the financial side.  Changes in how much money is available or even in the way in which we create money will not add to the resource base or make it cheaper to extract them.

I fear for the future of my grandchildren.

 

 

 

Why debt is a huge problem

Generally accepted wisdom tells us that excessive debt is a serious problem although some people question why government debt to a central bank is problematic. After all what is wrong with one government agency owing money to another?  Why not just let the debt build up?

In this case the generally accepted wisdom is probably correct because debt is an important part of our money supply.   If we were to lose our money supply our economy would be in big trouble.

Money is a complex part of our economy and I suspect few people, including a lot of economists, really understand how it works.  Fractional reserve banking is complex but I have found it relative easy to understand.  I have explained it in the essay  LETS go to market: Dealing with the financial crisis on this weblog and there are numerous explanations that can be found with any search engine.  I encourage you to figure it out.

About 90 per cent of our money supply is based on the debt created in fractional reserve banking. This is a problem for three reasons.

The first is that the money supply needs to be flexible up and down.  The amount of money we need to facilitate the exchange of goods and services must be proportional to the quantity of goods and services we need to exchange.  I know economists like to model the economy on a least squares regression formula which gives an upwards line with a steady slope.  However, the reality is that the economy behaves like a fractal which means there are a series of ups and downs and more ups and downs within each trend. The amount of money needed varies with each up and down but fractional reserve money can only keep on increasing.  This sort of works when there is continuous economic growth but if growth slows or reverses, then there are problems.

The second problem with fractional reserve banking is that interest is charged on the debt created. This adds a purely financial demand for more money in that it is not needed for exchange of goods and services.  If all outstanding debts plus interest had to be repaid at the same time there would not be enough money in the economy. From time to time this feature of fractional reserve banking catches up with us and we call it a financial crisis.

The third problem is that when there is a financial crisis lots of people lose their savings.  The need to save for a rainy day, or retirement, is a part of our psyche and fully exploited by the marketing arm of the financial industry but there are three ways in which we can lose our savings: a financial crises, inflation or a major economic downturn. these are more likely when the economy is not growing or declining. With the current economic climate most of us would probably be better off to live for today and worry about tomorrow when that day comes.  The best way to secure one’s future is probably a market garden.

These are real problems and from time to time they cause havoc in the lives of most of us.  Therefore we are right to worry about excessive debt.  The good news is that there are other ways of creating money and the bad news is that money is such an emotional concept that most people are not prepared to consider other ideas.

One of the other ways of creating money is discussed in my ebook Funny Money: Adapting to a down economy which is available free from the link at the top of this weblog.

We tend to take money for granted so long as the economy is working but it is such an important concept that we would do well to try to understand it and make changes.  I cannot see that happening so in the meantime we should remember the advise of Shakespeare: Neither a lender nor a borrower be.

 

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.

Let this time be not different

Please, let this time be not different.  Please let this recovery be the similar to all the previous recoveries.

I have just finished reading This time is different by Carmen M. Reinhart and Kenneth S. Rogoff.  They bring together statistical data on all the world’s known debt and banking crises and look for patterns that precede them.  Their title comes from people saying during each boom that there will not be another crisis because we now have knowledge and experience from previous crises and  “this time will be different.”

Following each crisis there has been recovery in which the economy has grown to a new high. For the sake of all the people who are suffering from the current crisis it would be good if this time is not different and we could have a full normal recovery.  It would be even better for the planet and our long-term well-being  if we could adapt our economy so that people would not suffer from zero or negative economic growth.

One of the things which is different for this recovery  is that the marginal cost of extracting energy, mineral and agriculture resources has increased.  We have used up the most easily available of these resources and those that are left take a lot more work to extract.  This is bound to limit the potential for further economic growth.  We should beware of believing economic growth can continue forever.

I think there is an element of truth in the Elliott Wave Theory which applies to economics as well as the stock market. This theory says ups and downs run in series of fives and after the fifth the overall trend reverses.  Within each up and down there are series within a series.  I don’t  know about the fives but I believe the economy is fractal in nature and that there can be major turning points.  We should not rule out the possibility that we have passed a major turning point and that for some time to come we will have a series of downs and ups with each down going even lower.

As I read this book I wondered how the crises impacted people’s lives.  How serious was the unemployment?  How did people cope with unemployment?  Who were the people who lost their savings from defaults or inflation and how did they cope?  Did some of the one percent find themselves joining the poor?

In the current crisis, the headlines indicate young people are being hit hard and are the lost generation.  Meanwhile the cruise ships are packed with older people planning their next cruise.

It could be that during an economic boom we have a psychological need for economists to be telling us the boom will not end in a crisis.  Then we can work hard to prepare for retirement and to provide short-term profits for people in the financial industry.   We want to hide from ourselves the possibility we will lose the benefits of our hard work to defaults, haircuts or inflation.

As I was reading about all the financial crises I was saying “why oh why oh why would anyone want to put effort into the financial industry when there is such a high probability we will lose a lot of our savings?”  But then I have never been much for ambition.

It takes a crisis to encourage a new way of creating money

Local Exchange Trading Systems have been around for some time but it appears it takes a financial crisis to bring them into their own.

Here are some links to news reports about the TEM currency being used in parts of Greece to replace the Euro. One,   two,   three.

So far as I can see the TEM is a LETS under a different name, maybe because of the different language.

I very much like the concept because it is a different way to create money.  It does not involve banks and loans and interest rates all of which are problems with the way our economy currently creates money.

It is sad that it takes a large-scale crisis to encourage this type of money system.  It is also sad in that the local scale limits it use and restricts the exchange of goods and services to just people in a local district.  To be really useful it needs to be expanded to a national level.

The development of the TEM illustrates that while a financial crisis can cause a lot of human suffering it is not the end of the world.  Recovery is possible.  I wish we could say the same about the other aspect of the current crisis – the depletion of the most easily accessible energy and mineral resources.

 

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.

A credit/money bubble and the financial crisis

The Buttonwood column in this week’s Economist discussed a book by Richard Duncan which proposes a quantity theory of credit and suggests the current financial crisis results from the collapse of a credit bubble

That Mr. Duncan would talk of a “credit bubble that would end in collapse” is surely a step towards understanding financial crises.

I am not sure there should be a distinction between credit and money because money is created when bankers make loans. As there is a fractional reserve system involved the bulk of our money supply is credit.  Thus the quantity theory of money and the quantity theory of credit are basically the same thing.

We could just as easily say the money bubble ended in collapse.

A further complication is that all this credit/money involves interest charged on those loans.

I am not aware of any economist who has tried to think out the implications of charging interest on the loans that make up the money supply but I suspect it is a big problem.  It seems to be something like a Ponzi scheme and Ponzi schemes eventually collapse.

A more detailed look the problems of money creation  is a part of the essay “LETS go to market: Dealing with the economic  crisis” on this weblog.

 

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.

Responsitibilty for the financial crisis

A news report suggests there will never be any criminal prosecutions from the financial crisis.

This is because we are all to blame.

We all want/have wanted the highest possible returns on our investments and pension funds and the people higher up the line have taken advantage of our own greed to line their own pockets.

I suspect that a lot of what happens in courts has more to do with revenge and scapegoats than it does with justice.

LETS go to market: Dealing with the economic crisis

A 4000-word essay titled “LETS go to market: Dealing with the economic crisis”  has been added as a page to this web log.  Some of the ideas in this essay have not (yet) been presented in the web log.

The ideas in this article are outside mainstream economic analysis but I believed they are mostly based on the economics I learned as a student at the University of British Columbia.

We look at the formula from the quantity theory of money which I prefer to call the connectivity       formula  because it shows how the real part of the economy connects with  the financial.   There have been many ups and downs in the Q part of this formula.  These changes have impacted previous economic crisis.  The underlying cause of the current crisis is probably the unsustainable use of resources.

Three ways of creating money are considered  (gold, fractional  reserve and Local Exchange trading system [LETS]) and the advantages and disadvantages of each. If there is anything that should be considered funny money it is fractional reserve money.  Therefore I suggest we expand LETS into  a National Exchange Trading System.(NETS)

Such a radical change in our financial organization would be an opportune time to make other changes on our economic organization.  I would like to see the perfect competition model  used as a guideline.

I believe subsidies should be given to consumers rather than producers therefore I propose that transfer payments and subsidies should be replaced with a universal subsistence program.

You can read the essay here.

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.

The Euro zone’s impossible dilemma

Some economist are worried that attempts to deal with the euro zone crisis are going to force Europe into a recession.  Here’s a link to one such forecast.

It’s a valid fear but one that applies to the whole planet rather than just Europe.  The probable cause of a world-wide recession is that we are using resources at a rate which is not sustainable.

If this is true then policy makers face an impossible dilemma.

Policies which lead to recession will hurt a lot of people and especially the poor.  In this case the line between rich and poor will likely be quite high.

The conventional wisdom is that to deal with a recession governments should spend to stimulate the economy even if they have to go massively into debt.

Stimulating the economy when there is resource depletion is going to deplete resources even faster and will bring forward a major crash.

A further complication is that the Euro zone financial crisis will likely lead to a sharp reduction in the money supply.  Without money the exchange of goods and services will be curtailed.

Resource depletion combined with a loss of money supply has the potential to be disastrous.  But it should leave a few resources for the survivors.

Do financial crises really cause a drop in output?

The following was posted inThe Economist comments  to an artice “Lessons of the 1930s” in the December 10, 2011 edition.

“As in 1931 and 2008, a grave financial crisis may cause a large drop in output.”

This short sentence in this article reflects what appears to be conventional economic wisdom and  needs to be challenged because it could be that a drop in output causes financial crises.  Or it could be that one feeds the other.

During the 1930s America experienced its most severe ever drought and there may have been other problems in the physical side of the economy. Most of us are too old to remember.

Today there are people who claim we are using resources at a rate that is 150 percent of the sustainable rate.  If that is so, or even partly so, it is not surprising we are in an economic crisis.

If it is true that current problems are because our use of resources is unsustainable, then quite different policies are required.

The biggest news story of the year

The Huffington Post asks what is the biggest Canadian news story of the year.  Here is my answer:

http://www.huffingtonpost.ca/2011/12/05/what-was-canadas-biggest-news-story-2011_n_1116964.html?ref=canada

The biggest news story of the year is the economic crisis which is being felt around the world.  It has been reflected in and overwhelming number of headlines.

The probable cause of the crisis is a depletion of resources.  Some people figure we are using resources at a rate that is 150 percent of a sustainable level.  This is showing up as a financial crisis.

A further problem is that as a financial crisis it threatens to wipe out a major chunk of the money supply as banks create money when they make loans.  This will further restrict our ability to exchange goods and services.

A lot of economists want to deal with the crisis with government stimulus spending.  However, if resource depletion is the root problem, then increasing our economic activity will make the crisis even worse.  The answer is to try to even out the pain of austerity.

(The author of this comment has a web log on economics at https://economics102.wordpress.com/)

Crises, referendums and impossible questions

Leaders don’t always speak for the people they claim to represent.  Therefore the Greek referendum may be a good idea.

The question is can the financial crisis which is threatening a number of countries around the world be resolved.  One doesn’t want to be defeatist but if we really are using resources at 150 per cent of the sustainable rate, then there is bound to be some serious economic problems.  Is it realistic to think we can beat the odds?

If we can’t beat the odds, should we then be looking at an orderly wind down in the hope we can minimize the human suffering?

Some times there are no answers.

Bitcoin: an attempt at a new way of creating money

Bitcoin, an attempt to establish a new “peer-to-peer” virtual currency is described in an article in The Economist of June 16, 2011.

One can accept the need to search for new ways of creating money. I believe the recent financial crisis was in part a failure in the way in which our economy currently creates money. (Money is created when bankers make loans, subject to a multiplier effect from the requirement to maintain reserves. When a whole lot of loans went bad this decreased the money supply, again with a multiplier effect. With a suddenly decreased money supply, the economy went for a loop.)

One of the problems with the bitcoin system is the quantity of money available is strictly controlled according to a formula.

I have always liked the quantity theory of money which states that MV=PQ where M is the money supply, V is the velocity at which it changes hands, P is the price or price index and Q is the quantity of goods and services produced.. Therefore as Q goes up (or down) there also need to be changes in at least one of the others. If we want prices to remain constant, then we need a way of creating money such that the supply can easily be varied according to the quantity of goods and service produced.

Dangerous debt

I came across this article from the Guardian about the U.S. spend or cut debate shortly after I started reading This Time is Different: Eight Centuries of Financial Folly by Carmen M. Reinhart and Kenneth S. Rogoff.  The article reports Paul Krugman is urging  the Obama administration to go with a trillion dollars of stimulus.

In the book the second paragraph of the preface talks of excessive debt accumulation.  Granted that the authors are talking about dept during a boom, but if that is a problem what is it during a  recession.

If there is one common theme to the vast range or crises we consider in this book, it is that excessive debt accumulation, whether it be by the government, banks, corporations or consumers, often poses greater systemic risk that it seems during a boom.  Infusions of cash can make a government look like it is providing greater growth to its economy that it really is. Private sector borrowing binges can inflate housing and stock prices far beyond their long-run sustainable levels, and make banks seem more stable and profitable they really are.  Such large-scale debt buildups pose risks because they make an economy vulnerable to crises of confidence, particularly when debt is short  term and needs to  be constantly refinanced.  Debt-fueled booms all too often provide  false affirmation of a government’s policies, a financial institution’s ability to make outsized profits, or a country’s standard of living.  Most of these booms end badly. Of course, debt instruments are crucial to all economies, ancient and modern, but balancing the risk and opportunities of debt is always a challenge, a challenge policy makers, investors, and ordinary citizens must never forget

My own reasons for objecting to stimulus spending is stated in the post Economic policy, least squares and the Elliott wave

The financial crisis, banks and money creation

Throughout the financial crisis I have seen nothing about the role of banks in creating our money supply. It is a very simple process yet many people who work for banks can’t believe it yet alone everyone else. (Google money creation and you will get numerous explanations including this one from Wikipedia http://en.wikipedia.org/wiki/Money_creation

The important thing is that when banks make a loan they are creating money. Because banks are required to keep a small percentage of deposits on reserve (the fractional reserve system) when new money is added to the banking system the money creation is multiplied depending upon the reserve requirement. Central banks add new money to the system usually by buying government bonds.

All this means that banks are an essential part of our exchange of goods and services. Without them there would be no economy. It is not that some banks are too big to fail, it is that banks are too important to fail.

There has been a lot of talk recently about the power and the evil of bankers and attempts to increase regulation of the industry. It is clear that bankers are extremely powerful people and some are probably evil to varying degrees. However, I cannot see how we can hope to discuss, evaluate and even reform the banks if we don’t recognize and take into account their role in money creation.

I would also suggest there may be other ways of creating money but that is so radical as to be treasonous.

%d bloggers like this: