Rrrr…umm no, maybe just Evolution is coming

From the middle of the 2008 financial crisis, there have been a lot of talks about debt, money, financial stability, macro prudential policies and so on.

In October 2008 the World was on the edge of the abyss. Banks almost bankrupted, prices were falling hard, unemployment skyrocketed, stocks and corporate bond prices were crashing. Then a few months later, in March 2009, the Fed launched its first round of quantitative easing. In April, the Financial Accounting Standards Board allowed banks to make their own estimate of their assets regardless of current market prices. Finally, the newly elected Obama government embarked on a massive spending program.

Six years down the road, after roughly 8 trillion spent by Washington and more than 4 trillion of the Fed’s balance sheet expansion, the US economy seems at best stalling, at worst contracting.

As we outlined in "A thousand blue bubbles", politicians and central bankers do not always take demography and debt into consideration. As a result, the next US recession could also mark the starting point of the worst financial crisis from the infamous Great Depression of 1929-1932, as neither Washington nor the Fed have any more solutions left to offer. This is an important point to understand, since billions of people risk being caught in a downward financial spiral that historically has led to consequences as drastic as war.

As Nobel Prize Winner Robert Schiller recently said: “"Unlike 1929, this time everything-- stocks, bonds and housing --is overvalued". The good news is that forcing people to think about financial systems and money also opens new perspectives. It makes us realize that if a solution is not possible within the current system, it can become realistic simply by changing some parameters and moving towards something new without necessarily a big bang.

What is money?
In order to fully understand what is happening, we need to understand what “money” really is. Money, as we know it, is only a medium of exchange. It may shock some to know that money has nothing, absolutely nothing, attached as an intrinsic value. Its only value lies in one’s trust in the bank if one keeps money in a bank account, or in the government’s ability to collect taxes to face its obligations –if money is kept in the form of a bank note. And of course, money can be used as a unit of measure.

There was a time when money was backed by gold and/or silver and hence there was an intrinsic value attached to it, but this has not been the case for several decades now. Still, we are told that money is a form of “savings”, which it only is if one has it in its physical form during a deflationary bust.

In essence money is “Trust”. With “trust” in both governments and banks decreasing every day, we wonder if and when the point of no return will be reached, and what will happen then.

How is Money created?
From nothing. Money is created when a commercial bank gives a loan to a business or to a person. Central Banks do not create most money, except for coins and banknotes, which represent less than 10% of the global stock of money. Commercial banks do not even lend out deposits, since they do not need it. They do not lend out other people's money, nor legal reserves. They simply create, by the “magic” of double accounting, both a loan and a new deposit. So, money is literally created from thin air, or to be more precise, in today's terms by pushing ENTER on an accounting entry. This point has tremendous implications. The Bank of England makes this quite clear in their 2014 report.

Some historical perspective
Before 1933, and for more than six centuries, money was at least formally backed by gold and/or silver. What we have seen over centuries is that, in reality, bankers loaned much more than the gold and silver they had in their vaults, creating “debt bubbles”, resulting in financial crisis, economic turmoil, wars and social unrest.

It was the case for example in Florence, and some years later in Venice. Between 1340 and 1350, King Edward III partially defaulted on his “war bonds”, exposing the holes in the biggest banks of the world at the time—the equivalent of today’s Wall Street and Federal Reserve.

The motivation for both the Florentine and Venetian bankers to loan more than they had in their vaults in gold and silver is pretty clear: they were able to “subtract” big profits from the real economy from thin air, thanks to interest rates on lending, at least while they were considered solvent. Thus, Fractional Reserve Banking, the practice of lending without deposit, was born.

That financial crisis was so intense that it resulted in a decimation of worldwide population of nearly one third between 1350 and 1450. Of course, the factors behind a full century of wars, starvation and epidemics like the black death, were multiple. But it cannot be denied that the financial crisis of Florence and Venice played its part (for more information, see the Schiller Institute's explanation).

By comparison, the German Hyperinflation of 1922 and Great Depression of 1929-1933, which resulted in the Second World War, were merely minor financial blips. One might echo the phrase“Nihil novi sub sole”, or there is nothing new under the sun .

This is, very succinctly, how a supposedly commodity-backed currency system led the western world for more than six centuries, from war to war, bubble to bubble, and through boom and bust cycles.

From the Gold standard to our “Modern” financial system
The consequence of linking money to a commodity was that if a bank lent money to a business or to a person, it was, at least theoretically, obliged to put aside the equivalent to cover that loan in gold and/or silver. Hence, its ability to invest would have been negatively impacted. In other words, in a commodity-backed currency system, the loan originator needs compensation on top of the credit and inflation risk. This is known as the opportunity cost because credit ability is constrained by the quantity of gold owned. Then, assuming that the amount of money lent is really covered by gold or silver, the opportunity cost in such a system is justified.

But as we collectively lived under such a commodity currency system for several centuries, when this system effectively ceased in 1933 under President Roosevelt, nobody noticed this “tiny” accounting flaw. Suddenly, commercial banks were allowed to issue credit without any constraint. Under this new system of credit money, the opportunity cost should have disappeared, since it ceased to exist. However, thanks to direct competition from Central Banks who continued to pay the opportunity cost to their depositors, this same cost was then pushed upon both private and public debtors. In other words, when the link between money and gold or silver was broken, currencies were no longer covered by any intrinsic value. Yet credit continued to be affected by an inexistent opportunity cost.

The biggest beneficiaries of this new status were, more than banks themselves, the largest depositors keeping large balances of cash in their bank accounts, and hence receiving undue interest on such balances. This opportunity cost can in essence be associated with the central bank’s rate as it represents the biggest portion of interest. In the case of the US, the Fed Fund Rate averaged 5.11% from 1954 to 2014. Taking all of that information into account, the Fed gives us a perfect example of compound interest (interest on interest). 5.11% over a sixty year period result in an astounding 1,899%, or nearly 20 times the initial capital.

What does all that mean?
It means that the “owners” of large sums of money over that period were able to make gains which were almost twice the ones made by small and mid-level entrepreneurs, who were forced to borrow in order to launch their businesses. This is why we have seen Small and Medium Enterprises (SMEs) disappear, and with them, little by little, the Schumpeterian “Entrepreneur”.

This also means that governments and households have paid large sums of undue interest. The whole process contributed to the concentration of wealth in the hands of a small group of people. In the case of governments, due to being over-indebted, one consequence is a higher level of taxation than that which would have been the case otherwise. Not to mention the unnecessary burden put on emerging and even poorer countries, who had to pay astronomical amounts of interests for having the privilege of being indebted in dollars, pounds or euro. China is the second largest economy in the world, and yet it still has less power inside the IMF than France.

It begs the question: how would it be possible otherwise, that 85 people have more wealth than the poorest 3.5 BILLION of the poorest? This may also explain why our economies are forced to grow at a rate that is at least equal to that paid in interest, just to keep the metaphorical boat afloat.

What does that mean for us today?
Now that we understand where money comes from, let’s fast forward to 2015. We are able to study and compare matter and antimatter, explore Mars, modify DNA, live longer and better, produce cars that run on electricity alone, safely produce and store hydrogen…and yet we still struggle under a six-century-old monetary system. We are told that all of these achievements were possible because of the capitalistic structure of the past two centuries. This may be partly true, but today, monopolies and big corporations are more of a brake on innovation than drivers of it.

Corporations are so big and powerful today, that they sometimes dictate the rules of the financial game to governments. This point may be controversial, but at least one Nobel Prize Winner, Joseph Stiglitz, warns us of the potential danger that such imbalances represent. Strangely enough, SMEs and family businesses seem to be more of a true wealth creation engine. Yet all this time, Nobel Prizes have been awarded to several people in economics who constructed “theories” based on false assumptions, and nobody even noticed.

Another example of a case showing that “theories” do not always work in the real world can be found in Japan. The country is in its second decade of quantitative easing, and it is still struggling. Doing more of something that has not worked for two decades may not have the desired (positive) effect, and we may see in real time what a sudden loss of confidence means for a currency.

With that example in mind, if we look at how the economy works today, central banks and governments are run under the very same false assumptions as those theories that led to things like extended quantitative easing. In Europe, it is only after six years of a real crisis of humanitarian proportions in Greece, Spain, Portugal and Italy that people are just starting to realize the effects.

What about inflation?
One may argue that central banks setting a “cost” for the use of money is at the very center of our capitalistic and financial system, and that this tool is essential in controlling both inflation and deflation over time, as well as the business cycle.

But there is no logical evidence to support that argument in a free market. First of all, it has been clearly shown that in a free credit money system, such cost has to be zero as there is no justification for it. Secondly, in a truly free credit money system, inflation would probably be much less, if not non-existent, than the one witnessed under the current system, which bears the same characteristics as those of the gold standard. Finally, even within the current system, there is only little evidence that rates and central banks can control the inflation-deflation rate.

Towards some potential solutions?
There have been many theories on money and interest, and even some successful experiments of local currencies after the great depression in the 1930’s. One of them was the successful implementation of a local currency in Wörgl, a small Tyrolean village, in the aftermath of the 1930 crisis. Its creation helped to bring unemployment down by 25% in a few years, while the rest of Austria saw an increase of a sizable 20%. The man behind this local currency was Silvio Gesell, a German economist born in 1862 in Aix la Chapelle and a “strange prophet” according to world-renowned economist John Maynard Keynes.

This same approach is behind the WIR Network in Switzerland. WIR was born as a cooperative company for medium and small entrepreneurs, in 1934, as a response to the crisis. The network not only still exists today, but it counts one out of five small and medium business in Switzerland among its members, for a total of 65,000 companies. Incidentally, during the 2008 turmoil, WIR bank suffered neither loss nor stress.

A group of South African economists at freedomfrominterest.org has done a great job of identifying the very central mathematical flaw in our financial system of opportunity cost. Having scientifically demonstrated that the biggest component of interest, the opportunity cost, has no logical basis, is already a great achievement and hopefully represents a new start for the world economy.

Of course, the fact that, at least in most of the G7 countries, central banks have kept rates at roughly zero percent has temporarily stopped the hemorrhaging. However, it has not redistributed wealth, hence the still fragile situation.

As Raoul Pal, a modern macroeconomist with incredible foresight, suggested many times over the last few years, a debt moratorium on several if not all of the G10 countries is almost unavoidable if we want to have a chance of kick-starting the flailing world economy.

Such a moratorium can be conducted in two possible ways:

- by choice and in an ordinate manner, by redistributing wealth in the first place and then restarting with new and equal opportunities rules;

or

- by force, like in the 30’s, in a chaotic manner through a global crash and chaos. This may, in turn, lead to mass poverty and social unrest, if not wars.

Centrally planned economies often fail because they create too much imbalance and inefficiency in the long term. On the contrary, free markets and free currencies do much better in both economic and social terms. But they have to be free, in the first place.

Inspired by Charles Sannat, who likes to close with a quote from the late great John F. Kennedy :

Those who make peaceful revolution impossible will make violent revolution inevitable.”

Sources:

http://rt.com/op-edge/261401-us-china-ww3-soros
http://freedomfrominterest.org
http://www.amargi.co.za
http://www.wir.ch
http://www.globalmacroinvestor.com/About.asp

Photo credit: geralt via Pixabay, CC0 Public Domain License