13 December 2007

Political, not banking, crisis

The world's central banks have made it easier for the world's commercial banks to increase the amount of debt circulating around the world economy. They began by concertedly reducing interest rates, making it cheaper for commercial banks to lend money. This had little effect, so yesterday they acted together to actively create new money.

It is not clear how this money was 'created' but it was probably by the selling of government bonds, in other words increasing the value of the public debt that we will have to pay off through taxation. Since there is no asset to balance this debt the central banks are guilty of just the sort of monetary inflation that the government says is impossible when policemen want a pay rise. Such action is defensible, it seems, when it is financial investors who want a pay rise.

Is it the fact that the word 'inject' is always used about the creation of debt-money by central banks in this way that leads journalists to use the metaphor of a drug pusher, encouraging debt-addicted banks to go back for another fix? To me the more appropriate metaphor is that of the weak parent.

The role of the central bank is to ensure what the jargon calls 'fiscal probity', which means not lending in an irresponsible way. But how could banks judge what is responsible or not when lending to people to gamble on the future value of unplanted cocoa crops is acceptable? No clear boundaries here. And when the unruly children see their playfully created 'financial instruments' blow up in their faces they are not punished or even reprimanded but simply payed off and allowed to continue. No tough love in the world of banking.

Since the reserve ratio (the proportion between bank lending and assets of real value held in the banks) was abandoned, central banks have only required that commercial banks act with prudence. The purchase of junk assets, such as mortgages held by people with no incomes to pay them back, is a clear example of imprudent behaviour. But do the central banks punish banks for this? Of course not, they just enable this sort of lending to continue.

Central banks, and the governments they answer to, are in an uneviable situation of their own making. Following the ending of credit and exchange controls, the deregulation of financial markets, and the ceding of control of monetary policy to banks by governments, political control over money has been abnegated. The role of politicians was to ensure a money system that served the real economy and our interests as citizens. The role of banks was to maximise profits for shareholders. If things are as bad as they currently seem, and the whole monetary system fails, this will be a disaster for us all.

To see what happened when Argentina experienced a 'credit crunch' see my article.

For more on the creation of money see Richard Douthwaite's excellent (and short!) book The Ecology of Money.

Or you could buy Market, Schmarket where this is covered in Chapter 6.

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