Tuesday, 1 February 2011

Lessons from the financial crisis: Understanding Money (1)

Perhaps the biggest task in practical political education is to understand how the financial system works and help bring it under democratic control. Two opportunities to make the case for democratic reform of banking are the Independent Commission on Banking and the UK budget on 23 March: both urgently need to hear from victims of the financial crash and the millions excluded from the banking system whose services and opportunities have been shrunk as a result. Educators have a responsibility to help people understand the system and take part in making it work better.

The 2008 financial crash has already cost vast amounts in lost output, jobs, wealth, public services and personal misery. In the US “Nearly $11tn in household wealth has vanished ... The collateral damage of this crisis has been real people and real communities. The impacts of this crisis are likely to be felt for a generation" according to the official US Financial Crisis Inquiry Commissions (FCIC). Western governments pledged a mind-boggling $11 trillion of public funds to support the banks in their hour of need according to the IMF. Although only some of this was spent, everyone will pay for the bankers' failures. The Governor of the Bank of England said on 25 Jan that living standards will be cut as “the inevitable price to pay for the financial crisis and subsequent rebalancing of the world and UK economies.” Inevitably, the poorest and least powerful are hardest hit, while bankers reap staggering bonuses.
The crisis was entirely avoidable, and yet economic crises will happen again and again until society learns how to manage the financial system better.
Big cities like London suffered repeatedly from cholera and other epidemics in which thousands died until the city authorities understood the source of disease and designed systems for water and sewerage that worked for all citizens. Diseases are part of nature, but epidemics are the result of human actions and therefore preventable by designing healthy systems.
Make no mistake, “this crisis was the result of actions, decisions, and arguments by those in the financial sector. The system that failed so miserably didn’t just happen. It was created. ... Those who played a role in creating the system and in managing it ... must be held accountable.” (Joseph Stglitz, in Freefall, Free Markets, and the Sinking of the World Economy,  Penguin 2010) See Stiglitz speak on Fora TV.  In Fool’s Gold (Abacus, 2010), Financial Times journalists Gillian Tett tells the dramatic story of “how an entire financial system went wrong, as a result of flawed incentives within banks and investment funds, as well as the ratings agencies; warped regulatory structures; and a lack of oversight.”
Oversight and regulation are public duties which dramatically failed the public. Citizens cannot assume that politicians, officials or regulators can repair the system while bankers invest millions in lobbying to protect their interests. Western politicians are hypnotised by the “chunky tax tax revenues” which banks extract from the public (£61bn in 2008-09) without questioning how the money was obtained.
The central problem is not technical but ethical. Gillian Tett concludes that “the financial world’s lack of interest in wider social matters cuts to the very heart of what has gone wrong.” (p298) Without an ethical compass or social conscience, financial regulation alone cannot work. Regulations put in place after the 1929 financial crash and great depression were bypassed and stripped away to make 2008 possible. The world is awash with ‘dark money’, shadow markets, tax havens and the spoils of corruption, contraband and counterfeiting. Some of the world’s largest industries (eg drugs) flourish despite being utterly illegal and hounded across the world by governments with massive enforcement budgets.
Democratic rules and oversight are necessary, but we must start by inculcating moral principles and practices in every banker, financial institution and regulator. At very least, everyone who works in finance should swear a Hippocratic oath, an oath with the moral force of the Universal Declaration of Human Rights and the enforcement powers of the World Trade Organisation, International Monetary Fund and Bank of International Settlements combined.
Finance has an essential and useful role in the economy, but if the system is not brought under effective democratic oversight it could be swept away, like regimes in Egypt, Tunisia or Eastern Europe.
To hold these powerful institutions to account, we need to understand how the system works. Over the coming weeks I will explore key questions for democratic accountability of money and suggest some reading. The challenge for educators is to distil complex material into questions and information in a form that enables more people to discuss, understand and influence public policy on finance: please let me know if you can recommend any courses, books, videos, websites or other materials. 

A short course in money: (1) where it comes from
Money is a simple but powerful tool for economic self-management. It can give people information about the relative economic value of different activities, goods and services, which makes decisions easier and can reward activities which increase value. Value in this case simply means anything that people are willing to pay for, whether it is church services, food, football, heroin or slaves. Money that is not needed right away can be pooled to pay for bigger things like cathedrals, homes, factories, schools and spaceships.
Somehow society has to decide how this powerful mechanism should be used – what can people legitimately buy (alcohol but not cannabis, servants but not slaves), what public goods people value (monuments, roads, sewers, wars), how to pay for them (subscription, fees, insurance, taxes, conscription etc), how to look after people with no money or earning power (infants, the infirm) and how much power should different groups and individuals be allowed to exercise. All societies make these decisions, whether consciously or not. In a democracy, the people should decide these things, and to a certain extent they do.
But money and the financial system seem so mysterious that most essential decisions about money have been delegated to financiers. These “masters of the universe” have probably waged the most successful campaign in human history. They organised globally to persuade elected governments to give them responsibility for the world economy and then, when they screwed up, got governments to bail them out. Tax payers, consumers, workers and public service users will pay the price of their mistakes for decades, in loss of output, opportunities, public services and wealth.
Money has magical powers. When there is enough to go round and more for experiment, risk and frivolity people can act. But when money’s tight, people go slow or even stop. People lose their jobs, companies collapse and spending is cut. Although there is work to be done and people to do it, without the magic of money resources are wasted. People who control money cast a spell over individuals, governments and entire economies, so that an individual like George Soros could turn British government policy on its head, wreck the Conservative Party’s reputation, earn over $1 billion and cost the taxpayer £3.3bn over a few day in September 1992. Then for two decades the City cast a spell on the Labour Party and government. And when the banks failed in 2008, governments pledged trillions of Euros, pounds, dollars, Yuan and other currencies to stop banks from collapsing, then cut public spending to appease the money markets. No other industry enjoys such powers or privileges as finance.

How money works its magic
To understand how money magic works, I will use the example of a babysitting circle of 100 families which uses beans as tokens. Each family gets 10 beans when they join. One bean pays for an hour of babysitting and when they run out people can get more beans by babysitting for others. The system works pretty well. Many families enjoy going out a lot, but some families do more babysitting than others and pile up more beans than they need. The babysitting circle agrees that beans can be used to pay for home improvements and other odd jobs, so people are happy to save beans. One enterprising family, the Banks, offer to pay anyone with spare beans one bean for 20 a year (5%). At the same time, the Banks offer to lend beans to anyone who wants them, at a cost of two beans a year for 20 (10%). The Banks earn a fee from the difference in rates between lending and borrowing, but everyone benefits.

Now a remarkable thing happens. Out of 1,000 beans held by 100 families, 900 are deposited with the Banks family. They lend these to other families for home improvements and babysitting, so more people have fun going out and doing up their homes. But no sooner have they lent out the beans than people give them back to the Banks for safe keeping, who lend them out again. Soon the Banks have turned 900 beans into 9,000 beans and lots more people are doing up each other’s homes, babysitting and going out. The baby economy is booming.
This is known as fractional reserve banking and is one way money is put into circulation. As the economist John Kenneth Galbraith wrote, “the process by which banks create money is so simple that the mind is repelled. Where something so important is involved a deeper mystery seems only decent”. (Money: Whence it came, where it went, Houghton Muffin 1975)
This multiplication of money through credit is the first trick in the money-makers magic box. It works well so long as people repay their beans on time, so the Banks family have to be good judges of characters as well as friends of their neighbours. They need to know who is reliable and will replay. They keep good relationships, inquiring after borrowers’ well-being and the progress of their projects. When someone falls ill or has an accident and can’t repay on time, they encourage people to support each other so that no one fails to replay.
The BBC’s Business Editor Robert Peston describes how these “great conjurors” work in short film about banks.
Banks make billions from their ability to create money through credit, a right that traditionally belonged to the crown and is known as ‘seignorage’, which in a democracy should belong to the people. If as a democracy we decide that banks are best placed to create and manage money on our behalf, then at very least the power create money should be open and accountable to Parliament.

Read more
For other mainstream books on the financial crisis, see
Nouriel Roubini and Stephen Mihm, Crisis Economics: A Crash Course in the Future of Finance Penguin 2010
Anatole Kaletsky, Capitalism 4.0: The Birth of a New Economy, Bloomsbury 2010

Raghuram G. Rajan, Fault Lines: How Hidden Fractures Still Threaten the World Economy, Princeton UP, 2010
and the roundup in Moneyweek

For some good alternative analysis of the financial system, see:
David Boyle, The Little Money Book, Alistair Sawday, 2003, an excellent overview which warned  that "Derivatives need serious regulation before it’s too late."
David Boyle (Ed.) The Money Changers: currency reform from Aristotle to e-cash, Earthscan, 2002
Bernard Lietaer, a former top executive in the Belgian central bank, The Future of Money, Century 2001
Francis Hutchinson, Mary Mellor and Wendy Olsen on the history and thinking of social credit, The Politics of Money: Towards Sustainability and Economic Democracy, Pluto 2002
Michael Rowbotham, The Grip of Death (1998) and Goodbye America (2000), Jon Carpenter publishing
James Robertson & Joseph Huber, Creating New Money: A Monetary Reform for the Information Age, New Economics Foundation, 2000

Practical Politics is a personal view from Titus Alexander and does not represent the views of Novas Scarman, Democracy Matters or any of its members.

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