Reforming the financial markets - part 1

Why is the financial system on the brink of collapse, what is being done about it and what better alternatives could be brought in through the Simultaneous Policy campaign? Those are three questions which I aim to answer over the course of these two articles.

There is an in-depth article on the credit crunch on The Guardian website from Paul Krugman, new Nobel laureate for economics, which provides valuable insight. I'm not going to attempt to reproduce his argument, but will put some of it in terms that I can understand and fill in some of the gaps. For his article see:
http://www.guardian.co.uk/books/2008/dec/06/paul-krugman-financial-crisis-2008

Those who have followed proposals put forward for inclusion in the Simultaneous Policy will be familiar that for Monetary Reform, originating from James Robertson. This claims that commercial banks create money out of nothing as interest-bearing loans and demands that this role be taken over by central banks. Commercial banks would then be "linking potential lenders to potential borrowers ­ as many people wrongly assume they are now." The proposals failed to gain large support in the recently-completed voting round and are on the way out. Why? I think because people thought it cannot be true that banks create money out of nothing, otherwise credit would not have dried up.

The fact is that commercial banks do need lenders. This is why banks and building societies offer interest to savers to have a capital base from which to lend. If you want a loan, they can give you some of this money, which you repay with interest. Some of the interest goes to the lender, some goes to the bank - as profits and to cover liabilities because some borrowers will default. Banks are required to keep a certain level of stocks of money to maintain confidence in case savers decide to withdraw their deposits - if the bank told savers their money was not available no-one would trust the bank, everyone would try to remove their money and it would collapse.

So banks are acting as brokers between lenders and borrowers. However, because most savers simply leave their money in the bank to earn the interest, the banks are allowed a trick. They are able to lend more money than they really have on deposit. If you sign a contract for a mortgage, the bank can create the money out of nothing, write the amount into your bank account and you can use it to buy the house. This system is regulated by the central bank. It sets a limit on how much money the commercial bank can create.

Part of the solution being followed by central banks in the current crisis is to change the rules so that banks have to have a better ratio of loans to savings - that is, more money on deposit. This is why in the UK people say the banks that have been bailed out by the government are in a bind. Publicly the government is saying the banks should start lending again. But at the same time, the banks are trying to build up their deposits. This also explains why commercial banks feel it hard to pass on the full cut in the bank base rate when the Bank of England makes cuts.

According to Krugman, this issue will resolve itself and is not too serious in isolation.

The bigger problem is the shadow banking system, which is not regulated to the same degree. This is where the sub-prime mortgage problem originates.

An important fact to realise is that the assets of a bank are not the money they have from its savers, it is the loans they have with borrowers. Loans provide income. So a mortgage contract is an asset. What has happened is these have been traded, en masse. Investors have bought them because they provide a return as people repay the mortgage with interest. They were thought to be low risk because if someone couldn't pay, the house would be sold and clear the debt, plus a profit on top for the owner of the debt in default fees. But it all went wrong because house prices stopped going up and people who should never have been given loans in the first place started to default. Even if the house could be sold, the investor would get less than they paid to buy the contract.

So investors with billions of pounds invested in these assets have had to write them off as losses, which, for some, has pushed them to the edge of bankruptcy, or even into bankruptcy, in the case of Lehman Brothers.

Because financial markets have become globalized, these losses have had a devastating effect.

The banks and hedge funds that have made huge losses are trying to recover their positions. So they are sacking people. They are also selling assets they own overseas. I was living in Brazil until recently and the stock market was falling drastically as investors cashed in their assets. The supply of dollars dried up as investors bought up supplies to repatriate the money. Brazilian companies needing dollars to pay for imported materials have found it difficult to obtain dollars and the value of the dollar has soared, making imports more expensive and adding to costs. At the same time, Americans are tightening their belts so there is less of an export market. Annual growth in Brazil, predicted to be above 5% is now likely to be below 3%. Other countries are being tipped into recession.

There is another factor at play identified by Krugman. It is that money lending is now global, where banks or shadow banks find money at cheap interest rates (such as Japanese Yen) and lend it in countries with high interest rates (such as Brazil). This is called carry trade.
Krugman simply states: "And one of the casualties of the latest round of panic was the carry trade. The conduit of funds from Japan and other low-interest nations was cut off."

Personally I need a few more dots joined up to understand why this happened and the implications. Funds have dried up because faith in the organisations that ran the carry trade has evaporated with the collapse of Lehman Brothers, which was unable to honour its contracts.

Prior to this, people with Yen were keen to lend them even if the return was small. With lots of Yen on offer, Yen were cheap to convert into the currency of other countries where the money was to be leant. When the borrower in, say, Brazil, repaid the loan in Brazilian Reais, this was converted back to Yen and the payments made along the chain.

Now with no-one wanting to lend out Yen, for fear they won't be repaid, the exchange rate has gone up. A simple case of supply and demand. In Brazil people are still desperately trying to buy foreign exchange, so the value of the Real has fallen. The result? The conduit organisations receive the same amount of Reais, but they are worth less. At the other end, they get less Yen for them, because Yen are more expensive. So carry trade is not a profitable business.

Krugman says this is the real threat to the global system, because unfreeing this flow of financing is going to be far, far harder than persuading commercial banks to lend to would-be home owners and small businesses. The sums are many times greater, the business is international and regulation barely exists.

His solution is quick to say: "Policy-makers around the world need to do two things: get credit flowing again and prop up spending."

With major industrial nations posting a drop in GDP, the measure of economic growth, and emerging markets slowing, the fear is a global recession, which means job losses and people falling into poverty.

At least in the conventional model of economics that Krugman and others are following.

This is the scenario where it would be great to hear what the Monetary Reform proposals submitted for inclusion in the Simultaneous Policy would contribute. There are other aspects to it, still. Such as what has happened to the insurance that investors have bought in case borrowers default. But this is as much complexity as we need for now, or at least, as much as I can cope with.

In the second article, I'll look again at the Monetary Reform proposal and put forward some others showing how the coherent, policy making approach enabled by the Simultaneous Policy could make a really radical transformation addressing many issues simultaneously.