So why does all this matter?
First of all, you need to think back to the conclusion drawn in this post:
“Decisions about who to allocate credit to, and how much credit to allocate, are absolutely fundamental to the way the path the economy takes in the future.”
Right now, it’s banks who are making these decisions. Every time they decide to make a loan, they are deciding who gets access to credit. And while it’s true that a huge volume of credit for business is raised by selling financial assets on financial markets, this credit is only accessible to large corporations – small and medium-sized enterprises (SMEs) are not about to raise funds by selling commercial paper, they are dependent on banks.
But this is not just about allocating credit. This is about the creation of our money supply – all decisions about how much to create and in what sectors of the economy it will be spent are made by banks. The creation of our money supply is entirely privatised, with no intervention or regulation by the Government. Although you can only run a bank with a banking license (from the central bank); and although banks are regulated and have to comply with certain rules; and while the central bank will be monitoring aggregate levels of credit in the economy; no-one is monitoring, or thinking about, or worrying about, who banks loan the new money they create to and what it is then used for.
In the first week of this blog I said: “every economic choice you make – what you consume, what you save – will affect how the economy functions in the future.” This may be true, but the significance of the choices that households are making is nothing compared to the decision made by banks concerning credit creation.
And what kind of decisions do banks tend to make regarding loans? Well banks like making secured loans. When you take out a mortgage, it’s secured against your house. If you default on the mortgage, the bank will take possession of your house, so the bank has a protection against the risk of you defaulting. Similarly, financial assets can be used as security – specifically, a trader will borrow a multiple of the capital they have to invest, secured against the assets they are buying (it’s called trading on margin or margin trading, the margin being the proportion of your own funds you are investing).
As a result, the vast majority of bank loans are made for mortgages and the purchase of financial assets. Now stop and think about this. New credit – new money – is mostly used for buying property and for buying financial assets. Whatever happened to new credit funding investment (under the strict economic definition)?
But don’t these financial assets fund investment? Well it’s more complicated than that, something I covered in some detail in previous weeks – assets will intermediate savings back into the real economy, but this may not necessarily be spent on investment. And what I also demonstrated is that an increasing demand for assets can simply push their prices up rather than lead to more assets sold. And in the case of the stock market, almost all trading is on on existing shares, so it is just money passing between traders, with none of it going to actual businesses.
Now you know the old adage that printing money causes inflation, because more money is chasing the same amount of goods – in our current system most newly created money (i.e. most bank loans) are for mortgages and financial assets and this creates inflation in these markets.
In short, our current system of money creation is driving constant bubbles in the housing and stock markets. These bubbles keep happening, crashing the economy when they burst.
And this is just the beginning – there is much more to say about why this system ruins our economy, but we’ll leave it there for this week.