Over the last 2 weeks we’ve seen how our current money and banking system fuels cycles of boom and bust, with banks making loans (creating new money) for property and financial assets, not for new investment.
So would this system work if some degree of regulation ensured that the appropriate proportion of loans (new money) was directed towards investment? This is a good idea, and I don’t want to say emphatically that it wouldn’t work, but there is a fundamental flaw at the heart of the current system that this would not address. It’s a “systemic” flaw – the flaw is inherent in the way the system functions – such that even if banks were brilliant in their decision-making and used that brilliance to make loans to businesses that were going to be successful, and therefore weren’t addicted to secured lending against property and financial assets, we could still see a catastrophic cycle of economic crashes.
Over the last few months we’ve established that increasing productivity requires an increasing money supply, and that money is created when banks make loans. What I haven’t mentioned before is that, similarly, money is destroyed as loans are repaid (sorry for just bringing this up now – I don’t want to take time explaining it, so if this seems strange to you this page/video is very good, and well-referenced).
Imagine if we could regulate our current system such that credit creation is mainly allocated to business investment that increases productivity, and that these loans increase the money supply just enough to keep up with the increased productivity without any price deflation. But as the businesses repay those loans, the money supply starts to shrink again.
If productivity continually increases, it’s no good if the money supply shrinks. Even if productivity plateaus out, you need the money supply to stay at the same level, not be reduced as businesses repay their loans.
So in our current system we need the banks to keep making new loans not just to expand the money supply in line with increasing productivity, but also to replace the money destroyed as loans are repaid. The current system requires ever-increasing levels of private debt.
But there’s only so much debt that the private sector can sustain. It turns out that every major crash has been preceded by huge levels of private debt. Before the last crash, the economist Steve Keen was urgently warning people that it was coming, largely based on the levels of private debt. The news media and right-wing politicians are always having a tizzy over Government debt, but it’s private debt that we really need to worry about (and private debt is currently matching pre-crash levels).
There are also massive environmental implications of our current financial system. To prevent a shrinking money supply we need ever-increasing levels of debt, which means we need continual growth to keep paying for this debt. It is pushing us to grow, and grow, and grow, regardless of the environmental consequences.
As it happens, Keen published a new book in April this year, “Can We Avoid Another Financial Crisis?”, which I read a couple of weeks ago. Although the first draft of this section of the blog was written in January, what Keen has to say fits in so well that next week I will use his book to shed more light on this phenomenon of private debt.
