The global financial crisis
The global financial crisis was 40 years in the making, perhaps longer. Once again the tipping point for the crisis has been confused with the source of the crisis. Even on this there is disagreement. Some point to the overly optimistic home-loans to the poor of America repackaged and resold as prime assets. Others point to the British government’s freezing out of the Icelandic banks as the tipping point of the crisis. However the underlying cause of the Global Financial Crisis is that the catalyst was being treated as though it was an outcome itself.
Perhaps at this point it would be worth restating why money is a catalyst:
Even though money has a role in trade, it is simply a catalyst to trade and has no intrinsic value. To understand this it is perhaps important to consider the role of a catalyst. In chemistry a catalyst plays an active role in a chemical reaction with other chemicals, but is unchanged by it. Money performs this role in trade. It enables a farmer to trade pigs for groceries, grain and machinery parts. It enables a teacher to trade hours spent at school for an overseas plane trip (amongst other things). It plays an essential role in every economy throughout the world, and makes a world economy possible. As these examples show, money is only a catalyst to trade, not trade itself. For money to work in this way, it must: have a consistent value, be able to be stored indefinitely, and be accepted by those an individual is trading with.
When you understand this, it makes it much easier to understand why the global financial crisis occurred, and perhaps wonder why it had not occurred years earlier. Certainly as things currently stand it will occur again.
At this point it may be worth retracing the history of money. In its early forms money was related to a standard measure. Indeed the first currencies were standard amounts of particular precious metals. Then as these got worn, or intentionally reduced, they were replaced by less valuable representations with a promise that if presented to the government of the day, the government would produce the equivalent amount of the original material. Then because coins were heavy, these same promises were placed on notes, eventually giving us the paper currency we are so familiar with. It was only in the 1930’s that this direct relationship between the promises made by government, and a government’s requirement to have access to precious metal, was broken with the abandonment of the gold standard. At the time it was argued that governments had access to many other assets and so restricting the amount of currency in circulation to an amount of gold kept in a vault was old fashioned and unnecessary. As a general principle this is correct, providing the principle itself continues to be adhered to and understood.
In the 1970’s this principle was abandoned by Richard Nixon, who needed to be free of its restraints, and floated the dollar so that the market could decide its value. Other countries soon followed suit. This subsequently allows a government to print as much money as it likes. The only restriction is that the market will determine the relative value of the money. To reduce the temptation of governments to print their way out of debt, most foreign debts of governments are held in another currency. The US dollar is the preferred currency for the vast majority of global trade, even when there is no involvement of the US in the trade. This is why the media constantly refers to the value of the local currencies compared to the US dollar.
As most businesses like to avoid things they cannot control, financial institutions introduced tools to assist businesses to take currency fluctuations out of their international trade considerations. The financial institutions received a fee for doing this. They also took measures to reduce their own exposure to currency fluctuations, which in turn created more financial tools. The vast majority of these tools have a zero-sum-gain that is similar to a bet, when the losses and gains of all those involved are added together the net result is zero. It is in effect a very sophisticated form of gambling. When the long established International bank Barings was made insolvent overnight in 1995 by the actions of a rogue trader on its staff in Singapore, the high stakes nature of this form of gambling was abundantly clear to everyone. The Asian financial crisis also made it clear that countries and governments could also be affected. Indeed the global financial traders intentionally pushed some countries to the brink through prolonged attacks on sovereign currencies.
In the eyes of many businesses in various countries and for different reasons, money was no longer as stable as it once was:
- it did not have a consistent value
- it could not be stored indefinitely (at the same value)
- it might not be acceptable to one’s trading partners.
Global financial markets feed on this uncertainty, creating increasingly complex financial tools promoted to reduce risk, while at the same time increasing it. In the zero sum gain of financial trade, the market always ‘clips the ticket’, taking a transaction fee. So it should not be surprising that the volume of financial transactions has grown exponentially to a point that it is now over 100 times the volume of real trade. The global financial traders had turned a simple catalyst into a complex game of frenetic activity in which no one really knew what was going on.
Governments had unwittingly played a major role in establishing this scenario. By floating their currencies they had endorsed the financial markets. In disconnecting their currencies from any standard of measure, they had made money truly virtual in nature. While a dollar is still a dollar, and a pound a pound, they are only worth what people believe them to be worth. If people believe they are worthless, then they are exactly that.
The global financial crisis was a standoff between the governments that had created the play money, and the financial institutions that were playing with it. The governments blinked first, knowing that to save the money they also had to save the institutions. This is because for most people money is not coins or notes, but ‘numbers at the bank’. So the governments did what they did to protect money as a concept and keep the catalysts of trade functioning. They bailed out the institutions.
The behaviour of governments since the global financial crisis is telling. In the US where the vast majority of its debt is in its own currency, the government was still printing money at an estimated rate of sixty million dollars an hour five years after the GFC began. It is certainly an easier way of making cash that working for it or taxing people. In Europe where the legislation prevents mass production of new money, austerity was in vogue. Britain did a little of both, trying to both appease a public that thinks the government should behave like a company, whilst at the same time printing money to pay for the excessive debt it took on behalf of its institutions.
The global financial crisis is only over so long as everyone agrees to look the other way and pretend that money is real. In fact money is effectively real only as long as we all believe it is. So don’t tell anyone it is not – it will be our little secret – OK?
Recap
- Reward for effort – asset inflation gave people a sense of wealth
- Value is relative – global trade provided cheap goods
- Trade requires difference in value – the west traded false wealth for cheap consumables
- Money is a catalyst – the money markets corrupted the catalyst, potentially destroying it
- Trade creates economic ecosystems – a global ecosystem of trade was threatened by instability in the catalyst – the US dollar
- Economic measurements are incomplete – level of government debt taken on during the financial crisis does not take into account the ability of governments to service debt through increased money supply