7-22-09, 10:15 am

In my last article, 'Notes on How the Financial Sector Really Works,' I contrasted what the modern financial system was claimed to do with how it really works. How, instead of channeling funding from personal savers into productive industrial investment, it now seemed to operate in reverse. Industrial and commercial companies are now net depositors with the banks who lend the money to fund personal consumption, or finance unproductive state expenditure. This went hand in hand with a speculative appreciation of all sorts of paper assets. Notional profits from trading in this appreciating paper were then distributed to the executives, traders and shareholders of the banks, undermining their capital base. When the level of debt eventually became unsustainable, the major banks in New York and London were revealed to be effectively insolvent. The first sign of this was a run on the Northern Rock Bank. This bank had experienced rapid growth by embarking on a British version of sub-prime lending—offering mortgages of more than 100% of property prices. Because the funds from its millions of small depositors were insufficient to fund this expansion, it had become dependent on the wholesale money market—borrowing essentially from other banks or large industrial companies. Fractional reserve banking has from its inception depended on banks having a large number of depositors. Because of the law of large numbers, the amount that these customers want to withdraw in a single week will be pretty stable. A bank can estimate this fairly accurately and needs keep only a small reserve of cash. But Northern Rock was getting only about a third of its money from its millions of depositors. The other two thirds came from a few dozen big lenders. This was something much more risky. The law of large number no longer applied. It only took a handful of these big lenders to withdraw their cash for the Northern Rock to become insolvent. When rumors of this spread, the small depositors took flight. Queues formed at every branch as customers clamored to withdraw their cash. At first the British Government said that there was no need to panic as the existing deposit guarantee scheme ensured all deposits up to £30,000. Then they changed their tune and said that the government would nationalize Northern Rock and guarantee all deposits, however large. This set a critical precedent. Rather than allowing major banks to fail, the state would bail them out. This policy came to be generally adopted in the UK and US as more and more institutions were shown to suffer from the same fundamental weakness as Northern Rock. Governments have expressed relief that their action has prevented the sort of cascading collapse that occurred in 1929, but the cost has been a growth in public debt unprecedented since the World Wars. Taxpayers are ending up having to pay for the billions pocketed by the bankers. This raises the question whether there was any other feasible policy available? There was an alternative policy, but its implications made governments recoil. The failing banks could simply have been allowed to fail. The deposit guarantee scheme operated in the UK guaranteeing up to £30,000 per depositor, was generous, similar policies applied, or could have applied elsewhere. £30,000 is about 18 months of average wages. Only a tiny minority of depositors could afford to hold this much cash in the bank. So the great majority of people would not have lost anything. There would have been no need for a general panic. But some creditors would have lost in a big way. Although the most customers have only modest amounts of cash deposited, a few very rich people and institutions have tens of millions deposited. To them, the deposit guarantees were practically worthless. They would not have been ruined. They hold diversified portfolios not just cash. But they would still have faced huge losses. Prime losers would have been other banks, those that had outstanding money market loans to failing banks. We would have seen an even bigger cascade of insolvencies than actually transpired. But by itself, these insolvencies did not destroy any real wealth. Real wealth in the form of commodities, buildings and equipment remains untouched by a financial meltdown. What would have been destroyed were some claims on that wealth by the rich. The trillion dollar public bailout was done to protect those claims. If all bank deposits above the guarantee limit vanished, the plutocratic class system would be threatened. For what is money? Adam Smith, founder of economics, said that money was 'the power to command the labor of others.' In modern plutocracy millions in your account play the same role as a patent of nobility under the old feudalism. Modern Grand Dukes like Buffet and Gates titles are on a bank's hard drive rather than parchment, but they, like their aristocratic predecessors command the lives and labor of hundreds of thousands. Most people would look on with indifference or satisfaction were that class to loose some of their titles and grandeur. The only danger to the real economy would come if payments could not be cleared and working credit could not be supplied to industry. If the banks all closed down, credit card and check purchases would become impossible. So the failing banks would have had to be put into administration to ensure that ordinary commercial transactions could go on. But how to ensure that working credit was still there for industry? The credit system had become vastly over-extended. The ratio of virtual bank money to real money had become unsustainable. Either the state had to resort to the printing press to create more $ and £, or the virtual money had to be canceled. The alternative to quantitative easing, was the Jubilee—the general forgiveness of all debts. A modern Jubilee would have declared all debts incurred prior to Day Zero legally invalid, with the exception of modest guaranteed bank deposits. Those toiling to meet mortgage and credit card debt would have been liberated. The taxpayer would have been freed from the crushing burden of the national debt, and surprisingly, the banks would have become uber-solvent. Their liabilities would have shrunk relative to their cash reserves. Suddenly, their ability to lend would have improved. Such measures are not of themselves socialistic. Industry would have remained privately owned. But it would have hit the aristocracy of money the way the French revolution hit the aristocracy of land. It is for this reason that only socialistically inclined governments have deliberately set out to cancel debts. The Russian social democrats did it after 1917, and shortly later, albeit inadvertently the German social democrats achieved a similar effect via hyper-inflation. Today, the governments of the UK and US, have veered towards the German 1920's course: printing money to pay for wars current or past. The Jubilee is the more honest and progressive course.