I’m not happy with this post. I tried to mix some rather speculative economic thinking with an attempt to explain to a wide audience, and it doesn’t work. I’ll rewrite it as geeky economic article.
The asset bubble that started in the late 1990s and exploded in 2007 as the financial crisis was caused, in my opinion, by our monetary system. In particular, the following cycle took place:
- The general public in western, mainly Anglo-Saxon, economies started using real estate as hard money, profiting from its parasitic appreciation linked to GDP growth. The real economy deflated against housing.
- Banks issued new money backed by the rising real estate. This broke monetary policy by expanding the money supply first as intended but then beyond, as banks used securitized debt to evade regulation and recycle their license to create money and use it as their capital.
- A positive feedback loop developed, where appreciating houses led to banks issuing more money, which led to inflation of money against housing. The market responded by raising house prices further, until both housing and housing-backed money crashed.
The system of money used by western economies, although no secret, is not widely understood by the public. I’ll explain how our monetary system works, how it caused the crisis, and how it ought to be reformed in principle. Obviously I have no tried and tested new system to propose, but I’ll try to articulate what new conditions it should meet.
Hard money and its parasitic appreciation on GDP
The traditional conception of money is as a fixed quantity, such as a ton of gold. It changes hands, and some people hoard it, but it doesn’t grow or shrink. That way the value of goods can settle against gold through the market. This “hard money” concept served well for most of history because the size of the real economy didn’t change much either. In a static economy, a gold coin buys a sack of wheat, say, now or in a hundred years. Using gold does nothing to erode inequality, but doesn’t amplify it either. Sitting on gold yields zero return, so any productive investment whose risk-adjusted real return is above zero beats that, and will probably get funded.
We’re in the third phase of the financial crisis that peaked in 2008. The events of 2007-2009, which are generally called “The Crisis”, were only phase two. The three phases are:
- Phase One: The bubble. Creation of false assets by financial capital, mostly banks and smaller players in the property market. These assets have a nominal value way in excess of their real earnings potential, and that gap in value is hidden.
- Phase Two: The stall. Transfer of the deficit of those assets to state balance sheets under emergency conditions. Private insolvency becomes state liability, while the gap between nominal and real wealth remains outstanding and is now visible.
- Phase Three: The payback. Closing of the gap by a transfer of funds from the public to states. This may be achieved by means such as austerity, taxation, write-off, default, or inflation. These different options hurt or benefit different groups.
We’re in phase three, and the reason we have austerity in most of the west is that austerity is the method capital wants to see used to resolve the gap. Using austerity in the payback phase serves to consolidate the gains that capital made in phase one, such that the whole cycle is a transfer of real funds from the general public to capital. Austerity is the “hard money” way to close the cycle. It’s the only way to close it that refuses to accept nominal losses.
Using inflation (by printing money), taxation of capital gains, debt write-off, or controlled default would allow the valuation gap to close by eroding rather than consolidating the nominal gains made in the bubble phase. These options wouldn’t be clean but they would be fairer and less destructive of the real economy. These options are very unfriendly to capital, so they’re absent from politics. The US Fed is using a small amount of inflation, presumably to reduce damage to the real economy, while the fabulously independent European Central Bank insists on a hard Euro and austerity. The ECB is working as intended, since the whole point of an independent central bank is to avoid taxation of capital in situations like this. On the whole, present monetary policy is strongly in favor of wealth and capital and against social cohesion or development.