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The Global Financial Crisis might have a more subtle origin

Bad banking

A lot of ink has been already spent explaining how bad US banks were in assessing their customers and how clever they were in discharging the undisclosed credit risk to others. And we will witness what this is going to mean for JP Morgan: if the 13 billions dollars fine is confirmed, it would be the largest fine ever faced to date by a private institution! Consistently with common practises in the banking world, the unspoken and implied message was that failure to repay debt (default) was only related to the debtor, not being able to ensure enough income to repay the debt. Systematic factors are indeed included in traditional credit analysis, but mainly to derive correlation between debtors, i.e. how likely the default if a debtor generates the default of another debtor.

Is it endemic?

We should consider another lens, genuinely systematic, which takes into consideration what money is. Because money is not linked to gold anymore and is fundamentally equivalent to debt, a credit crunch has to be fundamentally related to what money actually is! It is actually interesting to recall the simple example of the Fractional reserve. So: out of my $100 deposit, my bank will keep $10 as a fractional reserve and lend the other $90 to another customer: Peter. When Peter spends the $90, the recipient, John, will see his account augmented by $90. At this point in time, my bank statement will show a balance of $100 and John’s will show an increased balance by $90. This process can continue: out the exrra $90 John has in his account, $9 will be kept by the bank as a reserve and $81 will be lent again. Yes: in this example so far, $100 are the “real” money and $90+$81=$171 are the “virtual” money, generated through debt. Now it’s time to address another parameter: interest. In practice, John and Peter will have to give back $171 plus interest. If the bank has generated the $171 (that will be destroyed once the debt is repaid), how is the money to pay interests going to be generated and by whom?

Well, the short answer is that nobody has generated it! So there are two possibilities: either somebody generates this money – i.e. more debt – or these interests will have to be paid out the existing and circulating money. The first solution doesn’t really solve the problem because paying interests by generating more debt just procrastinates the situation for longer and makes it a bigger issue (it doesn’t stop countries to increase public debt in order to pay interest on older debt)! The second solution has a direct consequence though: if some of the circulating money – i.e. debt – is used to pay interest, some loans will not be repaid because the money has been destroyed while repaying interest on some other debt!
Default is a logical consequence of the fact that money is debt and that debt is repaid with interest. In other words, the system produces (undesired?) default by design: it should be expected that default occurs every time no further debt can be generated to pay for interests on older debt.

We should expect more

Following this approach, default is “part of the game” and needs to be expected, but with what amplitude? If its existence is linked to interest, it is reasonable for its amplitude to be linked to the interest rate levels: should high rates mean high interest amounts and higher number of defaults? Not necessarily: the dynamics is far more complicated and, anyway, not immediately: interests are usually post-paid and it require some time for the numbers to add up: i.e. years. This means that, in normal circumstances, every few years, a credit crisis needs to be expected. With all the relationships between economies that are currently observable – and all the ones that are not observable or we don’t know about yet – it is practically impossible to determine where the credit crunch is going to happen, but there should be no doubt it will.

So, it is acknowledged that the bad credit practices in place mainly in the US, together with a more-than-suspicious involvement of the rating agencies, triggered a series of consequences which the Global Financial Crisis has been the most serious consequence. But we should probably consider these as a contagion mechanism of a disease that actually has its root cause elsewhere: not matter how individual players organise themselves, the system will inevitably produce default. Misbehaviours will amplify or accelerate, as an electric sparkle, operating in a problematic debt-based monetary system, made of gun powder: the explosion shouldn’t be a surprise, should it?

There is no action from the Governments and/or the Monetary Authorities on this point. Strengthening risk processes is desirable but this system will create default anyway and would it really be such a surprise if another crisis happened again?


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{ 9 comments… add one }
  • Moiz Mehmood 21-Oct-2013, 14:55

    There are various theories around credit creation and one of them says that if the newly created money results in the creation of “value” then that does not result in asset price bubbles and hence defaults. There are many academic and practitioners who blame Alan Greenspan’s loose monetary policies for laying the foundations of the credit bubble that burst in GFC. If there is too much unproductive money floating around then a bubble would be created somewhere. Is the current QE producing a bubble somewhere?

    On another note, at a macro level there are always defaults and banks do account for them in their provisions for bad and doubtful debts. Would that explain the missing interest if no new money is created?

    • ArmandoGherardi 21-Oct-2013, 17:33

      Interesting questions, Moiz!
      I’ll give my answers and you’ll let me know if I have addressed them….

      1) The fact that nobody has generated the money to pay the interests is the main issue. If it needs to be paid with the circulating money, then some debt will be left unpaid, i.e. default. If Central Banks need to implement QE, it means that they think that more money – i.e. more debt – needs to be in the market and, this way, if you like, they make the problem bigger. In my view, the problem exists before QE gets in the way. Anyway, the Bank of England has announced that they may not apply any QE for a while…..

      2) Provisioning for bad debt is an accounting necessity: if a loan is accounted for through accruals, it can only produce profits; it will produce losses only when a default occurs. So, out of a portfolio of loans, there is an expectation that some losses will occur (through default) and provisioning reflects this in the balance sheet. Setting provisions aside satisfies the bank balance sheet, not the whole system. Don’t forget that a default has other consequences apart from the monetary ones….

      • Moiz Mehmood 22-Oct-2013, 08:55

        I think there is a slight difference in how we view money. If we see it purely as an instrument of debt then yes, creating new money will eventually cause a debt bubble. Money is a store of ‘value’ as well as being an instrument of debt. So if the newly created money actually creates ‘value’ in terms of additional goods and services then central banks can continue doing that without causing long term issues. The problems only starts when that newly created money just ends up chasing existing goods and services in the economy. This is when you should see the formation of asset price bubbles which would eventually burst and cause defaults.

        • ArmandoGherardi 23-Oct-2013, 11:15

          I understand what you’re saying but I don’t see how issuing money can create value….

  • Ari 21-Oct-2013, 19:19

    Subtle origin indeed, However we’ve been in a fractional reserve system for a long time and thus central banking. Although I personally have mixed feeling about fractional reserve system. It is providing central banker with the tool necessary to control inflation, eg. controlling the reserve rate -> controlling money supply -> controlling inflation.

    Whether or not the debt created by this method can be paid or not that is another story. I guess, as long as there is inflation and inflation is within a set of tolerance then it is still payable in perpetuity. unless of course if the money is used for non-appreciating spending. 🙂

    I do however stand by my belief that the GFC is because of David X Li’s Gaussian Copula model to value CDSs and CDOs. The assumptions are all skewed and broke apart when the market decide otherwise… I wonder where he is now?

    • ArmandoGherardi 23-Oct-2013, 11:10

      You’re right, Ari: the primary objective of Central Banks is the inflation control. And they fundamentally have two tools: money supply and base rate. But every time money is supped, debt is generated and interest is expected as well as full repayment. My opinion is that it can go ahead in perpetuity.
      Regarding CDO pricing and copulas, there is nothing wrong in the model: the issue was disclosure of accurate information about the assets backing the CDO (that’s why I am alluding to transparency and rating agencies….).
      I’m not saying that the ‘bad behaviours’ played no role: I’m saying that they have exacerbated and accelerated a process that was already there because it’s embedded in the system.

  • Despre 29-Oct-2013, 16:35

    I see the banking system same as I see the circulatory system in a normal human. There is a longer circuit of blood where blood circulates from heart to organs without including the heart to lungs pathway and there is a shorter circuit of blood between heart and lungs. Now, the arguments about GFC can be strongly cut in two, because anything that has to do with production, consumption, etc. is part of the large circuit of money, and everything that is on the central’s bank balance sheet is the short circuit of money. I would not bother in the discussions about GFC with the large circuit of money at all.

    The current monetary system is based on debt not because there is no alternative, but because government has been taken away the right to issue currency. Consider this quote: “If our nation can issue a dollar bond, it can issue a dollar bill. The element that makes the bond good, makes the bill good, also. The difference between the bond and the bill is the bond lets money brokers collect twice the amount of the bond and an additional 20%, whereas the currency pays nobody but those who contribute directly in some useful way. … It is absurd to say our country can issue $30 million in bonds and not $30 million in currency. Both are promises to pay, but one promise fattens the usurers and the other helps the people. ”

    I also consider there is some hipnose about this fiat currency as really being valuable. You only need to see how the system crumbles when a currency is disavowed, e.g. during the replacement of a government, which were plentiful in Europe in XX century. The current fiat currencies are only valuable because people consider it valuable; and the fight is for the assets which baked the fiat currency. Interest only helps the owners of the process of producing money to aquire more asset control. The assets are what’s the other side of the balance sheet of a central bank. Many don’t see this, but with a barter system you would not have taxes, interest, and fiat currency would be useless. But when some governments achieved the exit from this circuit they have been obliterated and replaced with governments obedient to the circuit. US in the XIX century is prime example, it has been in and out of the circuit several times.

    • Armando Gherardi 31-Oct-2013, 14:59

      I couldn’t agree more with what you say!
      There are some allegations that Heads of State or Prime Ministers were assassinated as soon as they attempted to move their country out of such monetary systems!
      (Just found a topic for another post!)

    • Despre 04-Nov-2013, 21:47

      Just notices some mistakes, please feel free to correct the previous response, sorry for the mistakes.

      *hipnose = should be “hypnosis”
      *baked the fiat currency = should be “backed the fiat currency”
      *aquire more = should be “acquire more”