money and the global debt crisis

Money and the Global Debt Crisis

I. A Brief History of US Banking

Timeline of US Banking

Colonial Experience • Bills of Credit issued in anticipation of future taxes; principle

currency of colonies. • Colonies typically gave their bills of credit legal tender status:

compels creditors to accept these bills at face value• Currency Act of 1751 eliminated colonies ability to issue paper

currency• Act of 1764 extended prohibition to all colonies

Continental Congress• No Federal government; “Continentals” beginning in May 1775; • Redemption in anticipation of future taxes.

Timeline of US Banking• Bank of North America 1781 (First Bank established in the US; within 10

years 3 more appeared)• (1st) Bank of the United States 1791• (2nd) Bank of the United States 1816 (20 years)• “Free Banking Era” - Money was privately issued bank notes,

redeemable by law in gold or silver; no central monetary authority; Congress failed to impose reserve requirements

• 1846 Treasury of the US created by legislation• 1862 Legal Tender Act authorizes issuing of “Greenbacks” declared

legal tender and redeemable in gold at some future time (value fluctuates on basis of battlefield successes)

• National Currency Act 1863, 1864 establishes a uniform currency and a national banking system…

Timeline of US Banking

Most important dates• 1913- Federal Reserve established….

– The Federal Reserve Bank, aka “The Fed” was established in 1913- it prints money, but is a private corporation.

• 1944- Bretton Woods Regime established (international gold standard, IMF, World Bank, etc.)

• 1971- Bretton Woods officially dismantled (end of the gold standard)

Two Debates about Central Banks

1. Whether or not there should be a central, national bank.

2. Whether or not the central bank should be private or public.

• These issues tend to get confused, but are in fact distinct. You should keep them separate in your mind.

Two Debates about Central Banks1. Whether or not there should be

a central, national bank. – Debates between Thomas

Jefferson and Alexander Hamilton, for example.

– Today, Ron Paul wants to abolish the Federal Reserve, and all central banks.

– However, today all functioning governments have a central bank (e.g. European Central Bank, Bank of England, etc.)

Two Debates about Central Banks2. Whether or not the central bank should be private or

public.– Much less discussed! The Federal Reserve Bank of the United

States is a private corporation, consisting of 12 regional banks. – Although the Fed Chairman is appointed to office, the banks

themselves are private, for-profit institutions. The Federal Reserve is no more “Federal” than “Federal Express”!

– Dennis Kucinich has recently called for the Fed to be nationalized and made part of the US Treasury.

Fractional Reserve Banking

• Suppose you lend Bob $100, but require Bob has to give you back this money (or part of it) whenever you ask for it.

• Realizing you probably aren’t going to ask for more than $10 back, Bob keeps $10 and loans out the rest of the “deposit” to Jane.

“Bob” the BankDepositor Borrower

You “lend” the bank $100.

Bob keeps $10, but lends out the rest of the $90.

Fractional Reserve Banking• “Bob” makes money by lending out this money at a higher interest rate

than he has to pay when he pays you (the depositor) back. The bank borrows ‘short’ and lends ‘long.’

• The problem is that, typically, the bank has to wait before it gets back the $90 it loaned. If you, the depositor, ask for your $100 back, the bank won’t have it! It will have to get it from someone else’s deposits….


Bank owes you $100, whenever you want it.

Borrower owes bank $90 + 10% interest, in 1 year.

Fractional Reserve Banking

A matter of Faith

• The monetary system requires faith (aka confidence or trust)

• The Banking and credit systems require collective faith, or confidence, in order to work!

• Central Banks (and banking regulations) work to prevent panics by restoring public confidence that lenders will get their money back (and to do other things like control inflation, etc.)

A matter of Faith

This also causes, however, a problem, because banks and other lending institutions may take more risks if they know they will be bailed out in the end. This is known as the problem of moral hazard.

Bank Runs• Because the bank only has 10 percent of its total deposits on reserve, it

necessarily cannot redeem all deposits at the same time. A mass withdrawal by depositors is called a bank run. When a bank run happens, the demands for cash exceed the bank's ability to pay, and if the bank cannot raise enough money, the bank becomes insolvent.

• A Bank Run is an inherent risk of fractional reserve banking.


Bank owes you $100, whenever you want it.

Borrower owes bank $90 + 10% interest, in 1 year.

Where does our Money come from?

• In the US, the Federal Reserve prints “Federal Reserve notes” which function as legal tender or fiat money.– This money essentially

represents debt, to be explained below…

– US coins, however, are produced by the US Treasury, and do not represent debt.

Where does money come from?

Two Steps:1. The Fed creates all new

money as debt, from “thin air.”

2. Private banks then take this new money and create 10x this amount through fractional reserve banking. This process is called the money multiplier process.

1. How new money is created by the Federal Reserve (in US)

US Treasury The Fed

IOUs (Bonds)

Federal Reserve prints money, from nothing, and pays Treasury.

Money as Debt

Treasury Federal Reserve and other

Private Banks

US Treasury ‘sells’ bonds. (T-Bills)In exchange for money now, Treasury gives IOU’s, to pay back this money, plus interest.

IOU

Cash

Whatever bonds the other banks do not purchase, the Federal Reserve purchases.The Federal Reserve can exercise a power that the Treasury cannot: it can simply print the money from nothing! But it creates this money as debt.

How new money is created by the Federal Reserve (in US)

How money is created

• "The study of money, above all other fields in economics, is one in which complexity is used to disguise truth or to evade truth, not to reveal it. The process by which banks create money is so simple the mind is repelled. With something so important, a deeper mystery seems only decent.”

• "Under capitalism, man exploits man. Under communism, it's just the opposite."

(1908 – 2006)

2. How 10x (or more) this amount is created by private banks...

Money Multiplier Process• The bank, having received the

deposits, now lends the new money it has borrowed. Because the newly circulated money also eventually ends up in a bank, the amount of money created from an initial deposit by the Fed is a multiple of the original amount. This is called the money multiplier process.

How 10x (or more) this amount is created by private banks...

Money Multiplier Process• The money multiplier is the inverse

of the reserve ratio. If the reserve ratio is 10 percent, for instance, then the money multiplier will be 1/.10=10. This factor will be multiplied by the amount of money initially put into circulation to derive the total amount of money that is eventually generated from this amount. For example, a $10,000 loan from the Fed eventually generates $100,000 of new money.

The Bretton Woods System The Allied Powers established the

Bretton Woods System of international trade and finance in 1944, just prior to the end of WWII, in Bretton Woods, New Hampshire.

Bretton Woods established a US dollar gold standard.

The exchange rate of all other currencies to the dollar was fixed. Indirectly, then, all currencies could be exchanged for dollars, which could be exchanged for gold.

The End of Bretton Woods

By 1968, the Federal Reserve removed all gold backing of the US dollar

The Bretton Woods regime officially ended in 1971 (during the Nixon administration). Thereafter, US currency was not backed by gold, and the value of international currencies could fluctuate against one another.

This is known as a floating exchange rate.

II. Money 101

Money as Power

• Money is a form of Power, defined as the ability to produce intended effects (Bertrand Russell)

• Money represents a virtual asset, a financial claim to real resources, like other people’s labor.

• A given sum of money is only worth what it can purchase: the sum total of exchangeable goods (including labor and resources which can be productively employed or not)

• The relative distribution of any given sum of money at any given time represents the relative financial power to control these resources.

Money and social power

• Money has always been an object and instrument of social struggle. Moreover, the struggle over money is inextricably linked to the power to define what money is in the first place.

• This struggle is expressed ideologically as a contention over whether the value of money is based on “intrinsic value” (e.g. specie) or whether the value of money is established by legal fiat or social convention (cf. Carruthers and Ariovich 2010)

The State and Money

“Legal” or Social Theory of Money• Money is whatever people believe or

treat as money! Money is an abstract social power; it is an unconditional means of payment defined by law.

• Money is a token; all money has been fiat money.

• Aristotle: “Money (nomisma) by itself is but a mere device. It has value only by law (nomos) and not by nature.”

• Nomos = law or custom.

What are the origins of money? Two Views

1. “Legal” or Social Theory of Money

• Money is whatever people believe or treat as money!

• Aristotle: “Money (nomisma) by itself is but a mere device. It has value only by law (nomos) and not by nature.”

• Nomos = law or custom.

2. Commodity Theory of Money

• According to this view, money is merely an intermediate commodity, such as gold and silver, possessing intrinsic value which becomes, by common consent, a widely used means of exchange.

The Commodity Theory of Money is wrong

• According to this view, money is merely an intermediate commodity, such as gold and silver, possessing intrinsic value which becomes, by common consent, a widely used means of exchange.

• The commodity theory of money is generally not supported by historical evidence.


• Money is whatever the law (or custom) says it is…– In other words, money is gold only when the state defines money

as gold, or when enough people with enough power treat gold as money, (but gold is not naturally or inherently money)

• A functioning currency presupposes legal power, and the historical relationship between money and political sovereignty is well established (cf. Carruthers and Arviovich, Zarlenga 2002, Del Mar 1968, Innes 2004).

• Coins, wherever they have been observed to circulate as media of exchange, have undoubtedly functioned as tokens.


– “There is overwhelming evidence that there never was a monetary unit which depended on the value of a coin or a weight of metal; that there never was, until quite modern times, any fixed relationship between the monetary unit and any metal; that, in fact, there never was such a thing as a metallic standard of value” and that moreover, ancient and medieval coins were mere tokens, the value of which could not possibly depend on their weight (Innes 2004: 16).

Two views on monetary policy

• In American History, two positions on money arose: Bullionists advocated a ‘hard money’ policy and the traditional gold standard, whereas the greenbacks insisted that money was a legal artifact and that money has value because of, and only to the extent that, people acted as if it were valuable (Carruthers and Ariovich 2010).

• Politically, the greenbackers lost and gold convertibility was reinstated. By 1900, the Gold Standard Act eliminated silver standard alternatives.

Money as Debt

• Today, all new money is loaned into existence as debt. Because of the application of interest, total debt will always exceed the size of the existing money supply.

PRINCIPAL (ORIGINAL AMOUNT

OWED)

NEW MONEY

CREATED

Money as Debt

• Total debt, can therefore only be repaid in full by issuing more debt to cover the interest payments. Exponential debt growth and bankruptcies are therefore built in to the monetary infrastructure.

PNEW

MONEY CREATED

= PI<

LESS THAN

Money as Debt Summary

• The money flowing through our economy has been created through the issuance of debt. Money enters the economy when banks create money in return for the promise to repay that debt with interest at some time in the future. All positive balances in our accounts, except for a very small percentage reserve, are lent out to others at interest. Debt and money are the mirror of each other. If we all paid back the money we owed, there would be no money left in circulation, and leave the interest on the debt unpaid (Korowicz 2010).

How money is created in the US: Taxing or Borrowing

• To raise money, US government must either tax or borrow.

• The US Treasury does not exercise the legal authority to spend new, debt-free money directly into circulation, but must instead borrow from the Federal Reserve and other private investors whatever it doesn’t collect in taxes.

• It cannot just ‘print money’ into existence! When it does this, it is actually borrowing this money from the Federal Reserve, a private bank.

Debt and the Rise of Finance

The inordinate Rise in DEBT

Taken from Monthly Review 2008: Sources: Flow of Funds Accounts of the United States,

Financial Debt and Profits

55.0

66.7

78.3

90.0

1998.0 2002.0 2006.0 2010.0

19992000 2001

2002

2003

20042005

2006 2007

2008

2009

2010

Public debt (% of GDP)

Year

Fra

nce

55.0

65.0

75.0

85.0

1998.0 2002.0 2006.0 2010.0

19992000

20012002

2003

2004

2005 2006

2007 2008

2009

2010


Year

Ge

rma

ny

90.0

94.7

99.3

104.0

1998.0 2002.0 2006.0 2010.0

1999

2000

2001

2002

2003 2004 2005

2006

2007

2008

2009

2010


Year

Gre

ece

20.0

53.3

86.7

120.0

1998.0 2002.0 2006.0 2010.0

19992000

20012002 2003

2004

20052006

2007

2008

20092010


Year

Ice

lan

d

20.0

35.0

50.0

65.0

1998.0 2002.0 2006.0 2010.0

1999

2000

2001

20022003

20042005

2006 2007

2008

2009

2010


Year

Ire

lan

d

50.0

63.3

76.7

90.0

1998.0 2002.0 2006.0 2010.0

1999 2000

2001

20022003

2004

20052006

2007

2008

2009

2010


Year

Po

rtu

ga

l

30.0

41.7

53.3

65.0

1998.0 2002.0 2006.0 2010.0

1999

2000

20012002

20032004 2005 2006 2007

2008

2009

2010


Year

Uni

ted

_S

tate

s

0.0

0.1

0.3

0.4

0.5

0.7

0.8

0.9

1.1

1.2

1976 1984 1992 2000 2008

Ratio of Financial Debt to Total GDPUnited States (1976-2008)

Year

Fin

anci

al D

ebt/G

DP

1.8

2.0

2.1

2.3

2.4

1996 2000 2003 2007 2010

Total Debt to GDP RatioUnited States (1976-2008)

Year

Ra

tio

0

20

40

60

80

100

1976 1984 1992 2000 2008

Financial Borrowing as a Percentage of Total BorrowingUnited States (1976-2008)

Year

Pe

rce

nta

ge

0.4

0.5

0.6

0.8

0.9

1.0

1976 1984 1992 2000 2008

Ratio of Household Debt to GDPUnited States (1976-2008)

Year

Ra

tio

Unemployment

2

5

7

10

12

1990 1997 2003 2010

US Unemployment Rate1990-2010

Year

Pe

rce

nta

ge

Unemployment

• A “structural” crisis? The Economy as it exists only employs about 80% of the labor force, or less!

2

5

7

10

12

1990 1997 2003 2010

US Unemployment Rate1990-2010

Year

Per

cent

age

Inequality

30.0

32.9

35.7

38.6

41.4

44.3

47.1

50.0

1970 1980 1990 2000 2010

Percentage of Total Income Earned by the Top 10 PercentUnited States (1970-2009)

Year

Pe

rce

nta

ge

Income Inequality within the US

• How much of this can be attributed to debt itself?

• Which is the more fundamental social antagonism (conflict of interest): workers vs. owners, or debtors vs. creditors? 30.0

32.9

35.7

38.6

41.4

44.3

47.1

50.0

1970 1980 1990 2000 2010

Percentage of Total Income Earned by the Top 10 PercentUnited States (1970-2009)

Year

Pe

rce

nta

ge

The Current Crash: A time line of Events

A closer look: 2007February: First noted increase in subprime mortgage defaults

June-July: Difficulties over how to value MBS’s market dries up - **IKB (small German Bank) requires 3.5 billion euro rescue package

August6th- **American Home Mortgage Investment Corp. declares bankruptcy9th- **French bank BNP Paribas is unable to value structured products cuts financing to 3 large investment funds17th- Fed reduces ‘discount rate’ to 5.75; broadens collateral banks can use

September18th- Fed lowers interest rates to 4.75; discount rate to 5.25%**Northern Rock- First bank in UK to fall victim to a bank run in over a century

NovemberEarlier estimates of total loss in mortgages, $200 billion, had to be revised upward

December11th- Fed cutes ‘federal funds rate’ by .25 percentage points12th- Fed announces creation of Term Auction Facility (TAF)

A closer look: 2008**Bear Stearns defaults March 13th; JPMorgan Chase acquires Bear Stearns for $236 million ($2 per share)

**Fannie Mae and Freddie Mae placed under“Federal conservatorship” Sept 7th

- Constitutes a “Credit Event” Triggers payments on Credit Default Swaps (CDS’s)

**Lehmann declares bankruptcy (not bailed out)

** Merill Lynch sold to Bank of America for $50 billion

**AIG (invested heavily in CDS’s) ; stock prices fall 90% on Sept 16th.- Federal Reserve bailout of $85 billion in exchange for 80% equity stake; extended another $37 billion in October; another $40 billion in November, and counting…

**Washington Mutual suffers ‘silent’ bank run; placed under FDIC receivership, then sold to JPMorgan Chase

- **Wachovia bought by Wells Fargo

Sept 19th- Treasury Secretary announces $700 billion bailout

** Stock market loses about $8 trillion, from peak in October 2007.

What went wrong? Systemic Crisis

Question: why do many businesses fail all at once, at the same time? Individual business error doesn't explain systematic failures.

Answer: There is considerable agreement on the proximate, or immediate, cause:

TOO MUCH DEBT, TOO LITTLE INCOME Banks ran out of prime borrowers; Too much debt

relative to income growth to pay it off...

Profit and Growth

• Private Institutions, like private banks, spend money in order to make money, i.e. a profit.

• Money is only spent if they expect to earn a profit. Banks not only aim to “Grow” in the sense of earning more profit (in absolute terms) than previously. They also aim to:1. Earn a higher rate of return than previously,2. Earn a higher than average rate of return (relative to their

competitors or other conventional benchmarks)• Corporations seek to beat the average rather than

meet the average rate of return.

The allocation of money and resources

• Implication: Money may not be spent on public goods like infrastructure, health care, education, etc.

• This leads to cut-backs in social programs, not because there is no money to pay for them, but because there is no incentive for private financial corporations to allocate the money in this way. They only spend money when they expect that doing so will earn them a higher than average rate of return.

Leverage and Bank Growth

• To grow a bank must make more loans.• One way a bank can lend more is to increase

its leverage. • LEVERAGE = DEBT: Leverage measures the

degree to which assets are funded by borrowed money.

• In short: a Bank must borrow more to lend more.

Leverage and Bank Growth

Banks can make more money in three ways:1. Borrow at lower interest rates;2. Charge higher interest rates;– Banks have little control over the first two.

Competition between banks for funding enforces some uniformity of interest rates.

3. Make more Loans! (aka increase its “Leverage”)

Increasing LeverageA Bank’s Balance Sheet

Assets = (loans)

1. Equity = cash (The Bank’s own

earnings)(aka “capital” or

“liquidity”)2. Debt =

Liabilities(Deposits and

other Debt)

Recall that Banks have reserve requirements:

1. In reality, this reserve does not have to be in the form of cash: it can also be in the form of any asset with a price (i.e. any commodity that can be traded)

Increasing LeverageA Bank’s Balance Sheet

Assets = (loans)

1. Equity = cash (The Bank’s own

earnings)(aka “capital” or

“liquidity”)2. Debt =

Liabilities(Deposits and

other Debt)

2. Nor does this reserve have to be owned by the bank! It can be borrowed (i.e. part of the reserve requirement can come from debt, as opposed to equity)

Increasing Leverage: ExampleStep 1: A Bank’s Balance SheetAssets $10 cash reserves$90 loans

Equity $10Debt $90

(demand deposits)

Leverage is calculated by the debt-to-equity ratio: L = D/E.

Step 1: L = 90/10 = 9Step 2: L = 100/10 = 10.• Increasing “leverage”

means borrowing more money.Step 2: Maximizing “Leverage”

Assets$100→$110

Equity $10Debt $90→$100

Securitized Banking (selling loans)

• Think of “securities” as IOUs that are in turn traded and passed along, as in a game of ‘hot potato.’

• Securities end up functioning as money (i.e. means of exchange, or currency)

Loan sales increased

0.00

0.05

0.10

0.15

0.20

0.25

0.30

1990 1995 2000 2005 2010

Ratio of Loan Sales to Loans HeldUnited States (1991-2008)

Year

Ra

tio

*Ratio of Secondary Market Loan Sales to Commercial and Industrial Loans Outstanding

Repurchase and Sale Agreements

Repos and Mortgages

Bank Runs Revisited

• The financial panic of 2008 was essentially a “bank run” in the repo markets.

Bank Runs Revisited

• IOUs circulated around as money. Banks who had these IOUs borrowed against them in short-term contracts, i.e. they used these IOU’s as collateral (or ‘securities’) to borrow.

• Like a mortgage, I usually have to put up something I own as collateral worth some percentage of the money I am borrowing. Let’s say that’s 90%. If I default on my loan, the bank gets this property, worth 90% of the value of the loan. This is called ‘securitized’ lending, because putting up collateral makes it less risky, or hence, more secure.

Bank Runs Revisited

• When the value of these securities dropped, because people stopped making their mortgage payments, this (loan to value ratio) was not met.

• Lenders demanded that they be paid back, or else be given more collateral, i.e. more securities.

• This is basically a mass withdrawal on the debtors who had to find more securities or sell them to raise more money. The sale in turn caused the prices of these securities to decline even further!

• The financial panic of 2007-8 was essentially a ‘bank run’ in this secondary ‘repo markets’

Two Schools of Thought

Neoclassical (De-regulation) Markets are efficient: The “Efficient Market

Hypothesis” (EMH) states that assets are correctly valued in financial markets

Non-market forces are to blame

Mantra: De-regulate!

Keynes/Minsky (Regulation)

Financial Instability Hypothesis

Markets are inherently unstable

Mantra: Regulate!

Examples of De-regulation:

1. Basel I and Basel II lowering of capital requirements2. Repeal of Glass-Steagal Act: separates investment

from commercial banks• Hyman Minsky: Says that market success over time

leads to complacency; people forget the risks of the financial markets, and take excessive risks.

Most important problem was overall lack of regulation. Neoliberalism destroyed US economy in the 1980s → increase in financial speculation

De-regulation is to blame

The “Global Pool of Money”

This implies that the housing bubble was a result of China, and other countries, saving too much money, which they lend to US banks and financial institutions.

Foreign holdings of” agency” MBSs (those issued by Fannie Mae, Freddie Mac) = $250 billion (10%) by 2000; $1.5 trillion (23%) by 2008 2007, net US international debt

= $2.5 trillion = combined GDP of Latin America and Africa

½ of this debt is held by developing countries Source: http://www.treas.gov/tic/mfh.txt

Inequality and the Crisis Primarily associated with John

Maynard Keynes, and Karl Marx Beginning in the 1970s, wages stop

rising, or at least doesn't keep pace with rising productivity. This results from a number of factors including:

Globalization, firms relocate abroad pushing wages down here

Immigration Women entering the workforce

→ doubles the workforce pressing down wages

*New Technology

Wage and salary disbursements as a percent-age of GDP

Inequality and the Crisis During past 30 years, there has been a PROFIT BOOM; but this

has NOT been distributed as compensation and wages to workers. Rising wages cuts directly into profits.

This presents a problem to business: how do you keep consumption levels high without sacrificing profits by rising wages?

Answer: GIVE WORKERS CREDIT CARDS RATHER THAN RAISES. Debt is a substitute for rising wages. But this was unsustainable in the long-term

In short: inequality is economically unsustainable.

Environmental Considerations Since capitalism began, the global “North” (i.e. the developed/'First

world' countries) could grow with constant or even declining commodity prices: including important raw materials and natural resources

In the 1990s, however, this changed. The NIGs (new industrial giants) including China, India, Russia,a nd Brazil experienced growth rates up to 3x faster than the advanced countries. In fact, a 1/3 of total annual world growth is attributed to the NIGs.

The NIGs represent over 50% of humanity! Their industrialization has caused an increased demand for energy, food, and other raw materials. Their growth depends on cheap materials, but their demand for raw materials increases their scarcity, and their price.

money and the global debt crisis

Economy & Finance