Neil Emerick
3 November 2008
opinion
Johannesburg — THE past few weeks have seen citizens of Europe and the US grapple with numbers that seem Zimbabwe-like in nature. Exactly how many zeros does $700bn have? What would € 1-trillion look like stacked up?
While the average consumer may struggle to understand the enormity of the credit collapse, he can recognise the impact on his house price and his savings. This is a monumental event and deserves comparison with the 1929 crash and subsequent depression.
However, I do not believe it is the free market that has let people down, but rather the inevitable result of government intervention going back to the 19th century. Today's credit crunch is the conclusion of a series of historical mistakes . The problem lies not with greedy capitalists but what greedy capitalists do with ever increasing government money.
In the old days, banks issued private notes when depositors handed over gold for safe-keeping. Some way down the line these financial warehouses realised people were trading their receipts rather than coming in for the gold. So, with interest to be earned, why not issue more receipts than there is gold? That is, as long as everyone doesn't come in at the same time, you can issue just as many receipts as are necessary to cover the gold withdrawn on a "normal" day.
Thus was born what today we call fractional banking; the ability for banks to create money by issuing receipts for which there is only a fraction of true "value" reserved in their vaults. Then governments muscled in, granting themselves monopoly rights to print paper money, albeit backed by gold. Private banks were no longer allowed to issue their own money, having to keep reserves of government money instead. However, just after the First World War governments abandoned their promise to redeem notes for gold, promising instead to redeem for US dollars. All fine until 1971 when the US broke its promise to repay in gold and we entered the era of what one sarcastic historian dubbed "random-walk monetary theory".
How does this relate to the credit crisis? In the past 30 years, governments have manipulated interest rates under the view they can change real values in the economy (such as employment and economic growth). They print money to increase bank reserves, the banks lend to Joe Soap, who uses the money for property. Prices begin to rise. This is the boom.
Then comes bust. Risk has been under-priced and the market starts to unravel. However, it is not that markets become irrational. Rather, it is that moment when they perceive their irrationality and attempt to rationally correct things; the realisation that the emperor is indeed butt-naked.
My suggestion then is the current crisis is not the result of a free market, but a market-free banking system, where governments continually intervene to mess up the prices people associate with risk and credit. Lowering the price of credit does not create wealth. It misallocates resources.
Some monetarists think the only solution is a return to gold-backed money, but this would be unrealistic . What would a better system look like? In the early 1980s British banks were working off reserves four times higher than today. The link to real cash has become tenuous. So why not abandon government money completely? Banks should issue their own digital credits and facilitate payments and loans with no tie to government money . But what would private money be worth?
The answer lies in creating collateralised assets based on real "stuff" in the economy. I could pledge my house to the bank and receive so many digital credits. I use those credits for consumption or lend them out through the bank as intermediary. The bank's balance sheet shows a real asset for every credit. In other words, it is close to a 100% reserve system. If a bank were to issue more credits than it had security for then borrowers would spend their credits with other banks while depositors withdrew their assets. Such action would warp the bank's balance sheet, ensuring they stop lending and encourage deposits through a higher private interest rate.
This may seem like a major leap from the status quo, but how much more unrealistic is the current government plan to restore confidence in the system? We are told the problem is a lack of trust between banks. One would think to get banks to lend in a risky environment a higher interest rate would be required. Instead, governments are printing more and more paper money to lower the natural rate of interest, creating in essence a financial price control.
In summary, governments have kept interest rates too low for the past 30 years, creating money that banks turned into cheap loans which went to the wrong people. Fractional banking coupled with unbacked paper money is a house of cards and only the abandonment of both will restore stability to the world financial system.
Neil Emerick is a councilor of the Free Market Foundation.
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