A glance at daily news reports and inept political measures taken by governments around the world to counteract the recession indicates that most people simply to not understand the economic mechanics of what is going on. But help is available.
At Paddy Allen’s Global recession – where did all the money go?, Dan Roberts explains the basic economics involved, detailing the money and banking mechanics behind the current worldwide financial and credit crisis.
The first thing to understand is that this recession was inevitable. Financial lending institutions have stretched their lending powers far beyond healthy limits. Borrowers have entered into mortgage agreements for outrageous home prices based solely on the idea that markets would go up indefinitely. Executive salaries and e.g. employee bonuses in some business sectors, especially at the investment banks, have mutated from “awards for outstanding work” to out-and-out “pilferage of company and client assets”. Oil prices have reached the level of “pure theft”. Something has to give, and it has.
The bottom line is that there is a tremendous gap between the actual number of let us say US$ in circulation worldwide – this is estimated to be about $4 trillion dollars – as compared to the “dollar assets” on the books of banks, which are listed at nearly $40 trillion dollars (according to the Bank of International Settlements).
How can such a situation have developed? And what does it tell us about the nature of money and wealth?
The reason for this discrepancy between “money in circulation” and “alleged bank assets” is that banks can lend out much more money than they actually have on deposit.
The example given in the Guardian article cited above is instructive and we amend it a bit here to make it easier to understand by increasing the hypothetical amounts so that we can talk about mortgages.
If a bank customer deposits $500,000 cash into his bank account, the bank can lend that money out, and it does, but it is obligated to keep some percentage of that amount, let us say $1 of every $5 lent, so that it must keep $100,000 and can lend out only $400,000 to someone who is, for example, buying a house (home) on mortgage.
The seller then takes that $400,000 and, for the sake of this example, puts it into his account in that same bank. In fact, no actual money changes hands. It is all just a matter of “journal entries”.
The bank can now lend out 4/5ths of the $400,000 to a different house buyer, who thus mortgages a smaller house for $320,000. The seller of that house puts that money into his account in the bank.
The bank loans out 4/5ths of that money, again to a house buyer, who mortgages an even smaller house at $256,000. The seller of that house puts that money into his account in the bank. The bank then loans out 4/5ths of that amount, etc., etc.
In sum, in spite of only a $500,000 initial deposit of “real money” the bank can in fact ultimately lend out nearly $2,000,000, and make handsome profts from the interest payments of that money. It promises to pay the depositor let us say 4% interest annually on the money (= $20,000 per annum) and charges its borrowers 6% interest on the $2,000,000 in mortgage loans (= $120,000 per annum), for a net profit of $100,000 per year.
In turn, the initial $500,000 cash deposit, is paying the rent of the bank, the salaries of the employees, etc., and a percentage is retained for cash transactions.
It is a fantastic money-making system for the banks when the system is working normally.
But what happens if the borrowers in the above example default on their mortgages and the foreclosed houses are worth much less than the mortgage amounts or if the those homes can not be sold on the market at all, except at prices much below worth? And what happens if too many depositors at any given time want their money back? In such cases, the banks are broke, because the entire system is not based on tangible, physical money but rather on accounting entries in journals, representing “promises to pay”, i.e. “credit money”. The banks in such cases say they have suffered “a loss”, but in fact they never had the money to begin with.
Nevertheless, it is strictly this theoretical “credit money” which drives the modern world economy. If credit were based on the actual tangible, physical money which people actually have, then the world economy would come to a standstill. There simply is not enough real money in circulation to cover even a small percentage of our annual economic transactions. This author has even been in stores that take no cash payments. They think people are joking.
So, to repeat, if people start defaulting on their loans in big numbers, the banks come into an impossible situation, because they have lent out much more money than they actually have. Worse, if their depositors make “runs on the bank” to stupidly put their money under their mattresses, then the bank is soon dry of dollars, long before all depositors have been satisfied, and it then no longer has any liquid assets at all and can then provide no more credit, thus bringing the economy to a halt.
And precisely that is what is happening today.
The situation has been made much worse by so-called “credit derivatives” which have inflated the theoretical amount of money “out there” to about $60 trillion dollars, and, after various scams called “swaps” and the like, the notional value of such derivatives reached the incomparably absurd sum of $863 trillion dollars – “many times the value of all the economic activity on the planet“. Indeed, the net value of the world economy is estimated to be about $290 trillion, and the annual GDP of Planet Earth is calculated at $55 trillion.
Bailouts in essence, provide government money as a “journal entry” so that institutions and private individuals can continue to go about their business. The problem is that injecting a couple of trillion “journal entry dollars” into the system at the top of the economic ladder – bailouts, as it were – is not working as it should. The reason for this is because the economy, in an admittedly oversimplified model, is according to Dan Roberts defined by four basic variables:
M – the amount of money in circulation
V – how fast that money circulates
P – the price of goods
Q – the quantity of goods sold
The formula is MV = PQ
It is easy to see that even if M – the amount of money in circulation – is greatly increased, the multiple of P times Q can drop greatly if V – the velocity of money in circulation – slows down – and it HAS been slowing down greatly, because people are afraid to spend and have slowed their buying to a snail’s pace. The result is recession, or, if it continues, an economic depression.
As we see from the foregoing discussion, the critical element on the left side of the equation is not so much M, the amount of money in circulation. Rather, it is how fast it is circulating. The less people spend, the smaller V, money velocity, becomes. If V drops to, for example, 50% of what it was, the amount of money available has to be doubled to keep the equation balanced.
As the multiple of M times V drops, this has a corresponding impact on prices and the quantity of goods sold. If M times V drops enough, not even price cuts can stem the tide, as the quantity of goods sold decreases to way below retail inventories. The economy is then in severe trouble. Things are so bad that auto manufacturers such as Toyota have even rented a ship in Sweden to store their unsold cars, because they have exceeded their maximum permissible “on land” inventories.
So, we have to get people buying goods and services again. But how do we do this?
What measures need to be taken by governments to counteract the current economic recession?
Everyone has been concentrating in the equation on M, the money in circulation, via “bailouts”, as the solution to the problem, and M is surely an important variable, but not nearly as important as V, the velocity of any economy, and this is primarily the velocity of spending.
Germany is demonstrating to us through one of its economic recovery measures what kinds of things need to be done to get the economy “moving” again. As written at the Guardian just a week ago, February 26, 2009, at a time when other car manufacturers are closing their doors:
“German car manufacturers are celebrating a record boost in domestic sales that has been put down to the introduction of a government bonus given to consumers who trade in their old vehicles for new ones….
Under the scheme, which is set to cost the government €1.5bn (£1.33bn), those who trade in a car that is over nine years old receive €2,500 (£2,230) towards a new model.
The hugely popular response to the bonus in Germany has caused waiting lists for cars – particularly small models like Polos, Golfs and Corsas – to stretch to months. Politicians are now coming under pressure to extend the bonus to social welfare recipients.“
The lesson of this German measure, now being adopted in other European countries, is that governments have to take economic measures which leave citizens no other basic alternative but to spend, and you do it by increasing V, the velocity of spending, rather than by increasing M, in this case money in the hands of institutions, through bailouts.
Money given to the top, stays at the top, and they already have far more than enough. That is the flaw in the bailout solution. That money is not going where it is needed. You get the economy moving again by redistribution to the lower echelons, those who spend. You offer them freebies, coupons, whatever. That is how your average consumer is driven by Madison Avenue advertising to spend every day. Nothing has changed. You DO NOT get the economy moving by giving Apple (or any corporate counterpart) money. Rather, you give money to consumers to buy iPhones. With cars, banks and any other kinds of goods or services, it is no different. Put the bailout money into the hands of the BUYERS, and things will improve, but not otherwise.