Who’s bailing whom? Challenging the private credit system

from Jim Stanford

The time since 2008 has been a crucial historical moment for progressive economists to pull back the green curtain that surrounds the operation of the for-profit banking system, and expose that system for what it is: a government-protected, government-subsidized license to print money.

The problem is, as soon as you start saying things like that, people conclude you are some kind of wacked-out conpiracy theorist nut-bar.  It sounds insane to claim that private banks have a license to create money out of thin air.  As John Kenneth Galbraith put it, “The process by which banks create money is so simple that the mind is repelled.”

[Of course, it doesn’t help that there really ARE a lot of wacked-out conspiracy theorist nutbars out there, talking nonsense about the illegality of the Federal Reserve system and other drivel.  Job one is dissociating our more reasoned and fact-based critiques from all that.]

The simple truth is this: private banks have the power to create new money when they issue leveraged credit.  They have used that power poorly: facilitating asset bubbles rather than real capital accumulation, and jolting the economy with on-again-off-again surges of credit rather than the steady supply we need.  Every bank that does this is inherently vulnerable (even Canadian banks), since no bank has money in the vault to pay its depositers if they all show up demanding cash.  (More precisely, in modern terminology, every bank depends on the overnight liquidity cooperation which, when it isn’t there, causes banks to fall overnight … a la Lehman Brothers.)

The reason that weaker banks get targeted by speculators first is not because they are the only ones at risk of failure.  It’s because they’re the obvious ones to go after first — and the most vulnerable to short-selling, rumours, and everything else that makes the current system so fantastically and unproductively fragile.  If the speculators turned on any other leveraged bank (including Canada’s), they could fail, too.  It’s just that by staying out of the spotlight, and looking relatively strong (though still fragile in the absolute sense), that other banks hope to survive. 

That’s like the old adage I learned while in Alaska this summer.  To survive a bear attack, you don’t have to run faster than the bear.  You just have to run faster than the other person you’re hiking with!  Exactly the same logic explains how limited is our own banks’ claim to stability.  Canadian banks couldn’t survive a run any more than Greek banks.  It’s just that the Greek banks will be caught by the bear before ours.

Exposing what exactly banks do, how unique (and lucrative) is their power, how inherenetly fragile the whole system is, and how unproductively its power has been wielded, lays the groundwork to demand a whole new approach to managing the credit system.  Instead of thinking of credit as a profit-centre in its own right (especially since there is no real social value created in the financial sector anyway), we should think of it as a utility: something the economy needs, delivered in a stable and rational manner, in order for anything else to work productively.  Kind of like “turning on the lights” for the whole economy.

I don’t think left economics has risen to the task demanded of us at this moment.  Empty jargon about “reassuring the markets” still dominates discourse over what happened in America, what is happening in Europe, and what will happen elsewhere.  There’s almost no comprehension about how banks work, and how and for whom they operate, just a widespread (and justified) fear of what will hapen if they collapse.  We need to be more forthright and blunt about exposing private finance for what it is, and demanding changes (phrased in concrete not utopian ways) to use the power of credit (that is, the power to create money out of thin air) for good, instead of evil.

To that end, here is a slightly longer version of my column in the Globe and Mail on the ongoing European crisis, and why it’s completely wrong for German taxpayers to complain about bailing out free-spending Greeks.  I’m sure I will be roundly denounced as trying to resurrect “social credit” or some such claim.  It’s a tough job, but someone’s got to do it.

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The 17 member governments in the Euro zone are currently voting on a larger, more powerful bailout fund, the European Financial Stability Fund (EFSF).  Officials want 440 billion euros for the kitty, with new powers to buy European government bonds and invest directly in banks.  The goal is to enhance the confidence of financiers in Euro-zone bonds and banks – countering speculative attacks that have pushed up interest rates and shaken confidence.  All members must approve the expansion, which unless any of them have an economic death wish will occur by mid-October.

However, the expansion has sparked lots of public grumbling.  “Why should taxpayers in countries that followed the rules bail out countries that didn’t?”, the complaint goes.  This sentiment won’t stop any country from approving the expansion (Germany, the lynchpin, endorsed it last week).  But it will constrain politicians’ subsequent efforts to reign in the crisis.

The public’s ire, while understandable, is misdirected.  It isn’t Greece and other weak states that are being bailed out.  It is the banks that lent money to those countries.  If it was only about letting Greece default, that would have happened two years ago.  It’s the feared collapse of banks in France, Germany, and elsewhere – causing a credit freeze and continental depression – that officials are racing to prevent.

So German taxpayers aren’t bailing out big-spending Greeks.  They are bailing out German banks (and, more precisely, the financial investors who own those banks).  Those banks created leveraged credit out of thin air, worth many times their actual capital, and lent it to Greece.  They will now fail when Greece (and others) fails to pay it back.

So far the Euro rescue has focused on bending over backwards to try to assuage the fears, and the demands, of the owners of financial wealth.  They are euphemistically referred to as “the markets.”  But in fact, they are sentient human beings – human beings who own money. 

These human beings are unilaterally demanding very high interest rates for loans to indebted states.  But those escalating interest costs, together with the fiscal side-effects of continuing recession, are making the crisis worse.  Perversely, the tougher the cutbacks get (and the cuts in Greece, Ireland, and elsewhere have been historically unprecedented), the worse the crisis gets.  And even the expanded bailout fund won’t be enough to hold back the speculative tides when the “markets” turn against the next fiscal weakling.

European officials must also reassure financiers about the credit-worthiness of the banks themselves – trying to nip in the bud speculative attacks which could quickly become a full-fledged run on the banks (à la Lehman Brothers).  Since private banks have the legal power to multiply their capital many times over into new loans, any bank, so leveraged, is vulnerable to such a “run.”  Euro officials want the governments to pay to shore up the private banks.

But it’s not necessary that grumpy taxpayers foot this bill.  The risk is that huge amounts of privately-created credit might suddenly disappear – first through sovereign default and then, far more dangerously, through bank collapse.  So why not just replace that disappearing private credit, with new credit?  That doesn’t require taxpayers to fork over anything.  It simply requires policy-makers to take over management of the credit system itself.

In other words, instead of doing everything to keep private financiers happy, European officials need to replace the private debt-credit relationship with a publicly managed one.  The private credit system which created all that money, and lent lots of it to Greece, will eventually be socialized, in two distinct ways.

First, the debt itself will be socialized (as the Europeans take continental responsibility for the bonds of hard-pressed member states).  But more importantly, the leveraged money-machine that created the credit and lent it with wild abandon in the first place, will also be socialized.  Banks will be “recapitalized,” a euphemism for injecting hundreds of billions of euros of public capital into the banking system to offset the capital that will disappear with the coming defaults.  Those new funds can and should be created by (public) banking, through the European Central Bank; taxpayers needn’t pay a cent.  So far Europe’s ultra-conservative finance officials reject this idea, opting instead for government-funded partial bailouts; they thus block the full socialization of debts that could truly solve the crisis.

Ironically, debt socialization is exactly what occurred in the U.S., albeit in a very lopsided way.  Government took responsibility for massive private debts, and bailed out the private banks that created it.  Some of the cost was borne (unnecessarily) by government itself.  But much was financed by the Federal Reserve, which in essence created new money (just like private banks do every day of the week) to keep the system afloat, through “quantitative easing.”

The basic property relations that underpin the whole system, however, were not reformed in the U.S., despite the state’s essential role in saving it from itself: the system is still steered by (subsidized) private financiers, now reaping fortunes again from their business of creating money out of thin air and applying it to most profitable uses (usually involving placing bets in the global casino known as “derivatives” trading).  Perhaps the Europeans will do better than the Americans at demanding some kind of quid pro quo for the public interest, out of this enormous rescue.

Inevitably, however, the system will be socialized, because the private credit system is now untenable.  The only question is, in whose interests that socialization will occur.

We don’t need to ask taxpayers to cough up a cent of real money for either type of bailout – whether of heavily indebted countries or over-leveraged banks.  We need to find an alternative way, through public banking, to create new credit to replace the private credit now teetering on the edge of destruction.  That’s a proposition that Germans and Greeks alike should celebrate.