Let’s not sidestep what happened last week.
What you saw was indiscriminate selling, market wide. The ASX lost close to $50 billion. Heck, hundreds of stocks made new 52-week lows.
The most expensive stocks got the worst of it.
CMC Markets said ‘there was no particular trigger for the meltdown it appears investors were locking in gains ahead of a number of key market events over the next 36 months’.
But I don’t buy that.
Sure, maybe a few investors were locking in profits after they saw the market tumble.
But it’s not how the declines started. A switch was flipped in investors’ minds, the realisation that credit was drying up and that stocks might quickly decline.
The idea started with a few, and then infected the many. Are the speculators to blame? No, no.
I blame the banks and their frivolous creation of money.
Let me explain.
Banks don’t lend and they don’t borrow
Banks are incredibly important to our economy. And it should be plainly obvious to see why.
One of their most important roles is to house savings and lend it out to individuals and businesses. So then why are economists struggling to fit these financial intermediaries into their models?
Let’s look at GDP for a moment. GDP, or gross domestic product, is simply all the goods and services produced by a nation.
If Australia’s GDP is $1.3 trillion, that’s $1.3 trillion worth of goods and services produced in any given year.
I won’t bore you with the maths, but there are a couple of figures that go into this number, consumption, private investment, government spending…
The driver of GDP is value added activities. For example, a lumberjack might cut down a tree so it can be used for construction. This is a value added activity because that tree is now worth much more as lumber than it was as a tree.
The problem economists run into is what to do with banks. What value do they create?
‘They [economists] actually have been struggling for decades with what to do with the financial sector,’ Professor Richard Werner said in a Russia Today interview.
‘Why? Because GDP, which is actually created by national income accounting by adding up value added activities. And that’s where the financial sector has a problem. What is the value added?
‘It’s been so difficult that essentially the national accounting statistician have had to make up a fictional value and just add it onto GDP, saying “Ok, that’s maybe is what the financial sector is doing.”’
Werner goes on to say that the financial sector does not actually add any value. It subtracts value. One way the sector subtracts value is through ludicrous fees they charge as stewards of capital.
It’s why I believe billions of dollars continues to pour into cryptocurrencies and blockchain-related projects. The vast majority are trying to create a new system, where the value subtracted by banks is put back into the economy.
According to Tech Crunch, there was about $1.3 billion invested in blockchain globally this year.
One example is Circle. It’s a mobile peer-to-peer payment platform that allows users to hold, send and receive dollars.
You still need to pay a fee to use Circle. However, you will pay no additional fee for exchanging money or sending dollars overseas. It’s a step in the right direction, I say.
But this isn’t the secret the banks are trying to keep. In fact, they are actually one of the biggest investors in blockchain technologies. In fact, US investment bank Goldman Sachs was one of the initial backers in the Circle project.
What banks don’t want you to know are the simple activities they do on a daily basis.
You see, banks don’t lend money. They don’t take your deposits. They’re not the financial intermediaries you think they are.
Banks have one purpose and one purpose only: to create money out of thin air.
A deposit is not a deposit and a loan is not a loan
You might’ve come across the term fractional reserve banking. It’s the idea that banks take on deposits, and then use those deposits to make loans. The value of loans they can create will depend upon the reserves they’re required to keep.
So for example, if a bank has a reserve requirement of 10% and $10 billion in deposits, the bank can hand out as much as $100 billion worth of loans.
But banks don’t do this. They don’t take your deposit and transfer it to borrowers. Professor Werner explains:
‘Banks are being thought of as intermediaries, but this is not really what’s happening. They’re creators of the money supply…Banks are thought of deposit taking institutions that lend money. The legal reality is, banks don’t take deposits and banks don’t lend money.
‘So what is a deposit? A deposit is not actually a deposit. Its not bailment, it’s not held in custardy. At law, the word deposit is meaningless. The law courts and various judgements have made it very clear, if you give your money a bank, even though it’s called a deposit, this money is simply a loan to the bank.
‘So there is no such thing as deposit…what about lending? Surely they’re lending money? No they don’t. Banks don’t lend money. Banks, again at law it’s very clear, are in the business of purchasing securities. That’s it.
‘So you say, “Ok, don’t confuse me with all that legalese, I want a loan.” Fine, here’s the loan contract, here’s the offer letter and you sign. At law, it’s very clear, you have issued a security, namely a promissory note. And the bank is going to purchase that.
‘That’s what’s happening at law.’
Ok, so this just means the words we’re using are wrong, so what?
But say you’re the person borrowing money from the bank. Do you think deposits from the bank are being transferred into your account?
As we saw, a deposit is not a deposit and a loan is not a loan. Banks are in the business of purchasing securities. So, all they’re doing is buying various securities, which adds to the assets and liabilities on their balance sheet.
Again, what does this mean? Well, as the borrower, no money has been transferred to you. The money will be in your account, but it did not come from deposits.
Like I said before, the banks create this money out of thin air.
What happens when money is free?
Now, you might not be too happy with what I’ve just said. Money creation generally doesn’t bring on happy thoughts.
But it can be glorious. Money creation can lift countries form developing to developed. It can improve living standards. It can create opportunities and reduce inequality.
However, that’s only if this money creation is in-line with the creation of goods and services. Meaning, the creation of money is funding value-added activity in the economy.
And of course, this doesn’t happen.
Banks create money for unproductive project, speculation and consumption.
So when banks create money for unproductive uses, demand for goods and services goes up (because there’s now more money in the system), but the amount of goods and services remains the same.
This is how we get inflation and sky high asset prices.
Why do you think Aussie property prices are so high?
Banks have created too much money for the purpose of asset ownership transfer, an activity that adds little to no value to the economy. So when you get lots of money vying for a fixed asset, prices can easily get out of hand.
Or what about stock prices the world over? Valuations are high because banks have created too much for speculative purposes.
Again, this speculation adds no value to the economy. In fact, aggressive lending for both of the above activities just decreases everyone’s purchasing power.
When things really get out of hand, that’s when you get the making of a financial crisis. Too much money is created for unproductive activities, causing asset prices to skyrocket. Then, it’s only a matter of time before the music stops and there aren’t enough chairs for everybody.
Unproductive businesses that were able to survive under cheap money go broke when liquidity is sucked out of the system. Homeowners who’ve bitten off far more than they can chew default on their promissory notes (loans).
The only ones not drastically hurt in the process seem to be banks, which tend to do just fine in the end.
Clearly our system has faults. It could all run smoothly. But greed and poor incentives cause bankers (and everyone else) to do stupid things.
It’s not hard to see why so many people buy into the long-term vision of cryptocurrencies: a new system, free of intermediaries and wild money creation.
I don’t know if we’ll get there within the next few years or even in my lifetime. All I hope is that we take small steps in the right direction.
Editor, Money Morning
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