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The Financial Meltdown - An Explanation

2008 Nov 14

It is November, 2008, and we are witnessing a global financial meltdown of unprecedented and monumental proportions. We are living in interesting times. What began as mortgage defaults in the U.S. became a sub-prime mortgage fiasco which led to bankruptcies, the credit crunch, economic slowdown, global recession and financial meltdown. How could anyone in the business to know of these things not have seen this coming?

What I hope to accomplish in this article is to instill within you a deep understanding of why this is all happening. In order for you to be able to wrap your heads around this you have to strip away any preconceived and deeply ingrained ideas about money and the economy.

The current economic system is very complex and complicated. Yet, everything is interconnected. When we go to the baker and purchase a loaf of bread, this seemingly simple and innocent act can trigger an endless chain of events that spreads across the globe. This is what is known as the butterfly effect which can be summarized as follows. A butterfly flapping its wings in China could possible change the movement of air around it so as to eventually affect the weather in Phoenix, Arizona. This is very far reaching and profound thinking.

Let us begin by understanding what sharing and bartering is all about. It helps for me to use simple situations in order to peel away the complexity of our current monetary system. Farmer Joe raises a few dozen cattle on his ranch, while next door to him, farmer Dan grows vegetables such as potatoes and carrots. Farmers Joe and Dan are amicable country folks and they share their produce with each other. Joe supplies Dan with milk, cheese and meat while Dan provides vegetables. They only trade what each of their families need and no more. No money is exchanged and we call this bartering.

It may so happen that farmer Joe produces more dairy and meat than what farmer Dan produces in vegetables. But this does not mean that Joe is wealthier than Dan. So long as Dan can get the dairy and meat his family needs and can match the exchange with his vegetables, all is fair. When this is not the case, maybe because of a poor crop that year, Dan may not be able to fulfill his side of the exchange. Dan may offer one of his sons to work on Joe's dairy farm in order to achieve a balanced trade.

This brings us to the first observation. Having a surplus does not necessarily give you wealth. However, when someone else is indebted to you it gives you power over that person.

Bartering is not a very convenient method of exchange. It relies on the double coincidence of wants. You have to find someone having what you need and one who coincidentally wants what you can offer. This is where money or currency plays a vital role. At this point we can see that money is a promise, an I.O.U., to provide a good or service of comparable value at some future date. Money allows you to exchange over long distances and time. Money has no intrinsic value. We can create money, a promise or I.O.U., by simply writing out that promise on a piece of paper.

You might not have thought of it this way, but we print our own paper money every time we write a cheque. Let us suppose that your friend John has a guitar that you would like to buy from him for $100. You say to him, "I don't have the cash on me right now, so will you take a cheque?" John looks at you and trusting that you will not rip him off, replies, "Sure thing, bro." Now, whether you actually have $100 in the bank is of no significance at this point. You have just written an I.O.U. on a piece of paper and John trusts you. He has confidence that you will honour your promise to pay.

Now if John endorses the back of the cheque with his signature, that piece of paper can now be traded to anyone else just as if it were real money. John exchanges the $100 cheque for a drum set. In fact, the same $100 cheque gets traded many times over and each recipient of the cheque accepts it on faith, with confidence that it is worth the $100 written on it. This can go on indefinitely whether or not there is $100 sitting in the bank. The system functions entirely on trust, on consumer confidence.

Then one day, many years later, you sell your old computer for $100 and the buyer offers you a cheque for $100. You look at it in amazement and say, "Hey, this is the same cheque I wrote out to John ages ago. The son-of-a-gun never cashed it. I always wondered what became of him and my cheque. Look, it even has my signature on it." You willingly accept the cheque in exchange for your computer. Then you ponder what you should do with it. After a brief thoughtful moment, you quickly realize that the piece of paper is worth nothing to you. You just rip up the cheque and toss the pieces in the dust bin.

In fact, you can write out as many checks for as much money as you wish without having any cash in the bank. As long as people have faith in your cheques and as long as no one redeems any of your cheques, they are as good as gold.

We will come back to this later.

A major difference between an I.O.U. and currency is that when an I.O.U. is returned to the original issuer, it can simply be destroyed since it has no value. Currency, on the other hand is recirculated into the system and the money supply keeps on expanding.

The promise or I.O.U. that you have made on a piece of paper is your commitment that you intend to provide a good or service of comparable value some time later. When this actually occurs you will have completed your half of the bargin. Until it occurs, someone else is holding an unredeemed I.O.U. and that person potentially has power over you. Hence, we reiterate and expand on the first observation that financial wealth gives the holder power over others. In other words, money lenders have power over borrowers.

We now come to the story of the money lenders.

We will begin this part of the story with the goldsmiths. The goldsmiths made coins from gold and silver and they needed a secured place to store their precious metals and finished coins. Before long, the goldsmith would also store other people's gold in his own vault. He would then issue receipts to indicate how much gold was being held for safekeeping. People found that it was cumbersome to retrieve their gold holdings whenever they needed to trade and that it was more convenient to exchange their gold receipts instead of the actual gold.

A goldsmith could lend some of his gold to someone for a small fee or surcharge for the effort and risk he was willing to assume. The borrower could then park this gold back with the goldsmith who would issue a receipt for the amount of gold stored. Later, an enterprising goldsmith realized that he could lend out "gold" by just issuing a receipt. Moreover, he could issue more receipts than the actual amount of gold he held in his vault. The public would not be any wiser as long as everyone did not redeem their receipts for real gold all at the same time.

This brings to light another observation. When someone borrowed gold from the goldsmith, the loan was repaid when the gold was returned. If the borrowed gold was parked with the goldsmith, all the borrower had to do to repay the loan was to return with the receipts for the gold. The goldsmith can then destroy the receipts. But the borrower still had to pay the loan fee, surcharge or interest, and this had to be paid in real gold. This gold had to come from somewhere. The interest could also be repaid in receipts which meant that someone's gold was being used as payment.

In a large and diverse economy, this is not a difficult problem. One can likely acquire more gold or receipts from another lender or through employment or trade.

The issuing of more receipts without the backing of real gold can go on unnoticed so long as people do not redeem their receipts. The payment of interest is facilitated by finding another lender or by passing on the indebtedness to another person. This can go on indefinitely in a growing population, market and economy.

This is not unlike a pyramid or Ponzi scheme. This is a con game. This is non-sustainable.

And yet, this is what banks do in our current monetary system. Banks create money out of thin air. Banks issue loans by simply increasing the balance in your account. Banks expect a return on investment through interest charges. These payments are made by the borrower having to take out more loans from another bank. The money supply grows unnoticed so long as the population and the economy keep on growing. This is the fundamental reason why all mainstream bankers, economists, governments and corporations depend on growth. Without growth, the entire scheme comes crashing down like a house built from a deck of playing cards.

And as if this wasn't enough, we have bankers, financiers, traders, investors, speculators, mutual funds, pension funds, hedge funds, stock markets, money markets etc. all involved in creating a huge global financial bubble, inflating prices on thin air and no real assets, building what we call ficticious capital, all to satisfy one thing, greed. Sooner or later the bubble has to burst.

This is the fundamental reason for the current financial meltdown. And there is another psychological reason for the economic downturn. The credit crunch and economic slowdown did not have to occur at all. This is not like an elephant that wants to go whichever way he wants.

Just as the person who can write any number of cheques while having no money in his account, the bank can lend out money with no deposits in its vault. As long as the public has confidence that the situation is all under control, it is business as usual. And that is the crux. Our current monetary system demands public confidence. If we all went to the bank at the same time to close our accounts and withdraw our savings, the bank would have to close its doors and declare bankruptcy. That is what is happening today. That is what is causing the financial crisis. With loss of confidence, people are redeeming their receipts, cashing in their chips. Banks are recalling their loans and credit for business expansion has dried up.

So to summarize, the financial meltdown is a result of a flawed and corrupt monetary system. It is triggered by collapse of public confidence, not of the system, but of the safety of their savings and investments and what the future holds.

There are two more sinister things that are happening but I will leave that for another time.


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