Tuesday, May 17th | 16 Iyyar 5782

May 26, 2011 12:36 pm

Myth and Finance Capitalism

avatar by Gabriel Martindale

It shouldn’t be true, but ‘truth’ is very often a social construct. That is to say what makes for ‘truth’ is simply enough people repeating the same thing, until contradicting the consensus becomes tantamount to madness, like saying the sky is pink, or elephants are a root vegetable. Whether or not the statement in question corresponds to reality is often logically un-connected to its status as ‘truth’. For example, anthropogenic global warming may or may not be happening but its truth status for the vast majority of people, who never have and never will investigate all the scientific evidence for themselves, is dependent wholly on it being announced by the media, teachers, politicians, celebrities and the like. Sometimes the consensus truth is right and sometimes it isn’t, but in either case the mechanism for enforcing it is the same: just keep saying the same thing over and over.

One example I have pointed to on this blog are the public spending ‘cuts’ in the United Kingdom. Both supporters and opponents of the coalition government repeat that these cuts are ‘radical’, ‘savage’ and ‘swingeing’  and so that is the truth, even though the math says that government spending is rising. I’m now going to deal with another example, starting with a quote from a book review in the Times Literary Supplement (Feb 18th, 2011, p. 25) that I happened to be reading the other day:

All political parties, of the Left as well as the Right, and society in general, bought into the idea underpinning liberal economics that human beings acted rationally in markets which were therefore self -correcting as long as governments did not interfere unduly … The result was a period of about twenty years after 1989 during which neo-liberalism assumed the status of an unchallengeable orthodoxy; regulation was light and scrutiny barely adequate …

I happen to think the TLS is the best literary journal in the world bar none, and I don’t particularly want to bash it. Almost identical quotes could be taken from almost any edition of any magazine anywhere in the western world.

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And it’s total rubbish.

The author was talking specifically about financial markets, so we’ll ignore the obvious point that in every western country, public spending is over 40% of the economy. Moreover, the notion that banking regulation is light is an easily disprovable falsehood, as anyone can discover by attaining a copy of their country’s legislation (remember to bring a trolley!), but we’ll let that slide too. Rather, I’m going to make some more general observations about the finance industry in western countries.

Every industry has a commodity and in the financial industry that commodity is money. For most of human history, money has meant either silver or gold; in some places it has been copper or some other metal, in prison it is cigarettes and apparently the Incas used jade. In the modern West, though, it is something quite different: pieces of paper with pretty pictures on them.  (Actually, since about 9/10s of all money in circulation only exists on computers, it is actually ‘1’s and ‘0’s on a microchip). About a hundred years ago notes had written on them ‘promise to pay the bearer on demand…”, meaning that you could take them down to the central bank and get a given amount of gold or silver, so these notes were actually only symbolic representations of the real money: precious metals. Things have changed a little since then; if you repeat the experiment now, you will be given in exchange for your piece of paper with pretty pictures on it a new, cleaner … piece of paper with pretty pictures on it!

So, when you buy a luxury yacht or a Porsche, you have bought your goods with paper worth perhaps as much as two or three naptacks for use as scrap paper or fuel. Why would any auto- or yacht-dealer be mad enough to exchange their wares for that? One answer is that, in my experience, most people operate under the impression that their money is actually backed by some valuable commodity. However, many vendors are more clued up than that, so, again, why don’t any of them demand something more valuable for their goods, like a stick of candyfloss? The answer, is a thing called ‘legal tender law’, which means if they refuse to take your pieces of paper with pretty pictures on them, police will roll up and put them in gaol. In more primitive times our ancestors traded in shiny metals; we prefer to use a currency backed by ignorance and violence.

So, the central bank makes the money and the government forces people to use it. Things are actually a little more complicated than that. If you or I were to print our own pretty pieces of paper or hack into our banking file and start typing zeroes, we’d go to prison for the crime of ‘counterfeiting’. However, certain companies with a license from the government called ‘banks’ are allowed to invent money whenever they want, lend it out and call their fraud ‘fractional reserve banking’, which is legal. Since banks typically lend out the same money deposited in their vaults up to fifty times, things can get somewhat dicey if too many depositors want to take out their money.  This actually happens relatively frequently, but there’s no problem since the central bank just prints off some more pieces of paper, or types some more zeros and lends them to the bank. Again, if you or I were to try and replicate any part of this process we’d be criminals. In conclusion, then, money in the western world is created by banks lending out pieces of paper they don’t actually have and wouldn’t be worth anything if they did, which they in turn borrow from a central bank that can print off as much or as little as it wants, with the whole thing being propped up by the government threatening violence against anyone who doesn’t want to use them.

That’s observation number one about the financial industry. Observation number two is that the vast majority of transactions in that industry involve party A giving party B some money and B giving that money back later with a bit extra. This transaction is called a ‘loan’ and the calculation determining how much more B has to give back is called ‘interest’. Of course, the financial industry cuts up these loans into little bits, assesses and sells them on in endless complicated manoeuvres, but without the loans there’d be nothing else to do. The amount of interest charged on a loan, then, is the key variable in the key transaction in the whole financial industry. If the industry was unregulated one would expect the interest rate to be worked out according to supply and demand, as millions of borrowers and lenders hammered out terms in a competitive environment.


The interest rate is set by the central bank. This involves a massive and consistent intervention by the central bank which, creates, destroys, lend and borrows huge amounts of money every day in order to nudge the interest rate to where they want it. Anyone who wants to lend or borrow thus has their transaction determined not by market conditions, but by the wisdom of about five or so ‘experts.’

On to observation 3. Since stagflation in the 1970s, governments have had to take account of the fact that most of the great ideas for managing the economy invented over the 20th century don’t work and never will. This hasn’t stopped them from using them, of course, rather they find new justifications like ‘fairness’ or the environment. However, one measure has come to be universally relied on as the key tool of economic management and that is setting interest rates. If you want to get economic growth motoring, you put them down, if things seem to be overheating and inflation is out of the 2% comfort zone (2% is already too high, but that’s another blog), then you ramp them back up again.

So, with these 3 observations made we can perhaps answer a question that befuddles many. Most of the time, short of plague or famine, markets work well enough at getting goods to where they are wanted and avoiding either great shortages or surpluses. But with financial markets everything seems totally upside down: they lurch from crazy boom to drastic recession in minutes and bankers earn unimaginable amounts of money one moment then manage to lose even more the next. The response of the Left and most of the media is that there is some mysterious quality to money that makes financial markets inherently and uniquely unstable and irrational. The response of the mainstream Right is that money markets are rational if you just squint hard enough. However, there is another alternative. Pick any commodity you want from TVs to corn and imagine that:

a)      The production of this commodity is a monopoly of the government and certain licensed companies, it being a criminal offense for anyone else to make it.

b)      The price for this commodity is controlled by the government buying and selling huge amounts of this commodity, based on the determination of a council of experts.

c)       They use the price of this commodity to try and manage the whole economy.

What you’d expect is a market  gone completely haywire with crazy profits for some and disaster for others. This outcome would happen regardless of whether in other ways the market was highly or lightly regulated. This is exactly the case of financial markets.

Money is a commodity like any other, but since almost every transaction uses it, it is the most important one to any economy. The story of financial boom and bust is, once the most elementary and ascertainable facts about money are known,  one of the failures of central planning in almost the only industry still run according to statist principles. In our Kafkaesque public discourse, though, it’s a failure of laissez-faire.

For how long?

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