October 10th 2015

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COVER STORY Will drought and falling dollar spike food prices?

CANBERRA OBSERVED Nationals extract good deal in Turnbull takeover

EDITORIAL Obama's climate gambit: do as I say, not as I do!

FAMILY AND SOCIETY Senate committee says no to marriage plebiscite

NATIONAL AFFAIRS Turnbull divides party in Cabinet reshuffle

RURAL AFFAIRS FTAs eat away at our food and agriculture surpluses

RELIGION IN RUSSIA Byzantine Catholics driven underground

FINANCE Hidden by a metaphor: the secret life of money

EDUCATION Proliferation of screens making kids no smarter

NATIONAL AFFAIRS Cabinet door must be open to public service

FAMILY AND SOCIETY Child-support program under the microscope

PUBLIC POLICY Prohibition of drugs has the evidence on its side

CINEMA Kids will love pixelated Aussie classic: Blinky Bill: The Movie

BOOK REVIEW Hope for the Land of the Southern Cross

BOOK REVIEW Evaluating arguments against free will


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Hidden by a metaphor: the secret life of money

by David James

News Weekly, October 10, 2015

A popular debate in financial circles is over the merits of fiat money, currency that derives its value from government regulation, or law. Fiat money differs from commodity money, which is usually based on a precious metal such as gold, or representative money, whose value is based on a claim on a commodity.

Since the ending of the gold standard by Richard Nixon in 1971, the world has mostly reverted to fiat money. The important thing to remember about this is that it means money is regulations.

Shortly thereafter there was a push in the English-speaking world, aided by the pro-market ideologies of Margaret Thatcher and Ronald Reagan, for financial deregulation. Notice a small logical flaw? If fiat money is regulations, then how can the financial sector be deregulated? It is like trying to take the hydrogen and oxygen out of water in order to increase its wetness.

The illogicality of the idea was slyly concealed by a deeply deceptive use of language. Finance language heavily depends on water metaphors, which are entirely misleading. It is unlikely that this is deliberate; it is more probably reification: making the intangible appear to be concrete. But its consequences have been, and remain, devastating.

The water metaphors have many variants. Analysts talk routinely of capital “flows”, which is the rate of transactions, or financial “liquidity”, which is the willingness of investors to participate in markets.

Economists speculate about equili­brium, indeed one popular economic theory is General Equilibrium Theory, the notion that markets should be allowed to find their “level”, in much the same fashion that water does.

Deceptive metaphor use

Money can be “channelled” into investment, or sources of capital can “dry up”. There are colloquial phrases like the “trickle-down effect” (wealth at the top will make its way to the lower levels) and “a rising tide raises all boats” (when the economy is doing well everyone benefits).

By creating the linguistic illusion that money is a fluid, the impression is created that resources and capital are flexible and can be moved around easily as long as barriers are removed. The barriers to that fluid are, of course, governments. Hence claims about the need to “deregulate” the financial system in order to create greater efficiencies and encourage capital to find its appropriate level.

A picture resembling a system of locks and weirs is conjured up. It is a startling demonstration of how powerful a metaphor can be.

Having successfully spread this false picture, the next step was to sideline governments’ role in setting rules. After all, governments were preventing the capital “flows” from finding their right “level”. So instead of governments setting the rules, entire markets were set up in which the traders made up their own rules.

The main arena was the derivatives markets – financial instruments that are derived from more conventional transactions such as currency exchanges, interest-rate swaps, future bond or equity prices – in which traders gambled with each other using fabulous amounts of confected money.

The current global capital stock of derivatives (it has actually started falling slightly) is about $US630 trillion, according to the Bank for International Settlements, which, depending on how one looks at it, is about twice the conventional capital stock of the world. The entire U.S. federal debt is about $US17 trillion. It is an eye wateringly large amount of “money” (if that is what one can call it).

It is here that the discussion of the relative merits of fiat money becomes redundant. This is not fiat money; it is not based on government rules. It would be better described as meta-money: a new layer of finance in which money is made out of money in an infinite regress. It is hard to know whether to call this “real” money or not. What is real money? It is not correct to say that money is a metaphor, but it is not wholly incorrect, either.

The absurd game of Russian roulette with the monetary system came to its inevitable conclusion in the global financial crisis (GFC). In September 2008 the entire monetary system of the world came within a matter of hours of entirely collapsing. As U.S. Congressman Paul Kanjorski has revealed, approximately $US500 billion went out of U.S. money markets in one morning in what was an electronic run on the banks.

The U.S. Treasury threw about $US100 billion at the problem, the market-based solution. When it was realised that that would not work, the bureaucrats in the U.S. Treasury decided, for the first time in about two decades, aggressively to regulate, to set the rules. In other words, they sought to reimpose fiat money. Every American money market account was temporarily closed and bank deposits were underwritten up to $US250,000.

Had they not done so, the Treasury later estimated that $US6 trillion would have gone out of the U.S. banking system by the end of the day (not that there would have been anywhere for it to go). Banks lend out at least 20 times their capital base, so that $US6 trillion converts into $US120 trillion. It would have spelt the end of the American banking system and destroyed the monetary system of the world.

The cost of fixing up the mess created by meta-money – re-establishing fiat money – has been extremely high and will not be repeatable if there is another crisis. It is estimated that the American government spent more than $US6 trillion on the bailout. Interest rates have been reduced to near-zero levels for the better part of a decade to keep transactions “flowing” (“maintain liquidity” as the expression goes).

Greed run amok for the common good

But the underlying problem has not been dealt with: the trickery of pretending that financial markets can be “deregulated”. If financiers are allowed to make up their own rules, the results are entirely predictable. The only unknown is when the crisis will hit. In effect, what we are witnessing is a new form of hyper-usury: distilled greed run amok in which it is not even necessary to produce a good or service to make money; one can simply make money from money.

It is hardly surprising, in such an absurd environment – much of the derivatives and foreign-exchange activity is driven by extremely complex mathematics – that people look longingly at the gold standard era. But the challenge is not to move away from fiat money to commodity money. The challenge is to end meta-money. A return to either fiat or commodity money would be infinitely preferable.

In the wake of the financial crisis not one prosecution has been brought against managers of the money centre banks. This was in part because the crisis was on such a scale that simply keeping the system going was an overwhelming imperative. But it is also because of the immense power of the major banks.

The derivatives market is 97 per cent dominated by six banks, which make about $US35 billion a year from the trade. This is conducted off-balance sheet, which leads to the question: “Why bother having a balance sheet at all if so much activity is not accounted for?”

The problem is just as severe with Australian banks as with their overseas counterparts. According to the Reserve Bank of Australia, in 2010 off-balance sheet assets, mostly derivatives, were about $US15 trillion, more than seven times the banks’ on-balance sheet assets (The RBA no longer produces the data).

These are puny amounts compared with the American banks, however. JPMorgan Chase has $US1.9 trillion in assets and $US70 trillion in deriva­tives exposure. Citibank has assets of $US1.3 trillion and a $US62 trillion derivatives exposure. Bank of America has a ratio of $US1.4 trillion to $US38 trillion and Goldman Sachs has a paltry $US105 billion in assets compared with $US48 trillion in derivatives. Deutsche Bank has $US75 trillion in derivatives exposure, about 20 times German GDP, according to finance news website Zero Hedge.

If the derivatives markets were put under some facsimile of control by being brought on to exchanges, making them more transparent, the banks would lose $US7 billion a year, according to estimates by Robert Johnson, president of the Institute for New Economic Thinking.

$US600 million well spent

Johnson argues that a financial bill gets through Congress about every five years, so the profit at risk for each bank is about $US35 billion. So the $US600 million that they spend to lobby American politicians, which overwhelms Washington, is pocket money. Unsurprisingly, the big investment banks have been mostly successful in avoiding greater governmental control.

The derivatives market has not been adequately supervised and although the Basel Committee on bank regulation mutters about strengthening the capital requirements for derivatives (keeping capital in reserve as a protection if something goes wrong), little has happened. Meta-money talks, and it continues to triumph over fiat money.

The fact that it is now known, since the GFC, how damaging this barely sane financial debauch can become is not trivial. At least the risks are better understood and there will be greater preparedness. In an environment of extreme artificiality, which the contemporary financial system is, knowing how the artifice can go horribly wrong is helpful. We can always change the things we invent.

But not while we are seduced into thinking that money is a force of nature, a fluid that “flows” to its right level, and which has to be “deregulated” so that it can be free to be natural. There is a price to pay for nonsense, and in this case the price could be extreme: the imperilling of the monetary system. One wonders what would have happened if the U.S. Treasury had not decided to govern aggressively on that fateful day in 2008; how would the rules of money have been re-established?

Underlying this edifice of nonsense is the tautological notion that the expression of individual self-interest adds up to the collective interest. Former chairman of the U.S. Federal Reserve Alan Greenspan admitted that he “made a mistake in presuming that the self-interests of organisations, specifically banks and others, were such that they were best capable of protecting their own shareholders and their equity in the firms”. Only a specialist fool like Greenspan could have been surprised by the outcome.

Most ordinary people can easily imagine what will happen when we allow the world to be ruled by extreme greed, masquerading as something between a force of nature and an expression of the collective interest. It is to be hoped that there will be a steady return to governments governing.

David James is a Melbourne journalist, writer and musician.

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