Introduction
In this blog post, I will argue that the financial system is broken due to several factors, including rising income inequality, increasing debt burdens on governments, antiquated fractional banking systems and the fragility of debt-laden developed economies. I will explore the historical context behind these issues and examine the role of central banks, fractional reserve banking, and factors that have contributed to these issues and discuss their implications on the economy.
Section 1: The Historical Context
To understand the current state of the financial system, we must go back to 1971 when the Nixon administration decided to temporarily suspend the convertibility of the US Dollar to gold. This decision, made in response to the financial pressures of the Vietnam War and foreign governments withdrawing their gold from the US, led to the greatest global monetary inflation ever seen. For a detailed account of this historical event, please visit 'https://wtfhappenedin1971.com/'.
Section 2: The Creation of Money and Debt
Today, money is primarily created in two ways:
The Federal Reserve purchases eligible collateral, such as Treasuries, and enters a debit in their Fed ledger while crediting one of the Systemically Important Banks or 'money center banks' (e.g., JP Morgan Chase, Citibank, etc.), this money sits as ‘reserves’.
A bank issues a loan, such as a mortgage, by creating new money (* cue magic wand ) thereby crediting the seller's account with the dollars. The bank can create vast amounts more of new 'credit money’ (5x-10x-20x depending on reserve requirements) while only leaving a ‘fraction’ of the money in reserve. The mortgage becomes an asset on the bank's balance sheet and a liability for the homeowner. As the homeowner pays down the principal, fiat money leaves the system.
In sum - all money today is an IOU, that is Debt. So when the Federal Reserve ‘print money’ to stave off different financial crises - they are actually just making the problem worse, because the ‘money’ printed is debt.
And as we have seen recently with banking runs, there should be some honest re-assessment of how banking is done (see e.g. Caitlin Long’s post).
Section 3: The Growth of the US Economy and Income Inequality
Since 1971, the US economy has grown significantly, with GDP increasing from 1.2 trillion USD per year to 22 trillion USD in 2020. However, this growth has not been evenly distributed. While average household income has risen from $10,600 to $66,000 per annum - approximately 6x, the amount of financial instruments has grown by 33x. This disproportionate growth in assets has contributed to increasing income inequality, with the wealthiest 0.1% benefiting the most from the financial system. So to re-cap -incomes have grown 6x, but assets have grown 33x. In my mind these increases in Debt are making the rich richer, and the poor poorer:
Section 4: The Cantillon Effect and Crony Capitalism
The current financial system primarily benefits the 'Cantillonaires,' or those with first access to new money, such as megabanks and the wealthiest 0.1%. This phenomenon, named after French economist Richard Cantillon, posits that when new money is created, it benefits those who first gain access to it as they enjoy undiluted purchasing power. By the time the new money reaches the regular wage-earner, prices and interest rates have risen to account for the new money, thus negating any benefits.
So while GPD has been growing, the middle class has not seen the benefits:
The aftermath of the 2008 financial crisis revealed a shift from a functioning capitalism to crony capitalism, where the large banks and wealthiest 0.1% reap the profits while losses are socialized and paid for by taxpayers. Recently (written March 2023) we have seen how the smaller, regional banks are suffering deposit flight as they are not covered by the FDICs ‘unlimited’ backing that is available for the SIBs, so the trend is that the large SIBs become even larger, swallowing their smaller competitors.
Section 5: The Keynesian Folly and the Future of Developed Economies
Currently, developed economies are not only taking on new debt but also printing more money to support government spending, and with US interest rates rising the proportion of tax revenue going to pay interest could rise dramatically. This approach is reminiscent of Japan's Keynesian folly, where economic problems are addressed by printing and stimulating more. The question remains: how will developed countries overcome this economic predicament?
Conclusion: The financial system is broken due to rising income inequality, increasing debt burdens and an antiquated banking system not responding to technological challenges evident today.
In the next post we’ll explore possible solutions and options.