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The Banking Crisis, the Break Down of Trust and Local Currencies

Brian Davey | 15.03.2008 19:38

A letter to councillors in Nottingham about the banking crisis and an article about how the banking system may go belly up in the next few weeks or months.

(1) Sent today (Saturday) to a number of councillors - with copies to Transition Nottingham and elsewhere

Dear Councillor,

I am writing to you about the banking crisis and the effects that it could have on Nottingham. On Wednesday of this week Martin Wolf, who is a visiting professor of Economics at Nottingham university and who runs the a column in the Financial Times in which the world's leading mainstream economists debate issues, published an article in that column titled "Going, going, gone: a rising auction of scary scenarios". You can read the article yourself to verify what I am about to say on the Financial Times web site

In this article Professor Wolf reviews the views of different economists about what the likely losses are to the global banking system. As the months have gone by since last August, when the awareness of the crisis first surfaced in
the financial markets, the estimates of the potential losses have got bigger and then bigger again. In this regard the economist who first saw this problem coming, a Professor Nouriel Roubini of New York University’s Stern School of Business, believes now that total financial sector losses could be as much as $2,700 billion. Professor Wolf comments:

"Suppose, then, that Prof Roubini were right. Losses of $2,000bn-$3,000bn would decapitalise the financial system. The government would have to mount a rescue. The most plausible means of doing so would be via nationalisation of
all losses. While the US government could afford to raise its debt by up to 20 per cent of GDP, in order to do this, that decision would have huge ramifications. We would have more than the biggest US financial crisis since
the 1930s. It would be an epochal political event."

Professor Wolf then concludes by saying

" I suspect Prof Roubini’s latest estimates are excessively pessimistic. But I am not certain this is so, given his record: just look at the vicious interaction between falling asset prices, financial stress and spending. We must pray that the Fed can clean it all up, without excessive collateral damage. Unfortunately, such prayers often go unanswered."

A few days later the Investment Bank Bear Stearns has collapsed and the rescue being organised by the Federal Reserve Bank in the US is to stop a domino effect of banking and financial sector collapses.

So, to repeat, we could be facing an economic and financial situation of "epochal" dimensions which would "decapitalise the financial system". In more ordinary language that would mean the banks would go bust. A chain reaction of broken banks in the US would undoubtably spread into the UK and the rest of the world. It would have a catastrophic effect in Nottingham the same as everywhere else - and not just on Capital One and Experian. It would effect all of us. You as city councillors would then be faced with a huge challenge
and huge responsibilities.

The point is that, apart from the small amount of notes and coin that we all carry around with us, the overwhelming bulk of the money supply on which all economic transactions are based are bank deposits which are created when banks lend money. If the financial system goes belly up then there would be no money to conduct the economic transactions of everyday life. This would be a true emergency in which civil disorder and public health would be threatened.

Banking crises in which the money supply available for ordinary business dries up are extraordinary events but they are not unknown and so there are precedents as to what can be done in such circumstances. This includes situations in which cities have organised their own currencies to cope with the extraordinary circumstances and provide some means to keep going in the basic necessities of life, for example in Argentina.

As Richard Douthwaite explains "Buenos Aires province, home to 38% of the country’s population, found itself unable to pay its employees and to keep schools and hospitals going. Unable to borrow, it printed its own money – the patacon - and in August 2001 began paying with that instead. In some months, public servants got 90% of their wages in patacones.

Businesses in the provincial capital, La Plata, were divided over whether to accept patacones. The Volkswagen dealership had a sign up saying it would, the electricity company announced that 60% its bills ould be paid in the new
money and McDonalds offered a meal called the Patacombo. But Carrefour, a big supermarket chain, turned them away until it lost so much business that it was forced to capitulate. After that, everyone was prepared to accept the new
money. You could pay your taxes in them, keep them in a special account at your bank and even get them out of ATMs alongside pesos and dollars.

Buenos Aires was the ninth Argentinean province to print its own money. By November 2001 the provincial currencies made up 15.8% of the total cash in circulation nationwide."

I have to say that, in my view, the development of a local currency, to be used in parallel to the national currency would in any case be a good idea to stimulate arrangements in which local needs are met by local people. However,
I am writing to you now with this information because it is not inconceivable that you and other local authorities would need to co-operate with concerned and responsible citizens to launch a local currency if the global banking system collapses.

Yours sincerely

Brian Davey
Ecological Economist
A copy of this letter was also sent out on the transitionnottingham e mail list as a personal viewpoint...

(2) Sent Tuesday of last week

In Transition Nottingham we are focused, quite rightly on the twin catastrophes of climate change and peak oil and gas. However there is another crisis evolving that is increasingly grabbing people's attention - a credit
crunch and the threat of the deepest depression since the 1930s. To get a sense of this in a recent report in the Financial Times an economist employed by the bank UBS told a Financial Times journalist, Gillian Tett, that losses
from the credit crisis could total a trillion dollars. These losses are coming out of the capital of the banks and, because the banks cannot lend more than a fixed multiple of theire capital base, it means that bank lending may fall dramatically:

As one commentator puts it

"....a loss of $1,000bn in capital ..... could, if applied mechanically, lead to a $22,000bn contraction in outstanding lending. That would certainly lead to a deep depression. Obviously, this cannot be allowed to happen. But it
brings up the point that this is in significant respects a solvency crisis." (Martin Wolf in the Financial Times).

While the high energy prices have been a major part of this crisis there's a lot more to it than that. We need to understand this credit crisis in its own terms which is why I have written this briefing paper. I hope you find it
useful. (This was written just before I read the Martin Wolf article referred to above in which banking losses are discussed as possibly being even higher)


To watch the financial markets since last August has been like viewing a multiple car pile up on the motorway, in slow motion. Each month that passes a new link in a chain reaction of spreading chaos and fear has emerged as a
new bank, a new market, and a new institution has reluctantly admitted that it is in deep trouble. Each time journalists and commentators from the big financial companies and the regulatory authorities comment on what this means for the future. Each time their prophecies get gloomier and more panicky. Comparisons are made with economic and financial crises of the past and
gradually the comparison with the Great Depression of the 1930s is creeping in to the financial columns.

Some commentators saw this coming a very long time ago while others have been more slow to adjust their greed driven euphoric optimism - but increasingly the hard data supports the pessimists. Nowadays one hears the view that the pessimists were saying a long time ago, repeated over and again - in the jargon of economics: this is not a liquidity crisis this is a solvency crisis.

What's the difference? A liquidity crisis is a temporary shortage of cash that short term borrowing arrangements can get you through because your business is basically sound. A solvency crisis cannot be solved by borrowing because
anyone looking at your business can tell you are broke and no one with any sense lends to a business that is broke - it is throwing good money after bad.

That's not to say that broke institutions never get bailed out - when they are banks they may well get bailed out by us, the tax payers.

Why do banks get bailed out? The banks are not just any businesses. In our current economic system the banks not only look after our money they actually create our money. If the banking system goes belly up then the money with
which to conduct all our economic transactions simply dries up. This would be catastrophic for our economic system - correction, it probably will be catastrophic for our economic system.

No matter who we are, rich or poor, the money system is something we share. We have to use it for most of the arrangements of our existent. No one invented it and it evolved as a joint product of humanity which we are all compelled to use, whether we like it or not. However, one group of people own and control this system - bankers. Thus it follows that bankers are aware that they will always be bailed out.

In an article on the Financial Times web site Martin Wolf, their economics correspondent, and a visiting professor of economics at Nottingham University argues that:

"The world has witnessed well over 100 significant banking crises over the past three decades.....No industry has a comparable talent for privatising gains and socialising losses. Participants in no other industry get as self-righteously angry when public officials – particularly, central bankers – fail to come at once to their rescue when they get into (well-deserved) trouble. Yet they are right to expect rescue. They know that as long as they make the same mistakes together – as “sound bankers” do – the official sector must ride to the rescue. Bankers are able to take the economy and so the voting public hostage. Governments have no choice but to respond.....It is the nature of limited liability businesses to create conflicts of interest –
between management and shareholders, between management and other employees, between the business and customers and between the business and regulators. Yet the conflicts of interest created by large financial institutions are far
harder to manage than in any other industry."
Regulators should intervene in bankers’ pay by Martin Wolf

In the fairy tale for the children the central banks and the financial regulatory authorities control the banks so that they act responsibly. What happens in practice is that the financial regulators and central bankers are themselves bankers. Thus the truer picture of financial regulation is told by someone like Nick Leeson, who broke the Barings Bank. (I wouldn't normally refer people to an article in the Daily Mail but this one is worth reading)

According to Leeson alongside the "best brains" in the trading rooms, competing fiercely and taking risks, there are also " the grey men of the back office.... They do the paperwork behind the traders' deals and run the regulatory systems. It is their job to monitor the markets and ensure checks and balances are properly applied. These bankers are invariably not up to it. The front end of the business is far more profitable. The brightest and best are seduced by the lure of big bonuses, leaving the thirdraters and burn-outs to take safe desk jobs in staid institutions such as the Bank of England."

So, to summarise, the banking industry has the governments and public where it wants us - because we all need to use the money system and they are the people that create the money they cannot be allowed to fail.

Let me emphasise the point about the banks actually creating money. Many people assume that the banks lend on money that they are loaned but this is not really so. Whereas if you or I print banknotes we can be prosecuted for forgery the banks have the right to create money and do just this. They do it
every time that they lend.

Let's say I go to my bank and arrange a loan to cover 90% on a £100,000 house secured against the building itself. I put up the missing 10% (£10,000) personally.

After the sale has gone through, the vendor lodges my £90,000 cheque in her bank.

This gives that bank funds to lend out and, since its business is lending money, it lends out 90% of its customer's deposit, keeping back 10% as a reserve.

Thus the £90,000 loan creates another deposit in another bank, and 90% of that will be lent out too.

From bank to bank the deposits can go, each creating the basis for another, smaller loan, so by the time the effects of my initial £100,000 purchase have worked themselves through the system, loans totalling £1m will have been

Most of the money generated by this lending cycle, which I started off with just £10,000, my 10% deposit, will have been spent on buying property or some other asset. With lots of other people are doing the same thing, borrowing to
buy assets, the price of assets will go up, thus creating the collateral against which the banks can lend even more money. When they lend this will push the price of assets even higher and more and more people will rush to borrow from banks and mortgage companies to get on the property ladder.

This is what economists call a "bubble". The process would and should be self limiting if lenders acted with a certain amount of restraint and kept an eye on lending standards. After all people have to be able to re-pay their loans
with interest. The ability to make repayments on loans - the most common lending standard is to set a limit as a multiple of your income - say 3 to 3.5 times your income if you are buying a house on your own.

However, and this is the crucial point, the lenders have not acted with restraint and the financial regulators have let them get away with it.

In recent years there has been a clear trend towards higher multiples, in some cases as much as 7.5 times annual salary (although 4 to 5 times salary is more common).

This is mainly because interest rates, since the late nineties, have been consistently low and much less volatile and there was an assumption that they would stay low. So it was that lenders felt the threat of borrowers being
overstretched by sudden interest rate rises had gone down. And so they were happy to lend more and more. Because mortgages were cheaper to repay it was assumed that there was less chance of borrowers defaulting, even on bigger loans. Further reductions in lending standards occured when 100% mortgages were offered and then lenders started offering 40 or even 50 year mortgages as compared to 25 year ones.

In each case the lending standards went down and down and the financial regulators did not a damn thing about it. They let it happen. These very clever bankers were convinced that everything was OK and that a tide of financial innovations in the finance industry was making the management of
the risks of lending much more efficient.

One of these innovations was the so called 'originate and distribute' approach to creating loans. In the good old days if you borrowed money from the bank then the bank remained the institution to which you owed money. Thus it was
that your debts were managed by the bank manage that knew something about your financial affairs. Now however the banks and mortgage institutions lent money and then, so to speak, consolidated the IOUs from their customers, and sold them on as bonds to other financial institutions for a fee. These were called collatoralised debt obligations or CDOs.

Under this new originate and distribute regime, the more the banks lent the greater the fees - but it no longer mattered to them whether the people who they were lending to were credit worthy or not as it was other institutions
that were holding the debt, not them. They had sold it on and picked up a nice sale fee. It became in the interest of financial institutions to sign up anyone to a credit deal and then pass the parcel to someone else. The so called sub prime debacle ended up lending so called NINA loans - loans in which people with No Income and No Assets could buy their

Of course these poor people are now defaulting and that means that the companies and banks who were sold this so called "toxic waste" are now in dire straights.

(Before moving on it is worth thinking about the growing number of people enticed into borrowing in this way by predatory lenders. In recent years psychiatric research has found that the debts that people have got into have
literally made people's lives a misery with high rates of depression, clinical anxiety and suicide. The predator lenders, acting irresponsibly have made millions of people psychologically sick. Ref: "Debt and mental health:
the role of psychiatrists" Chris Fitch, Robert Chaplin, Colin Trend & Sharon Collard in Advances in Psychiatric Treatment Vol 13 pp 194-202 for a review of the literature on this).

Before going further it is worth pointing out that the word "credit" originally means " to believe" and " to trust" - as when people say "Would you credit it". Credit is based on trust. I say this to preface the remark that you will hear it said frequently that the cause of the current banking difficulties is that banks do not trust each other and will not lend to each other. This is not surprising as the bankers are well aware that they have been selling each other worthless junk and what they now fear if they lend to one of these institutions that has been sold rubbish, that is covering up its losses, that they might be lending to an organisation like their own that will go bust. In that case they will lose even more money. In any case, as they are sitting on large losses they do not have that much to lend.

You might ask yourself how the hell that the other banks should be so stupid as not to be able to see that they were buying rubbish. Part of the answer to that question is that baking is a global industry that is evolving very
rapidly and, when the staid borrower-lender relationship between bank manager and bank customer was replaced by IOUs that were sold on, these IOUs were soon being parcelled up and traded all over the world. So no one had any real
sense of what was going on. In the meantime an illusion was developing that a whole mass of apparently sophisticated financial deals was providing guarantees against losses.

Thus you couldn't possibly lose out if you brought the NINA loans because they had been given an AAA rating by a credit ratings agency. Never mind that the credit rating agency was actually paid to give an AAA rating. It sounded good. In any case there were lots of other clever wheezes invented to make it feel just right. For example, you could insure the debt that you held against default. When lots of money is being lent and times appear good getting paid money to insure against the possible default of AAA rated bonds seems like a pretty safe gamble. However, it was a gamble and, in retrospect it doesn't appear that it was a good one.

What you are seeing with a company that gets paid an insurance premium against default is a whole new line of business, which became more and more complex, where companies paid other companies supposedly to take the risk off them. One company tells you that the bond you have is AAA and gets a fee. Another company insures you against default and gets a fee. There were lots of these kind of operations which appeared to reduce the risk of business. Let's say you were investing in another country then there was always a risk that changes in foreign exchange rates would move against you so when you tried to move your money back into your own currency you would lose out. So another
kind of trade started to carry that risk for you as well, again for a fee.

Of course, looked at the other way round, the other company was gambling that in exchange for its fee companies would not default or exchange rates would not move so much that THEY made a loss. One companies hedge was another
companies gamble. The financial markets started to boast that these new "financial innovations" as they called them were super sophisticated ways of managing risk. As risk was now better managed the aggregate amount of risk that the banks were taking went up and up. In the financial markets the view took hold that they couldn't lose and the gambling grew into what were really ever more complicated ways of betting - all with the cover story that the gambling was
a way of reducing risks, rather than building them up.

Indeed lots of these complicated casino style activities were actually ways of getting round the financial regulations supposedly set up to make the whole
system safer.

For example, let's say that your countries financial regulations are such that you are not allowed to speculate with other people's money in other countries financial systems. The regulations say that all your assets must be
denominated in your own currency. No problem, Credit Suisse First Boston invented a financial derivative just for you. It was called the 'Quanto' - this was a financial security issued by a bank in which the interest payments are
based on interest rates in another country but paid to you in your own currency.

In fact it is extraordinarily complex to make accurate assessments of the risks of holding financial instruments like this. And if you don't understand the risks you are taking you are not managing risks better you are making
them worse. As this system of risk management has crashed it has been repeatedly admitted that these financial "products" were so complicated that no one has understood them.

The archeologist Joseph Tainter explains that civilisations collapse, not so much because of stress surges, but because their co-ordination systems become so complex that they can no longer cope with stress surges. The co-ordination
systems made possible by fossil fuels and energy technology are complex beyond the powers dreamed by earlier civilisations but the complexity of the financial system is clearly now so great that it cannot cope with a stress
surge either.

When the UK Parliament's Treasury Select Committee had hearings recently on the Northern Rock debacle the Committee criticised investors for buying into complex financial products “they did not always fully understand” in the
hope of obtaining high returns.

Some such products are described in the report as “ludicrously complex” a point illustrated by the occasion upon which Lord Aldington, chairman of Deutsche Bank UK, could not explain to the committee what a CDO-squared was,
despite the fact that Deutsche Bank is involved in the CDO market.

What was happening here was often enough another case where the sharks who ran the banking operations were actually engaged in predatory financial practices against companies and other banks. It wasn't just poor people without assets
and without income - other banks and companies were ripped off. Far from the staid, reliable pillars of the community the banks were being run by crooks.

This is not mere rhetorical statement. Not long ago a Professor of Organisational Ethics at the Cass Business School, Roger Steare, undertook integrity tests on more than 700 financial services executives in several major firms and came to the conclusion that "There is a systemic deficit in
ethical values within the banking industry. This will not change by hanging a few people out to dry," says Professor Steare.

The results of these tests indicate that as a group, they score lower than average in honesty, loyalty and self-discipline, he said. He compared traders
to "mercenary hired guns", who regularly switch firms to maximise earnings.

The increasing complexity of the system meant that the information and sophistication gap between lenders and borrowers became highly exploitable so that, instead of financial risks being carried by the institutions with the
greatest ability to bear the risks, others, who were out of their depth were enticed into taking on risks and ultimately making losses which they should never have been ventured into. Even big name companies like Proctor and
Gamble came unstuck as they gambled in derivatives - retrospectively admitting that they did not know what they were doing. This was when they were seduced into making business arrangements by bank traders whose own
motivations were to make multi-million pay bonuses rather than focusing on customer care. (Frank Partnoy "Infectious Greed" Profile Books 2004).

What was not recognised in this process of increased complexity, increased predation and fraud, and the self serving illusion that risk was being better managed than it had ever been before in history was that the complete
opposite was happening - the banking system was becoming dangerously unstable.

Those who looked closely at what was happening and had eyes to see could tell that large elements of the banking system, that had been thoroughly corrupted were bust. This ethical sewer on which we all depend for our economic life is now in a state of panic because none of the bankers trust
each other and the consequences for the rest of us are profound - for we depend on these people for that which keeps all economic activity going - the circulation of money.

As should already be clear the idea that this major social, economic, cultural and ethical crisis is going to be solved by a few reforms of the type suggested by Professor Martin Wolf is laughable.

As I have said the money system is something that everyone in society has to use. We have no choice over that. Moreover, since the money system was not invented by the brilliance of any individual or created by the hard work of
any other individual or group, but evolved out of a long social-historical process involving the whole of society, rather like language or the legal system, it is hard to justify the idea that any individual or corporation
should have the right to use the monetary system as if they owned it. Yet this is what bankers to. They have, in fact, privatised a social and cultural "commons".

This privatisation is obviously highly advantageous because it confirs the right to create money. If monarchs or states have that right then their first use of money, seignorage, without having to give anything in exchange, means they can spend out of the social product (on wars for example). Bankers by contrast obviously create money because someone is prepared to sign a contract with them for a loan to be paid back with interest. (Or that was how it used to be before bankers earned fees for selling the loans they have
created to some other sucker that carries the risk).

In fact we are in a worse situation than the bankers failing to carry the can for their mistakes. There is a deeper and more fundamental problem It is only if the economy is still growing that there is additional real output to be sold to pay for the interest on debts. Without the extra output there will be a lot of foreclosures and re-possessions. In a non growing economy if bankers are going to get repaid with interest then everyone else is eventually going to end up having their possessions taken over by bankers at some rather vicious fire sale prices. Clearly that doesn't sound like a functioning economy with much of a future.

In fact if the real economy doesn't grow (fast enough) then an expansion in credit and the banking sector is only possible through the kind of asset price speculation that I have described - which is bound to come a cropper
eventually as it becomes more out of line with underlying economic fundamentals. Reform will not solve this. Putting in some grey regulators from the industry or tinkering with the system of incentives and bonuses will not get to the heart of these more fundamental problems. The monetary system must be managed as a commons that serves us all. The banks right to create money as debt needs to be abolished. Its inherent logic of pushing a destructive growth dynamic must be brought back under control.

Sadly I think there is little chance that the government and bankers will pay any attention to these kind of ideas - and they will certainly give no publicity to them. This means that if one wants to see an alternative monetary system one must create it oneself. If, as is not impossible, the
financial and monetary system goes belly up over the next few years as the world economy overshoots the limits to growth, the need will be to develop local and DIY currencies to replace bank and debt money rather than "calling
on" government and bankers to reform themselves. (Some chance of them paying any attention to that!)

One approach is to issue local currencies starting them up as if they were book or gift tokens. In the initial stages they can be converted back into the national currency at a fixed rate and are accepted as payment medium in a
local community just the same as national currency notes and coin. Once they are in general circulation and generally accepted as payment in a locality then, with general agreement, one can remove exchangeability. The key to
getting a currency to function as a currency is acceptance and familiarity. This depends on having a community based organisation that is trusted to manage the money system in the interests of all rather than in the private interests of bankers and individuals - bound by a constitution that keeps a check on the money makers....A currency based on tokens has been established in Totnes by Transition Totnes.

Local currencies spent into existence by local authories in Argentinia became generally accepted when there was a currency crisis in that country.

As Richard Douthwaite explains "Buenos Aires province, home to 38% of the country’s population, found itself unable to pay its employees and to keep schools and hospitals going. Unable to borrow, it printed its own money – the
patacon – and in August 2001 began paying with that instead. In some months, public servants got 90% of their wages in patacones.

Businesses in the provincial capital, La Plata, were divided over whether to accept patacones. The Volkswagen dealership had a sign up saying it would, the electricity company announced that 60% its bills ould be paid in the new
money and McDonalds offered a meal called the Patacombo. But Carrefour, a big supermarket chain, turned them away until it lost so much business that it was forced to capitulate. After that, everyone was prepared to accept the new
money. You could pay your taxes in them, keep them in a special account at your bank and even get them out of ATMs alongside pesos and dollars.

Buenos Aires was the ninth Argentinean province to print its own money. By November 2001 the provincial currencies made up 15.8% of the total cash in circulation nationwide."

They were withdrawn later as the central bank was frightened that Argeninia would break up. All such alternative systems eventually come under intense pressure to be packed in when the national currency and monetary system is on the mend. This happened in Austria in the 1930s when a local currency system succeeded in dramatically reducing unemployment in the town of Woergl in the Great Depression. Tough - it threatened the bankers and they stepped in to put a stop to it.

However, we should seriously think of the implications of this historical experience. The banking system is a major system underlying the growth economy. Once the growth economy is broken by peak oil and peak gas and climate change it is to be doubted that a debt based money system that requires and assumes growth is either viable or desirable....Perhaps the bankers may try to use the law to break local currency systems - but it is worth creating the widest possible awareness to show that they have lost the
moral authority to run the money system.

Possibly the biggest depression since the 1930s is in prospect. We need to start afresh.

"The process of money creation is so simple, the mind is repulsed"
-J.K. Galbraith

Thanks to Richard Douthwaite for some of the ideas for this paper.

Brian Davey
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Amazing (and scary) piece, Brian!

18.03.2008 12:21

Scary stuff, well written and with a lot to take on board. I'm going to have to think about this for a while to let it all sink in.

In the meantime, I found this video a few months back which really helps explain the crazy house of cards that is the fractional reserve banking system.

It talks about similar principles to some of the stuff explained here, but makes it very easy to understand.

CRUCIALLY: in a way which we can use to explain things to other people, while avoiding complex jargon!

MONEY AS DEBT - 47 minutes, but it's well worth a watch:

Dave Bass
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