How and why are bubbles created in the financial system? Is it a random error in the path or a structural element of the circumvention of the rules of the functioning of the market?
The capitalist economic system has an inherent tendency to develop instability that results in a severe economic crisis. The main mechanism that pushes the economy towards crisis is the accumulation of debt. The mechanism of debt accumulation operates in “good” economic-business times where businesses in profitable sectors of the economy are rewarded for increasing their debt levels. The more one borrows, the more profit one seems to be able to take.
The increasing profit lures other entrepreneurs into this practice and encourages them to increase their debt levels.
The “tribes” of borrowers
Since the economy is growing at a good pace and borrowers are showing obvious improvements in their financial “health”, banks are increasingly willing to lend. Over time, however, the rate of debt accumulation begins to increase faster than the borrower’s ability to repay and service the debt.
At this stage the foundations are laid for an economic collapse – according to this view growth carries the seeds of the downward economic cycle.
In this case, we distinguish three types of borrowers:
1. The first type are called “hedge borrowers”, who through hedging have the ability to cover all debt payments from their cash flows.
2. The second type are “speculative borrowers,” who can only meet the interest payments, but must continually exceed their debt to repay the original principal they borrowed.
3. The third type is the so-called “Ponzi-style” borrowers, who cannot repay either the interest or the principal borrowed. These borrowers depend on the appreciation of their assets to refinance their debt, and the risk the borrowers take is very high.
From rise to fall – the “financial volatility hypothesis”
The above classifications describe what is called the “financial volatility hypothesis”. According to the financial instability hypothesis, the financial structure of the capitalist economy becomes increasingly fragile during a period of prosperity. The longer the period of prosperity, the more fragile the system as a whole becomes.
In particular, “in a prolonged period of positive growth, capitalist economies tend to develop a financial structure dominated by hedge financing units into one in which units engaged in speculative activities and “Ponzi-type” financing acquire a large weight”.
The debt market and its role in turbulence
The financial volatility hypothesis also posits that in virtuous economic cycles, banks and other intermediaries try to entice investors to buy debt through sophisticated financial market innovations.
Intermediaries of this type are called “debt traders”. The hunt for more profits forces investors in the financial markets to put their money in financial instruments that have very little investment substance – remember subrimes products or otherwise “toxic” financial products – but are attractively… packaged, so that they can to be sold.
However, once financial conditions transform for whatever reason, the true situation of many borrowers is necessarily revealed, leading to a crisis.
Banks restrict the supply of capital and borrowers are pushed into bankruptcy because they cannot renew their borrowing to repay debts after the onset of a financial crisis. As time passes, both borrowers and lenders tend to become reckless, and the situation develops into a financial crisis. However, why should this be the case?
Does credit expansion lead to instability?
- Savings that return to the economy in the form of loans for productive economic activities are the “key” to economic expansion.
It is those savings that provide the possibility of primary accumulation for the purpose of producing tools and machinery, allowing the expansion of final goods.
This expansion, in turn, allows for a further increase in resource savings which supports the creation of a more sophisticated production base. Introducing liquidity into the system does not change this process.
Individuals can use liquidity to increase savings, which allows the wealth creation process to expand. Whenever someone lends money, the borrower can acquire consumer goods that will support their capital base while they produce goods and services.
In the above example, credit expansion due to savings growth cannot be negative for the economy. Conversely, such credit, when fully supported by savings, leads to solid economic growth.
The expansion of credit with full capital base support does not result in good times in the economy being a precursor to bad times and crushing crises. Capital accumulation makes the economy more robust and less vulnerable.
- Unsupported credit and financial instability – when savings do not support borrowing
The problem, however, erupts when savings do not support borrowing. The borrower, who holds worthless money, exchanges it for final consumer goods, drawing liquidity from the savings pool without any additional real support in the money supply.
The real wealth producers who have contributed to the consumer goods pool – the savings pool – will find that the money they hold over time allows them to buy less consumer goods – because the real value of money becomes of diminishing value due to the increasingly inflationary environment in which the economy operates.
The reason is that the borrowers have consumed some of the consumer goods, diverting wealth (the process of producing goods and services) away from wealth-producing activities to the holders of money that simply came out… from the printing presses of central banks.
As the rate of unsupported credit expands relative to the supply of capital that has arisen from saving, less savings become available to real wealth producers. Consequently, less savings means less production of new wealth.
In an extreme case, if everyone just consumes without contributing to the savings pool, no one will eventually be able to consume.
Free economy and credit expansion
In a free market economy, intermediaries such as banks will find it difficult to extend unsecured credit – and the system will inevitably lead to credit suffocation. The banking system, as today with the suffocating credit conditions that prevail, are likely to face difficulties in meeting their duties in the context of their economic activity due to lending that is not supported by savings.
The threat of default may or may not deter banks from seeking to extend unsecured credit. Therefore, there is no inherent tendency in the capitalist system to create credit without the capital backing of savings which would destabilize the economy.
In the modern capitalist economy, what enables banks to engage in the mindless expansion of credit that makes the capitalist system unstable is the existence of central banks and their overriding rule of independence.
The central bank enables banks to participate in the expansion of unsecured credit by giving the signal to expand the “bubble” it creates.
At the end of the day during settlement time, if Bank A’s position is less than fifty dollars and it cannot settle a claim from Bank B, it can sell some of its assets to the central bank to obtain cash , thereby preventing the ‘collapse’ of Bank A – remember the bankruptcy of Lehman Brothers (2008).
Bank A can also secure the fifty dollars with a loan from the central bank. Where does the central bank get the money? It actually creates money out of thin air – it creates… something out of nothing, by printing money.
The Central Bank creates something out of nothing, by printing money
The modern banking system can be considered a huge bank, which is guided and coordinated by the system of central banks.
Retail banks and more generally all banks in this context can be considered branches of the central bank. Through injections of liquidity in the context of monetary policy (quantitative easing), the central bank ensures that the banking system has “adequate liquidity” so that banks do not fail and a domino collapse is not created – the famous bail-in or bail-out plans out.
To avoid the threat of cyclical crises and the instability of the capitalist system, what is needed is to close all the loopholes for the creation of fake money – money that is not based on a real pool of savings.
In these cases, the only way to correct the supposedly vicious cycle in a free market economy is through a greater dose of government and central bank intervention in the economy – meaning that the problem will be called upon to solve the problem.
The responsibility of Central Banks and the correct solution
We therefore conclude that it is not the expansion of debt as such that leads to instability, but the expansion of credit on the terms of the captured money print, without being supported by a correspondingly large savings pool. It is the very existence of the Central Bank that triggers the current unstable economic environment.
It is through credit not backed by savings that capital is diverted from productive to unproductive activities, which in turn weakens the process of real wealth production.
The resulting instability comes from the prevention of the efficient functioning of the capitalist system by the central bank.
To return to the virtuous economic circle we must either give central banks their central autonomous role:
1. to direct capital flows to real wealth production, preventing the capital they provide from being diverted to speculative stock and capital market investments or to the repayment of current loans. In this case, as Western societies, we will have to accept that over-indebted companies-zombie companies cannot be sustained. By not channeling capital to these companies, the economy and the business environment will clean up. On the other hand, politicians will have to accept the painful political cost and social pain of unemployment and bankruptcy that will be caused.
2. either to stop the Central banks from printing money without having a savings pool.
3. To close the Central Banks once and for all (this is an impossible scenario).
