3. Financial cancer and ‘growth’

How do the activities of Universe Two affect the vast majority of us who live in Universe One? Guess what. The answer is really simple. The more resources Universe Two syphons out of Universe One, the poorer it gets — the more austere the lives of its citizens.

Take a look at this quote: “Money and banking proved not to be a form of alchemy, but the Achilles heel of capitalism — a point of weakness that threatens havoc on a scale that drains the life out of a capitalist economy”.

That’s not the scribbling of some loonie lefty extremist. It’s the verdict of Mervyn King, former Governor of the Bank of England, reflecting on his experiences during the great financial crisis of 2007–8.

A little bit of draining and syphoning won’t do too much harm. But what I now need to convince you of is the scale of what is happening and the natureof the process. Cancers take off when a cell sloughs off the normal mechanisms and constraints that channel its energy into functions that support the body as a whole, to focus instead on a new purpose of unconstrained growth. Growth for its own sake.

That’s what we’re now suffering with Universe Two. A financial cancer has taken hold and it is draining the life out of the body that hosts it, Universe One. What’s worse, for the past 40 years economic makers have deliberately fostered and promoted this financial cancer — praising it for being an engine of wealth creation because is represented ‘growth’ (money making).

And oh my gosh, look at how it has grown!

Credit

Banks create money out of thin air by lending it. The more they lend, the more money they can make on this lending. So banks always want to lend more, and over the past decades policy makers and regulators have set them ‘free’ to do so. As a result, lending and debt keeps growing and growing.

In the 1950s, in advanced economies total private domestic credit equalled 40% of GDP. By 2010 it was 160% of GDP. Total global debt was 240% of global total GDP at the turn of the century. Now it’s over 335%.

In the 1950s, in the US, total debt (including government, companies, households and financial institutions was equivalent of 70–80% of GDP. Of this debt, financial institutions accounted for little more than 1%. By 2007, total debt had reached nearly 300% of GDP. And debt taken on by financial institutions, mainly to fund financial market trading, accounted for a third of this sum, — around 100% of GDP.

I’ll say that again. The amount of money borrowed by financial institutions to fund their money conjuring activities is now as big as the economy itself.

You might have thought that the great financial crisis of 2007 might have reduced the appetite for debt. But far from it. There has been a 50 per cent surge in worldwide debt since the Crash. Government debt has risen 77% (partly to pay for the costs of bailing out the banks). Corporate debt is up too, by 51%.

To see what this debt overhang means, consider this simple arithmetic. If the volume of debt is as big as national income or GDP, and if it bears an interest rate of around 5% (as it does), and if this rate is above the economy’s growth rate (typically 1% to 2%), then all the growth in income — and more — is taken by the creditors. This is now such an economically important phenomenon that academics have had to invent a new term to describe it: “seignorage”: “the revenue derived from the creation of new money and the introduction of this money into the economy”.

Because the activities of Universe Two are so far removed from the daily experiences of those living in Universe One it hard for us to grasp the scale of its activities. But here’s one measure: the amount of money circulating in the economy itself. Citizens of Universe One think of money in terms of the cash they have available to spend on goods and services. A lot of money is spent this way, but nothing compared to what’s happening in Universe Two.

Prior to the financial crisis of 2007, for every £1 of base money (that is the money circulating in Universe One) there was £80 of commercial bank lending: the banks’ conjured money was 80 times more than the money that ordinary people earn and spend.

Financial markets

Remember the bet we invented in the coffee shop about Arsenal winning the premier league — the one we sold to Sara, who sold it on to Sunil [link]? There are three ways to make money on the money markets. The first one is to actually win your bet. That’s risky. Not many traders are really very interested in that, because they might also lose the bet.

(Actually, if experience is anything to go by, the risks aren’t all that bad because when the conjuring trick fails and the whole system crashes, it’s us — the public — who end up picking up the bill. In 2008, this bill amounted to $4.6 trillion in the US. In the UK, it reached £133 billion in cash plus £1 trillion in guarantees and indemnities. These bills became part of the public sector spending deficit and a prime driver of ‘austerity’.)

The second way to make money on the financial betting markets is by charging fees for administering bets, as Dave did for our bet. This can earn you tidy sums if the volumes are big enough. And they are. In 2017, 25.2 billion derivative contracts were traded in exchanges. Average daily turnover of bets on these markets reached $1.6 trillion a day.

The third way to make money out of financial assets is to trade them. There are now two parallel derivative markets. The first market is for ’over the counter’ (or OTC) derivatives that trade outside of regulated arenas such as stock exchanges. The second market, for ‘exchange trade derivatives’, takes place within formal exchanges.

As we’ve seen, there is no limit to the number of bets you can invent and trade, so the amount of money ‘invested’ in this activity is free to grow exponentially. Without limit. And that is exactly what it has done.

In 1984, the value of oil futures trading was less than 10% of physical oil production and consumption. By 2015 it was 10 times bigger than total physical oil production. Trading in foreign exchange markets averaged $5.1 trillion per day in April 2016, according to the Bank of International Settlements. Trading in this market is now 73 times bigger than total global trade in goods and services.

Finally, consider this. In 2007, the notional value of interest rate derivatives was $400 trillion, about nine times the value of global GDP at the time. In 2015, the OTC derivative market was worth $605 trillion. Remember, this is just one of two derivative markets, but this market alone is more than ten times the value of global GDP, which stood at $57.5 trillion.

As Adair Turner, former chairman of the UK’s Financial Services Authority writes in his book Between Debt and the Devil, “Trading in derivatives played a minimal role in the financial system of 1980 but it now dwarfs the size of the real economy.”

And this financial cancer is continuing to grow. In a recent interview, Mark Carney, the Governor of the Bank of England observed that the UK’s financial sector was already worth 10 times the value of the UK economy (£19 trillion to £1.9trillion). But, he added, on current trends “could be worth 15- 20 times the UK’s economic output in 25 years”. And that, he was implying, was a good thing.

The Money Mirage revisited

I started this Blog by talking about the Money Mirage. At the heart of the Money Mirage lies the Universe One belief that money equals wealth, that there is a one-to-one correspondence between the amount of money available and the amount of real resources available to do real things, that ‘making money’ equals wealth creation.

But as Universe Two continues on its money making activities without any reference to the real world, not only are these beliefs not true, they are not true on a scale that most people simply struggle to countenance. This cancer is virulent. In a few short decades, at breathtaking pace, we have moved from a world where wealth was created by making things to one where taking has replaced making and is going to drain the life from our society.

So what exactly are its symptoms?

Next in this series: 4. Entitled to be rich? The New corruption

Previous: 2. The Money Makers

Bibliography

Books and articles I found particularly useful researching this blog include:

• Adair Turner, Between Debt and the Devil: Money, Credit and Fixing Global Finance, Princeton University Press, 2017
• Mervyn King, The End of Alchemy: Money, Banking and the Future of the Global Economy, Abacus, 2017
• Nicholas Shaxson, The Finance Curse: How Global Finance Is Making Us All Poorer, Bodley Head, 2018
• Gillian Tett, Fool’s Gold: How Unrestrained Greed Corrupted a Dream, Shattered Global Markets and Unleashed a Catastrophe, Abacus, 2010
• Richard Bookstaber, The End of Theory, Financial Crisis, the Failure of Economics, and the Sweep of Human Interaction, Princeton University Press, 2017
• Michael Hudson, J is Junk Economics, ISLET, 2017