St Paul's Institute

The Values of Money: Financial Bubbles

by The Revd Andrew Studdert-Kennedy

Posted: 31 Aug 2011

<< Part Six: Endless Growth?

Since embarking on this project to learn more about the financial world, I have had a large number of conversations with past and present bankers, financiers and financial journalists. One of the most striking features of these conversations has been the way those with experience of finance seem to be accepting of, or resigned to, the inevitability of banking crises. With a sanguinity that is almost alarming, I have heard how such instability is intrinsic to modern capitalism and that just as the banking crisis of 2007/8 was not the first, nor will it be the last or worst.

An IMF study of the years that elapsed between 1975 and 2007 identified 125 systemic banking crises in 95 countries, a further 208 currency crises and 63 Sovereign Debt crises. Why is there such instability?

There is widespread agreement that the immediate cause of every period of financial instability is the expansion of credit. In a modern economy, banks are the principal source of credit - businesses and households borrow from them because, as the notorious credit card claimed, it takes the waiting out of wanting. Credit summons the future to the present, by enabling businesses and consumers to skip the need to save before investing or buying.

In theory readily available credit should stimulate economic growth, but what seems to have happened is that there has been an excessive expansion of borrowing which is inherently unstable. 'Cheap credit increases investment and expenditure driving up the cost of land, machinery and labour, forcing companies and households to run down their holdings of cash and borrow more', says Dominic Hobson, editor of Global Custodian. 'At some point this divergence between the cash being deposited with banks and the credit being advanced by them must come to a halt. In this way every credit boom must end in a credit crunch'.

So if some credit (or borrowing) is good for an economy, why has there been an excess of it that leads to such instability?

In part the answer seems to be that it is not obvious at what point the level is 'excessive'. Who determines this, or is it only discovered too late?

In theory the central banks determine this, by setting capital ratios, but they do so with very limited success. In part this is because they are under political pressure to keep booms going and this is where we all have to acknowledge our own share of responsibility in the system's failures. For this reason, it is very important not to paint bankers as the pantomime villains of the piece, just as it is tempting to do the same with Rupert and James Murdoch.

Given the regularity of such bursting bubbles, it would seem that the credit cycle is something no one is able manage. It would appear that the process whereby credit is created may well be at the root of the problem.

Modern banking doesn't work in the way that I suspect most people think it does. Most of us probably assume that a bank can only lend money which someone else has deposited with them as savings or in a current account. In practice it works very differently, because banks lend not only up to the amount of cash deposited with them by their customers, but many times that amount.

They lend money they don't necessarily have thereby deliberately incurring contractual liabilities which could never be honoured simultaneously. In other words the system hinges on the assumption that not everyone will ask for their deposits back at the same time.

Far from banks looking after the money of their depositors, the depositors are effectively lending money to the banks, and the banks are then lending that same money again and again to a lengthening list of third parties. Going into the crisis of 2007/8, the US banking system supported deposits worth 100 times its reserves of cash. In other words, 100 people could lay claim to every dollar on deposit with an American bank!

The system, known as leveraged fractional reserve banking, gives the banks immense power because it allows them control of the supply of money in the economy. Banks create money.

Every time a bank makes a loan it creates a new deposit to match it. By way of illustration, if a bank makes a loan of £1,000, it adds an asset of £1,000 to its balance sheet representing the amount it will be repaid by the customer. It also credits the customer's current account with the same amount effectively creating £1,000 of electronic money.

Given how readily credit can be created, it is easy to see why the system might naturally lead to excess and the kind of instability that has been common place in the past. Indeed, Dominic Hobson believes that leveraged fractional reserve banking is the 'great canker at the heart of modern finance'.

The banking system is subject to a major commission at present and changes in the way it functions are widely anticipated, but during my conversations and reading, I have also had cause to ponder the nature of money itself. Is there something about money itself that makes it tend towards excess? This is the next area to consider.

Part Eight: No Longer a Noun >>

This piece is part of a series by Revd Andrew Studdert-Kennedy exploring the role of the financial sector and how we might come to understand it better.

About this author

Revd. Andrew Studdert-Kennedy is Rural Dean and Team Rector of Marlborough.

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The opinions expressed in this article are those of the author, and do not necessarily represent the views of St Paul's Institute or St Paul's Cathedral.