Systemic Risk and Deposit Insurance Premiums

In the wake of the financial crisis, many economists are trying to come up with creative new ways to deal with systemic risk: the risk of a “wholesale bank failure” and failure of the financial system in general. I just finished reading Judge Posner’s recent book, A Failure of Capitalism. In it, Judge Posner makes a convincing case that individual bankers can (and did) make rational decisions that, at least in the aggregate, greatly increase systemic risk. I don’t wish to go into the details of that analysis here; I just want to assume its truth.

When rational actors make decisions that create negative externalities, it often falls upon the government to adjust the incentives to account for those outside costs. In banking, for instance, Citigroup might make certain decisions that increase its risk of bankruptcy to 1%. For a smaller bank, that risk would only be negligibly important: the bank could fail and go into receivership. But for Citigroup, of course, such a failure would have broader effects: it would not be able to keep the (many) promises of payment it regularly makes to other banks (cascades); it would create a “fire sale” situation wherein bank assets would have to be sold by the FDIC at a sharp discount; and confidence in the economy overall would sharply decline. A systemic risk regulator would intervene to prevent a Citigroup (or one of its similarly-sized cohorts) from taking these individually rational (but systemically risky) actions. Even Tyler Cowen suggests that we might need such a regulator, and it probably needs to be the Federal Reserve. I respectfully disagree.

I think the best way to regulate systemic risk is to use the insurance premiums charged to banks by the FDIC’s Deposit Insurance Fund (DIF). In very simple terms, the FDIC charges banks an insurance premium that is used to cover depositor losses when banks fail. Under the current system, under 12 U.S.C. 1817, the FDIC charges a “risk-based” premium that is supposed to be based on: (1) the probability that the DIF will incur a loss for that institution (i.e., that the institution will fail); (2) the likely size of any such loss; and (3) the revenue needs of the Fund. Trouble is, the premium is only based on the individual size of each bank’s risk to the Fund. Therefore, when calculating Citigroup’s premium, the FDIC does not include any of the “contagion” effects noted above. The FDIC isn’t actually charging for the real “likely size of any loss” that the bank will suffer from a big, interconnected bank’s failure.

I’ve seen a few different studies outlining how we could actually set the premiums to account for the systemic effects of a bank failure. I’m not going to venture into that. My only point is this: properly scaled, deposit insurance premiums that include systemic risk would obviate the need for any “systemic risk regulator.” If banks that create systemic risk faced increased premiums of any significant size, one would expect them to adjust their behavior to reduce the risk. In fact, the best approach might to charge punitively high premiums. One could anticipate that these punitive premiums could quash the moral hazard created by government bailouts; banks would know that they would pay a high price for setting themselves up to be “too big to fail.” Best of all, even if a bank was so brazen as to generate systemic risk in the face of high premiums, the money collected from the bank’s premiums would be enough to clean up the (system-wide) mess resulting the bank’s failure.

Of course, to accurately assess the premiums and let the market work its magic, the FDIC would need access to an enormous amount of information at banks. Not a problem! The FDIC has the right to examine any FDIC-insured institution if the FDIC’s board of directors finds the examination is necessary “for insurance purposes.” 12 U.S.C. 1820(b)(3). That would simplify the issue of setting up an entirely new systemic risk regulator with the authority to examine the books of market participants.

Gold & Your Money, Insurance For Your Wealth Part 3 – What Could Start a Global Financial Meltdown?

In the first article in this series; Gold and Your Money – Insurance for Your Wealth During a Financial Meltdown; Part 1 – Gold as Money or One World Currency? We discussed potential relationships between a financial crisis, gold and its use in those times and the US and world’s governments’ objections to such use and the most likely first choice for them in this situation – a ‘One World’ currency.

In the second article of the series: Gold and Your Money – Insurance for Your Wealth During a Financial Meltdown; Part II – Return to a Gold Standard? We explained what a gold standard means, how it dominated our countries economic history until 1934 and what it would do to our economy if it were re-instituted. We discussed the advantages to the citizens for such a move and the problems it would create for today’s career politicians. In this article, we will explore the different components relating to a potential economic meltdown or crisis and events that might kick start a financial meltdown. They are more realistic than ever before in or history. The forth article will help us decide if there are conservative measures we can take to protect ourselves and those we love in case it all starts to un-wind.

To fully appreciate what it might take to ignite a financial meltdown, we need to get a clear picture of where we are today. If the economy was growing from a base of solid economics, this topic would be nothing more than speculative thinking. Morbid speculative thinking of which I would have no part. My faith would tell me to focus on what’s good in life. It still does, but my experiences, skill sets, AND my faith, mandate that I write what I see and let you decide what it means for you.

Without going into pages and pages of detail (I do that in a forum discussed below), a quick survey of current economic conditions are warranted.

The stock markets and financial markets in general seem to be trying to hold up in spite of what is generally bad news. There is this sense that everything is on the edge….like it is waiting for something to push or pull it one way or another. Do you feel it? There is nothing anywhere on the near term horizon that looks strong enough to pull the market up with any real, continued, well supported recovery. Unfortunately, if there was a direction that the facts would be pointing to…it would be for a decline. This recovery really has no legs. There is not a stitch of evidence suggesting anything else. And there any number of ways a correction could start.

For example, let’s say another wave of increased home foreclosures begins to show up. It has. In spite of the U.S. Governments 75 billion Home Affordable Modification Program (HAMP), foreclosures rose again in April and are on course to exceed the 2.8 million initiated in 2009. Over 932,000 filed in the first three months of 2010. In addition, there are a great number of adjustable mortgages coming due this year. Add the same rate of foreclosure’s in the commercial real estate market and we have the makings of an economic crisis knocking at our door.

The largest bankruptcy in the history of America recently happened when the huge commercial real estate-mall owner operating company General Growth declared bankruptcy – roughly 9.7 billion dollar bankruptcy…the largest in U.S. history. To begin to understand this, Wikipedia lists the GDP of over 191 countries – 69 of which are smaller than this one bankruptcy. Search Wikipedia for global GDP or go to my website..

There is much evidence that the only reason we have not seen this already is because the market is being artificially supported knowing that the combination of residential and commercial would crush the U.S. economy taking most of the world with it. Lenders are holding on looking for government bailout funds while hoping and praying for a turn around sufficient to get them back in the black.

On February 11, 2010, the Huffington Post ran an article titled: Elizabeth Warren Warns About Commercial Real Estate Crisis, ‘Downward Spiral’ For Small Businesses and Local Banks.

“There is a commercial real estate crisis on the horizon, and there are no easy solutions to the risks commercial real estate may pose to the financial system and the public,” says a report issued Thursday by the Congressional Oversight Panel, the bailout watchdog led by Harvard Law professor and middle-class advocate Elizabeth Warren. It went on to report:

“Over the next five years, about $1.4 trillion in commercial real estate loans will reach the end of their terms and require new financing. Nearly half are “underwater,” meaning the borrower owes more than the property is worth. Commercial property values have fallen more than 40 percent nationally since their 2007 peak. Vacancy rates are up and rents are down, further driving down the value of these properties.” You can read more on this article and access the link at the end of this article.

There are many stories about this if you go looking for them. This may not be main stream quite yet…but it is widely known.

And by far the worst sign of all is our own government’s complete denial of fiscal restraint with their wild and undisciplined spending via freshly printed fiat money at paces never witnessed in history. With every additional dollar they create and flood in the economy, the farther away we are from knowing what will happen next. It seems obvious to me that they do not know what to do and are just working month to month. In truth they have very few options left, most all have been spent.

And they are not alone. Virtually every economy in the world that had any semblance of stability printed billions of their own currency as a global stimulus ensued in the aftermath of the economic crisis of October 2008. From Viet Nam to Dubai to China, Europe and many, many more governments went to their Treasuries and Central Banks and authorized them to print more currency in an aggressive attempt stave off economic collapse. The world’s economies are on edge.

If we were to add a political crises or two, that could be the last straw to break the camel’s back. Lord knows there are enough options to qualify. Of course the wars the U.S. is fighting now could take a turn or grow in scope. Certainly Israel comes to mind. Iran seems to be hell bent to crash one way or another – into Israel, or the rest of the world as we all tire of annihilation as an agenda. Throw in an earthquake in a major financial center… Think that a little crazy – did you ever think a volcano could do what it did to much of Europe? We are all so tied together today that it is like a big house of cards. If we learned anything in late 2008 it has to be that.

With global economies on shaky ground, and investors around the world hyper nervous just waiting to push the panic (sell), button, any combination of economic – political – environmental situations could trigger fear which moves to selling which moves to panic and a global crash like 2008 or worse.

It may in fact have already started. Smaller western style economies are already failing. Iceland led the group. Next it was Greece. This does not take into account money the International Monetary Fund has given to countries on the brink of economic collapse. Well respected Roubini Global Economics (RGE), commented on April 20, 2010:

“Public debt sustainability has exploded as a serious issue in advanced economies, most notably in the euro-zone’s “PIIGS”-Portugal, Italy, Ireland, Greece and Spain-but also in many larger OECD economies, including the U.S. These issues within the Euro-zone stem primarily from a loss of competitiveness, high wage growth and labor costs which outstripped productivity, undisciplined fiscal policies and, crucially, the appreciation of the euro between 2002 and 2008.”

The International Monetary Fund and the Euro-zone countries have come under increased criticism by the markets and it’s own citizens around their in ability to deal with the continued debt sustainability. They target Spain, which is not yet in the minds of many typical citizens still focused on Iceland and Greece as the next country with potentially worse economic and labor market problems needing international help and strategic economic and political reform not likely to happen. Its citizens would have to willingly accept a greatly reduced standard of living. They won’t do this on their own. No matter – they will be forced to in the near term as will so many countries trying to live so very far from their means.

So follow the progression…the worlds economies were on the brink of economic collapse in late 2008. They all printed large amounts of un-funded money and infused their economies with it artificially stimulating economic growth. This debt is still out there and the support it provided is now moving through the system and losing its affects. From a balance sheet perspective, all of these economies, the US included, are worse off than ever before…and we are approaching that same place…again. Is another round of stimulus funding an answer? It cannot go on forever. Sooner or later, spending or own money that we are borrowing from ourselves beyond what we can ever pay back just can’t work. It is not wrong to flatly state that we have never been here before. We have not. This is all a grand experiment and I am certain we will have our answers sooner rather than later. One to three years is my guess.

These countries share similarities to the US economy. They all of course had run up so much debt, that it became apparent to the rest of the world that they would never see their money so they stopped lending. These economies were so far underwater, that without additional loans to fund their debt, they collapsed. Social programs and other free spending habits of politicians who had no idea what the word ‘no’ meant bankrupted these countries. These politicians had the power to protect their citizens to be sure, but the citizens themselves shoulder a fair amount of the blame. Many apparently believe(d) that the government was a source of unlimited funds that would never circle back and hurt them individually. Sure.

You ever get an underlying sense…a gut feeling or a spiritual knowing that things are not right? Often these feelings are supported by subconscious gathering of data…a cumulative affect of bits of information over time. I am there now – are you? If so, perhaps much of what you and I feel today fits into this category, or, maybe God is allowing us to see ahead of time that everything has a reckoning.

What is the point you ask? The point is we are being offered some time to take some steps none of us had probably even considered up until 2007 or certainly 2008. Real value will become paramount. Unfunded, inflated, fiat “systems” will be exposed to steep losses. You need to transition your thinking. Thinking more about what holds value when everything we thought about value changes. Then you need to quietly acquire as much of this as you can. And, if you are smart about it, you focus on things that minimize losses should we be wrong about all of this and an economic miracle takes place and we get back on a solid track in the next few years.

This represents a time to implement a solid plan B. I have studied what should be a part of your plan B. I will talk more about this in the next article in the series. Gold and Your Money – Insurance for Your Wealth During a Financial Meltdown; Part IV – What are Reasonable Precautions I Can Take to Protect Myself Without Being an Alarmist? Copies of this article as well as the early releases in the series and other related articles can be accessed on my site mentioned below.

Conclusion: I want nothing more than to be wrong about this. I can’t tell you badly I want this to correct without real serious pain. If it got that bad like it did in the fall of 2008, and stayed that way for some time, it would get very ugly. People who had things others valued would have some control of their level of pain. Items needed to survive top the list of course. After some time, a form of economy would start to take shape. Start at least thinking about how you could participate in that economy while taking steps today that minimize your risk if this never happens.

Global Accounting Information Systems – Some Assembly Required

Financial accounting and reporting can be challenging for many organizations, but for the world’s largest home furnishings company this proved to be especially difficult at the end of the 20th century. IKEA, the Swedish-founded global furniture giant based in the Netherlands operates 280 retail stores in 26 countries, 29 trading offices in 25 countries, and 11 distribution centers in 16 countries. IKEA also owns and operates its own industrial supplier called Swedwood, which has 5 production units in 5 countries. Add to the mix over 1000 other suppliers across 55 countries and the framework is set for a truly global organization where the potential for growth is seemingly limitless, however at the same time it creates a complex global network where accounting information can be hard to manage.

IKEA has experienced solid sales growth every year since its first store opened in Almhult, Sweden in 1958, yet the company has just recently started to grow at a rapid pace. Since 2000, annual sales have more than doubled from 9.6 million euros to 23.1 million euros in 2010. IKEA is able to achieve these results for a number of reasons, such as its strong focus on supply chain management, raw material sourcing, cost management, manufacturing efficiency and economies of scale, and company-wide culture of frugality and doing things within small means. However, despite all of these strong attributes the success of any company is highly dependent on its ability to manage cash flow and financial information so that it can make strategic business decisions and drive future growth.

One often-overlooked aspect of a company’s financial success is the quality of its accounting information systems. Because of its global nature, IKEA was forced to examine its financial system in the late 1990’s due to euro compliance regulation and the Y2K threat. Roger Neckelius, IKEA’s Chief Information Officer and other IKEA executives quickly realized that the company’s myriad of antiquated accounting systems was inadequate for their short term goals of regulatory compliance and their long-term goals of a common, streamlined system that could be used across the IKEA world.

Ulrika Martensson, the Project Manager responsible for implementation of the replacement system began her search with certain criteria that had to be met, such as having one system for all of IKEA that was flexible enough to handle the different needs of the various business units and its users. The system would have to be capable of a quick implementation, and possess the ability to grow along with the company.

Martensson got everything she wished for when IKEA decided on Coda Financials from the United Kingdom, but wasn’t quite prepared for the amount of work that was required to tailor their product to IKEA. The Coda system required that every type of financial transaction was “defined” such as payables and receivables. However, in a way this was a blessing in disguise because of IKEA’s enigmatic and complex organizational structure. As mentioned earlier, IKEA has a vertically-integrated supply chain with numerous components all over the world. But it is also a privately-held company with a unique “ownership” structure. The IKEA Group is the group of companies within IKEA that handles the core elements of the business such as product research and development, production and distribution, and retail sales. The IKEA Group has a parent company called INGKA Holding B.V., which in turn is owned by the Stichting INGKA Foundation, established by the IKEA’s founder Ingvar Kamprad. Furthermore, the Stichting INGKA Foundation funds the Stichting IKEA Foundation, a Dutch charitable organization which supports humanitarian initiatives throughout the world. Because the Coda system was customizable, it allowed for a much easier conversion process for the variety of business units within IKEA.

Martensson also took advantage of the system’s flexibility to solicit input from end users across IKEA and tailor the system to their needs. This is an ingrained part of the IKEA company culture – to work together and come to an agreement before making a decision. However, when it comes to financial information system standardization and compliance this democratic approach isn’t always ideal. Martensson admitted that she gave the users too much leeway and instead should have taken a firm stance that the users were required to adapt to.

Nonetheless, Martensson and her team made quick progress rolling out Coda to 12 countries over a 4 month period. They overcame differences in foreign banks automated payment systems, Europe’s complicated VAT system, and the complexity of IKEA’s organization itself to achieve their goal of a September 1st, 1999 go live date.

IKEA’s journey in the late 1990’s to switch over to a common financial system shows the effect of globalization and the need for companies to adapt in an ever-changing business environment. Not only did the successful implementation of CODA ensure regulatory compliance by IKEA, but it also enabled the company to be more transparent in terms of financial reporting throughout the organization. Executive management no longer had to extract information from the myriad of financial reports that existed prior to the CODA implementation; it had common information in a common format at its fingertips to help make sound decisions to secure the long term financial success of IKEA.

Dodd-Frank Vs The Financial Industry

he capitalist version of the Golden Rule goes something like this, “He who has the gold, makes the rules.” This is exactly what we are seeing with the implementation of the Dodd-Frank Act. The financial institutions have the resources to stall, drag, markup, and negotiate on every one of the 243 rules, 67 studies and 22 periodic reports the Act contains. The most recent markup session was a classic example of, “The Golden Rule” at work. The House Agricultural Committee’s recent markup session included bills to gut the most important parts of the Dodd-Frank Act. The committee invited 5 individuals to discuss these matters, four from the financial industry and one person from the private sector, Wallace Turbeville of the Americans for Financial Reform.

The timing of this session was critical as it came right on the heels of the London Whale testimony before the Senate Permanent Subcommittee on Investigations. The London whale was the JP Morgan trader who accumulated an outsize losing position, at one point reaching a negative value of more than $150 billion dollars before finally paring the reported loss to just over $6 billion. The crucial point here is that JP Morgan lied about the debt from beginning to end and was able to transfer funds internationally among its branches to hide the loss. One of Dodd-Franks’ most important pieces is, “extraterritoriality.”

Extraterritoriality is what is supposed to protect the American financial system from a meltdown somewhere else on the globe. This act would ensure that American firms who hold risk outside of the U.S. must still use our reporting standards. This is the loophole JP Morgan used to hide the losses of the London Whale for so long. This piece of legislation also increases transparency by creating a public swaps global clearinghouse so that the vast majority of these can be readily monitored. This is a good thing. However, this would hurt the financial industry’s profits through more reporting man-hours as well as additional execution, clearing and margin requirements.

The next major challenge with the implementation of the Dodd-Frank Act is the, “Bank Derivatives Subsidiaries.” This is intended to eliminate, “too big to fail.” The financial industry is having a hard time coming to grips with the notion that it may have to separate its trading and banking operations. Dodd-Frank got this right. Investment firms should be investment firms and banks should be banks. It’s one thing for a bank to loan out excess deposits. It’s quite a different matter when the bank is using your excess deposits to trade European debt markets, crude oil or any other trade the bank would like to initiate with your funds. Just a few years post crisis and the banks already want us to allow access to taxpayer funds to cover their losses. Trading becomes a pretty easy game when the taxpayer money is there to cover the losers.

These are the two primary points of contention with several others falling under the umbrella of the previous two paragraphs like, “Business Risk Mitigation and Price Stabilization Act.” This is a margin act. When a product is hedged, there is still risk for the financial institution. Therefore, the Dodd-Frank stipulation that the financial entity engaged in the hedge transaction should keep sufficient margin on hand to cover market movement. This splits the previous points if the trading entities are spun off from the banking sector as well as creating a trading entity that can be monitored while assuring client funds in the banking side of the business remain safe.

The era of, “too big to fail” must come to an end. Individuals who put their money in banks deserve to know that it’s safe. There was a time when customers worried that their money may be stolen by crooks robbing the bank. I doubt anyone ever thought of the crooks in the bank stealing their money. The financial industry must undergo a paradigm shift in this respect and realize that they cannot be all things to all people and therefore must choose between investment banking and customer banking. Dodd-Frank implementation is a daunting task. Current estimates are that somewhere between one quarter and one half of it has been put into place. If the finance industry has its way, that’s as far as it will go and the people with the gold will have arranged the rules to suit themselves once more.

Three World Financial Crises: A Full Account

To understand the financial crises that the world has been going through you need to understand what money is, so I start there. I go on to examine how banks lend and borrow money. Then I look at the crucial part played by the ‘bond market’ which is used by governments and companies to raise the money to cover their expenditure. After that, I explain the financial relationship between a Government which has to spend and raise money and their Central Bank which helps them to do it. Finally I look at how the economic climate changes and why the world has been experiencing a series of financial crises.

Money, Currencies, Exchange Rates

Money is denoted in currencies which are controlled by their governments. In the US it is the dollar; in the eurozone of 17 governments it is the euro; in China it is the rimini; in the UK it is the pound. The euro is an anomaly since it is not controlled by a single government (more about that later).

Within a country (or zone in the case of the euro) there is a knowable amount of money in circulation. The amount depends on the definition of money that is used. ‘M0’ is the narrowest of the several definitions: it is the total amount of the particular currency in notes and coins that is owned by all persons and entities, whether in their wallets or in their safes, including, in the UK, the safes of banks. Other definitions include forms of money such as deposits in bank current accounts, deposits in savings accounts with banks or other institutions, and term deposits, only repayable on a specified date.

Money in a particular currency is a commodity (like copper, wheat, oil, gold) which can be bought or sold with another currency at a rate determined by the market. As with any commodity, the price is higher if you are buying than if you are selling. Thus a bank might quote an exchange rate of 1.6 US$/GBPound for buying dollars with pounds and 1.5 US$/GBPound for selling dollars in return for pounds.

The existence of money and money markets makes trading in goods and services easy and leads to increase in wealth for individuals and nations. Without money there would be a brake on transactions. For example, a bricklayer who wanted to buy a pair of shoes would have to find a shoe maker who wanted some bricks laid (the process called barter). If they cannot find one another they are both the poorer. Because money exists, the bricklayer can earn money laying bricks for anyone and buy goods and services from anybody who has got what he wants.

Lending, Borrowing, Commercial Banks

Once money is accepted as payment for goods and services, individuals start to accumulate bank notes and coins. They need a bank to keep it safe until they are ready to make use of it. Some owners of money have more money than they need while others have less. So it becomes useful for pairs of individuals to agree that one should lend money to the other. Just as money lubricates the exchange of goods and services between buyers and sellers, so banks lubricate the use of money, bringing together lenders and borrowers. The lender usually requires the borrower to pay back a greater sum than they have borrowed, the extra being the ‘interest’.

Commercial banks offer safe keeping to holders of money. The Bank opens a ‘current account’ for the owner of the money and agrees to repay it on demand. It also offers the account holder facilities for making and receiving payments to and from third parties by such means as cheques, standing orders, direct debits and internet transactions. As the Bank gathers more depositors and the total sum of the deposits increases, the Bank finds itself in possession of large quantities of money sitting in its vaults doing nothing. This money does not belong to the Bank and, in principle, it is repayable to the depositors instantly on demand. In practice, the daily demand for repayment is a small fraction of the total. The Bank is providing a service to depositors for which it is not being paid unless it finds ways of making a profit from this service. There are several such ways:

– charge depositors for running their current accounts

– offer depositors temporary loans (overdrafts) on which the bank charges interest

– lend some of the idle money of its depositors to third parties and charge interest

But there is another important way for banks to make a profit by lubricating the use of money:

– first borrow money from other parties for an agreed period for which the Bank will pay the lender interest; for example, through deposit and term deposit accounts

– then use the money that they have borrowed by offering loans to others at a higher rate of interest than that which they are paying to the parties from whom they have borrowed.

There have been times when banks have been careless and greedy in using the money of their depositors. Rumour spreads that a bank may have difficulty in repaying deposits on demand. There is a ‘run’ on the bank, the rumour becomes reality and the bank has to close its doors. After some recent incidents, banks are becoming more tightly regulated and required to keep greater Reserves to cover the excess of their lending over what they owe. But it is debated how big the Reserves must be.


When governments, banks and companies need extra money for the conduct of their business they get it by selling bonds. The bond unit has a name, like ‘Treasury $100 5% 2018’. The seller of the bond will pay interest of 5% on the face value of $100 and will buy back the bond at its face value on a specified maturity date in 2018. Such bonds are negotiable: units of the bond may be bought and sold in the money market until its maturity date. The interest rate at the time of issue depends upon the credit-worthiness of the borrower. The re-sale value of the bond on the bond-market varies with market conditions. If interest rates go up to 5.5% the price of this particular bond might fall to $88. If interest rates go down to 4.5%, the price might rise to $115. But near its maturity date in 2018 the price will converge on its face value of $100.

Credit-rating Agencies are commercial companies who rate the credit-worthiness of organisations, including governments. They are influential in determining the interest rates that have to be paid by governments and companies. Three well-known agencies are Moody’s, Standard and Poor’s and Fitch. Their credibility seems to have survived their failure to foresee the over-lending by Freddie Mac, Fanny Mae, Lehmann Bros, the Royal Bank of Scotland and others before the 2007-8 world financial crisis.

Central Bank, Bank rate, Foreign Exchange Reserves

Each national currency has an associated Central Bank. In the UK the central bank is the Bank of England. Central Banks have the legal right to create money with which to buy bonds from their governments and others at an interest rate or Bank Rate of their choosing. They sometimes try to stimulate the economy by keeping interest rates very low and by buying up bonds in the open market. Some call this ‘quantitative easing’ while others call it ‘printing money’. But the Central Bank only supplies notes (printed money) when asked to do so. Usually the money is created by transfers from the Bank’s own account to the receiver’s current account in return for the seller’s bonds. The Central Bank cannot go bankrupt since it is allowed to issue any required amount of new money to meet all demands.

Central Banks hold reserves of money. Gold was once paramount, but today foreign currencies, especially the US dollar, are more important. Additionally countries possess ‘drawing rights’ on the International Monetary Fund (IMF). Such reserves give a Central Bank a means for controlling the exchange rate for its currency. If for example the rate for its currency is rising, the Bank may sell its own currency and buy foreign currencies on the market, so keeping its exchange rate down and the prices of its exports low.

Government Income, Expenditure, Deficit and Debt

Governments spend money on many things: education, defence, social services, transport, and so on. The amount that they spend is their expenditure for the stated period. The government can pay for a large part of its expenditure with its income, mostly derived from collection of taxes. But usually its income is less than its expenditure. The difference is its deficit:

Public Expenditure – Public Income = Public Deficit, for the stated period.

Something has to be done about the deficit or there will be no money in the Government’s current account. So the government borrows money by selling bonds on the bond market (in excess of bonds that are due to be redeemed).

Public Deficit = Net Value of Government bonds sold, for the stated period.

Government are usually given a high credit rating since they are generally considered unlikely to default on their repayments. The interest they have to offer on the bonds will be lower or higher depending on whether their credit-rating is high or low.

As stated above in the Bonds section, bonds have to be repaid on the maturity date specified at the time of issue. So government are continually issuing and repaying bonds; the net total of bonds in issue constitutes the total of Government (or National) Debt:

Total Net Issue of Bonds = Total Government Debt, at the stated time.

The size of Government Debt is sometimes expressed as a percentage of Gross Domestic Product (GDP) (a sort of national annual income). For the UK this was 62.8% in November 2011. This sounds high but not when compared with the 300% of annual income that an individual may borrow for a long-term loan (mortgage) on their house. But it is higher than the government would like because interest has to be paid on the bonds that make up the Debt; and that interest has to be included in the government’s expenditure. As with individuals, interest on borrowing can become a significant part of expenditure and ought to be kept as low as possible. There can be no rigid rules but usually Governments should restrict their borrowing to paying for capital projects for which there will be a payback: like borrowing to build roads, railways, schools and flood defences. But the cost of social services, pensions and defence should be met from current taxation averaged over a few years.

To borrow or not to borrow is a difficult choice when the activities that make up the nation’s GDP are not flourishing. If government debt is already high, to borrow more may undermine the government’s credit-worthiness as well as increase the government’s interest payments. But not to borrow may necessitate cutting government expenditure and increasing poverty and unemployment.

Other financial bodies and activities

I have mentioned only those financial bodies and activities that I thought essential to explaining the world’s money problems. But there are many others which may contribute to those problems and I now give them a brief mention. Stock exchanges all over the world fix prices for buying and selling shares in large companies. Specialist markets trade in commodities such as oil, wheat, copper, gold. Investment Banks borrow money from wealthy clients and aim to invest it in profitable ventures and take a commission on the profit. Markets also offer investors various sophisticated ‘financial instruments’. For example, there will be a price for which you can buy the right to buy say 1000 shares in Fizzy Cola at a stated price per share on a stated date; this is known as a ‘call’. You can also buy a ‘put’ giving you the right to sell on a similar basis. ‘Futures’, as they are called, exist also for currencies and bonds. These activities may amplify a developing banking crisis.

The Economic Climate

Like the weather, the economic climate can change from warm and sunny to cold and bleak, and then back again. For the economy,

warm and sunny translates into: GDP rising (growth); low interest rates on public and private debt; low inflation; easy access to credit for businesses and private mortgages; tax rates going down; falling unemployment; stock market share prices rising (‘bull’ market).

cold and bleak translates into: GDP steady or falling (recession); high interest rates on public and private debt; inflation rising; shortage of credit for businesses and private mortgages; tax rates going up; rising unemployment; stock market prices falling (‘bear’ market).

There has always been a tendency for a long period of economic sunshine to give way to a period of bleakness. But in recent years we have witnessed the storm clouds blowing up rapidly, precipitating a world financial crisis, not once but 3 times. What happened?

The Recent Financial Crises

Crisis 1: This was a ‘mere’ stock market crisis, small compared to the banking crises which were to follow. Its seeds were sown in the second half of the 1990s which saw huge rises in the value of internet companies, the ‘ bubble’. Often the rises were not due to big profits: huge investments were made in companies making no profit at all. But they were perceived as being likely to earn those profits in the future when they had succeeded in establishing their internet niches. In a case like Amazon such confidence was justified but in others it was not. For example the big UK company GEC which had made large profits from defence and domestic hardware decided to switch its assets into internet activities, overpaying for the assets that it acquired. In the early 2000s, the ‘dot com bubble’ burst, stock market prices fell and growth of world GDP slowed down. In the UK, GEC went bust.

Crisis 2: But that was a mere ripple compared with the 2008 crisis. This started in the US with the selling of ‘sub-prime mortgages’ to less well-off buyers, who were tempted by rising house prices and attractive interest rates (sub-prime means more risky). Some buyers took out their mortgages for second-homes or for investment in housing. The big public US mortgage providers, known as Fanny Mae and Freddy Mac were deeply involved. The interest rates on these sub-prime mortgages were in fact higher than banks and investment houses could earn elsewhere, so they were all eager to make the loans or to buy the mortgages from original lenders in order to increase their profits. They forgot the risk of wholesale default on repayment by sub-prime borrowers. Foreign banks like Northern Rock, Royal Bank of Scotland (RBS) and Halifax in the UK, banks in Ireland, Iceland and Europe also poured their money in. At last it became clear to many that there was a risk of huge losses should US house prices start to fall and interest rates start to rise. The perception became self-fulfilling. Fear grew and sub-prime house buyers found not only that they could not afford the mortgage but that their house was worth a lot less than the mortgage. So the lenders of the mortgages would not get their money back. In the US the big investment bank Lehman went into liquidation. In the UK, Northern Rock was the first to suffer from a run on the bank with savers queuing up to get their money back. The UK government, fearing a more general banking crisis, moved in quickly to guarantee the survival of Northern Rock. Before long it was bought by the UK government (nationalised). But this was only the beginning. Banks all over the world were affected and there was fear of a breakdown of the banking system and a massive recession in world trade. In late 2008 world leaders agreed on a huge provision of money by their central banks to avoid the collapse of the commercial banks. In the UK for example this resulted in the government becoming the majority shareholder in RBS; and persuading Lloyds Bank to take over the potentially bankrupt Halifax with government assistance. As it turned out the latter action did Lloyds no good and the government became a majority shareholder in Lloyds Bank as well.

Crisis 3: As the world financial system was beginning to recover from the 2008 sub-prime mortgage crisis, a third one was starting: the eurozone crisis. As noted above, the euro is different from other currencies in that it is not a national currency nor is there a normal Central Bank. Instead there are 17 national governments using the euro as currency in their 17 countries. There is a sort of central bank, the European Central Bank (ECB), but it is responsible to 17 governments.

(Why was such an unmanageable system ever set up? The reason of course is that the believers in a federal Europe were pursuing their goal of ‘ever closer union’, ratcheting power from nations to the European Commission in Brussells.)

In Ireland, Greece, Italy, Portugal and Spain, government deficits and government debt are high and the bond market sets high interest rates. None of these individual countries has the right to demand that the ECB buy its bonds to finance its deficit; so they are obliged to pay the market rate which they cannot afford. Then they are forced to cut government expenditure and raise taxes. In Greece this has led to public disorder. So far the European Union’s solution has been to speed up the journey to ‘ever closer union’ by requiring its members to yield to Brussells control over their national budgets. The UK refused to take part in this process and incurred the public displeasure of the ringleaders, France and Germany. But it is likely that other countries in the EU will refuse when their peoples understand the proposed weakening of the power of their national parliaments.

It is seems unlikely that the eurozone can survive in its present form. Countries may leave and revert to their own currencies. This could be weak countries like Greece, but it could also be the strongest country, Germany. The exchange rates could then adjust, balancing the individual economies and restoring growth.