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 ‘dot.com 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.