Ian McAuley. Is capitalism redeemable? Part 5: When finance goes its own way

Nov 17, 2014

One of the world’s most useful social institutions is money, but it’s hard to think of it in its social context.

To understand the social value of money, think of a world without money, or a country where, through recklessness the currency has been debased, as happened in the hyperinflation in the Weimar Republic in the 1920s.

Barter served us well when few articles were traded – grinding stones, pituri and ochre in the Australian outback – but not in Germany in the 1920s and certainly not now. Complex trades require some agreed currency, not necessarily having any utility in itself, but with an agreed value in exchange. It’s that need for agreement, and for trust in those who control the currency, be it obsidian, rare shells, gold, or US Treasury Notes, that gives money that social context.

Besides facilitating exchange, money also allows those with a temporary surplus to lend to those with temporary deficits – the wealthy individual funding someone else’s startup business, the older generation lending to the younger generation to buy houses. Such deals involve a huge range of instruments – loans, mortgages, equity and so on – but what they have in common is the need for some level of trust. Trust that the debtor intends to repay, trust that the terms of the deal are protected by some external authority, trust by the creditor that the debt will not be whittled away by inflation.

Apart from times when we are caught short of cash – when the taxi fare is blown on the last race at Randwick – individuals don’t go around lending and borrowing. We do so through financial intermediaries, such as banks and stockbrokers. When we make deposits in these institutions we must be able to trust that they will act responsibly (in line with normal risk/return tradeoffs). That is, they will assess the quality of the way they invest that money on the depositor’s behalf and act as responsible trustees.

That’s the way money serves the economy – by facilitating trade and investment. Thanks to what is known as “fractional reserve banking”, money isn’t some fixed entity: if there is trust and confidence money expands. When I borrow to buy a house or to set up a business I use that money to pay a builder or to hire workers, who, in turn use some of that money to lend to others through their bank deposits.

These arrangements serve us well, until we lose sight of this practical, mundane function of money. They start to fall apart when we start to think that money itself is something real, as wealth, rather than as a means of denoting wealth.

It’s hard to put a date on this confusion of money with wealth. The Biblical warning about “love of money” suggests it goes back a long way. On the other hand, older Australians can remember when bankers were respectably dull people who drove Holdens, wore Fletcher Jones suits, and ate roast lamb with three veg on Sundays.

Something was changing when we started to hear life insurance salesmen (they were men) and bankers re-brand themselves as financial planners, and when they later re-branded themselves as “wealth managers”, when the Holden was replaced by a BMW and the Fletcher Jones suit by a Hugo Boss.

The situation worsened as traders bought and sold financial instruments, sometimes not even knowing what acronyms such as “CDOs” stood for, let alone knowing about any connection these instruments may have had to any physical reality. Hence the GFC.

The GFC is most easily understood as a loss of trust, as a loss of the social capital that allows borrowers and lenders to deal with one another.

It meant that money literally disappeared. That doesn’t mean people’s or businesses’  bank accounts suddenly shrank, but it meant that many debts were never repaid, that some investments went belly-up, that investments in pension funds went backwards, and that people and businesses became reluctant to lend and invest. Governments tried to stimulate their economies with low interest rates and “quantitative easing” (i.e. printing money), but as fast as they injected money into the economy people took it out again, often re-investing in the safety of government bonds – the equivalent of putting banknotes under the bed. They no longer trusted the financial system, and trust, once lost, is very hard to restore.

That has been the main consequence of the GFC – a crisis that could have been avoided had governments not been so gung-ho about deregulating the financial sector in the 1980s.  As is so often the case, rather than replacing obsolete regulations with more appropriate ones, they went down the path of deregulation.

The other cost to the economy has been manifest since well before the GFC, and that has been the distortion of incentives in the economy. The message in the financial boom was that doing anything useful in the real economy was a mug’s game: playing with money was where the big returns were to be found. The finance sector took in some of the world’s most mathematically talented graduates, who could have been contributing to the real economy in engineering or science.

In so doing it worsened economic inequality, damaging the already tenuous links between contribution and reward. Inequality, its causes and consequences, is the subject of the next two contributions.


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