An Obsession with Cash

For me, it was this very question that led to not just a perpetual answer-finding expedition, but also to a personal reinvention. In 2006, when I was in my early twenties, I left my country of origin and travelled to France with a very clear objective. Dissatisfied with a budding career as a marine engineer, I left everything behind to seek adventure and camaraderie in the French Foreign Legion .

Between 2006 and 2011, I served in the renowned 2^nd REP,¹ and during this time, I was deployed on multiple occassion in Africa and Afghanistan. Apart from being an extremely formative period, these deployments also led to the development of an introspective streak which sparked and channelled an intellectual curiosity. I realized that every time I was in a country of conflict, I began to ask myself the same questions. Some of the questions are those which every soldier thinks about. When will this be over? When will I get home? What will I do after that?

But the most recurring question was with reference to the gargantuan sums of money being spent by the government (French or otherwise), every time they put boots on the ground. Not counting the loss of life, the economic cost of the war in Afghanistan cost the French government over €3.5 billion between 2011 and 2014 (Conesa, 2015). For other countries the figures are even higher. The Watson Institute of International and Public Affairs,² states that the United States federal government has spent or obligated $4.4 trillion on the wars in Afghanistan, Pakistan, and Iraq (Watson Institute, 2015). As of 2016, a Congressional Research Service (CRS) report states that the cost of keeping a single American soldier in Afghanistan is a wincing $3.9 million (Thompson, 2015).

Where does this money come from? Is it being paid just by taxes or is there another source? These were the questions that I continuously asked myself as I came to the end of my contract with the Legion. In an attempt to find these answers, I enrolled myself in a master’s in business degree program at prominent business school in France on leaving the Legion. It was here that one realised that although we are taught how to account and invest money, we never looked into the mechanics of making money, which is the origination of the subject. Moreover, this is a phenomenon that is not just restricted to one institution. A large number of institutions currently practice this teaching methodology. Just ask around your own entourage and note down the results.

While the reason for this occurrence will be looked at in a later part of the book, for the time being we come back to the question of how money is made and where it is created. In today’s complex and sophisticated societies, it is insufficient to only examine the economic attributes of money in order to grasp its true meaning.

To understand the way money is created and to gauge its pertinence, one must be prepared to study it in the context of a particular society. Money, after all, is a means of communication wherein individuals communicate on how they will transfer value. Currency in this case is the medium that is used to exchange value, and the medium of value exchange can take different forms. But the underlying architecture and the executed purpose has always been the same: to facilitate trustworthy interactions.

If a certain kind of money is to exist, then it needs perform three functions : it needs to be a store of value, a unit of account, and a means of transfer. These three attributes manifest themselves in the form of a currency which is a physical representation of trust within a society. You do not need to trust a person to accept his money or vice versa. What allows trade to function in a modern-day economy is the fact that we trust the medium of exchange, be it dollars, euros, or anything else.

Currencies in general have always been in a gradual state of evolution, with its format varying as economies evolve. Early money was more a commodity rather than a currency and had an intrinsic value in itself. Examples of early money include cattle, seeds, and even wood. In fact, Tally sticks made of polished hazel or willow wood, were used in England from 1100 AD and only abolished in 1834.³ Hence the origin of the phrase “tally up.”

Gold and silver were the generally accepted forms of exchange and measurement of wealth for a long period in the history of money .⁴ The bimetallic system of money gave rise to the gold standard in early 1900s and during the Bretton Woods conference in 1946, it led to the creation of a fixed exchange rate. By this method, a country’s sovereign currency was pegged to gold, giving each denomination of the currency a value that could technically be redeemed in gold.

As gold and silver were cumbersome to store, carry, and use, towards the eighteenth century, a new much more portable and convenient form of currency in the form of “commodity-backed” money started to be used. The difference between this form of money and previous forms was that the currency by itself had no intrinsic value. Unlike gold and silver, this form of money was based on an understanding that the currency held by a person could be redeemed for a commodity in exchange.

As the century rolled on it was this form of money that evolved into fiat money, which is currently used by modern economies. Fiat currencies came into use in 1971 following the decision of President Nixon to discontinue the use of the gold standard. The end of the gold standard helped sever the ties between world currencies and real commodities and gave rise to the floating exchange rate. A distinguishing feature between commodity-backed currencies and fiat currencies, however, is the fact that it is based on trust and not a tangible value per se. Fiat currency is backed by a central or governmental authority and functions in purpose as a legal tender that it will be accepted by other people in exchange for goods and services. It can be looked as a type of IOU, but one that is unique because everyone who uses it trusts it. The value of a currency is hence based on trust rather than an exchange for a certain commodity.

It is the concept of trust that is quintessential to the story of money as it is directly related to debt and the production of cash. We trust our banks to hold our money and our borrowers to repay their debts. We might hedge against the chance of a default by charging interest rates, but the basic concept is a trust-based one. These two incarnations of trust are the fundamentals of money creation.

There are three main types of money: currency, bank deposits, and central bank reserves. Each represents an IOU from one sector of the economy to another (McLeay et al., 2014). Today, in a functioning economy, most money takes the form of bank deposits, which are created by commercial banks themselves. The public holds money in the form of currency, whilst their banks hold money in the form of non-interest paying demand deposits and interest paying checkable accounts. Paper currency and bank deposits hold no value as commodities. It is the confidence that people have with respect to their ability to exchange money for assets, goods, and services that give value to the currency.

The transfer of confidence from an interpersonal relationship to a proxy of value is what makes money a special social institution (King, 2006). In any given society, anyone could make financial assets and liabilities by giving out personal IOU’s every time they wanted to purchase something, and then tally up their credit and debit IOU’s in a ledger. Indeed, in medieval times European merchants would trade with one another by issuing IOU’s and settle their claims at fairs, thus cancelling out debts (Braudel, 1982). However, for such a system to flourish, it would require a great deal of confidence that the person who owes you something is trustworthy and will repay their debt. Worse still, even if a person is trustworthy, they might have dealings with persons who are untrustworthy and who may default, thus making the trustworthy person unable to repay your loan. But with money, we no longer had to deal with this issue of untrustworthiness as everyone trusts in a medium that allows for the exchange of goods and services.

It is this symbol of trust that gives a currency value and allows it to execute its three functions. Fiat currencies lack intrinsic value but still function as a medium of exchange. The value of a country’s currency is set by the supply and demand for country’s money and the supply and demand for other goods and services of its economy. This value is also directly connected to the currency’s availability, the price to be paid to acquire it, and the scarcity of its supply.

As cash is withdrawn from accounts, the amount of money circulating in the public physical realm conversely increases. This allows a currency to derive economic significance based on the currency’s trading position, its parent country’s GDP, and whether the country imports more than it exports. When the country is a large importer, it can also find its currency being used as a peg by other dependent economies, as is with the case with the US dollar and the Euro.⁵ As the value of a currency is based on supply and demand of the currency, a question that arises is with respect to the manner in which the main drivers of money creation are adjusted in a free market. In order to understand this concept, we need to refresh our understanding of fractional banking, inflation, and the role played by central and commercial banks.

Fractional reserve banking and debt-based money

To understand the concept of fractional banking it is important to first acknowledge that although central banks and governments belong to the same ilk and work in unison with respect to the issuance of sovereign coin, it is the central bank that actually influences how much money to create based on the inflation targets and the interest rate. The reason for highlighting this distinction is because the central banks of most countries are independent enterprises and their monetary policy decisions do not have to be approved by a president or anyone else in the executive or legislative branches of government⁶ . The working model, which is identical for more advanced countries, is based on the model of the Bank of England, which was established in 1694 as a joint stock company to purchase government debt.⁷ Under this model, when a government needs money for carrying out its functions, they exchange bonds with the central bank. The central bank then creates and issues the money in exchange for the government bonds (T-Bills included) and interest. In this way the central bank works in unanimity with the government but still retains a relatively independent status.

The second point to consider is the relationship between the quantity of the currency and the value it represents. While scarcity plays a foremost role in giving value to a currency, this value is directly proportional to the usefulness of the currency to be traded for goods and services. This usefulness is measured by the demand for the currency, while the scarcity is determined by the quantity of the currency supplied. The delicate balance between these two scales gives a currency its value and it is the goal of every currency-issuing country to stabilize either the supply or the quantity of its currency in circulation within its territories as well as outside.

As the value of a currency is only calculated by the amount of what it can buy, its value is inversely related to the general level of prices of goods and services in an economy. Hence if the supply of money increases more rapidly than the total amount of goods and services provided by the economy, then prices will rise. This phenomenon is called inflation. The opposite of this phenomenon is called deflation and results in a general lowering of prices.

Thus, most central banks construct monetary policies that allow them to uphold a low rate of inflation, which in turn provides stability to the value of their currency. This in turn provides sustainable growth and economic constancy. As money creation and control of its supply play such pivotal roles in an economy, it is no surprise that the central banks play a major role of control in this domain. However, the process of money creation also occurs in commercial banks. In fact, the majority of money in the modern economy is created by commercial banks by issuing debt.

Prior to delving into the mechanics of money production and the issuance of debt, we also need to define the types of money that slosh around our economies, namely, broad money and base money. Broad money refers to the money that consumers use for transactions. It includes currency (banknotes and coin), which are an IOU from central banks, and bank deposits, an IOU from commercial banks to consumers. In general, broad money measures the amount of money held by households and companies (Berry et al., 2007).

Base money , also known as central bank money, comprises of IOU’s from the central bank. This includes currency (an IOU to consumers) but also central bank reserves, which are IOU’s from the central bank to commercial banks. Base money is important because it is issued by central banks and thus allows them to implement monetary policy. Although the production of broad and base money is closely linked, broad money, i.e., IOU’s to customers from commercial banks, is in much greater circulation than in base money, i.e., IOU’s from the central bank. The graph in Figure 1-1, taken from a 2014 report from the Bank of England, illustrates this:

Figure 1-1. Different forms of money in circulation

The reason for this large difference between broad and base money is because commercial banks have a greater capability to create money. If you were to pick up an undergraduate book on economics, this is something that is not lucidly stated. You might come across a description more along the lines of, “banks are financial institutions approved by law to receive deposits from individuals and savers, which they lend to businesses, thus allocating capital between various capital investment opportunities.” But as seen from Figure 1-1, the role of commercial banks seems to go far beyond this simplistic definition.

The most important function of commercial banks is the creation of credit. Commercial banks do not simply act as intermediaries that hold savers’ capital and lend out these deposits as loans. When a bank offers a loan, it is also simultaneously creating a matching deposit in the borrowers account. It is here that the intricate dance between central and commercial banks leads to the creation of debt-based money.

When a client makes a deposit of their money with a bank, they are simply exchanging a central bank IOU for a commercial bank IOU. The commercial bank does get an injection of capital, but it also credits the client’s account for the sum deposited. Once again, this operation works on trust. The client trusts the commercial bank to repay the sum deposited on demand. As a result, banks need to ensure they have sufficient amounts of money to be able to repay the IOU’s. For this to occur, the bank deposits have to be easily convertible into currency, which is the case today.

As deposits can be converted into currency, the act of making new loans becomes crucial for creating money. When a bank makes a loan to one of its clients, it credits the borrower’s account with a higher deposit balance. However, at the same time, it is also creating a new entry in the liabilities section of its ledger. Although this liability previously did not exist, and hence does not have any physical representation in the form of currency, it is in effect an entry in the bank’s account. But as all these entries can be converted into currency, the instant it issues debt the commercial bank is creating new money. Hence, loans create deposits and not the other way around.

Th manner in which commercial banks create money by making loans or issuinig credit may be hard to digest if this is the first time you are reading about it, but it is how money is created today. When a commercial bank issues a loan to a client, for example to buy a house, it does not give this loan in cash. Instead, it credits their account with a deposit that amounts to the mortgage. As they make the loan to the borrower, they also credit their assets on their balance sheet. The house may belong to the client who has taken out the mortgage, but it is actually an asset of the bank till the loan is paid off. So even if the loan is payable at a later date, the money is available immediately for the small price of sacrificing ownership temporarily.

The owner of the mortgage now uses the loaned money to pay for the house. In doing so, they inject capital into another business, in this case a real estate agency, or a household if it was a private sale. Hence, via the issuance of debt, commercial banks create money, credit, and purchasing power. The vast majority of what we consider money is created in this manner. Of the two types of broad money, bank deposits make up between 97%–98% of the amount currently in circulation. Only 2%–3% is in the form of notes and liabilities of the government (McLeay et al., 2014).

How much debt commercial banks issue and how that debt is utilized are therefore topics of great importance. Rather than exchanging currency , most consumers use their bank deposits as a store of value and as the medium of exchange. Once a bank creates money by issuing debt, most people use that money to make and receive payments via their deposits rather than currency, especially as transactions today are mostly digital. That money is then swapped from account to account as consumers make payments via the interbank clearing system. As a result, once money is created, it is almost sure to rest in the banking system with very little being extracted to be used in the form of cash.

From the description above, it would seem that the amount of new money that was created by this method should equal the amount that is lent. But there are a number of other factors that change this equation. To understand how this works, we need to look at the subject of fractional banking from a quantitative perspective, as we ask ourselves how much new money can the commercial banks create in this way.

To respond to this question, we now turn our gaze from broad money to base money, which is created by the central bank. As mentioned above, since money creation and control of its supply play pivotal roles in an economy, central banks play a major role of control in this domain. As such, they are responsible for ensuring how much debt is issued by commercial banks, without which they would not be able to control the supply of money. This lever of control exists in the form of capital requirements .

Capital requirements play an important role in the production of debt-based money as they offer, among other things, a safeguard to a bank run. Since a bank creates money as it makes out loans, they are at risk of running out of physical currency in the case that a large number of the depositors decide to withdraw their deposits. To address this risk, commercial banks are obliged to hold some amount of currency to meet deposit withdrawals and other outflows, but using physical banknotes to carry out these large volume transactions would be extremely cumbersome. Hence, commercial banks are allowed to hold a type of IOU from the central bank in the form of central bank reserves, which is calculated as a ratio of the total capital held by a commercial bank. The central bank also guarantees that any amount of reserves can be swapped for currency should the commercial banks need it.

A modern commercial bank is required to hold legal reserves in the form of vault cash, as well as balances at their central banks which are equal to a percentage of its total deposits. This percentage figure is calculated to determine the minimal capital requirements which a bank requires to hold in order to minimize credit risk. The authority that sets out these international banking regulations is the Basel Committee on Bank Supervision, which is part of the Bank for International Settlements (BIS), an international financial institution owned by central banks.⁸ The total capital that is held by a commercial bank is classified as Tier 1, Tier 2, and Tier 3 capital .⁹

As per the Basel III stipulations, the minimum amount of capital to be held by the central bank depends on the size of the commercial bank. Banks are grouped into two categories: Group 1 banks are those with Tier 1 capital in excess of €3 billion and are internationally active. All other banks are categorised as Group 2 banks (European Banking Authority, 2013). As of March 2016, under the implementation of the Basel III framework, the average capital ratio for Group 1 banks is 11.5%, with a Tier 1 capital ratio of 12.2% and total capital ratio of 13.9%. For Group 2 banks, the average capital ratio is at 12.8%, with a Tier 1 capital ratio of 13.2% and a total capital ratio of 14.5% (BIS, 2016).

In the context of creating money these capital requirements, in the form of tiered capital controls, allow central banks to control the issuance of debt, and hence money, by commercial banks. For the sake of simplicity, let’s assume that the minimum amount of capital to be held by a commercial bank (Group 1 or Group 2) is rounded off to around 10% of its total capital. The capital percentage to be held at the central bank would then be calculated as:

This 10% minimum requirement is the basis of fractional reserve banking. What it shows is that according to the rules stated by the BIS, a bank only needs to have a fraction of its money in reserve, in this case 10%, in order to make out loans. Based on this stipulation a commercial bank can expand the deposits held by them by keeping only 10% of a deposit in their reserves and lending out the remaining 90% at a fixed or variable interest rate. In other words, by only keeping a fraction of the initial deposit, the bank can perform lending activities on the totality of the deposit. It is for this reason that this practice is called fractional banking .

By the rules of fractional banking, if $10,000 is deposited at a commercial bank, then only $1,000 is to be held in the deposits, while the remaining $9,000 can be loaned or invested by the bank. The deposit figure in the depositor’s account will read $10,000 even though only 10% of the account holder’s original deposit actually exists in it. However, the loan is not made on the $9,000 now held by the bank. Instead the bank will make a loan and agree to “accept promissory notes in exchange for the credits to the borrower’s transaction accounts” (Federal Reserve Bank of Chicago, 2011). Loans (assets) and deposits (liabilities) both rise by $9,000. Hence, the reserves are unchanged by this transaction, but the deposit credits in the borrower’s account now adds new capital to the total deposits of the bank.

As a result, the initial deposit of $10,000 is divided into $1,000 in reserves and $9,000 ready to be loaned. The $9,000 to be loaned enters a borrower’s credit account and continues to follow the same rule. Only $1,900 is to be kept in reserves and the remaining $8,100 dollars can be loaned. This cycle repeats itself, till the original deposit of $10,000 could theoretically lead to the creation of $100,000 in the bank’s deposits.¹⁰ It can thus be seen that savings of consumers are not the primary source of deposits that allow commercial banks to lend. In the modern economy, commercial banks are the creators of deposit money and rather than lending out deposits that are placed with them, the act of lending creates deposits—the opposite of what is typically described in most economic textbooks (McLeay et al., 2014).

The number of deposits that are created by commercial banks is significanlty influenced by the interest rate set by central banks (other factors include inflation rate, net interest margin, etc.). If the interest rate is high, it leads to an unprofitable lending opportunity, as the loans offered by a commercial bank are recorded as how much the bank owes it clients. Hence, deposit creation is lower at high interest rates and higher at low interest rates. If bank deposits are created by the issuance of loans, then the repayment of loans, in the form of currency or existing assets, leads to their destruction. Thus, a second factor that affects the number of deposits being made is the market. If the market sentiment is not friendly for investment, consumers could prefer to not take out loans or to pay existing loans back to stave off risk. This is further affected by competing banks, which might offer lower interest rates on the loans they offer consumers. As a bank’s profitability depends on receiving a higher interest rate on the loans than the rate it pays out on its deposits, the limits to which it can create deposits and maintain market share are affected by the margins strategy executed by their competitors.

The central bank also sets the interest rate that is paid on central bank reserves held by the commercial banks. The interest rate that the commercial banks receive on the deposits they place at the central bank in the form of capital requirements thus naturally influences their willingness to lend money to consumers and to other banks (interbank lending). The central bank calculates this interest rate by enacting monetary policies which are aimed at meeting the inflation target set by the government. By keeping a stable consumer price inflation (generally around 2%), monetary policy tries to ensure a stable rate of credit and money creation. The interest rate is also not set by a chosen quantity of reserves. Rather, it is based on the price of credit, which is governed by supply and demand of credit. An increase in the demand for credit raises interest rates, while a decrease in the demand for credit decreases them.

Thus, the central bank controls the short-term interest rates based on the pricing of credit supply and the interest payments it needs to make on the reserves it holds in relation to the monetary policy objectives .¹¹ But as the supply for reserves to the central bank and currency (broad money) is determined by the loans given by commercial banks, the demand for base money is heavily influenced by the loans being made by commercial banks. Furthermore, the quantity of reserves already in the banking system does not directly constrain the creation of broad money by the issuance of debt. For example: The Bank of England has no formal reserve requirements. Commercial banks do hold a proportion of non-interest bearing cash ratio deposits with the Bank of England for a part of their liabilities. But the function of these cash ratio deposits is non-operational. Their sole purpose is to provide income to the Bank of England (McLeay et al., 2014). The real determinant behind credit extension by commercial banks is based on profitability.

Our Waltz with Debt

The profitability that is associated with the issuance of private credit is thus a subject of vital importance. It is through the issuance of credit to consumers and businesses that broad money is introduced into the economy. As the demand for private credit goes up, so does the money supply in the form of currency and deposits. This brings us back to the graph in Figure 1-1. Why is it that broad money is many multiples of base money? The answer is demand for credit. Remember that credit expansion is profitable for banks that are issuing loans, as it means more deposits. Hence, if the demand for credit goes up, commercial banks stand to gain. For over four decades this demand has been growing.

Between 1997 to 2007, private credit grew at 9% per annum in the US and 10% per annum in the UK ¹² . At the same time, private sector leverage also saw a spectacular rise. In the UK, private sector leverage went from 50% in 1964 to 180% in 2007 (Turner, 2015), while in the US, household debt to income ratio went from less than 0.5 to 2.2 (Sufi and Mian, 2014). Figures similar to this were seen in most of the other developed economies and, more recently, this pattern has been repeated in many emerging economies as well. In most cases, private credit grew faster than the economy in terms of GDP.

By tracing and plotting these figures, we notice that the demand for debt has steadily grown over the past six decades. This increasing demand for debt was the result of actions and policies issued over this period that have defined the current highly leveraged economic climate. While it is beyond the scope of this book to analyze this subject in detail, a short note must be dedicated to it, as tracing the history of today’s debt-ridden culture is as important as finding a solution to it. Sidebar 1-1 summarizes a series of events that offer some insight into how we got to where we are today.

The events described in this sidebar seem to portray debt as a necessary evil which was used unscrupulously under the guise of profit maximization. However, this was the result of economic pressures and the decisions of leaders of a new regime who were experimenting with new ideas. This is not to say that an increase in the demand for debt and the growth of the private credit industry was a completely manufactured process. Debt by itself is vital to growth, and any civilization that used some form of money has also used some form of debt instrument (Graeber, 2012). As individuals and businesses try to grow and achieve higher levels of prosperity, they often need debt in order to expand and scale. The question we need to ask ourselves is how much debt do we need in order to grow and achieve a certain threshold of prosperity at a societal level?

The reason we need to ask this question is because of the central role debt plays in our economies. As we have seen, the current monetary system is based on debt and debt-based money. In the words of Marriner Eccles, Governor of the Federal Reserve, “If there were no debts in our money system, there wouldn’t be any money.” Hence, to respond to the question of how much debt is needed, we need to understand our attachment to incurring debt. Could the same kind of prosperity not be achieved from equities instead? What is so enticing about debt and why is it omnipresent in all discussions?

The answer to these questions lies in security and ownership . With equities, the return to the investor is directly related to the success of the business project being funded. However, increased sales of equities come at the price of dividing the company’s ownership pie. Even if the project is successful, the share of the profits now needs to be distributed among the other shareholders. A reaction to the reduced ownership has been seen witnessed in recent years in the form of bonuses. As business managers know far more about the business than the investors, they can siphon profits towards themselves and reduce dividends and returns to investors if they decided to. The increase in the size of salaries of business managers is representative of this practise.

In contrast, bonds are looked at as being more secure since they offer a fixed predetermined return and do not infringe on the owner’s territoriality. Furthermore, there is more flexibility with debt as liquid bond markets offer investors the chance to invest in long-term assets which they can sell for liquidity in the short term. However, this sense of security with debt instruments comes with other complications. First, coupled with fractional banking , debt-based currency and debt finance can be used to fund even more debt. This can create a danger of excessive dependence on debt, as the repayment of outstanding debt also relies on the supply of debt. If a company needs capital to expand and uses bonds intensively to do so, then without the continued issuance of debt, these companies would be forced to stem investment and see the prices of their assets fall. This also makes them more vulnerable to falls in investor confidence and reductions in bank loans.

The effect of market conditions on the issuance of debt is hence a key issue, and recent research from a team of Bank of England economists has found that there is an interesting cyclical relationship between capital ratios and lending conditions. In a paper titled “In Good Times and in Bad: Bank Capital Ratios and Lending Rates,” Osborne, Milne, and Fuertes found that in good times more bank capital was associated with more expensive credit, and in bad times it was the opposite. According to them, the reason has to do with changes in banks’ risk appetite between boom and bust times. While the BoE research does not imply a causal effect from capital ratios to lending rates, to the extent that there is one, it gives pause to think about the vulnerability of debt-laden companies.

It is not just companies that are affected by this. As described in Sidebar 1-1 and in previous parts of this section, households as well have become increasingly leveraged over the past decades. Thus, market changes also affect their decisions as to where they employ their debt to generate prosperity. When the economic climate changed in the 1970s, to hedge against any future form of economic turbulence, households and businesses increasingly turned to the real estate sector, as for most consumers, land or home equity was and is their only source of wealth. As consumers turned their investments to the housing sector, the primary business of banks shifted from lending to develop companies to mortgage lending. In fact, the standard role of the financial sector to lend for investment in the business sector constitutes a minor part of banking (Jorda et al., 2016).

This relationship between debt and the real estate industry is particularly important, for when we analyse any developed or developing nation, we always see a pattern of economic disasters being preceded by large increases in household debt (Sufi & Mian, 2016). This phenomenon occurs because of the underlying inequality between borrowers and savers. Most savers have financial assets and little mortgage debt while most borrowers have a low net worth which is why they need to borrow to invest in housing. This is why the vast majority of lending for the purchase of real estate is highly skewed towards the acquisition of already existing assets instead of funding new commercial or housing real estate (Dorling, 2014). The banking and capital market system is thus lending borrowers capital to compete with one another for the ownership of already existing assets, which makes location pivotal given that land and location are immovable entities.

In good times, there is a high demand for credit (which pushes up the price of credit), and a number of households purchase leveraged assets. As competition for the same pieces of land increases, so do land prices and the credit needed to acquire it. But the claims on these assets belong to the savers who make the deposits that enable the loans. If market confidence were to dissipate (as it did in the roll-up to the sub-prime crisis), house prices fall as borrowers attempt to deleverage themselves. As this effect gains momentum, the losses are more concentrated on other borrowers who are the worst off to begin with (which is why they needed to borrow), as the value of their liquid assets begins to fall. The fact that almost 60% (as of 2014) of lending is siphoned to investment in real estate (Jordà et al., 2015) thus compounds the effect and accelerates the process in order to create a bust. Past and present remnants of events like these can be seen in the form of “ghost towns” that exist in various parts of Ireland, Japan, Spain, and, more recently, China.¹³ Hence, a system that thrives on credit-financed consumption and directs large investments to the real estate industry, produces cycles of overinvestment, concentrates risk on the debtor, and is intimately linked to wealth inequality.

The cycles of overinvestment in real estate irrigated by the issuance of excessive credit thus creates a misallocation of real resources. But the problem is exasperated when the supply of credit is cut, as it occurs in the wake of bust or a crisis. What this leads to is a debt overhang effect. A debt overhang is a debt burden that is so large that a household or entity cannot take on additional debt to finance future projects, even if these projects are profitable enough to enable it to reduce its indebtedness over time (Campbell et al., 2010). Sufi and Mian describe this effect in their book, House of Debt, and so does Danny Dorling in his book, All that is Solid. What these researchers show is that during good times, house prices rise, which tempts debtors to borrow and acquire these assets of rising value. However, when the market turns, the higher the leverage the greater the fall, as the debtor falls in net worth with the fall of the asset price. If a household takes a 90% loan-to-value mortgage, then a 5% fall in house prices eliminates 50% of the household’s equity in their house (Turner, 2015). As a result, the debtors find themselves in a situation in which the debt they owe becomes increasingly unrepayable. Without the ability to sell their asset for the price they bought it and without the ability to access another line of credit (as creditors become wary as well), their debt levels remain constant while wages remain unchanged. If the bursting of a housing bubble also leads to unemployment for the borrower, the situation is worsened as now there is no source of revenue to manage the debt. This series of events, or others similar to it, are one of the reasons recovery has been slow following the crisis (Jorda et al., 2016).

While crises can cause great harm, the debt overhang created by excessive debt issuance can have more long-lasting effects . As house prices fall, those households and companies which are highly leveraged attempt to reduce their debt levels by cutting expenditure and investment. At the same time, the lack of demand for credit causes creditors to also reduce their expenditures. The cumulative effect of these two changes results in choking investments, higher unemployment levels, and a reduced demand for goods and services. In the past, to overcome these effects and boost spending, monetary policies aimed at reducing interest rates and employed the use of nontraditional instruments, such as quantitative easing (QE), in order to boost the supply of credit. While the effects of QE and other recently employed tools will be discussed in a later part of this book, the key point to consider is that the use of such measures is limited, since borrowers who are already overleveraged do not wish to get into more debt. Hence, the demand side of credit availability becomes the more pressing issue (Koo, 2014), for even if credit is supplied at a low price, the debt overhang effect reduces the demand for credit.

When companies cut investment and households reduce spending, government deficits increase as tax revenues fall and social expenditures for the unemployed increase. As a result, the debt that was issued in the private sector increasingly leads to rising public debt. Just as dancers move in gracious circles in a Viennese waltz, the interconnection of financial markets with a sovereign’s economy further metastasizes the effect of the debt overhang and causes it to spread into other sectors of the economy and across other economies.

The figures show this effect: Between 2007 and 2014, global debt rose from 269% of GDP to 286% of GDP (Dobbs et al., 2015). Dissecting the branches of this increase in public leverage, however, leads to a dichotomous realization that is reflected across a variety of economies. For example: Between 2008 to 2015, the US household debt to GDP ratio fell from 99.03 to 79.95,¹⁴ and private debt to GDP fell from 212.28% of GDP to 194.72 % of GDP.¹⁵ At the same time, public debt to GDP went from 92.34% to 125.34%¹⁶ for the same time period. Figure 1-2 illustrates this phenomenon.

Figure 1-2. Shifting of debt between private and public sectors Source: “Debt and (not much) deleveraging” (2015), McKinsey Global Institute

Although the figure shows a general upward trend with regards to public debt growth, the same report goes on to show that evolution of debt and debt overhang is getting increasingly divergent and picking up pace. Moreover, in a few developed countries such as France, Sweden, and Belgium, private sector debt has actually grown since the crisis along with public sector debt. In emerging economies, the rising leverage levels in both private and public sectors since 2008 is also becoming a subject of concern.

This was to be expected after the crisis. As growth retracted in developed economies in the aftermath of the crisis, it led to a slowdown of the imports from emerging nations. As a consequence, these countries were forced to shift from export-led growth to domestically led growth, which was fuelled by an expansion in domestic credit. This was most noticeable in China but was not restricted to it. Also, as interest rates in advanced economies were reduced to ultra-low levels, investors seeking a higher yield on bonds began funding projects in emerging economies. As bonds offer a more secure option of investment, firms in emerging economies began to issue debt instead of equity to benefit from the change in market confidence and to attract this growing pool of foreign credit supply. As a result, in contrast to the early and mid-2000s phase, this new wave of FDI was primarily fed by the bond market and, as a result, the share of emerging-market bonds owned by foreign investors has doubled from $817 billion to $1.6 trillion between 2009 to 2013 (Dobbs et al., 2015) (Buttiglione et al., 2014). It would seem that the waltz of debt is the folk dance of GDP growth.

How much debt is too much debt?

The rising debt levels of countries forces us to revist the question we asked ourselves in the previous section, which is, how much debt do we need in order to grow and achieve a certain threshold of prosperity at a societal level? It would seem that debt and growth go hand in hand, as over the past few years, debt-type instruments have gained preference over equity-type instruments (in terms of stock market capitalization) (Buttiglione et al., 2014). As this trend grows in markets across the globe, it raises questions about why economies need growing amounts of debt to grow their economies. More importanlty, we need to determine if this debt-based growth model is sustainable.

The reason for this apprehension with regards to a debt-based growth model stems from a number of reasons. At the private level , the amount of debt affects investment and consumption decisions. At a public level, it affects spending and taxation as well as determines the resistance to crises and shocks, as considerable evidence shows that high quantities of debt stock increase vulnerability to financial crises (Jorda et al., 2011) (Catão and Milesi-Ferretti, 2013). However, the cause for the popularity of purchasing debt-based assets is because it is less likely to cause repayment problems and assumes that the debt will be repayed through future income streams. But this is where the issue arises. In light of economic stagnation and immobile wage rises, the capacity of repaying the debt is increasingly challenged. This is not reserved just to developed economies but also concerns the emerging economies and is most prominent today in China.

At the end of 2015, China recorded its weakest growth in a quarter of a century at 6.9%. In an effort to boost economic growth, in February, the Bejing government moved to inject cash into the banking system to provide low-cost credit to firms and consumers (Wildau, 2016). While this can be said to fund innovation, that argument loses some substance in light of other economic facts. Between 2008 to 2014, Chinese total debt increased by 72% of GDP, or 14% per year. This is almost double that experienced by the US and UK in the same period. As a result of this credit expansion, overall leverage of the Chinese economy is almost 220% of GDP, almost double the average of other emerging markets (Buttiglione et al., 2014). As a result, China is experiencing a growing credit expanion and slowing nominal GDP . While Figure 1-3 showcases this contradiction, the slowing down of China’s productivity is indicative that servicing and repaying debt will be difficult in the future.

Figure 1-3. Chinese leverage and underlying nominal GDP growth Source: “Deleveraging, What Deleveraging?”, 16th Geneva Report on the World Economy

As mentioned before, the ripple effects of debt are cyclic and excessive debt levels augment that effect. If households and businesses find themselves too constrained to pay off debts or take on more debt, then on the flipside, creditors become reluctant to extend new loans or renew standing commitments as they are uncertain if debtors are capable of servicing the debt. As a result, the cost of credit goes up, making debt unattractive and, in some cases, unsustainable. The interconnection of markets further spreads this effect, such that a credit crunch in one sector can induce a wave of foreclosures and threaten the banking sector, which in turn can produce a sovereign debt crisis if the banks need to be bailed out by their governments. This in turn adds fuel to the fire, as the expectation of bailouts could lead to lower repayment discipline among private-sector creditors, especially if debt problems are amply widespread in the economy to render punishment threats non-credible (Arellano and Kocherlakota, 2014). All in all, funding to innovation drops, entrepreneurial activity declines, unemployment rises, and a recession sets in.

The effect of rising debt levels is further affected by the fixation of investing in real estate and for the purchase of already existing assets. In the UK, for example, approximately 15% of total financial flows actually went into projects for new investments in 2013. The rest was used for the purchase of existing corporate assets, real estate, or unsecured personal finance to “facilitate lifecycle consumption smoothing” (Tett, 2013). Debt can be beneficial when it is used for generating economic activity. But as the evidence documented in this section shows, debt today is not used for the production of new businesses, and the increasing amounts of debt are reaching beyond repayment capacities. As debts are also deposits in banks, non-repayment of private debt affects banking and thus creates systemic risks.

Furthermore, debt problems of one country are not just a sovereign matter. As financial institutions are wedded together via a complex system of payments, the vulnerability of one state’s debt levels can be contagious to other states. Large international banks and hedge funds typically borrow most of the money with which they purchase assets. If the prices of these assets were to fall due to pessimistic market conditions, the value of the firm’s liabilities (i.e., debt) could exceed the value of its assets. In this case the value of the firm’s equity drops as well. Hence, higher leverage levels create situations of insolvency. Ultimately, excessive debt resembles a Ponzi scheme (Das, 2016). Households, firms, and nations need to borrow increasing amounts of debt to repay existing loans and maintain economic growth. The fact that the credit system has been allowed to develop in this direction on an international scale with the aid of shadow banking is the final piece needed to understand this puzzle.

Shadow Banking and Systemic Risk

In 2005, Alan Greenspan gave a speech titled “Economic Flexibility ” at the Federal Reserve Board in which he stated, “These increasingly complex financial instruments have contributed to the development of a far more flexible, efficient, and hence resilient financial system than the one that existed just a quarter-century ago. After the bursting of the stock market bubble in 2000, unlike previous periods following large financial shocks, no major financial institution defaulted, and the economy held up far better than many had anticipated.” ¹⁷

The financial instruments that he was referring to were the entities and instruments created by commercial banks ,¹⁸ to form complex credit intermediation chains involving multiple layers of securitization ,¹⁹ multiple leveraged parties, and an opaque distribution of risk (Dobbs et al, 2015). Two years after he gave the speech, the true effects of the financial complexity were seen with the sub-prime crisis.

Understanding how this happened is a corollary to the growth of debt. As seen in Sidebar 1-1, following the Reagan-Thatcher era, the sector of finance and banking began to grow and progressed to become a bigger player in the economy. With growth in banking, asset management, insurance, venture capital, and private equity, innovation of financial products expanded and countries with financial hotspots like the UK, Switzerland, and the US gradually found the financial sector accounting for a greater share of employment (in the financial services industry) and GDP.

This growth of financial products was a by-product of the growing tendency to take on debt both by households and firms. As consumers demanded more debt, which was increasingly easily available, it gave the incentives to create these products and also led to the growth of the intra-financial system through which these products were traded. Increasingly, there was a strong accord that the activities which the intra-financial system were engaging in led to better price discovery, better allocation of capital, resources, and risk, and was making economies more stable and resilient to shocks. The statement made by Alan Greenspan was indicative of this consensus, although there is no evidence that economies have become more efficient since the increase in financial complexity since the 1970s (Turner, 2010). What had come out of this increased complexity was an addiction to debt-led growth and the development of the shadow banking system.

A 2012 paper by the Federal Reserve Bank of New York provides an understanding of shadow banking . It states, “Shadow banks are financial intermediaries that conduct maturity, credit, and liquidity transformation without explicit access to central bank liquidity or public sector credit guarantees. Examples of shadow banks include finance companies, asset-backed commercial paper (ABCP) conduits, structured investment vehicles (SIVs), credit hedge funds, money market mutual funds, securities lenders, limited-purpose finance companies (LPFCs), and the government-sponsored enterprises (GSEs)” (Pozsar et al., 2012). In essence, it is the practice of providing credit via non-bank channels.

Since 2008, as bank lending declined in most advanced economies, most of the credit for non-financial firms has come from non-bank channels in the form of corporate bonds, securitization, and lending from non-bank institutions. As these financial intermediaries offered credit intermediation outside the regular banking system, they lacked a formal safety net (IMF, 2014). In spite of being cognizant of this risk, prior to the crisis, financial institutions increased their financial engineering activities.

The reason banks participated in such high risk activities was the same reason they had issued credit easily prior to the crisis. It was profitable. As banks continued to grow, as they had for the previous forty years, they aimed to get bigger. The drive for growth and profitability thus encouraged them to take on more risk. This was first seen in the lowering of lending standards, which was the primary reason for the sub-prime crisis. As these mortgages got added to the assets section of the banks’ balance sheet, they were channelled into speculative activities under the guise of securitization, and used for trades such as arbitrage, market-making, and position -taking, that had nothing to do with client needs and which added little to economic activity. The porosity of the inter-financial system with other banks, hedge funds, and asset managers ultimately resulted in the balance sheets of banks being filled increasingly with these shadow banking assets. Although it is broadly defined as credit intermediation outside the conventional banking system, shadow banking constitutes about one-fourth of total financial intermediation worldwide (IMF, 2014). The shadow banking system also trades in the OTC derivatives market, which had grown rapidly in the decade up to the 2008 financial crisis (BIS, 2008). As of June 2015, after significant reductions and regulations, the OTC derivatives market was valued at $553 trillion (BIS, 2015). Global GDP amounted to $73.17 trillion²⁰ at the end of 2015.

As shadow banking grew so did its complexity. Intermediation was a long-standing practice in banking prior to the crisis. But as a result of the slicing and dicing of derivatives, simple forms of securitization became increasingly complex. In the case of debt-based derivatives, the maturity transformation risks of the underlying asset were further replicated in the securities, thus creating new forms of credit and multiplying counterparty risk. The opaqueness of information regarding these products were another factor that led to their spread. As there is a disproportionateness of information between the sellers, buyers, and regulators of these products, it is harder to regulate them. As a result, the financialization of securities weakens the market mechanisms in the long run, with contrived and volatile values (Das, 2016).

It would be tempting to say that the regulators were asleep at the wheel. But the reality of the situation is that regulators and macroeconomists had been following the rules to a large extent. Indeed, their models and policies were based on well-known economic theories, statistical analysis, and the understanding that increased complexity led to more efficient and just markets. So why did so many economists not see the crash coming?

The primary reason for the widespread belief that increased complexity of the financial market leads to better efficiency is because of the existing macroeconomic theories regarding the interconnection between financial markets and monetary policy . Over the past 30 to 40 years, the standard theories of economics have regarded and treated markets as a veil through which the monetary policy would permeate. The financial system was left to function as it was traditionally supposed to, holding deposits and issuing debt, and macroeconomists focused on controlling the economy via interest rates and inflation targets. This disconnection between macroeconomics and banking and financial markets have now gotten to the point that very little attention is actually paid to the way money and debt is created. This is representative even at the educational level, as most universities and business schools today do not focus a great deal of their curricula on banking and credit. Understanding the reason for this requires us to look at the way economics is looked at.

In spite of our technological evolution, macroeconomic theory is still firmly based on two well-known concepts: the efficient market hypothesis (EMH) and the rational expectations theory (RMT) . As per these concepts, expectations of players in a market are formed on the basis of past experiences, typically as some kind of weighted average of past observations and the availability of new data. The players then make optimal use of this information in identifying opportunities and thus their expectations will be correct, considering any unavoidable errors. This is the crux of the rational expectations theory. As a result of these expectations, based on experience and new data, if there is a change in the way an event was supposed to occur (say a change in tax rates), then the players will immediately change their expectations regarding future values of this event even before seeing any actual changes. As all players have access to the same information, albeit at different levels of granularity, bad decisions made by one player are offset by good decisions made by another. This makes beating the market impossible as the stock price of a share intrinsically incorporates all the relevant information. This is efficient markets hypothesis.

Although the EMH and RET might be a reasonable starting point for understanding economics and stock markets, it is not the whole story and is questionable in the present-day context. In today’s complex economic climate, which is peppered with shadow banking, changing regulations, and cyber-attacks, real-world investors do not have access to “all relevant” available information. The theories have an explanation for this and state that expectations can fail to be rational in the strong-form sense²¹ if investors fail to use all available relevant information, or if investors fail to make optimal use of all available relevant information. However, it fails to consider that even if investors have the same information, differences in psychological make-up can lead to systematic differences in expectations. It also assumes that stock prices are determined by “intrinsic value” and is thus static, as it ignores positive feedback loops.

Yet the models used by most central banks to gauge how economies function, called dynamic stochastic general equilibrium models ,²² are based on these theories. Even more surprising is that in these models the operations of banks are not taken into consideration, although they do look at microeconomic data pertaining to large companies and households in aggregate.

This approach to macroeconomic theory is a relatively recent phenomenon and coincidentally began being applied in the late 1970s. Prior to this period, work done by prominent economists such as John Maynard Keynes, Irving Fisher, and Henry Calvert Simons, focused profoundly on the way money was made. While the reasons for this divergence in academic disciplines is the subject for a book in economic history, this approach of using the EMH and the RET while subtracting the role of banking was the primary reason why a number of economists did not see the crisis coming. Although debt is so tied up with the monetary system, these theories and the economists who created models based on them, believed that increased complexity led to better price discovery, and thus considered debt to be vital to economic growth. Is it thus a surprise that we have not been paying attention to the creation of money?

Rethinking Debt-based Capitalism

One hopes that the arguments and facts provided in the previous parts of this chapter help clarify the reason we need to look at debt with a greater amount of introspection. Debt by itself is important and useful, but excessively high debt levels slow economic growth, push down wages, lower living standards and make it harder to borrow when hit by a crisis or an emergency. This is true for households as it is for nation states, and the net sum effect of bulging debt levels are periodic cycles of booms and crashes followed by recessions. Our tendency to invest in real estate, global imbalances, and the increasing inequality within societies are the fundamental reasons for a credit intensive cycle that has lasted for the past few decades.

Following the crisis of 2008, recent changes made by regulators are now turning back the wheel of time. During the Reagan-Thatcher era, financial markets were liberated from a large number of restrictions. This action was repeated in the nineties under the Clinton-Blair era. While the Blair government handed over the responsibility of setting interest rates from the Chancellor of the Exchequer to the independent Bank of England in 1997, the repeal of the Glass-Steagall act in 1999 effectively matched the same gesture in the US. The enactment of the Volker rule, which restricts US banks from making certain kinds of speculative investments that do not benefit their customers, is a return to the older form of banking regulations when deposits were not used to trade on the bank’s own accounts.

While the net effect of these rulings, along with stricter regulations following the LIBOR²³ scandal, do apply new restrictions on the ability of commercial banks to participate in speculative activities, they have been coupled with extraordinary measures such as quantitative easing (QE) and quantitative and qualitative easing²⁴ (QQE). This is not to say that the regulators and central bankers were wrong in doing what they did. Following the events of the crisis of 2008, pumping money into the economy at ultra-low rates was better than not taking any action. But it replays the dance with debt all over again, as thanks to the current modus operandi, governments have to borrow and pay interest to central banks for the newly minted money they push into the economy. As a result, the payoff from conducting QE ends up as an income for the central bank and can be accounted as a profit.

The supply of cheap money has also exacerbated the inequality within societies as the public money that was used for bank bailout and stimulating the economy has fuelled a boom for those with financial assets. As QE stimulates the market by increasing money supply, and hence asset prices, it is those with the greatest amount of asserts that stand to gain. Apart from perpetuating the cycle of debt-based money, the benefits are skewed towards the rich due to the unequal ownership of assets. The increase in the prices of assets also means that those households willing to take loans to purchase them, now need to take on a higher level of debt than prior to QE. Public debt reductions are thus offset by private debt increases.

What is needed to break this cycle is a rethinking of capitalism from a fundamental level. Not only do we need to think of a less credit-based growth model, but we also need to relook at the theories and models that we use today, for they are blatantly out of date with respect to the complexity and diversity of today’s financial markets. Furthermore, measures need to be taken to address both the underlying causes and disproportionate debt issuance and the ensuing instability fuelled by fractional banking and shadow banking. While a number of measures have been taken to address some of these issues, these measures have been reactive rather than proactive. In light of increasing levels of automation and threats of robotization of jobs, this approach is akin to trying to stop a bleeding artery with a Band-Aid instead of a tourniquet.

In the meanwhile, the growing diaspora of FinTech and Blockchain-based solutions offers us a spectrum of possible solutions both at a technical as well as a managerial level. But the solutions provided by decentralized applications and tokenized pseudonymous identities also requires rethinking the regulations rule book. The following parts of this book illustrate how and why rethinking the rule book will be fruitful to society, and how these technologies could be employed to better measure and manage our financial systems and our economies, while offering solutions to the problems of the future.