Who’s Bailing Whom? Challenging the Private Credit System

The time since 2008 has been a crucial historical moment for progressive economists to pull back the green curtain that surrounds the operation of the for-profit banking system, and expose that system for what it is: a government-protected, government-subsidized license to print money.

The problem is, as soon as you start saying things like that, people conclude you are some kind of wacked-out conpiracy theorist nut-bar.  It sounds insane to claim that private banks have a license to create money out of thin air.  As John Kenneth Galbraith put it, “The process by which banks create money is so simple that the mind is repelled.”

[Of course, it doesn’t help that there really ARE a lot of wacked-out conspiracy theorist nutbars out there, talking nonsense about the illegality of the Federal Reserve system and other drivel.  Job one is dissociating our more reasoned and fact-based critiques from all that.]

The simple truth is this: private banks have the power to create new money when they issue leveraged credit.  They have used that power poorly: facilitating asset bubbles rather than real capital accumulation, and jolting the economy with on-again-off-again surges of credit rather than the steady supply we need.  Every bank that does this is inherently vulnerable (even Canadian banks), since no bank has money in the vault to pay its depositers if they all show up demanding cash.  (More precisely, in modern terminology, every bank depends on the overnight liquidity cooperation which, when it isn’t there, causes banks to fall overnight … a la Lehman Brothers.)

The reason that weaker banks get targeted by speculators first is not because they are the only ones at risk of failure.  It’s because they’re the obvious ones to go after first — and the most vulnerable to short-selling, rumours, and everything else that makes the current system so fantastically and unproductively fragile.  If the speculators turned on any other leveraged bank (including Canada’s), they could fail, too.  It’s just that by staying out of the spotlight, and looking relatively strong (though still fragile in the absolute sense), that other banks hope to survive. 

That’s like the old adage I learned while in Alaska this summer.  To survive a bear attack, you don’t have to run faster than the bear.  You just have to run faster than the other person you’re hiking with!  Exactly the same logic explains how limited is our own banks’ claim to stability.  Canadian banks couldn’t survive a run any more than Greek banks.  It’s just that the Greek banks will be caught by the bear before ours.

Exposing what exactly banks do, how unique (and lucrative) is their power, how inherenetly fragile the whole system is, and how unproductively its power has been wielded, lays the groundwork to demand a whole new approach to managing the credit system.  Instead of thinking of credit as a profit-centre in its own right (especially since there is no real social value created in the financial sector anyway), we should think of it as a utility: something the economy needs, delivered in a stable and rational manner, in order for anything else to work productively.  Kind of like “turning on the lights” for the whole economy.

I don’t think left economics has risen to the task demanded of us at this moment.  Empty jargon about “reassuring the markets” still dominates discourse over what happened in America, what is happening in Europe, and what will happen elsewhere.  There’s almost no comprehension about how banks work, and how and for whom they operate, just a widespread (and justified) fear of what will hapen if they collapse.  We need to be more forthright and blunt about exposing private finance for what it is, and demanding changes (phrased in concrete not utopian ways) to use the power of credit (that is, the power to create money out of thin air) for good, instead of evil.

To that end, here is a slightly longer version of my column in today’s Globe and Mail on the ongoing European crisis, and why it’s completely wrong for German taxpayers to complain about bailing out free-spending Greeks.  I’m sure I will be roundly denounced as trying to resurrect “social credit” or some such claim.  It’s a tough job, but someone’s got to do it.


The 17 member governments in the Euro zone are currently voting on a larger, more powerful bailout fund, the European Financial Stability Fund (EFSF).  Officials want 440 billion euros for the kitty, with new powers to buy European government bonds and invest directly in banks.  The goal is to enhance the confidence of financiers in Euro-zone bonds and banks – countering speculative attacks that have pushed up interest rates and shaken confidence.  All members must approve the expansion, which unless any of them have an economic death wish will occur by mid-October.

However, the expansion has sparked lots of public grumbling.  “Why should taxpayers in countries that followed the rules bail out countries that didn’t?”, the complaint goes.  This sentiment won’t stop any country from approving the expansion (Germany, the lynchpin, endorsed it last week).  But it will constrain politicians’ subsequent efforts to reign in the crisis.

The public’s ire, while understandable, is misdirected.  It isn’t Greece and other weak states that are being bailed out.  It is the banks that lent money to those countries.  If it was only about letting Greece default, that would have happened two years ago.  It’s the feared collapse of banks in France, Germany, and elsewhere – causing a credit freeze and continental depression – that officials are racing to prevent.

So German taxpayers aren’t bailing out big-spending Greeks.  They are bailing out German banks (and, more precisely, the financial investors who own those banks).  Those banks created leveraged credit out of thin air, worth many times their actual capital, and lent it to Greece.  They will now fail when Greece (and others) fails to pay it back.

So far the Euro rescue has focused on bending over backwards to try to assuage the fears, and the demands, of the owners of financial wealth.  They are euphemistically referred to as “the markets.”  But in fact, they are sentient human beings – human beings who own money. 

These human beings are unilaterally demanding very high interest rates for loans to indebted states.  But those escalating interest costs, together with the fiscal side-effects of continuing recession, are making the crisis worse.  Perversely, the tougher the cutbacks get (and the cuts in Greece, Ireland, and elsewhere have been historically unprecedented), the worse the crisis gets.  And even the expanded bailout fund won’t be enough to hold back the speculative tides when the “markets” turn against the next fiscal weakling.

European officials must also reassure financiers about the credit-worthiness of the banks themselves – trying to nip in the bud speculative attacks which could quickly become a full-fledged run on the banks (à la Lehman Brothers).  Since private banks have the legal power to multiply their capital many times over into new loans, any bank, so leveraged, is vulnerable to such a “run.”  Euro officials want the governments to pay to shore up the private banks.

But it’s not necessary that grumpy taxpayers foot this bill.  The risk is that huge amounts of privately-created credit might suddenly disappear – first through sovereign default and then, far more dangerously, through bank collapse.  So why not just replace that disappearing private credit, with new credit?  That doesn’t require taxpayers to fork over anything.  It simply requires policy-makers to take over management of the credit system itself.

In other words, instead of doing everything to keep private financiers happy, European officials need to replace the private debt-credit relationship with a publicly managed one.  The private credit system which created all that money, and lent lots of it to Greece, will eventually be socialized, in two distinct ways.

First, the debt itself will be socialized (as the Europeans take continental responsibility for the bonds of hard-pressed member states).  But more importantly, the leveraged money-machine that created the credit and lent it with wild abandon in the first place, will also be socialized.  Banks will be “recapitalized,” a euphemism for injecting hundreds of billions of euros of public capital into the banking system to offset the capital that will disappear with the coming defaults.  Those new funds can and should be created by (public) banking, through the European Central Bank; taxpayers needn’t pay a cent.  So far Europe’s ultra-conservative finance officials reject this idea, opting instead for government-funded partial bailouts; they thus block the full socialization of debts that could truly solve the crisis.

Ironically, debt socialization is exactly what occurred in the U.S., albeit in a very lopsided way.  Government took responsibility for massive private debts, and bailed out the private banks that created it.  Some of the cost was borne (unnecessarily) by government itself.  But much was financed by the Federal Reserve, which in essence created new money (just like private banks do every day of the week) to keep the system afloat, through “quantitative easing.”

The basic property relations that underpin the whole system, however, were not reformed in the U.S., despite the state’s essential role in saving it from itself: the system is still steered by (subsidized) private financiers, now reaping fortunes again from their business of creating money out of thin air and applying it to most profitable uses (usually involving placing bets in the global casino known as “derivatives” trading).  Perhaps the Europeans will do better than the Americans at demanding some kind of quid pro quo for the public interest, out of this enormous rescue.

Inevitably, however, the system will be socialized, because the private credit system is now untenable.  The only question is, in whose interests that socialization will occur.

We don’t need to ask taxpayers to cough up a cent of real money for either type of bailout – whether of heavily indebted countries or over-leveraged banks.  We need to find an alternative way, through public banking, to create new credit to replace the private credit now teetering on the edge of destruction.  That’s a proposition that Germans and Greeks alike should celebrate.


  • Letters to The Editor Globe and Mail Toronto October 4th.

    Investor Bailouts

    Is Jim Stanford the only economist who gets it? (Bailouts; Give European Taxpayers a Break, October 4th 2011) Investors & banks chose to buy Greek Bonds when their interest rates were high. The interest rates were high because the risk incurred was higher than other countries bonds because, as the investors knew, the Greek economy is less efficient than say Germany or the U.S.

    Now that the risk has actually materialised the banks and investors now want the taxpayers in Greece, Germany and the rest of Europe to pay for their losses (bail them out). Strange that when capitalism works; the investors, banks and corporations get to keep the profits yet when it fails; the taxpayers are forced to cover the losses.

    Talk of socializing banks, in the Globe and Mail, may sound like denigrating motherhood or spitting on the flag but it’s high time we realized that the unregulated, Friedmanist approach to the global economy is not working, is damaging everybody and we need to look for a deeper , more rational, analytical explanation of how the so called “Free Markets” work and why sometimes they don’t.

    Other than Mr. Stanford, I don’t hear that dialogue.

    Jim Young

    Burlington, Ontario

  • Excellent perspective. My initial observation is that the excessive debt has arisen because we are collectively Wimpy (I’ll gladly pay you Tuesday for a hamburger today). My follow up observation is that I subscribe to Minsky’s prediction that a Tuesday when the game ends will eventually arrive. Is the implication of your recommendation to socialize the banks that this socialization would be a prelude to an orderly debt forgiveness process?

  • Jim Stanford is quite right in stating that (commercial) banking is really a public utility and not some private activity devoid of externalities. Our whole payment system relies on a reliable and solid banking system. So there is certainly an argument in favour of public-owned banks, so that the government keeps a close eye on what is going on in this industry, beyond regulatory institutions.

    It is also true that banks create credit out of thin air, as long as other banks have faith and confidence, but there is nothing wrong about this as long as the main focus is real activity rather than financial speculation.

    There is also nothing wrong in eurozone banks lending to the Greek government or any other eurozone government. After all, all these governments and banks use the same currency, so there was no exchange risk. Canadian banks lend huge amounts to Canadian federal and provincial governments.

    Jim wonders whether governments or the European central bank should bail out the banks that suffer capital losses when Greece defaults (say at 50%). First, it should be pointed out that the losses, while large, will not be humongous. What is really worrying is whether this will be followed by other European countries defaulting, in particular countries such as Spain and Italy which are now under attack from speculators and other purchasers of naked credit default swaps (who expect Portugal and Ireland to be among those countries forced to finance the stability fund to save Greece, but then Italy and Spain will have to finance the fund to save Portugal and Ireland, then France and Germany will finance the fund to save Italy and Spain, and so on, until finally only Slovakia and Luxembourg will be left to save Germany!)

    Jim wonders whether the ECB or the governments should bail-out failing banks, purchasing newly-issued shares of the banks. First, it should be pointed out that European national central banks are already lending huge amounts to banks from the countries under attack (and even others). What happens right now is that banks that accumulate surpluses in the clearing and settlement system prefer not to lend them to “dubious” banks, so that these banks (from the PIIGS notably) are forced to borrow funds from central banks (this is what Jim calls the modern kind of bank run). We have a curious situation where banks can borrow funds from the ECB at 1.5% while they can lend funds to PIIGS governments at a much higher rate.

    Thus, to some extent, the ECB is already exposed to bank defaults, even if the ECB holds collateral (sovereign debt that might default). Thus it makes some sense for governments to issue securities and to purchase bank shares with them (taking over or socializing the banks). The problem is that while net debt will not necessarily increase, gross debt will, thus creating a vicious circle.

    But Japan has a 200% gross debt to GDP ratio and nobody seems to care. Thus there must be something wrong with the structure of the eurozone.

    Clearly, if the ECB had not been set up under the pretense that lending to banks is good while lending to government is bad, the whole crisis could have been avoided in 2009, with the ECB purchasing government securities on secondary markets as soon as interest rates on sovereign debt started to move up. But when it gave up its self-inflicted norms, in May 2010, it was already too late, as the attention of markets had turned on the eurozone and its structural defects.

  • Yes and Might I add Marc that is it not just way too conveniant that the imposition of such anti Government lending discourse and the focal point being Greece falls right into the – keep the cross hairs off us- private banking system. In fact, as Kim points outm that to me is the most salient point in his piece, we have all been hood winked and by our own lack of ability to analyze the situation. (potentially because a lot of what transpired has been hidden and is still hiding in the vaults of Goldman Sachs and JP Morgan and such.

    Even right now, this very second with thousands protesting on Wall Street, we have no clear data on who bought what, how much outstanding debt is still out there, how much is toxic because of mark to market and and whole plethora of legal advisors, accountants, and corporate interests.

    Pile on Greece is the mantra and the herd sure seems to be quite thristy for that small watering hole called Greece.

    To get to resolutionw e need to have a proper investigation into the privatization of banking and credit creation and activities upon which these magical surpluses are being used by the financial elite to go double down on with the future of the human race. Truly that is what is going on here- more of what brought the original house down in 08 is all haphazardly in play again, and this time the house is broke and the bankers have all the cash.

    I still say we go back to somekind of well planned globalized green Keynsiansim, which pretty much mirrors, Marc’s last point.

    Good post Jimbo! You go girl.

  • A few additional comments on banks:

    I agree that banking should be a utility and that many financial derivatives should be regulated out of existence. Nonetheless the banking system plays a critical role in a monetary economy, mainly by creating the loans and corresponding deposits out of nothing that allow for economic growth. It also takes and manages deposits and withdrawals and as such is part of the settlement and clearing system for payments between households, businesses and governments. Every bank liability is offset by an asset and regulation requires maturities line up so the banks don’t suddenly wind up unable to meet the demand for withdrawals. Of course if they become too optimistic about the credit worthiness of those they lend to, à la Minsky, some of their assets will turn out to be worth less than they originally expected. If their loan loss provisions and capital are insufficient to cover this the bank is insolvent. If other banks suspect this is case they may refuse to lend to them on the overnight market or there could be withdrawals they cannot meet. Then the banking system freezes up. This happened during the financial crisis in the US, the UK, and Europe, after Lehman went under.

    The role of the central bank and associated entities is then to be lender of last resort and make good on the bad bank’s liabilities and wind it up if necessary. If the entire system is at risk then the central bank must support the whole system.

    In the US, faced with a financial and economic crisis, the central government, supported by its central bank, was able to simply create trillions of dollars out of nothing and shore up the private sector and the central government. There has been no banking crisis in the US since the intervention of the federal government and its central bank. The situation is similar in the UK.

    The cause of the US banking system near-collapse was the fraud it engaged in at a stupendous level – knowingly lending vast sums to people who could not possibly make the payments on their loans and issuing trillions of dollars of worthless financial derivatives and selling them around the world.This was allowed because the banks were deregulated. Neoliberal economists provided the cover story for deregulation with their free market mantras. It took 15 years or so for deregulation to fully occur and over the course of that time the banks captured the regulators, so much lighter regulation became almost no regulation at all. Interestingly, the FBI warned of the fraud but was called off. Elliott Spitzer, governor of New York, the centre of US banking, was going after the banks but was forced out of office due to a convenient (not for him) sex scandal.

    In Europe, the European Central Bank (ECB) was initially prohibited from buying government debt, so bail-outs by other governments of heavily indebted countries were necessary. The inability of the ECB to buy government bonds was one of the fatal flaws of the euro from the beginning. The unstated assumption was there would never be a serious economic downturn or financial crisis. This was pointed out by many economists before the euro was set up but they were ignored. The Euro only lasted 10 years before the predicted flaws exploded, threatening its existence.

    The ECB is buying bonds now but with great parsimony as it insists on severe austerity by the beneficiaries. The European crisis is entirely of its own making and due to the obvious flaws inherent in eurozone institutional arrangments. As an aside, Michael Hudson has an interesting theory that European bankers don’t actually want a quick resolution to the sovereign debt problem because they hope to get their hands on hard assets of the bankrupt countries at fire-sale prices as repayment of their loans: government real estate (Greek islands?), utility companies, other service providers, etc.

    With respect to the Canadian banks, they did not capture the regulators and did not engage in fraud, at least not in Canada. The CIBC did engage in dubious practices in the US with Enron. Our banks sailed through the financial crisis quite easily, and while some some government support was provided, no capital injections were required.

    That said, there is no doubt Canadian banks have a remarkably sweet deal. They have an oligopoly, only 5 major banks, in one of the wealthiest countries in the world. They are guaranteed by the government of Canada and are in fact a remarkably profitable public-private-partnership.

    Of course an argument can be made to nationalize them. The Canadian government is the monopoly issuer of Canadian dollars. Why should it allow private interests to run the banking system and reap vast profits? The same reasoning applies to our natural resources. Why do we allow so much of our natural wealth, especially energy, to be extracted by private, often foreign-owned interests? At least our banks are domestically owned.

  • Mario Seccareccia

    Jim, I’m really happy to see that you are posing some really deep question about the nature of our monetary and financial system, and I very much appreciate the points that you raise.
    Money and, indeed, the whole monetary system, is in the nature of a public good. Unlike the farmer, say, producing grain in Saskatchewan, it’s the state that sanctions the very existence of money. Since it permeates all activities, there are tremendous externalities. Moreover, the whole system rests on trust, which could lead to its implosion if the counterparties lose confidence in each other, as it happened in 2008, and required the state to step in to provide liquidity. Because of these externalities, perhaps even on purely neoclassical grounds one can make the case for banks being public utilities.
    In fact, historically there is a rich tradition of public banking, especially in Europe. However, it doesn’t necessarily mean that nationalizing private financial institutions would in itself solve the problem, since, if the culture of banking and finance changes (as it has as a result of looser regulation, etc.), it could spread the instabilities regardless of whether the financial entity is private or public. We saw the problem even here in Canada with some of our major public institutions, such as the Caisse des dépôts et placement du Québec, which engaged in some really reckless behaviour because everyone else was doing it! For this reason, as much as I am all for the need to socialize the financial system, unless we delineate more clearly what these institutions can and cannot do, the mere process of changing ownership would not guarantee the elimination of the problems that we have faced over the last while.
    This problem becomes even more obvious when one looks at the current situation in Europe. It would not be at all clear to me that merely having public banks would have changed much of the actual dynamics of what is going on there. The problem with Europe is one of an institutional structure that was set up, as I have argued elsewhere, on the basis of a Mengerian conception of money that sought to separate money from the state in the process of unification of all these disparate countries of Europe. It is this institutional separation that denied the need for a central fiscal authority having access to the ECB that is causing all the problems. Indeed, if the Greeks had never joined the euro and had retained the drachma since 2002, Greece would not now be on the verge of financial collapse.
    Hence, as much as I may be all for the socializing of the banking and financial system for both personal ideological reasons and for exactly the reasons previously mentioned about its public good nature, the problems that we faced in 2008 with securitization à outrance and the problem that our confrères in Greece and of southern Europe, including Ireland, are nown facing, would not be solved by the mere change in ownership. It’s a primarily a problem of delineating more clearly the institutional boundaries of what they can and cannot do and/or the institutional problem of setting up a monetary system (in Europe) on neoclassical precepts that defies the laws and, indeed, the existence condition, for a viable monetary system there.

  • Low and medium income taxpayers are already having difficulty filling the trough for private banks and other Systematically Destructive Institutions. SDIs continue to take advantage of their private money creation powers, they continue to irresponsibly loan, borrow and bet, they continue to resist proper regulation (including separation of banking, insurance, and real estate, and financial transactions taxes), and they continue to resist fair corporate taxation and their responsibilities in job creation, while manipulating prices and destroying nations, peoples, and environments. It makes sense to allow central banks to become the sole creators of credit, if central banks are fully public, transparent, and subject to participatory democratic governance.

    Private financiers enjoy impunity, more rights, more profits, and privacy protection, in current ‘free’ trade deals. This must change. Fully public institutions have more accountability. Governments also need to create policy to provide for full public pensions, education, healthcare, insurance, and other services, as well as jobs. People currently rely on unreliable RRSPs, RESPs, and other unstable investments. The government has to provide for human rights according to its own, international, and moral codes. RRSPs, RESPs and other private investments haven’t provided for human rights, lost half their value in the last crash, and are at risk again.

    The situation is unacceptable. Governments need to do their jobs. Private financiers have failed too many times. We made the mistake, after nationalizing the Bank of Canada in 1938, of allowing private banks to also create money. Look what they’ve done with those powers. Economies and ecosystems are in ruins. In Canada and around the world, truly socialized credit creation needs to be given a chance, for the first time in history.

  • Do an article talking about the dailybail.com

    Lots of great stuff there.

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