Sunday, August 10, 2008

Crunched credit

From the Socialism Or Your Money Back blog

One victim of the credit crunch is the theory that banks can create new purchasing power which didn’t exist before, i.e., can “create” credit. While the writers of economics textbooks show mathematically how in theory the banking system as a whole could on certain unrealistic assumptions turn an initial deposit of £1 into £9 or even £99 (and while currency cranks get hold of the wrong end of the stick and that an individual bank can do this), practioners and journalists who observe them know this not to be the case. They know that banks can only lend out money that has been deposited with them or which they themselves have borrowed or their own capital.

First, a practioner, Bill Browder, chief executive of Hermitage Capital Management, a hedge fund (and, incidentally, grandson of Earl Browder, one-time General Secretary of the American Communist Party who lost his job in 1946 when Moscow zagged and he went on zigging):

“The banking system is the financial circulating circulation system. If the circulating system doesn’t work, the patient dies” (interview with the (London) Times 4 August).

Precisely. Banks and other financial institutions involved in lending are in the business of circulating, not creating, money and capital. Ideally from a capitalist point of view, they circulate money from where it is not being used to where it can be applied the most profitably. As Browder points out, the credit crunch represents a clogging up of this circulation of money and capital which, if it continues, could have widespread repercussions on the real world of production.

Now, the financial journalist, Anatole Kaletsky of the (London) Times:

“. . . the whole point of a bank is to exchange short-term, liquid, fixed-value liabilities for long-term, illiquid assets whose value is hard to guage - this liquidity and maturity transformation is, in fact, the main social function that a banking system provides” (14 July).

In other words, banks borrow short to lend long. Borrow ready cash (either from depositors or, these days, from short-term money markets) at one rate of interest to lend to capitalist firms in the hope of earning a higher rate of interest (it has to be added that, these days, banks also engage in speculation on currency and other markets in the hope of making a capital gain bigger than what they have to pay to their depositors and creditors).

What has happened is that their speculation with a view to a capital gain has gone horribly wrong as they put money into bonds which they themselves describe as “toxic” because not all that credit-worthy. Which now nobody wants to hold, so their price has fallen. This means that, instead of making a capital gain they have suffered capital losses, but they still have obligations to their depositors and still have to pay interest on their short-term borrowings on the money market. But because inter-banking trading has slowed down – nobody wants to be left holding a parcel of toxic bonds – the interest rate on these borrowings have gone up.

The banks are reluctant to borrow as much as before from this source. Which means they have less to lend out. Hence the credit crunch. Of course if they really could conjure up money out of nothing then could never be a credit crunch.

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