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Teetering on the financial brink



An often overlooked fact about the financial system is that it entirely depends on trust. When trust starts to evaporate, especially between the big players such as banks and insurance companies, the whole artifice is put into peril. Trust in the system is now at an extreme low and that points to extreme danger.

 Main image: Australian banknotes (Melissa Walker Horn/Unsplash)

Consider some recent examples of what happens when trust fails. In the lead up to the global financial crisis of 2007-8 the players in the repo (repurchase) market, a place where banks raise short term cash, stopped trusting each other. It led to a panic that eventually spilt over into distrust in the interbank lending market, which keeps money moving around the globe. Interbank lending froze, effectively cutting off the blood supply of the whole system and almost destroying money itself. 

The problems exposed in 2008 were never solved and in September 2019 there was another crisis in the repo market. This time, though, the markets were engulfed by an even bigger problem: the COVID-19 crisis. Western central banks frantically printed money, either by issuing government debt or simply plucking it out of thin air by using a process called quantitative easing, which involves buying back government or corporate debt. That flooded the market with liquidity and covered up what was looming as a repeat of 2008.

It brought a temporary reprieve but the system continues to worsen. It is a point repeatedly made by analysts who criticise fiat money, which is backed by government regulation rather than a physical substance like gold.

At one level, these criticisms are reasonable. Governments cannot print money indefinitely without eventually causing a collapse. But it can be argued that the real issue is not too much control from governments, but a lack of it. After financial deregulation in the 1980s, central banks lost oversight over the quantity of money (in Australia, the government could once instigate a credit squeeze to restrict the amount of money but that mechanism is no longer available). Now they only have one tool left: the cost of money, or interest rates. With rates near zero in most developed economies, that tool has largely gone, too. There is no ammunition left.

The system is teetering. Most Western economies, including Australia, are mired in unsustainable debt that is only kept from collapse by interest rates close to zero (in Australia it is household debt that is most perilous). If inflation starts to rise, and central banks raise interest rates in response, a collapse seems unavoidable.


'Far from eliminating the human element, Bitcoin has been subject to human emotion to an extreme degree, matching previous financial crazes.'


Yet if ‘fiat’ money is in trouble, what exactly is the alternative? For one thing, it is not true that the system is entirely controlled by government fiat. The base rules are set by government regulation, but banks actually create most of the money and it is their reckless lending that is behind the explosion of debt. And then there is the derivatives market, which is ‘valued’ at US$600-1000 trillion and generates $US6 trillion in cross border transactions a day. That is completely independent of government fiat, if it is to be called ‘money’ (the participants resolve disputes with an informal panel of lawyers).

Then there is bitcoin, whose popularity is a symptom of the declining trust. It is called a ‘trustless’ system because there is no need to believe in any human, it is all based on an algorithm derived from game theory. Bitcoin has one obvious advantage (as does gold). Unlike fiat money or derivatives transactions there is only a finite amount available; the quantity is controlled. It also seems to match what the libertarian Austrian economist Frederich Hayek hoped would emerge: a type of money that in a ‘sly roundabout way’ would be something government could not stop. 

But the idea that it represents a libertarian victory is almost certainly an illusion. Bitcoin has been co-opted by big financial players and turned into a financial asset for diversifying investment. Neither is it particularly viable as a means of exchange, although some weaker countries are considering making it legal tender.

Far from eliminating the human element, bitcoin has been subject to human emotion to an extreme degree, matching previous financial crazes. Its value has been gyrating wildly because of (very human) market sentiment, especially the shifting opinions of Elon Musk. Bitcoin is also usually valued in US dollars, which is a fiat currency. It may appear to be an escape from untrustworthy authorities, but is it?

The base problem remains how to foster trust in capital itself. Unfortunately, technocrats are poorly placed to solve that because they are trained in how to make moves within the system when what is needed is an understanding of how to make changes from outside the system. 

Finding ways to restore some control over the quantity of money by reversing some aspects of financial deregulation might be one place to start. Working out how to forgive debt, have a jubilee, without imperilling the private banks is another idea worth examining. Trouble is, the authorities are too busy putting out fires to work out how to stop them happening in the first place.



David JamesDavid James is the managing editor of businessadvantagepng.com. He has a PhD in English literature and is author of the musical comedy The Bard Bites Back, which is about Shakespeare's ghost.

Main image: Australian banknotes (Melissa Walker Horn/Unsplash)


Topic tags: David James, fiat money, debt, Bitcoin



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Existing comments

Brian Livingston “Public Defender” in the “Ask Woody” newsletter details how Bitcoin is highly vulnerable to scams, so not something trustworthy at all. https://www.askwoody.com

Frank S | 08 June 2021  

Governments should put money in to the economy when there are unused resources like labour, in the health system, aged care, research, development. They should invest in infrastructure such as roads, rail, including high speed rail, etc. They should support investment by Australian companies in Australia. They should take money out of the system by taxation, especially by means of a progressive consumption tax based on income less savings above a tax free threshold. Purchase of foreign currency should should be seen as consumption not saving. Money should be seen as the blood which flows through the economy, enabling the economic life that Australia deserves.

Peter Horan | 08 June 2021  

“If inflation starts to rise, and central banks raise interest rates in response, a collapse seems unavoidable.” Although NAB economist Alan Oster says borrowers need not expect steep rises until 2025, rates have begun rising. In the US, more businesses report higher prices and slower supply deliveries than at any time since 1979, just before a bitter three-year recession. The big difference is that in 1979 the US budget deficit was just 1% of GDP. Today is between 15% to 20% of GDP. An Asia Times writer notes that the US Federal Reserve in in denial about inflation, and “The Fed, in short, is up the creek without a paddle.” In addition, because of the “spendthrift lunacy” of Washington, global inflation is seeping into China, meaning their prices will rise. And while “trust in the financial system is now at an extreme low”, so too is trust in government, bureaucracy and Big Tech. Covid-19 has killed nearly 4 million people world-wide. Yet until last week, the Ministry of Truth’s Commissar Zuckerberg forbade anyone raising the possibility the virus “escaped” from a lab under penalty of getting one’s account vaporized. We are living in an Orwellian world.

Ross Howard | 09 June 2021  

Do we need foreign trade? If you’re a working economist, you’d have to say yes because to say no is to invite career marginalisation. Perhaps there are retired treasury boffins out there with some non-conventional but empirically measured views of the matter. The foreign trade to GDP ratio of the US from 1970 to 2021 increased from 10% to 26%. For most of its modern history, the US hasn’t needed the rest of the world which is actually a good place in which to be since the rest of the world seems to be a source of mosquito bites, with the mosquitoes getting bigger. And, at 26%, it probably still doesn’t. Australia’s ratio is about 45% which makes us rather reliant on mosquitoes. Singapore’s ratio is about 320% which makes that nation’s ability to say anything high and mighty about international morality about zero, unless it can use some group of nations to protect its platitudinous flank. China, of course, isn’t much given to being lectured about anything, platitudinous or not. And here we are in the Great Eden of the Holy Spirit, or Southland, or whatever, food, minerals, intellectual capital, lots of land….

roy chen yee | 10 June 2021  

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