AN UPDATED AND MORE DETAILED EXPLANATION WITH EVIDENCE OF WHAT HAPPENED IS NOW AVAILABLE HERE

To understand the 2008/09 credit crisis, we need to look back at another US financial crisis in the early 1970s.

At that time, the US government was financing the Vietnam War, not by raising taxes, but by borrowing from the Federal Reserve: in effect, by printing money.  Raising taxes would have reduced the voters' share of what the US produced to allow the government to have a larger share.  But it would have been political suicide to raise taxes to pay for a war that did not have popular support.  Printing money enabled the people to keep spending their money and allowed the government to continue to finance the war.  As the country bought more than it produced, it had to import more than it exported.

At that time the US dollar was convertible into gold, so some countries supplying the US the additional imports converted the US dollars they earned into gold.  Consequently, US gold reserves fell.  By 1971, they had fallen to about half the level they had been at the end of the Second World War.

Rather than fixing the problem by raising taxes to pay for the war, President Nixon continued to print money but declared that the US dollar was no longer convertible into gold. He treated the symptom, not the problem.  

Yet countries supplying the excess imports needed to be paid.  While US gold reserves were now protected, US foreign reserves were not.  So US foreign reserves continued to decline.

In 1973, to address this problem, the US government declared that it would no longer convert US dollars into foreign currency.  This gave the government the right to effectively print as much money as it liked without being responsible for the outcome. 

To justify this stand, the government declared that it was adopting Milton Friedman’s proposed floating exchange rate system.  Milton Friedman believed that if a country’s money supply could grow at a steady rate, the economy would grow at a steady rate and  it would not have business cycles.  It was not possible to control the money supply under a fixed exchange rate because foreign exchange transactions affected foreign reserves and the money supply.  He proposed a system where foreign exchange transactions did not affect foreign reserves and the money supply.  Instead, the exchange rate would float to balance the foreign receipts and foreign payments.

It has been found that Milton Friedman’s theory of targeting the growth of the money supply has not provided economic stability and the policy has been abandoned.  However, his floating exchange rate system has continued.       

Also, it was found that floating the dollar did not solve the problem of excess spending.  The US continued to buy more than it produced.  Instead of affecting government debt, the private sector had to borrow foreign currency or sell their shares and other securities to pay for the imports. 

Therefore, US foreign debt increased and foreign ownership in the US increased.  The US government convinced itself that the rising foreign debt and selling US securities and businesses offshore was not their problem.  Furthermore, economists blamed the current account deficit on the foreign capital entering the US economy.    

As the excess US dollars were now bottled up in the US, the practice of printing more money caused inflation.  In response, official monetary policy changed from controlling the balance of payments to controlling inflation.

Now that creating money no longer affected foreign reserves, economists argued that all bank lending should be deregulated.  Therefore, not only could the Federal Reserve print money to finance government spending, banks were allowed to create money to finance private sector spending.  This exacerbated the problem. 

The requirement that foreign exchange transactions could not affect the domestic money supply had another profound effect on the economy.  In the past, any increase in exports would cause money to enter the country and stimulate the economy, raising demand mainly for domestic products, but also some imports. 

Under the floating exchange rate system, any growth in exports required an equal increase in imports.  The only way that could happen was for the exchange rate to rise to make imports cheaper and local products more expensive.  So as exports increased in areas such as computers, computer software and pharmacy products, the US had to increase its imports of other products such as clothing, footwear and cars.  Therefore, export success in some industries meant the demise of other industries.  It created the rust belt.  Rather than being seen as a problem, it was praised as a feature of the modern international economy and called globalization.

Banks earn profits by earning interest on their loans.  The more money they lend, the more interest they earn.  In the 1990's and up to 2008, the banks paid large commissions to their salesmen and mortgage brokers to increase lending.  It was in this environment of commissions for mortgage brokers and deregulated financial markets that the banks began lending to people who could never repay: and so created the current credit crisis.

While industries in the USA were collapsing, domestic debt and foreign debt were rising.  To enable the economy to function and grow, the money supply must grow by the amount of real income plus by the square of inflation.  So if inflation causes prices to double, the amount of money in the economy has to quadruple.  For countries with a floating exchange rate system, the only source of new money is bank credit. Bank credit is domestic debt.  We can also see that for countries like the USA, for every billion dollars of bank debt, the country need an additional billion dollars of foreign debt.  So the country's domestic and foreign debt must rise geometrically while the foreign debt rises arithmetically.  If this were to continue, eventually the country would not be able to support its domestic and foreign debt. This will cause a crisis. (See money and unsustainable debt.)

A solution will require more than just propping up the existing flawed monetary system.  It will require a change in monetary policy such as adopting the optimum exchange rate system or the guided exchange rate system.  That system requires banks to hold national savings in the form of foreign reserves (or reduce foreign debt) before they lend and allows lending to grow only as national savings grow.  Also, it provides for a more stable exchange rate that manages the economy so as to attain full employment with low inflation.

 

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  Last update: 8 February 2011