A Cracked Pillar

In the second article of our new Guest Blog, Jenny Floxi looks at the modern financial sector and exposes the flaws and weaknesses that led it into the 2008 Financial Crisis.

The main pillar of the modern economy is without doubt the financial sector. By the time capitalism had secured its position as the leading social formulation of modern society, most of the innovations that occurred thereafter were strongly attached to the rise of the banking and the credit system. Someone could actually argue that capitalism is the realization of Plato's fear of “money”, whether in it's tangible form or not, since it manages to enchain every aspect of society. The various schools of economic thought however,  have offered their own interpretations of what they regard to be the most effective monetary and financial structures of society, with the main conflict taking place between the Neoclassical and the Post-Keynesian approaches to money and its derivatives.

“Accumulate! Accumulate! That is Moses and the prophets” Marx declared with regards to money while writing Volume One of Capital. This claim is not too far from the mainstream perspective of how money and the banking system operate. They declare a commodification of money, (the socially acceptable means of exchange) and the extrinsic substance of it in society. Furthermore, the banking sector is shaped like a pyramid, with a monetary-based foundation that is provided by a non-market entity - the central bank or the government. The credit system can then grow once the existence of real money becomes a prerequisite. In this respect, the banking system has to passively wait for customers to make deposits before it can initiate the lending process. Economic growth then comes miraculously from the theory of the “money multiplier effect”, as the reserve deposit of loans will act as an accelerator so the bank's lending activities can expand exponentially. In addition, the exogeneity of money deprives it from any capacity to influence the whole economy. However, the neoclassical economic framework neglects some “minor” exceptions of how the banking system really operates.  
In fact, there is no reserve ratio. The central bank has no real control over the total monetary base and the financial system retains full control of money. So this model gives a completely abstract illustration of how the capitalistic economy really works.

A more accurate argument on the financial and monetary operation, would be an edited version of the aforementioned Marxian quote  as follows: “Borrow! Borrow! That is Moses and the prophets”. Indeed, capitalism's major intrinsic feature is the greed of expansion based on uncertainty.

Capitalists earn what they spend and this adjusts proportionately on the credit system. The credit model has no edges (neoclassical pyramid depiction) as it is based on a cyclical illustration of the financial sector, where the two layers of indebtedness allow continuous expansion with no monetary base. To be more specific, in a simplified version, there is someone who borrows from the bank due to lack of assets, the bank borrows from the central bank the desired amount in the form of bank reserves and subsequently makes the loan contract possible with the addition of a preferable interest rate.

Within the current system every new loan creates money, which is plunged into circulation and shifts fictional growth up. Thus, financial agents have an active role in economic growth during the endogenous determination of the credit creation process. Overall, the economy can grow exponentially as long as the demand for loans is plentiful and the CB or inter-bank lending work properly. In other words, the rate of debt is equal to growth. But is exponential growth sustainable? Is there a zenith point? Have all social variables been counteracted?

The developing procedure is not risk-free for society, as the augment of inflation is lurking within the credit function. Furthermore, monopolization of the economy has already shown its impact on unemployment rates. The “tamer” of this dynamic system is the Central bank and its essential role within the economy as a price maker, a quantity taker and the adjustor of the interest rate of lending. The unlimited expansion of the loan supply implies an unlimited amount of money creation, which threatens the economy with inflation. Combining the above with the money market and its short-term assets for trade, calls the Central Bank to intervene by targeting the interest rate of overnight transactions. This way the money markets will be restricted and a possible generalized instability in the case of a banking counterpart who is unable to clear their balance sheet will be avoided. Essentially, the transmission mechanisms (CBs intervention) are directly targeting the level of inflation by setting official rates of interest. In correspondence, long-term lending rates will be reduced via direct intervention of short-term rates.

In short this abstract way of the financial operations creates an extremely fragile system because it is based on the confidence of the banking sector. Though, no one ensures the continuous smooth fluctuations of inter-banking relations where efficient financial agents are willing to lend to their inefficient counterparts (who are unable to clear their balance sheets). The only factor able to prevent money creation relies on behavioral features. Hence, all it takes to trigger the collapse of the entire economy is a banker who, through fear of a bleak economic outlook and widespread uncertainty, becomes reluctant to lend and therein triggers an economic crash.

Does this reminds you of something?

The collapse of the “too big to fall” American financial institutions in 2008 triggered a domino effect that brought the global economy to its knees. After the shock, financial counterparts in fear of losing more money restricted their investment activities and so countries in need of financial support to keep up with their budget deficits found themselves unable to do so. Subsequently, nations like Greece, Italy and Spain faced difficulties to meet their external debt obligations that put an additional burden to internal issues. Such is the interconnectedness and interdependence of the whole world that nations can crumble at the hands of the butterfly' effect whereby the hopes, fears and doubts of a handful of individuals can shape or shatter the global economy.

Written by Polyxeni-Jenny Floki