Forty years ago, in the second year of an economics degree, I learned how the banking system not only facilitates saving and lending but actually creates money to match the desire of business and households for investment and consumption. It does this by lending a multiple of the funds deposited.
This is possible because each loan is spent and finds its way back into the banking system. In this way the economic wheels are oiled and growth is facilitated.
This felicitous state of affairs can continue indefinitely so long as a few fundamentals hold true:
• The lenders must believe that they will ultimately be repaid and, that in the case of default, the assets they hold as security will continue to have sufficient value to cover such defaults. This is affected by both their view as to the likely level of defaults (which in turn depends on the labour market and company profits) and their view as to the likely future value of the mortgaged assets.
• Borrowers must continue to believe that borrowing is worthwhile. That is, that the assets they are purchasing or developing will have greater value than the total loan, including interest payments, and that they will have sufficient cashflow to cover progressive interest and principal payments.
• Everyone must believe in the ability of the banking system to cover deposit withdrawals and make future loans. Pretty simple stuff. But note the number of times I have referred to views and beliefs. Without confidence, money and wealth are destroyed at the same leveraged multiple at which they have been created. That is why, from time to time, government intervention is absolutely essential to economic stability.
The current financial crisis is not only a reaction to the irrational exuberance caused by years of very strong global economic growth.
It is also in part a result of the degree of intermediation that has built up in financial markets, causing massive leveraging and misinformation and a complete disregard for risk. Huge financial incentives have caused selective blindness or corruption at all levels, from the big name global banks, the wholesale packagers and financial engineers, through to mortgage brokers and sections of the financial planning and accounting industries.
The entire finance sector is faced with a crisis of confidence that has also spilled over to the real economy in an alarming way.
I do believe that the stockmarket, in spite of its daily gyrations, is probably a perceptive indicator of future economic conditions.
However, precisely because governments have to restore confidence there can be no quick fix.
There will continue to be doubts as the social psyche absorbs and then deals with the shock. In these circumstances, politics is bound to take centre stage and represents a real challenge to the maturity of our system (and our media)