setting themselves up, in the tradition of the Roman moneylenders, on benches around the trading halls and squares of the main towns, offering loans to farmers while accepting the future grain harvest as collateral.
As this business grew, the Jewish merchants began offering insurance against crop failure, and they also took deposits in the form of bills of settlement. The funds from these deposits, which were held for merchants until they needed them to settle grain trades, could be lent out to other farmers, as long as the bankers kept enough to settle other deals. If they didn’t, they risked a broken bench (Latin bancus ruptus, from which we get the term bankrupt).
When wars disrupted business in Italy, some of these Jewish bankers migrated northwards, taking their merchant-banking practices into Germany and eventually the Netherlands and Britain, often becoming goldsmiths as well as bankers, charging fees for storing other people’s gold in their vaults. The goldsmith would write a deposit receipt, which the owner would then show when wanting to take out some gold. As with those eighth-century Chinese banknotes mentioned earlier, it became the custom to use these deposit receipts as currency in themselves, instead of carrying the actual gold around. A goldsmith would hand over the specified quantity of gold in exchange for the note, whether it was presented by the original depositor or by someone else.
By lending out more money, or bank notes, than they held on deposit, bankers had begun to create money out of nothing. For example, if a merchant deposited a pound of gold with the bank, they received a note for that pound. The note represented the gold, and could itself be used as money. At the same time, the banker could lend out some of the gold to a farmer who needed to buy seed, and who would repay it with interest after the harvest had been sold. If the merchant returned for the gold, or spent the bank note and another trader wanted to redeem that note, the banker would repay the pound of gold from other deposits.
Thus begins a process by which the banker makes money – the interest on loans – from lending out gold that belongs to someone else. The business depends on taking in more gold to cover the repayment of previous deposits. The banker is effectively creating money, but also getting stuck into a cycle of debt creation that is dependent on new gold coming into the bank. The system works as long as new wealth is being created in the economy. If people stop bringing in gold, the banker can no longer repay all the depositors and goes bankrupt.
The banking system today is little changed in principle, apart from the addition of central banks, which supposedly guarantee the deposits of the nation’s citizens. The main difference is one of scale. The financial sector has grown into a dominant force that affects everyone’s lives, and the effects are mostly bad. Figure 28 shows the growth of debt in various countries.
The grand illusion
Wealthy people don’t need to borrow money. When the wealthy borrow, it’s usually because they can use the money to make more money. This is what banks do.
The really poor of the world don’t borrow either, because nobody will lend money to a person who has no assets, and no prospects of earning more than pennies. It is mostly the middle classes that borrow, though one of the features of the credit boom was that banks had started lending to people on the margins of poverty, people who wouldn’t have been granted mortgages in the days before bank deregulation.
Figure 28
But effectively, the financial system represents a massive transfer of wealth from the middle classes to the very rich. In the boom years, the middle classes were happy to accept this, or at least they mostly didn’t question it, because they were buying houses that were going up in value. They were becoming quite wealthy themselves, and even if this wealth was tied up in the value of the houses they lived in, and therefore wasn’t actually available for spending, the banks were happy to offer new loans based on that increasing equity. The good times kept rolling along on this rising tide of debt.
There was only one problem: the whole thing was an illusion and the credit bubble had no basis in reality. As I’ve already pointed out, the real wealth of the economy was growing at a much lower rate than GDP figures implied.
As the banks invented increasingly elaborate ways of profiting from the build-up of wealth, both real and artificial, they lost sight of the true value of the assets they were using as collateral. In particular, they lost sight of the true value of housing, as shown in Figure 29, but to some extent they also became detached from the true value of everything else, including money.
Figure 29
Perhaps the problem goes so deep that it’s impossible to see from a skyscraper window but, whatever the reason, these highflying traders and gamblers appear to have lost sight of a simple truth: there is no real value to be gained from unproductive credit creation and speculation. Such activity is not real work, which perhaps explains why so many traders can’t wait to take their final bonuses and move on to something more genuinely rewarding.
The growth of finance; derivatives explained
As we have seen, a change occurred during the second half of the 20th century, as the golden age of real industrial expansion gradually turned into a more tarnished age of financial expansion. The economies of the developed world came to rely less on making things and more on shifting accumulated wealth around. Even large industrial corporations moved into the finance game, as it became easier to make a profit from lending money than from making real stuff. General Motors, for example, was making two-thirds of its profit from its finance division by 2004 and, in the same year, Ford made a loss on car manufacture but a billion-dollar profit from its credit business.
Global competition hit the manufacturing industry much harder than it did the financial sector, where the costs of labor and materials are less significant. The whole concept of productivity and efficiency that has been such a driving force in the real economy – the survival-of-the-fittest mentality that requires job-cutting to stay competitive – hardly applies to investment banking, where one trader can make millions simply by pressing a few keys on his keyboard, just as long as his luck doesn’t run out.
But it is exactly this lack of real jobs and industry that makes the growth of the financial sector so damaging to the real economy. When banks made most of their money by lending to industry for investment in new wealth-creating business, or by lending to the middle classes so they could buy homes and cars, they had a direct link to the real world. It was in bank managers’ interest to make sure their customers prospered.
All that changed during the 1980s and 1990s. Thanks to new legislation forced through by the influential executives of Wall Street and the City, many of whom had close links to government in both the US and UK, liabilities became limited. Commercial banks began to indulge in practices that had previously been limited to investment banks, resulting in a new bonus culture in which managers and traders got rich using other people’s money. Combined with new technology that made international trading and speculation much easier, this led to a rapid rise in what has come to be known as ‘shadow banking’.
Figure 30
