How Free-Market Fundamentalists are Hopelessly Wrong, III: money, debt and blindness

Part I presented the evidence that economies in the free-market era delivered only mediocre performance before crashing in the disastrous Global Financial Crisis.  Part II showed how the standard theory of free markets bears no useful resemblance to real economies, and its application amounts to pseudo-science.

Returning to the GFC now, there is a particular reason free-market economists claim the GFC was unforeseeable:  debt and money play no role in their standard equilibrium economic models.  They claim one person’s debt is another person’s asset, and so aggregate “demand” is not affected by debt.  This would be true in a barter economy, or if the banking system was based entirely on savings, for only in those cases would the extra purchasing power of the borrower be balanced by the reduced purchasing power of the depositor.

However this is not how our real banking system works, as economists should know, even if many of the rest of us did not.  New money and new purchasing power are created out of nothing every time someone gets a loan.  No-one’s purchasing power is reduced.  This is because banks are only required to retain deposits equal to ten percent or less of what they loan.  Thus your new loan comprises ten percent or less of someone else’s savings, and the rest of the money is created out of nothing.  This is called fractional reserve banking.  I have simplified a bit, and there is also a so-called shadow banking system that creates even more debt out of nothing, but this is the essence, and the detailed version is even worse.

There would be no problem if debt were at a steady level, because when a loan is paid back the extra money is removed.  However private debt in Australia rose steadily for nearly forty years, relative to GDP, until in 2007 it measured 160% of GDP, as documented by Steve Keen.  In 2007 our net private debt increased by an astonishing 20% of GDP, thanks mainly to a housing price bubble.  We were living on our credit card, living beyond our means.  Without that huge injection of new money, our economy would have been in severe recession.  The US had a similar bubble, and its bursting triggered the GFC.  Our bubble is still there.

You might think economists would know all about money and where it comes from, especially as the fractional reserve system is included in basic economics text books.  However the implications I have just spelt out seem to escape free-market economists, perhaps because money and debt won’t fit into their comfortable abstract world of theoretical equilibrium.  Instead they dismiss what has probably been the major destabilising process in modern economies for the past several hundred years through the elementary error that one person’s debt is another’s asset.  Because debt is not in their models, it does not seem to be in their thinking either.

This seems to be the reason for the amazing blindness of free-market economists to the excessive build up of private debt (totalling $600 trillion by some estimates) that eventually brought the financial system crashing down.  Yet anyone who gets a loan can understand the problem:  when you get a bank loan, society’s total purchasing power goes up.  As you pay it back, purchasing power drops.  The US is in deep recession because many people are being forced to pay down their debt, rather than buy more stuff.  When our bubble bursts, the same thing will happen here.

To sum up these three articles, free-market economists have no basis, in theory or in practice, for their claim that free markets are the best way to organise an economy.  Worse, their theoretical mind-set blinds them to how deregulated money and debt destabilised the economy and brought on the disaster of the GFC.

There are other fundamental problems in our rather anarchic economic system that are not specifically related to the free-market ideology but are equally in need of reform.  For example the dominant measure of the “success” of economic management is that the Gross Domestic Product increases, but the GDP takes no account of whether or not the activities it measures are useful.  The priorities of our societies are severely distorted as a result.

Better ideas are available, from modern theories of self-organising systems and many scattered practices operating in parallel to the present system.  It is possible to envisage market economies that are neither socialist nor old-style capitalist, that provide reasonably for everyone and that cease the destruction of the planetary environment on which we are totally dependent.  But that is another story.


One thought on “How Free-Market Fundamentalists are Hopelessly Wrong, III: money, debt and blindness

  1. Pingback: Appropriate Science | Better Nature: commentary by Geoff Davies

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