Wall Street Meltdown – Failure of Central Banking System

The Edge, 20 Oct 2008

The money meltdown observed in Wall Street in recent weeks does not come as a surprise to many. Indeed this is what some monetarists have been warning about for some time.

Wall Street is the financial district of New York City. It is the home of the New York Stock Exchange, the world’s largest stock exchange by market capitalization of its listed companies.

Triggered by the subprime mortgage crisis beginning around July 2007 the money meltdown has been taking financial giants down, one by one. Following the financial distress of Bear Stearns, Countrywide and so forth, prominent investment banker Lehman Brothers is among the latest to go into bankruptcy. Other additions to the list include Freddy Mac, Fannie Mae, Merrill Lynch, AIG insurance and Washington Mutual. And the list is expanding.

Isn’t it perplexing how an institution like Lehman Brothers, established more than 150 years ago, with all the experience, managerial or otherwise, gained over those years, that employs among the best brains and utilize the best of computers can go into bankruptcy?

The converging failure of all those financial giant institutions is a clear indication of a systemic failure. Washington is grappling on how to fix this humongous crisis that many say is only next to the Great Depression of the late 1920s. Perhaps it is too early to say that it is next to the Great Depression for so far we have only seen the tip of the iceberg.

The US federal government’s liability to tackle this problem can go beyond a trillion dollars with the latest being Treasury Secretary Henry Paulson and Federal Reserve Chairman Ben Bernanke urging the US lawmakers to approve USD700 billion to bailout the failing banks. Nonetheless, faced with little choice an amended proposal was signed into law by President Bush on 3rd October 2008.

Most of us have no idea how big one trillion dollars is. Well, if one were to spend a million dollars per day, that is around RM3.3 million per day, everyday from the day Jesus Christ (peace be upon him) was born about two thousand years ago until today, you would still have money left that would allow you to continue spending so for about another 700 years!

But what caused this monetary meltdown? Paulson puts the blame on defaulting mortgages and hence the War Against Defaulting Homeowners. Can Paulson’s USD700 billion bailout bring about the needed solution? Many do not think so, if the money is to be used simply for buying-up the ‘toxic’ mortgage-backed securities. A viable solution needs to address the root of the problem. More analysis is needed and more questions need to be answered, like why more and more homeowners default on their mortgage and why their default can bring down an entire financial system, threatening even the whole global financial system, need to be analyzed and put into perspective before a viable solution can be suggested.

Some monetarists have warned since years ago that such a crisis is sure to unfold due to one simple reason: that money in the present system is nothing real but nevertheless carries with it compounded interest charges. In the absence of an anchor, as that existed in the Gold Standard or Bretton Woods of the past, monetary expansion has been the inevitable consequence of the current debt-money system. Compounding interest causes money and debt to grow exponentially way beyond the level that can be matched by the growth of the real economy. The excess liquidity brought about by this monetary expansion has been ‘pushed’ into pricing, among others, derivative securities structured layers above layers, including the current mortgaged-backed securities in question. The over-creation of money is precisely the reason why we observe periodic ‘bubbles’ and their ‘busts’.

In real money systems where money is something that’s real like gold, or a currency that is redeemable for gold, overexpansion is neither easy nor desirable for that would require actual gold to do so. Accordingly, real money like gold cannot get destroyed. It would be in the possession of someone or some entity in all economic circumstances.

But in the current fiat money system, where money is not backed by gold, monetary expansion is achieved easily by the stroke of the pen, by creating money out of thin air. Indeed, the US’ $700 billion bailout money would practically be created out of nothing. An additional characteristic of fiat money is that it can also get destroyed in certain circumstances, like in loan defaults, destroyed merely through accounting process. Such destruction of money is also partly responsible for the occurrences of recessions.

The subprime mortgage crisis is a cause for such destruction of money and the shrinkage of loanable funds and accordingly the failure of large mortgage lenders like Freddie Mac and Fannie Mae. Since the fiat money system is nothing but an accounting system, where money within the economy is predominantly a web of double-entry accounting records, the failure of one institution affects another and yet another in a domino-effect style.

The subprime crisis’ destruction of money and credit is indeed threatening to push the US into a deep recession if not a depression. Therefore, given the current ‘flawed’ monetary system an expansionary monetary policy is warranted and hence provides some justification for the bailout.

However, the current situation is different from that of the Great Depression of 1929, the cause of which was the high taxes of the Smoot-Hawley Tariff. The depression then was caused by severe monetary contraction which was a fault of the government itself. But in the present case, the problem emanated from the inability of the real sector to service its mortgage debt, which then translated into a monetary shrinkage. The US government, therefore, correctly recognized that it needs to put money back into the economy through the proposed bailout. Otherwise the productive economy would contract severely.

Nonetheless, there is one other crucial point that needs to be addressed, i.e. the increased loan defaults by individuals and businesses commonly referred to as the Main Street. The US’ real economy, having being heavily indebted, is not in a position to assume more debt. Hence to put the economy back on track, the US needs to also bailout Main Street as much as it bails out Wall Street. Some form of debt write-off for the Main Street is very much necessary. Otherwise Paulson’s USD700 billion bailout will not only fail to solve the problem but would bring about a huge transfer of wealth from Main Street to Wall Street, i.e. from the productive enterprises to the bankers. The bailout would then be like reviving the dead temporarily. It would be a one-time payoff to the bankers before the system dwindles again – hence the much opposition to the bailout proposal. Some even accuse the bailout as being a humongous theft or treason.

A failure by the US to stop this monetary meltdown swiftly can send a shock-wave globally, threatening to collapse the global monetary order. Indeed the crisis has already spread to Europe. Following the earlier distress of few prominent banks there like Northern Rock, now mortgage lender Bradford & Bingley is being nationalized. Fortis, a large European bank headquartered in Brussels is being bailed-out by three European governments – Belgium, Netherlands and Luxembourg – for a sum of USD16.4 billion. As a consequence of all these bailouts, the global economy will have to face another round of global inflation.

Paulson’s bailout plan is however not a welcome particularly to countries with huge dollar reserves. China, for example, has voiced its unhappiness towards it, for the plan would only further dampen the value of the dollar and hence its dollar reserves. If in disappointment, China were to dump its dollar reserves, the dollar would effectively become a dead currency.

The entire saga is the manifestation of what some monetarists have been predicting. The debt-based monetary system with compounding interest is simply unsustainable and what we are witnessing now is the failure of the central banking system. Now is the US’ turn. Soon it will be the turn of other central banks. A global financial and economic crisis is, therefore, seems onrushing. Such chaos is likely to push the price of gold, the historically undisputed real money, to new heights all through next year and even beyond.

The world has come to a crucial crossroad in its modern history. It has no choice but to put in place, urgently, an alternative global monetary system, replacing the current central banking system, that necessarily must be based on real money – so as to introduce a just and stable fixed-exchange-rate system, conducive for sustainable economic development.

As Alan Greenspan put it in a recent interview, “You didn’t need a central bank when we were on the gold standard.”

But one should expect the global financial and political elites to attempt to establish a new global monetary order that concentrates even further power in their hands – like a global central bank with a global currency that is still fiat in nature. Prudent governments should oppose such attempts.

Note that President Bush had earlier warned countries from taking remedial actions on their own for that could affect the interests of other countries. Such are signs that a global central bank could be in their agenda. Also note that after the recent G-7 meeting in Paris, the International Monetary Fund announced that it is ready to lend substantial resources to countries in need of capital in the financial crisis. When major economies of the world are facing a monetary meltdown, where would the IMF obtain its ‘substantial resources’ if not created out of nothing? Nations should realize that if major economies can bailout their financial institutions using freely created money they could also do the same. Why then borrow from IMF at interest?

It is interesting to note, that after the collapse of the Soviet Union in the early 1990’s, the US occupying the pinnacle of the capitalistic model is unable to sustain itself, even as unilateral superpower, brought down by the inherent fallacies within its own debt-based monetary system.

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