Bill Totten's Weblog

Saturday, September 18, 2010

How We Got into this Situation ...

... and What We Can Do to Get Out

by Alistair McConnachie

Prosperity (October 2009)

The following was delivered by Alistair McConnachie at the Thirteenth Annual Bromsgrove Conference on 3rd Oct 2009 and was published in the October 2009 issue of Prosperity.

In this presentation I want to talk about three things: How did we get here? What are we doing about it? Where do we want to go?

This will require me to look at the process which is called "quantitative easing".

We've already looked at the dangerous use of "derivatives" by the banking system - financial products which are derived from another asset - and how these financial "products" contributed heavily to the present situation.

What I want to do now is repeat to you how the man in charge of the USA explains the situation.

I quoted from President Obama's speech in the second presentation. Here he is again, at an earlier part of that same speech to Georgetown University. He sums up the cause of our present problems very well (our emphases):

As has been widely reported, it started in the housing market. During the course of the decade, the formula for buying a house changed: Instead of saving their pennies to buy their dream house, many Americans found that suddenly they could take out loans that by traditional standards their incomes just could not support. Others were tricked into signing these subprime loans by lenders who were trying to make a quick profit. The reason these loans were so readily available was that Wall Street saw big profits to be made.

That's correct, and let's remember that the reason the banks could make these loans is because of the fractional reserve system which enables them to create money to lend - as we saw in the second presentation in this series today - up to eight to ten times the amount of money deposited with them.

By this method the private banks are inflating the money supply. If private banks were forbidden from multiplying money in this way then not only would that limit the amount of money available for reckless loans, but it would also limit house price inflation - which is a direct consequence of banks being able to create money to lend in this way.

Eventually it would bring the prices of houses to a stable level which would enable young people to get on the housing ladder.

Okay, back to the President. He explains:

Investment banks would buy and package together these questionable mortgages into securities, arguing that by pooling the mortgages the risks had somehow been reduced. And credit agencies that are supposed to help investors determine the soundness of various investments stamped the securities with their safest rating when they should have been labeled "Buyer Beware".

No one really knew what the actual value of these securities were, no one fully understood what the risks were. But since the housing market was booming and prices were rising, banks and investors just kept buying and selling them, always passing off the risk to someone else for a greater profit without having to take any of the ultimate responsibility. Banks took on more debt than they could handle.

... Then the housing bubble burst. Home prices fell. People began to default on their subprime mortgages. And the value of all those loans and securities plummeted. Banks and investors couldn't find anyone to buy them. Greed gave way to fear. Investors pulled their money out of the market. Large financial institutions that didn't have enough money on hand to pay off all their obligations collapsed. Other banks held on tight to their money and simply stopped lending.

He then goes on to say:

... The heart of this financial crisis is that too many banks and other financial institutions simply stopped lending money. In a climate of fear, banks were unable to replace their losses from some of those bad mortgages by raising new capital on their own, and they were unwilling to lend the money they did have because they were afraid that no one would pay it back. It's for this reason that the last administration used what they called the Troubled Asset Relief Program, or TARP, to provide these banks with temporary financial assistance in order to get them lending again ... {1}

Now what the President is saying here is that the recession was caused by excessive and irresponsible lending, and the use of derivative instruments called securities, but that we can't get out of it until banks start lending again.

Think about that!

The economy cannot improve until we start indebting large numbers of people again.

That is an acknowledgement that the wheels of our economy can only turn if they are oiled by debt.

It is admitting that debt drives our economy. That the economy won't start moving again until we put more debt in the engine.

Then it will take off at speed again: Then we'll have debt-propelled growth again.

To say, we've got a crisis based on debt and the way out of the crisis is more debt, is like saying, "I need to borrow more money ... to pay off my debts".

President Obama has been badly advised if he thinks the solution to a crisis which resulted from too much bank-created debt in the system, is to borrow even more bank-created debt!

He's been badly advised if he thinks the best way to get out of this hole is to keep digging. We need to break this debt cycle.

What Are We Doing About The Crisis?

Let's take the example of the UK.

Banks are not lending. Money is not coming into society. Banks lend by multiplying their deposits. So, the theory goes, if we help them build up more deposits then they will be able to lend more again.

How to do that? The theory is to allow the Central Bank - in the UK, it's the Bank of England - to create money and put it into the economy. Banks will eventually get that money and build up their deposits.

So, the Bank of England is creating money and injecting it into the economy by a process called "quantitative easing".

What is "Quantitative Easing"?

Essentially, QE means the Bank of England printing money, electronically, and pumping it incrementally into the economy via the private sector gilts market.

What Are "Gilts", and Who Buys Them?

* A gilt-edged security - is a type of bond - a government bond. It is sold by the Treasury to private investors, such as individuals, corporations, pension funds, banks ...

* The Treasury takes the money, and it is used for public spending - health, education, transport and so on.

* The Treasury promises a return to the investor, at a fixed time in the future, with interest.

This year, 2009/10, the Treasury will try to sell GBP 220 billion of bonds {2}. These gilts are advertised on a regular basis. For example, here is the latest advert for a gilt auction which appeared in the Sunday Telegraph, 20 September 2009 {3}.

When we speak about the "interest on the national debt" we're talking about the interest on these gilts.

How Quantitative Easing Works

According to the Bank of England (our emphases):

The aim of quantitative easing is to inject money into the economy in order to revive nominal spending [unadjusted for inflation]. The Bank is doing that by purchasing financial assets from the private sector. When it pays for those assets with new central bank money, in addition to boosting the amount of central bank money held by banks, it is also likely to boost the amount of deposits held by firms and households. This additional money then works through a number of channels, discussed later, to increase spending. {4}

Yes, that's correct, one of the "channels" by which it increases spending in the economy, is through the fractional reserve system. New deposits in the corporate banking system allow it to lend out new money - as we saw in the second presentation - up to eight to ten times the amount originally deposited in the bank.

Remember what President Obama said, "... the truth is that a dollar of capital in a bank can actually result in $8 or $10 of loans to families and businesses. So that's a multiplier effect ..." {5}

The theory here is that this debt balloon will "increase spending" and somehow boost the economy again.

How QE Has Benefitted Money Reformers

In one major way, QE has undoubtedly been good for Money Reformers. Prior to QE few people would believe us when we said that the Bank of England had the power to create money out of nothing. When QE was first introduced, there was general disbelief among many that the Bank could do that. Now it is laid bare for all to see. It is accepted. The Bank of England - and the Central Banks of all countries - can create money out of nothing.

That is a significant step forward for our message. We don't have to fight against that barrier of disbelief anymore.

So is "QE" what we are after? Well, it is a big step in the right direction, but it is not the full story ...

Firstly, the BoE is creating money and putting it into the economy by buying gilts from the private sector - from people who have already bought gilts from the Treasury.

It is not purchasing gilts directly from the Treasury. To do that would be the BoE directly financing the Treasury.

It is not giving money directly to the Treasury. It could do that. It would be revolutionary. It would be direct Central Bank financing of the Treasury - direct financing of the public purse.

Yes, it could purchase gilts, or another kind of specific instrument directly from the Treasury and the Treasury could take that money and use it to ... well ... do all the things which Money Reformers advocate. For example: fund the deficit, pay the interest on the national debt, reduce taxes, support public services, spend on infrastructure, and so on.

Yes, it could purchase gilts directly from the Treasury or it doesn't even have to purchase gilts, it could simply give the money to the Treasury ... debt-free. So why doesn't it?

Leaving aside the fact that it has never been done before, and leaving aside the fact that the big players who make money out of the bond markets wouldn't like it, it is ... actually ... illegal!

Article 101 (TEC), Prohibits Direct Public Financing

Direct Central Bank financing of the Treasury is illegal under the Treaty establishing the European Community (TEC). It is forbidden by Article 101, introduced by the Maastricht round of treaties.

1. Overdraft facilities or any other type of credit facility with the ECB or with the central banks of the Member States (hereinafter referred to as 'national central banks') in favour of Community institutions or bodies, central governments, regional, local or other public authorities, other bodies governed by public law, or public undertakings of Member States shall be prohibited, as shall the purchase directly from them by the ECB or national central banks of debt instruments. {6}

From the perspective of the European Central Bank it makes sense to prohibit that option because otherwise it would render irrelevant the European Central Bank.

Where Should We Go Now?

Ten years ago we couldn't get people to accept that the Bank of England - or any Central Bank - could create money. Today it's accepted. Everyone now accepts that the BoE can create money out of nothing. We've won that argument.

Now we need to point out that instead of creating GBP 1 billion and buying gilts in the private sector, it can create GBP 1 billion and simply give the money to the Treasury - by-passing the bond market merry-go-round altogether.

Just as time has shown us to be correct regarding the ability of the Central Bank to create money. So time will eventually show that the bond market merry-go-round is neither a necessary nor appropriate way for us to raise our public finance.

Our Central Bank can create our money for ourselves.

And it can give that money directly, and free of debt, to the Treasury, which can put it into society as a debt-free source of funding.

We can have our own publicly-created, debt-free money supply. The creation of money can become a public service ... under public control ... for the public good.

We should not have to, and we will not have to, and never again will we need to, rely upon the corporate banking sector and its debt-based money system - which it abuses for its own profit at the expense of our society.

QE has proven that the Central Banks can create money, but at the moment the process is acting only to prop up the corporate private banking system which creates our money supply out of nothing, via the fractional reserve system, as a debt for its own private profit, to the detriment of the public and our economy.

The Take-Home Message

Trying to save the economy by encouraging lending is like trying to pay off your debts by borrowing more.

The fact that we need to "encourage banks to lend", that is to say, encourage indebting people even more, in order to provide our economy with new money, demonstrates the reality of our debt-based economy ... which requires a constant state of indebtedness in order to function. It demonstrates the folly of relying upon the corporate banking sector for the supply of money into our society.

Instead of relying on the corporate banking system for the supply of money via the debts which it creates for its own private profit ... the real solution is to enable the Central Bank to take responsibility to create our money supply directly and publicly, free of debt.

Rather than creating money and purchasing gilts from the private sector, the Central Bank should create the money and give it to the Treasury - put it directly into the public purse - and bypass the bond market altogether. That money will then be spent into society via government spending. The corporate private banking system will then compete to attract this money into its savings accounts and build up its capital reserves in this way.

This will be done at the same time as these private banks are forbidden completely from creating money via the fractional reserve system, thereby ensuring that inflation does not occur and that they will be unable to multiply this money eight to ten times.

This will Mend the Banks, Free ourselves from Debt Slavery and give us a Stable and Sustainable Economy.

Postscript: Since this speech was made, a proposed draft Parliamentary Bill entitled, "The Bank of England (Creation of Currency) Bill" - which delivers this exact reform - has been published. It can be found at

{1} President Barack Obama, "Remarks by the President on the Economy", Georgetown University, Washington, DC (April 14 2009)

{2} Reuters, "Britain to issue record 220 billion gilts in 2009/10" (April 22 2009)

{3} Advert, "Gilt Auctions in the Period 1 October to 31 December 2009", The Sunday Telegraph, (September 20 2009), page B5.

{4} Bank of England, Quarterly Bulletin, 2009 Q2, Vol 49, No 2 at 91.

{5} President Obama, op cit and quoted in Prosperity (October 2009), pages 4-5 at 5.

{6} Article 101 of the Treaty establishing the European Community (TEC) is found in the consolidated version of the current treaties, published in the Official Journal of the European Union 29.12.2006 C 321 E/83-84: The current Article 101 TEC was introduced, as Article 104, by the Treaty on European Union, also known as the Treaty of Maastricht (OJ 29.7.1992 C 191).

Bill Totten


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