It is notable that as the continuing financial crisis (credit crunch, recession, sovereign debt crisis, whatever you will) develops, there are those observers who claim that capitalism itself is in crisis while others describe plainly the confusion about what economic system we currently have and what will happen if it does collapse.
Will Hutton hits upon the problem (this “…entire financial edifice, underwritten by tiny amounts of capital…”) but fails to draw the logical conclusion. Unfortunately, Mr. Hutton fails to clearly define capitalism and does not show how the current system we have meets that definition. Mr. Hutton, like many critics and commentators on the current crisis, seems to lack a unified theory that allows him to fully understand the causes of the current crisis and obvious solutions. As a result, he is reduced to rather confused speculation and unsupported assertions.
There is a school of thought, (to which Mr. Hutton belongs) that asserts that businesses and state work together to increase wealth for society as a whole. We are in the current mess because we have deviated from this basic principle and transformed into a system where entrepreneurs do what they want without any thought to state or society.
Strangely, the actual economic system we have seems to more closely resemble Mr. Hutton’s ideal society rather than the one which he criticises – but only superficially. Government is heavily involved in business and banking, but businesses and government are necessarily antagonistic towards each other. The primary source of this antagonism is, of course, taxation wherein the government helps itself, at many levels, to shares of the business’s income. It also imposes tax collection responsibilities upon the business and the bureaucratic costs that go along with that.
Capitalism may be defined as “an economic system in which the means of production are privately owned and operated for profit”. Similarly, a “free market” is one free of government control and intervention. Individuals may freely and voluntarily transact with each other with no interference from the government (which may, for example, prohibit certain services or products, or impose certain terms through legislation). There can be no crisis in such a system because it clearly is an intrinsic part of human nature. One person’s will to trade their personal property in return for personal property voluntarily traded by another. Even in the most government controlled environment (say a prison) this process of voluntary exchange will occur. It cannot be stopped.
The actual system that is under threat of collapse is the system by which governments finance themselves over and above their explicit tax revenues. It is the fiat money central banking system. This system has grown and developed over the centuries and began in England during the seventeenth century with the establishment of the Bank of England. The original purpose of the Bank of England was to finance the wars of England but it is now used to indirectly finance the welfare state and the various pet projects of bureaucrats. It is the key method by which the state maintains its legitimacy as an agency with the ability to grant benefits to the populace. This is to ensure a grumbling compliance while the state significantly and covertly increases taxes, through a range of methods, to enable its continued expansion.
By combining the existence of a central bank with a fiat currency and fractional reserve banking, the state can raise funds significantly in excess of the official tax rates. The central bank buys the government bonds by printing money. This purchase therefore is entirely financed by inflation. Since it’s a rare thing for a government to run a budget surplus, this debt will never be repaid. Rather there is a tendency for the debt to increase until the inevitable crisis hits. But growing interest payments on this debt lead to a smaller slice of the budget pie for the population, future higher official taxes or higher future inflation when the central bank prints more money to buy more bonds (think Quantitative Easing). In this way, the population are gradually taxed through the reduction of their currency’s purchasing power.
However, there is another link in this chain: fractional reserve banks. The banks provide a capitalist veneer to the veiled and unofficial tax system. On the one hand they purchase domestic government debt which they can either hold or sell on to the central bank (for a profit). On the other hand they will buy foreign sovereign debt (such as Greek debt) which now apparently carries an implicit guarantee from the European Union and European Central Bank. These banks create new money through the fractional reserve process and in practice, for every £100 a customer “deposits” into the system, the bank lends £99. This vastly multiplies the funds available to the bank and allows them to not only increase their lending to individuals and businesses but also to governments, foreign or domestic. Moreover, in the short term, the increased supply of credit lowers the cost of this debt.
It is easy to see how governments benefit from this system. It allows them, not only to benefit from inflation but to vastly increase taxes on both current and future generations! This is essentially what government debt is – a higher tax in the future. Much like a narcotic it is pleasure now but pain later. But while the governments and banks generally benefit from the pleasure, the pain is felt by the citizenry.
In this manner, the government uses this cheap and apparently endless supply of credit to pursue its goals, whether they are war, welfare or infrastructure projects. Additionally, this process creates an unsustainable boom, initially raising business profits and by extension, tax revenues. This is the “financial edifice, underwritten by tiny amounts of capital”. And it is government that is responsible for its existence as well as being a major beneficiary of it.
Inevitably, the boom must come to an end. Not only are banks hammered by bad debts accruing from failing businesses, or individuals who can no longer afford to pay their mortgages, but governments are hit by plummeting tax revenues at the same time that interest rates on their debt shoot upwards. For the banks the hits keep on coming with sovereign debt (from Greece, Spain, Italy and others for example) now effectively worthless and heading towards default. Therein lay the causes of the European sovereign debt crisis.
Now we can see clearly that this is not a crisis of capitalism or free markets. It is a crisis of government caused by fraud on a grand scale. The fraud of the fractional reserve banks which pervert the very nature of a bank “deposit”; the fraud of the central bank which counterfeits money and manipulates prices; and finally, the fraud of the government, which as an institution has over time created this inflationary and unstable financial system as a method to surreptitiously expropriate resources from the population which it serves, in order to finance its expansion.
Unfortunately for the governments, they are as vulnerable to market realities as are the banks. And there is a limit to their ability to tax the population no matter what the method. The Keynesian idea was that the increased government spending financed by the inflationary banking system will boost the economy so that the government can repay debt with increased tax receipts in the future. Thus, it was believed that the boom would carry on indefinitely. However, there is no escaping economic reality and the inflationary boom must end in a bust.
When the crisis initially started it was easy for governments to simply blame the banks. As we have moved from a sub-prime housing debt crisis to a sovereign debt crisis, this story is less convincing. Regardless, no matter how much governments publicly criticise the banks, they are bound to bail them out since banks are a crucial factor in government financing. And it is the population who will meet the cost of this bail-out.
Free markets will survive this crisis simply because the will to voluntarily produce and trade is an intrinsic part of human nature. There is no crisis of capitalism, but there is a crisis of government. Specifically, the fraud of government debt financing is now unravelling, having come face to face with economic reality. Unwilling to confront this crisis (which would require a default by several governments at best and the likely bankruptcy of several major banks) governments will take the steps to prolong it until the inevitable and total failure of this deceitful system.