In theory, Nixon cutting money free in 1971 appears to confer great power on Central Banks. In practice, however, they are just the forced and automatic accommodators of the money creation decisions of the private banking and broader financial system.

The Great Depression following the Wall Street crash of 1929 has been widely blamed on the flawed policy response of the US Federal Reserve. Most famously, the doyen of monetary economics, Milton Friedman, argued that the collapse of the US money supply by a third between 1929 and 1933 turned a brutal day on the stock market into a multi-year depression.

In Friedman’s view, the failure of the Federal Reserve to maintain the money supply caused the vicious cycle of collapsing banks, activity and hope:

“The Federal Reserve System could have prevented the decline (in the money supply) at all times. The terrible depression which followed the crash was a direct result of bungling by the Federal Reserve System.”

Ben Bernanke, the Fed Chairman during the global financial crisis, powerfully endorsed these views at Friedman’s 90th birthday celebration in 2002:

“Let me end my talk by abusing slightly my status as an official representative of the Federal Reserve. I would like to say to Milton and Anna: Regarding the Great Depression. You’re right, we did it. We’re very sorry. But thanks to you, we won’t do it again.”

Central to the views of Friedman and Bernanke is the assumed ability of the Federal Reserve, or any equivalent central bank, to broadly determine the money supply. In simple terms, as the controller of the effective dollar printing press, the Federal Reserve is assumed to be the exogenous controller of the quantity of dollars. In practice, the mechanism by which the Fed is assumed to exercise this control is familiar to all who have had the dubious pleasure of sitting through an economics class on the “money multiplier”.

As is invariably outlined for simplicity in such classes, assume that the reserve ratio set by the Fed for the banking system is 10 per cent and assume that the Fed wants to increase the money supply by $1,000.

Click here for part one of the series: “Nixon legacy still shaping our world: Part 1 – Rome to gold”

They begin by effectively printing or keystroking $100 to buy $100 of US Treasury bonds on the open market. The seller of the bonds deposits her $100 proceeds at her bank, which puts $10 aside as the ‘reserve’ and loans out $90 to a customer looking to pay his gas bill. The gas company deposits their $90 proceeds at their bank, which put $9 aside as the reserve and loans out $81 to a customer looking to go to the opera. The opera company deposits their $81 proceeds at their bank and the process continues until a total of $1,000 in “new money” has been “created” i.e. the policy objective of the Fed to increase the money supply by $1,000 has been achieved.

In practice, money creation runs in completely the opposite direction. Simply put, banks create money by granting loans, and crucially, this power is now effectively limitless.

The fact that banks in the US, the UK and elsewhere no longer need to meet any reserve requirements has no relevance to this debate. The crucial point is the direction of causation. The Fed seemingly determines the money supply with the private banking system meekly accommodating its wishes. Comfortingly, while Nixon may have smashed its age-old anchor, money nonetheless remains tethered to central bank control.

Unfortunately, for those comforted by belief in the wisdom and power of central banks, this conventional story of central bank control is false. In practice, money creation runs in completely the opposite direction. Simply put, banks create money by granting loans, and crucially, this power is now effectively limitless.

For example:

  1. A bank grants a loan of $10,000 to a customer to buy a car. The bank credits the current account of the customer, who writes a cheque for $10,000 to the seller of the car.
  2. The seller of the car deposits the cheque to her bank account. If this is the same bank as that of the car-buyer, this bank now has an asset in the form of the loan to the car-buyer, balanced by a liability in the form of the deposit from the car-seller.
  3. Alternatively, if the car-seller deposits the cheque at a different bank, the bank of the car-buyer will borrow $10,000 via the inter-bank market to transfer to the bank of the car-seller, and while having the same asset as before, it is now balanced in the form of this inter-bank loan.

The net effect of this process is that $10,000 has been created from nothing and is now circulating in the economy. The bank which granted the loan is profiting from charging a higher interest rate to its car-buying customer than it pays to either the car-selling depositor or, in the alternative case, to the inter-bank lender. This profit potential incentivizes the bank to repeat the process as often and to the largest extent possible.

In theory, the conventionally argued constraint on this is two-fold:

  1. The bank must fulfil a reserve ratio i.e. it must hold a certain percentage of its assets in “reserve” at the central bank. While in theory this enables the central bank to control the quantum of loans granted by the bank, in practice the central bank must acquiesce to the lending decisions of the bank by ensuring that sufficient reserves are always available for the bank to meet its reserve ratio. In practice, even in the era and in the countries where a reserve ratio exists, there is no reserve constraint on the bank loaning and thereby creating as much money as it chooses.
    This reality was summarized clearly by economist, Basil J. Moore in 1983:
    “Once deposits have been created by an act of lending, the central bank must ensure that the required reserves are available. Otherwise the banks, no matter how hard they scramble for funds, could not in aggregate meet their reserve requirements.
  2. The bank must also fulfil a capital ratio i.e. it must hold a certain percentage of capital, such as equity provided by its shareholders, to its assets such as loans. While again, in theory, this enables the central bank to control the quantum of loans granted by the bank, in practice, a bank determined to grant more loans is free to both increase its capital via retained profits and/or raise fresh capital without any interference from the central bank. In practice, there is little capital constraint on the bank loaning and thereby creating as much money as it chooses.

Small wonder that money has exploded since Nixon cut it free. Banks, and subsequently shadow banks and the broader financial system, are overwhelmingly incentivised to do little else.

Arguably, the economist, author and diplomat John Kenneth Galbraith made the most memorable statement of this reality when wryly reflecting on the extraordinary power of private banks in his 1975 book Money: Whence it came, where it went:

“The process by which banks create money is so simple that it repels the mind.”

Small wonder that money has exploded since Nixon cut it free. Banks, and subsequently shadow banks and the broader financial system, are overwhelmingly incentivised to do little else. For example, although unchanged for centuries, in less than four decades after the collapse of Bretton Woods bank assets/liabilities in the UK as a percentage of GDP exploded by a factor greater than five:

UK Banking Assets as % of GDP

Source: Sheppard DK (1971) and Bank of England

The then Governor of the Bank of England, Mervyn King, summarized this powerful dynamic at a speech in New York in 2010, Banking – from Bagehot to Basel and Back Again:

“The size of the balance sheet (of banks) is no longer limited…banks (can) manufacture additional assets (loans) without limit…Gross (bank) balance sheets are not restricted…”

We live in a world where almost all our money is borrowed into existence. Created endogenously within the private banking and broader financial system, this money is borrowed by governments, households and corporations at interest rates higher than that paid on the liabilities created.

Click here for part two of the series: “Bretton Woods to Dollar dominance”

Unsurprisingly, propelled by this compelling incentive and facing no effective constraint, the banking and broader financial system has unleashed an unprecedented money explosion.

Money explosion

The pithy insight of US economist Hyman Minsky is particularly helpful in grappling with this explosion: “Everyone can create money; the problem is to get it accepted”.

In practice, an unanchored global reserve currency, The Geithner doctrine, and privately created endogenous money have combined to overcome the problem. The unhindered capacity to create unlimited money – guaranteed by the major central banks, and therefore universally accepted – has unleashed an extraordinary money explosion.

In his 2015 book Other People’s Money: The Real Business of Finance, John Kay uses the more sobering term “financialisaton” to capture this phenomenon. Opening with an evocative description of the towering skyscrapers of Wall Street and the City of London, he poses the seemingly simple question about the activities of their well-rewarded occupants: “But what do all these people do?” With palpable bemusement, he then provides the answer:

“To an extent that staggers the imagination, they deal with each other… the assets of these banks mostly consist of claims on other banks. Their liabilities are mainly obligations to other financial institutions.”

While the detachment of the banking system from the real economy is remarkable, the behaviour of the broader financial system in exploiting its compelling incentive to create money is what really interests Kay:

“The finance sector establishes claims against assets – the operating assets and future profits of a company, or the physical property and prospective earnings of an individual – and almost any such claim can be turned into a tradable security.”

One of the most well-known examples was probably the Bowie Bond. The wily and much-missed singer raised $55 million from investors in 1997, secured on the future revenues of the 25 albums he recorded before 1990. Even more significantly, as outlined again by Kay, the creation of such securities fuelled the further explosion of “derivatives”:

“If securities are claims on assets, derivative securities are claims on other securities, and their value depends on the price, and ultimately on the value, of these underlying securities. Once you have created derivative securities, you can create further layers of derivative securities whose values are dependent on the values of other derivative securities – and so on.”

For the most devoted followers of the legendary investor Warren Buffett, the biggest date in the diary is the release of the Berkshire Hathaway annual letter to shareholders. Since the first letter in 1965, Buffett has used this often-ground-breaking missive to share his thoughts on a wide range of issues – none have proven as prescient as his offering in 2002:

“The range of derivatives contracts is limited only by the imagination of man or sometimes, so it seems, madmen… The derivatives genie is now well out of the bottle, and these instruments will almost certainly multiply in variety and number until some event makes their toxicity clear… We view them as time bombs, both for the parties that deal in them and the economic system… In our view, derivatives are financial weapons of mass destruction, carrying dangers that are potentially lethal…”

Ignoring Buffett, the explosion of mortgage-backed-securities and related derivatives in the run-up to the global financial crisis warrants special mention.

To the great shock of policymakers and investors around the globe, when some of these borrowers began to miss payments, the global financial system froze.

With customary aplomb, the process was summarised by the 2017 Nobel prize-winning economist Richard Thaler, and the actress Serena Gomez, in a famous scene from the 2016 movie The Big Short. Seated at a roulette table in a crowded casino, the unlikely duo explains the step-by-step explosion of the markets for mortgage-backed collateralised-debt-obligations (CDOs), synthetic CDOs, and credit-default-swaps (CDSs) – all securities or derivative securities ultimately dependent on a relatively small number of increasingly pressured US mortgage borrowers.

Click here for part three of the series: The Cold War, the Geithner doctrine and the travails of Deutsche Bank

To the great shock of policymakers and investors around the globe, when some of these borrowers began to miss payments, the global financial system froze, and the greatest financial and economic upheaval since the great depression followed.

Since the fuse was lit by Nixon, the unhampered financialisaton or money explosion has spawned an increasingly fragile economic system gingerly underpinned by a bewilderingly diverse array of densely interwoven and dizzyingly opaque promises.

Contrary to much conventional economic thinking, the all too familiar pattern of boom, bubble and bust should be little surprise.

Crucially, these promises are ultimately backed not by those who make them, but by the major central banks and their necessarily passive governments. The explicit reality of this unstable asymmetry, where the default of debtors must not be allowed to impact the bulk of their creditors, is arguably the central and enduring legacy of the global financial crisis.

In short, we remain hostage to a banking and broader financial system compellingly incentivised and effectively unhindered from exploiting a stacked “heads I win; tails you lose” relationship with the rest of society. Contrary to much conventional economic thinking, the all too familiar pattern of boom, bubble and bust should be little surprise.

Boom, bubble and bust

Shortly after the collapse of Lehman Brothers in September 2008, Queen Elizabeth opened a new building at the London School of Economics. Amid the gathered dignitaries, including some world-renowned economists, she famously asked the question about the dramatic crisis dominating headlines, and concerns, around the world: “This is awful. Why did nobody see it coming?”

In response, the British Academy convened a forum the following June of “experts from business, the City, its regulators, academia and government”, and summarised their answer in a letter to Buckingham Palace a month later.

Tellingly, the letter is more a summary of the confusion that gripped conventional thinking, than a satisfactory answer to the question. In truth, when the most serious financial and economic crisis since the great depression erupted, the response of conventional economic thinking can best be described as shock.

The period from the end of the Cold War until the global financial crisis had seemed to validate much conventional thought. More particularly, the march of globalisation, technology, financial innovation and free-market ideology had seemed to produce, and promise, a great moderation in the behaviour of the global economy. 

For financial markets and policymakers, the tantalising prospect that, in the words of then UK Chancellor Gordon Brown, “we have eliminated boom and bust” had seemed more a self-evident success than a theoretical aspiration.  When this proved delusional, the confession of long-time Federal Reserve Chairman Alan Greenspan to a congressional committee in October 2008 memorably captured the new, shaken mood:

“Yes, I’ve found a flaw (in my ideology). The modern risk management paradigm held sway for decades. The whole intellectual edifice, however, collapsed in the Summer of last year and the crisis has turned out to be much broader than anything I could have imagined.”

In a provocative speech in 2012, The Dog and the Frisbee, seeking to draw lessons for policymakers and regulators from the crisis, Andrew Haldane of the Bank of England neatly set the context for the enduring flaw in the thinking of Greenspan:

“Modern macroeconomics has its analytical roots in the general equilibrium framework of Kenneth Arrow and Gerard Debreu. In the Arrow-Debreu framework, the probability distribution of future states of the world is known by agents… Modern finance has its origins in the portfolio allocation framework of Harry Markowitz and Robert Merton. This Merton-Markowitz framework assumes a known probability for future market risk… Together, the Arrow-Debreu and Merton-Markowitz frameworks form the bedrock of modern macroeconomics and finance.”

Unfortunately, we don’t live in a world of the coin toss or the casino, where outcomes and their probabilities are known to us ex-ante. We live in a world of wrenching uncertainty where very often the most important outcomes are utterly unknowable. The trader, author and philosopher of uncertainty, Nassim Taleb, captures this clearly in his story of the turkey in the run-up to Thanksgiving:

“A turkey is fed for 1,000 days – every day confirms to its statistical department that humans care about its welfare ‘with increased statistical significance’. On the 1,001st day, the turkey has a surprise.”

In parallel with the discrediting of the Arrow-Debreu and Merton-Markowitz frameworks, the “financial instability hypothesis” of long-neglected US economist Hyman Minsky, first published in 1975, has been widely re-embraced.

While the details differ, there is little fundamental difference, for example, between the ‘South Sea bubble’ which so entranced the London of Isaac Newton, and the ‘property/credit bubble’ which so seduced the Ireland of Bertie Ahern.

The characterization by Minsky of the macroeconomy as a system prone to bouts of dramatic instability generated endogenously by the financial system, chimed with the experience before and after the collapse of Lehman. His key insight that stability can lead to instability plausibly captures the long post-Cold War stability, and its shuddering denouement. 

Financial crises have of course always been a feature of economic life. Certainly, since the advent of the modern market economy in the early 18th century, the pattern of vaulting boom followed by depressing bust has been a constant.

While the details differ, there is little fundamental difference, for example, between the South Sea bubble, which so entranced the London of Isaac Newton, and the property/credit bubble, which so seduced the Ireland of Bertie Ahern.

Unarguably, however, the post-Nixon world of endogenously created explosive money has turbocharged this pattern. According to the IMF, 147 individual banking crises have occurred between 1970 and 2011. More broadly, the global financial system has been rocked successively by the Latin-American debt crisis, the savings and loans crisis, the Nikkei collapse, the Asian crisis, the dot-com collapse, and the global financial crisis.

In the final piece of this series, I’ll discuss the impact of Nixon’s legacy on the stunning rise of China and then reflect a little on the future.