Roots of the financial crisis: overproduction?

At a large meeting of civil society / non-government organizations last November 11 in the University of the Philippines campus, I was particularly interested in the presentation of the main speaker, Dr. Walden Bello, who thought that the root of the crisis was due to the “capitalist crisis of overproduction”. This analysis has its origins of course in Karl Marx’s critique of capitalism. Walden’s analysis was generally echoed by speakers like Ric Reyes and Frank Pascual, who like Walden are key personalities of the legal Philippine Left. Walden cited data showing how most Western countries had their production facilities running way below capacity. A number of the meeting panelists and participants thought it was time to wave once more the banner of socialism.

While we in the Philippine Greens are not socialists (see my post on the Green-Red dialogues), I have also been looking closely at the phenomenon which they call “overproduction” but which to me suggested “abundance” (see my posts on “abundance“). So I was interested in engaging Walden further in a discussion.

In a subsequent group discussion led by Walden himself, I presented my question framed in the following context:

I agreed that it was important to identify the roots of our current problems. (We’d be wasting much of our time and resources if we focused on symptoms rather than root causes. Worse, making a wrong diagnosis and directing efforts at wrong causes might even make the problem worse.) But I didn’t think the current crisis was due to overproduction, which typically refers to commodities and material goods. Rather, the crisis was due to “overproduction” of money and credit, particularly the latter. (I was stretching the meaning of “overproduction” here.) Governments — the U.S., in particular, because of its huge expenditures associated with the wars in Iraq and Afghanistan — were printing too much money and private firms like banks and credit companies were creating too much money. To me, all these money creation, without the corresponding blood, sweat and tears that we ordinary people have to go through to earn money, was pure theft. When someone can simply create money to exchange for things we worked hard to create or earn, they are stealing from us pure and simple. It is this “toxic” money, not associated with the production of real goods but simply created out of nothing, that leads to hyper-inflation and speculative bubbles.

Then I asked Walden what he thought of proposals which some of us in the Philippine Greens have raised to control the above, such as to return to a metallic (say, gold) standard for money, and to raise the fractional reserve requirements of banks (limiting their capacity to create credit out of nothing), and to restrict the operations of credit card and similar companies.

Walden focused his answer on the overproduction issue and reiterated his data about undercapacity in Western countries. He also said Central Banks are restricted in their capacity to print money. U.S. money was instead coming increasingly from Asian (principally Chinese) sources. He also said the gold standard was part of the Bretton Woods agreement, which U.S. President Nixon in turn abandoned in the 1970s. Since the Bretton Woods agreement carries a negative connotation among IMF/World Bank critics, I took this to mean Walden didn’t want going back to the gold standard. Unfortunately, we didn’t have time for a deeper discussion.

It seemed to me many participants and maybe even some panelists did not understand the implications of fractional reserve banking and therefore were unable to appreciate the proposals I raised. If my guess is right, then they would be in no position to understand the real roots of the global financial crisis either.

In a banking system with a fractional reserve requirement of, say, 10% (i.e., 10% of all deposits must be kept in reserve, the rest can be loaned out), the banking system can theoretically lend not 90%, as most people think, but ninety over ten or nine times (yes, 900%!) the total deposits. Where did the additional 810% come from? Out of nothing. The banks can earn real money in interest out of this credit money they created out of nothing. So while ordinary people like us have to devote real time and effort to earn a monthly income or to produce real goods to sell to the market, the rich set up banks that create money out of nothing which they then lend out to earn real money from the interest income, which they can use to hire real employees and buy real goods.

As I said, this is theft pure and simple.

Anyone who wants to understand the whole process must read about fractional reserve banking from any textbook on banking and finance.

The lower the reserve requirements, the more credit money the banks can create out of nothing. This is the source of most financial bubbles. Whether it is the bubble, real estate bubble, housing bubble, or stock market bubble, they are all in the last analysis funded by credit money which banks create out of nothing. These bubbles can exist and persist as long as people trust the system and keep their deposits in banks. Once that trust is lost, the bubbles burst, and those who cannot get out their deposits in time are left holding an empty bag (or the burst balloon).

I realized that many participants and some panelists did not understand this whole process because the proposal to adopt the Islamic banking system was raised and seriously discussed. While the Islamic system of not charging any interest is not bad in itself, it reflects the idea that charging interest itself is bad. This is a debatable point. When you lend real money (i.e., money you worked hard to earn), I think it is reasonable to charge some interest for the usual reasons (risk, overhead, etc.). But to charge interest on money created out of nothing, that’s theft.

This is what creates financial bubbles, and this is what the proposal of some Greens is directed against (I say “some” because it has not been officially adopted by the Philippine Greens).

If you want to understand the credit bubble, you must understand fractional reserve banking.



  1. Posted November 14, 2008 at 6:40 pm | Permalink

    Of course I agree entirely with your statement regarding the importance of getting the “right” conceptualisation for any problem: In my experience, the road to hell really is paved with good intentions. So the “right” analysis of context and language within which the “problem” is formulated is essential -if the “solution” is to be prevented from making matters even worse.

    In this context, it was interesting to see (from your account) how you tried to persuade Walden Bellow to reconceptualize his approach -and how he apparently resisted your efforts. It seems to me that this demonstrates a general trend in human nature -a resistance to “thinking around the problem” if it undermines one’s own (financial, emotional or intellectual) “vested interests”. Presumably, there can be many differenrt foundations for this, including a person’s intellectual and emotional backround, professional training and political allegiance. Quite often it seems that dealing with the personal prejudices and preferences of the individuals concerned (within a social hierarchy) forms a large part of any group problem solving process. Indeed such “personal” (personality) problems can severely inhibit “rational” problem solving.

    This all suggests that only very trivial “problem solving” involves a single “problem” (or a single solution). Usually (in any practical context) we are faced with a hierarchy of problems -all of which need to be provided with a “solution” before the main problem can be tackled. From experience, it seems that a large part of this “hierarchy” involves the social structure of the problem solving group and the conceptualisation of the problem itself. However, an important part of the problem solving hierarchy also involves the (culturally determined) modes of thinking of those participating in the process

    Applying these thoughts to your account of the “discussion” with Waldon Bellow -it would seem that high up in the hierarchy is the “problem” of the way people discuss “problems” (and their “solutions”). Often these discussions do not seem directed at “problem solving” but at “face saving” for the participants. So defending one’s (ideological) position becomes more important than exploring the real issues involved.

    Presumably, this problem (of conflictual and not exploratory discussion) is the result of a deeply rooted western philosophical belief in the existance of a single “universal” truth. In turn, this leads to the assumption that if you and I disagree -then one of us must be wrong and so the discussion degenerates into a “proof” of who is the right and who is (logically) wrong. Like a medieval trial by combat -the opponents “slug it out” and assume that the winnar (by divine intervention) is always right. The idea that both may be “wrong” -or both could also be right never seems to enter anybody’s mind. Presumably because in a binary truth system such things are a logical impossibility and questioning the “truth” of the logic system involved is not generally seen as a useful part of the battle of opposing ideas.

    In my view, instead of arguing over what might be the (single) solution to whatever the problem is concidered to be -it would be more useful to try and understand better how the various concepts and proposals involved might relate to each other and, especially, what exactly they might (partly) contribute to a “solution” regarding (which of) the problems being investigated: It is probably true that understanding the fractional reserve system may be essential to understanding the credit bubble -but is the “credit bubble” the “real” (and only) problem underlying the current “financial” problem? What exactly is the “problem” -and what are perhaps mere symptoms of the problem?

    How, for example, does the current credit bubble relate to other “bubbles” -such as the earlier “South Sea bubble” and the Dutch Tulip bubble -both of presumably happened long before Bretton Woods and the “fractional reserve” system were introduced? How do these “early” bubbles relate to the “dotcom” and later bubbles? Are there common factors (that go beyond Bretton Woods and the fractional reserve system)? Is there perhaps a “deeper” problem involved somewhere?

    It seems to me that the current global economy appears to be fundamentally built on the principles of a pyramid scam: As long as everybody keeps building the pyramid then it continues to grow -but as soon as somebody the system, then the whole thing collapses. If this is true -then there is also a powerful ‘ideological’ element involved (a belief in the pyramid system -and perhaps a love of the pharaoh buried underneath it). Propaganda seems to be the only thing propping up the whole construction process.

    However, how this pyramid/propaganda process relates to “overproduction”, “abundance”, Bretton Woods and the third socialist international -I’ve no idea. On the other hand, I suspect that exploring the connections (and definitions imbedded in the concepts involved) might ultimately prove more useful than fighting for one’s (perhaps arbitrally chosen) corner.

  2. Roberto Verzola
    Posted November 15, 2008 at 11:30 pm | Permalink

    Hi Trevor,

    Part of my work involves conducting a 3-day basic course on sustainability. One of the things we do in the course is to simply list problems of Philippine society, as the participants see it, and then rank them by how often they were cited. We then focus on the most-cited problems. We split into smaller teams and each team is asked to draw arrows between problems to indicate cause-effect relationships, to identify causes and effects and to get the team to focus more on causes, especially root causes (i.e., causes higher up the cause-and-effect chain).

    It is interesting that many such diagrams end up not with a hierarchy of problems (i.e., a problem tree) but a web of problems, creating circular and interlocking cause-and-effect chains where there is neither root cause nor final effect.

    We use this exercise to introduce the concept of what we call “systemic problems”, problems which are so interrelated that each one is mutually reinforced by others. You may manage to solve a single problem, but if the other problems persist, then the problem you solved will tend to reemerge, because its causes have not been eliminated.

    The message here is that systemic problems have no simplistic solutions but must be solved together.

  3. Roberto Verzola
    Posted November 16, 2008 at 10:27 pm | Permalink

    Hi Trevor,

    I checked the bubbles you are referring to. The Dutch tulip bubble occurred in 1637, simply because of a public craze about tulips, it seems, which briefly led to astronomical tulip prices. The South Sea bubble hit Britain in 1720, based on a trading monopoly granted by the British government to South Sea company. High public expectations pushed the company’s stocks high-sky for a while.

    I get your point that these bubbles are not due to fractional reserve banking (FRB). A public craze feeds on itself, drives the price of the target commodity upwards, until the craze spends itself out and the prices collapse.

    My point is that FRB makes bubbles inevitable. (I don’t think tulips or monopolies do.) I compare FRB to the game Trip to Jerusalem, where you give players in a circle one less chair than the number of players, and everytime the music stops, every player must find a chair. There will always be one who won’t. FRB with a 10% reserve requirement is somewhat worse, because banks can lend 9 pesos for every 1 peso deposit. Nine players will be fighting over one chair when the music stops (i.e., the public loses confidence). The Dutch tulip and South Sea bubbles need not have happened. But FRB makes bubbles inevitable.

    My main argument against FRB however, is not that it makes financial bubbles inevitable, but that FRB institutionalizes theft. It enables private banks to create credit money out of nothing, and then to charge others interest fees when that money is loaned out and to confiscate collateral from borrowers unable to pay back their loans.

  4. Posted November 17, 2008 at 4:04 pm | Permalink

    Hi Obet,

    Regarding comment 2:

    The exercize you describe above is exactly the kind of systematic (Systems Theoretical) approach that I was advocating: By “hiararchy” I meant a “layered” system (involving different “levels” -with some things being contained within others like a chest of drawers with boxes full of boxes inside the drawers) -not specifically an umambiguously separated system where each item could be specifiesd as being “above” or “below” another. I’m afraid that I don’t know a good name for such a “layered” system (which can be found in the “directory structure” of every computer).

    To be honest, I suspect that useful disciplines like “Systems Theory” have become perhaps deliberately removed from public conciousness because they would be too effective in undermining the dangerious ideology of consumerism -as developed and projected in the “information age”.

    Regarding comment 3:

    I’m afraid that here too, the ancient ghost of “concrete/abttract” is still haunting the discussion:

    If we apply the above “systematic” thinking to the “problem” of FRB -then presumably (as I believe we both agree) we see that there were bubbles previous to the FRB and these got institutionalised by the FRB system. Surely this implies that there is some “mechanism” (human or otherwise) that is “outside” (bigger than) the FRB -which (for some reason) it was felt by (a person or persons unknown) to be good to institutionalise.

    Therefore, perhaps in order to understand the FRB it might be interesting to look at the wider context and try and pin down what exactly the (mental, physical, financial, etc.) “mechanisms” were that lead to the institutionalisation of these apparently dangerous practices. Of course, it might also be useful to have detailed understanding of what exactly was institutionalised (and why) as this might (in turn) help to uncover the “needs” that lead to the creation of FRB in the first place.

    Presumably, if one focusses too much on the FRB itself -then one might miss important mechanisms operating outside (and prior to) the FRB. Indeed, this is an important part of a magician’s bag of tricks -getting people to concentrate on one thing so that they miss the real manipulation process happening elsewhere.

    It seems that our minds are great magicians -so we need to be very careful if we are to be sure that they are not playing tricks on us (and others).

    As you say above -when problems are “systemic” then indeed, arguing over “cause and effect” and focussing too much on one aspect of the problem can make it impossible to understand the complex interactions that create the “effects” that mesmerize us.

    Unfortunately, we only have limited time to study such things. This means that getting the language and methodology right so that we are able to interface with others (with different perspectives) in productive ways then becomes an additonal “layer” in the complex problem solving process.

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