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 dot.com 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.

The world financial crisis: a programmer’s perspective

I wrote the piece below some ten years ago, during the height of the Asian financial crisis. Because of its relevance to the current global crisis, I’m posting the piece here.

Globalization: poor design?

by Roberto Verzola

Most successful designers of complex systems follow basic rules of design.

Whether it is a spaceship that will land men on the moon, or a worldwide network of ten million computers such as the Internet, or a huge computer program with fifty million lines of code, or a tiny computer chip with two million transistors on it, the design rules are surprisingly similar.

One of the most basic rules in designing complex systems is called modularization. The rule says one should break up a complex system into smaller parts. These smaller parts – usually called modules – should be more manageable and relatively independent from each other. The modules should interact only through a few well-defined interfaces. Each module should have high internal cohesion. The coupling between modules should be minimized.

A good example is the Apollo lunar mission. One of the most complex systems ever made by human beings, it used modularization all through out, from the design of the spaceship itself, to the electronic circuitry that comprised much of its automatic intelligence. The mission’s spectacular success is a tribute to the effectiveness of modular design.

Another example is the Internet, a computer network designed to survive a nuclear attack. Again, the basic rule in the design of the Internet was modularization. The Internet implements communications through relatively independent network layers which interact with each other only through well-defined interfaces. Internet communications protocols have also been broken down into simpler protocols. There is a protocol for transferring mail, another for news, and still another for files.

In economics, modularization means that countries should try to become as self-sufficient as possible and as independent from each other as possible. It means that interaction between economies should be minimized and should occur only through well-defined regulations. Coupling among economies should be minimal.

Globalization, the current trend among economic planners, violates the design principle of modularization. By tearing down “well-defined interfaces” between economies, globalization increases the coupling among countries and makes countries more instead of less dependent on each other.

A complex system with high interaction among its parts becomes more prone to system failures. It is difficult to modify and to improve. It becomes error-prone, yet the errors are more difficult to identify and to correct. In a poorly-designed system, attempts to correct errors often introduce more errors into the system, making it even more failure-prone.

From a systems view, a globalized economy is a badly designed economy. It will be prone to errors and failures. It will be difficult to maintain and to improve. Attempts at correcting its failures will result in even worse problems.

Look at the problems of today’s globalized economy. Because of the free movement of goods, diseases spread quickly from one corner of the globe to another. CFCs produced in one country damage the ozone layer and threaten the health of the citizens of other countries. Toxic wastes produced in the North find themselves being dumped in the South. Chernobyl’s radioactive emissions threatened the dairy industry of the rest of Europe. A stock market crash in the U.S. would probably send stock prices worldwide tumbling. Because of the free movement of capital, job insecurity as well as speculation has become a global problem.

These are all the consequences of the bad design inherent in a tightly coupled global economy.

Despite this, economists often insist that globalization is inevitable, and the best we can do is to adjust to it.

For a designer’s viewpoint, of course, there is no such thing as “inevitable.” Every design is the result of a conscious or unconscious effort. Poor designs become inevitable only because the designer relaxes on his rules, and adopts an “anything goes” approach. To the economist, on the other hand, relaxing the rules is called “liberalization”, “deregulation”, or “leveling the playing field”. And “anything goes” is called “free-market competition”. A relaxation of the rules then makes it easy to violate the basic principles of good design, and makes globalization inevitable.

Who want the rules relaxed? These are mostly the global corporations, the main beneficiaries of globalization. They are the equivalent of global variables in software.

Software engineers try to eliminate global variables or turn them into local variables. Because global variables can easily cause changes behind the back of the system designer, they make the whole system unreliable and crash-prone. When global corporations use transfer pricing to maximize profits at the expense of the host country, or when they switch to highly automated equipment and minimize local employment, or when they compete with local entrepreneurs for skilled labor or for bank loans, or when they suddenly pull out liquid assets for some reason or another, we are witnessing what system designers call the “undesirable side-effects of global variables.” Thus a fundamental rule in system design is to avoid global variables.

Faced with a badly-designed, non-modular system, designers frequently find it easier and more cost-effective to simply junk the design and to start from scratch.

Perhaps, this is what we should do with globalization.

[From Chapter 22, Towards a Political Economy of Information by Roberto Verzola]