Something stands out when one tries to understand the roots of the economic crash and the following crises that are currently engulfing Europe and the U.S.  It is how money is created. There are two related elements to this. One is what the bank does if you go to it and ask for a loan for a business, mortgage, etc., and the second is fractional reserve banking. Without some knowledge of these two tools of finance, no true understanding of the way the economic system works or the crash is possible.

The campaigning group Positive Money explains that in the U.K., only 3% of the money supply is in the form of notes and coins created by the government. The rest, 97%, is electronic money created by banks out of nothing when they make a loan. It is created by typing the amount on a computer and crediting it to your account. The interest charged varies, and in the case of loans on credit cards it is exorbitant. With this power at hand, it is not surprising that banks use the hard sell to get people to take loans. An enormous part of the money created in this way, hundreds of billions of pounds over the 10 years before the crash, found its way into financing mortgages for housing, which grew from 1997 to2007 by 370%. Hundreds of billions more of this new money went into financial services and casino type banking. “Meanwhile,” the group notes, “lending to businesses has stagnated, harming the real economy and lowering employment and growth”.

This enormous increase in the money supply for mortgages inflated the price of housing by 200% over this period.  During the same period, the population grew by 5%, and the number of houses by 10%, so it is clear where the blame lies for rocketing house prices.  As households spend more to keep a roof over their heads, less money is spent on the other necessities of life, thus depressing demand and contributing to the recession. How much money have U.K. banks created?

“[UK] Banks created over £567bn in 2007 alone. As a result of this reckless money creation, the total amount of money (and therefore debt) in the economy has doubled in a little under 8 years—from around £1 trillion in 2001 to over £2 trillion in 2009. Shockingly, only 8% of this created money goes to businesses which contribute to GDP. The vast majority of the rest is used to speculate on house prices and financial assets.”

One can see that if you want to create a bubble economy that enriches the banks, but starves the wealth creating sector, you would be hard put to devise a better system. The bursting of the bubble becomes inevitable, leading to the misery and ruin of millions of lives.

Fractional reserve banking is the other wheeze bankers have at their disposal, to maximize their profits regardless of the effects it could have on the economy of a nation. This is where the banks keep a percentage of the money deposited and lend the rest.  It sounds perfectly reasonable theoretically as we don’t all want to draw out our money from the banks at the same time.  However, when one considers what could actually happen, a different picture emerges.

Here is how it works: let us assume the reserve ratio is 10%. Customer A deposits £100 in the bank. The bank lends £90 to customer B who deposits the £90 in his/her account which may be in any bank. His bank then lends £81 (90% of £90) and so on. Theoretically the £100 deposit could become equivalent to £1000 (100+90+81+£72.90+…..). The reserve ratio in the US is 10%, while the UK holds a voluntary reserve ratio and the average has been at around 3.1%. That implies the £100 deposit in a UK bank could expand to a value of over £3000.

The more one reads about all of this, the more incredulous one becomes, that in a democratic society where we elect governments to look after us such power should be given to the banks.

Regulations that are supposed to prevent abuse were relaxed to the point where governments had no idea what the bankers were doing.  Combine all of that with the notion of “too big to fail” and it is not difficult to see why the crash happened, and barely affected the 1% masters of the universe.

Changes and reforms of such a system must go to the heart of the problem, namely the enormous power given to the banks to create money out of nothing.  Removing that power is essential for the economic health of a nation. This is how Positive Money puts it:

“Removing the power to create money from the banks would end the instability and boom-and-bust cycles that are caused when banks create far too much money in a short period of time. It would also ensure that banks could be allowed to fail without bailouts from taxpayers. It would ensure that newly-created money is spent into the economy, so that it can reduce the overall debt-burden of the public, rather than being lent into existence as happens currently.”

Will our politicians, from whichever party, push for these reforms and save us from the misery of the collapse of the next bubble?  I am not holding my breath.