To put things into perspective, even the lowest of these estimates ($4.6 trillion) is greater than the entire inflation adjusted costs of World War II borne by the United States. Indeed, WWII cost the U.S. at the time $288 billion, which adjusted for inflation would amount to $3.6 trillion today. It is even harder to believe, but true, that $4.6 trillion is higher than the inflation adjusted costs of the Louisiana Purchase, the New Deal and the Marshall Plan, the Korean and Vietnam Wars, the S&L debacle, and the NASA race to the moon combined!9
This begs the question: at what point do the costs for rescuing the bank system become unbearable? Governments learned in the 1930s that they can’t afford to let the banking system go under, as this brings down the entire economy. What they may learn in our times is that they can’t afford to save the banking system.
REREGULATION OF THE FINANCIAL SECTOR
As after every crisis, the political leitmotiv is to “ensure that it never happens again,” and the solution that is invariably proposed is to tighten regulations on banks to plug the holes through which the latest problem showed up. History shows, however, that we have engaged in the same cat-and-mouse game between regulators and banks for several centuries, actually since the beginning of handing the money issuance function to the private banking system. To be precise, while such reregulation may avoid the repetition of the identical traps and abuses next time, over time, new loopholes will be discovered or created, resulting in a new variation of the same type of banking crisis.10
In addition, massive and very sophisticated lobbying is mobilized to reduce the scope of reregulation, or to provide useful loopholes from the beginning. Let us take the example of Washington, because it is one of the few places where we do have relatively reliable numbers on lobbying. During the debate on reregulation of the U.S. banking system, more than three fulltime lobbyists were working for the banks for every elected official! Is it surprising that all the talk ended up with relatively marginal changes in the system?
CONVENTIONAL SOLUTIONS: NATIONALIZATIONS
There are two conventional ways for governments to prop up the banks’ balance sheets, both involving a form of nationalization. The first is nationalizing what Ben Bernanke called in his presentation to the U.S. Congress the banking system’s “toxic assets.” The second is nationalizing the banks themselves. Let’s briefly explore the advantages and disadvantages of both.
NATIONALIZING THE TOXIC ASSETS
This solution is invariably preferred by the banks themselves. It consists of either the government (in the initial Paulson bailout plan, for example, it is the U.S. Treasury Department) or a specially created institution funded by the government buying assets from the banks that they now want to jettison. Of course, determining the price at which these assets are purchased is a very tricky issue, particularly when a liquid market for such assets has dried up completely, as was the case in 2008.
Buying the toxic assets clearly doesn’t convince everybody as an appropriate remedy.11 It is also by far the most expensive solution, because it doesn’t take advantage of the leveraging factor available in the banking system. Consequently, the injection of money by the government as capital directly to the banks is a lot more effective financially.
NATIONALIZING THE BANKS
The second way to buttress the banks is by governments providing capital directly to banks themselves, either by buying stocks or by acquiring a newly issued preferred stock. In Europe, governments have typically taken the bank nationalization road: it was the option taken for instance in Sweden in 1992; and in 2008, first for Northern Rock in the UK, and then for a wide range of banks in all countries by mid-October.
There are two advantages in this approach compared to the previous one of nationalizing the toxic assets. First, thanks to the fractional banking system by which all money is created, when banks make loans to customers, they can create new money at a multiplier of the amount of capital they actually have. Consequently, if a bank’s “leveraging factor” is 10, then injecting $1 billion in the bank’s capital makes it possible for it to create at least $10 billion in new money, or carry $10 billion in problem assets. In fact, the multiplier is typically much higher. For instance, Lehman Brothers’s and Goldman Sachs’s ratio of assets to capital were respectively 30 and 26, before they both disappeared. Some European banks have had an even higher leverage: BNP Parisbas at 32; Dexia’s and Barclays’s both estimated at about 40; UBS’s at 47; and Deutsche Bank’s at a whopping 83.17.12 Therefore, very conservatively put, it is ten times more financially effective for governments to bolster the balance sheets of the banks directly than to buy toxic assets.
The second advantage to buying bank shares instead of toxic assets is that there is generally a market that indicates some relative value between different banks. In contrast, when the market for toxic assets has dried up, there is no such indication, and the decisions can be quite arbitrary.
The banks themselves, of course, prefer to avoid the dilution of bank equity and control that this approach implies. Politically, nationalizing the banks also sounds like the “socialization” of the economy, since the former communist states nationalized their banks. This ideological taint may explain why this approach was not initially considered in Washington.
UNRESOLVED PROBLEMS
The first objection to nationalizing banks or their toxic assets is the well-known “moral hazard” problem. If banks know that they will be saved when in trouble, they may be tempted to take higher risks than otherwise prudent. When these risks pay off, the profits are held privately and translated into generous dividends for the banks’ shareholders and extraordinary bonuses to management. But when they fail, the losses end up being absorbed by the taxpayers. The current salvage programs confirm that this problem hasn’t gone away and is unavoidably further strengthened by new bailouts. Christine Lagarde, minister of economic affairs, finances, and industry in France, stated, “Moral hazard has to be dealt with later … Maintaining the functioning of our markets is the top priority.”13 This is exactly the argument that pops up at every systemic crisis.
Secondly, even if both strategies—bailing out the banks and reregulation of the financial sector—were implemented reasonably well, neither resolves the “second wave” problem: The banking system will get caught in a vicious circle of credit contraction that invariably accompanies the massive deleveraging that will be needed. Depending on how the reregulation is implemented, it may actually inhibit banks from providing the finances needed for a reasonably fast recovery of the real economy. In any case, given the size of the losses to be recovered, it will take many years, in the order of a decade, certainly more than enough time to bring the real economy into real trouble.
In practice, this means we are only at the beginning of a long, drawn-out economic unraveling. The social and political implications for such a scenario are hard to fathom. The last time we faced a problem of this size and scope was in the 1930s, and that event resulted in social and economic problems that ended up manifesting violently in a wave of fascism and ultimately World War II. Still, there are important differences vis-à-vis the situation of the 1930s. So far, the situation is less extreme economically, in unemployment and business bankruptcies, than what happened in the 1930s. On the other hand, governments are now a lot more indebted than was the case at the beginning of the Great Depression, and today’s crisis is a lot more global than was the case then.
More important still, a financial/banking issue isn’t the only one we have to deal with. It happens to coincide with several major global challenges, by now generally accepted: climate change and mass species extinction, the increase of structural unemployment, and the financial consequences of unprecedented aging in our societies. In some respects, therefore, today’s crisis is less dramatic, and in others far worse than what the previous generation had to face.
NATIONALIZING THE MONEY CREATION PROCESS
Nationalizing the money creation process itself is an old proposal; tho
ugh a less conventional approach, it reappears periodically in the “monetary reform” literature, particularly during periods of major banking crises such as the 2008 crisis. For historical reasons, the right to create money was transferred to the banking system as a privilege, originally to finance wars during the seventeenth century. So, contrary to what some people believe, our money isn’t created by the governments or the central banks: it is created as bank debt. When banks are private, as they are in most of the world, the creation of money is therefore a private business. If the banking system abuses this prerogative, this privilege could or should be withdrawn. The logic is not new: money is a public good, and the right of issuing legal tender belongs at least theoretically to governments.
So, while bailing out the banking system through nationalizing banks or nationalizing the problem assets is the classical policy choice, it can also be expected that proposals for nationalizing the money creation process itself will reemerge, as they have in previous predicaments, including the 1930s. Under a government-run monetary system, the governments would simply spend money into existence without incurring interest at its creation; banks would become only brokers of money they have on deposit, not creators of money, as is the case now.
This would definitely make systemic banking crises a problem of the past. It would also make it possible to relaunch the economy through a large-scale Keynesian stimulus at a much lower cost to the taxpayers, given that the money thus created wouldn’t require interest payments to be reimbursed in the future.
One objection to a government managing the monetary system is that governments may abuse this power, issue more money than is appropriate, and thereby create inflation. That argument is valid. However, given that the current method of creating money through bank-debt made the twentieth century one of the highest inflationary centuries on the historical record, inflation is obviously not a problem specific to the process of money issuance by governments. Furthermore, there is no reason that Milton Friedman’s proposal for the issuance of money by the central banks couldn’t be applied to governments as well: put in place a rule that obliges the issuing body to increase spending by no more than a fixed 2 percent per year, reflecting the improvements of productivity in the economy.
The most important reason that this solution is unlikely to be implemented is that it will be doggedly resisted by the banking system itself. The financial system has always been and remains today a powerful lobby, and losing the right to create money would hit it at the core of its current business model.14
Our own objection to this solution is that, even if governments were to issue the money, while that might protect us from banking crises, it would nevertheless not solve the core systemic problem of the instability of our money system. In short, it might protect us from banking crises, but not from monetary crises.
UNDERSTANDING SYSTEMIC STABILITY AND VIABILITY
The solution we propose below is new, and relates to the identification of the fundamental systemic reason for our monetary and financial instability. Understanding this solution, however, requires that we review some evidence as to why a systemic problem is likely, that we develop a scientifically sound understanding of its nature, and, finally, that we identify effective ways to address the trouble.
The good news now is that we know a lot more than in the 1930s, and that we have many more tools available than even a decade ago. Consequently, it is now possible to identify the deeper underlying systemic causes as well as a new way to deal with them. Furthermore, this new way is one that governments can afford, and that actually addresses a number of other social and economic issues that exist even when there is no financial crisis.
At first sight, it may not be the bankers’ preferred solution, but it would actually stabilize their own portfolios while structurally stabilizing the economies of the world. It would also give them a whole new line of business, in activities that would be particularly attractive for local and regional banks. Introducing such a systemic solution is the only way to avoid periodically repeating the banking crisis exercise, which all conventional approaches are condemned to do because they deal only with some of the symptoms, and not the cause.
BEYOND THE BLAME GAME
A lot of energy and ink have been spent trying to allocate the blame for this disaster. Greed in the financial sector, lack of oversight by regulators, policies that overemphasize deregulation, and incompetence at various levels have all become favorite targets. Our view is that any or all of these may indeed have played a role, but at the core we are dealing, as already stated, with a much deeper systemic issue.
Floating exchanges rates, introduced by President Nixon in 1971, were the last structural change introduced into the global monetary architecture, and are increasingly being blamed as another cause for the instabilities. However, even before this period, boom-and-bust cycles involving banking and monetary crises were, in Charles Kindleberger’s words, a remarkably “hardy perennial.” Kindleberger inventories no less than forty-eight massive crashes, ranging from the 1637 tulip mania in Holland to the 1929 crash on Wall Street.
Such repeated financial breakdowns, in very different countries and times, under different regulatory environments, and in economies with very different degrees of development, should be seen as a first telltale symptom of some underlying systemic or structural problem.
If such a deeper issue is involved, it would explain why each new set of regulations achieves, at best, a reduction in the frequency of banking and monetary crises, without getting rid of them or their horrific economic and socio-political costs. If such a deeper structural problem exists, it would also explain why even some of the brightest and best-educated people on the planet have not been able to avoid major financial catastrophes, however diligently they do their work, whether on the regulatory or on the financial services side. Finally, if our money system is indeed a structural “accident waiting to happen,” then even if it were possible to perfectly control greed through innovative, tight regulations, this could only defer when the next disaster would hit.
STABILITY AND SUSTAINABLE VIABILITY IN COMPLEX FLOW SYSTEMS
We now have scientific evidence that a structural issue is indeed involved. The theoretical origin of this evidence may be surprising to the economic or financial community, although it wouldn’t be such a surprise for scientists familiar with natural ecosystems, thermodynamics, and complexity or information theory. The science that explains this issue rests on a thermodynamic approach with deep historical roots in economics.15
In this view, complex systems, such as ecosystems, living organisms, and economies, are all seen as matter-, energy-, and information-flow systems. For example, the famous food chain is actually a matter-/energy-/flow-network built of complex relationships among organisms. Plants capture the sun’s energy with photosynthesis; animals eat the plants; species then eat each another in a chain to top predator; only to have all organisms die, decompose, and have their energy/matter be recycled by bacteria. Similarly, economies are circulation networks consisting of millions of businesses and billions of customers exchanging different products and services, which when taken as a whole, are supposed to meet the needs of all participants.
For the past twenty-five years, major progress has been made on understanding what makes natural ecosystems sustainable or not. This work is the natural extension of Nobel Prize–winning chemist Ilya Prigogine’s and Club of Rome cofounder Erich Jantsch’s work with self-organizing energy-flow systems. In fact, according to Kenneth Boulding, many early economists held energy-based views of economic processes. This changed when those who favored Newtonian mechanics during the late nineteenth century (such as Léon Walras and William Stanley Jevons) turned economics into today’s familiar views on the mechanics of “rational actors” and the reliable self-restraint of general equilibrium theory, an approach which completely dominates not only practically all of today’s mainstream academic economic literature, but also the boardrooms and politi
cal venues of the world.16
A growing body of empirical and theoretical work, published under different academic banners such as self-organization theory, universality theory or nonlinear dynamics, shows that all flow systems follow certain universal principles and patterns.17 Consequently, as Sally Goerner says about universality: “all [flow] systems, no matter how complex, fall into one of a few classes. All members of a class share certain common patterns of behavior.” Similarly, Predrag Cvitanovic explains, “The wonderful thing about this universality is that it does not matter much how close our equations are to the ones chosen by nature; as long as the model is in the same universality class … as the real system, both will undergo a period-doubling sequence. That means that we can get the right physics out of very crude models.”18
The existence of parallel patterns and dynamics explains why similar energy-flow concepts and analysis methods apply to economic systems as well as natural ones. Decades of studying natural ecosystems, in particular, have led to very sophisticated mathematical understandings of how a network structure affects an ecosystem’s long-term viability, as judged by its balance between efficacy and resilience. Efficacy measures the ability of a system to process volumes of the relevant matter-, energy- and/or information-flow.
Resilience measures the ability of a system to recover from a disturbance. These variables have been more formally defined as follows:
Efficacy: a network’s capacity to perform in a sufficiently organized and efficient manner as to maintain its integrity over time;19 and
Resilience: a network’s reserve of flexible fallback positions and diversity of actions that can be used to meet the exigencies of novel disturbances and the novelty needed for ongoing development and evolution.20
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