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"The Heart Of The Economic Disorder Is A World Financial System That Has Gone Rogue"

By Will Hutton, originally posted in The Guardian

The world economic order is collapsing and this time there seems no way out

Europe has seen nothing like this for 70 years – the visible expression of a world where order is collapsing. The millions of refugees fleeing from ceaseless Middle Eastern war and barbarism are voting with their feet, despairing of their futures. The catalyst for their despair – the shredding of state structures and grip of Islamic fundamentalism on young Muslim minds – shows no sign of disappearing.

Yet there is a parallel collapse in the economic order that is less conspicuous: the hundreds of billions of dollars fleeing emerging economies, from Brazil to China, don’t come with images of women and children on capsizing boats. Nor do banks that have lent trillions that will never be repaid post gruesome videos. However, this collapse threatens our liberal universe as much as certain responses to the refugees. Capital flight and bank fragility are profound dysfunctions in the way the global economy is now organised that will surface as real-world economic dislocation.

The IMF is profoundly concerned, warning at last week’s annual meeting in Peru of $3tn (£1.95tn) of excess credit globally and weakening global economic growth. But while it knows there needs to be an international co-ordinated response, no progress is likely. The grip of libertarian, anti-state philosophies on the dominant Anglo-Saxon political right in the US and UK makes such intervention as probable as a Middle East settlement. Order is crumbling all around and the forces that might save it are politically weak and intellectually ineffective.

The heart of the economic disorder is a world financial system that has gone rogue. Global banks now make profits to a extraordinary degree from doing business with each other. As a result, banking’s power to create money out of nothing has been taken to a whole new level. That banks create credit is nothing new; the system depends on the truth that not all depositors will want their money back simultaneously. So there is a tendency for some of the cash banks lend in one month to be redeposited by borrowers the following month: a part of this cash can be re-lent, again, in a third month – on top of existing lending capacity. Each lending cycle creates more credit, which is why lending has always been carefully regulated by national central banks to ensure loans will, in general, be repaid and sufficient capital reserves are held.

The emergence of a global banking system means central banks are much less able to monitor and control what is going on. And because few countries now limit capital flows, in part because they want access to potential credit, cash generated out of nothing can be lent in countries where the economic prospects look superficially good. This provokes floods of credit, rather like the movements of refugees.

The false boom that follows seems to justify the lending. Property prices rise. Companies and households grow overconfident about their prospects and borrow freely. Economies surge well above their trend growth rates and all seems well until something – a collapse in property or commodity prices – unravels the whole process. The money floods out as quickly as it flooded in, leaving bust banks and governments desperately picking up the pieces.

Andy Haldane, Bank of England chief economist, describes the unfolding pattern of events as a three-part crisis. Act one was in 2007-08 in Britain and the US. Buoyed for the previous decade by absurdly high inflows of globally generated credit that created false booms, they suddenly found their overconfident banks had wildly lent too much. Collateral behind newfangled derivatives was worthless. Money flooded out, leaving Britain’s banking system bust, to be bailed out by more than £1tn of liquidity and special injections of public capital.

Act two was in Europe in 2011-12, when it became obvious that the lending had been made on the incorrect assumption that all eurozone countries were equal. Again, money flooded out and Europe only just held the line with extraordinary printing of money by the European Central Bank and tough belt-tightening measures in overborrowed countries such as Portugal, Greece and Ireland. It might have been unfair, but it worked.

Now act three is beginning, but in countries much less able to devise measures to stop financial contagion and whose banks are more precarious. For global finance next flooded the so-called emerging market economies (EMEs), countries such as Turkey, Brazil, Malaysia, China, all riding high on sky-high commodity prices as the China boom, itself fuelled by wild lending, seemed never-ending. China manufactured more cement from 2010-13 than the US had produced over the entire 20th century. It could not last and so it is proving.

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Not surprisingly, this article concludes with the latest official request for monetary paradrops, just as we have said all along is the endgame, just as Macquarie confirmer last night. Because before the entire financial system collapses, everything will be tried in the one last, very desperate - and ultimately futile - effort to preserve it.

Readers can read the full article here.