Skip to content

Why are we in a global financial crisis – The Problem with Orthodox Economic Theories

I am copying and posting the entire of the following blog as I want nothing to stand in your way of this essential reading.  But do go to Simon Dixon’s new website to read his other  equally thorough and clear posts on the fundamental causes of the financial crisis. Emer O’Siochru

By Simon Dixon

Today, as I write, the new merged UK banking giant Lloyds has underestimated the loss that is about to be incurred as a result of the merger with HBOS. The banking giant has received a huge bailout selling more shares to the government and is on its way to being yet another private bank doomed to nationalisation.

On the television I hear no mention of why this might be apart from propaganda trying to make the public angry about the CEO’s who have taken too much bonus and ’caused’ all this mess. It is very easy to divert attention away from our unsustainable system by blaming the crisis on greed when you have every newspaper and television show focusing on greed as the cause.

We are in this mess because as mentioned in prior posts we are running our economy on economic theory that does not work. Orthodox economic theory refuses to recognise that almost all of the money in our economy is created as a debt through loans. This is what a banking licence permits you to do. We are in a global financial crisis as our economy thinks that the cause is greed and lack of regulation and the cure is to take on huge fiscal burdens, leading to the nationalisation of banks so we can implement further regulation.

Nobody discusses that our economy is built upon an unsustainable foundation that will inevitably lead to a financial crisis. We do NOT need to nationalise our banks we do need to nationalise our money supply. We are here not because of some conspiracy theory about the banks or excessive greed, we are here because of our philosophy of how we should run our economy and our theory of how we should control the amount of money in our economy.

There is a huge problem with orthodox economic theories – they don’t work in the real world and the global financial crisis is evidence of this. Economists must recognise the significance of the fact that almost all money in our economy has been created through debt, debt that can never be repaid without a complete depression, if we are to get anywhere near a solution and to reach sustainable economics. Economics must question the foundation of theories such as the multiplier and the quantity theory of money and start to look at the facts. This article discusses some of the problems with orthodox economics and how it has contributed to the current global financial crisis and our philosophy of more debt, more bailouts and more bubbles to turn around our economy.

To set the foundation on current thought, as we speak the government is in the midst of decreasing interest rates until we inevitably reach zero (Monetarism in order to stimulate consumer and corporate debt), bailouts and huge stimulus packages (Keynesian fiscal policy in order to increase the national debt) and the new one is quantitative easing (The Bank of England creating money out of thin air to buy government debt). All these policies are aimed at creating more debt, because the reality is – our economy needs more debt to sustain growth and prevent a depression under our current debt based economy – take away the debt and there is nothing because almost all of our money supply is created through debt – no debt, no money. As you all know I am not against debt, I am against mixing up debt with supplying money to our economy – a task that must be nationalised. Money is far too important not to be supplied through the public sector. This system is only justified through orthodox economic theories and our misunderstanding about how to supply money to our economy as discussed below.

Traditional Money Theory

Orthodox economics does not recognise the importance of almost all of the money in our economy being created as a debt to a bank. Under the current system if our economy wants more money, we need to create more debt. More debt means more interest to be repaid. More interest to be repaid means less purchasing power. Less purchasing power means more debt to survive and so on and the cycle continues. These facts need to be incorporated into economic theories of money.

The first thing to recognise in such a debt based system is that money borrowed is not money lent; it is money created. Economists know this, but fail to apply it throughout their discipline. At the heart of the economy is money, and at the heart of modern economies is a misunderstanding about money. This misunderstanding comes from some of the theories outlined below.

The Multiplier

The suggestion that banks create money was once regarded as pure fantasy by both bankers and economists, who insisted that banks merely lend money. However, modern economics textbooks are quite open about the process. The ability of banks to multiply the quantity of money beyond the amount originally deposited with them is given an accepted title – ‘the multiplier effect’.

In conventional theory, the multiplication of money is not seen as being open-ended. Money creation by banks and building societies is not seen as an expanding process in which money created by past loans is perpetually recycled, re-loaned, providing an endless supply of new money, building up into a vast infinitely ballooning total f money and debt. The entire system is supposed to be self-limiting, with controls and restrictions built into it. According to theory, it ought not be possible for an economy to operate on 97% bank-created credit as it is today. According to theory, the money supply ought not to have been able to inflate with no more than 3% contribution from the government. According to theory, such vast multiplication should not have been possible, but the theory does not meet the facts.

Rather than an infinitely expanding balloon, the system of money creation by banks and building societies is supposed to resemble a pyramid. It is sometimes referred to as the ‘pyramid of credit’. At the base of the pyramid is a firm foundation of true money, the coins and notes created by government. Above this is the narrowing pyramid of bank created credit, which, because of the legal restrictions on banking can only reach a certain height.

Chief among these legal restrictions is that known as the ‘liquidity ratio’. This is supposed to set a strict limit to the amount of money that banks can create via loans. For some years, the liquidity ratio was set at 10%. This meant that a bank could only issue loans equivalent to 90% of the money deposited with it at any one time, since it had to retain 10% of its deposits in liquid form, such as cash. The pyramid of credit is built up by stages, at each stage a smaller round of loans leading to a smaller number of new deposits.

At the first stage, only 90% of the original, true money could be loaned, and thus return to the banks as new deposits. Of this new, smaller set of deposits, again only 90% could be loaned, and thus return to the banks as a further set of new deposits. Each round of loans is built on 90% of the previous round, and in the end, after a series of even smaller loans, the final loan is a minute amount, and the pyramid of credit is complete. Once the pyramid of credit is complete, no more money can be created by lending, unless what the books refer to as ‘brand new, true money’ is introduced at the base. In other words, only when the government creates and supplies more coins and notes as debt-free cash can the system start again, building up a further pyramid of loans on the new money.

There is only one trouble with this theory. It doesn’t apply. The liquidity ratio was abandoned in 1981 as part of the deregulation of domestic and international finance. Banks are now legally allowed to lend and re-lend without the restriction of a liquidity ratio. In fact, for years, the banking system had found ways round the liquidity ratio by investing in short-term government securities, (Which are re-deposited in banks once spent and are actively a part of the money creation process) and it had long been functionally meaningless.

The other restriction traditionally supposed to act upon banking is that known as the asset / reserve ratio. It was a requirement on banks to have sufficient sums of their own money as a standby. The purpose was to make sure that the amount of money they possessed as a company – their own capital reserves – was adequate to cover any loans that might default and not be repaid. A reserve / asset ratio of 10% meant that if banks had made loans of £10,000,000, they must have £1,000,000 in their own company reserve. In the UK, a reserve of about 10% has generally been regarded as adequate, and was for many years a legal requirement. However, like the liquidity ratio, the reserve / asset requirement has been abandoned. Today, at the time of this writing, the only legal reserve / asset requirement on banks is that 0.5% of all their assets be logged with the Bank of England in the form of notes and coins. Financially, this is a total irrelevance. As a limitation on banking it is also meaningless, since the Treasury supplies notes and coins to commercial banks to meet the general demand, and this 0.5% simply becomes part of the overall demand for coins and notes!

The reserve / asset ratio has been replaced by the ‘capital adequacy’ ratio. Again, this is a requirement on banks to have sufficient capital of their own, and is set at 10% on international agreement. But there is no requirement that this 10% reserve be held in cash; indeed the bulk of the banks capital is held in the form of investments, especially government bonds. But whenever a bank purchases government bonds or any other investment using money from its capital reserves, the money enters the economy, and then registers as a new deposit. Instead of being a restriction on banking and money creation, the money supply process is actually sustained by such bank purchases from reserves.

Despite the fact that both the liquidity ratio and capital reserve have either been abandoned, or become totally meaningless or counterproductive restrictions, economics textbooks and banking theory still present money creation in the context of these supposed restrictions.

The last thing that is being suggested here is that a restoration of these controls is what is needed. As we speak the government is discussing more regulation as the solution for the global financial crisis. History has shown, there has hardly been a moment in history when the banking system has actually been under control, and this will never work, except to the disadvantage of the majority of the population, the banks themselves and the functioning of the economy. The point about the multiplier theory is that it has allowed economists to believe in and present the current system as one that operates under control, when it empirically does not.

Under this understanding most believe that bank credit only lasts for the duration of the loan, and upon repayment will be cancelled out of existence. This is not what actually happens at all! As any bank manager will confirm, when money is repaid into an overdrawn account, the bank cancels the debt, but the money is not cancelled or destroyed. The money is regarded as being every bit as real as a deposit; it is regarded by the bank as the repayment of money that they have lent. That money is held and accounted as an asset of that bank.

The fact that upon repayment, money that they have created is not destroyed, but is accounted as an asset of the bank, proves beyond dispute that when banks create money and issue it as a debt, they ultimately account that money as their own. The only factor which disguises their indisputable ownership of the money they create is the fact this returning money is usually rapidly re-loaned.

Borrowing in the modern economy almost always outpaces repayments, which is why the money supply escalates. This means that money returning as repayments usually does not accumulate in the banks own account, but is quickly re-loaned, along with more debt.

When borrowing is sluggish, during a recession as we are in today, some banks can be awash with money from past repayments in their own account. This surplus money can be used to boost the banks balance sheet as is badly needed today or can be used by the banks and building societies to make investments, purchasing stocks and bonds available on the world money markets, boosting their company reserves hugely, and placing beyond doubt whose money this is.

The point about repayments is that money is not destroyed, but is withdrawn from circulation. Thus the total of deposits held by the population is decreased. In this sense, a deposit has been destroyed, but not the money. Upon repayment of a loan, money returns to the bank or building society that created it. This money then only re-enters the wider economy if someone else takes out a loan, or if the bank spends the money on an investment. Either way, this money is accounted and treated as the banks own property. Therefore it is true to say that loans are temporary, but the money created by banks is permanent. Once created, it belongs to the banks, constantly returning to their ownership and control, with the repayment of each debt. This is how 97% of all money in our economy is created today and economic theories must recognise this if we are to reach the conclusion that we need to nationalise our money supply not our banks.


As the government does not directly control our money supply and the multiplier effect has ballooned out of control, the Bank of England uses monetary controls indirectly by controlling interest rates and the cost of borrowing. Another element in economic theory relating to banking and the money supply is the use of interest rates. Fluctuating interest rates are used both to influence the rate of bank lending, and as a policy intended to cover almost the entire realm of economic management. As we cannot control our money supply directly we must influence the money supply indirectly through interest rates. The school of thought from which this economic policy derives is the Chicago School, initiated by irving Fisher, and later championed by Milton Friedman. It is the ideology which completely dominates modern economic thought.

The philosophy is to give full rein to the free market, whilst attempting to guide the overall activity of the economy by managing the money supply. This a government does by lowering or raising interest rates through the monetary policy of the central bank. This alternatively encourages and discourages borrowing, thereby speeding up or slowing down the creation of money and the growth of the economy. Low interest rates encourage both industrial investment and consumer borrowing, leading to a growth in the money supply. High interest rates mean that new borrowers are deterred and the growth in the money supply is slowed. The fact that, by this method, people and businesses with outstanding debts can be suddenly hit with huge extra charges on their debts, simply as a management device to deter other borrowers, is an injustice quite lost in the almost religious conviction surrounding this ideology.

Just when the economy is getting going, investment is healthy, jobs are being created and production and prosperity are increasing, the economy is deemed to be overheating , and the great bogey, inflation, appears. And the only way that modern economics can think of to cope with a financial phenomenon over which all economists disagree – inflation – is to stamp on the entire money supply, throwing the entire economy into recession, bringing bankruptcy to millions.

This method of controlling banks, inflation and the money supply certainly works; it works in the way that a sledgehammer works at carving up a roast chicken. An economy dependent upon borrowing to supply money, strapped to a financial system in which both debt and the money supply are logically bound to escalate, is punished for the borrowing it has been forced to undertake. Many past borrowers are rendered bankrupt; homes are repossessed, businesses are ruined and millions are thrown out of work as the company sinks into recession. Until inflation and overheating are no longer deemed to be a danger, borrowing is discouraged and the economy becomes a stagnating sea of human misery. Of course, no sooner has this been done, than the problem is lack of demand, so we must reduce interest rates and wait for the consumer confidence and the positive investment climate to return. The business cycle begins all over again.

There could be no greater admission of the total and utter inadequacy of modern economics to understand and regulate the financial system than through the wholesale entrapment and subsequent crippling of the entire economy. If we think that this is better than controlling the money supply directly by nationalising our money supply then it is no wonder we are in a global financial crisis.


Orthodox economics explains inflation as ‘too much money chasing too few goods’. Michael Rowbotham believes Inflation is not caused by too much money; it is caused by too much debt-money. He believes Inflation is entirely due to a lack of permanent stable money stock and our reliance upon bank credit to supply the majority of our money. The backlog of debt constantly feeds through into industrial costs, raising prices and depressing consumer spending power. It is this lack of purchasing power – the gap between prices and income -which Michael believes is the driving force behind inflation. His theory seems to be the most consistent with the real world facts too.

Inflation is nothing but the upwards drift of prices and wages in an economy where industry is desperately trying to recoup outlay and cover all the financial costs of production, whilst the consumer is desperately trying to bridge the gap between their income and the price of goods. Inflation is the result of the two sides of the economy – consumers and producers, wages and prices – being set at odds by the perpetual lack of purchasing power, and it is quite endemic under a debt based system

In economics inflation is attributed to the very opposite! Inflation is declared by most economists to be ‘too much money chasing too few goods’. In an economy based 97% upon money that has had to be borrowed into existence, when the total of debt is in excess of the entire money stock, when everyone is competing for what money exists to avoid further debt, when the money in circulation is required both as a medium of exchange and also required to repay the debt that created it, when a booming economy has been financed on the back of consumer borrowing and industrial borrowing for investment, when our everyday experience is that there is never enough money and when there is a superabundance of goods and services of all descriptions – quite honestly, does ‘ too much money chasing too few goods’ sound realistic? Quite honestly, which is the more likely? That inflation is due to excess money or the backlog of debt? Turning their back on debt and completely ignoring one half of the spiralling money supply process, economists deem inflation to be caused by ‘too much money’.

The idea that inflation is due to debt and excessive banking is not a novel suggestion, indeed it is contained in the very word ‘inflation’ which was originally applied to the expansion of money by banks beyond its true amount through the creation of additional credit. However, the suggestion that the action of banks in ‘inflating’ the currency could lead to price inflation has in recent years been completely swamped by a single theory of inflation – the Quantity Theory. This argues that if the quantity of money, or its speed of circulation, rises to the point where more money is available than is necessary for the purchase of goods currently available, then the prices of those goods will rise to absorb this ‘excess’. Inflation is thus seen as an automatic and inevitable result of any increase in the money supply above that needed for the purchase of goods. The quantity theory of inflation, which disregards completely the nature of money and the impact of debt on prices and incomes, is contradicted by almost every piece of evidence we have, whilst the role of debt in causing inflation is confirmed.

Over the centuries, there has been a constant complaint by ordinary people of poverty amidst plenty – not ‘too few goods’ but ‘not enough money’. There has also been a parallel complaint by industry of the difficulty of finding a market for their goods at prices that allowed them to stay in business. A difficulty in producing goods is never industry’s complaint. The difficulty is in selling goods, which strongly argues a lack of money, and in meeting costs, which strongly argues excessive debt. Inflation as ‘too much money chasing too few goods’ seems historically completely different to reality. But it does show a striking parallel with the increasing reliance upon bank debt-money.

If inflation were anything to do with ‘too few goods’ it ought to have died out decades ago with the choice of goods growing exponentially, not increased over the years.

As for ‘too much money’, how can this be said to apply? As we have seen, the average family and the average business is up to its eyeballs in debt of one kind or another mortgage, overdraft, credit cards and hire purchase. What is more, the level of personal and business debt has increased over the last fifty years, at precisely the time that inflation has become an annual feature. Add this to the fact the governments constantly complain of not enough money to spend on pensioners, hospitals, education or whatever.

The economist’s explanation of inflation is riddled with such contradictions and inconsistencies. None of it makes sense, and none of it explains why inflation is so persistent, despite all efforts to control it. In particular, there is a complete failure to account for the fierce price inflation that occurs during a period of economic boom when there is no question of ‘too few goods’. Why do prices soar during a boom? Why is competition deemed suddenly inoperative as a factor holding down prices, just when competitive growth is at its most intense?

The reason the prices rise once recovery is underway is that firms have been investing, and must repay the costs associated with this investment. The debt may be in the form of a bank loan, or it may be in the form of an obligation to pay dividends on a new share issue, but either way, new overheads have been incurred and these must be reflected in prices. The rapid price inflation during a boom is caused by firms charging the true financial cost of goods. Prices begin to reflect what firms actually have to charge in order to meet their costs. As prices rise, incomes get left behind and the lack of purchasing power in a debt economy starts to become apparent. This price rise and lack of purchasing power continues until no more debt can be sustained and we enter a financial crisis as people default on their debts.

Such an analysis also helps to explain the behaviour of prices during a prolonged recession. During a recession, the gap between prices and incomes that would be evident if firms charged the full price of goods is masked. Firms try to hold back costs and so keep prices low. But they cannot do this indefinitely. If a recession continues for a number of years, more and more firms are unable to defer costs, and slowly prices start to creep up to meet costs. The fact that such price increases are due to pasts costs incurred, and not current wage rises, is obvious, yet economists are totally stumped by the phenomenon of inflation during a prolonged recession, or ’stagflation’ as it is termed.

Almost all the instances of hyper-inflation have taken place in economies crippled by their debts. The South American and African countries where inflation has at times ranged between 100% and 500% per year were all, without exception, suffering at the times from huge debts to the IMF and World Bank 0 debts upon which they had to make substancial annual repayments. The inflation in Germany during the 1920’s, which is often attributed to the German government running up an excessive government deficit, was equally associated with an explosion of debt.

The global financial crisis

As a result of this debt based system growth can only be sustained if we continuously take on more debt to supply the economy with the money it needs. However, the money the economy needs can never be achieved, as there is more debt than money, so we must continually re-finance in an endless spiral of debt. This debt incurs ever increasing interest charges and leads to price inflation as the only way to service past industrial debts.

In a situation where prices are rising relative to income, consumers have three options; either accept that their income buys less, press for higher wages, or borrow to buy. Of these, seeking higher wages was once seen as the ‘least-worst option’; however this simply produced the spiral of wage / price inflation of the 1970’s. A rise in wages can never close the gap between prices and incomes, since the gap is not due to the level of wages, but the effect of debt. All that a rise in wages achieves is to push up prices yet higher, the debt component of prices and the erosion of incomes by mortgages both remain.

Leading up to the financial crisis, people tended to regard ‘borrowing to buy’ as the least-worst option. Of course, all this borrowing meant lower disposable income in the future, whilst all industrial borrowing for investment will be represented in higher prices in the future. We are told that consumers have spent beyond their means and bankers have been greedy. The reality is consumers have re-financed to survive as banks have propped up the unsustainable system for as long as possible by increasing debt levels until the only borrower was those sub-prime borrowers who eventually defaulted. To blame this on consumers overspending and banks over lending is just an inevitable consequence of unsustainable economics and all they did was maintain debt to prop up the system for as long as possible. Now the government steps in and takes on the debt the economy needs to sustain the unsustainable.

This cycle is now over, we must nationalise our money supply not our banks and we need to move towards sustainable economics. Our current policies are all geared towards sustaining the unsustainable through increasing consumer and industrial borrowing (Lowering interest rates), increasing government borrowing (Fiscal stimulus and bailouts) and quantitative easing (Creating money out of thin air and loaning it to the government).

The mathematics of debt is uncompromising and the gap between prices and incomes in a debt economy cannot be concealed indefinitely by ever more debt-buying.

What we are experiencing now is a true deflation, involving falling prices and wages. The result is massive bankruptcies across the economy. This is hardly surprising since, with a general fall in both prices and incomes, the debt component of the price of goods is increased.

Concluding thoughts

To refer to bank credit creation as ‘the money supply’, as both government and economists do is completely misleading. The whole point is that, apart from the government’s trivial 3% contribution of coins and notes, there is no money supply. To call mortgages and loans ‘borrowing’ is also misleading. They are charter for the private creation of credit, charged at interest, and advanced against a person’s future income, allowing the purchase of goods already in existence, but for whose purchase insufficient money exists.

Also, the intermediate squabble between left and right on taxation and spending priorities does not represent the full range of choices. The real political option is embraced by the creation and supply of money by government instead of private banks when we nationalise our money supply. This completely opens up the economic options of extra funding, increases the political choice of expenditure and offers the prospect of true welfare. How dare a government claim it cannot find the money to pay for this or that when they do not bother to create any money?

A full understanding of the financial system provides a solution for so many micro and macroeconomic conundrums and financial contradictions that it can only be described as a revelation. The analysis and proposals for monetary reform offer a leap forward in economic understanding of quite breathtaking dimensions, and promises a revolution in the entire discipline. Academically, as well as in practical terms, to say this is exciting is an understatement.

Posted in News.

Tagged with , , , , , , , .