For the past 5,000 years, the concept of money as a store of wealth and an instrument of commerce has been one of the defining ideas of humanity. What began as a simple invention has morphed into the hulking and insatiable apparatus that is the global financial system.
Today, that system intrudes into almost every part of life. It is there when you receive your pay, when you tap at the cash register, when you travel or buy goods from overseas, and — if you’re lucky — when you borrow for a car or a house, or when you put money away in superannuation or a pension account.
As well as being an essential ingredient in everyday life, money plays a critical part in grand human ventures such as social fairness, democratic government and environmental protection.
The modern financial system is subject to a wide range of risks. The ability to contain and corral those risks affects people’s wealth and well-being, their capacity and incentives to work, the integrity of corporations, and ultimately the rule of law.
In the classic 1946 film It’s a Wonderful Life, depositors demand their money from a small-town building society. Manager George Bailey (in an unforgettable performance by James Stewart) explains that the money is not in the building society’s vault; it has been lent to other people in the town. “The money’s not there,” Bailey pleads. “Your money’s in Joe’s house … And in the Kennedy house, and Mrs Macklin’s house, and a hundred others.”
Bailey’s explanation reflects a widespread idea of how banks work. According to this idea, banks gather funds then lend out those funds or a proportion of them. This picture of banking permeates popular culture and popular notions of finance.
In 2008, during the crisis that rocked the foundations of Western capitalism, author and Harvard professor Niall Ferguson published The Ascent of Money. His goal was to explain the underpinnings of the crisis and put it in its historical context.
Ferguson’s book repeated uncritically the It’s a Wonderful Life explanation of how banking works. Seventeenth-century banks, he explained, had pioneered what would become the foundation of modern finance: “fractional reserve banking”. That mode of banking exploited the fact that “money left on deposit could profitably be lent out to borrowers. Since depositors were highly unlikely to ask en masse for their money, only a fraction of their money needed to be kept in the [bank’s] reserve at any given time.”
The George Bailey–Niall Ferguson explanation of banking is widely held, and it was long ago a valid explanation of how banks worked. But as a descriptor of banking today, it is categorically incorrect.
When you borrow money and your bank credits your loan account, the account balance is created anew, “from thin air”, not from or in relation to existing deposits or other existing money. And as you repay the loan principal, the money created at the time of the loan gradually disappears, reverting to its previous form of airy nothingness.
The Bailey–Ferguson picture of bank lending is back to front, and the nature of bank deposits is also widely misunderstood. The unnerving reality: a positive balance in your bank account does not correspond to a stock of “money” held somewhere for you, over and above the account balance. The account balance is all there is. It is the record of a promise from the bank, effectively an IOU. (Inter-bank payments are likewise commonly misunderstood. A transfer of bank-created deposit funds from one bank to another does not involve any movement of funds. Instead, the first IOU is cancelled and replaced by a new IOU in the “receiving” bank.)
Your deposit account is a liability for your bank, and as a depositor you are no more than one among many of the bank’s unsecured creditors. In normal times, a promise from a private bank is nearly as good as a promise from a government or a central bank. But in a crisis, the promise is worth much less, and can be worth as little as nothing at all.
These differences in understanding are the tip of an iceberg of confusion.
Today, the leaders of the largest private “money centre” banks certainly understand how banking works, and they use this knowledge every day to their own advantage. They do so through the nature of the loans they make and the terms they set, and by offering new products that extend the concepts of lending and deposits into the world of contingent events.
With derivatives and other engineered financial products, the mega-banks routinely make huge profits from financial gambles, secure in the knowledge that governments are more likely than not to bail them out — even if the gambles put the whole system at risk.
In the 1990s, two Australians discovered the hypocrisy and precarity of modern finance. One of them, Kate Jennings, was working on Wall Street when she blew the whistle on what she’d seen. She wrote an excoriating novel, Moral Hazard, and a series of articles that drew attention to the grifts, rip-offs and unsafe gambles that were undermining global finance.
Ian Shepherd, too, was a banking insider and he, too, had seen the worst excesses and dangerous risk-taking that endangered not just individual institutions but whole economies. Noticing a meta-trend that tied together all the mega-trends that were transforming finance, Ian conceived of a new type of tradeable security and a new kind of market. Optimistic that the new market would restore integrity and put the public interest first, he set out to build it.
Kate and Ian had both been students at Sydney University in the late 1960s and early 1970s. Four decades later, in the aftermath of the 2008 financial crisis, ABC journalist and broadcaster Phillip Adams interviewed Kate about the broken culture of finance and the causes of the GFC. Ian heard the interview and just had to get in touch.
He and Kate met and combined forces in a fight against the financial status quo. In 2014, that fight reached a surreal climax when Ian and his supporters went head to head in a legal clash with a consortium of the largest private banks, including financial giants JP Morgan and Citigroup.
The legal fight would have profound implications for the biggest financial market in history. It would also recast America’s system of patenting and innovation. The stakes were so high that the foremost names in IT and consumer products — names such as Google, Amazon, Facebook, IBM, Adobe, Microsoft and Hasbro — joined in, as did the US solicitor general.
Today, Ian Shepherd’s and Kate Jennings’ discoveries about finance remain acutely relevant. The foundations of the global financial system are still dangerously fragile, and the system is still deeply one-sided — stacked to benefit a small number of large private banks at the expense of customers and taxpayers.
In today’s world of fintech, cryptocurrencies and private equity, Ian’s and Kate’s insights are an indictment of private greed and government negligence. They are also a diagnosis of the likely causes of the next big financial crisis. And they provide a compass and a key to a fairer, safer and more democratic financial future.
This is an edited extract from Alice by Stuart Kells, published by Melbourne University Press.
