No Fuse Box for the World's Financial Circuitry - Vivek Kaul's Diary
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No Fuse Box for the World's Financial Circuitry

Feb 9, 2017

39

Imagine the next time you went to turn out the light at home there was a chance - a very small, but real chance - that a fault in the system would shock you and destroy every other electrical appliance in your house.

Would the risk bother you?

Let's say the odds were something like 1 in 500. You switch the light off 499 times and you're fine.

On the 500th things go BOOM!

Would that bother you? Keep you up at night? At the very least it'd turn the act of switching the light on or off into a nightmare.

Here's the thing: you may not realise you're taking the risk, but the financial system has a flaw just like this deep within it.

The risk of a shock - a moment when the system short circuits and becomes hugely dangerous - is ever present.

Understanding why that is may not be pleasant. But this single insight could help you manage your money more effectively than anything else. It's probably the most important edition of Capital & Conflict I'll ever write to you.

Let me explain why.

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A system without a fail-safe

Let's go back to the electrical system in your house.

It's an apt metaphor for understanding the financial system. Why?

Because the reason we don't live in terror of an electrical fault destroying our homes is because we know the system has a fail-safe built into it.

We know if there's a power surge or a fault there are numerous safety nets built in: fuses and circuit breakers that trip; and an earth wire to ground the voltage in the case of a fault.

Even if you don't know how these things work - and I'm no expert - we all know on one level that the system has been tested.

There are safety structures in place to prevent one fault becoming a fatal systemic failure.

(I actually learnt all about this the hard way last year. The first house my wife and I bought was an old cottage in need of a fair bit of work. We didn't realise it, but the electrics were completely "non-standard". One electrician told us parts of them were pre-war. Had we not refitted them and there'd been a fault in one of our electrical fittings... there was no effective earth. The system had no fail-safe.)

Here's the thing though...

In the financial system, there is no fail-safe. That's the inherent flaw that gives the entire ecosystem a weak spot... and inbuilt fragility... that makes it much more unstable that it seems.

The global financial crisis proved this. After decades during which the greatest credit bubble ever seen (at that point) blew up - it only took a matter of days to go from normality to complete and utter panic.

That's the very definition of a fragile system.

Is faith a fail-safe?

What's the flaw that creates the fragility?

It's simple to understand... once you get your head around it. It involves two complementary ideas.

The first is that in a fractional reserve banking system, there isn't enough money to pay everyone's claim on their money.

Fractional reserve banking essentially means banks can lend out far more money than they hold back in reserve. A bank may have £100 in deposits but have lent out £1,000 against it. Its reserves are a fraction of its liabilities.

There's a major benefit to this, by the way. When the economy is booming, it means banks can create credit to fund economic growth without being restrained by deposits. It's a financial innovation that helps the economy to grow. It works 99.9% of the time.

The problem is in the rare cases when large numbers of people ask for their money back. The bank cannot pay all the claims against it at once. That's why bank runs are so dangerous - only the first few people (relatively) can get their money out before reserves run out.

People fear loss more than they desire gain. It's an asymmetrical trade. When people are scared they want the ultimate security: their money, in their own hands, under their complete control.

But we can't all have the ultimate security! Only a few of us can. It's a logical conundrum. I have savings in the bank. I can go and withdraw those savings if I like. If a crowd of other people do the same thing... I can't. The money isn't there.

That's a huge flaw.

It means our money is only safe - in fact only exists - within the system so long as we believe it to be so.

Faith is our fail-safe. But faith, belief and trust are transitory. They're highly volatile: you can lose faith in something quickly and it takes a long time to come back. So they're not effective as a fail-safe at all.

Anything that makes us question our faith in the system is therefore highly dangerous.

The second idea is connected to the first. It's the fact that we have a fiat monetary system - money unbacked by any real asset that can be printed at will.

That means that, in effect, if a bank runs out of money... the government can simply step in and pay its claims in freshly minted currency.

But then we run into that problem again. Fiat money requires us to have faith in it to have any value. If printing money causes people to question their faith in the currency itself... it's very hard to rebuild that faith before the currency loses all its value.

Or to put it another way: faith is the glue that holds the system together. Therefore anything that causes people to lose faith or distrust the banking or monetary system can cause a rapid collapse. The fail-safe is in our minds.

That's the opposite of an electrical fail-safe, or any other system that's been designed to "fail well" - ie, without catastrophe.

The fuse box works whether you believe it will or not. Every person in the country could decide they don't trust power to go to earth in the event of a fault. It wouldn't matter. It'd still go to earth.

Please note: This article was first published in Capital and Conflict on February 8, 2017.

Nick O'Connor is a writer and editor at Moneyweek. He is also the publisher of Exponential Investor.

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2 Responses to "No Fuse Box for the World's Financial Circuitry"

Rajeev Agrawal

Feb 12, 2017

Dear Nick,
Congratulations, a very nice article indeed.
With the cashless economy proposal of Mr. Modi, I get a bit worried that the Indian economy will run on virtual money which is not backed by currency notes in circulation.
There will not be a fuse control box and there will not be any accountability such as against the currency printed and in circulation.
Wonder if my understanding is wrong somewhere!!!
Thank you and warm regards,
Rajeev

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Rajiv

Feb 10, 2017

Very well written article that explained a complex point in an easy-to-understand language. Thanks for sharing your knowledge.

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