Whenever you take out a loan the temptation is to imagine a big mountain of money in a secure vault somewhere.

Your friendly bank manager, a nice affable chap, is on hand doling out credit to any soul who can jump through his hoops.

This is miles, no decades, away from the truth. Here’s how debt works today ….

In order to lend money, banks have to borrow it from another bank. Usually, that bank has also borrowed it from another bank … and so the borrowing continues.

As collateral for these loans many banks put up their assets. Many of these assets are themselves funded by loans.

Some are even bundles of loans, grouped together to allow the income generated through the loans’ repayments to be considered an asset.

So what you end up with if you seek debt advice in the UK in the end is a pile of debts, each secured against another. As the pile rises the whole structure becomes shakier and shakier, making the architecture of the whole system riskier and riskier. Not what a good economist wants to hear.

America In Debt

In case you don’t believe me, here are some figures for the USA in 2007:

total value of all goods and services produced: $13.5tr

total amount of money in circulation: $0.57tr

So half a trillion dollars has somehow funded 13 trillion dollars worth of economic activity? Get real!

This is a leverage factor of around 20:1 … some banks had been leveraging their assets at up to 40:1. In the meantime, Ordinary Joe, when buying a house is only allowed a leverage factor of 3:1.

Man! If I could leverage my income at 40:1, I’d be buying my senator’s house! Wow .. the common man lives in a mansion. Or, more likely…..

…. this is utter madness!! It’s like driving a car faster and faster and faster because you haven’t reached the bend in the road yet. When that bend arrives, you’re going too fast and there’s a huge and bloody car crash. Period.

Better Rules For The Economy

So let’s get three things straight in our new economic architecture:

Only money is money. It’s the common denominator in any economy, used to measure the value of all things. Only the Central Bank can create it. Assets are items which may be of value in the future. They can be offered as loan collateral but only (say) 80% of an asset’s value can be lent. Their imagined value cannot be called money. Debts are an absence of value, not the creation of money. They may not be considered assets and no institution’s debts may exceed their assets’ value (ie. a 1:1 gearing)

Do you agree with these points, or do you think they’re far liberal or restrictive? Or can you think of something which needs to be added to next week’s topic: competition and growth?

Either way, I always enjoy hearing your views and discussing them with you.

Don’t be shy! Post a comment below or start a thread on the Green Options Discussion Forum!

Related Posts:

Is Your Money Safe Where It Is? What About Green Stocks?

Wealth and Value : New Economic Architecture Required

Lehman Brothers Collapse: New Economic Architecture Required

Picture Credit: “National Debt” by Digiart2001 from Flickr under Creative Commons Attribution Share Alike Licenese.