Monday, 29 September 2014

The sustainability of the financial system

Robert Slatcher - Principal Consultant

Everyone is very familiar with the three pillar concept of sustainability (environmental, social and economic). Given that the three pillars are intrinsically inter-connected it does raise the question as to why the economy is the often overlooked pillar.

Despite the recent financial crisis and subsequent global recession, there has been very little focus on the world economic system in the context of sustainability. Perhaps this is a consequence of the complexity of finance, and the fact that although we play an integral role within it, we very rarely see the inner workings or wish to understand how it all happens. It is much simpler to comprehend the process of exhausting non-renewable fuels or the concept of global temperatures increasing and affecting the climate we experience, than abstract concepts relating to the movement of money and wealth generation.

However, when the very basic principles of our economic systems are interrogated, it is possible to see a system that is at odds with the fundamental concept of sustainability.

How is money created?

To explain this requires a quick crash course in finance (a detailed description is provided by the Bank of England). Money is created by banks, initially by central banks (e.g. the Federal Reserve in the US or the European Central Bank) through various mechanisms. Once created, this money can be loaned out, and when loaned out it is done so with an attached rate of interest. This money usually goes to commercial banks to be loaned out again to individuals and business with an attached rate of interest. Commercial banks can also create money as they can issue loans to a greater value than the monetary reserves they hold. As such, a bank could loan out ten times the value of money they actually hold in reserve. The issues this can cause were covered in a 2013 comment piece in The Telegraph.  Once created, a loan counts as money, therefore banks can generate money from the reserve they hold - this is known as fractional reserve banking.

Now, if there is a finite pot of money in the world and the money originally generated by the central banks had a rate of interest attached to it - where does the money come from to pay that interest? The answer is nowhere, only banks can create money. So, to pay the interest, more money needs to be created. The amount of additional money required is made greater by the fact that commercial banks can create more money and more interest debt from the original pot of money. This reduces the value of money already in circulation and doesn’t solve the problem, as the newly created money also comes with interest. Fractional reserve banking is a very efficient method of creating additional money and therefore interest debt from an initial smaller pot of money.

So the basic principle of our global financial systems is a system that is always in debt and, as there is never enough money to pay the interest on debts, there will always be financial inequality. Somewhere someone is bearing the brunt of that shortfall.

Sustainable Growth

It is generally acknowledged that growth is essential but it should be sustainable. In other words, growth needs to happen at a rate that our global resources can maintain. However, in order to service an unrecoverable debt associated with interest on money generation, our rate of growth is focussed on servicing that debt. As such, our concept of growth is driven by the measure of financial sustainability rather than environmental and social sustainability.

Given this conflict between the three pillars, shouldn’t a greater focus be given towards economic sustainability? After all,  the inherent flaw in the economic  system is arguably a major barrier to achieving social and environmental sustainability?

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