Aspire CPD

Big Picture

Can the financial system be trusted?

22 Jun 2021 2 month(s) ago

Investors ask what and who they can trust, but they should also ask how much the system can be trusted.

The biggest question posed by investors is what and who to trust? A question that is asked less often, yet is at least as important, is how much can the system itself be trusted? As was seen in the 2007-8 global financial crisis, when trust in the system collapses it can threaten to bring everything down with it. 

The options if there is insufficent trust are limited because the different types of investment are inter-related. There is bitcoin, which is more outside the conventional system, but there are many unanswered questions about it. But if the global financial crisis taught us anything, it is that assessing the health and trustworthiness of the system is important.

It is an often overlooked fact about the financial system is that it entirely depends on trust. When trust starts to evaporate, especially between the big players such as banks and insurance companies, the whole artifice is put into peril. Trust in the system is now at an extreme low and that points to extreme danger.

Consider some recent examples of what happens when trust fails. In the lead up to the global financial crisis of 2007-8 the players in the repo (repurchase) market, a place where banks raise short term cash, stopped trusting each other. It led to a panic that eventually spilt over into distrust in the interbank lending market, which keeps money moving around the globe. Interbank lending froze, effectively cutting off the blood supply of the whole system and almost destroying money itself. 

The problems exposed in 2008 were never solved and in September 2019 there was another crisis in the repo market. This time, though, the markets were engulfed by an even bigger problem: the COVID-19 crisis. Western central banks frantically printed money, either by issuing government debt or simply plucking it out of thin air by using a process called quantitative easing, which involves buying back government or corporate debt. That flooded the market with liquidity and covered up what was looming as a repeat of 2008.

It brought a temporary reprieve but the system continues to worsen. It is a point repeatedly made by analysts who criticise fiat money, which is backed by government regulation rather than a physical substance like gold.

At one level, these criticisms are reasonable. Governments cannot print money indefinitely without eventually causing a collapse. But it can be argued that the real issue is not too much control from governments, but a lack of it. After financial deregulation in the 1980s, central banks lost oversight over the quantity of money (in Australia, the government could once instigate a credit squeeze to restrict the amount of money but that mechanism is no longer available). Now they only have one tool left: the cost of money, or interest rates. With rates near zero in most developed economies, that tool has largely gone, too. There is no ammunition left.

The system is teetering. Most Western economies, including Australia, are mired in unsustainable debt that is only kept from collapse by interest rates close to zero (in Australia it is household debt that is most perilous). If inflation starts to rise, and central banks raise interest rates in response, a collapse seems unavoidable.

Yet if ‘fiat’ money is in trouble, what exactly is the alternative? For one thing, it is not true that the system is entirely controlled by government fiat. The base rules are set by government regulation, but banks actually create most of the money and it is their reckless lending that is behind the explosion of debt. And then there is the derivatives market, which is ‘valued’ at US$600-1000 trillion and generates $US6 trillion in cross border transactions a day. That is completely independent of government fiat, if it is to be called ‘money’ (the participants resolve disputes with an informal panel of lawyers).

Then there is bitcoin, whose popularity is a symptom of the declining trust. It is called a ‘trustless’ system because there is no need to believe in any human, it is all based on an algorithm derived from game theory. Bitcoin has one obvious advantage (as does gold). Unlike fiat money or derivatives transactions there is only a finite amount available; the quantity is controlled. It also seems to match what the libertarian Austrian economist Frederich Hayek hoped would emerge: a type of money that in a ‘sly roundabout way’ would be something government could not stop. 

But the idea that it represents a libertarian victory is almost certainly an illusion. Bitcoin has been co-opted by big financial players and turned into a financial asset for diversifying investment. Neither is it particularly viable as a means of exchange, although some weaker countries are considering making it legal tender.

Far from eliminating the human element, bitcoin has been subject to human emotion to an extreme degree, matching previous financial crazes. Its value has been gyrating wildly because of (very human) market sentiment, especially the shifting opinions of Elon Musk. Bitcoin is also usually valued in US dollars, which is a fiat currency. It may appear to be an escape from untrustworthy authorities, but is it?

The base problem remains how to foster trust in capital itself. Unfortunately, technocrats are poorly placed to solve that because they are trained in how to make moves within the system when what is needed is an understanding of how to make changes from outside the system. 

Finding ways to restore some control over the quantity of money by reversing some aspects of financial deregulation might be one place to start. Working out how to forgive debt, have a jubilee, without imperilling the private banks is another idea worth examining. Trouble is, the authorities are too busy putting out fires to work out how to stop them happening in the first place.

Reader note: This is general reporting only and should not be considered in any way to be investment or tax advice, including for individuals. For more information please read our disclosure statement.