KEY POINTS:
In the main we trust the commercial and central banking system to manage the supply of our money system wisely, but there have been several times when this has not been the case. The Federal Reserve in 1929-1932 halved the amount of credit available, which stoked the Great Depression. The infamous South Seas bubble of 1720 expanded credit so much it led to massive inflation and a big bust.
In recent years the amount of credit made available has been expanded greatly, not only by banks lending more, but from the development of derivatives.
Derivatives are financial assets whose value depends on the value of one or more other assets, and are used by traders to hedge their bets on movement in prices of things like interest and exchange rates. Their use has also resulted in leveraging up the vast increase in the supply of credit; by 2006 the world's economy was awash with money derived from the issuing of credit.
Money lent into existence by banks is issued as credit in the form of bank loans which make up most of the world's money supply. All new loans made by banks increase the money supply. So when a bank approves a loan and the borrower draws on it to pay for a home extension, the builder, electrician, painter and suppliers get paid and deposit the money they receive drawn upon the credit available.
People throughout the Western world have been drawing upon the credit allowed to them to better their lives. In New Zealand many of us found we could afford a better home, so we did. Prices went up as borrowers believed they could keep up their payments. The belief in their ability to repay debt gave assets their rising value.
Now, a failure of this belief has caused the downfall of two large banks: Bear Sterns in the US, and Northern Rock in the UK. (What triggered the failure of belief in the first place goes back to the sub-prime mortgage issue in the US and is outside the scope of this article.)
In both cases central banks stepped in to restore depositors' belief that their money in bank accounts remained safe, though two of the banks' shareholders lost up to 90 per cent of their investment in these banks.
The US Federal Reserve has also lowered the interest rate in the hope people will continue to borrow and keep the economy supplied with credit so business and personal monetary transactions may continue.
Now, unfortunately, many in the global banking and financial system have let us down again, with calls for greater control over those who greatly expanded credit in such a way that, in many cases, it is not repayable.
Greed by financiers has been the driver, and that has seen US financial services grow its profits from the corporate sector from 10 per cent in the early 1980s to 40 per cent in 2007!
But despite being let down by some in the banking and finance sector, nothing has changed. The production system is not failing, though there is a failure to some extent in how we finance its expansion. People still go to work and jobs will still exist so long as there is enough money to allow us all to buy, sell and invest. The productive capacity of the world remains sound, and will continue to expand so long as our man-made monetary system continues to do its job. Why shouldn't it? There is no reason for it to fail, except if the people responsible for it at this crucial point make the wrong calls, especially in the US.
Indeed there are signs the US has decoupled to some degree from much of the rest of the world. For instance, in the first quarter of this year, China's growth has continued, with GDP growth for 2008 expected to be 10 per cent. Domestic sales there will rise by about 15 per cent. China will not go into a recession because domestic trade, consumption and domestic investment will drive growth.
Foreign direct investment into China since January 2008 exceeded US$18 billion ($22.6 billion). Domestic investment last year there was US$1.96 trillion. China's inflation has been largely from the prices of meat, dairy products, eggs and edible oils.
In these circumstances too, our Free Trade Agreement with China makes good sense. After all, we are all but a totally free trade country already. We can import anything we like from China and, except for a couple of items, with no duties imposed. The deal will open China to more New Zealand business in the same way New Zealand is already open to the Chinese. Trade Minister Phil Goff likens the deal to be of similar value to CER with Australia, maybe even better!
There are many other trade opportunities for New Zealand in other parts of Asia, in India, Australia, the Middle East and Europe, all of which are showing no signs of slowing, and won't so long as the US doesn't allow its monetary system nightmare to become a reality.
* Alasdair Thompson is chief executive of the Employers & Manufacturers Association (Northern).
