What Caused the Financial Crisis?

October 23, 2008 Updated: October 23, 2008

Lost among the extensive press coverage of our global economic crisis was a small news item that European countries may consider a revival of the 1944 Bretton Woods monetary system.

In such a system, currencies had fixed exchange rates tied to the U.S. dollar, and the dollar's value was linked to gold at a fixed rate. In my view, this constitutes the most significant news published during the financial crisis. I will attempt to explain why.

The 2008 global economic crisis is of course a major issue on the minds of people all over the world. Almost everyone has a decisive opinion about it, regardless of whether they understand its causes. But I often fail to find in mainstream media any mention of a central cause to this crisis, which is what I believe to be a massive increase in the amount of printed money during recent years.

It is unfathomable how these key developments—which have been openly going on for years—are overlooked. Ignoring the overabundance of money is like ignoring the elephant in your room; although in this case it is more like an entire zoo.

Everyone blames the U.S. banking system and its greedy executives, who lent money with outrageous irresponsibility. This is true, and indeed the banks and bond traders acted recklessly and even criminally. But this is not what made the financial crisis so severe.

Regrettably, an abundance of negative news has become an inseparable part of our daily lives, and we must reconcile ourselves to coexist with them. Crisis in the banking system belongs to this category. Financial crises occurred in the past and will always occur in the future simply because banking institutions are led by individuals—some of whom will always be imprudent, irrational, greedy, or even criminal.

As such, every country has a regulatory system to oversee the financial industry. But as we have seen, regulators are also people who may fail or get carried away. The reason that over printing of money is the main cause for the current crisis is because it increased dramatically the sums that are available for banks to lend.

Usually, the source of a bank’s lending is savings. Each economy has three major economic players: consumers, businesses, and the government. All three can save money or lend money. In aggregate, households typically save (which is not the case currently in U.S), while businesses and governments typically lend. The banking system and its financial markets mediate those who save and those who lend. Since total savings in an economy is relatively stable, the amount of credit (loans) given each year by banks should also be relatively stable.

Unprecedented Availability of Money

As mentioned previously, in recent years central banks have increased the amount of money they print each year by a factor of ten—from $100 to $150 billion annually to the order of $1 to $1.5 trillion. Thus, each year the banking system had more than almost a trillion extra dollars to lend. Bankers added fuel to the flame by substantially easing credit conditions. But even with favorable credit conditions, without massive amounts of money the global economic bubble wouldn't been inflated to this point.

In other words, the economy has always been a cyclical business. Periods of highs and lows are an inseparable part of the economy, but crisis of this magnitude are almost always a result of irresponsible policy by central banks. The talk of Europeans considering a revival of Bretton Woods shows that they grasp the failure of our global monetary system. Fundamental changes must be made.

It should be noted that the Bretton Woods system was also flawed and eventually doomed to fail, as it did in 1971. The system fixed exchange rates between currencies around the world, which is impossible to sustain. The price of everything— especially a currency—should reflect its economic value. No government can fix a price that differs from the economic value for a long time. Case in point: the current rampant inflation in China, after years of fixing the value of its yuan to the dollar.

There's little doubt that the global monetary system has to undergo a fundamental change. But this change must be based on a principle of limiting the printing of money (especially in a rate faster than the growth of population), and that free markets should ultimately set prices.

I see two possible solutions here: a return to a full gold standard, or setting up a global central bank that would be responsible for determining global monetary policy. The latter of course, would be very challenging. Central banks will not easily relinquish their powers.

But with the global economy on the brink of depression, decision makers have few options.

Itay Slonim is an investment manager and owner of a portfolio management firm in Tel-Aviv, Israel. This article is meant to arouse interest. It does not constitute investment advice and does not replace personal financial advice tailored to an individual’s financial conditions. For feedback, please email slonimi@netvision.net.il