They say no-one except Vince Cable saw the global financial crisis coming. They couldn’t be more wrong
As the radiochemist Frederick Soddy (1877–1956) pointed out, there is a fundamental disconnect in the economy between money and real wealth. Real wealth is made up of stocks of actual physical objects. Money, on the other hand, is not real wealth, but debt – a promise to pay in the future. While actual objects are subject to various physical laws, money is subject only to the abstract laws of mathematics. A consequence is that the debts of a person or society can explode until they bear no relation to everyday life.
Soddy was born in Eastbourne, England, but moved to Montreal in 1900 where he worked with Ernest Rutherford on the newly discovered phenomenon of radioactivity. There he and Rutherford discovered that radioactivity is due to the transmutation of elements: for example, uranium decays to radium, giving off radioactive particles in the process.
Following the award of the Nobel Prize for Chemistry in 1921, Soddy switched his attention from physics to economics. Having predicted correctly that nuclear weapons would soon be developed, he realised that the world was not a safe place for them, largely because of inadequate economic theories. He argued that many economic problems are created by the confusion between real wealth and what he called virtual wealth (i.e. money), which eventually manifests itself in the form of economic crises.
Real wealth can be calculated by adding up the values of objects. To use one of Soddy’s examples from his 1926 book Wealth, Virtual Wealth, and Debt, a farmer might have two pigs, which is twice as good as having one pig. Paper money, in contrast, has no value in itself, but only represents a debt, so it is actually a negative quantity. Such things do not exist in nature. As Soddy patiently explained: “The positive physical quantity, two pigs, is something anyone may see with their own eyes. It is impossible to see minus two pigs. The least number of pigs that can be physically dealt with is zero.”
Another difference between real and virtual wealth is that the former is subject to basic physical principles, including the effects of decay. Everything has a shelf-life, including pork products. However, money is just a number, so is not constrained by reality in the same way. Under fractional reserve banking, banks can even create it out of thin air. As Soddy wrote: “The virtual wealth of a community is not a physical but an imaginary negative wealth quantity. It does not obey the laws of conservation, but is of psychological origin.” Of course the value of anything, including gold bars, is largely psychological as well, but at least there is a connection with the real world.
The problem with this arrangement is that, without safeguards in place, virtual wealth soon exceeds the real wealth. The effect is multiplied by the existence of financial instruments such as derivatives. During a crisis, people want to swap virtual wealth for the real thing; but because virtual wealth is bigger than the real wealth, this can’t happen. In the absence of inflation, the only remedy is wealth destruction through stock market collapses, bankruptcies, foreclosures, bond defaults, forced taxation, and so on.
Out of steam
To stabilise the financial system, Soddy made a number of recommendations. These included abandoning the gold standard, letting international exchange rates float and ending fractional reserve banking. Perhaps because he was an outsider, his work was completely ignored by mainstream economists. A 1956 obituary in Science described him as a ‘crank’ on the subject of monetary policy: “His fanatical devotion to schemes of this sort, derided by the orthodox economists… was surprising to many who knew him first as a pioneer in chemical science”.
Despite this opprobrium, most of his policy prescriptions, such as replacing the gold standard with floating exchange rates, were eventually accepted in mainstream society. In fact, the only one that didn’t was his idea of a 100 percent reserve requirement for banks. The same plan was later promoted by the likes of Irving Fisher of Yale University, who called his version 100 percent money (he seemed unaware of Soddy’s work), and Milton Friedman, though apparently they weren’t considered cranks. In a 1927 review of Soddy’s work, Frank Knight of the University of Chicago agreed with Soddy that fractional reserve banking meant that ‘important evils result, notably the frightful instability of the whole economic system.’
Soddy compared the control of the money supply to the governor on a steam engine, which regulated the engine’s speed by providing feedback. If the regulator was properly designed, then any small alteration to the speed would be reduced through negative feedback.
However, this wasn’t the only possibility: a flaw in the design could mean that the regulator provided positive feedback, so that the engine oscillated wildly until it fell apart.
The price to pay
In the economy, the money supply tends to expand during good times because asset prices are rising, which allows more debt to be issued and excites entrepreneurial spirits. During a recession, however, credit dries up and the flow of money slows, which exacerbates the downturn. It therefore acts as a positive feedback, rather than a controlling negative feedback. The result, to use Knight’s phrase, is that the system can suffer from a ‘frightful instability’, the likes of which we are seeing now in Europe.
More recently, the idea of 100 percent reserves has been championed by ecological economists such as Herman Daly. The degree of positive feedback can also be moderated to an extent by increasing minimum reserves, and perhaps raising or lowering them dynamically to counterbalance economic trends.
If he were alive today, Soddy would not be surprised to see the tensions in Europe and elsewhere as countries grapple with the abstract mathematics of debt. He would also know that debts which have grown to an unreal size can never be satisfied in the real world. After all, we can’t have negative pigs.