This week I want to aim the article at those who normally do not frequent financial bulletin boards or sites. You, the reader, need to help me in this cause.

People who read financial BB's are already interested and to some extent (though not always) informed about how certain economic conditions occur and can hold a healthy debate about the cures for such ills.

However we are a small group of independent thinkers, we exist at the margins where we try and do our best to inform the public about the dangers and benefits of our financial system. How many of us have watched our family and friends adopt a fixed grin and a glazed expression as we try and explain the complicated world of money flows, interest rates, inflation, deflation etc? We all know the moment when they stopped listening; it was when they started looking over our shoulder to see if there is someone more interesting standing behind us to talk to.

This Weekly Report is for those who glaze over. The trouble is the target audience doesn't read my website or these financial boards. So this week I want you to do a little something for me, send this article to your friends, the ones that now know something is wrong but don't realise what the problem is. It will be available, in full, on my old blog here.

However, before I start the article proper I want to share a little something with you. In April I wrote a series of articles about G B Eggertsson and how his paper "An interpretation of The Deflation Bias and Committing to Being Irresponsible" was being used by the Federal Reserve as the plan to escape from the deflationary effects of the credit crash. Three of the articles were subscriber only but I have now enabled those articles to be read in full without subscription of any sort at An Occasional Letter From The Collection Agency.

That's it, the second to last mention of my site in this article, you have permission to cut and paste this article from here (see the acknowledgement at the end) if you wish to send on to your friends and relatives who you think need to know what is coming. Reproduction on other sites is allowed too. This article uses the US and to a greater extent the UK to describe the background. It is applicable to all countries that allow a fiat currency.

How did this happen?

You will have heard of the sub-prime defaults, that credit conditions have changed, that banks are struggling. All these things are the not the cause of the current problems but are the symptoms of a system that allowed itself to become a one way bet, a self reinforcing merry-go-round of increasing debt. Let me show you how it works and how it breaks.

Mankind has only ever truly created one thing, fiat currency. Fiat currency is cash, paper and coins that are only backed by confidence, for paper they are promises to pay the bearer, coins have an intrinsic worth depending on the metals used to make them.(Hence why coins have become smaller and lighter over the years, production costs need to be below the notional worth of the coin). Paper has practically no intrinsic worth, except to paper recyclers.

Mankind can produce as much paper and coins as it wishes and since it is all based on promises, these days you don't even need a note, you can electronically promise "cash" too. Think about a mortgage payment. It is paid by an electronic transfer of an amount out of your bank account to the mortgage lender. The "cash" was originally placed in your account to be able to make the mortgage payment by electronic transfer from the account of your employer or your interest bearing savings / investment account. No real paper was used, no bags of coin delivered. It all happened electronically.

You can see the temptation such a system offers. You can invent money, lend it to others who pay you interest and at the end of the term you get the principal back too. You do not need to have any collateral to make this happen, though we do have regulations for banks that say they must have a reserve amount that is a percentage of the amount of money they invent. As all money in a fiat system is invented and relies on confidence, it doesn't really matter if reserves really exist or not, except to fulfil regulatory requirements.

Let me show you the system in this simplified diagram:

At the basic level the system is that simple. As long as the costs and defaults are exceeded by the profit made from the interest received your reserves grow and enable higher levels of leverage. You can get very rich doing this.

However every so often in human history events make this simple idea break down. It doesn't matter what the event is but if it makes the costs higher that the interest received then the reserve shrinks. This stops the increasing levels of lending and in severe cases can cause lending levels to fall or even stop altogether.

This is what we call a credit crisis. They have happened before and caused the bankruptcy of many lenders. Those that survived such events usually did so because they refused to allow indiscriminate lending, they applied standards to borrowers, checking to see if they could repay loans and refused to leverage to the maximum potential.

If an economy is reliant on the ability to borrow to achieve purchasing power or increase productivity then a credit crisis has an enormous impact, stopping growth and commercial activity. This worries bankers who have no wish to join the list of "also ran" names of yesteryear. So they decided to try and protect their business model and move some, or all, of the risk to another sphere of the financial system. To do this they had to make such risk taking attractive to others by offering compensation.

Again, here is our simple model but with a basic level of protection added:

You can see what has happened; the original bank lending system now looks stronger as the risk is lowered at the expense of some of the interest income. But notice how the model now becomes acceptable to the Insurer who can use the new income to raise their own reserves. What was a very simple model has now, with one change, morphed into a multi-party system that can be continuously expanded as risk is offloaded to other parties.

So what can go wrong?

• 1. Interest income does not cover costs.

  If the amount of interest charged is too low to cover costs, interest rates on variable products can be raised. If the product is fixed rate then either customers can be encouraged to take variable rates that can be reset higher (after a lower introductory offer) or the debt can be packaged together and sold on to another party at a discount.

  2. The principal may not be repaid.

  The bank will invoke its insurance policy to cover the losses if the principal worth is calculated to have dropped below a certain level previously agreed with the Insurer. The payout can then be added to the reserves to ensure the bank complies with regulations.

  3. Regulations change.

  If the governing body decides that banks need to hold a higher percentage of reserves compared to lending then capital must raised to boost the reserves (e.g. Basel 2). This can be achieved by borrowing, rights or bond issues or by reducing the amount of lending.

Any one of these circumstances alone would not cause bankruptcy. Even a half decent capitalised bank could survive 2 of these events running concurrently. However if banks (and the Insurers and other lenders) have stretched the leverage out to 20, 30 or 40 times reserve capital and all 3 of these circumstances arrive at the same time you then have a credit crisis.

Remember the financial system relies on confidence. If confidence in the survivability of the system or part of the system is impaired then the structure slows and stops. In an extreme crisis the system may well go into reverse. Sub-prime became the headline for the current crisis but it is just a manifestation of the events above all occurring at the same time:

In many ways the 3 events almost seem to have been perfectly timed to cause the maximum damage, with rates moving higher from 2004 to 2006, just as many sub prime, Alt A and jumbo mortgages began to reset from teaser rates to higher nominal rates. In 2007 and 2008 capital requirements and the accounting and pricing of assets changed as Basel 2, sponsored by the Bank of International Settlements (BIS) came into force.

Certainly anyone in an informed position could have seen that the situation was set to deteriorate rather than stabilise. Without doubt the effects of these events where under-estimated by those charged with ensuring the Financial and Monetary system remained fit for purpose.

How is the financial system made fit for purpose?

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