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The idea that broke the world

Image: Paul K

When the English and French armies landed on the shores of the Crimean peninsula in October 1853 they were ill-prepared to fight a war.  Logistics – the science of provisioning armies at a distance – was in its infancy; and armies were still expected to forage for at least some of their supply needs by pillaging the local agriculture.  Supply shipping was required to cross the Bay of Biscay and round the Iberian Peninsula before sailing the entire length of the Mediterranean, passing through the straits and sailing halfway across the Black Sea.  Ships regularly arrived in the wrong order, or had been loaded chaotically so that non-essential cargo had to be unloaded in order to access essential equipment, ammunition and rudimentary medical supplies.  In order to build a base at Sevastopol, the support fleet had to be unloaded and despatched to the opposite shore of the Black Sea in order to harvest Turkish timber.  The only saving grace was that the internal communications of feudal Russia were even worse.

One problem that was resolved by the British and French engineers in the Crimea was how to get supplies unloaded at the port up the steep surrounding hills and onto the plateau above where the troops were fighting.  The technology they deployed was to be central to the human activity of mass slaughter for the next century.  They built a railway.  Railways were in their infancy at this time.  However, by a twisted chain of events, the Crimean War was to have a huge impact on the development of the railways on the other side of the planet.

By 1853 the British had become dependent upon imports to feed its growing urban population even in peacetime.  With the outbreak of war, Britain was to engage in another aspect of warfare that would continue for another century – the import of food and materials across the Atlantic from the USA.  American farmers saw a big boost in demand as a result of the war coming on top of the early industrialisation and urbanisation of US towns and cities.  In order to profit from the growth in demand, the farmers had, somehow, to move their produce from the countryside to the cities and the ports. 

Railways provided a potential solution.  In 1837, however, the USA had been blighted by the collapse of an earlier railway investment bubble; so there was little appetite among investors for a repeat performance. It was at this point that one of the most seductive – and deadly – ideas ever entertained by a human rose to the forefront of our collective consciousness.  As Timothy J Riddiough records:

“In the early 1850s the owners of the La Crosse & Milwaukee railroad hit on an idea. Why not approach local farmers, particularly those farmers whose property lay near the path of the railroad line and its depots, and ask them to mortgage their farm to the railroad in return for shares of stock in the railroad? The dividends from the stock would be at least equal to the interest required on the mortgage, where the dividend-interest swap negated any need for the farmer to come out of pocket for interest payments on the debt. In fact, no cash changed hands at all between the farmer and the railroad in this debt-for-equity swap…

“Now, the second step of the transaction was for the railroad to monetise the RRFMs so that it could purchase the track and equipment necessary to expand the line. The solution to this problem resulted in what we believe to be the first case of mortgage securitisation executed in the United States. It was a railroad farm mortgage-backed security – effectively a covered bond offered by the railroad to potential investors located on the east coast and in Europe.”

Instead of investing directly in the building of the railways, bondholders were investing in a derivative instrument that paid them a share of the growing income from the farms.  Provided that the growing demand for farm produce continued, and provided that the railways continued to profit from transporting the produce from the farms to the cities and ports, investors could get rich.  What could possibly go wrong?

We know to our cost today what goes wrong when the banking and finance corporations inflate derivate bubbles.  But in the early 1850s this was a new idea.  When the Crimean War came to an end in February 1856, European demand for US agricultural produce slumped.  Famers began to default on their mortgages; and the derivatives based upon them began to fail.  In 1857 the inevitable panic took hold as investors desperately sought to cut their losses.

Had anyone had the sense to drive a stake through the heart of the idea of securitised derivatives in 1857 the world might have been spared untold suffering.  But securitisation is too seductive; and its short-term rewards too great for it to remain in its tomb for long.  As Cathy M Kaplan notes:

“While writers point to the origins of securitisation in a number of precedents, including the farm railroad mortgage bonds of the 1860s, the mortgage-backed bonds of the 1880s and a form of securitisation of mortgages before the 1929 crash, the modern era of securitisation began in 1970. That was when the Department of Housing and Urban Development created the first modern residential mortgage-backed security when the Government National Mortgage Association (Ginnie Mae or GNMA) sold securities backed by a portfolio of mortgage loans.”

In its modern form, securitisation is supposed to make the issuing of loans safe for the banks by standardising risks.  To understand this, imagine that you are the manager of a bank.  You have issued 100 loans to businesses and households that you believe to be credit worthy.  However, you also know from the statistics that in the course of these loans being repaid, three percent will default… but you do not know which.  One way around this is to take your hundred loans (stage 1 below) which include the three which will default, and divide the income from them into 100 pieces (figure 2).  These can then be repackaged into an investment bond – a securitised derivative – made up of one percent of the income from each of your 100 loans (stage3).  You now have 100 derivatives that each carry the same risk; allowing you to sell them to third party investors with a reasonable degree of certainty that they will deliver the promised return.


Households and businesses apparently benefit from this arrangement because banks are able to be less conservative in their lending practices.  Banks benefit because instead of waiting – sometimes for decades – for the return on their investment, they can be repaid more or less immediately.  Investors also, apparently, benefit because of the standardisation of risk – the three percent default rate has already been built in.

Governments had, in fact, driven at least a partial stake through the heart of securitisation in the years following the 1929 crash.  The impact of depression and the rise of political extremism that plunged the world into a conflict that killed perhaps 85 million people convinced politicians in the aftermath that is should never be allowed to happen again.  The introduction of mortgage-backed securities in the USA in the 1970s had been subject to close regulation; while elsewhere in the world they were still illegal.

This was to change in the 1980s as governments sought an alternative to the economics and politics of a post-war consensus that was rapidly breaking down.  In the USA, this involved a gradual deregulation of the banking and finance sector.  In the UK the change was far more abrupt and can be seen in data compiled by Steve Keen showing Britain’s historical debt to GDP ratio:

In 1980 the Thatcher government began its experiment in selling off public assets in order to kick-start economic growth.  To begin with, they focused on the sale of Britain’s then massive stock of public housing.  For ideological reasons, Thatcher believed that if people owned their homes rather than renting them, they would have a greater stake in society and would be less likely to engage in radical politics or trade union activity.  And, more cynically, it is much harder to go out on strike when you have a mortgage to repay every month.  The problem for Thatcher was that the people who she wanted to purchase their homes were not the kind of people Britain’s highly conservative banks would ever consider lending money to.  So Thatcher had to follow the Americans and begin dismantling the regulations.

The big change came in 1986 with the “Big Bang” financial deregulation which finally removed the stake from the corpse of securitisation; paving the way for the banks to bring fire and brimstone down upon the people of the earth once more.  At the time, the conservative nature of banking was regarded as sufficient to prevent a re-run of the financial chaos that banks have always created throughout our history.  This, however, overlooked the fact that banks had only been conservative in their practices because of the regulation that Thatcher decided to remove.  As Kaplan points out:

“During the late 1980s and the 1990s the securitisation market exploded. This was aided in the United States by the REMIC legislation and changes in SEC rules, and fuelled by the growth of money market funds, investment funds and other institutional investors, such as pension funds and insurance companies looking for product. In the 1990s commercial mortgages began to be securitised. Outside the US, countries including the UK and Japan adopted laws that allowed for securitisation. The vastly expanding global consumer culture, where access to credit to purchase everything from houses and cars to mobile phones and TVs was taken as a given, continued to stoke growth in the volume of securitisations.”

Those who lived through the period will remember the banking revolution that took place.  At the end of the 1970s most people did not have a bank account.  Wages were paid in cash, and any savings people had left over at the end of the week would be put in a building society – an organisation little different to a modern credit union.  In the early 1980s, the Thatcher government used their control of public services and nationalised industries first to bribe and later to force millions of workers to open bank accounts in order to have their wages paid by bank transfer.  These first bank accounts were mostly cash accounts – the account holder could only withdraw cash; they couldn’t write cheques or agree a loan or an overdraft.  As the regulations were dismantled, however, access to credit became easier.  Overdraft facilities were added to most accounts, and cheque books and cheque guarantee cards were distributed.  Credit cards, loans and mortgages quickly followed.  By the late 1990s Britain’s householders struggled to open their front doors because of the mountains of junk mail offering pre-approved loans, credit cards and mortgages.

During the period the banking sector also changed beyond recognition.  In the 1970s, Britain was served by a patchwork of local building societies and regional banks whose names – Westminster, Midlands, Principality, Bradford and Bingley, Yorkshire, Halifax, Cheltenham and Gloucester, etc. – reflected the communities they served.  And then, apparently for no good reason, almost all of the building societies began to bribe their members into agreeing for them to “demutualise” and become banks.  At the same time, the banks themselves turned from small regional companies into multi-trillion pound corporations towering over the globalised industrial economy.  It used to be that when America sneezed the world caught cold; by 2008 if any one of Royal Bank of Scotland, Barclays or HSBC even reached for their proverbial handkerchief, the entire global economy risked meltdown.

What had actually happened was that – whether by accident or design – Thatcher had given the banking and finance companies the keys to the nation’s currency printing press.  Building societies (and credit unions) function in the way most people still think banks operate – as intermediaries that loan depositors savings to borrowers at interest; and making their money from the difference between the interest paid by borrowers and the interest paid to savers.  But banks never operated in that way.  The fractional reserve system allowed banks to create currency out of thin air whenever they made a loan.  The only check on this – one removed during the deregulation – was that the central bank could enforce a reserve; a percentage of cash that had to be held in the banks vaults.

The main barrier to banks lending too much new currency into the economy, however, was the risk of default.  A mortgage borrower might require a loan of tens or even hundreds of thousands of pounds.  A business loan might run into millions.  And the only guarantee the bank had that it would be repaid was the borrower’s signature on the bottom of the loan agreement together with a claim on the borrower’s assets if the borrower defaulted.  This situation demanded that banks be located locally, with branch managers going out of their way to ensure that borrowers manage their money prudently.  In short, since repayment was a long-term exercise, banks themselves had to be in it for the long term.

Securitisation upended our relationship with the banks.  As Kaplan explains:

“Another effect of the exponential growth of securitisation as a vehicle for all forms of lending was the change in the balance of the relationships between lenders and borrowers. This became very clear post-2008 in the aftermath of the financial crisis. In the long-ago days when banks lent to businesses and people, a bank lent money for a mortgage and took a lien, and if there were problems the individual worked it out with his or her bank. Securitisation and disintermediation of risk changed all of that. Banks sold the mortgages into huge pools where one mortgage would be one of tens of thousands…”

Since banks could offload the risk to third party investors more or less immediately, they no longer had an incentive to get to know their customers; still less worry about how or even if they were able to meet their long-term commitments.  All that mattered was that banks ramp up the – now electronic – printing presses and churn enough new loans into existence as they possibly could.  The reason banks became behemoths was that they were paying themselves with currency that they themselves were creating out of thin air, the risk from which was being carried by someone else.  The reason building society CEOs were desperately bribing members to allow them to convert was so that they could get on board the gravy train before it all went sour.  And the reason you and I could not open our front doors was because they desperately needed new lambs to the slaughter to keep their Ponzi scheme going.

Detached as all of this seemed prior to the 2008 crash, it ultimately rested upon the belief that all of the debt that had been created – with interest attached – could be repaid in the future.  The economists even made up a banking unicorn story of their own called “The Great Moderation” to convince everyone that we could keep on borrowing without repeating the economic crashes that had happened every time we had done the same thing before throughout our history.  Both GDP and inflation could be held at around two percent using the interest rate to prevent inflation getting out of control.  The industrial peace that had broken out in the 1990s meant that workers’ wages could also be held at two percent, preventing wage inflation and giving a degree of certainty to businesses and investors.  Politicians could base public spending and tax decisions on this stabilised economy.

What the economists forgot – or dismissed as an “externality” – was that the wealth that all of the new debt-based currency is supposedly an equivalent to and a claim upon must itself continue to grow at that same two percent.  When it comes to issuing debt-based currency that largely resides as bits and bytes somewhere on a bank computer system, two percent growth sounds trivial.  But a growth rate of two percent can be represented in a different way – as a doubling every 35 years.  Creating twice as much currency as there was 35 years ago was simple enough; creating twice as much of all of the stuff that seven and a half billion humans have to consume to keep the system running is another matter altogether.  Sooner or later one or more of the raw resources that had to be fed into the system at an ever increasing rate was going to stall.  It did not matter which.  All that mattered was that when the rate of resource extraction growth fell below the rate of growth required by the debt-based monetary system, the bubble was bound to burst.

In 2005 the conventional oil which had fuelled the creation of the debt-based global economy reached peak production.  Alternative, expensive oil would eventually fill the gap for a few more years.  But in 2006 the oil shortage led to a big spike in oil prices.  Since almost everything humans consume is either made from, produced using or transported with oil, the short-term impact of oil price rises was a general rise in prices across the economy.  In an attempt to curb this inflation, central banks began to increase interest rates.  The resulting economic slowdown saw businesses fail and households default.  The derivatives issued by the banks, just like the mortgage-backed railroad bonds in 1857, then began to fail.  Investors fell back on the insurances that had been used to give additional value to the derivatives; but these, too, began to collapse as so many households and businesses went bust in so short a time.  And then, to their horror, the bankers discovered that their investment departments had bought into each other’s dodgy derivatives too.  The whole system broke down and had to be defibrillated using massive volumes of central bank currency also printed out of thin air.  Ever since, the bankers have been playing a game of “extend and pretend” in the hope that someone, somewhere will figure out a way out of the crisis.

Not only had securitisation required the raping of the planet that we depend upon for life support; it had eventually consumed itself; and in its current form it is rapidly destroying the nation states that so foolishly removed the stake from its heart.  Donald Trump is the relatively benign (compared to what is coming) manifestation of the new nationalism that is the people’s response to their financial enslavement.  Brexit is part of the same response, as are the populist movements across Europe.  But even these movements can offer little practical response to our growing predicament.  As Nicholas Shaxson at the Guardian observes:

“A growing body of economic research confirms that once a financial sector grows above an optimal size and beyond its useful roles, it begins to harm the country that hosts it. The most obvious source of damage comes in the form of financial crises – including the one we are still recovering from a decade after the fact. But the problem is in fact older, and bigger. Long ago, our oversized financial sector began turning away from supporting the creation of wealth, and towards extracting it from other parts of the economy. To achieve this, it shapes laws, rules, thinktanks and even our culture so that they support it. The outcomes include lower economic growth, steeper inequality, distorted markets, spreading crime, deeper corruption, the hollowing-out of alternative economic sectors and more…

Dismantling the system may be what is driving the new populism, but building viable alternatives is a far harder prospect.  The damage done to the planet is so great that massive changes are required if humans are to survive at all.  But like an operation designed to remove cancerous tumours from a failing body, there is a real danger that the necessary surgery will kill the patient anyway.  And perhaps the biggest sting in the tail of securitisation is that the surgeons and scientists, engineers and technicians, and the poets and artists that we needed to help us through our predicament never got to realise their potential.  The securitised loan parasite got to education too, turning it into a commodity to be bought and sold and turning students into “customers” financed by securitised student loans. 

Somewhere out there is the person who might otherwise have figured out how to build a grid-scale thorium reactor or a molten salt heat storage battery or any one of a million barely glimpsed technologies that might have allowed humanity to end its addiction to fossil fuels and their chemical derivatives without condemning six out of every seven of us to death from starvation.  Sadly, the great minds that may have delivered us from our fate – whether by the collapse of the system or of the environment that sustains us – ended up working for the banks instead.  As Shaxson notes:

“It may seem bizarre to compare wartorn Angola with contemporary Britain, but it turned out that the finance curse had more parallels with the resource curse than we had first imagined. For one thing, in both cases the dominant sector sucks the best-educated people out of other economic sectors, government, civil society and the media, and into high-salaried oil or finance jobs. ‘Finance literally bids rocket scientists away from the satellite industry,’ in the words of a landmark academic study of how finance can damage growth. ‘People who might have become scientists, who in another age dreamt of curing cancer or flying people to Mars, today dream of becoming hedge-fund managers’.”

Some people fantasise about what they might do if they ever had access to a time machine.  Many, commonly, talk about going back to 1920s Germany or Russia to assassinate Adolph Hitler or Joseph Stalin before they could inflict misery and death upon millions.  I have a more humane idea.  In the unlikely event that any of my readers ever do find themselves in possession of a time machine, travel back to the offices of the La Crosse & Milwaukee railroad company in the early 1850s.  And when that railway clerk who has been charged with finding a way to finance the new railways says, “hey I’ve got a great idea for monetising farm mortgages,” drive that stake deep into his heart.  Burn every fragment of paper that he ever made notes on.  And then pray that nobody else manages to stumble upon an idea that has unleashed more human misery and destruction than the vilest dictator could ever dream of.

As you made it to the end…

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