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The Financial System

Changes to the monetary and taxation systems will provide mechanisms for curtailing two of the three forms of unearned wealth that drive much of the injustice and exclusion that blights today’s world.


Changes to the financial system will be necessary to address the third: gains from speculative investment. Speculative investment takes real wealth from those who create it, and drives the expansion of the money supply.

The objective of the financial system should be to act as intermediary between people with savings and those who seek funds for investment. Under the monetary reforms outlined above, the financial system would also have a role to play in the distribution of newly issued money to those in need of investment funds.

Currently, economically beneficial transfers of funds constitute only a fraction of one per cent of the transactions made in financial markets. Those markets constitute an industry that exists primarily to enable those with spare cash to earn more by extracting wealth from the real economy. There is no moral basis for allowing such activities to continue. As we have noted, given that they benefit a tiny section of the global population -far less than one per cent -in a properly functioning, progressive democracy they would be outlawed.

It seems unlikely that such activities could be curtailed through the tax system. Current efforts to impose a miniscule tax on financial transactions -the so-called Tobin Tax -are treated with disdain by the financial markets. At the time of writing, some European politicians seem set on implementing such a tax. While this is encouraging, and may raise revenue to help governments deal with challenges arising from the financial crisis, it will have little impact on the rent-seeking behaviour of those who play the markets.

The only way to return financial markets to their proper and useful purpose is for more people to understand how damaging their current activities are.

They conspire directly to deny economic opportunities to millions of hard-working people. The interests of speculators are diametrically opposed to those of the ordinary saver.

Armed with improved knowledge of how finance works, and the impact it has, the majority must take control of the economy and put the financial sector back to work for the common good. Until this happens living standards and the general quality of life will continue to decline.

The financial system will only be able to fulfil its legitimate role if there is a huge psychological change on the part of investors. The obsession with short-term profits over steady long-term returns must end. Using financial devices to extract wealth from the real economy by borrowing money (created solely for the purpose) to speculate in markets has to stop.

The financial markets are also over-involved in lending for house purchases. We have seen the negative effects of house prices being so high relative to earnings. House prices are inflated by increases in land values which have two sources: the general uplift that arises from economic advance and public infrastructure investment (and which would still occur under a stable money supply) and the bank credit made available for home purchases which further drives up land prices.

The link between residential land values and bank credit is not a direct one, however. Banks create money to lend for a house purchase when a home changes hands, but this doesn’t mean that the amount of money in circulation is equal to the total value of residential property. In this sense, the ’money’ represented by land values is not real, it is a reflection of demand and supply coupled with the preparedness of banks to lend.

Increases in wealth represented by the appreciating value of a home can only be realized by selling it, or by borrowing more under an ‘equity release’ scheme. Residential land values do not provide a “ready source of cash with which to pay any tax imposed on them. Given these complexities, while collecting resource rents through a tax on land vales would be an effective way of redistributing unearned income enjoyed by commercial landowners, it may not be the answer in respect of residential land. Here, the best way to prevent runaway house prices may be to restrict bank lending.

Opponents of land value taxation (LVT) argue that it’s not viable in any society where many people own their homes because it will be perceived as an unwarranted additional tax, and because people see their homes as investments, not just as places to live. The first argument is weakened if, like other resource rents, LVT is seen as a replacement for existing taxes. What you lose in LVT you gain from reductions in your income tax.

The second argument is harder to refute: only when people no longer treat their homes as investments might taxing residential land values become politically acceptable. This requires the economy to provide sufficient opportunities for everyone to enjoy lifelong economic security without relying on over-inflated land bubbles. If this could be achieved, then people would no longer require their homes to be appreciating assets to ‘see them right’ when they retire.

The true value of a home is the cost of building it, or, in the case of an existing property, the cost of rebuilding it. These values are easily calculated. One way of addressing the negative impact of rising land prices on the market for residential property would be to limit the amount a bank could lend for home purchase to a percentage of the rebuilding cost. Currently, millions of people are priced out of homeownership because banks keep creating money to lend to homebuyers. The more they create and lend, the higher prices rise; the only real beneficiaries are banks and their shareholders. Under a system of money creation geared to ensuring money-supply stability, banks would no longer be incentivized to drive up house prices in this way. There would still need to be enough cash in the system to satisfy the demand for mortgages, but other schemes might be developed for funding house purchases.

By addressing the out-of-control rises in the value of residential land, either by limiting bank lending or by collecting the general uplift of rising land values as a resource rent, the principal cause of insufficient supply would also be addressed. Builders will not build new homes if they cannot make a profit because the combined cost of land and construction drives prices beyond the purchasing power of prospective buyers. If inflated land values were taken out of the equation, and if those in the least-well-paid jobs were properly rewarded, the housing market would gradually return to an equilibrium position where supply and demand were reconciled, and where, ultimately, everyone could afford to own a home. Think of the positive effect that this would have on communities, family life and society in general.

Limiting bank lending will not solve the problem at the top end of the housing market, however; among people who don’t need to borrow, even to buy a home costing millions.

If LVT is politically unacceptable because it hits ordinary people unfairly, then perhaps it would be more palatable if it targeted just the super-rich, especially those (nearly all of them) whose wealth is derived from rent-seeking activities.

A simple formula could be adopted to decide which homes attract LVT. Perhaps all primary residences worth less than twice the national average might be exempted. Whatever scheme were to be adopted, it should be remembered that it is the combined impact of changes in the economy ­reducing the earnings gap, limiting bank lending, building more houses and a carefully targeted tax on land values -that would deliver equity in the housing market. It would bring vacant homes into use, stop urban sprawl and could eventually end homelessness.

As currently constituted, the financial system delivers outcomes which are unjust and socially destructive. Everyone who is prepared and able to work has the right to a job that pays a just wage. They also have a right to a roof over their heads. The economy is failing to deliver on these fundamental objectives because the markets for labour and housing are manipulated in the interests of elite privilege. Only when a critical mass of people realize the damaging impact of financial markets on wider society will democracy be able to defeat vested interests.

Excerpt from Four Horsemen: The Survival Manual.

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