# Colm Fitzgerald: Money and the housing bubble



## ColmFitz (3 Jul 2011)

_Colm Fitzgerald gave a thought provoking paper on quantititive easing  to the Society of Actuaries recently. I invited him to write a piece on Money and the Housing Bubble which I reproduce below. 

Since we suspended speculation on house prices I have asked a few people to write a balanced review of the issues. Colm is the first to respond to the invitation. 

_ _As this is a well thought out and well written article, I would ask people to respond to it in a similar manner. 

Colm Fitzgerald (DCU) is an Adjunct Lecturer in Financial & Actuarial Mathematics in Dublin City University. He has been developing and using financial mathematical models for trading purposes for the last 17 years and was previously Head of Quantitative Trading in Bank of Ireland Global Markets.
He holds an MA in Economics and is a qualified Actuary. He is an external consultant to Rosenblatt Securities and a founding director of Paragon Research Ltd._

Brendan Burgess

*Money and the Housing Bubble *
We all know money is important. Surprisingly, just how important it is, is often lost on some people.

  Money is the principal means of exchange in countries. Most distortions in our economy, e.g. our recent housing bubble, can be easily explained by looking at things from the point of view of money.

  Rightly or wrongly, the total amount of money in our country is not a widely publicised fact. Between 1996 and 2007, the total amount of money in Ireland increased by more than 540% - another not very publicised fact. In my opinion this was the result of extreme ineptitude by our Central Bank, our financial regulatory system and our Government.

  Where did all the extra money come from you may ask?

  Shockingly, the vast majority was effectively printed by Irish banks, AIB, BOI, Anglo etc. If a government prints money it’s considered bad – but letting banks print it, and in vast quantities, is disgraceful. Yet this happened with practically nobody in Ireland saying anything!

  I will come back to how the banks did this later in the article.

  But first, why was this important?

  According to what is called ‘the Quantity Theory of Money’:

  The amount of money in a country * the number of times it goes around the system

  = the volume of all goods and services * average prices

  Historically, if the amount of money in an economy increased (due to printing money say) - this would largely lead to price inflation. 

  If everyone in the world was given twice the amount of money that they already had, it would not make anyone better off as there would still be the same amount of goods and services – and their prices would probably double.

  What happened in Ireland?

  How come after the amount of money increasing by over a factor of five, that we did not have huge inflation? Quite simply it was because the price adjustment largely happened in the housing market! The prices of most of our goods and services are largely determined internationally and were less affected.

  All the extra money printed by our banks caused the house price bubble.

  The amount of money in Ireland has fallen by about 25% since 2007 – resulting in our housing market crash. Before I get into how did happened, I’ll first explain how the banks effectively printed so much money in the first place. It makes me sick thinking about how they were allowed to do this.

  Historically, going back to the Renaissance, banks typically kept only about 10% of their money in cash. This 10% was to provide money to depositors as they needed it and to handle bad debts in times of recession.

  Suppose you have a country where there is only €100 of cash. If this is all deposited in a bank, the bank keeps €10 (10% of €100) and will lend €90. Suppose this €90 is deposited in another bank, that bank then keeps €9 (10% of €90) and lends out €81. Suppose again this €81 is deposited in another bank, that banks keeps €8.1 (10% of €81) and lends out the remaining €72.9. This process continues so that effectively the €100 of cash has turned into €100 and €900 of loans and consequently €1000 of deposits. So effectively, €100 of cash was printed by the Government, and another €900 has effectively been printed by the banks !!

  Ok there is some maths here, but stick with it – if you get this you will understand about what’s going on in our country much better.

  What happened in Ireland in the 1990s and 2000s (and also in the rest of the world) was that banks were allowed to get away with keeping much less than 10% of money received in cash. At the height of the boom, the banks were only keeping about €2.50 for every €100 lend out. 

  This meant that in a country with €100 of cash, the banking system was creating €3900 of loans (>than the €900 of loans above). So effectively, by keeping less in reserve the banks were effectively printing massive amounts of money. This is due to the fractional banking system in both Ireland and most countries around the world.

  It was seriously inept of the authorities to allow this to happen.

  Firstly, when the burst came, the banks were looking at losses of about 10%, but they only had 2.5% in reserve so they were incredibly bankrupt. Why were they allowed to hold so little in reserve, it’s so shockingly inept how this was allowed to happen.

  What’s even worse than this is that ‘prudence’ was then enforced on the banking system, requiring them to hold much higher reserves.

  This effectively meant that the money ‘printed’ by the banks would effectively be destroyed !!

  If there is €100 in cash and the banks have created about €3900 because they are holding €2.5% reserves – if they switch back to holding 10% in reserves, they are only creating €900 – so the overall amount of money in the economy crashes.

  Going back to our Quantity Theory of Money – a sharp fall in the money supply causes either a fall in the volume of goods and services and/or a fall in prices. But as the housing market took up most of the adjustment as money was being created in vast quantities, it has also taken a lot of the adjustment on the downside – hence our rapidly falling house prices. Ireland is a small open economy so our domestic markets often have to take the biggest adjustments.

  In summary then, with very little if any publicity, our banking system created huge amounts of money over the space of about 10 years, resulting in huge house price appreciation. Due to the nature of the way this money was created, it was not going to be sustainable. There was always going to be a crash when the next recession came as the banks were being allowed hold less than 10% in reserve – so not only would they go bust, they would also cause a huge contraction in the amount of money in the economy, causing the housing market, and the economy, to crash.

  It is really terrible that the authorities that allowed this to happen have got away scot free. It is sheer ineptitude what they allowed happen. Probably the worst element of this was when they got rid of the 2.5 earnings multiple for mortgages.

  Typically house prices are about four times average incomes. 

  It is considered that a normal worker will be able to pay back 2.5 times his income over the course of his working life. In the case of a couple, who would typically buy a house, the limit was 2.5 times plus one times spouse’s salary. This meant with an often sizeable deposit, a couple could afford to buy a house with the help of a mortgage.

  This regime should be sustainable and sound over the long term – as indeed it was.

  It would be sheer lunacy to consistently lend more than these earnings multiples as, firstly the borrower may not be able to repay the loan, and secondly if they cannot afford to pay it back, the bank would be left with an asset that may be lower in value than the loan (houses are typically prices about four times average incomes).

  At the height of the boom banks were lending at 7, 8 and sometimes 9 times salaries – for individuals to buy houses that were worth (in the long run) about 4 times salaries. 

  How could our authorities have been so stupid to let this happen?!?

  Sadly, banks are still lending at nearly 5 times salaries so our housing market has further to fall. Most transactions that are going through at the moment are based on a mortgage so this is feeding through into prices.

  In Dublin house prices got to nearly 18 times salaries at the height of the boom. They are back down to about 7 times. But alas they have further to fall to reach their long term levels.

  There is very little rocket science in the article. Our financial regulators are supposed to be financially sophisticated so this should be relatively simple for them. But alas they were incredibly inept.

  There should be much greater awareness of the total amount of money in our country – as distortions in it can have huge implications for us. Our economics journalists fail to report on this. This needs to change, the public needs to be aware of this.

  It goes without saying that our regulators need to get their act together in a much bigger way – and let’s not forgot our politicians who we trust to run our country. Surely they too should understand how important the total amount of money in our country is !!!


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## Complainer (3 Jul 2011)

Good article - I get most of it, but I have a couple of queries.

1) It would be good if Colm could explain more about the differences (if any) between cash in the economy and credit in the economy. When he talks about the total amount of money in the economy, is he talking about cash or credit or both.

2) It does indeed seem outrageous that the Govt and regulators allowed this to happen. Was their clear reporting of the relevant figures at the time?


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## onq (3 Jul 2011)

Thanks to Colm for his article, which, it seems, touches the surface of the problem in all the key areas.

Allow me to expand the discussion on one of these, the role of the BIS in setting the fractional reserve ratio.

I understand that banks used derivatives amongst other means to fudge  compliance with the previous limit for fractional reserves set by the  BIS.
The requirement to comply with this ratio set by the BIS appears to have  contributed, if not directly caused, the current world financial  crisis.
I understand that Banks and Insurance companies use actuaries to advise  them of potential risks and set rates of interest on loans etc.

If banks were at 2.5% why then was the 10% ratio re-imposed in such a way as to make them bankrupt overnight?
Did the BIS not have actuaries on board warning them of the likely consequence of their actions?
Is the BIS not the prime mover behind this current fiasco?

If so, the involvement of the BIS seems to have the qualities of a hammer wielded by a thug, rather than a scalpel held in the swift sure hands of a trained surgeon.

Who ordered this?

ONQ.


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## Jim2007 (3 Jul 2011)

ColmFitz said:


> It is considered that a normal worker will be able to pay back 2.5 times his income over the course of his working life. In the case of a couple, who would typically buy a house, the limit was 2.5 times plus one times spouse’s salary. This meant with an often sizeable deposit, a couple could afford to buy a house with the help of a mortgage.
> 
> This regime should be sustainable and sound over the long term – as indeed it was.
> 
> ...



With the exception of the above, I have to say that I find the article to be rather simplistic in it's analysis.

As seems to be traditional with most Irish economists, this author ignores the fact that the Irish economy is not independent, it is part of the Euro zone and as a result the Irish government acting alone can have very little influence on the money supply or interest rates.  And to some how suggest that they could have done something about it is misleading.

To the best of my knowledge the deposit/lending ratio for the banks was not changed and none of the banks have been found to have exceeded those limits.  So to suggest that the bankers woke up one morning and decided to change the ratio and start printing money is simply wrong!  The fact is that the necessary deposits were there at the time, so where did they come from? Some no doubt was as a result of wealth generation within the economy, but much of it came from the rest of the Euro zone - pension funds and so on as suggested by Mr. McWilliams.

I fully agree with the author when he suggests that the lending practices of the banks was crazy!  But I'm also willing to accept that most of the banks will have been using nice maths models produced by colleagues of the author when it can to assessing these risks!  Why, because I've been here before with the Long-Term Capital Management fiasco during which I spend time trying to explain the weaknesses of the Black–Scholes model to a senior manager at one of the banks who lost a lot of cash on that one.  And also because UBS AG, one of the major international players who lost over $50b has come to the same conclusion - over reliance on maths models.

In the cold light of day the one group that could have done more were the politicians/government, although they could not do much about the money supply or the lending practices, they could have acted to discourage the bubble in a few ways:
- Reduce or remove tax breaks on home ownership
- Introduce a high wealth tax on property
- Introduce tax breaks to encourage savings
And so on... but if they had done this, would we have re-elect them??? I think not!

The reality is that the cause of bubbles is far more complex than this article suggests and furthermore, no matter what we do now, there will be future bubbles and we will most likely get burned again!

Worth a read:

Extraordinary Popular Delusions and the Madness of Crowds

Manias, Panics and Crashes: A History of Financial Crises

Jim.


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## ColmFitz (3 Jul 2011)

money is a means of exchange - both cash and credit fall into this category


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## Purple (4 Jul 2011)

Jim2007; excellent and informative posts. Thank you.


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## Chris (4 Jul 2011)

There are some very valid points in the article, but it falls very short on important details. The author correctly identifies that increased money supply is the cause of price inflation and that the banks create money and how they do so. But he fails to acknowledge that since the founding of the Euro the ECB has increased base money supply by 260%, which has a massive effect on the 540% increase in money supply in Ireland.
The author also fails to identify the fact that it is the ECBs responsibility to set minimum reserve requirements, which are set at 2%, so the banks were above this limit.




Jim2007 said:


> And while it is true that Basle III, will require banks to meet a higher T1 ratio, which will result in them being less profitable, they will at least be less risky from a depositors point of view.



Very good point. The author of the article and others on this thread are trying to argue that increasing reserve requirements after they were kept far too low for far too long is what caused the problem. The problem was the low reserve requirements in the first place, and if they had not been increased bank's would be in a lot worse shape. It's like taking away drugs from an addict, the withdrawal symptoms are caused by the prior taking of drugs, not by the fact that drugs are no longer pumped in.


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## onq (4 Jul 2011)

Chris said:


> It's like taking away drugs from an addict, the withdrawal symptoms are caused by the prior taking of drugs, not by the fact that drugs are no longer pumped in.



You're describing Cold Turkey.

"Cold Turkey" is what addicts experience when drugs are completely taken away.
Only the most cruel, unintelligent and right  wing pseudo moralisers see this as a means of addressing drug addiction today. 
This won't help the addict to overcome the addiction - it is widely  accepted that an addict has to be led to a desire to give up the drug  first.

Referring to the previous level of addiction as the proximate cause of withdrawal symptoms is a disingenuous argument.
It is the lack of the drug which triggers the withdrawal symptoms and may possibly lead to death just  as too much of the drug will trigger an overdose and death.
The correct procedure is to replace the highly addictive active ingredient with a less addictive one and gradually reduce the dosage while encouraging healthy eating, exercise and rest habits to bring the body to a state of normality.

All of the above is well-known, but its far convenient for some to "allow" naive, moralistic first-principle argument to cloud judgement where it is not based on medical and personal experience.
It appears that it is precisely this lack of competence that is supposedly guiding the BIS and the people Jim tells me it fronts for - the ECB, the FED and the IMF.
Or so they would have us believe.

ONQ.


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## DerKaiser (4 Jul 2011)

Nice simple article.  Shouldn't be criticised for keeping it simple.

Banks lent up to 8 times income on house purchases.

They could only do this through massively increasing the credit supply. They could only do this by holding lower cash reserves and through an increasing loans to deposits ratio.

The regulator could have limited these vital actions in any number of ways.

Simple as that. Yes you can delve deeper into why it happened (opening up of the market to foreign banks, ECB funding, etc) but that's not necessary to understanding what happened and how it should have been stopped.

Some people obviously don't like the simplicity, but you can't argue the facts.


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## Complainer (4 Jul 2011)

DerKaiser said:


> Nice simple article.  Shouldn't be criticised for keeping it simple.
> 
> Banks lent up to 8 times income on house purchases.
> 
> ...


I recall some discussions and news articles during the boom years saying that the regulator was pretty powerless on the particular issue of income multiples in lending. Could you be more specific as to what the regulator could have done?


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## Brendan Burgess (4 Jul 2011)

I have moved the ONQ and Jim comments to this thread. 

Please keep the main comments as a response to Colm's post. 

Brendan


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## DerKaiser (4 Jul 2011)

Complainer said:


> Could you be more specific as to what the regulator could have done?


 
Always believed that they had some control over stress tests. It could have set up the parameters of a stress test to have more appropriately restricted excessive lending on both micro (individual mortgage customer) and macro (bank capitalisation) level.


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## onq (4 Jul 2011)

ColmFitz said:


> Between 1996 and 2007, the total amount of money in Ireland increased by more than 540% - another not very publicised fact. In my opinion this was the result of extreme ineptitude by our Central Bank, our financial regulatory system and our Government.
> 
> Where did all the extra money come from you may ask?
> 
> Shockingly, the vast majority was effectively printed by Irish banks, AIB, BOI, Anglo etc. If a government prints money it’s considered bad – but letting banks print it, and in vast quantities, is disgraceful. Yet this happened with practically nobody in Ireland saying anything!



To suggest all this came about via increased money supply is not entirely correct and takes the focus off the real villains of the piece - the government of the day and the practices of both the lending institutions and the estate agents.

I am not in a position to confirm where all the money "came from" but as far as I know credit is simply created out of nothing by double-entry book keeping on the part of the banks, with actuaries advising on what, if any, monies should be kept in reserve over and above the legally required minimum.

At the time I understood that any shortfall was made up by Irish banks borrowing abroad at historically low interest from European Banks in countries where savings were not being used in enterprising development in those countries.

This suggest responsibilities may arise for both Germany and France in the current fiasco in which we find ourselves since less freely available money on the international markets would also have reduced the credit flows into Ireland.

In short at every macro level there was a derogation of duty both to foresee the disaster that increasing the money supply so drastically would cause and to restrict the supply to manageable rates at every level from the BIS, the European Central Banks, the IMF, the Irish Central Bank, the Irish Regulator, the Head Office of each lending institution and each branch.

All these supposedly highly intelligent, highly qualified, highly experienced highly paid people simply didn't know what was going on.
Quite frankly, either these people are intelligent and they did know, or they are fools who should be fired.
Only in the military do you get away with "I was only following orders".

And even that old canard is discredited.

====================================

Initially, there was no vast money supply or lack of regulation promoting development.
Ireland's use of the €7-8 Billion of Structural Development funds from the EU had opened some new areas for development in the late 1980's and early 1990's.
But it was the introduction of the tax designation of sites to encourage investors to develop derelict urban sites that promoted the growth of the Irish Construction Industry.

I can confirm, through my involvement in the growth of the designated development market for apartments from circa 1990-1998 and my observations on that market thereafter, something of what occurred.

Initially many of the new buyers were indigenous to the areas being developed or had formerly lived in those area and had maintained social ties to that area and returned to it when an opportunity presented itself - such was the feedback developers I spoke to received.

A prime example were some inhabitants of large tracts of Tallaght who had been moved out as part of a local authority re-housing scheme from centre city areas which were subsequently regenerated. When the apartments became available they chose to move back into the city, buying a new one bedroom apartment for €36,000 in 1994.

The provision of these newly constructed apartments as part of a managed development which you could purchase outright for a reasonable amount relative to average incomes at the time opened up a new market in Dublin and the other designated areas.

====================================

There were two fatal flaws driving this golden age of apartment building.(i) Tax Designation
The effect of the tax designation over time was to encourage developers to partake of their own product for both tax write-off, investment and buy-to-let purposes. 

(ii) Block Buying
Instead of requiring the apartments in a tax designated scheme to be made available only to purchasers as sole domiciles, which would have lessened demand significantly, the government allowed block buying by both developers and institutions.​These two measures distorted the market and caused hyperinflation of apartment prices. They placed homeowners on an average wage or salary of circa €25-35,000  in direct competition with millionaire developers, pension funds and  wealthy private investors.

However there was a third major incentive for developers to get involved in the market and which was never addressed in a timely manner at any point - the 20% Capital Gains tax. 

I can recall an animated discussion back in 2004 with a client while Cowan was still Finance Minister where I was taken to task for daring to suggest that the Capital Gains tax should be increased to 40% as was then being mooted in political circles.

====================================

Into this distorted market waded the banks and building societies, realizing that there were profits to be made if they only relaxed their lending policies.
These same institutions knew well that in 1992 the Commercial lending rate had been reported at 22% and the house mortgage rate had hit 16%.
This caused people on two incomes in three bed semis in Tallaght extreme financial hardship even on the 2.5 + 1 ratio of mortgage lending.

The lending institutions' new found evangelism for all things in the apartment market had a knock on effect in the housing market.
A buying panic set in amongst a generation that had expected to live with their folks until they married and now saw the prices of hosues recedign from them at an alarming rate.
Huge salaries in the financial sector created expectations that were intrinsically unsupportable in the longer term in other sectors of the Irish economy.
But only the lending institutions inflated profits could afford to pay people to do very little all day except look good in a suit and take orders.
All of this further fuelled the inflation in the residential market.

====================================

But the banks didn't stop there, they went from -

- lending money prudently on the 2.5 + 1 Ratio under which I bought my first house in 1992, to 
- selling money with 100% mortgages and 5:1 rations from circa 1998 to 2002, to
- shovelling money at people offering 110% and above mortgages, extensions on the mortgage, new cars on the mortgage at many times the multiple of maximum earnings, even for couples who intended to start families with the consequent reduction in disposable income this brings.

Worst of all was that fact that people were induced into taking out mortgages and loans over initially 25 years, rising to 35 years (!) at historically low interest rates without the likely consequences of this or their other outstanding loans being fully considered.

====================================

Therefore, suggesting that the relaxation of reserve ratios or an increase in money supply - in and of itself - caused all this is to miss the more complex picture.
It ignores the symbiotic relationships that developed between estate agents, mortgage advisors and lending institution agents [some of which was exposed by Prime Time a few years ago].
IMO these relationships constituted inducement which amounted to criminally negligent behaviour that failed to observe any duty of care to the recipients of the loans in relation to prudent borrowing requirements.

ONQ.


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## Purple (4 Jul 2011)

Excellent post ONQ. Very informative.


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## DerKaiser (4 Jul 2011)

onq said:


> I am not in a position to confirm where all the money "came from" but as far as I know credit is simply created out of nothing by double-entry book keeping on the part of the banks, with actuaries advising on what, if any, monies should be kept in reserve over and above the legally required minimum.


 
As far as I know the actuaries are only involved in signing off the solvency of insurance companies, not banks.


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## onq (4 Jul 2011)

Der Kaiser, I stand corrected.

Purple, its sort of a summary of a lot of disparate comments made by me over the years and I know it includes what may seem like comments that are not attributed to people who have a shared or similar experience and who also may have commented on AAM.

I did that from memory in about an hour and so didn't have time to cross-check possible sources. Anyone who feels they should have received an attribution, please comment or contradict if I've misremembered anything.

ONQ.


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## Chris (5 Jul 2011)

onq said:


> Therefore, suggesting that the relaxation of reserve ratios or an increase in money supply - in and of itself - caused all this is to miss the more complex picture.



I agree with a lot of your observations, especially around government interventions that fueled the bubble. However, none of this would have been possible if the money hadn't been there. The only way the excessive amounts money found their way into Ireland and especially property is because the ECB increased base money supply by 260% and required minimum reserves of only 2%. If the money supply had not increased then something would have had to have come down in price by exactly the same amount as property prices went up. Instead everything went up in price with property being at the top.


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## onq (5 Jul 2011)

I agree in principle with what you say Chris, but that availability of the money only created the potential for disaster.
It required a lot of active incompetence on the part of the players I mentioned to create the crisis.
The money didn't jump into people's accounts by itself, and people aren't herd animals. 

ONQ


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## Jim2007 (5 Jul 2011)

onq said:


> people aren't herd animals.
> 
> ONQ



Sorry, I under great pressure right now, so can't stop... Did you get to read the UBS report I referenced at the start????  If you want to see just how stupid senior people can be read it.  These guys started out sell mortgage securities for sub-prime loans to clients as high risk products... but in series of steps over the period the they convinced each other that these things were in fact a very solid low risk investment so they reduced their sales efforts, kept them for themselves and blew $50b of their own capital on them!

The human factor plays major factor in all bubbles, just look at Tulip mania for a start. People just don't act with the level of clarity you'd expect, even at the top table.

Jim.


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## Chris (6 Jul 2011)

onq said:


> I agree in principle with what you say Chris, but that availability of the money only created the potential for disaster.
> It required a lot of active incompetence on the part of the players I mentioned to create the crisis.
> The money didn't jump into people's accounts by itself, and people aren't herd animals.


I actually believe that especially in artificial bubbles all human reason is put aside. Ireland's own property bubble is a perfect example of how people here went into a total herd mentality; "I better buy a house or two quickly before I got priced out of the market", was the mantra of the day. When people are offered large amounts of money almost for free then it is no surprise that people will take up the offer without too much thought.
I'm not trying to distract from government's responsibility in creating the crisis. Governments fueled the credit and housing bubble through acts of commission (increasing money supply, subsidising certain industries, subsidising home owners, etc.) not by acts of omission (not enough regulation or oversight). But ultimately this would not have been possible if the money supply had not been increased by the huge amount that it was.



onq said:


> You're describing Cold Turkey.
> 
> "Cold Turkey" is what addicts experience when drugs are completely taken away.
> Only the most cruel, unintelligent and right  wing pseudo moralisers see this as a means of addressing drug addiction today.
> This won't help the addict to overcome the addiction - it is widely  accepted that an addict has to be led to a desire to give up the drug  first....



I have a cousin who has battled with alcohol, cocaine and LSD addiction for about 20 years. He is finally sober 24 months, and I can tell you that he was not given alcohol or cocaine or LSD during rehab. This is exactly what is happening in Greece. Greece is addicted to borrowed money, and rather than the EU assisting to reduce the level of debt  it is increasing the level of debt. That is like going into rehab where there is a bar and some drug dealers.


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