Why we can’t let banks fail

One of the concerns with the Greek (and Irish and Spanish and Portuguese and the rest of Europe) debt crisis is that a number of banks will have to take a loss. It is tempting to say “so what, banks are rich and their shareholders can cope with a loss better than anyone else.

But there are some complications. Banks are essential in creating the money supply. When banks make a loan they create money and the total money supply is increased.. When the loan is repaid, the money supply decreases until the money is re-loaned and the supply goes back up.

Thus the money supply is constant – until a central bank purchases government bonds. This is the creation of new money but because of fractional reserve requirements (banks are required to hold a percentage of deposits in reserve against withdrawals) money created by the central bank is called high powered money and the money supply goes up with a multiplier effect.

All this is explained in any textbook on the economics of money and banking. What I have never seen explained is the effect on the money supply when a bank writes off a loan. Probably it has the reverse effect of high powered money – a decreased money supply subject to the same multiplier.

In most cases the writing off of loans will have little effect on the money supply However, if the amounts to be written off are large as was the case with the American housing crisis or is likely to be the case with any sovereign debt write off , the impact on the money supply will be substantial and it we lead to an abrupt decline economic activity.

Banks and their shareholders my be rich, but if they suffer loses on their loans, a lot others will become much poorer and out of jobs.

(Here is a link to the wikipedia article on money creation)

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