Why we can’t let banks fail

It appears investors are putting money into banks in the belief the banks are safe because governments can be relied upon to bail them out the next time they get into trouble.  These investors could be right.

It’s not so much that banks are too big to fail, it is more that they are too important to let fail.

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.  Because the central bank pays for these bonds by adding to the liabilities of its balance sheet, 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.

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

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. People will invent alternatives to the lost money but the initial devastation will be  a problem.

 The Americans are considering cutting back on their food stamp program.  My prediction is that when the next financial crisis happens, keeping the banks going will come before feeding people.

One way to reduce the importance and power of the banks would be to find a new way of creating money.  One proposal for doing this is in the essay “LETS go to market: Dealing with the economic crisis” on this weblog.

Let’s end this post with the following quote attributed to Henry Ford.

“It is well enough that people of the nation do not understand our banking and monetary system, for if they did, I believe there would be a revolution before tomorrow morning.”

(This is an update of a post originally published in June, 2011.)


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What caused the financial collapse?

Here are four causes of the financial crisis not based on conventional economic wisdom:  the way in which we our economy creates money, the using up of the most accessible energy and mineral resources, the greed of most of us and imprudent or fraudulent banking practices which allow bankers to make excessive profits.

For a more conventional explanation see this article in The Economist.

We all use money and many people are very good at “making” money but very few understand its function and how it is created.  As gold and other items have traditionally been used as money we treat it as a commodity with some value of its own.  But money is a tool to facilitate the exchange of goods and services.  It is a token of purchasing power.  It is important that we have just the right amount of money to use otherwise we have inflation (too much money for the transactions we want) or deflation (not enough).

The money we use results from fractional reserve banking in which banks are required to keep a percentage of their deposits as reserves.  How this works is explained in the essay “LETS go to market: Dealing with the crisis” on this weblog.  It is complex but I find it  easy to understand.

Our money supply is based on loans made by banks and upon which they charge interest. For this system to work there must be a continuously increasing supply of money which sort of works so long as the economy is growing.  However, even a slowdown can cause problems because we need the right amount of money for the number of economic transactions.   I think this is a Ponzi scheme and therefore it is bound to collapse.  Periodic financial crises are built into the way we create money.  This is one of the causes of the current crisis.  When the U.S. mortgage bubble burst the money supply and the financial system collapsed.

There are two sides to the economic equation.  One side deals with the financial and the other with the physical goods that provide us with food, shelter, clothing. transportation and toys.

Since the industrial revolution we have been living in unprecedented increasing prosperity.  However there is some evidence that since the 1970s the growth of this prosperity has been slowing down and maybe even declining.  My theory to explain this is that we have used up the most easily accessible of the energy and mineral resources and it now takes more energy to recover what is left.  To use jargon, the marginal costs have increased.  This is bound to affect standards of living as more effort must be applied to resource extraction and less to other things.  This is background to the financial crisis.

Wall Street bankers are the kings of greed who got their riches partly be being in the right place at the right time.  They also make good scapegoats.

A scapegoat is somebody you blame for the consequences of your own weaknesses.  Most if not all of us have some greed and this was a factor in the financial crisis.  Before and since the crisis many people wanted the most they could get.  This includes the savers and investors who wanted the greatest returns to the poorer people who wanted housing they couldn’t afford.  Every time I go to the ATM machine or actually enter the bank I am reminded the financial industry is still appealing to the greed of its customers.

The final cause of the financial crisis is that bankers are smart enough to realize they can increase their margins and make huge profits by mismatching the terms of deposits and loans.  At the best this is imprudent.  It could even be fraud.

Bankers are financial intermediaries in that they collect deposits and make them into loans.  The difference in interest rates provide a margin which covers their expenses and provides some profits.  Prudent banking requires that the terms of the deposits and loans match.  Thus if a banker makes a loan for ten years then he should have on hand ten-year term deposits of the same amount.  Breaking this rule can be very dangerous and very profitable.

The reason for breaking the rule is that the longer the loan the greater the risk and therefore the higher the interest rate which will be charged on the loan and which must be paid to get deposits committed for the same time. A banker who finances a long-term loan with short-term deposits can increase his margin.  Prior to the financial crisis the banks were financing long-term mortgage loans with short-term deposits, some of the deposits were committed just for one day at a time.  This worked well when the economy was going well but when it became apparent there were problems the depositors became worried about their money and refused to roll them over.  As banks are required to only keep a fraction of their deposits on hand there was a limited number of depositors who could be refunded.

I think this should be considered fraud against the depositors or in this case the taxpayers who covered the losses.  It was necessary for the government to step in  because we would have lost even more of our money supply and that would have been disastrous.  The question which probably should not be asked: are bankers continuing to mismatch deposits and loans?

So there you have it, my list of four factors which contributed to the crisis.  All of these will be challenging to change.  Some ideas for change are in my essay “LETS go to market: Dealing with the economic crisis.”


If you liked this post your are invited to comment, press the like button and/or click  one of the share buttons. If you disagree you are invited to say why in a comment.  While I like the idea of sharing this platform, my personality is such that I don’t reply to many comments.

Low wages and supply and demand for people

One has to have a great deal of sympathy and understanding for those fast food workers demanding a living wage and one also has to fear that the supply and demand for bodies will keep them down.

There are lots of other people, out of sight and/or not counted,  struggling to survive on low incomes.  They too deserve compassion and understanding.

It has been said that the profits of the fast food industry are sufficient to double the wages of all its workers.  This is not the issue.  The issue is that wages are determined by supply and demand.  The reality is that there are more people than there are jobs.  Some firms have demonstrated they can make good profits by paying their employees well but human nature is such that most employers will continue to pay as little as they can.

Technology has reduced the need for workers and reduced transportation costs have increased the supply of workers from other countries.

With the world economy in crash mode the plight of low-income people is likely to continue and even get worse. At the same time a few will continue to get richer.  The one thing which could level the field would be hyperinflation which would hurt everyone.

Another indication of the oversupply of workers is the declining power of private sector unions.  Public sector unions are still doing well because they have monopoly and political power.  I would have more respect for teachers’ unions if they were to go on strike demanding an increase in well fare rates.

I believe subsidies should be given to consumers rather than producers.  Therefore I would like to see some sort of universal income scheme such as a guaranteed annual income or the negative income tax proposed by Milton Friedman.  This probably would not halt the economic decline but would be fairer than the way we now treat people.  It may be that the American dream is just a  dream.

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