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.
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. (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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Filed under: banks, money, Economics | Tagged: banki failures, banks, central banks, Economics, fractional reserve, fractional reserve banking, government bonds, money, money and banking, money creation, money supply | 1 Comment »