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.

Internet financial firms

The potential for geeky financial firms is featured in an article in last week’s The Economist.  At this time the firms are small compared to the banks but there is probably enough potential that the banks could be threatened.

This could be both good and bad.

It will be good if there develops and alternative to fractional reserve banking.  I am thoroughly convinced that money creation by fractional reserve debt is a Ponzi scheme which frequently collapses in a financial crisis.  If these firms do replace the banks and avoid fractional reserves  we will have to find another way of creating money.  Whatever it is it will require that the money supply be flexible up and down to correspond with the level of economic activity.  I rather like the concept of Local Exchange Trading Systems which could be expanded to a national level.

The not so good feature of geeky financial services is that they would be an ideal new venture for large firms such as Amazon, Facebook or Google, firms whose commitment to privacy appears to be limited to their own.

buttom2I can see two groups rubbing their hands at the prospect of one of these large firms becoming  involved in most financial transactions.

The first are those in the online advertising business who use information about people to target advertising and the second are government spooks and those in government who believe they know what is best for the rest of us and want to control our lives.  Just think: emails, friends, shopping and financial data on everyone all available from one source. I wonder if the spies already have access to personal  financial data.

Probably the people into social control are the most threatening.  Once the monitoring  systems are all in place it will be easy for somebody to misuse them.

Another article this week, from Forbes,  talks about small groups of people getting together to provide each other with financial support.  This sounds like the early  credit unions on the Canadian prairies where a lot of transactions took place on someones kitchen table.

The risks of making loans

Crowd funding for unsecured personal loans is interesting in that it spreads the risk and potentially dangerous in that  it may attract investors who ignore the risk factor.  It is also unique in making loans that do not add to the money supply via fractional reserve banking.

An article in this week’s The Economist reports on some American firms that are making crowd sourced loans to individuals usually to consolidate and reduce the cost of credit card borrowing.  This model means borrowers get a cheaper interest rate and depositors get more on their deposits.  This is different from crowd sourced funding for business development although both involve risk.

CCBill_20120401When ever one makes a loan, either directly or though an intermediary (a bank deposit) one is transferring purchasing power to somebody else.  Mostly one hopes to get more purchasing power (interest or dividends) back.  There are three risks in doing this:  a government may decide to give you a haircut, the person may default or you may get caught by inflation.  We can try to protect ourselves from default by purchasing deposit insurance.  I don’t know how to protect ourselves from a haircut or inflation.  Maybe by supporting the Tea Party.  These risks will always be there no matter how bankers try to offload them.

As I understand it the crowd loan companies allow you to put a small amount of money into a number of loans.  Each amount is tied to that loan and your deposit is returned to you if, as and when the borrower repays the loan.  This allows you to spread your risk among a number of borrowers.  This may let lenders think they are reducing their risk but most business and financial models work well when the economy is growing and have problems when growth declines.  There is some probability our economy will continue to decline for some time to come.  Here is the risk statement of one of these companies.

I like that this way of funding loans does not involve fractional reserve banking and thus has a neutral impact on the money supply.

I fear that too many people will see the higher interest rates being paid on deposits and  ignore or not realize the risk involved.  If and when the risk becomes reality, there will be a lot of crying and screaming and possibly a lot of suffering.

It may be that the risk in crowd funding is no greater than with other forms of saving/making loans.  It is just a little more obvious. I still think that given the current economic situation the best investment is a market garden.

Banking – a risky business now and in medieval times

Modern bankers are protected from personal bankruptcy by the concept of “too big to fail.”   This hasn’t always been the case as in medieval times banking was a very risky business with failed bankers losing everything.

I have just finished reading Money, banking and credit in Medieval Bruges by Raymond de Roover who discusses a number of issues about money and banking most of which are still relevant.

His book covers the Italian merchant bankers who used bills of exchange to avoid shipping specie, the Lombards who operated as pawnbrokers to provide licensed usury and retail credit and the money changers who were the forerunners of today’s commercial banks.  It is the latter that I found most interesting.

One of the first things to impress me was de Roover’s use of the term purchasing power to describe money.    When so many people think of money as a commodity with a value in its own right, it is important to be reminded that the main function of money is as purchasing power.  He points out the Italian merchant bankers used bills of exchange to transfer purchasing power from one place to another.  Also the money changers transferred purchasing power when they assisted their customers to transfer funds from one person to another.

Briefcase_Vector_DesignMedieval bankers knew that loans to princes and governments were perilous and should be avoided.  Considering the amount of debt owed by governments today is so great it will never  be repaid this is probably a good rule.  Rolling over debt plus interest is a racket and a lot of people are going to lose a lot of purchasing power.   Some will find their retirement plans disappearing.

De Roover is emphatic that the money changers were creating money through their fractional reserve policies.  They were accepting deposits and making transfers of purchasing power by via entries from one account to another.  As all the money changers were physically close they could do transfers between customers of different bankers.  As most of their transfers were on paper and they kept about 30 per cent in reserve,  much of the money in their strong boxes was available for other uses.  Some was loaned to customers as overdrafts and the rest was invested in commercial ventures.  In either case they were creating fractional reserve money and adding to the money supply.  Modern banks follow a fractional reserve policy and are creating money when they make loans.

Because of usury laws no interest was paid on deposits or charged on overdrafts.  They made their money on exchanging currency and from investments.  This is interesting because I believe interest being charged on fractional reserve money/loans causes us a lot of problems.

By making investments in commercial ventures the money changers were living dangerously because this money was not on hand if requested by depositors.  Financing long-term investments with short-term or demand deposits is a high risk business plan and many money-changers found themselves bankrupt.  De Roover quotes a medieval source as saying that in Venice 96 out of 103 banks came to a bad end.  He figures this may be an exaggeration but in any case banking was a high risk venture and many bankers lost everything.

When we had our banking crisis a few years ago some bankers were financing sub prime mortgages with overnight loans.   This was more dangerous than the medieval money changers because it was on a much larger scale.  This practice was highly profitable because of the high spreads between short- and long-term interest rates.     When it became apparent these mortgages were problems the overnight financing was no longer available and the banks were in serious difficulty.

The difference between the money changers and Wall Street bankers was that the money changers were very small operations.  The concept of too big to fail had not yet been invented.  Even so the payment transfer function was so important that new money changers quickly appeared and eventually a number of medieval cities established civic banks to perform that function.

There are a number of issues discussed in this book many of them still problems even if on a much larger scale.

I have long believed that banking is a risky business and that there is a need to find a way of creating money other than the fractional reserves of banking.  I still do.

 

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.

Bitcoins, gold and pyrite

Bitcoins and gold may have some speculative value but as a solution to economic problems or as a form of money they are on a par with pyrite

As I understand bitcoins their main feature is that the supply of them is intended to be finite.  This will make them great for speculators but as a form of money they come with the same problem as gold and that is that the amount of money in an economy needs to be flexible.  Through history there have been a number of situations where authorities have tried to limit the money, sometimes by trying to force a gold standard, and the result has been serious depression.  I wonder if bitcoins were invented in part because gold is in limited supply.

circleBitcoinProbably the increasing interest in  bitcoins is a psychological reaction to economic uncertainty and fears of hyperinflation which would wipe out the savings and pensions of a lot of people.  Given that the economic crisis is based on problems in the resource base gold and bitcoins may not be useful.  A better hedge would be a market garden.

Another feature of bitcoins is that they can be used online anonymously .  This makes them great for illegal transactions.   No wonder some regulators are saying bitcoins should come under their jurisdiction.

So far as I can see the main use of bitcoins is for speculation.

The basics of banking

Somebody has questioned how it is that banks can/should make their profits on the spread between deposits and loans.  Sometimes, when we are familiar with a subject we ass u me that everyone understands all the basics.

In the jargon of economics banks are financial intermediaries which means they are the facilitator between people who have money to lend and those who want to borrow.  People with money they don’t want to spend immediately can deposit that money in a bank.  The bankers then lends that money to somebody who has an use for it.

Bankers charges interest on the loan.  Some of that money is paid as interest on the deposit and the balance, the difference between the two interest rates, is the spread with which the banker pays his expenses and takes his profit.  It is very similar to the retailer who purchases goods wholesale and marks them up to sell at a retail price.

DooFi_PiggybankThat is the core business of banking.  Boring.  However there are a couple of additional factors which make banking  very important and very risky.

The first is that banks operate under the fractional reserve principle which means they are required to keep a percentage of deposits as cash or in a form which is immediately available.  This is just in case many people want their deposits returned at the same time.  Loans cannot always be called in quickly.  A “run” on the bank has to be most bankers worst nightmare.  I believe all bankers would lie about the financial health of their banks  to try to prevent a run.

I try to avoid dealing with bank loans staff but a couple of times I have asked how it feels to be creating money.  They cannot believe they are creating money in making loans but to those who have studied economics of money and banking that is what they do.  The process is explained  in the essay “LETS got to market: Dealing with the economic crisis.”  I figure the process is a Ponzi scheme and responsible for a lot of economic evils.  It also gives bankers a great deal of power.  Because banks create money it makes them so essential for the economy they cannot be allowed to fail.

The second complication is that making loans is a risky business in that borrowers are not always able to repay their loan.

This can be a problem for the economy as a whole  because if the banks have to write off  a large quantity of their outstanding loans,  the money supply can drop quickly and without money the exchange of goods and services stops.

Risk also  makes it easy for bankers to take for themselves some huge profits.  The general rule is that the longer the term of a loan or deposit the higher the interest rate charged or paid  because the risk is higher.  Prudent banking requires bankers to match the terms of their loans and deposits so that a loan for five  years is matched with a deposit that is committed for five years.  Thus the depositor gets more interest because he/she is carrying more risk.  In an ideal world the spread will be the same for all time periods.

But bankers can make huge profits by financing long-term loans upon which they receive a high interest rate with short-term deposits upon which they pay low-interest rates.  This way they increase the spread and take the rewards of the  higher risk.  This  tactic increases the risk as interest rates can go up above the returns from the loan or depositors may decide to withdraw their money.  I know of a Canadian financial institution that purchased some government bonds (made a loan) at ten percent.  Management expected interest rates to go down so that the interest received would be greater than what they had to pay on deposits – a nice profit,  This was just before interest rates went up to 19 percent and for a while the loses were considerable for the size of the institution.  Just before the financial crisis of 1907/08  at least some of the Wall Street banks were financing long-term sub-prime mortgages with low-cost overnight deposits.  As it became apparent a housing crisis was in the making the depositors stop renewing their deposits.

Of course when risk becomes reality and banks are faced with huge loses they are so important they cannot be allowed to fail and taxpayers end up paying for the risk.

So there you have it.  Prudent banking is simple and boring.  Breaking the basic rules brings in huge profits and ends with a major crisis.

Counting money

Bank tellers tend to be very fast and very accurate at counting money.  Economists have a more difficult time of it.  They can’t even agree on a definition.  This post was prompted by this article criticizing The Fed on how it measures the money supply.

Once upon a time I worked as a journalist.  I used to say there are two types of figures.  One kind we photographed and put on the front page and they help to sell newspapers.  The other kind help to put things into perspective.  When I got to university and wanted to study economics I found I didn’t have the calculus skills to do econometrics so I have stayed with my idea that statistics help with perspectives.

mystica_Coins_Money_Economics is about relationships.  It is about the relationships that go with the exchange of goods and services and since some exchanges involve the state it is also about our relationships with governments.

Not all exchanges can be recorded let alone measured therefore statistics are of limited use.

Mathematical concepts are useful in that they can simplify the analysis of relationships and help us understand what is happening.  Sometimes statistics can be useful for evaluating things we want to believe.  One should be leery of drawing conclusions from emotional accounts of events.  For example, a former professor claimed that during the industrial revolution things got worse for working people before they got better.  One of his arguments was highly emotional newspaper accounts of children dying in poverty.  I would have been more convinced it he had produced statistics of child mortality rates before, during and after the industrial revolution.

Back to money.  For economists it is difficult to count because there are so many things including cigarettes and candy have been used and there are a number of economic  definitions  depending upon what types of bank deposits are included.  I figure money should be defined as anything that represents purchasing power including and especially computer impulses.

Money is my favorite subject although I have never wanted to be a bank teller.

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