Why we hate bankers

The following was posted as a comment on The Economist website to an article on demonizing bankers in the January 7, 2012 issue.

http://www.economist.com/node/21542389

The reason bankers are the focus of economic frustrations is that they create money when they make loans.

By creating money they have lots of opportunities to take cuts for themselves, they have the power to say what projects go ahead and by whom and they get to charge rent (interest) on the money they create.  Those are three good reasons for people to hate them and for bankers to tolerate the hatred.

(The author of this comment has a web log on economics at https://economics102.wordpress.com/)

Temporary money for a bailout

Here’s n interesting little story about money.

A tourist in a small depressed Irish town leaves a hundred pound note with the hotel keeper while he inspects the rooms.

While the inspection is happening the money is used to by a series of business people to pay off their debts to each other and lands back with the innkeeper just as the tourist returns to collect his money and leave..

The story ends with these lines:

“No one produced anything. No one earned anything. However, the whole town is now out of debt and looking forward to a brighter future.

And that, gentle reader, is how a successful bailout works.”

This town was using debt as money which is the case in our own economies.  However, this “bailout” was only able to work because there was no interest charged on any of the debts.  It could be that we would be much better off if we were to create our own money supply without interest charges to make things more complicated.

The people of this town would probably be better off if they were to use playing cards or candies as money or better still adopt a LETS (local exchange trading system).

Credit crunch and the money supply

Mark Carney, the governor of the Bank of Canada, and recently appointed to the Financial Stability Board, to oversee international financial reform has made the news by pointing out there may be a new wave of credit tightening as a result of the European debt crisis.

When bankers and economist worry about a credit crisis they are talking about a decline in money supply.  This is because banks create money when they make loans.  If they don’t make loans there will be less money around.

In a declining economy there are two things to note.

First, as we feel the squeeze from an unsustainable use of resources, there will be need for less money in the economy. Otherwise there will be inflation.

Second, if the money supply declines more than is needed, then there will not be enough money for the exchange of the goods and services we are capable of producing.  This too could contribute to the recession.

Effect of Eurozone deal on money supply

An analysis article on the Guardian website lists six problems facing the Eurozone following the deal in which a pile of Greek debt will written down by 50 percent.

The problem which catches my attention is number five: that Europe’s banks could starve the economy of credit.

Europe’s banks have been told to take a more realistic view of the billions of euros worth of sovereign bonds they hold on their books, and make sure they’re holding enough capital to protect themselves against the risk of default by Greece, Portugal, Spain and Italy. They could do that by raising investment in the financial markets – from cash-rich states such as China, for example – or they could choose instead to repair their balance sheets by reducing their liabilities. That would mean calling in loans and depressing new lending to families and businesses throughout Europe – exactly the credit crunch eurozone politicians are so keen to avoid. Any such lending squeeze would be likely to exacerbate the slowdown that is looming: many economists already expected the European economy to slide into recession in the fourth quarter of the year.

When they talk about credit the really mean money supply.  One of the risks of this deal is that there may be a major reduction in the money supply in Europe and probably around the world.

This is serious. As well as having to cope with a slowdown because we are using resources at an unsustainable rate the economy may further depressed because their will not be enough money supply to facilitate the exchange which is still possible

Bitcoin: an attempt at a new way of creating money

Bitcoin, an attempt to establish a new “peer-to-peer” virtual currency is described in an article in The Economist of June 16, 2011.

One can accept the need to search for new ways of creating money. I believe the recent financial crisis was in part a failure in the way in which our economy currently creates money. (Money is created when bankers make loans, subject to a multiplier effect from the requirement to maintain reserves. When a whole lot of loans went bad this decreased the money supply, again with a multiplier effect. With a suddenly decreased money supply, the economy went for a loop.)

One of the problems with the bitcoin system is the quantity of money available is strictly controlled according to a formula.

I have always liked the quantity theory of money which states that MV=PQ where M is the money supply, V is the velocity at which it changes hands, P is the price or price index and Q is the quantity of goods and services produced.. Therefore as Q goes up (or down) there also need to be changes in at least one of the others. If we want prices to remain constant, then we need a way of creating money such that the supply can easily be varied according to the quantity of goods and service produced.

Dangerous debt

I came across this article from the Guardian about the U.S. spend or cut debate shortly after I started reading This Time is Different: Eight Centuries of Financial Folly by Carmen M. Reinhart and Kenneth S. Rogoff.  The article reports Paul Krugman is urging  the Obama administration to go with a trillion dollars of stimulus.

In the book the second paragraph of the preface talks of excessive debt accumulation.  Granted that the authors are talking about dept during a boom, but if that is a problem what is it during a  recession.

If there is one common theme to the vast range or crises we consider in this book, it is that excessive debt accumulation, whether it be by the government, banks, corporations or consumers, often poses greater systemic risk that it seems during a boom.  Infusions of cash can make a government look like it is providing greater growth to its economy that it really is. Private sector borrowing binges can inflate housing and stock prices far beyond their long-run sustainable levels, and make banks seem more stable and profitable they really are.  Such large-scale debt buildups pose risks because they make an economy vulnerable to crises of confidence, particularly when debt is short  term and needs to  be constantly refinanced.  Debt-fueled booms all too often provide  false affirmation of a government’s policies, a financial institution’s ability to make outsized profits, or a country’s standard of living.  Most of these booms end badly. Of course, debt instruments are crucial to all economies, ancient and modern, but balancing the risk and opportunities of debt is always a challenge, a challenge policy makers, investors, and ordinary citizens must never forget

My own reasons for objecting to stimulus spending is stated in the post Economic policy, least squares and the Elliott wave

The financial crisis, banks and money creation

Throughout the financial crisis I have seen nothing about the role of banks in creating our money supply. It is a very simple process yet many people who work for banks can’t believe it yet alone everyone else. (Google money creation and you will get numerous explanations including this one from Wikipedia http://en.wikipedia.org/wiki/Money_creation

The important thing is that when banks make a loan they are creating money. Because banks are required to keep a small percentage of deposits on reserve (the fractional reserve system) when new money is added to the banking system the money creation is multiplied depending upon the reserve requirement. Central banks add new money to the system usually by buying government bonds.

All this means that banks are an essential part of our exchange of goods and services. Without them there would be no economy. It is not that some banks are too big to fail, it is that banks are too important to fail.

There has been a lot of talk recently about the power and the evil of bankers and attempts to increase regulation of the industry. It is clear that bankers are extremely powerful people and some are probably evil to varying degrees. However, I cannot see how we can hope to discuss, evaluate and even reform the banks if we don’t recognize and take into account their role in money creation.

I would also suggest there may be other ways of creating money but that is so radical as to be treasonous.

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