Why we have financial crises

I believe the root cause of financial crises is in the fractional reserve system of creating money.  Therefore the way to avoid future crises is to change how we create money.

Dear Reader,  This post requires you to understand how money is created by the banks.  I’m feeling too lazy to write that up now so if you don’t already know I encourage you to figure it out.  Google “fractional reserve money”  or look at my essay “LETS go to market: Dealing with the financial crisis” or these other posts on this weblog.  It may appear complicated and overwhelming but if you think it out it should be easy to understand.  I think very few people understand this process which is unfortunate because we can not reform something people don’t understand.  There is a lot of emotion when dealing with money.

There are two aspects to the economy – the physical and the financial.  It’s a distinction which is easily forgotten because we measure the physical side in financial terms.    Both of these can cause economic crises and solutions probably require knowing where the problem originates.  A complication is that a physical problem can and usually does trigger a financial problem.  I believe our current economic problems are largely physical in that we have used up the most easily accessible energy and mineral resources.  There are lots of resources left but they are becoming more and more difficult to extract.

The big problem with fractional reserve money is that  interest is charged on the money created by the banks.  But the process does not create money to cover the interest.  So long as the economy and the money supply continues to grow there is no problem.  However, when growth ceases and the money supply contracts there just isn’t enough money in the economy to repay all the loans with interest.  It’s sort of like a Ponzi scheme.

Fractional reserve banking is about increasing the money supply but to the best of my knowledge not much thought has been given to when the process unfolds.  Just as money can be created out of thin air it can just as easily disappear into thin air.  This is a problem because money is essential in our economy for the exchange of goods and services.  Even a small reduction in our money supply can cause severe economic hardship because losses on bank loans come out of the reserves.  Thus losses are high powered money or leverage in reverse.  A run on the bank would also be a loss of reserves if the money is put under some mattresses.  If the money is transferred to another bank then there would be no loss of money supply to the economy although it would take some time for the adjustments to work through the system.

During the crisis of 2008 I figure the losses to the banks reduced the money supply forcing a slowdown in the physical side of the economy.  During the crisis people talked about a shortage of credit and the need for banks to start lending.  As our money supply is based on loans this is the same as saying we didn’t have enough money to facilitate the exchange of goods and services.

The U.S. officials dealing with the crisis were aware of the danger to the economy. They were also aware that a large part of the economy was sound and that the banks had to be saved so as to not have a complete collapse.  They were in a bind because saving the banks appeared to be saving people who did not deserve to be saved.  To have let the banks fail would have hurt all of us.  That is the power of the banks.  They are too important to fail.

The financial intermediation industry is focused on the double  R – risk and rewards.  The great  profits and bonuses of the industry are based on maximizing the rewards and passing the risk on to others.  As a general rule the higher the risks the greater the rewards.  In an ideal world the rewards would go to the people taking the risks but bankers have ways of grabbing the rewards while leaving the risks with the depositors.

The first thing they do is that their  marketing focuses on expected returns.  The risks involved are seldom mentioned so that customers don’t demand the rewards to go with the risk they are taking.  Governments try to protect savers with deposit insurance schemes although the real reason is to prevent runs on the bank.

The second trick is leverage.  If you did your homework you know that banks are required to keep a fraction of deposits on reserve for people who want to withdraw their deposits.  The smaller this reserve requirement the greater the leverage and the more money they can create and the larger the profits.  Regulated banks are told how much they must keep on reserve.  Unregulated financial institutions can get away with greater leverage – until things go wrong and they cannot repay their depositors.

The third profit-making stunt is to finance long-term loans with short-term deposits.  As short-term interest rates are generally lower than long-term interest rates this increases the spread/margin for the banks.  Some people claim this conversion of short-term deposits into long-term loans is a great accomplished of the financial system.  In fact it is a very dangerous practice and through the centuries many bankers have lost their businesses, if not their shirts. (But the profits were great while they lasted.) This is because when there is a crisis people will refuse to roll over their short-term deposits.  With no way to call in their loans the banks become bankrupt even though most of their outstanding loans are good.

If banks were to match the terms of their deposits with the terms of their loans their business would be financial intermediation rather than speculation and the risk would go to depositors  who are carrying the risk in any case.

I hope you can see from these notes that there are serious problems within the financial industry and the fractional reserve way of creating money.  Money is such an emotional issue and the interests of the financial industry are so strong that I believe it will be impossible to make reforms.  

 

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