Why your savings and pensions are at risk

The fractional reserve way of creating money means a lot of people are at risk of losing all or part of their savings and pensions.

If there is too much money supply in the economy then we have inflation and people with savings or pensions lose some of their purchasing power and those who owe money benefit because they repay their loans with less purchasing power.  Now you know why governments and the people who speak on their behalf promote mild inflation.  This is at least unauthorized taxation if not theft.

pexels-photo-2105902If you have deflation, then people who are owed money win because they are repaid with more purchasing power than they loaned.  The borrowers lose because they have to repay with more purchasing power.

To be fair to everyone we need to manage the economy so that just the right amount of money is available at all times.  At a time when the economy is on a down trend, this is very important as too much money puts us in danger of hyperinflation.

Getting this amount right has long been a challenge to central banks although the common sense answer is fairly simple.  The money supply should vary with the quantity of goods and services we want to exchange and it should be flexible up and down.

The wrench in the simplicity is the fractional reserve way of creating money.  When banks make loans they must (or should) keep a fraction of the amount on reserve for when the depositor wants his/her money returned.  As the amount is only a fraction banks are at risk of a “run” if depositors lose faith.  And because of the fractional reserve there is a multiplier effect involved.  Does not this sound like a set up for a crisis?  The mechanics of this process are a little complex although I have always found it easy to understand. To figure it out I suggest you Google “fractional reserve” or look at my free e book Funny Money: Adapting to a Down Economy or look at the essay Going to Market on this weblog.

The other end of the wrench is  that interest is charged on the loans made by the banks.  Mainstream economists have given little or no thought to the consequences of this. Because all of our money is created by the making of loans, if all the outstanding debt were to be paid off at one time there would not be enough money to repay it all because of the interest.  The charging of interest on the debt/money means there is never enough money available to repay all outstanding debt. Inflation is built into the fractional reserve way of creating money.

The system works only so long as the economy and the money supply continues to grow.  An upset in either means crisis of which we have had many.

The relationship between money supply and economic output is expressed in a formula, MV=PQ, some times known as the quantity theory of money.  Money times the velocity at which it circulates in the economy is equal to a price index times the quantity of goods and services produced.

I get ticked off because this is frequently taken to mean there is a direct, proportional relationship between the money supply and the inflation rate or price level.   Can’t people see there are four variables in this formula?  Total output is an important part of this formula.  If it should happen to go down something needs to happen to another variable.

Our society has a strong commitment to economic growth and a need to keep it growing so that people will not suffer from unemployment.   Some desperate people are trying to stimulate growth by increasing the money supply. This may increase inflation but it will not lead to growth unless we can find inexpensive energy and mineral resources to support it.  I suspect the new American president has  his eye on parks and reserve lands to encourage more economic activity.  He will probably succeed in the short term to be followed by a major economic collapse.

This blogger thinks we need some major economic reforms, not only in our financial system but in our commitment to economic growth.  We need to minimize our production and exchange of goods and services so we are using fewer energy and mineral resources.

A lot  of people operate on faith in our financial system and ignore suggestions we need reform.  I think the risk is so great that prudent people will at least give some thought to these issues.  It is your savings and your pensions and your future that is at risk.

 

 

Please help promote this weblog

Please send the link to this post to your friends and social media.  Promoting a weblog can be difficult.  I get some referrals from LinkedIn.  I used to get quite a few from Reddit but I have been “shadow  banned” for linking to my own weblog.  Self promotion (and free speech?) are serious offenses on Reddit. I figure my strength is in the thinking that goes into the posts and I thank you for helping.  (r/economics   r/libertarian   r/economiccolapse  r/Degrowth )

Free Funny Money

Here is a free promotional giveaway of the new ebook Funny Money: Adapting to a down economy.  This book is now available on Amazon Kindle and Smashwords.  The next step is for me to make some formatting corrections so Smashwords can distribute it to a number of book stores.

FunnyMoneyArtPowell-final

Smashwords allows authors to create coupons for discounts and free giveaways.  I have made a coupon to give this book away free for about two weeks. The code is HS63E and it expires on March 19, 2016

The book is available at: https://www.smashwords.com/books/view/620310

The book is also available at the Kindle book store at http://www.amazon.ca/gp/product/B01CH1LF6W?*Version*=1&*entries*=0  

at the regular price of 99 cents. So far as I know Amazon does not allow the free giveaway for the publishing option I have chosen.

This book is critical of some aspects of economics and endorses others. The author, who has also read history and anthropology, questions economic growth and the fractional reserve way of creating money. He has come to terms with the market economic model as a set of guidelines for economic policy. The current economic crisis is resource based in that we have used up the most easily accessible of energy and mineral resouces.  We need a guaranteed income scheme and a new way of creating money.

This columnist from The Economist is encouraging theft

This post is to accuse the Buttonwood columnist in The Economist of encouraging the theft of people’s savings.

In the Nov 30th 2013 issue he/she says “Debt needs to be reduced by default, inflation or financial repression (keeping interest rates as low as possible).”

Lots of others including economists concerned with government policy make similar statements.

The problem is that one person’s debt is another person’s savings.  Therefore when debt is reduced by default or inflation it is going to take away from somebody’s savings.  This might be more visible if loans were made directly from a saver to a borrower without the financial intermediation of banks.

It might also be easier to understand if we were to define money as something representing purchasing power.  Thus a loan is a transfer of purchasing power from the lender to the borrower.  If the loan is not repaid because of default or is reduced by inflation then the lender has lost some of his/her purchasing power.

Some people might say the losses from default are carried by financial institutions.  This is true only if the banks are making excess profits.  If they are not making excess profits and maybe even if they are the losses are most likely to be spread over all their depositors in the form of reduced interest payments.

Of course people who owe lots of money, especially governments, benefit from inflation because they don’t have to repay as much purchasing power.  The ideal should be price stability – zero inflation and zero deflation.

However it happens default or inflation reduces the purchasing power previously owned by savers.  To me this is theft by or on behalf of borrowers.

Government debt default and the money supply

A United States debt default will hit the economy as a reduction of government spending and it could also  hurt by forcing changes in the money supply.

The first thing to say about debt is that there is so much of it around the world that there is a high probability most of it will be written off either by defaults of inflation.  This debt is not so much borrowing from children as a transfer of purchasing power within this generation, some/most of which will never be returned. And those with the most are likely to lose the most but will still probably be more comfortable than the rest of us.

The second thing to say is that the probable root  cause of the economic crisis is in the real side of the economy as well as the financial sector.  We have used up most of the easily accessible energy and mineral resources and those that are left take a lot more work to extract.

If the United States defaults  some of its debt the government will have less money to spend.  As government spending is a component of gross domestic product there will be a reduction in economic activity.  Government spending currently makes up about 20 percent of GDP but only a small part of this will likely be cut immediately.

The effect of a debt default on the money supply is more complex and uncertain.  A drastic reduction in the money supply would bring a lot of economic activity to a halt.

Money is based on loans issued by the banks, involves fractional reserves (they are required to keep a percentage of deposits as reserves)  and dependant upon what is called high powered money which is subject to a multiplier because of the fractional reserves. (for and explanation of how money is created see these links, one, two.)  In a default one issue would be how much the losses fall upon institutions subject to fractional reserves because losses would reduce their reserves.  A reduction in their reserves would bring down the quantity of loans they could make – by a multiplier.  Thus the money supply in the economy would be reduced and without money the exchange of goods and services becomes difficult.

Under normal circumstances a reduction in the money supply would mean a reduction in the real economy.  But the real economy is already in trouble as noted above.

At this point I need to remind you of the formula MV=PQ.  The money supply times its velocity or the rate at which it changes hands is equal to prices or a price index times the quantity of goods and services.

In an attempt to stimulate the economy central banks have been using “quantitative easing” to inject more high powered money into the financial system so the banks will have more money to lend.   If the above formula is correct then there should have been a reduction in velocity or an increase in prices (inflation) or economic activity.  It may be that velocity has fallen but there is little evidence that inflation or GDP has increased.

If the formula is correct then something has to have happened to one of the other variables.   One possibility is that at least some of this extra money has gone into the financial markets and inflation has hit stocks.  If this is correct, then a reduction in money supply could hit the financial sector.

So there you have it a U.S. default would probably lead to a reduction in economic activity and it could also cause problems in the financial markets.  I just had a horrible thought.  What would happen if a lot of the major countries were to default at the same time?

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.)

 

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.

Let this time be not different

Please, let this time be not different.  Please let this recovery be the similar to all the previous recoveries.

I have just finished reading This time is different by Carmen M. Reinhart and Kenneth S. Rogoff.  They bring together statistical data on all the world’s known debt and banking crises and look for patterns that precede them.  Their title comes from people saying during each boom that there will not be another crisis because we now have knowledge and experience from previous crises and  “this time will be different.”

Following each crisis there has been recovery in which the economy has grown to a new high. For the sake of all the people who are suffering from the current crisis it would be good if this time is not different and we could have a full normal recovery.  It would be even better for the planet and our long-term well-being  if we could adapt our economy so that people would not suffer from zero or negative economic growth.

One of the things which is different for this recovery  is that the marginal cost of extracting energy, mineral and agriculture resources has increased.  We have used up the most easily available of these resources and those that are left take a lot more work to extract.  This is bound to limit the potential for further economic growth.  We should beware of believing economic growth can continue forever.

I think there is an element of truth in the Elliott Wave Theory which applies to economics as well as the stock market. This theory says ups and downs run in series of fives and after the fifth the overall trend reverses.  Within each up and down there are series within a series.  I don’t  know about the fives but I believe the economy is fractal in nature and that there can be major turning points.  We should not rule out the possibility that we have passed a major turning point and that for some time to come we will have a series of downs and ups with each down going even lower.

As I read this book I wondered how the crises impacted people’s lives.  How serious was the unemployment?  How did people cope with unemployment?  Who were the people who lost their savings from defaults or inflation and how did they cope?  Did some of the one percent find themselves joining the poor?

In the current crisis, the headlines indicate young people are being hit hard and are the lost generation.  Meanwhile the cruise ships are packed with older people planning their next cruise.

It could be that during an economic boom we have a psychological need for economists to be telling us the boom will not end in a crisis.  Then we can work hard to prepare for retirement and to provide short-term profits for people in the financial industry.   We want to hide from ourselves the possibility we will lose the benefits of our hard work to defaults, haircuts or inflation.

As I was reading about all the financial crises I was saying “why oh why oh why would anyone want to put effort into the financial industry when there is such a high probability we will lose a lot of our savings?”  But then I have never been much for ambition.

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.

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.

A Chicago plan for reforming banks

This week I came across a couple of articles about the Chicago  Plan for reforming banks and I like it because it proposes changing the way in which we create money and gets rid of the evils of fractional reserve money.

This plan was proposed in the 1930s by some economists from  Chicago and suggests banks be reorganized into two separate identities.  One type of bank would only accept deposits which would be kept 100 per cent with a central bank.  This type of bank would probably have to charge fees for looking after the deposits but they would be safe (except from inflation which would probably be less of a problem – or haircuts.)  No more fear of bank runs.

bankThe second type of bank would be a financial intermediary in that it would make loans based on 100 per cent equity deposits of its customers.  As all deposits would be equity, customers would know there are risks of a loan not being repaid.

As most, if not all,  bankers would see immediately, this would be the end of outrageous Wall Street profits.  Under the current system bankers make huge profits by taking for themselves  the premiums from risky loans but when the risk becomes reality somebody else takes the losses because the money creation feature of banks makes them too important to fail.  People putting money into a loan making business would know the risks and expect the returns to compensate.  The end of fractional reserve money creation would also do away with the leverage which allows bankers the profits from creating money on which they charge interest.

According to the Chicago Plan governments would create the money supply at zero interest.  This would be good in that interest charges would not be built into money creation thereby  reducing the potential for inflation.       My concern is that governments make decisions for political rather than economic reasons.  To me a national LETS (local exchange trading system)  would be preferable way to create money because the amount of money in use would depend upon the collective decisions of individuals.  For the sake of price  stability it is essential that the money supply should be flexible up and down.

When I wrote my essay “LETS go to market: Dealing with the economic crisis” I didn’t put a lot of thought into how to organize banking with a national LETS money system.  I didn’t know it then but the creators of the Chicago plan had already done that.

High deposit interest rates – a warning sign

When shopping most of us want to get the most we can for our money and that applies to the interest on our savings accounts.

However, a word of warning.  Sometimes when financial intermediaries are having problems they try to hang on by offering a higher interest rate on deposits.  This attracts more deposits which may help in the short-term but   reduces their margin between the cost of deposits and what they can charge for loans.  This only  adds  to their problems.

money_back_stickerThere have been cases of financial institutions doing this but it wasn’t enough to save them.  Some people who thought they were being smart, including some municipal treasurers, have been caught.  While some deposits are covered by deposit insurance it is probably better to stay away from troubled banks.  These days the interest rates being paid on savings are so low that most of us are probably just as well off to go with safety rather than returns.

This note was prompted by this article about some Canadians who are looking for the best returns on their savings.  I don’t want to say that every firm offering a higher interest rate is in trouble, but it can be a warning sign.  At least ask questions.

Banking, risk, greed and a house of cards

When I took the  course on economics of money and banking,  banks were said to be financial intermediaries which means they act as the facilitator between savers and borrowers.

I thought about this a lot as I read House of Cards by William D. Cohan published by Doubleday in 2009.  It is an account of the history and collapse of Bear Stearns & Co. which was the fifth largest investment bank in the United States.

It appears the two big problems in this bank failure were risk and greed.

When a person borrows money there is some risk that he/she will not be able to repay the loan.  The longer the term of the loan the greater the risk. As interest is in part to allow for risk the longer the term the higher will be the interest rate charged.

The question: Who is going to take the risk? The depositor or the banker?  Whoever takes the risk should also get the interest compensation.

It is clear from this book that the bankers took upon themselves the risk although when the risk became reality  their depositors also lost.  The bankers may not have realized, may not have wanted to realize, the risk they were taking.,

What makes this risk attractive is that short-term interest rates are generally much lower than long-term interest rates.  Therefore a banker can make lots of money by taking short-term deposits with which to make long-term loans.  And this is what Bear Stearns was doing.  A large chunk of the mortgages they were holding in a couple of hedge funds were financed with overnight deposits.  Apparently this was/is a common practice on Wall Street.   There are two risks in doing this: short-term interest rates may move against you or your depositors may  withdraw.

So long as the economy was experiencing economic growth it worked and the bankers made obscene fortunes.  But when economic growth slowed down and it became known that these sub-prime mortgages were not as sound as they had been  promoted, the bankers found that their short-term  lenders refused to re lend the money. Disaster. And these guys had the nerve to whine when it became apparent they were going to lose some of their personal fortune.  They also had to be rescued because banks create money and are too important to let fail.  When Bear Stearns went down there was a lot of worry that the whole financial system would collapse.

One has to note this way of working probably under priced the risks of the sub-prime mortgages and that the investment bankers had a vested interest in doing so.  It made it much easier for them to sell their wares.  If the full risk of the sub-prime mortgages had been charged in interest rates most low-income borrowers would not have been able to afford them. (It is interesting that the U.S. government starting with Clinton encouraged this business by asking the banks to finance  housing for low-income people.)

It is probably safe to say most of these investment bankers were con artists.  However, I would suggest that to have a successful con you must have at least two greedy people.  It is hard to con somebody who is not greedy.

So how do we prevent bankers from taking upon themselves excessive risk?

The first answer is to changed the way in which our economy creates money so that banks are excluded from the process.  For more on this please see the essay LETS go to market: dealing with the economic crisis  on this weblog.

The second thing is to require banks to match the terms of their deposits and loans.  They should make their profits out of the spread between the interest rates they pay and charge. The risks and rewards should go to depositors according to the decisions they make.

The third thing us to require them to publish lots of information about their business.

As for greed, governments should probably not try to legislate. Greedy people should be expected to take the consequences. (Lets make a distinction between cons involving two greedy people and exploitation by a person who has superior strength)

Wall Street has rebounded from this  crisis.  One  has to wonder of any lessons have been learned or are investment bankers still financing long-term loans with short-term deposits.  If so there is potential for another crisis.

Bank gambling with long-term loans and short-term deposits

Turning short-term deposits into long-term loans is one of the main reasons banks exist, enabling customers to have the comfort of deposits that can be withdrawn at any time together with the certainty of mortgages that might last for 25 years.

This statement from a columnist in The Economist  contradicts what I always thought was prudent bank policy – that the time term of a loan should be matched by a deposit of an equal time term.  To mismatch these terms is to use other people’s money to gamble on which way interest rates are going to move.

I know of a Canadian financial institution that purchased a pile of government bonds at ten percent expecting interest rates to go down in which case the deal would have been profitable.  This was just before interest rates went up to 19 percent and this business lost a pile of money as it had to pay a lot more on short-term deposits than it received on its long-term bonds.

This was an extreme case but with the current economic instability we should probably be asking banks to publish information about how the time-terms of their deposits and loans are matched.  Banks should make their profits on the spread between deposits and loans.

 

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.

Protecting customers from the banks

What can governments do to help consumers protect their interests when dealing with financial institutions? (Or any other industry)   I suggest increasing competition and requiring firms to publish more information would be more effective than regulation.

I figure governments pass legislation to restrict competition.  This allows firms in the protected industry to collect  profits they wouldn’t otherwise get.  When the firms protected by the legislation get out of hand and blatantly exploit their customers governments introduce regulations to limit the offensive behavior. This is to protect consumers.

Generally the way to restrict competition in the financial industry is via licensing.  Therefore the way to increase competition is to loosen licensing requirements so that more firms can get into the industry.  More competition should reduce the opportunities for exploitive behavior.

The other way to protect the interests of consumers is to require firms to publish plenty of information about their business so their customers have the knowledge with which to protect themselves.  In banking this should include detailed information about their loan portfolios.

Shouldn’t  depositors have the right to know to whom their money has been loaned?   If a depositor has this information then he or she can evaluate the safety of the deposit.  If there are concerns about where a firm is lending one’s money then one can take the deposit someplace else.

This post was written after reading in The Guardian a concern that financial reform in Britain will not lead to more competition.  You can see the article here.

Regulating banks and competition

This week’s The Economist has an article about a small bank in Texas which is challenging in court the Dodd-Frank act passed two years ago to increase the regulation of the banking industry.

I have a theory that most if not all economic legislation works to restrict competition and it appears the Dodd-Frank act does this by making life difficult for the small banks.

It also appears small banks, or at least this one, being small have to follow prudent banking practices and have fewer opportunities to gamble with other people’s money.

Maybe the best way to regulate the financial industries is to ensure they are highly competitive and repeal legislation which restricts competition.

Of course the big banks would turn their lobbyists loose on this one.

 

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Banking union and rearranging the deck chairs

One of the ways being proposed to deal with the European part of the economic crisis is  centralized banking supervision.  More on that in this article in this week’s Economist.

The question here is would a banking union solve the problem.

Back when Russia was trying central planning and having problems, some people figured the solution was decentralized central planning.  Banking union  sounds like the reverse thinking. It also sounds like rearranging the deck chairs.

If the basic problems is the people or institutions or governments to whom the banks have loaned money are unable to repay those debts then centralization will not work because it will do nothing to reduce or repay the debt.

I think the financial side of the current economic crisis is rooted in the way we create money.  For more on this please see the essay on this  weblog titled “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.

Running at banks

Today’s issue of The Economist has an article fears of bank runs in Europe.

Runs on banks are such serious things that you cannot expect any banker to tell the truth when his bank is threatened.    A large enough run would also impact a country’s money supply and that has to be a concern for all of us.

If a bank is unable to refund its deposits it is probably because its loans have gone bad.  It could also be because the banker has made some bad bets such as  on interest rate movements.

There is so much debt around that most of it, especially that of governments, will never be repaid.  The best that can be done is to keep rolling it over.  There is a high probability that eventually a lot of people are going to lose their savings either from bankruptcy or inflation.

Deposit insurance schemes can protect against small problems – the banker who makes a bad bet on interest rates – but I’m not sure they can protect against the general widespread debt problem we now face.

According to the article one suggestion for Europe is greater financial integration.  This could delay the crisis but would probably bring everyone down at the same time.

 

Money creation problems on YouTube

It’s great to see a criticism of how we create money getting a good airing on YouTube. (Here)

Victoria Grant is a 12-year old young lady who speaks with a great deal of confidence on a subject about which most people know nothing.  It is hardly surprising that she got a standing ovation for her explanation of how the banks and government are defrauding Canadians.

She clearly has  a good understanding of the problems with our money creation mechanisms but her proposed solution would probably be an even greater ripoff.

She got it right on when she said “under the present system all money is debt” and when she points out debt is enslavement.  I would take issue with her suggestion that money issued by the banks if fake while money issued by the Bank of Canada is real.  It is probably good that both are money “generated out of thin air” as the alternative, a commodity money, has its own problems.

Her concern is that the Canadian government is defrauding us by borrowing money from the banks and paying commercial interest rates. I would be more concerned that the government will never be ale to repay its debts with the same purchasing power as it borrowed.

Miss Grant’s solution is for the government to borrow directly from the Bank of Canada rather than the commercial banks and use the money for economic infrastructure..  This is quantitative easing and would increase the money supply.  It would work only if there are available lots of physical resources for infrastructure and that is not clear.

If the increased money supply is not matched by an increase in the goods and services produced, the result would probably be inflation.

Inflation is a more subtle and more efficient way for governments to steal from their people.  Any one with financial assets in fixed prices or with pensions would lose purchasing power.  I’m not sure Miss Grant would want that.

However, she should be lauded for pointing out some problems with our banks and money supply and for getting a lot people to think about them.

Ridiculous explanations for the economic crisis

This post was prompted by the Buttonwood columnist in The Economist.

Sometimes it seems that some economists come up with ridiculous theories to explain the economic crisis.  These theories divert our attention from basic issues and allow some people, including columnists, to ignore the obvious and maintain their faith that the world will soon return to its golden age of prosperity.

When I studied economics the professors would draw on the blackboard an x shaped graph.  Sometimes the lines would be labelled to represent the financial side of the economy and the physical side of the economy .  This is an important distinction but it is forgotten as soon as we leave the blackboard.  This could be because it is easier to measure the physical side of the economy in financial terms.

Both sides of this graph have the potential to cause economic chaos.

On the financial side the way in which money is created is so complex and convoluted that even bankers won’t believe it.  Not only is it complex but interest is charged on the money created making it into a sort of Ponzi  scheme

On the physical side we have been using resources at such a rate that those which are left require a lot of energy to extract.  It’s hardly surprising that “of 34 advanced economies, 28 had lower GDP per head in 2011 than they did in 2007. ”

To deal. with the economic crisis, rather than thinking up theories which blame it on some scapegoats, we need to look at the basics and do some sour searching regarding our own lifestyles.

Extending “too big to fail”

This weeks Economist has an article about extending the definition of “too big to fail” to include a number of other types of financial business.

When dealing with banks I think we need to distinguish between too big to fail and too important to fail,

When any business fails its shareholders and customers stand to lose. Is it the responsibility of government to protect shareholders and customers from the risks of doing business?

Financial intermediaries which take deposits, make loans and follow fractional reserve policies, i.e. banks, are  special cases in that in making loans they are creating the money supply with which we exchange goods and services.  This makes them too important to fail because a bank failure decreases the money supply.

One has to note most bank deposit customers are protected by deposit insurance to the extent there is enough money in the insurance fund.

This money creation role provides the rationalization for regulating banks and other financial intermediaries.  But what is the rationalization for regulating other types of business that handle money?  Perhaps by extending regulatory powers it appears the authorities are doing something about the economic crisis.

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