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.

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Pensions or a cruise?

A columnist for The Economist says people should ensure their pensions are adequate before they think of a world cruise.  I think the world cruise should come as soon as possible and worry about the gas bill later.

It could be that we have conflicting conflicts of interest in these recommendations.  One of my stepsons and his wife are entertainers on a cruise ship and the columnist probably has friends in the investment industry and gets some of his income from advertising and subscriptions from the industry.  You can read the column here.

Retirement is important for a lot of people.  A few years ago it was fashionable to plan for retirement at the age of 40 or 50.  Now that columnist is suggesting people may have to work beyond normal retirement age in order to have the lifestyle they desire.

Retirement planning is easy when the economy is growing and everyone believes that growth will continue.  But when growth ends all those plans and savings are likely to fall apart.  There are three things that can happen to savings and retirement funds:  inflation can wipe out their value, firms can fail or governments can decide to give haircuts.  It is not clear that there will soon be a return to economic growth.  Given the current economic uncertainty, any one of these could happen at any time.

The columnist suggested that inflation-linked government bonds  “should be the building blocks  of a pension portfolio.”  This ignores that most governments are carrying more debt than they will ever be able to repay.  When the Ponzi scheme explodes a lot of people will find their dreams destroyed.

In the meantime, those in the investment industry are doing short-term well out of all those people worried about their retirement income.

So far the economic crisis has mostly hurt young people.  If or when it hits older people and they can no longer afford cruises the cruise industry will have a surplus of ships.  They may then have lots of work for an Italian cruise captain with some experience at decommissioning ships.  I encourage people to take a cruise before he gets called back to work.

Here’s a Irving Berlin/Fred Astaire song from 1936: “Let’s face the music and dance”  or cruise.

Ignorance about how money is created

Sometimes I wonder if central bankers have a conspiracy to keep us ignorant of how money is created in our economy.

They use expressions like adding to their balance sheets, credit in the economy or quantitative easing all of which relate to increasing the money supply.

When  central banks buy government bonds on the market or from the government they create money for the purchase and add the amount to their balance sheet.  This new money injected into the economy is called high-powered money and thanks to fractional reserve banking the amount is increased by a multiplier.

For an explanation of how money is created and some of the problems associated with this process, please look at my essay LETS go to market: Dealing with the financial crisis.

The U.S. Federal Reserve Board has been  criticized for not injecting high powered money into the economy early in the crisis of the 1930s.  Once this process was started the economy started to pick up.

But things are different today.  It appears bank lending and business spending is limited not by a lack of high-powered money but rather by a lack of opportunities.

In any case, money is such an important part of our economy that it would be good if a few more people than central bankers understood how  it is created.  It may take a little thinking out but I believe most of us should be able to understand the process.  An afterthought: maybe central bankers use these terms because they don’t understand how money is created.

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