Hiding from the economic crisis

Why are interest rates so low?  It’s a question which has apparently been occupying a couple of North America’s top economists but this blogger sees the discussion as a screen hiding some very important economic issues.such as the root cause of the economic crisis and values which will guide us in trying to  find a solution.

On the surface the answer is simple.  Interest rates are the price of money and are determined by supply and demand.  They are low  because that is where the two balance.  They appear low because we are used to high returns on our investments and are reluctant to give them up.  There is no reason why interest rates could not be zero and maybe they should be.

To understand the root cause of the economic crisis we need to go into a macro economics classroom and watch the lecturer draw his basic diagram on the blackboard.  It is in the shape of an”x” with one side representing the financial side of the economy and the other the real or physical side.   This is important.  As we measure the physical part of the economy in financial terms it is easy to forget the distinction and analyze economic problems only in financial terms.  We need to ask what is happening to the physical side of the economy because it could be that is where the problem is.

This blogger figures the problem is with the resource base.  There are lots of energy and mineral resources left on this planet but we have exploited the most easily accessible.   Those that are left take a lot of time and energy to extract and this is causing a lot of economic problems.  It could even force us into negative growth.  This is a much more serious problem than why interest rates are low.  It is also an extremely difficult problem because it challenges some deeply held beliefs and values.  It’s a lot easier to talk about why interest rates are low.

Some ideas about how to fix the economy are included in the essay “LETS go to market: Dealing with the economic crisis” on this weblog.  A major feature of that essay is a proposal to change the way in which we create  money.

The emotions surrounding money make it a such a difficult subject that few people understand the economics of money and banking. This is unfortunate as money is so essential to how we exchange goods and services.  I encourage you to take a look at the essay.

While I prefer to see low interest rates as a symptom rather than the problem here are  some observations.

Money should be considered a tool to facilitate exchange rather than as a commodity with a value of its own As the quantity of goods and services we want to exchange varies up and down  so does the amount of money supply we need,  If there is too much money there will be inflation and if there is too little money there will be deflation.   Some people believe there should be mild inflation but this reduces the value of savings and should be  considered theft.

Quantitative easing has been an attempt to stimulate economic activity by increasing the money supply.  It has resulted in a rising stock market but has done little for the real economy.  That has to be a sign of a serious problem which has not been identified.

The way in which we create money, known as fractional reserve banking, is a heavy-duty problem because it is based on loans on which interest must be paid.  If all debts had to be repaid at one time there would not be enough money in the economy.  It is a Ponzi scheme on a grand scale and it is no wonder we experience frequent financial crisis.  For more on this topic see these previous posts on this weblog.

I believe we are facing a serious economic problem in that it is not clear there can  be a return to economic growth.  Dealing with this will require some major changes in our way of life.  It is disappointing that two of our most well-known economists are protecting us from having to deal with this with a frivolous argument. It’s as if they are playing in the turkey poo on animal farm and producing gobbledygook.

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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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Payday loans, slavery and money creation

What is the marginal cost of making a payday loan? Or any other type of loan?  The answer to this question should help to answer a question about interest rates on loans raised in the Buttonwood column of The Economist, November 30, 2013 issue. What interest rates should lenders be allowed to charge?

Unfortunately loans and credit are complicated beyond simple economics because the making of loans is an instrument of exploitation even to the point of slavery and because credit is involved in how we create money.

Economic theory tells us that so long as there is competition the price of a product should be equal to the marginal cost of producing that product.  Therefore for loans the marginal cost would be the cost to the lender of acquiring the money to loan (i.e. the interest paid to the depositor of for payday lenders to their source of funds) plus the operating costs and the cost of loans written off.  The legitimate interest rate to charge on a loan should be easy to calculate and for banks we can compare the rates they pay on deposits and the rates they charge for loans.

It appears the need for credit is almost universal at least in large-scale economies.  I’m not sure about hunting and gathering groups which practice a sharing economy.  It appears there has always been a need for short-term lending of the type done by payday lenders.

The problem is that the making of loans can be an instrument of exploitation.  One of the quickest ways to get control over a person is to lend them some money.  In peasant societies people borrow to put on funerals and weddings and if they cannot repay they sometimes find themselves in slavery.

In our own society there are probably lots of people with dreams of doing something other than the daily employment but they are unable because of their debt load.  All this consumer debt works as an instrument of social control for the one percent.  So long as we are in debt we work to support their goals and interests rather than for our own.  If a person wants to be truly free one should try to live without  borrowing.

As for payday loans Mr./Mrs./Miss/Ms Buttonwood says:

“Provided the terms of the loan are made clear, then it should be up to borrowers to decide whether to accept the costs involved. An interest rate is simply the price of money.”

Once again this is simple economics without the human factor.  For many people there are times when  it may not be easy “to decide whether to accept the costs involved.”

The other complication with lending is that our money supply is based on fractional reserve loans by financial institutions.  As money is essential for the exchange of goods and services it is also essential that we carry a debt load.  Says Buttonwood

“But businesses and consumers are positively encouraged to borrow. Indeed, when debt growth slows, as it has in recent years, an air of panic develops about how to get it going again.”

There are a number of problems with the fractional reserve method of creating money, most of which have been discussed elsewhere on this weblog and especially in the essay “LETS go to market: Dealing with the economic crisis.”  Basically it is a Ponzi scheme which is urgently in need of reform.

The reform proposed in that essay, a national Local Exchange Trading System (LETS) should also help with the need for short-term credit.  It would be a lot less exploitive as no interest would be charged and control over the money supply would be in the hands of all people.  A national LETS system would transfer a lot of economic decision-making from bankers and governments to individuals.

There are consumer loans and there are business loans.  Loans are a transfer of purchasing power from one person  to another and interest is compensation for the transfer.  A LETS system  should take care of the need for short-term consumer  credit.  The compensation for business loans should come out of the profits in which case they should be considered equity.

Back to the question of caps on interest charged on payday loans.  Is it the role of government to prevent some of its citizens from exploiting others?  If yes, then governments should limit interest  rates  charged (marginal cost is a guideline) or find another way of creating money so that the need for short-term consumer credit is easily satisfied.

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.

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.

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.

Money, interest rates and purchasing power

This week’s The Economist has a column on the implications of high and low interest rates.
One of the problems with money is that we treat it as a commodity – something which has a value of its own. Every time I use the bank’s ATM I told to let the bank put my money to work for me (and the bank).

We would have fewer macro financial problems if we were to think of money as a tool that facilitates the exchange of goods and services.  It is a concept  which represents purchasing power.

One of the things I like about local exchange trading systems (LETS) is that they create money that only facilitates exchange.  It has no value of itself and there is no interest involved.

This is in contrast to fractional reserve money which is based on debt issued by banks and upon which interest is charged.

In a fractional reserve system when we deposit money in a bank or make a loan to somebody we are transferring purchasing power to somebody else.  We do this expecting a return of even more purchasing power.  But this additional purchasing power is an illusion.  It  comes at the expense of somebody else or it  leads to inflation.

When the economy is growing more goods and services are being produced so there is extra to be purchased and the problem is not so obvious.  When the economy is stagnant there are no extra goods and services to be distributed and this is showing up in the form of low interest rates.

 

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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