Thursday, 29 January 2009

Unsound banks, unsound money -- a very unsound idea

Banks are in the money business.  It’s not just the Reserve Bank who prints money: government banking laws allow them to “print” money electronically -– in the words of Charles Holt Carroll, “organising debt into currency,” on the back of reserves they don’t actually have.

Banks create this currency electronically, backed only by lender’s promises to pay, at a ratio of up to twenty, forty, even fifty times the actual reserves that are held by the bank.  Among bankers and professional economists, this is called “fractional reserve banking.” It is a system that allows the bankers to grow very rich very quickly, and the economists to inflate the economy beyond what is sustainable.  From boom to bust at the behest of those who’ve been allowed to pretend they can create something out of nothing.

You can see the problem with banks lending out much, much more than they actually have. In fact, you’ve seen one primary problem in the news for most of the last year. 

Which is this: What happens if every depositor wants their money out all at once.  If you want to know whether your friendly local bank is "sound," then just ask yourself what happens when queues of depositors start forming outside, for whatever reason, insisting they be given their money back. What happens isn’t difficult to predict, especially since you’ve seen it happen with increasing frequency.  Once you identify that modern banks are inherently bankrupt, and it is on the back of this inherent bankruptcy that our money supply system is based, then you realise that the whole system is as far from sound as it’s possible to be – and it’s no wonder that modern economies are racked by such violent booms and busts.

And you can see the problem too with a huge component of the money supply being backed only be debt that’s been organised into currency – and in fact, you’ve seen that in the news for most of the last year as well.

Which is this: when the value of loans drop, as they have precipitously over the last year, then so too does the amount of “currency” in the system.  So too does the amount of “credit” available in the system. So when the value of existing loans takes a big dive, so too does the money supply.

Which means this system of supplying money is as far from sound money as it’s possible to be. 

And you can assess how far from sound it is -– and how big a dive the money supply and the credit available for the loan markets has taken -– from the picture below showing the market caps of some of the world’s biggest banks, and how big a dive they’ve taken over the last year. 

It’s not just a big dive, it’s a swallow dive off a cliff. 

If you want to get a visual idea of how big the world’s economic problem is, then here it is right here, courtesy of the Financial Times (click to enlarge):



  1. I'm not sure you're using a good example there. If a bank takes $100 as a deposit, and lends it out to someone to buy a house, there no leveraging there, but the bank still won't be able to give your $100 back if you walk in and ask for it. It's the problem the decent finance companies had, with timing only. If they didn't lend the money back out at all, then they wouldn't have any means on getting the income they need to pay you interest on the sum you deposited.
    I don't disagree that the leveraging side causes trouble, but the fact that everyone can't get their money out with no notice isn't a symptom of that problem.

  2. Um, that's not fractional reserve banking you're describing there, TWR.

    If that's all that happened -- that banks took in time deposits and lent them out -- borrowing long and lending short -- then we'd have no problem.

    But they don't take in your $100 and lend out just $100. They actually create new credit out of thin air.

    They take in your $100 and use it as a 'reserve' against which they can lend out $1000, or $2000, or more, with the only backing for this newly created money being the 'assets' for which the newly created credit is being extended -- with all the attendant problems of inflation, deflation, boom, bust and deleveraging, and the inherent bankruptcy of every bank who's so engaged.

  3. Exactly my point. They would *still* be in the crap without FRB. So when you say : "
    Which is this: What happens if every depositor wants their money out all at once. If you want to know whether your friendly local bank is "sound," then just ask yourself what happens when queues of depositors start forming outside, for whatever reason, insisting they be given their money back. "
    , it's not a good argument against FRB as it would happen with or without it.

  4. I think you're overlooking the importance of "time deposits" in my point above.

    Absent FRB, if a bank is lending out only their time deposits, then they're in a position to borrow long and lend short. That's a very safe position to be in.

    If they go further, and lend out some of their demand deposits as well, then they face a further risk, but one that can be absorbed in the rest of the banking system.

    But it's once they step off the FRB cliff ... that's when they really start trying to walk upon clouds.

  5. P.C.,

    I think you're misunderstanding the thrust of Rothbard's article (as did I before my friend Armin set me straight).

    Banks do not create money out of thin air; the 'Rothbard Bank' example at the start of the article was to illustrate what would happen in the absence of central banking - i.e. in a free-market system where anyone could print money.

    Rothbard then goes on to explain that nowadays the only bank that can print money is the Fed, & shows how that drives inflation that is amplified (but not driven) by FRB.

    It's a fairly subtle distinction (& I think Rothbard did a lousy job of explaining things) but it's an important one nonetheless.


1. Commenters are welcome and invited.
2. All comments are moderated. Off-topic grandstanding, spam, and gibberish will be ignored. Tu quoque will be moderated.
3. Read the post before you comment. Challenge facts, but don't simply ignore them.
4. Use a name. If it's important enough to say, it's important enough to put a name to.
5. Above all: Act with honour. Say what you mean, and mean what you say.