Borrowing things that don’t exist

In my previous post I spoke about the role of interest rates in balancing the supply of real savings (from depositors) and demand for those savings on the part of borrowers (investors):

What’s difficult to grasp here is that savings are not just abstract dollar notes. When I save, I am implicitly producing something of value (e.g. I bake some bread) and providing it to the economy whilst simultaneously not consuming anything (I don’t take anything back from the economy). As the baker, I might save a couple of hundred dollars a week. What I’m actually saving though is not dollars, but loaves of bread – I’m creating a surplus of a few thousand loaves of bread in the economy which have been created, but not consumed, and are available to be “invested” by a borrower who can eat that bread for a while, during which he will not be baking any bread (e.g. while he’s building a garage in his back yard). All around the economy there are millions of people in all walks of life that are saving in this manner. Some of them are saving flour, some are saving metal, some are saving wooden planks – yet others are saving accounting services and computer programming services and yet others again are saving health insurance or health care. All of these things are very real physical resources – resources that will be required by investors that need to “borrow” from the economy to start new companies or buy tractors for their farms etc. and the interest rates that savers negotiate with borrowers is the “price” of savings.

However in the absence of a sound monetary system, loans in our current economy are able to be made irrespective of whether any real savings are present or not. What then happens when this occurs?

To understand the consequences of lending in the absence of savings, imagine an economy where Mom and Pop go to work each day in an orchard. They work hard and each week they take their fruits to market and make just enough money to get by… no more and no less. They have sufficient money to maintain the orchard and their equipment and they have sufficient money to pay for phone, TV, good steak, nice wine – to live to the standard to which they’ve become accustomed. Their standard of living need not necessarily be a poor standard of living, but they are none the less consuming 100% of the fruits of their labour (excuse the pun) each week and at the end of the year they have no cash savings whatsoever – their account balances at the local bank are exactly the same as they were at the start of the year.

Now imagine that all of the entrepreneurs all over the country are in exactly the same situation as Mom and Pop – which is to say that everyone is consuming the totality of their production and there are no real savings made by anyone.

Finally imagine that, despite the complete absence of any additional deposits or savings, the banks decide to make new loans in this economy to a bunch of people. In creating these loans the banks are issuing new credit which will be used as a medium of exchange and are therefore expanding the effective money supply. The result is, rather predictably, that the new money that has been lent by the banks bids for resources in the economy (metal, wood etc.) in addition to the money that was already being used to bid for these resources and the price of goods goes up – in particular the price of those goods demanded by the people who received this new credit goes up as does the price of anything the bankers are buying (since the bankers will now be earning additional money by way of interest)… which is a classic inflationary scenario. The immediate effect of this is that Mom and Pop won’t be able to buy good steak – they have to buy hamburger meat instead because steak costs too much. Left to their own devices Mom and Pop would rather consume all the fruits of their labour immediately and would rather eat steak than eat hamburger meat and save, but they have now been forced to reduce their standard of living so that the bankers can issue new loans.

What is even more nefarious in all of this is that had Mom and Pop decided to save then they would have been paid interest on their savings – which is to say they would have received some long term benefits from delaying immediate consumption and satisfaction of their needs. If the interest rates were high enough to entice them to do this then Mom and Pop would even have been better off for having done so. However, since the banks didn’t want to pay them sufficient interest to entice them to save (and make available the real savings that were required for the new businesses to start) and found it more expedient to simply force them into slave savings mode – essentially confiscating a portion of their wealth that had previously been used to maintain the standard of living that they aspired to – Mom and Pop will get nothing for their trouble aside from the pleasure of eating hamburger meat rather than good quality steak. If they’re lucky, the bank manager might give them a good poke in the eye next time he sees them – at least then they’ll know who stole their steak.

Eventually the new money in the system will push up the prices of the fruit that Mom and Pop sell and they will regain the standard of living that they had before. However, in the short term Mom and Pop have unwittingly been forced to lower their standard of living to pay for the new investments that the bank decided to “fund”. The banks will recover interest on the money they lent to investors so they’re more than happy to extend these loans. The bankers basically get to take a bit of Mom and Pop’s wealth, lend it out, make a tidy profit and chuckle smugly to themselves over champagne on their yachts.

However, the above is not an accurate portrayal of what is currently taking place in the economy. For, the above is merely what happened in the past 8, 15 or 100 years (depending on how far you want to trace back inflation, which has been more or less unchecked since the invention of central banking in Britain). What is happening now is rather different. For, the banks have already issued the credit and already expanded the money supply. What is becoming apparent presently is that many of those who took advantage of the lines of credit that were offered are perhaps no longer (or never were) in a position to pay the money back. Since modern banks do not maintain 100% reserves, when someone defaults on a loan the implication is that money actually disappears from the banking system entirely (just as quickly as it appeared in the system upon the creation of the loan in the first place).

What are the consequences for Mom and Pop in this case? In the absence of additional money injected into the system what we could expect is less people bidding for an unchanged quantity of goods, services and basic resources in society and thus price deflation. So we’d expect to see more or less the opposite of what we saw during price inflation. And just as the initial inflationary period was bad for Mom and Pop (because other actors in the economy saw the new money resulting from inflation before them and were able to outbid Mom and Pop for resources) we might expect the deflationary period to be a bit of a boon for Mom and Pop. Where price increases hit other goods before they hit fruit and veggies before, we’d expect the price decreases accompanying deflation to come to the fruit and veggie sector of the economy later than it hits other sectors of the economy… So initially perhaps Mom and Pop will be able to buy a bit more than they were able to buy before, with the same quantity of money. Those who will initially be struggling during the deflationary period are those who defaulted on their loans (naturally) and those who extended credit to these people (typically the banks). Eventually price deflation would hit the fruit and veggie sector as well, and Mom and Pop’s standard of living will go back to where it was before.

The above is something of an oversimplification since strict labour laws typically prevent companies from lowering people’s salaries and so the only way they have of cutting costs during a deflationary period is by laying off staff – resulting in rising unemployment. Adjustments to the structure of capital in the economy accompanying such a “bust” following an inflationary boom will also necessitate re-skilling and likely temporary unemployment in order to heal past wounds. However a full discussion about the structure of capital is beyond the scope of this post. More importantly for this post, the above description of a deflationary recession simply isn’t what’s currently occurring anyway. What is currently occurring is that the banks and governments around the world are frantically injecting money into the system to make up for the trillions (literally) of dollars that they pulled out of thin air over the past 8 years and which are currently evaporating as individuals and companies default on their debts. Deflation, it is held by those in the seats of power, is the worst evil known to man and must be avoided at all costs since deflation apparently causes unemployment (to be clear, not a theory I agree with but this is the common thinking anyway). For banks that make their money by inflating, the pain associated with deflation is clear to see. Furthermore, they have a trump card – the banks never lent their own money – they lent yours. They pretended to be deposit institutions that would hold their depositor’s money safely in locked vaults. In reality banks are not deposit institutions at all but highly leveraged investment institutions. They keep only the tiniest fraction of the money that depositors give them. On the back of 30 million dollars in deposits a typical bank will lend almost one trillion dollars out, and therefore when but 3% of their loans go bad most banks will have no reserves whatsoever remaining. They can loose all of the money that has ever been deposited with them if they are not able to recover a mere 3% of their loans. The fact that banks lose other people’s money (depositor’s money to be exact) is the Achilles’ heel of the general public.

In effect, the banks have a hostage: people’s deposits. Were it not for their deposits, Mom and Pop would probably say, “What do I care if prices go down? Let the banks sink – f#$% em, they’re rich pricks anyway!” And given that the banks essentially got rich by stealing Mom and Pop’s wealth, you’d have to have some sympathy with Mom and Pop for holding such a view. However even Mom and Pop (who don’t have any savings) have at least a little money deposited with the bank – they keep sufficient funds in their current account to ensure that they’re able to conduct their day to day affairs with respect to the orchard they own and the management of their household. Mom and Pop don’t want to loose that money. Furthermore, although on aggregate the rate of savings in the United States may currently be low, there will always be some people that save and others that don’t. Those people that have been squirreling away money for years to save up for their wedding or their children’s education certainly don’t feel very comfortable about the idea that those hard earned savings might just evaporate overnight because the bank that they held those savings in happened to be, in actual fact, a highly leveraged investment vehicle and not the trustworthy deposit institution that they had presumed it was (because of the big “BANK” sign over the door).

As such, the idea of moral hazard (which most people haven’t even heard of) was all too easy to sweep aside in the mass media. What was focused on instead was the frightening possibility that people might loose their deposits. A short term cure for that particular problem has thus been sought without any regard to the long term consequences of the actions taken to bring about such a quick fix.

Long term, the problem will only raise its ugly head again because banks do not lend their own money – they lend yours! The system of fractional reserve banking with a lender of last resort means that banks get to earn interest on the loan of fictive money while times are good (interest that they pay their staff salaries and healthy bonuses from) and then when it all turns to custard they really don’t care, because government and the lender of last resort are both more than willing to cover up their crime by picking up the tab (and I use the word crime here in the most literal sense, since the use of false certificates of deposit which is characteristic of fractional reserve banking is recognised as a crime and known as embezzlement in all other industries). No amount of government regulation can counter-balance this. We know (as do the banks) that the government is willing to make use of force to ensure the payment of any loans that banks make and which go bad (i.e. government makes tax payers pay back the loan). For this reason, after the dust has settled in the current crisis people will continue to deposit money in banks such as Fortis and UBS, treating these institutions as the safe deposit institutions that they always treated them as despite the fact that their actions have betrayed them as being anything but, time and time again… and it will be business as usual.

The band aid which will be put on the open gash left in our economies will be completely ineffective regulation (it has to be ineffective since it does not address the root cause of the problem) and commentators in 2014 or 2016 will be taking about how the free market has failed them yet again and brought about yet another unavoidable crisis. The reality, of course, will be that the free market had nothing to do with it – the free market hasn’t been seen anywhere near the banking sector for well over 100 years.