Credit Collapse Cometh by Daniel Oliver, Myrmikan Capital, LLC
Let us review the insanity that is our banking system: a saver deposits $100 into a fractional reserve bank. The bank opens a demand account for the depositor, which means it must pay him back immediately whenever he so demands. Assuming the law requires a 10 percent reserve, as is common, the bank can lend $90 of the deposit to someone else, for example, the buyer of a house. The home buyer agrees to repay the loan over ten or even thirty years, notwithstanding that the depositor’s loan to the bank is payable on demand! This alchemy is called “maturity transformation”: the depositor’s current funds come to finance a bid on long-term, illiquid assets. A better word would be “fraud.” If any person tried this trick beyond the safety of a bank charter, he would go straight to prison.
Maturity transformation is only the beginning of the story—the home buyer borrowing $90 from the bank for thirty years (financed by the depositor’s $100 demand money) pays it to the seller, who then deposits it back at a bank as current funds. This bank, whether it is the same or different, treats this deposit the same way the original deposit was treated: it lends out 90 percent of it at term, adding an additional $81 of term debt and another $81 of demand deposits. The process repeats—$72.90 of debt is created, then $65.61, then $59.05, ad infinitum—until there is $1000 of debt financed by the $100 deposit. In this way, when a bank receives a deposit of $100, the banking system doesn’t lend out half, or even 90 percent of it—it lends out ten times the amount! The $900 surplus is conjured out of thin air, ex nihilo. If reserve requirements decline to 5 percent, then the banking system can lend out $2,000 of term loans from a $100 demand deposit.
Reread the last sentence. The brain almost forces a reconsideration of the process. Try explaining the paragraph above to the branch manager at your local bank and you will receive a blank stare or perhaps hostility.1 No one can dispute John Kenneth Galbraith’s assessment: “The process by which banks create money is so simple that the mind is repelled.”
Keynesians and monetarists (who differ from Keynesians only in that they prefer their central planning to be done by central bankers instead of by Congressmen) see no danger with the fractional reserve process. So what if $100 is transformed into $2000, as long as that $2000 figure remain constant. If prices start rising, the central planners can raise reserve requirements to squelch the process and reduce the amount of money. If pesky depositors ask for their money back, threatening to unwind the entire credit structure, then the central bank can print up more of the stuff (unlike under the gold standard, under which banks had no choice but to call in loans to meet depositors’ demands).
The error in the Keynesian/monetarist view is that it confuses credit with money and ignores the effects the fractional reserve process has on the structure of production. In a hypothetical “evenly rotating economy,” as Ludwig von Mises put it, individuals would allocate their spending between current consumption and investment, which is nothing more than enhanced future consumption.2 The maturity transformation feature of modern banking takes current funds, held as such, ready to be used for current needs, and uses it instead to fund investments in long-term assets for which consumers have expressed no demand, and then uses the fractional reserve process to increase that funding by ten or twenty fold. Eventually, overcapacity in these classes of assets drives rents below what is required to meet interest payments, the investments fail, the banks collapse, and depositors lose everything.
The dirty secret of banking is that it does not allocate credit—it creates artificial credit that directs entrepreneurs to build assets that consumers don’t want based on savings that don’t exist. In every other field of human endeavor, declining marginal utility eliminates super-profits. There will never be a second Henry Ford in the auto industry or Steve Jobs in the personal computer industry or Larry Page and Sergey Brin of the search engine industry. But banking, and banking alone, has made men rich for thousands of years (excepting political patronage). Operating under the so-called “3-6-3 rule” (bankers pay depositors 3 percent, lend their money out at 6 percent, and hit the golf course by 3 o’clock), the $100 transformed into $2000 of debt generates a profit of $60 per year.
Fractional reserve banking cannot survive in a free market. When banks overissue their notes and deposits, they depreciate, and customers race to the bank to convert their holdings back into gold to earn an arbitrage. Even if the right of redemption is suspended, the bank’s depreciated liabilities will not circulate. Unless, of course, the state accepts the deposits of its various banks at face value in the payment of taxes, which is nearly always. In that case, Gresham’s Law directs that the market hoard good money, like gold, and spend the bad money. The shaky deposits of the most aggressive banks become the standard of value.
While the fractional reserve process is progressing, the economy booms—politicians take the credit and distribute the largess of surging tax revenues. When the process retrogrades, as it must, they blame the bankers. Usually only the bottom of the cycle is the very system questioned. It is somewhat extraordinary, then, that Mervyn King, Governor of the Bank of England from 2003 to 2013, should write in his recent book:
The idea that paper money could replace intrinsically valuable gold and precious metals, and that banks could take secure short-term deposits and transform them into long-term risky investments, came into its own with the Industrial Revolution in the eighteenth century. It was both revolutionary and immensely seductive. It was in fact financial alchemy—the creation of extraordinary financial power that defy reality and common sense. Pursuit of this monetary elixir has brought a series of economic disasters—from hyperinflation to banking collapses.
How true. But what to do now? We are not at the bottom of the cycle, as in 1933 or 1981, wondering which policies to implement to prevent it from happening again. We are near the top, with the central banks having saved the malivestments from liquidation in 2008 and encouraged more. There is nothing to be done, in fact. The malinvestments will liquidate, and it will be ugly. As Hayek lamented in 1979:
I had preached for forty years that the time to prevent the coming of a depression is during the boom. During the boom nobody listened to me. Now people again turn to me and ask how we can avoid the consequences of a policy about which I had constantly warned. I must witness the heads of governments of all Western industrial countries promising their people that they will stop the inflation and preserve full employment. But I know that they cannot do this. I even fear that attempts to postpone the inevitable crises by new inflationary path may temporarily succeed and make the eventual breakdown even worse…
The breakdown has already begun. In our system, it isn’t