Tuesday, 25 February 2014

Private banks just exacerbate booms and busts.

In relation to banks, Martin Wolf said “I accept that leverage of 33 to one, as now officially proposed is frighteningly high. But I cannot see why the right answer should be no leverage at all. An intermediary that can never fail is surely also far too safe.”
I gave some answers to that question here. And here is another answer….
The higher are capital ratios, the easier it is for private banks to lend money into existence. E.g. if the ratio is 5%, banks only need one pound of extra capital for every nineteen pounds of extra lending. Now what do private banks do with that freedom? That is, are the main gyrations in their money creation activities explained by sudden upsurges in the number of worthwhile and viable industrial investments?
Well as should be obvious to everyone apart from new-born babies and the inmates of mental homes, “worthwhile industrial investments” has nothing to do with the gyrations in bank lending. The gyrations are explained almost exclusively by outbursts of irrational exuberance: e.g. house price bubbles. For example in the three years or so prior to the recent crises, bank lending (red in the chart below) in the UK was expanding far faster than the expansion of base money (blue).

And of course the state (in the form of the central bank and/or treasury) have to counteract those gyrations.
So why not just ban private money creation altogether, first, because the state already creates a form of money, i.e. base money, and second, if private banks are allowed to create money, that simply leads to instabilities which the state has to counteract?

1 comment:

  1. If we think of state money (base money) and bank money (money created from bank loan activity), then we can ask if the ratio between the two forms of money is important.

    The first thing we notice is that we can not distinguish which dollar (or pound) has been created by government or bank. Does that mean that the ratio between the two is unimportant? I think not!

    Bank loans are made with the expectation that they will be repaid AND they are backed by collateral. The more loans the bank makes, the more valuable the collateral (if more money supply tends to increase prices). At some point, after a round of easy lending, a trap awaits when lending is no longer easy. Then, collateral values fall, loans are recalled, and lenders acquire collateral on the cheap.

    A great program for a lender with a long time horizon.

    The turn-around-point comes when banks are clearly lending the deposits from previous loans. At this point, the ratio of loans to deposits approaches or exceeds 1:1.

    At this point, all of the government money can be considered to be placed into government securities, leaving none for backing bank loans or bank deposits. With no government money remaining in the system, recall of bank loans reduces the deposits on a 1:1 ratio, rapidly contracting the money supply. Bank collapse follows close behind.

    Based on this description, I would suggest a safe banking ratio could be found at loans-equal-half-of-deposits. At this ratio, government created base money would be one-half of all deposits and bank created deposit money would be the second half of all deposits.

    Not quite so drastic a change as you are suggesting.


Post a comment.