But whatever you think about fractional reserve banking, whether or not you agree with its critics, the truth is that we no longer have it.
As the above-linked NY Fed article notes:
In practice, the connection between reserve requirements and money creation is not nearly as strong as the exercise above would suggest. Reserve requirements apply only to transaction accounts, which are components of M1, a narrowly defined measure of money. Deposits that are components of M2 and M3 (but not M1), such as savings accounts and time deposits, have no reserve requirements and therefore can expand without regard to reserve levels.
And as Steve Keen notes – citing Table 10 in Yueh-Yun C. OBrien, 2007. “Reserve Requirement Systems in OECD Countries”, Finance and Economics Discussion Series, Divisions of Research & Statistics and Monetary Affairs, Federal Reserve Board, 2007-54, Washington, D.C:
The US Federal Reserve sets a Required Reserve Ratio of 10%, but applies this only to deposits by individuals; banks have no reserve requirement at all for deposits by companies.
So huge swaths of loans are not subject to any reserve requirements.
Some people doodle pictures, but I’m the type who mucks around random bits of historical price data just to see where it goes. For example, I love charts of the Dow Jones Stock index in the 1920s – it me it tells a vivid story of hopes and dreams and pain mixed with desperation. The wild fluctuations in the early 20’s, the solid gains of the mid 20’s then the euphoria and ensuing panic, well.. you know the rest.
A while a go, I came across a quote;
With an ounce of Gold, a man could buy a fine suit of clothes in the time of Shakespeare, in that of Beethoven and Jefferson…
What does a ‘fine suit’ cost today? Well, an ounce of Gold is just short of £700. If you went into Harrods, and asked for a fine suit, would that see you into an Armani or Zegna number? I think so.
So, the maxim seems to ring as true today as it ever did.
So my mind got to thinking – if an ounce of gold seems to buy the same stuff over the centuries as it does today, then it would seem to be a great proxy for true purchasing power.
The problem with looking at historical charts of stock movements, especially if you are trying to learn the lessons of history, is that the picture is muddied by the fact that the unit of account – i.e. money, does not do a very good job. It is rapidly decaying so when you compare over time, it just gives the wrong impression of what is going on.
For example, look at the stock market over the whole of the 70’s, and you think that equities didn’t do too badly. But adjust for inflation, and you soon realize that stocks lost over three quarters of their value in the first half of the 70′s!
So, the idea dawned on me: the price of stocks and shares are only represented in terms of money. What if you priced them in Gold instead of pounds and dollars?
Firstly: what data? Well, I stuck to the UK, and I chose the FTSE all share index. I took the index value for each day, going back a few decades. I then converted them into ounces of gold. The chart gave me a pretty shocking picture.
But then I realised I’d missed something pretty important. Stocks pay dividends. So, I added a 5% annual dividend return, and then reinvested it into my index. Surely that’d make my chart look less ridiculous? Erm, a bit… but not by very much.
What I was left with was a completely different view of history, and some pretty worrying revelations.
Firstly, my chart had nothing to say until the 70’s. This is because until then, money was gold – therefore priced in money or gold – it didn’t make a difference. In essence, the chart had no surprises.
But in the 1970’s, money was cut loose from gold, with some pretty shocking results.
FTSE All Share in terms of in oz of Gold (click to enlarge)
Some salient observations.
1. The mayhem of the early 70′s had some pretty catastrophic consequences for the world, and recovery only came in the 1980′s. From over 12 ounces of gold, down to nearly 1 ounce of gold is a pretty insane move.
2. Real growth took off in the 80′s, but something happened in the mid 90′s – the internet. This was a period of real economic growth, that morphed into a bubble, thanks to some pretty silly policy mistakes by Greenspan et al.
3. What happened in the 00′s? Wasn’t that supposed to be the ‘NICE’ decade? Wasn’t the stock market supposed to have risen back to its peaks?
My answer to this is that the noughties were a period of stagnation, economic misalignment, and we were all swamped by a money fraud.
The authorities were in such a blind funk in 2001, with the overriding perception that we were facing a 1929 style collapse, that they turned on the money gusher, and flooded the whole world with liquidity. This found its way into the greatest worldwide property bubble the world has ever seen.
But… this was not true growth – at least for the Western economies. Sure, great advances were made in some sectors of their economies, but huge misalignments of capital were occurring, and this decade of false signals to producers, but especially to Western consumers, is why we had the economic crisis of 2008.
Look where we stand now. In ruinous debt. Shackled to low interest rates and nervously watching retail sales and property prices. This is a direct consequence of our societies living the high life for ten years, without actually realising we were in decline.
We have been living like cannibals. Hollowing out ourselves out, yet living the high life. And this is all down to a pseudo neo-Keynesian/monetarist aggregate kabala fetish.
I feel a sense of panic looking at this chart, so what is the solution?
I see the panel of economic experts that is the acting industry have latched onto the Tobin tax, now re-branded the ‘Robin Hood Tax’. Never mind that Robin Hood fought against unjust taxes by tyrants: the modern day bogey man is the banker.
Now funny thing is, I do agree with a lot of the sentiment expressed by the morally indignant of Primrose Hill.
Yes, the financial world has grown out of all proportion to the real world
Yes, the rewards for participation in this job seem ludicrously high
Yes, bankers have been bailed out by tax payers and are now furiously spinning the wheels of casino capitalism faster than ever before.
Yes, we should do something about it.
But. Not this.
Firstly, why financial markets are important. The good that these things do is provide a price on the future. They allow us all to insure ourselves against the unknown, whether that be a fixed rate mortgage to buy your house, or a bond issue that allows a company to grow.
Financial markets provide sellers for the shares you want to buy, insurers for risks you want to avoid and lenders when you need to borrow.
Attack the market, and you attack its ability to do this job efficiently. The price will be paid by you.
It is said that the market will absorb the Tobin/Hood/Luvvie tax. Anyone who says this clearly underestimates the ability of a bank to pass on its increased costs. You will either pay directly by higher fees, or indirectly, as the cost of everyday things get more expensive.
And more expensive they will be as the Luvvie tax will infect its way through the whole system. At every stage of production, financial markets are used to quantify and reduce costs. Commodity futures allow manufacturers to fix input costs, freight derivatives allow shippers to control cash flow, forward foreign exchange allows import/export companies to insure against wild market swings, credit insurance allow insurance against default and so on and on.
But surely a tiny transactional tax would pass unnoticed? Well, it may seem tiny, but to many market participants this Luvvie tax will be huge. What people fail to understand is that a regular and competitive price in many instruments come from institutions that are prepared to turn over huge volumes in order to make a net margin often much smaller than the Luvvie tax. In one fell swoop, you make a huge proportion of this trading unprofitable, therefore you take away the ability of the market to provide a price. It’s always the way of ill thought out taxes: unintended consequences. Some arbitrary decision is made, and a myriad of economic activity suddenly becomes futile.
So what? Who needs them? Well, you do. Every time you want to invest in your pension, you will (indirectly) need to buy a bond or some shares. Where do you think the seller comes from? Charity? No, it is the myriad of active traders that act as the buffer between ‘real’ buyers and sellers of these things.
In the end, you will pay by being poorer as a pensioner, by paying more interest on your mortgage and by generally being gouged more by the banks.
And so, we turn to the banks. The true villain of the piece.
The problem with financial markets is that banks are allowed to actively participate in this trading game. It would be less problematic if banks used the markets merely to reduce their risks, but this is not what they do. They see markets as a lucrative opportunity to enhance their profits, and they seize it with both hands.
Why is this bad? Because they punt their customer’s demand deposits. They take the money set aside to pay your gas bill, multiply it up tenfold, then wade onto the casino floor. What allows them to do this with some level of (misplaced) confidence is the myriad of legislative favours, monopoly rights, tax payer protection and political pressure arrayed to support them.
Here at the Cobden Centre, we’ve bleated on time and time again about how fractional reserve banking conjures money out of thin air, but it is worth repeating. You deposit £100 of notes and coin in your current account, and this becomes the property of the bank to do with as they wish. You sign it over to the bank, who lend most of it out. £100 of cash, becomes £197 of purchasing power. Whomever gets £97 loan, deposits it at their bank, and the same happens again and again.
Are you happy that the £100 you think is being safely held aside for your weekly food shopping is being used to fund £1000 of credit default swaps? I thought not.
At the end of the day, what consenting adults do in the privacy of their own bedrooms is of no concern to you. What hedge funds do with their willing clients’ money does not concern anyone but the investor. What pure trading companies do with their retained capital is of no worry to you.
The problem is the banks. An the best way to put a stop to their nefarious influence is not by taxing them and innocent parties. Not by robbing pension funds. Not by forcing you to pay higher fees to manage your financial affairs (as you surely will). No, they way to deal with the problem that banking has become is simple:
James Tyler explains how to fix banking. This article originally appeared on hedgehedge.com.
Open your wallet. Take out that £10 note. It’s yours. Your property, to spend as you wish. Put it in a bank, and you enter Alice’s Wonderland.
Most people in this country believe that when your money is placed in a bank account, it remains their property. Nothing could be further from the truth. Once you hand it over, it becomes the bank’s property: what you get in return is a promise that they will repay you if you ask for it. Why does this matter? Because the bank will then lend it to somebody else – and not on the same terms.
Think about what this means for a while.
If the money has been lent to somebody else… surely it’s not there. Yet you have been promised instant access. Surely the person who has borrowed the money has the right to it? The fact is both you and the borrower can use the money – at the same time. How can this possibly work?
Well, the banks say “not everyone will want to take their money out at the same time. We carefully plan and monitor withdrawals, and we don’t lend the whole lot out – we keep some in reserve to cover withdrawals”. True, for every £100 you put in, they keep a hefty reserve.
This is a great news report from Zimbabwe via Al Jazeeera. It examines the ‘fantastic returns’ on the Zimbabwe stock exchange – and how traders are becoming ‘paper millionaires’. ‘Traders are astounded by the performance’. ‘Stock soar despite inflation’. I kid ye not.
Cobden Centre Advisory Board member and Chief Executive of Tyler Capital, James Tyler, sets out the case for 100% reserve banking.
Background
In October 2008 the Federal Reserve briefed a secret congressional committee that the US economy had, at one stage, been only a few hours away from a total meltdown in the financial system.
How did this come to pass, and how can we prevent it again?
The Problem
Fractional Reserve Banking (FRB) is an inherently unstable complex system.
Each and every bubble and crisis has some kind of link to FRB, going back thousands of years.
Even where financial crises are caused by natural disasters (the San Francisco earthquake of 1906 being a prime example), the financial crisis only followed because banks did not have enough reserves to pay out worried depositors – due to fractional reserves.
In a nutshell, depositors wanted what they thought was their property back, only to find it did not exist.
Over 70% of people in the UK believe that money placed in an instant access account remains their property. This is not the case.
Fractional Reserve Banking
Person ‘A’ deposits £100 of cash into his instant-access bank account.
At this point, he signs over property rights to the bank – the bank gives him a promise to return on demand
The bank retains a small reserve (say £3), and lends out £97 to Person ‘B’
Both ‘A’ and ‘B’ both have a claim to instant access on this money.
In one move, the bank has turned £100 into £197 of useable money
‘B’ buys a Widget from WidgeCo for £97
WidgeCo deposits the £97 with his bank ‘Z’.
Bank ‘Z’ now lends out around £94 to person ‘C’ keeping just under £3 as a ‘reserve’
Person ‘C’ borrows to buy computer, and pays £94 to ‘D’
Money supply has started its process of mushrooming:
‘A’ Has the right to £100
‘B’ has spent his claim to £97, and owns a widget
WidgeCo has a claim to £97
‘C’ Has spent £94 and owns a computer
‘D’ has a claim to £94
This process continues until there is no more money to lend
If any one person with a claim to their money exercises their right, the inverse pyramid collapses.
If person ‘A’ claims any more than £3 of his money, the inverse pyramid collapses.
Nouriel Roubini has officially left the “hedging your bets on the economy” camp. He has declared the markets to be frothy because super low dollar borrowing rates have turned the greenback into the funding currency for the carry trade.
Far more important than the peppy rally in the stock market is the resumption of early 2007 style risk taking in the credit markets. As Gillian Tett of the Financial Times noted last week:
Earlier this month, I received a sobering e-mail from a senior, recently-retired banker. This particular man, a veteran of the credit world, had just chatted with ex-colleagues who are still in the markets – and was feeling deeply shocked.
“Forget about the events of the past 12 months … the punters are back punting as aggressively as ever,” he wrote. “Highly leveraged short-term trades are back in vogue as players … jostle to load up on everything from Reits [real estate investment trusts] and commercial property, commodities, emerging markets and regular stocks and bonds.
“Oh, I am sure the banks’ public relations people will talk about the subdued atmosphere in banking, but don’t you believe it,” he continued bitterly, noting that when money is virtually free – or, at least, at 0.5 per cent – traders feel stupid if they don’t leverage up.
“Any sense of control is being chucked out of the window. After the dotcom boom and bust it took a good few years for the market to get its collective mojo back [but] this time it has taken just a few months,” he added. He finished with a despairing question: “Was October 2008 just a dress rehearsal for the crash when this latest bubble bursts?”
In other words, everyone seems to be in on this bubble except most borrowers in the real economy. But that wasn’t the main objective…it was to reflate asset prices to save the global banking system…by rerunning the same movie that drove it off the cliff in the first place (well, this is a sequel, so there are some minor plot changes, like the dollar rather than the yen as the basis for the carry trade).
WASHINGTON — In 2006 and 2007, Goldman Sachs Group peddled more than $40 billion in securities backed by at least 200,000 risky home mortgages, but never told the buyers it was secretly betting that a sharp drop in U.S. housing prices would send the value of those securities plummeting.
Goldman’s sales and its clandestine wagers, completed at the brink of the housing market meltdown, enabled the nation’s premier investment bank to pass most of its potential losses to others before a flood of mortgage defaults staggered the U.S. and global economies.
Only later did investors discover that what Goldman had promoted as triple-A rated investments were closer to junk.
