Fractional Reserve Banking - More Explanation....

This post is a follow on from many comments on my last post on fractional reserve banking. If this is your first visit to the blog, you may want to look at some of the posts linked to on the left before this post, as this post is a little narrow and more than a little abstract, and attempts to clarify the previous post. If you do want to read on, in order to understand this post, you will need to read my previous post, which is here and may find the comments made by readers helpful in understanding the questions I am trying to address.

Before going on, I will re-emphasise something that some people missed. I am very clear that the central banks do indeed create money (but more of that in a future post). However, this should not be mixed up with the principle of whether Fractional Reserve Banking FRB creates money. My post on FRB seems to very contentious, with one commentator on a forum being very complimentary about the blog overall, but also suggesting that I do not understand FRB. I think the problem prompting such comments is very basic, and is the subject of argument amongst the different schools of economics - the question of what money is.

Returning to the definition of money, in my original post I went to some effort to make clear my definition of money. The argument about whether FRB creates money depends on how you might define money. Perhaps I never made the relationship between FRB and money clear as one person asked why I added this discussion of what money is.

I specifically gave the case of the IOU to make the point of my definition. The IOU is only money in the narrowest sense because it has a limited use in exchange, as it is only meaningful to a very limited number of people who are able to assess the value of the IOU. I would quote the section of the original post here but it is quite long. As such you may wish to return to the post, and you will find it about a third of the way down (using the scrollbar).

As another aside, it might be noted that a fiat currency can be viewed as an IOU, as in a fiat system we just collectively (most of the time) believe in the value of the fiat money. There is no underlying contract that gives value to the money, but simply a belief that is has vale. This is a difficult point to summarise, so you may wish to read my post here as this discusses money in some depth.

The question at the heart of the debate is whether FRB allows the creation of money from nothing. If we go back to how the money creation argument let us look at another example which is as follows:

Depositor A deposits 100 gold coins into Bank A.
Bank A loans 80 gold coins to borrower A for the purchase of a house.
Borrower A writes an IOU for 80 gold coins made out to Bank A.
At this stage we still have a total of 100 gold coins.
The house Seller A accepts the 80 gold coins in exchange for the house.
Seller A then deposits the 80 gold coins into Bank A.
At this point in time, we still have only 100 gold coins in total.
Bank A again has in hand the 80 gold coins.
Bank A lends out 64 of the gold coins to borrower B to purchase a house.
Borrower B writes an IOU for the 64 gold coins.
And so the process might continue....

....But you will notice that on each occasion, the total number of gold coins never changes, and the amount that the bank can lend diminishes on each occasion. Furthermore, there is never an increase in the number of gold coins, just an increase in the IOUs. I have left out interest on this occasion for simplicity and also because (at some point) I would like to deal with this on a post about inflation and deflation. In the end, in the above scenario, the bank will only ever be able to lend a total of 80 gold coins.

The key question in all of this is how money is defined, and this is why I went to some effort to make clear what my definition of money actually is. Under my definition, money only exists in the collective minds of all of us. Whilst some might imagine that the IOUs are money, they are not money, they are IOUs whose value requires specialist knowledge, is highly speculative and they are therefore of limited use as money.

The whole point of a bank run is that, when push comes to shove, these IOUs can not be used as money, because the depositors will not accept a note from the bank that says 'at some point in the future, subject to all kinds of circumstances, we will be able to give you x number of gold coins' - the simple reality is that in a case where gold coins are the universally accepted currency, that is all that counts as money in real terms.

As the situation stands, when people lined up outside Northern Rock, they wanted and accepted £5, £10, £20 and £50 notes, not IOUs. By their definition this is the only money there is, and they collectively are the only people that matter, as they finally determine what money actually is. In other words, the banking system creates what they believe is money on their balance sheets, but the people that really matter (all of us) do not accept the 'money' on their balance sheets as 'money'. It is an entry in a book, and can not be used as a unit of exchange that is accepted by us all.

In the example I have given above, lots of IOUs are created but there are never more than 100 gold coins, and therefore no money has been created. When someone wants their money back, they will not accept the IOUs, but they will accept the gold coins.

I used gold coins on the basis that in everyone's minds eye, it could be seen that no more money is created in the system. In my discussion of the subject I make very clear that the 100 pieces of gold creates a total of 80 pieces of gold lending in a 20% reserve system. Even Ben Bernanke's discussion of FRB agrees with this saying the following regarding a 20% reserve system:

'At this final stage the ratio of reserves to deposits equals the ratio desired by the banks (20%). No further expnasion of loans and deposits can occur after this point because the ratio of reserves to deposits is at its minimum acceptable level.' - Macroeconomics, 4th Edition, Ben Bernanke and Andrew Abel, p525.

In other words, at the end of the system, no more than 80% of the reserves can be lent. However the money shuffles around, the total money 'out in the world' will never be more than 80% of the total deposits. In the case of inter-bank lending, as I pointed out, the amount of those reserves 'out in the world' actually diminishes each time a bank lends to another bank.

At its most basic, an IOU on a bank balance sheet does not constitute money. It does not constitute money because it is not accepted as a unit of exchange. This is why we have bank runs.

I can quite understand why people become so confused about this, as many people would like to imagine that the IOUs do constitute money, in particular many economists. However, the reality is that, when push comes to shove, this does not constitute money, which is why banks hold reserves. However everyone might try to pretend that an IOU is money, the truth that it is not money is revealed when a depositor asks for their money back.

The problem that we have here is made even greater by the fact that fiat money is of itself a form of money based upon nothing more than belief that it is money. However, it is the only medium of exchange that is universally accepted. The idea that IOUs on a bank balance sheet are money is occasionally tested, and whenever the test happens, it is found that it is NOT money. Once again, we can see this in the case of Northern Rock.

As before, comments are welcome. I hope that I can leave this subject and start to look at central banks, but will come back to the subject if anyone can do the following:

1. Show me how the IOUs held by Northern Rock, the numbers in their books, constituted money.
2. How, using gold coins, with no central bank input, a fractional reserve banking system might create more gold coins than depositors have put in (excluding interest payments). For the sake of ease, please try to use 20% reserves.
3. How a bank lending to another bank does not lead to diminishing credit outside of the banking system (again in a flat 20% reserve system)

As I have said, comments welcomed and I hope that I have clarified my point. Like many commentators on my last post, I am occasionally seduced by the idea that money is 'created' when I have read the clever arguments, but keep pulling myself back to the reality of what a depositor accepts as money, and also what I would accept as money. What would you accept as money if you went to get your money from the bank, and they refused to return your £10 as a bank note when you ask for it to be returned as such?

Now the US is in Real Trouble - Paulson and Bernanke Succeed

The breaking news in the Times is that the bailout of the US banking system will go ahead. Now, it looks like it is just a matter of detail, and the devil of how bad the decision will be will lie in the detail.

I have noted that, whilst visitor numbers are up, the percentage of returning visitors to the post is not keeping up (though is still high). That possibly means that some of the new visitors who are coming to this blog do not like what they are reading. I suspect that the reason for this is the belief that I am too pessimistic, that they just can not believe that governments can not 'fix' the problems. After all, 'something has to be done'. Government, apparently, can wave a magic wand of debt and fix the stored problems from at least ten years of erroneous financial management. If you reread the last sentence, the absurdity of the idea is self-evident.

Whatever the details, this magic wand will be damaging to the long term prospects of the US economy. When I first saw this crisis, the one thing that was impossible to predict was going to be how individuals would react to it. Whilst thinking that the US would go through some very unpleasant pain, I believed that the US economy would adapt and reinvent itself in light of the new market conditions. My optimism has significantly diminished.

For some reason I have not been discussing some of the hidden negatives in government borrowing. I suggest that you read here before continuing. The point is that government borrowing distorts the economy in more ways than you might imagine, in particular by hoovering up capital, by competing with productive uses of the capital. On top of this, there are the reasons I have outlined in several other posts as follows:

1. The bail outs are shifting the economic damage onto government balance sheets at a time when the governments of the OECD will need all the resources that they can get. As the world economy rebalances the Western governments will need to make structural adjustments to meet the challenges of the emerging economies, and the massive input of labour into the world economy that they represent. The bailouts will tie government finances in knots, and may actually precipitate a loss of confidence in the ability of governments to pay their debt obligations.

2. In taking on the damage from the financial system, governments are spreading contagion throughout the economy, including the healthy parts. This is due to the inescapable fact that, at some point in time, the healthy parts of the economy will be facing larger tax bills.

I have mentioned several times why this deal will do harm, even if it gives markets and confidence a lift in the short term. However, again as I have repeated many times, there are more problems in the banking system than just the toxic mortgage debt. The Times report has this to say about Paulson's purpose for the bailout:

'Mr Paulson hopes that once the market recovers, the Treasury will be able to sell the bonds back into the market and recoup taxpayer funds. He is also hoping that once the banks are able to rid themselves of such assets, they will begin lending to one another again and America's capital markets will return to normal.'

There is an assumption here that, if the current bad mortgage debt is cleaned off the books, that will be the end of the crisis. However, such a scenario does not account for the downward spiral of the economy - as it weans itself off consumer credit and house price growth, the drivers of the so called 'service economy'. Whatever is done to bailout the immediate bad mortgage debt, nothing will change the fundamental underlying problems, and those problems are going to reappear in the banking system. As the economy continues to spiral down, there will be a new tranche of mortgage based debt going bad, huge swathes of consumer credit going sour, as well as commercial lending going bad. Will the US government be able to continue with the bailouts? I think not.

A good example of the unwinding can be seen in the UK at the moment, in the troubles of B&B, a UK buy-to-let lender (for US readers, this means providing mortgages, often to private landlords, to rent out property). The Telegraph reports the following:

'Credit Suisse said: "Ultimately, B&B's biggest issue is asset quality and we doubt any major bank will want exposure to a £40bn mortgage portfolio with arrears almost double the industry, and where over 40pc of loans will be in negative equity if house prices fall 30pc peak-to-trough.'

The interesting point here is that B&B is particularly heavily exposed to a high risk part of the market, and they are therefore acting as a weathervane. Mortgage and consumer credit arrears are up (see here and here - both out of date so the situation will be far worse now), and will get far worse as unemployment climbs. This applies equally to the US and UK. The arrears are increasingly going to spread into what was seen as the safe lending, or the lending to those who were in employment and could previously manage their payments. Under normal circumstances, this would be a problem but would be a manageble problem. However, with balance sheets already in tatters, this becomes another crisis. The trouble is that the debt bubble has hidden the underlying weakness of the economy, and the banks have been acting and lending on a belief that the economy was strong. That has been a fatal miscalculation, and nothing can soak up the sheer scale of bad lending.

So will all of the financial institutions suddenly start lending to one another again? The answer is that they will continue to hoard capital, as they will be aware that they will need the capital to offset the losses in the coming months/year. The bailout will give them a breathing space, will prolong the life of the weaker institutions, but nothing can stop the ongoing losses and the next tranche of failures.

So what will this bailout, this 'doing something', achieve? It will just act to hobble the US economy, and at best delay the progess of the crisis without stopping it. It will buy time, but at the cost of the future speed of recovery of the US economy. The only upside will be that it will speed the devaluation of the $US, which will allow the US economy to become more competitive, albeit at the cost of the relative impoverishment that this implies.

It is not a good day for the US economy, and that also means that it is not a good day for the world economy.

Note: In some of my previous posts I have been discussing that the emerging market currencies will increase in value compared with those of the West ($US, Euro, £GB). I have neglected to mention that the same might be said of the big commodity producers. An interesting question will be whether the currencies that are pegged to the $US will free their currencies? My guess is that it will only be a matter of time, and I have noted others have a similar opinion (sorry, no refernces to hand on this point, as this note is a rushed afterthought).

Note 2: I recently discussed a report that was pessimistic about China, and have just found a new report that is far more positive about the prospects for China. As I keep saying, China is very opaque, and this means that it is a 'wildcard'. Even with $US devaluation they have significant resources available to carry them through the downturn, but will it be enough. See my post here for a discussion a discussion of why China is a question mark.

Note 3: Some time ago, I promised that I would write a further post on reform (in this case regulation), but have not managed to do this. The current events have been a bit of a distraction and I hope to return to reform in the future, as this is one of the main purposes of this blog. It is all very well to consider the problems, but what is really needed is solutions.

Note 4: I have found this in the Telegraph:

'Meanwhile, ratings agency Fitch said the vast bail-outs agreed yesterday by the US Congress do not add significantly to America’s public debt of 57pc of GDP since the money is being used to buy assets, which are backed by collateral. '

So let's get this clear. Nobody wants to buy this toxic waste, not even the sovereign wealth funds, even though the debt is available at firesale prices. Despite this, apparently the is backed by collateral, even though the collateral becomes worth less with every day that goes by. It is a bit like securing a loan against a burning building - fine if someone can put the fire out, but otherwise not really much use.

Final Note: I thought perhaps some light relief is in order; this from the Spectator:

'If you had purchased £1000 of Northern Rock shares one year ago it would now be worth £4.95. With HBOS, earlier this week your £1000 would have been worth £16.50, £1000 invested in XL Leisure would now be worth less than £5, but if you bought £1000 worth of Tennents Lager one year ago, drank it all, then took the empty cans to an aluminium re-cycling plant, you would get £214. So based on the above statistics the best current investment advice is to drink heavily and recycle.'

In current circumstances, this might be a popular investment tip......

Bernanke and Paulson - the Dynamic Duo?

The world is waiting nervously to see whether the bailout of the financial system will actually go ahead, with ever more dissent coming from congress in the United States. If the article I have cited is correct, it is not economics in the driving seat, but politics. Bearing in mind that the economists have got it so wrong in the past, perhaps (for once) that is a good thing.

Meanwhile, one of the curiosities of recent days is that oil has risen in price. This really is quite baffling, though not in the sense that it is rising through hidden unknown mechanisms. The baffling part is that oil is not something that can be stored, and has to be sold according to a price that is set by demand. Unless those investing in oil know that there will be a cut in supply, it is not entirely clear how they seek to profit, or even find safety in this commodity. Oil prices were falling previously for a good reason; that demand across the OECD was falling back. As such, they now have the oil, but they need to actually sell it to end users at a price that will cover their buying price. As ever, those who got in early stand to profit from this, but the followers will surely lose money - unless I am missing something critical here? On the other hand the flight to gold makes more sense, as gold is currently being driven by sentiment (a flight to safety), and can be held over the long term. At this point, you may ask for the difference. In crude terms, gold can be locked away and be held over long periods of time, whereas oil can not be stored in significant quantities. As I have said, perhaps I am missing something here, but I do not think so.

This situation perhaps illustrates the underlying fear in the market. On a related issue it appears that there are tremors over the state of the emerging markets:

'"The big surprise in store is what could happen in China. The potential for a deep recession in the US is already on the radar screen, but people will be stunned if China's economy contracts, as I believe it will. Investors could be massively caught out," he said.

"The consensus has a touching belief that emerging markets will prove resilient despite a deep downturn in developed economies. My view is that an outright contraction in global GDP is entirely possible next year."'

And

'The gloomy forecast comes as Fitch Ratings warns of mounting distress for banks in China, where debt has been shunted off books to circumvent state limits on credit growth.

The pattern looks eerily like the use of "conduits" by Western banks at the height of the credit bubble'

I have mentioned before that China is opaque, and whether it would be pulled down by the crisis was not entirely clear. I recommend you read my original post on China, as it covers both the positives and negatives in the Chinese economy, and explains why it is that it is so difficult to see the economy clearly.In my original post on China, I had the following to say in conclusion to my discussion of Chinese banks (having pointed out that their commercial and domestic property were looking like a bubble):

'In light of this, I must conclude that there may still be some suspect lending from the Chinese banks. This is pure speculation, but is based on experience 'on the ground'. This raises the possibility that there is also bad lending into business, in particular to the state owned firms. Such lending is not so visible, so it is impossible to say if this is the case.'

However, before writing off the Chinese economy, I would suggest taking a look at the post, as there are significant strengths. The fact that the problems of the US and Europe would hurt China was always evident (and something I predicted). However, whether the damage from the West is enough to pull back the Chinese economy into recession was my question. If it is correct and, as I suspected, the Chinese banks have continued their poor lending, then the balance tilts towards serious problems for China. This is a very worrying thought, as the legitimacy of the Chinese Communist Party is built largely on economic growth and nationalism. If economic growth fails.....

The same article is suggesting that there may be a worldwide recession, and readers of my posts will find this to be no surprise. The real question is how the pain will be spread, and it has always been my belief that the West is going to be where the real hurt happens. However, if we throw unrest (Revolution? War?) into the Chinese equation, then all bets are off. At that point we will enter a state of chaos from which anything may emerge. It was one of the points made in my original post. However, this is just one report, and as I have emphasised, China is opaque; call it a wild card if you will.

What of investing in Asia? I have already suggested that their markets will fall along with Western markets, but that there currencies will see strengthening, which should offset the pain of the falls for those who move their money into the emerging economies early. However, if China does fall, then political risk across Asia will be sky high. It is for these reasons that I have been emphasising that there is no real safe haven at the moment, except possibly gold. In the short term I suspect that we will see some strange market movements. The flight to safety into oil suggests that there is a considerable degree of panic, and panic does not aid rational thought.

In the meantime, the world waits on the success or failure of the 'dynamic duo' of Paulson and Bernanke. However, their intervention does not promise to save the day, because no super heroes are large or powerful enough to overturn economic reality. The curious point for them is that, whatever they do, history will be kind to them. If they fail, and the anyway inevitable crisis ensues, everyone will suggest that 'if only they had been listened to', and if they succeed the economy will still crash, and it will be seen as a valiant effort, but just not enough. In short, the idea that something could be done will persist.

An analogy for this is to think of a company that has long been successful. The management of the company changes, and they cut back on investment, increase the pay of their workers, and enjoy the comfort of market leadership. As time goes on, they fail to note that new companies are entering their markets, taking market share, and fail to react. Instead, they raise ever more money on the markets, and the market keeps paying. However, they are loading up with debt, and they are starting to use debt to pay back debt. Can anything be done to stave off disaster in the short term? They are broke - their revenues are falling, they have lost market share, and their lack of investment has left them poorly equipped to fight back. No one wants to lend anymore...

So, can our dynamic duo save the day? I will let you draw your own conclusions.

Note 1: I was posting on a forum and dug out one of the useful resources that I occasionally dig into for information. The resource can be found here. It is the Bank of England document on recent developments:

'Chart 1 shows the extent to which the United Kingdom’s gross external assets and liabilities have grown since 1990. In this 13-year period, both assets and liabilities
have increased by more than £2.6 trillion, at an average annual rate of more than 11%. This easily outstripped the 5.4% average annual growth rate of nominal UK
GDP over the same period. At end-2003, external assets stood at £3.55 trillion and external liabilities stood at £3.60 trillion.'

When we factor in that they include the multiplier effects from increase in debt are factored into economic growth, such that the GDP figures are completely removed from the the reality of real growth, then we have a very worrying situation indeed (these are problems discussed through various places in the blog).

Note 2: Just a quick comment on Gordon Brown cleaning up the City and the world financial system:

'Mr Brown will call today for global regulation. "Because the flows of capital are global, then supervision can no longer just be national but has to be global. And if we make these changes I believe London will retain its rightful place as the financial centre of the world.'

The first problem is that (as I have argued previously) it is actually regulation causing all the problems. The second problem is one of practicality. How can different systems across the world all find a common standard. The third problem is that, if all the world uses the same system, then the entire world system will all go down at once if there is a major failure in that system (an analogy that comes to mind was a historical calamity in which the whole of the US used the same variety of wheat, such that when a disease struck the whole years crop was devastated). As it is the system is interconnected, but at least different systems will have different vulnerabilites and exposures.

Happily, as trying to set up such a financial system will be akin to herding cats, it is very unlikely (I hope) to succeed. As such it is probably just grand standing, to be seen to be doing something; and an attempt to portray gravitas. As for the idea of regulation of banking pay, I have yet to see any solid proposal that goes beyond rhetoric, but the idea of government control of remuneration is one which brings the word 'despair' to mind. The banks may have been foolish, but much of the root cause for the foolishness was that all the banks were 'sound'.....and the reason that they were sound was because they met regulatory requirements. The fact that their capital base was built upon toxic waste slipped the regulators by....and now there is talk about regulation of remuneration?

Note for Tin Hat: In reply to your question, I have no secret investment tips. I just arranged my life such that (hopefully) the crisis will mostly pass me by.

Last Note: Just a point on the valuation of emerging market investments. A simple way to look at it is imagine you invest $1 in a US stock, and $1 in an asian stock, and both stocks fall equally in percentage terms in their markets. If the Asia currency is appreciateing against the dollar, even though the Asian stock has dropped in value, at least part of your wealth has been retained through the fact that when you sell that stock, the currency will ameliorate the effects of the fall in the stock value, as the value is measured against local exchange rates. Sorry, to mention this if it is obvious to you all, but just in case....