I can resist everything except temptation.
The Inflation Engine
I love the wit of Oscar Wilde.
Lydia’s banking descendants could write claim-checks on the gold and silver in their vaults and soon the paper claim-checks (which were far more convenient to use in practice) became the dominant money-form on Main Street. A classical gold standard with a gold reserve ratio of 100%. Lydian paper money was as good as gold.
But the bankers were clever. They realised that the claim-checks were becoming the only form of money people used in practice. People asking for loans now asked for it in the freely exchanging paper bills not piles of gold and silver. The bankers knew they could make their money work for them by re-lending the silver and gold in their vaults. But they didn’t even need to move the metal, they could just issue the receipts for the money. Every time the banker made a loan, the banker made profit in the form of interest – in fact it was the most lucrative part of the bankers business.
The credibility of the banker was very important. Nobody would trust a banker if they felt they would not get delivery of their precious metal deposits when they asked for conversion of their receipts into metal. Alas, bankers are smart but they’re also human. They can resist everything… everything, that is, except temptation. It didn’t take long for the bankers to realise that nobody but the bankers truly knew how much gold was in the bank vaults. The banker could play a little trick by lending out many more claim-checks for gold than actually existed in his coffers, thus earning more interest than their money supply would imply. The truth was, the money in reserve, in the vault, was only a fraction of the money in circulation. This was the birth of what exists today: it is called fractional reserve banking.
There are loads and loads of cute YouTube videos explaining this – like this one here. It’s not a conspiracy. It’s how the banking system works. What the banks do is they sort of expand or amplify the appearance of the actual real money in the system… they sort of… let me think of a word… errmmm… INFLATE the money supply. Yes. Inflation. That’s what it is. Because we know from Keynes that Inflation is first and foremost an monetary phenomenon (the rise in prices of everyday goods is just the standard method of measuring the effects of inflation, that’s all). In the same way that rising mercury in a thermometer is just an “effect” of rising temperature, rising prices is just an “effect” of an inflating monetary base.
Indeed over 90% of the currency we see today gushing around the system is not created by the central banks – it is effectively conjured by the inflationary property of the distribution mechanism; the private banks and their fractional reserve banking. Weird huh?
So you see the central banks can only control a small aspect of monetary inflation, the rest is left to the private banks and, of course, the broader economy’s capacity for business investment and lending. But the tools of the central banker have always been blunt and cumbersome. This is, of course, why, despite huge unconventional measures like quantitative easing measures and Negative Interest Rate Policies (NIRP) there is still talk of Fed impotence.
If you think that is weird, this is the bit which really freaks people out: when a bank issues a loan for currency which it does not have, that currency is simply created, effectively out of thin air. This is what we mean when we say currency is “loaned into existence”. This is what we mean when we say currency and debt are two sides of the same coin (if you’d pardon the pun). Currency = Debt… if you reduce the debt in the economy you also collapse the money supply. It’s just the way our monetary system is designed.
How Irish Eyes Cried
But something doesn’t feel right does it, dear reader? There is an inherent problem to this neat trick. Because the Lydian banking descendants have created a monetary system where there are far more claim-checks for real money (Gold and Silver) in circulation than there is physical money in the banking vaults. If everybody ran to the banks to demand their rightful claim on the money that the claim-check certificates entitle them to, the sleight of hand would be exposed. This is called a “run on the bank” and every single bank in the World is at risk from this.
There is a moral hazard here which most people don’t understand. Most people think they have their money in a bank account for safe keeping. That is not what actually happens. The minute you put your money in a bank account it is no longer your money. What you are actually doing is effectively lending the bank money – to do with it whatever it wants. If the bank fails and goes bankrupt, that money is gone. There is no impenetrable ring fence around “your” money. Of course, often the government “guarantees” consumer bank deposits by offering to prop up the banks’ business in time of crisis. But the financial community knows that the government does not have enough the confidence of the markets to actually back this claim up – there are just too many banks, too many deposits, too much debt. If the government really did back all the banks during a mass run, the government itself would go bankrupt. It’s just another confidence trick to put the public at ease.
After 2008 the Irish government tried to put the public at ease by guaranteeing their deposits and loans… … then immediately asked for and EU-IMF bailout because in doing so realised that their entire economy had turned into big pile of poop. See Lessons From Ireland’s Failed Bank Guarantee in the EU Observer.
On the 30th of March 2010 I wrote a piece called Autopsy on Ireland’s Balance Sheet. Where I referred to the then BBC’s editor, Robert Peston’s, article The Unbelievable Truth About Ireland And Its Banks where he says (I quote) “…the Irish government probably chose the worst of all strategies for propping up the banks. By guaranteeing all their liabilities in the autumn of 2008, they turned the bloated liabilities of the swollen banks into public sector debt.”
Indeed my article I quote another piece on bond market vigilantism (bond market vigilantes are a small number of huge bond investors who can exert influence on entire governments – it’s almost like open market activism on the fiscal policies of governments by fixed income investors). I quote:
You cannot simply make bad debts “go away”. You can hide them away in SIV’s or structures off the balance sheets of the banks, then you can then bail out and then subsidize the banking sector with tax-payers money, quantitative easing and a steeper yield curve. Then you can buy all the toxic waste and explode the balance sheet of the central bank while eager think-tanks in Government conspire ingeniously to run massive deficits to stimulate the economy. But the debt is not magically waived, it now just sits on the sovereign balance sheet and it is the sovereign state which now comes under the scrutiny of (foreign) investors and it is the sovereign state which now represents economic credibility of the nation as a whole.
As the greatest financial author of our generation, Michael Lewis, wrote on Ireland “a banking system is an act of faith”. In fact here is a quote from his excellent piece on Ireland called When Irish Eyes Are Crying [RECOMMENDED READING]. In typical Lewis fashion he hones in on an outcast, a financial delinquent, called Kelly. Kelly’s warnings of impending doom in the Irish economy were, of course, widely mocked and derided by the political establishment.
Kelly’s colleagues in the University College economics department watched his transformation from serious academic to amusing crackpot to disturbingly prescient guru with interest. One was Colm McCarthy, who, in the Irish recession of the late 1980s, had played a high-profile role in slashing government spending, and so had experienced the intersection of finance and public opinion. In McCarthy’s view, the dominant narrative inside the head of the average Irish citizen—and his receptiveness to the story Kelly was telling—changed at roughly 10 o’clock in the evening on October 2, 2008. On that night, Ireland’s financial regulator, a lifelong Central Bank bureaucrat in his 60s named Patrick Neary, came live on national television to be interviewed. The interviewer sounded as if he had just finished reading the collected works of Morgan Kelly. Neary, for his part, looked as if he had been dragged from a hole into which he badly wanted to return. He wore an insecure little mustache, stammered rote answers to questions he had not been asked, and ignored the ones he had been asked.
A banking system is an act of faith: it survives only for as long as people believe it will. Two weeks earlier the collapse of Lehman Brothers had cast doubt on banks everywhere. Ireland’s banks had not been managed to withstand doubt; they had been managed to exploit blind faith. Now the Irish people finally caught a glimpse of the guy meant to be safeguarding them: the crazy uncle had been sprung from the family cellar. Here he was, on their televisions, insisting that the Irish banks were “resilient” and “more than adequately capitalized” … when everyone in Ireland could see, in the vacant skyscrapers and empty housing developments around them, evidence of bank loans that were not merely bad but insane. “What happened was that everyone in Ireland had the idea that somewhere in Ireland there was a little wise old man who was in charge of the money, and this was the first time they’d ever seen this little man,” says McCarthy. “And then they saw him and said, Who the fuck was that??? Is that the fucking guy who is in charge of the money??? That’s when everyone panicked.”
Mervin’s Moral Hazard
The reality is, the banking system is, and always has been, an act of faith, a shell game, a confidence trick. There is nothing new or sensational about this, and yet many people choose not to believe it. They think it’s a conspiracy theory or a spook story. Banks don’t have enough money to repay their depositors – it’s as simple as that.
Bank runs on a faith-based trickery are not a thing of fiction, they exist even today. Back in 2007 Northern Rock experienced a run. I don’t know how these things start when they do or why they are triggered – it’s like a butterfly effect thing. But suddenly customers were queuing up outside the bank to be let in so that they might retrieve their hard-earned life savings. And what did the Northern Rock bank do? It shut the doors and simply refused to let the “customers” in! Police cars were called to the queuing masses to deter acts of violence or panic. Fractional Reserve Banking, dear reader.
The truth is these poor people were not “customers”… they were effectively creditors. Mervin King, the Bank of England Governor, was forced to step in and bail out the bank to protect the system as a whole and because a disinflationary backdrop could dissipate unconventional tactics and flippant money-printing. But why was he so hesitant? Why did he spend so long mumbling about “moral hazard”? The truth is, the moment you put your savings into a bank, you lose ownership of that money, the bank does with it what it wants and you take the risk on that bank being able to pay you back in the future. If the bank reveals it has no testicles under its bathrobe then ultimately that’s your problem, not the government’s, not the central bank’s problem. If the bank does get bailed out by someone or something, then you got lucky. But you have no right to this money under all circumstances, it is no longer yours, you should not expect to get it back if the bank blows up. As the tellers at Southpark Bank would say, when the money’s gone… “IT’S GONE!“.
However, in the past, bank runs have been generally localised. Retail banking was a local business despite the globalisation of the banking industry. At the very least a banking crisis could be contained to a particular country or region. One could even argue that the Lehman shock was due more to a collapsing financial system triggering bank runs, rather than the other way around.
But there was a time when there was a run on the entire monetary system. It was effectively multi-national run on the global currency arrangement itself. The mother of all runs on the faith… a swarm of monetary infidels would leave the most powerful men in the World with red faces. The reaction and subsequent consequences would set the tone for the global economic and monetary conditions we observe today. That’s another story for another time… time to hit the send button.