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Source: (consider it)
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Thread: Fractional reserve banking and related ills
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Eutychus
From the edge
# 3081
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Posted
For various reasons I have been mulling over the problems with the current financial system.
One of my Christmas presents was this book about the International Bank of Settlements, by a journalist who writes for the Economist.
I also happened unexpectedly on Margin Call and went on to watch Inside Job again (the whole thing is on YouTube if you dig around a bit), as well as looking at various much more anticapitalist and tinfoil-hat sources (such as this).
Leaving aside the wilder tinfoil-hat theories (eg this is all an Illuminati/masonic plot, Kennedy was assassinated for trying to break free of the Fed's stranglehold on the money supply, the world's wealth is controlled by just four families, etc.) my musings as of now go something like this:
- Where, if anywhere, is the dividing line between fractional reserve banking legitimately and usefully creating wealth and a Ponzi scheme?
- Is the practice of keeping major financial decisions out of the hands of governments, off the record, and in the hands of a select group of experts a sensible recognition of the need for expertise in a complex world or an invitation to abuse of power?
- Usury and/or lending with interest: does it inevitably concentrate wealth into the hands of a few, or is the problem one of systematic recourse to consumer debt?
- The financial system as it is appears inherently unstable, no lessons have been learned since the last crash, and most of the same people are still in charge. Sooner or later, another crash is inevitable. The playing field is so huge that we appear powerless. In the light of our calling not to leave the world but be "in, but not of" it, what might an appropriate christian response be?
They are all a bit inter-related in my mind, but feel free to run with any of these questions!
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Let's remember that we are to build the Kingdom of God, not drive people away - pastor Frank Pomeroy
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Enoch
Shipmate
# 14322
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Posted
What is 'fractional reserve banking'?
I suppose the question is, 'is Tower of Basel yet another great conspiracy theory, on a par with the Chronicles of the Elders of Zion or Fahrenheit 9/11, or is it a serious and objective examination of the facts?'
Its cover and the blurb on the Amazon site at the end of the link suggests quite a strong presumption of the former, but I suppose one should have an open mind.
The world financial system is inherently unstable, but sadly, that's hardly news.
The UK's state pension is a Ponzi scheme, but we all pretend it isn't.
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Brexit wrexit - Sir Graham Watson
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moonlitdoor
Shipmate
# 11707
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Posted
I don't see any resemblance between fractional reserve banking and a ponzi scheme. Could you explain more what you mean by that paragraph ?
Whatever you think of fractional reserve banking as a system, it's one that is used by every country and has been for a very long time, so it seems strange to hold it particularly responsible for the financial crisis of 2008. It seems more logical to look at factors that applied particularly at that time and particularly in the countries most affected.
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We've evolved to being strange monkeys, but in the next life he'll help us be something more worthwhile - Gwai
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Barnabas62
Shipmate
# 9110
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Posted
I think fractional reserve banking is here to stay! The whole thing is based on confidence that you will be able to get at your "cash" or "credit limit" when you want it, but we don't all want it at once. What can you do with money or credit reserves that you don't need immediately for purchase, apart from stick it under the carpet? Why leave NOT it under someone else's carpet? Banks have big vaults and access to even bigger vaults if they need the reserves. No skin off your nose if they use it while they've got it, so long as you can get it when you want to use it.
Problem is how much or how little fractional reserve you need to keep people playing along. If we all want to stick stuff under the carpet, the whole game is over, I think.
More to it than that; like how are transactions financed by money as a medium, rather than some sort of barter system. Money makes the world go around. A lot of that is other people using other people's money. Provided they can stump up when they need to, that's fine as well. But if it isn't, then Bad Things Happen.
And that's about as good as it gets from me. I seem to remember an SF short story where a man looked at Threadneedle St and began to say, like Victor Meldrew, "I don't BELEEEVE it". The whole thing began to crumble - then somebody shot him before it did ... (Think he had done something similar to Hell, first)
I'm sure that's a lot of help. ![[Biased]](wink.gif) I keep saying that I should read up on this some more, but then more interesting stuff comes along. Is there an Independent Financial Advisor Shipmate around?
[ 07. February 2014, 13:08: Message edited by: Barnabas62 ]
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Who is it that you seek? How then shall we live? How shall we sing the Lord's song in a strange land?
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Crœsos
Shipmate
# 238
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Posted
quote:
Originally posted by Eutychus:
- Where, if anywhere, is the dividing line between fractional reserve banking legitimately and usefully creating wealth and a Ponzi scheme?
The main social utility of fractional reserve banking is connecting lenders (a.k.a. depositors) to borrowers. Depositors pay in to a pool, from which approved borrowers are lent money and charged interest, generating a return. In a Ponzi scheme there is no borrowing party using the funds to generate a return.
quote:
Originally posted by Eutychus:
- Is the practice of keeping major financial decisions out of the hands of governments, off the record, and in the hands of a select group of experts a sensible recognition of the need for expertise in a complex world or an invitation to abuse of power?
Both. Any concentration of power is an invitation to abuse, hence the need for some form of accountability. For governments that's usually some type of democratic process. For financial institutions it's regulatory oversight. One of the biggest contributing factors to the recent financial crisis was the rise of what's been called the "shadow banking system", a series of financial institutions that perform bank-like functions (matching investors to borrowers) but fall outside the regulatory system as it existed at the time.
quote:
Originally posted by Eutychus:
- Usury and/or lending with interest: does it inevitably concentrate wealth into the hands of a few, or is the problem one of systematic recourse to consumer debt?
No, it's not lending with interest, also known as getting a return on investment, that concentrates wealth into the hands of a few. It's the ability of the wealthy to "game the system" by using their political influence to undermine the regulatory regime.
I'll leave the question about "an appropriate christian response" to the financial crisis for those who are Christians.
[ 07. February 2014, 14:20: Message edited by: Crœsos ]
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Humani nil a me alienum puto
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Doc Tor
Deepest Red
# 9748
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Posted
I think the singlemost significant problem in the world's banking systems is this: they are able to create their own money, independent of either governments or depositors.
Now they're able to essentially (in almost every respect it doesn't matter about the mechanisms by which they do this, all that matters is the result) create money, use it to buy something of actual worth, and then transfer the debt to that something. We see this all the time in 'leveraged buyouts' (aka we don't have the money really, just pretending we do) in which wealth is not so much created as destroyed.
Mortgages, as a form of leverage buyout (this house is 'worth' far less than £1m, but since the mortgagees can service a debt of £1m, that's what the cost is), are what caused the last collapse, and may well cause the next one.
If we ordinary folk are so massively in debt (£1.4tn in the UK), servicing that debt goes not to goods and services, but to financial institutions. Add to that the billions sucked out of the economy by financial mis-selling. Add to that the relatively high interest rates for borrowing, and low interest rates for saving - with the banks hoovering up the difference.
Banks are there primarily to make money for the banks, and unfortunately it's a zero sum game. The richer they are, the poorer we become.
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Forward the New Republic
Posts: 9131 | From: Ultima Thule | Registered: Jul 2005
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Crœsos
Shipmate
# 238
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Posted
quote:
Originally posted by Doc Tor:
Mortgages, as a form of leverage buyout (this house is 'worth' far less than £1m, but since the mortgagees can service a debt of £1m, that's what the cost is), are what caused the last collapse, and may well cause the next one.
No, it wasn't mortgages themselves that caused the last collapse. Mortgages have existed for centuries. It was banks trying to get fancy with mortgages, coupled with a disastrous subcontracting of banks' risk assessment functions. If we accept that he primary function of a commercial bank is matching up lenders and borrowers, there's no real additional utility gained by something as ridiculously complex as an adjustable-rate mortgage. The only function of such agreements is to be so complex as to obscure the actual terms of the loan.
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Humani nil a me alienum puto
Posts: 10706 | From: Sardis, Lydia | Registered: May 2001
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Lilac
Shipmate
# 17979
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Posted
Can anybody explain in simple terms how banks are able to issue Pound notes and put them into circulation? In Scotland there are several banks doing this, one of which is owned by a company in Australia. There's another in Ulster. There used to be around 6 Scottish banks at it, and at one time another in Cornwall.
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Seeking...
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Arethosemyfeet
Shipmate
# 17047
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Posted
quote:
Originally posted by Lilac:
Can anybody explain in simple terms how banks are able to issue Pound notes and put them into circulation? In Scotland there are several banks doing this, one of which is owned by a company in Australia. There's another in Ulster. There used to be around 6 Scottish banks at it, and at one time another in Cornwall.
They have to have equivalent funds (actually very high denomination notes) lodged with the Bank of England, and can circulate notes up to the value of those notes. The right to do this is a legacy of the introduction of paper money. The right is gradually being lost as it cannot be passed from one institution to another.
[ 07. February 2014, 16:05: Message edited by: Arethosemyfeet ]
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Eutychus
From the edge
# 3081
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Posted
quote:
Originally posted by Enoch:
I suppose the question is, 'is Tower of Basel yet another great conspiracy theory, on a par with the Chronicles of the Elders of Zion or Fahrenheit 9/11, or is it a serious and objective examination of the facts?'
The book has been marketed with lots of conspiracy-theorist dog-whistling, I think basically in an attempt to sell more copies, but it falls far short of the wilder tinfoil-hat theories.
What appears to be fairly unequivocally true from the book is:
- the huge immunity of the IBS: the building is off-limits to the Swiss police, for instance
- the off-the-record nature of its decisions
- the cosy relations between prewar Nazi-era industrialists and postwar industrialists facilitated by the IBS. There's obviously plenty of material for conspiracy theories right there, but even without any of them, it seems a bit troubling.
Croesos, thanks for the "compare and contrast" on the Ponzi scheme/fractional reserve banking. I'm going to have to think about that for a bit.
I agree that derivative financial instruments appear to be a large part of the problem - money has become more than a store of wealth and means of exchange (complementary currencies, anyone?).
Still processing the rest.
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Let's remember that we are to build the Kingdom of God, not drive people away - pastor Frank Pomeroy
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HCH
Shipmate
# 14313
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Posted
I'll make a stab at it.
Money is not simply paper money and coins. Money is also the balance in bank accounts. Most of the time, we do not exchange hard money but instead write checks or use credit and debit cards. Suppose a bank loans me $1000. I deposit it in an account, at that bank or some other, or I spend it and whoever then has it will deposit it. If the reserve rate is (for example) 10 per cent, one bank or another will keep a total of $100 on hand and then will be able to make more loans with the other $900. This process continues. A small change in the reserve rate has a large effect on the money supply. No one is minting coins or printing paper money except the government (at least in the U.S.).
If the reserve rate was 100%, there would be vastly less money available to borrow and business activity would be stifled.
Some people have suggested getting rid of coins and paper money and doing all transactions electronically. In that case, money would be simply the value in accounts, and we would still have the reserve rate phenomenon.
If I have this wrong, I hope someone will correct me.
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Eutychus
From the edge
# 3081
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Posted
quote:
Originally posted by Doc Tor:
I think the singlemost significant problem in the world's banking systems is this: they are able to create their own money, independent of either governments or depositors.
I suppose this is near enough to my answer to moonlitdoor's question about what might be pernicious about fractional reserve banking.
I can see all the advantages of fractional reserve banking, much as B62 has pointed out; but allowing banks or equivalent institutions to lend out more than they have in reserve leaves the door open for them to increasing their leverage indefinitely by printing money.
[ETA to HCH: what I think I have learned is that it's not governments that print money, but central banks - in the case of the US, the Federal Reserve]
[ 07. February 2014, 16:24: Message edited by: Eutychus ]
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Let's remember that we are to build the Kingdom of God, not drive people away - pastor Frank Pomeroy
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Crœsos
Shipmate
# 238
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Posted
quote:
Originally posted by Eutychus:
I can see all the advantages of fractional reserve banking, much as B62 has pointed out; but allowing banks or equivalent institutions to lend out more than they have in reserve leaves the door open for them to increasing their leverage indefinitely by printing money.
Not "indefinitely" in most systems. The ratio of assets to obligations is usually strictly regulated in advanced economies.
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Humani nil a me alienum puto
Posts: 10706 | From: Sardis, Lydia | Registered: May 2001
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Doc Tor
Deepest Red
# 9748
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Posted
quote:
Originally posted by Crœsos:
quote:
Originally posted by Doc Tor:
Mortgages, as a form of leverage buyout (this house is 'worth' far less than £1m, but since the mortgagees can service a debt of £1m, that's what the cost is), are what caused the last collapse, and may well cause the next one.
No, it wasn't mortgages themselves that caused the last collapse. Mortgages have existed for centuries. It was banks trying to get fancy with mortgages, coupled with a disastrous subcontracting of banks' risk assessment functions. If we accept that he primary function of a commercial bank is matching up lenders and borrowers, there's no real additional utility gained by something as ridiculously complex as an adjustable-rate mortgage. The only function of such agreements is to be so complex as to obscure the actual terms of the loan.
Well, yes and no. In terms of the packaging of mortgage debt as an investment so complicated even the banks themselves didn't understand it, what brought the financial industry down was that the value of the instruments had no relationship to the value of the actual bricks-and-mortar that supposedly backed them.
And that was fuelled by the ability of banks to leverage their balance sheets to increase the amount they could loan. Credit became not so much as cheap as easily available to people who shouldn't have credit because the proper credit controls had been relaxed by the Clinton administration. Cue a house price bubble that inflated at the same rate as peoples' ability to service the loans, until it all went pop.
I agree that the primary function of the bank is to match lenders and borrowers, but that's almost exactly what they haven't been doing for the better part of three decades. They don't want lenders, because they have to pay them. All they want is to sell customers expensive products and loans.
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Forward the New Republic
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Eutychus
From the edge
# 3081
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Posted
quote:
Originally posted by Crœsos:
Not "indefinitely" in most systems. The ratio of assets to obligations is usually strictly regulated in advanced economies.
Fair enough. I hesitated before adding the word. Would you like to point to any examples of what exceptions ("most systems"... "usually") you had in mind? Would you take the view that the problem is more one of people's propensity to indebt themselves?
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Let's remember that we are to build the Kingdom of God, not drive people away - pastor Frank Pomeroy
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moonlitdoor
Shipmate
# 11707
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Posted
My question was more specifically why the opening post compared fractional reserve banking to a ponzi scheme than why it might be pernicious.
As for the sentence you quoted from Doc Tor, I suppose it would be worrying if it was accurate. However the money created by banks under fractional reserve banking doesn't belong to the banks. Nor is it created independently of government and depositors. Reserves plus deposits equals loans. You can find a full description in any economics textbook.
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We've evolved to being strange monkeys, but in the next life he'll help us be something more worthwhile - Gwai
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moonlitdoor
Shipmate
# 11707
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Posted
I would type that the wrong way round of course. Loans plus reserves equals deposits.
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We've evolved to being strange monkeys, but in the next life he'll help us be something more worthwhile - Gwai
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Eutychus
From the edge
# 3081
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Posted
quote:
Originally posted by moonlitdoor:
My question was more specifically why the opening post compared fractional reserve banking to a ponzi scheme than why it might be pernicious
As I understand it, in a Ponzi scheme deposits are used for payouts (the supposed "interest" on earlier deposits), until the payouts exceed the deposits on hand. The fundamental flaw is that very quickly, deposits will never cover the theoretical total payouts due.
As far as I can see, in fractional reserve banking, the bank can never cover the theoretical total payments due (I accept that this may be deemed a) ethical b) useful).
To me at least, this is at least a superficial similarity; and plenty of people use the argument that they are exactly the same. (Evidence: I just put "fractional reserve banking" and "ponzi scheme" into Google and the top hit was this (which I have not yet read!)).
Please understand that any economics I did was a long time ago, that I'm much better at intuition than logic, and that I am not coming at any of this from any entrenched position.
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Let's remember that we are to build the Kingdom of God, not drive people away - pastor Frank Pomeroy
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Crœsos
Shipmate
# 238
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Posted
quote:
Originally posted by Doc Tor:
Well, yes and no. In terms of the packaging of mortgage debt as an investment so complicated even the banks themselves didn't understand it, what brought the financial industry down was that the value of the instruments had no relationship to the value of the actual bricks-and-mortar that supposedly backed them.
That's not really a problem in residential property. A proper valuation is easier for commercial or industrial properties, insofar as those generate revenue so the "real" value can be set at some multiple of yearly profit. As far as residential construction goes, a house is "worth" as much as you can sell it for, and that varies according to the strength of the rest of the economy.
At any rate, while the property itself serves as collateral on a mortgage what's really "backing" it from the bank's perspective is the borrower and his/her future earnings. It wasn't that mortgages came untethered from the value of the property that was the problem, it was the fact that they came untethered from borrowers' ability and willingness to repay the debt. One of the big culprits here is that most banks no longer maintain the ability to assess borrower's ability to repay in-house, but instead rely on externally generated credit scores, produced by entities with no real accountability and only a marginal stake in the accuracy of their product.
quote:
Originally posted by Eutychus:
quote:
Originally posted by Crœsos:
Not "indefinitely" in most systems. The ratio of assets to obligations is usually strictly regulated in advanced economies.
Fair enough. I hesitated before adding the word. Would you like to point to any examples of what exceptions ("most systems"... "usually") you had in mind?
The aforementioned "shadow banking system" comes to mind as an example. A lot of the investment banks and other institutions dabbling in repackaging mortgages were leveraged far beyond what sane regulators would allow for ordinary commercial banks.
quote:
Originally posted by Eutychus:
Would you take the view that the problem is more one of people's propensity to indebt themselves?
No. Take the already discussed example of a residential mortgage. The alternative to using debt to finance the purchase of a house is to attempt to save up the full purchase price of that house while also paying rent on some other form of shelter where the borrower would live in the meantime. A lucky few workers would be able to manage this about the time they were ready for retirement. I'm not sure that choosing the former over the latter is a "problem", even though it involves indebtedness.
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Humani nil a me alienum puto
Posts: 10706 | From: Sardis, Lydia | Registered: May 2001
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Doc Tor
Deepest Red
# 9748
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Posted
quote:
Originally posted by moonlitdoor:
I would type that the wrong way round of course. Loans plus reserves equals deposits.
But I'm reasonably certain that's not what happens. AFAIK, we have a situation where
(Deposits + Reserves) * (multiplier) = loans
so that banks can have more owed to it in loans than it possesses in deposits and any reserves. The multiplier is set by government regulation.
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Forward the New Republic
Posts: 9131 | From: Ultima Thule | Registered: Jul 2005
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Crœsos
Shipmate
# 238
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Posted
quote:
Originally posted by Eutychus:
As I understand it, in a Ponzi scheme deposits are used for payouts (the supposed "interest" on earlier deposits), until the payouts exceed the deposits on hand. The fundamental flaw is that very quickly, deposits will never cover the theoretical total payouts due.
As far as I can see, in fractional reserve banking, the bank can never cover the theoretical total payments due (I accept that this may be deemed a) ethical b) useful).
But even within that distinction they're kind of mirror-image opposites. A Ponzi scheme cannot pay out more than the deposits because it has no way of generating income (though it will typically fraudulently claim some kind of investment is going on). A fractional reserve bank cannot reimburse all of its deposits at once because those deposits are invested in income-generating enterprises rather than sitting in vaults somewhere.
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Humani nil a me alienum puto
Posts: 10706 | From: Sardis, Lydia | Registered: May 2001
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moonlitdoor
Shipmate
# 11707
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Posted
quote:
posted by Eutychus
As far as I can see, in fractional reserve banking, the bank can never cover the theoretical total payments due (I accept that this may be deemed a) ethical b) useful).
sure they can, because they have loans due to them which cover all the money they owe to their depositors. The problem is timing, the loans may be long term while the depositors may be able to ask for their money back any time, depending on the kind of deposit they have made. Of course the rate of default on the loans is also a problem.
Doc Tor, sorry but I think you are misunderstanding what happens. Say I deposit 100 pounds in Bank A, and it has to keep 10% as reserves. So it lends out 90 pounds to you. You decide not to use the money but just deposit it in bank B. Bank B has to keep 9 pounds in reserve so it lends out 81 pounds to Eutychus, which he deposits in bank C, which keeps 8 pounds and lends out 73 etc. That is your multiplier in operation and the money supply expands. But the total of all the money you and Eutychus etc etc have borrowed, plus the reserves, adds up to the amount I and you and he etc etc have deposited.
Don't infer from this that I think the banking system is wonderful or could not be reformed or improved. I am just trying to clarify what actually happens.
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We've evolved to being strange monkeys, but in the next life he'll help us be something more worthwhile - Gwai
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Dafyd
Shipmate
# 5549
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Posted
quote:
Originally posted by Crœsos:
quote:
In terms of the packaging of mortgage debt as an investment so complicated even the banks themselves didn't understand it, what brought the financial industry down was that the value of the instruments had no relationship to the value of the actual bricks-and-mortar that supposedly backed them.
That's not really a problem in residential property. A proper valuation is easier for commercial or industrial properties, insofar as those generate revenue so the "real" value can be set at some multiple of yearly profit. As far as residential construction goes, a house is "worth" as much as you can sell it for, and that varies according to the strength of the rest of the economy.
I don't see how the case is fundamentally different for commerical and residential property. The multiple of yearly profit you'd set for commercial properties would be entirely dependent upon what proportion the market was prepared to pay. The value of residential property, for most people, can be assessed in terms of some multiple of earnings.
I think the problem here in the UK is that a lot of residential properties are being traded not for use but as investments. And investment driven markets are prone to price bubbles. Certainly in the UK, the price of property has been steadily rising compared to average income.
quote:
At any rate, while the property itself serves as collateral on a mortgage what's really "backing" it from the bank's perspective is the borrower and his/her future earnings. It wasn't that mortgages came untethered from the value of the property that was the problem, it was the fact that they came untethered from borrowers' ability and willingness to repay the debt.
The mortgages in question were called subprime because somebody somewhere knew the borrowers were more likely than average to default.
The claim was that the assets being traded were priced at a level that reflected the risk. There were two problems. The first was that the risk didn't take into account the prospect of defaults increasing the supply of property and therefore lowering the rate of increase of property prices. The other problem was that the risk was assessed on the basis that the variation in price is a normal distribution. And it seems that variations in price do not occur over a normal distribution.
[code]
[ 07. February 2014, 20:37: Message edited by: Eutychus ]
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Crœsos
Shipmate
# 238
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Posted
quote:
Originally posted by Dafyd:
quote:
Originally posted by Crœsos:
That's not really a problem in residential property. A proper valuation is easier for commercial or industrial properties, insofar as those generate revenue so the "real" value can be set at some multiple of yearly profit. As far as residential construction goes, a house is "worth" as much as you can sell it for, and that varies according to the strength of the rest of the economy.
I don't see how the case is fundamentally different for commerical and residential property. The multiple of yearly profit you'd set for commercial properties would be entirely dependent upon what proportion the market was prepared to pay. The value of residential property, for most people, can be assessed in terms of some multiple of earnings.
It's different because residential property doesn't generate income out of which the loan can be repaid, unlike a commercial or industrial property.
quote:
Originally posted by Dafyd:
The mortgages in question were called subprime because somebody somewhere knew the borrowers were more likely than average to default.
The claim was that the assets being traded were priced at a level that reflected the risk. There were two problems. The first was that the risk didn't take into account the prospect of defaults increasing the supply of property and therefore lowering the rate of increase of property prices. The other problem was that the risk was assessed on the basis that the variation in price is a normal distribution. And it seems that variations in price do not occur over a normal distribution.
An additional factor was that by making the interest rate adjustable, as many sub-prime mortgages did, the chance of default of each loan was no longer independent. In a traditional fixed-rate mortgage the things which make one borrower default are unlikely to affect other borrowers. (e.g. if Bob loses his job it doesn't really affect Alice's ability to repay her mortgage.) On the other hand if interest rates rise across the board, it's likely to affect all borrowers (with adjustable-rate loans) at the same time, meaning you'd get a bunch of defaults clustered together at the same time.
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Humani nil a me alienum puto
Posts: 10706 | From: Sardis, Lydia | Registered: May 2001
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Eutychus
From the edge
# 3081
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Posted
quote:
Originally posted by Crœsos:
But even within that distinction they're kind of mirror-image opposites. A Ponzi scheme cannot pay out more than the deposits because it has no way of generating income (though it will typically fraudulently claim some kind of investment is going on). A fractional reserve bank cannot reimburse all of its deposits at once because those deposits are invested in income-generating enterprises rather than sitting in vaults somewhere.
Okay, so how come they are so often associated in the (rebellious) popular mind?
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Let's remember that we are to build the Kingdom of God, not drive people away - pastor Frank Pomeroy
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Crœsos
Shipmate
# 238
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Posted
quote:
Originally posted by Eutychus:
quote:
Originally posted by Crœsos:
But even within that distinction they're kind of mirror-image opposites. A Ponzi scheme cannot pay out more than the deposits because it has no way of generating income (though it will typically fraudulently claim some kind of investment is going on). A fractional reserve bank cannot reimburse all of its deposits at once because those deposits are invested in income-generating enterprises rather than sitting in vaults somewhere.
Okay, so how come they are so often associated in the (rebellious) popular mind?
Because the (rebellious) popular mind often has trouble with the idea of fiat currency. There's a fairly useful (though long) post by Brad DeLong on the subject. A sample:
quote:
It is simply not the case that we can cheaply and easily buy things with money because it is valuable. It is, instead, the case that money is valuable because we can cheaply and easily buy things with it.
One way into the tangle of understanding why it is wrong is to ask each of us why we are happy accepting money in exchange when we sell useful commodities. Hint: it's not because we are looking forward to going down to the bank, exchanging our bank notes for the little disks of gold usually decorated with pictures of bearded men on one side and allegorical female figures on the other with lettering saying things like "Fecund Augustae" or "Concordia Militum" or "Fides Exercituum" on them, taking our little disks home, and feeling happy looking at them.
That's not why we accept money.
We accept money because if we don't have any money we have to buy commodities with other commodities, and when we do so we are unlikely to receive the cost of production for what we sell. Have you ever tried to buy a latte at Peets with a copy of Ludwig von Mises's Money and Credit? It does not go well.
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Humani nil a me alienum puto
Posts: 10706 | From: Sardis, Lydia | Registered: May 2001
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Eutychus
From the edge
# 3081
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Posted
Thanks for that: more food for thought. Incidentally, the video mentioned in the blogpost is clearly the one I linked to in the OP.
So where have I got to so far?
- Ponzi schemes might look like fractional reserve banking in that both can collapse, but the similarity ends there. In fractional reserve banking the income is return on investment, not laundered deposits as in a Ponzi scheme
- Those broadly defending conventional banking think the issues are: obfuscatory loan offers, not made on the basis of actual ability to repay; quasi-banking organisations (shadow banking) which do not play by the rules; imbalancing influence of the rich on the decision-makers.
I'm still not sure about derivatives and the fact that the face value of the derivatives being traded is so far in excess of the value of any tangible assets. Those are probably not the right words.
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Let's remember that we are to build the Kingdom of God, not drive people away - pastor Frank Pomeroy
Posts: 17944 | From: 528491 | Registered: Jul 2002
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Dave W.
Shipmate
# 8765
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Posted
quote:
Originally posted by Doc Tor:
quote:
Originally posted by moonlitdoor:
I would type that the wrong way round of course. Loans plus reserves equals deposits.
But I'm reasonably certain that's not what happens. AFAIK, we have a situation where
(Deposits + Reserves) * (multiplier) = loans
so that banks can have more owed to it in loans than it possesses in deposits and any reserves. The multiplier is set by government regulation.
I don't think this is correct. For a bank, reserves and loans are both assets, while deposits and shareholder equity are liabilities, so the balance sheet equation is
(reserves + loans) = (deposits + shareholder equity)
as illustrated in this figure.
The "fractional reserve" refers to the amount of reserves the bank is required to hold (as cash or in its account with the Federal Reserve, which can quickly be exchanged for cash), expressed as a fraction of its deposit liabilities. In the US, the Federal Reserve has kept this fraction at 10% since 1992 (though it excludes certain kinds of deposits and is lower for smaller institutions.)
Posts: 2059 | From: the hub of the solar system | Registered: Nov 2004
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Eutychus
From the edge
# 3081
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Posted
quote:
Originally posted by Dave W.:
the balance sheet equation is
(reserves + loans) = (deposits + shareholder equity)
as illustrated in this figure.
Well of course that figure led to looking at steps 2 and 3. I've always found balance sheets to be counter-intuitive (customer deposits are liabilities, loans are assets).
What I've just learned (from here) is that there are two completely different meanings of insolvency, cash-flow insolvency and balance-sheet insolvency.
The immediate danger in fractional reserve banking is, as I understand it, one of cash-flow insolvency (a run on the bank) and not balance-sheet insolvency, so I'm not sure that illustration helps understand what's going on.
[ 08. February 2014, 07:12: Message edited by: Eutychus ]
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Let's remember that we are to build the Kingdom of God, not drive people away - pastor Frank Pomeroy
Posts: 17944 | From: 528491 | Registered: Jul 2002
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Eutychus
From the edge
# 3081
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Posted
quote:
Originally posted by Crœsos:
A Ponzi scheme cannot pay out more than the deposits because it has no way of generating income (though it will typically fraudulently claim some kind of investment is going on).
I'm not sure about this now. The Wikipedia page says quote:
Ponzi schemes sometimes commence operations as legitimate investment vehicles, such as hedge funds. For example, a hedge fund can degenerate into a Ponzi scheme if it unexpectedly loses money (or simply fails to legitimately earn the returns promised and/or thought to be expected) and the promoters, instead of admitting their failure to meet expectations, fabricate false returns and, if necessary, produce fraudulent audit reports.
So it seems to me that you are dissecting the simplest form of a Ponzi scheme, which is basically a chain letter with money instead of letters, rather than fancier variations.
In these more sophisticated cases, investments - perhaps high-risk, but perhaps legitimate - are made. The scheme is apparently not deemed fraudulent because of an inherent inability to pay the interest, but because of cooking the books once it can't. And if it collapses, it will be due to cash flow insolvency and not balance sheet insolvency. If these last two observations are correct, it's beginning to sound similar to, if not reserve banking, shadow banking, is it not?
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Let's remember that we are to build the Kingdom of God, not drive people away - pastor Frank Pomeroy
Posts: 17944 | From: 528491 | Registered: Jul 2002
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Enoch
Shipmate
# 14322
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Posted
quote:
Originally posted by Crœsos:
It's different because residential property doesn't generate income out of which the loan can be repaid, unlike a commercial or industrial property.
Not quite. Residential property can be let out, in which case it earns a monetary income. And if you live in it, I accept you've no liquid income from it, but you have the hidden income of not having to pay rent yourself. There used to be a time in the UK when you were taxed on that.
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Brexit wrexit - Sir Graham Watson
Posts: 7610 | From: Bristol UK(was European Green Capital 2015, now Ljubljana) | Registered: Nov 2008
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Eutychus
From the edge
# 3081
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Posted
quote:
Originally posted by Crœsos:
the (rebellious) popular mind often has trouble with the idea of fiat currency. There's a fairly useful (though long) post by Brad DeLong on the subject.
I've had a stab at reading this article now, as well as skimming this one mentioned earlier that was the first hit for "fractional reserve banking" and "ponzi scheme".
It seems to me that the nub of the "FRB=ponzi" argument is, to quote DeLong's aummary of the argument he is seeking to counter quote:
the larger the unbacked circulating medium [which if I've understood correctly is fiat money] the bigger the lie and the theft. It is all guaranteed to end in tears.
DeLong says this is "so so so so so so so so so unbelievably wrong" but loses me in his explanation. Specifically, I don't understand this bit: quote:
what if the government prints more fiat money than the illiquidity gap in your other wealth? Well, then people will say: "I don't need to hold all this extra money. I would be liquid enough with less." Everybody will try to run down their money balances, and so the price level will rise until the real money stock is just what people think covers the illiquidity gap between their other wealth and its cost of production.
Can you explain what he means by an "illiquidity gap" in simpler terms? I understand people being keen turn excess liquidity into less liquid assets (I think!) but not what he means by "price level" or the "real money stock".
I also note that equilibrium is said to be all about what people think, not about some mathematical absolute - I do remember my economics teacher often repeating "expectations, it's all about expectations". So it would appear to be about perception - which is of course how a Ponzi scheme works. To quote Wikipedia on affinity fraud: quote:
This ploy is used to trick new investors to invest in the scheme and to lull existing investors into believing their investments are safe and secure.
Commenting on the fact that amount of government debt taken out to rescue banks exceeds the total money supply, the "Wall Street Ponzi Scheme" article says quote:
The sheer size of the bailout efforts indicates that the banking scheme has reached its mathematical limits and needs to be superseded by something more sustainable.
If the whole thing is relying on perceptions and not reality, isn't there a similarity there?
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Let's remember that we are to build the Kingdom of God, not drive people away - pastor Frank Pomeroy
Posts: 17944 | From: 528491 | Registered: Jul 2002
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Dave W.
Shipmate
# 8765
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Posted
quote:
Originally posted by Eutychus:
quote:
Originally posted by Dave W.:
the balance sheet equation is
(reserves + loans) = (deposits + shareholder equity)
as illustrated in this figure.
Well of course that figure led to looking at steps 2 and 3. I've always found balance sheets to be counter-intuitive (customer deposits are liabilities, loans are assets).
That's because this is the bank's balance sheet, but you (a non-banker) will typically be considering transactions from the viewpoint of a depositor/borrower.
Suppose you have cash in your pocket - clearly an asset, right? Then you lend it to a friend (who agrees to pay it back in the future). Your friend now has both your cash (an asset) and also a debt (a liability) of the same amount. You don't have the cash any more, but you can consider the loan you made to your friend to be an asset (since you didn't just lose it or give it away, you're expecting to get it back.) So the same thing that appears as a liability from your friend's point of view appears as an asset from your point of view.
Similarly, the loan you get from a bank is simultaneously your liability and its asset; and the deposit you make to a bank is your asset and its liability. It really isn't any more counter-intuitive than the differing views you and your friend would have about the loan you made in the example above.
Banks can certainly run into trouble, but that doesn't mean they're Ponzi schemes. (Any business can fail, but that failure doesn't necessarily imply that criminal fraud has occurred.) The key distinction is actually in the quote you provided:
quote:
For example, a hedge fund can degenerate into a Ponzi scheme if it unexpectedly loses money (or simply fails to legitimately earn the returns promised and/or thought to be expected) and the promoters, instead of admitting their failure to meet expectations, fabricate false returns and, if necessary, produce fraudulent audit reports.
Ponzi schemes always involve lying about investments and returns; money collected from would-be investors is not actually used to buy assets on their behalf - mostly it's just stolen by the schemer for his own use. (The reference to legitimate investment vehicles doesn't mean that those vehicles could be considered Ponzi schemes by another name, it just means that some people may not intend to start a criminal enterprise but end up committing crimes while trying to cover up the failure of their otherwise legitimate business.)
The Ponzi schemer does have to keep some cash in reserve to maintain the illusion of the existence of assets, in case an investor/victim actually wants to make a withdrawal. But despite a superficial similarity, this isn't the same as fractional reserve banking. In the case of a bank, it's possible for every depositor to get all their money out as long as they are willing to wait for the bank's illiquid assets to be converted to cash; in the case of a Ponzi scheme, the victims won't get all their money bank no matter how long they wait, because there aren't any assets - the schemer has stolen their money and spent most of it.
Posts: 2059 | From: the hub of the solar system | Registered: Nov 2004
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moonlitdoor
Shipmate
# 11707
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Posted
You also need to give some thought to how a full reserve banking system would operate. Long term loans like mortgages can't be funded by short term deposits in such a system in the way that they can are under fractional reserve banking. So the money for long term loans has to come from long term deposits. Where are these going to come from ? Would the forms of investments and institutions offering them be more or less regulated than today's retail banks and building societies ?
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We've evolved to being strange monkeys, but in the next life he'll help us be something more worthwhile - Gwai
Posts: 2210 | From: london | Registered: Aug 2006
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Mertseger
Faerie Bard
# 4534
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Posted
I regularly attended the bi-weekly reserve strategy meetings as part of me job for a top ten US bank until a couple of months ago (I've since shifted jobs to a company that supports the banking industry), and I must say you all are explaining this material extremely well.
I will say that the current banking regulations are better than prior to the crisis. Basel II assume pretty much a static economic environment for its assignment of risk-weighted assets. Basel III (the post-crisis banking accord) demands that banks hold capital in relationship to stressed economic conditions; hence, the emphasis on "stress testing". And that stress-testing proved fairly successful at identifying specific troubled banks during the PIGS (Portugal Ireland Greece Spain) issues within the past two/three years.
That said, for the retail book (as opposed to the investment banking book where the issues around derivatives are far more crucial), banks will always have the issue that their capital can walk right out the door. Any retail bank can be brought down if enough depositors withdraw their assets in a short enough period of time. Deposit insurance should completely resolve that issue in theory because depositors will get exactly what they agreed to and expected to unless the entire national banking system collapses as a whole. In practice, though as we saw in the crisis people may withdraw their assets even in the presence of national guaranteed deposit insurance. WaMu was brought down by a bank run even though the deposits were FDIC insured. Regulations can't really address that issue because people are people (and should be able to withdraw their assets whenever they want to) and banks are banks (that is they are essentially a collection of deposits, at least on the retail side of the industry). Fortunately, though the retail banking side tends to be systemically safe as long as the national currency is fairly stable (no hyper inflation or any amount of deflation, really), and that's true because when the deposits go from one particular bank straight into other banks in the system even during a run on that bank.
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Go and be who you are:
The Body of Christ,
The Goddess of Body,
The Manifest Song of Faerie.
Posts: 1765 | From: Oakland, CA, USA | Registered: May 2003
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Mere Nick
Shipmate
# 11827
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Posted
Fractional reserve banking is just another name for banking. I'm glad my bank keeps some cash on hand so that I get some from my account when we need it.
This does a nice job of explaining it.
It's why I won't vote for Ron Paul.
All this reminds me of George Bailey explaining to his nervous depositors why not all of their accounts are there in cash form back in the vault and when Jed Clampett asked Mr. Drysdale how much money he had in his bank, then wanted to see it.
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"Well that's it, boys. I've been redeemed. The preacher's done warshed away all my sins and transgressions. It's the straight and narrow from here on out, and heaven everlasting's my reward."
Delmar O'Donnell
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