The Economic Perversity of our Banking System
Economics / Credit Crisis 2009 Jan 26, 2009 - 07:26 AM GMTBy: Joseph_Toronto
I recently wrote about the cause of this recession/depression being a collapse of the money supply. The money supply is collapsing because money is literally evaporating with each loan default and bankruptcy and is accelerated by the reverse multiplier effect of fractional reserve banking. Furthermore, given that the collapsing money supply is causing recession, banks are making things worse by doing exactly what banks are supposed to do to preserve their rapidly eroding capital. They stop their lending in a risky economy and buy risk free T-bills or earn interest in their excess reserve account at the Fed. This is the correct thing to do for bank stockholders, but incredibly and perversely is exactly the wrong thing to do for the economy.
Our entire money and banking system is perverse in that the only means of injecting money into the economy during tough times (scarce money) is through new loans from the banking system. Furthermore, the only means of reducing money in the economy during good times (easy money), is to call in loans.
During good times (easy money), banks obviously want to earn the higher profits from risky loans and will lend all of their capital, if able, creating a positive feedback loop (the money multiplier effect of fractional reserve banking) of money-induced euphoria (irrational exuberance). And again, obviously, in times of economic stress or decline when money is already scarce, banks certainly aren't going to put their precious capital at risk by lending it out thereby creating a negative feedback loop (the reverse multiplier effect) making the stress catastrophic.
Yes, we created this perversion with our early twentieth century infatuation for private enterprise capitalism and in 1913 delegated control of the money supply to an independent private banking system, the Federal Reserve (incredibly with only infrequent reports to Congress as a check and balance). Economically, it's quite dysfunctional, bordering upon farcical if it weren't so tragic.
Our cure for this dysfunction is to ask the central bankers to employ counter-cyclical monetary policies, which means in layman's terms, to induce its member banks to reduce their earnings in good times and to put their capital at risk in bad times. It doesn't seem very likely that's going to work as we are now witnessing a collapse in the money supply (bad times) because banks won't lend. Lip service was likely the most we were ever going to get out of “counter-cyclical monetary measures” and lip service seems to be what we got.
Speaking of lip service, I'd like someone to explain to me why the Fed unilaterally decided to start paying interest on bank reserve deposits at the Fed at precisely the very moment in history (10/6/08) when they should have been asking those very same banks to lend out those reserves into the collapsing economy.
Here's the Fed's justification for paying interest on reserves: “The payment of interest on excess reserve balances will give the Federal Reserve greater scope to use its lending programs to address conditions in credit markets…” . Ahem, but “Greater scope to address” seems to me to be fedspeak hocus pocus at its very best.
The gold bugs love to quote Thomas Jefferson when he said,
“If the American People allow private banks to control the issuance of their currency, first by inflation and then by deflation, the banks and corporations that will grow up around them will deprive the People of all their Property until their Children will wake up homeless on the continent their Fathers conquered.”
Although Jefferson placed blame for these effects on central banks which he opposed, in reality he was simply stating the obvious, that banks will do what banks do, lend their precious capital only in good times and preserve their capital in bad times. Our greatest and most intelligent economists, rather than state this obvious fact, draw silly analogies like “the Fed is pushing on a string”, to describe the Feds failed attempts to re-liquify the economy when banks refuse to lend into a bad economy. Oh, and don't forget that the Federal Reserve is in fact privately owned.
http://joesinvestoblog.com/?p=325
Very Best Regards,
Joe
Affiliated investment Advisors,Inc.
http://joesinvestoblog.com
joe@aiadvisors.com
Joseph Toronto has been a portfolio manager for 26 years for some of the largest institutions in the western U.S. In 1993, Joe founded Affiliated Investment Advisors, Inc., as a registered investment advisor for serious investors seeking professional management for superior safety and returns. Mr. Toronto is a Chartered Financial Analyst and is a member of the Salt Lake City Chapter of the Financial Analysts Society and the Association for Investment Management and Research. He has a Master's degree in investment securities and a B.A. degree with a dual major in finance and management.
Affiliated Investment Advisors, Inc. is a "traditional" portfolio manager for retirement plans, profit sharing plans, individuals, IRA's and other trusts. Affiliated's portfolio management services are NOT alternative "hedge" fund style and are “fee only” taking no commissions or performance incentives. Affiliated is not a stock broker or financial planner and does not sell any investment or insurance fund or product.
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