Heads In a Basket, by Robert Gore

Spend enough time contemplating the lunacy that pervades society and you find that physical reality offers blessed relief. Release a ball and it drops because of the earth’s mass and consequently, its gravity. It works every time, not subject to anyone’s whim. Gravity, time, space, light, energy, and other phenomena can be defined and explained. As science progresses, definitions and explanations change as scientists search for the logic that most closely correspond to reality. Many of humanity’s affairs, on the other hand, defy logic and deny reality.

One innovation combines the unfortunate propensities to defy and deny with the mathematical certainty of Boyle’s law and the mechanical precision of a dropping guillotine blade: debt. In exchange for a promise of future repayment, borrowers acquire the wherewithal to invest or consume beyond their current means. Creditors forego present consumption and assume the risk of nonpayment. Defiance and denial arrive when debtors cannot repay their debts. Mathematical certainty stems from compound interest: unpaid debt increases exponentially. Mechanical precision arrives with default, the only question being who bears the loss. Will it be the debtor’s, creditor’s, or both heads in the basket?

Much of a century’s worth of financial “innovation” represents a desire to defy logic and deny reality. At the heart of banking lies an uncomfortable reality: depositors have a right to their money on demand (hence the term demand deposit), but the bank cannot satisfy that demand if all of its depositors want their money at the same time. The money is lent out or invested as bankers seek a return. Only a fraction of it is kept on reserve to satisfy withdrawals (hence the term fractional-reserve banking). Depositors are unsecured creditors of the bank, which they may not realize until they are unable to withdraw their money. The financial system is inherently interconnected; a run at one bank can quickly become systemic.

Bank runs were a vicissitude of 19th century American finance, the primary impetus behind the establishment of the Federal Reserve. The central bank would supply what was termed an “elastic” currency (fiat money created by the central bank) to its member banks in exchange for sound collateral, mostly short-term commercial paper, to prevent bank runs and generalized panics from seizing the financial system. It was the first step by the government to ameliorate the central risk of fractional-reserve banking. The second came during the Great Depression with the establishment of deposit insurance, which put the government on the hook for deposits—the banks’ unsecured debts to its depositors—up to a limit that has been periodically raised. The Too Big To Fail (TBTF) doctrine puts the government on the hook for all of the liabilities of a select group of banks, deemed so large that their failure poses a systemic risk to the global financial system.

Fractional-reserve banking guarantees the banking system a front row seat for any significant financial perturbation. It is leveraged, a repository for large pools of depositor money, and at the heart of the payments mechanism. Getting a handle on how much banks are leveraged is virtually impossible. The large ones are in the thick of the derivatives trade, especially interest rate derivatives. The notational value of such derivatives is in the hundreds of trillions of dollars, many times world GDP, but much of that exposure is supposedly netted out. However, when counterparties fail, as they did in 2008, net exposures become gross exposures. While governments claim to backstop banks, the fundamental instability posed by fractional-reserve banking has not gone away. Nobody knows how much risk there is within the system, especially what’s lurking in the  TBTF banks. The regulators are as clueless now as they were in 2008, but confident that their vastly augmented regulations will prevent disaster. (SLL will take the other side of that bet.)

Much has been made, at least in the blogosphere, of recent proposals to abolish cash. The civil liberties aspect of such proposals merit attention and discussion, but there has been little notice of a more disturbing aspect. If cash is outlawed, then everyone must keep their money in banks and use the banking system for payments (Martin Armstrong mentioned it in a recent post, “This Time It Is Different,” armstrongeconomics.com). That makes everybody an unsecured creditor of banks, whether they want to be or not. Cash may be outlawed not just as one more step to the Orwellian state or to facilitate the central banks’ dopey effort to drive interest rates deeper into negative territory, but to keep money from fleeing the banking system when logic can no longer be defied, nor realty denied, and banks and financial systems crash as debt crushes the global economy.

Banning cash will make the unsecured liabilities (customer deposits) of a banking system that was insolvent seven years ago—and will be so again—the medium of exchange. While coins and paper money are backed only by promises from politicians not to create too much of them, they will represent Rock of Gibraltar solidity compared to those unsecured deposits trapped within the banks. Look at banking system risks now and imagine the new risks bankers will take when they know money cannot leave the system. It is the ultimate involuntary bail-in, preceding rather than following bank insolvency.

When the economy collapses under the weight of debt, there will be no way for depositors herded into the banking system holding pen to avoid the guillotine. Governments that won’t allow there own coins and paper to be used as mediums of exchange will certainly not allow gold or silver to function as such. However, in the black market that will be the only functioning economy, gold and silver will be accepted—albeit not legal—tender. Which suggests that if you want to keep your head out of the basket, put away some of those time-tested mediums of exchange now. Keeping your stash hidden from the government will be child’s play compared to getting anything of value out of failed banks.

WHEN THE DOLLAR WAS GOOD AS GOLD

AMAZON

KINDLE

NOOK