Bankers are no longer heartlessly stingy stewards of their banks’ capital and depositors’ funds, deniers of loans to all but those who do not need them, they are the fountainheads of democratic credit—loans for all! Banking has become a public-private partnership, although determining if banks are an arm of the government or vice versa requires time, effort, and a strong stomach. The question may prove as irrelevant as the distinction between coxswain and crew in a shell headed over a waterfall.
How many people know that when they deposit their money in a bank, they become its unsecured creditors and it uses their deposits to fund its loans and investments? Speculating with or investing other people’s money, offering some recompense for the usage but keeping most of the profits, has been an alluring business model for centuries. It is at the heart of banking. When done correctly, the depositor earns a return, individuals and enterprises receive loans that they repay, and the bank makes money.
It is not without risks. The wise banker navigates the Straits of Prudence between excessive greed and caution. He must keep money on hand for depositor withdrawals, but that money earns no return, so most of the bank’s funds must be “working,” earning a return on lending, speculation, or investment. Too aggressive, and the costs and losses from bad loans, speculations, and investments outweigh the returns from good ones. Not aggressive enough, and returns are inadequate to pay depositors interest, cover costs, and leave a satisfactory profit for the owners. The bankers’ Holy Grail is risk minimization and compensation maximization: public sector security and private sector pay. After a hundred-year quest, they have found it.
The Federal Reserve, established in 1913, was to meet the varying liquidity demands of what was still primarily an agricultural economy, and also act as an emergency lender of last resort during financial panics, lending against money-good but temporarily illiquid bank collateral to forestall bank runs, the old-time bankers’ worst nightmare. A nod was made to the gold standard; the legislation required 40 percent of the central bank’s assets to be backed by gold. However, this was clearly the fiat-money camel’s nose under the monetary tent. Step by step the link between dollars and gold was severed, from President Roosevelt outlawing the private ownership of gold in 1932 to President Nixon suspending the last vestige of convertibility, for foreign governments, in 1971. “Good as gold” morphed into “good as promises by always trustworthy politicians and bureaucrats not to debase dollars too much.” Dollars today are nothing more than pieces of paper or electronic accounting entries, buying about 2 percent of what they bought a century ago.
Knowing the Fed had their backs, like Ebenezer Scrooge on Christmas morning, bankers turned less heartless and stingy. The Fed is ostensibly independent, but is headquartered in Washington. Politicians like seeing money in their constituents’ pockets; bankers like invitations to Georgetown parties. The year 1913 kicked off a century-long democratization of credit. Bankers became great guys and (later) gals, and the banking system became the economy’s consumption-priming, job-creating silent partner. Regulatory capture is an iron-clad law in Washington, and that insidious process had begun even before the Federal Reserve Act was passed—bankers led by JP Morgan’s crew drafted the legislation.
Nobody had heard of “too big to fail” during the Great Depression, when many banks were too small to succeed. Scores of them, geographically confined by branch banking and interstate banking restrictions, went under because they were dependent on one region or industry for their survival. (Canada had nationwide banks and few failures.)
Doing something, no matter how conceptually flawed or counterproductive, was the New Dealers’ default option, and deposit insurance was one of many “somethings.” President Roosevelt was against deposit insurance, which put the government on the hook for a substantial portion of the banking system’s liabilities. He eventually signed the legislation (the Glass-Steagall Act of 1933), mollified by the law’s regulatory regime, which was sold as the way to keep bankers on the straight-and-narrow. The New Dealers’ creation—the Federal Deposit Insurance Corporation—now insures member bank accounts up to $250,000.
Banks have loans, investments, and speculations outstanding that are some multiple of their capital. A decline in value in their assets greater than the reciprocal of that multiple wipes out their capital. (If a bank’s assets are ten times its capital, a realized 10 percent drop in value eliminates that capital.) In the globally interconnected financial system, the failure of one bank impairs the assets of others, setting off a chain reaction. Asset prices collapse, economic activity implodes, and governments are on the hook for a major portion of banks’ deposit liabilities. “Systemic risk” has been the monster under the bed mega-bankers invoke to make their behemoths failure proof.
Too big to fail has been the final step to bankers’ nirvana. Heads they win, reaping the rewards of lending, investing, and speculating. If that comes a cropper, tails the government, and taxpayers, lose. Two consequences flow from bankers’ nirvana: the rate of expansion of credit is greater than the growth rate of the economy—claims on the economy increase as it becomes more indebted—and this debt imbalance leads to financial crises.
Regulation is a useless fig leaf. Bankers have every incentive to game the regulations. Even if they did not, you can’t regulate away bad ideas. Bankers’ nirvana is the culmination of bad ideas: central banking, deposit insurance, and too big to fail. World debt is substantially higher than it was in 2008; the too big to fail banks are substantially bigger. The inevitable tidal wave of the next crisis will wash away both banks and the governments with whom they are joined at the hip.
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