Failure of comprehension: Part 1

I believe that most of the financial debacle we are going through these days is due to the fact that there were two categories of people who truly understood how the system works and what was happening:

• - those who kept their mouths shut and made good money (even if a few of them later became disgusted and quit the game)
• - those who spoke about the game in the complicated language of academia and referenced papers, got approval from colleagues, (who also understood the game very well) , but increased the confusion in which the majority still is today.

Therefore, IMHO, the majority of information available in the public domain, on internet, is usually just a sea of aberrations born out of confusion. It is common to find on blogs and internet forums, (or even in respectable e-editions of main stream media outlets), nonsense like this:

"OMG! There are $1.14 quadrillion of outstanding derivatives and the US GDP is only $14 trillion. We are all going to dieeee!"

or even better:

"We have to abandon the fractional reserve banking scam and return to a sound system based on a god standard and 100% reserve banking"

I believe not even the most outrageous pure lie (or falsehood) can be as dangerous than a half truth constructed on ignorance and repeated as a mantra by a scared and confused crowd. If we really want to get out of this mess, we have to calm down and try to find how exactly the current system works and what exactly really happened. We have to start thinking (and expressing ourselves) in simple, common-sense terms and cut through the fog of lies and confusion. Of course, there is a price to pay for that. Once can make a short and brilliant demonstration, by using specialized terms or equations that cannot be understood by the average people, or one can use simple terms, but it will take a longer time to explain the problems. There is no middle way. If one tries to keep it simple and short, that is equivalent to "dumbing-down" the message and creating confusion by oversimplification.
Yesterday, I went through four respectable economic forums and six blogs discussing fractional reserve banking. Only on one forum I found three participants to the discussion, who truly understood what they were talking about (and they were brilliant). The rest (three other forums and six blogs) ...were ... let's say ...painful to read ...

After banging my head into keyboard, I decided to prove my own ignorance by tackling the issue of fractional reserve banking, trying to explain it in simple and clear terms. So let's start with some simple basic definitions:

Money is a mental (imaginary) collective convention used by a group of people. If you don't believe me just try to visit an isolated tribe in the jungles of Amazon and try to buy some food with a $100 bill. Still, you may get some food, if the locals perceive that federal reserve note as having some (artistic, magic or scarcity) value or if they are polite and bound by the traditions of gift exchange rituals.

Money is anything that is used for exchanging or storing the fruits of our labor. Gold coins, stones, paper banknotes, grains of salt, it doesn't mater. If two parties involved in a non barter trade agree that a monetary transaction is worth doing, then we have goods/services traded for what ever type and quantity of a medium of exchange they like. It is that simple. Money can be anything to which the convention of 'moneyness' is collectively applied/attached by a group of people.(More about that, with a slightly different twist, in this excellent blog)

Here I'm going to twist a little bit the classical definitions of the functions of money, in order to make things more obvious later. Money have two historical functions:
A) Barter intermediation, deferment and/or aggregation for the exchange of the fruits of our labor:

• intermediation- I sell a basket of apples in the market, to a baker, and, with the money I get, I'm going to buy bread from another baker, who makes a better and cheaper bread, but grows his own apples and doesn't need what I sell.
  
• deferment of exchange- I sell my apples in the market now, but I'm going to buy bread tomorrow or next week.
• aggregation- I sell one basket of apples, one bag of potatoes and ten bundles of firewood and with all that money I buy one nice straw hat (to replace my old, worn out, tinfoil hat)

In this primary role, money have a great effect of optimizing and promoting trade and production of real wealth in a society. The use of money allows for specialization and higher productivity. Even today, there are still currencies/money specially dedicated to this primary role, and the communities using them have real benefits. (Two such modern examples are LETS and WIR)

B) Storage of value and monetary transactions (lending) resulted through unbalanced trade:

• storage - I have every day one basket of apples in excess of my needs of buying bread. Since, I find nothing worth buying, I store the value of my excess productive output in money (I could just buy extra bread but it will get moldy in a few days)
• lending - the baker needs my apples but has no money to pay me until he sells the apple pies, therefore we agree to a loan. He makes his pies, sells them and gives me back my money in a week. If I refuse this vendor finance transaction, my excess apples will go bad in a few days and I'll have nothing to sell. This lending transaction is mutually beneficial as lending promotes the creation of real wealth in a society.

This second role raises some important ethical issues. Yes, continual increase in wealth accumulation can be the result of hard work by smart responsible individuals, who can generate more wealth than the average (let's say I work hard to take care of my orchard and I figured out the best way to take care of the apple trees). There is nothing wrong with a fair and honest competitive advantage. In reality, in most cases, consistent and well-above-the-average wealth accumulation is the result of unfair and fraudulent competition allowed to exist or even enforced by a corrupt government or state. Some people, in times of deep crisis and social distress, adopted the radical (and IMHO opinion wrong) solution of devising currency systems that discourage any significant accumulation, through certification and built in depreciation. This was the case of the famous Worgl Experiment, taking place in a small town in Austria, during the Great Depression. While, during those times of deep crisis, the adoption of such a system may have been justified, I don't think that such a system is the right solution, because over a long term it discourages fair and honest competition.

C) Wealth renting. Here things become more complicated. There is always a higher demand for loans than the existing wealth stored in money and available for lending. Because of this natural scarcity, since the ancient times (even before the Babylonian Empire) people with excess wealth stored in money have started to lend with interest, basically, renting/leasing money. Most common form of money renting in antiquity was through direct lending with interest, but there were also quite developed forms of insurance (financing of trade caravans, maritime trade and ... wars) and real estate (financing of housing and commercial real estate). There is a lot to talk about this subject, and those who believe the FIRE economy is a modern invention and our ancestors were stupid and unsophisticated, should read a little bit of history. )

When wealth renting evolved, specialization took it's course and we know for sure that in the Roman Republic there was already a well defined class of moneylenders, (not be confused with the Jewish money changers in the Temple), which were renting their own accumulated wealth, stored in money, by lending with interest. This trade become so profitable that even lending intermediation became very profitable, and the first banks formed around temples. We know that in 371BC one slave working in a Piraeus bank became a very successful wealthy man, by pursuing moneylending and real estate investment with passion. At this stage, we also have the first banking regulations, where state and religious authorities were limiting the interest rates and setting up bankruptcy regulations, especially in the agricultural sector.

It is believed that sometimes in the Middle Ages, fractional reserve banking was invented.Let's study the system with a simple example:


Example A
Let's suppose that we have:
- a small Babylonian kingdom with a population of 100 people
- in average a person produces in a year 11 gold coins worth of good and services and needs 10 gold coins: for buying necessary goods and services (food, clothing, shelter and medical care), and for paying taxes
- the kingdom has an annual wealth surplus worth 100 gold coins
- my great orchard allowed me to obtain in one year a wealth surplus of 100 gold coins (I have realized all the the surplus of the kingdom as personal wealth stored in money)
- the volunteer high-priest (who has a stonemason day job) has received sacred clay tablets with teachings from Bernankus (the god of banking and finance) on how to set up a fractional reserve bank with 20% reserve limit (the Babylonians were very risk adverse bankers)
- the interest on deposits is 1% and the interest on lending is 30%

The whole idea of fractional reserve banking (with X% reserve limit), is to take the money deposited by a person (depositor), keep (X%) in the bank, as a reserve, and lend the (100-X%) rest to another person at higher interest rate.
For example, I, as the only person (person A) with real wealth excess stored in money, can start the process by depositing my 100 gold coins. The bank (operating at a 20% reserve limit), keeps 20 in reserves and lends the rest ( 80 coins) to person B ( a captain who wants to set sail in a trade expedition). B uses the money to buy trade goods from the C (the local camel caravan chief). C deposits the 80 coins back with the bank. Out of his deposit 16 coins (20%) are kept in reserves, and the rest (64 coins ) are lent to D (the captain of the guard) who buys a house, from the house builder E. Of course, E deposits the 64 coins, out of which ... The process depositing-lending cycle is presented in Table 1.




If we suppose we had 50 cycles of depositing and lending, basically the we exhausted even the smallest fraction of a gold coin and the balance sheet of the Babylonian banks creates deposits worth 500 gold coins, loans worth 400 gold coins and keeps 100 gold coins in reserve.

Many people believe that when you deposit $100 dollars in a bank with 20% reserve requirement, the bank simply lends fraudulently $400 to someone else (or $900 in a 10% reserve system). The $500 in deposits and $400 in loans, can be created, in normal conditions, only after a large number of deposit-lending cycles and it is created because of the fact that when people are paid, they usually deposit their money back with the bank.

There are few observations here. The theoretical maximum amount of deposits created is equal to the existing reserve divided by the reserve ratio. 20%=0.2 (100/0.2=500)

After a sufficiently large number of banking cycles, the system reaches the limit of monetary expansion, when the reserve becomes equal to the total amount of surplus wealth (stored in money/currency) available in a society.

Anyway, the balance sheet of the bank looks kosher. Deposits = Loans + Reserves (500=400+100), no money is missing and the bank has a positive cash flow. So where is the fraud? Well,... the fraud is there but it is not obvious, and besides the fraud aspects there are also some big problems. Let's take them one by one:
1) Maturity mismatch fraud. If, in our case, the deposits and the loans are made with an equal fixed one year term there is no maturity mismatch fraud, but in the real world, loans (assets) are long term debt (for example a 25 year mortgage), while deposits (liabilities) are short term debt (such as 'on-demand' checking accounts and certificates of deposits with a maturity up to five years). For the bank balance sheet presented in Table 1, if person A withdraws all money in his deposit, the bank reserves are gone. Nobody else can get their money back on demand, even if all loans are good and will be paid back with interest in time. The bank is mathematically incapable to deliver its obligation to return the money deposited, in the case of short term (or on demand) deposits. In theory, one bank may sell loans (assets) to another bank to get liquidity/cash for returning deposits, but if all banks are hit by withdrawals and have to sell loans (assets), then who will buy those loans? (In our world is the taxpayer who buy toxic assets through government bailouts). This is basically what is happening now also with European banks relying on money market funds, hit by a shortage of short term dollar funding, coupled with the exposure to the US dollar (currency mismatch between assets and liabilities) and resulting in $1.1–1.3 trillion funding (deposit) needs by mid-2007, according to a recent BIS paper. Knowingly making representations that cannot be realistically/mathematically honored, IMHO fits the definition of a fraud. The excuse of government deposit insurance is another fraud, but I will talk about the deposit insurance fraud in a separate section.

2) Risk misrepresentation fraud. Most people believe that when they deposit the money into a bank, the bank just keeps their cash in the vault (in a pile, on a separate shelf, with their name on it, if possible). The banks cannot be held accountable for the ignorance of depositors, but things go actually farther than depositor ignorance. Let's suppose the Babylonian Insurance Deposit Corporation covers all deposits up to only one gold coin. Loan defaults and deposit withdrawals go both directly to the reserves. In Example A, if we suppose we have the first depositor withdrawing his money and the first 10 loans defaulting, the people with deposit accounts have 90% of their wealth wiped out, while the owners and managers of the bank, who made great profits and bonuses,... skate free (limited liability of bank shareholders).

Depositing money in a bank is not equivalent to entrusting money for safekeeping, but is in fact an act of investment low (or zero) dividend shares in a money renting company. Not representing clearly to the people that a depositor= an investor with limited rights in a money renting enterprise, IMHO, is another case of fraud. These two fraudulent characteristics are not a "necessary evil". There are banks practicing fractional reserve banking in a non-fraudulent way (unlimited liability), and those banks make good money without taking insane risks, and they have true depositors, not conned gullible investors in a risky money lending scheme. Here are some quotes form a recent Bloomberg piece:

In today’s crisis, Hoare [of C. Hoare & Co bank] has so far benefited, lifting deposits to about 1.8 billion pounds during the last 12 months. That’s mainly because it’s an “exclusive franchise” for the rich, said Simon Maughan, a financial analyst at MF Global Securities Ltd. The bank’s history has no relevance to the wider banking market, Maughan said in an e-mail. Hoare accepts his bank serves a niche, and it has missed out on historic opportunities to expand.
Hoare & Co. is an unlimited liability partnership, which means the family’s personal wealth, including Alexander Hoare’s solar-panel-topped residence and 50-foot yacht, can be seized if the lender collapses. That gives clients confidence, Hoare said.
“Everything apart from the shirt on our back is at risk,” Hoare said. “It keeps you jolly nervous.”

So there are indeed, non-fraudulent fractional reserve banks. I'm thinking to deposit my money with "C. Hoare & Co" , but... oops ! I can't, because it's "an exclusive franchise for the rich". Well,... I guess I'm going to keep my money in a "normal" bank and pray FDIC does not go bust. It is always a great idea to trust your government for preserving your safety and your property.

3) Excessive money renting profit. This is not really a fraud, but a negative economic effect of fractional reserve banking, which may lead to a larger politico-economic fraud perpetrated on the whole society.

Let's suppose the high-priest is setting up the bank in the courtyard of the temple. He needed clay tablets for the ledger and a table to conduct business. In order to start his bank, the high priest made an investment of 10 gold coins out of his own money for buying the necessary equipment. After one year, everything was great (no withdrawals, no loan defaults) and the high priest payed back 505 gold coins to the depositors (500 @ 1% interest), received 520 gold coins from the borrowers (400 @ 30% interest) and still had 100 gold coins in reserves.
Net profit =520 + 100- 505=115 coins. Not bad for a 10 gold coin investment. An annual profit of 1150% beats any other investment in productive activities, such as growing apples, making bricks etc. Moreover, we said that the total wealth surplus accumulation in the kingdom for the past year was 100 gold coins. Not only that the bank profits account for all the wealth accumulated in the kingdom, but the people of the kingdom are 15 gold coins poorer (total net household debt increased), than the year before, and one former stone-mason quit his productive trade and became a banker (he will not make real things worth 11 gold coins next year). By the way, next year the high-priest will decrease the reserve requirement to 10% in order to improve his profits....

For a 100 gold coins deposit of surplus accumulated real wealth, at 10% required reserve, the bank will generate 1,000 gold coins in deposits, 100 gold coins in reserves, and 900 gold coins in loans. At the end of next year the balance sheet will have:
-1010 coins liabilities (deposits that have to be returned)
-100 coins reserves (capital)
- 1170 coins in assets (money returned by borrowers with interest)
--------------------------------
Profit : 260 gold coins, (for a society that can accumulate in one year by productive means 100 gold coins). That means the total debt of the subjects of the kingdom will be of 160 gold coins. Actually it will be 182 gold coins because the profitable financial services sector will expand, and 22 people who were producing real wealth will switch to service jobs created by a sophisticated financial sector.

This miraculous credit expansion produced by a 10% fractional reserve banking system, will bring extremely beneficial effects for the development of the Babylonian service sector. The banking profits of next year will be used for:
-paying a 30 gold coin bonus for the high priest banker (who was making 11 coins a year as a stone mason). It's a bonus because he takes no salary from the bank. He does it all for the public good, for the people and for increasing the prosperity of the kingdom.
- hiring 3 young virgins who, before the financial miracle, were looming and weaving flax fabric (in the local textile industry at the same average industry salary of 11 coins). The 3 virgins will help the high-priest to study the esoteric complexities of the fertility rituals. The 3 (soon to be former) virgins will be happy with their new jobs, because they will receive an annual salary of 15 coins (36% salary increase for this highly skilled "services workforce" and all coming with a "lighter workload")
-hiring 4 farmers as landscapers with an annual salary of 10 coins (they will make less than before, when they were farmers, but landscaping is better and easier than toiling the fields and growing barley). Plus the people will feel better when they will see manicured loans in front of the temple, royal palace and the homes of well paid bank employees.
-hiring 4 people who worked in the produce market (farming and selling their own products), as bank tellers, at an annual salary of 20 gold coins (82% increase in salary for quitting farming and selling your own goods, and going into the financial services sector)
- hiring 4 flax farmers to sell things in the market at an annual salary of 5 gold coins. OK, these are low paying jobs (compared to what they were making before by growing and harvesting flax), but since the 3 virgins are not weaving fabric anymore, the farmers will go bankrupt anyway, because there will be no need for their flax. These losers will have to get a job to pay their debt and they will have to take these bottom-feeder wages. Plus, we need someone to sell things in the produce market, replacing the guys who became bank tellers. In order to make these 4 losers feel better about their shitty jobs, the high-priest will give them a catchy job title, calling them "Sales Associates"
- hiring 5 former farmers, fishermen and craftsmen to make cheap food and clothing for those who became poor (we must keep the poor happy). The cheap food will be made out of a mix of tar grease, dog turds and cow patties and will be called "healthy fast food". The cheap clothes will be made out of unwoven straw, and will be called "discount value clothing". In order to pitch the sales of this edible and non edible crap, and make the poor feel happier and richer, the advertising campaign will rely on using happy/smiley face symbols with catchy slogans such as "Happy Meals for your kids" and "Roll back prices"
- the remaining 5 gold coins (out of the 260 bank profit) will be used for advertising materials promoting the blessings of "fast food", "value clothing" and of course the blessing of a "sophisticated and innovative financial services sector".

So let's examine again the little kingdom in Example A with and without the financial services sector.
Without the financial services
Production of goods and services: 100X11=1100 gold coins
Consumption of good and services: 100X10=1000 gold coins
----------------------
Surplus: 100 gold coins

With the banking and financial services in place at 10 % reserve requirements (22 people going into financial and associated services).
Production of goods and services: 78x11=858 gold coins
Financial services earnings: 260 gold coins
Consumption of goods and services: (78x10 + 260) =1040 gold coins
------------------------
Surplus: 78 gold coins

Wow!!!! Banking is a blessing. It is true the total surplus value created in the kingdom decreased with 22%, but the average wage increased from 11 to 11.28 gold coins and that is a healthy 2.54% increase in the average standard of living in just one year. Not bad. Not bad at all.... Consumption increased in one year with 4%. Hmmm ... the high-priest/banker who made those great profits from his bank, told the people that the key of getting richer is to consume more. This is a discovery of new type of economy, which from now on will be called "consumer economy".

Of course, there is that little issue of total household debt increasing from 0 to 182 gold coins in just one year, when before, nobody was in big debt. If we add the debt number to the total consumption in the kingdom, we obtain something like this.

Production of goods and services: 78X11=858 gold coins
Financial services earnings: 260 gold coins
Net total household debt: 182 gold coins
Consumption of goods and services: (78*10 + 260) =1040 gold coins
------------------------
Surplus: -(104) gold coins (a real wealth deficit of 104 gold coins)


These guys, who have an obsession with debt and real wealth are annoying. Who cares about total real wealth in the system, when the banking profits are so high? A simple financial calculation (made by using the goal seeking function in a spreadsheet) shows us that, had the subjects of the kingdom, increased their spending to 8%, the average (apparent) income would have increased by 5%. One crazy man said also, that such an increase in spending would have resulted in doubling the banking profits and an increase in the household debt of the "rich" subjects with more than 240%... and that is unsustainable. But who has time to listen to these lunatic nobodies?

If the issue of household debt becomes serious, the rulers of the kingdom can always hide its effects by offsetting it with increased budget spending. The government will always run increasing budget deficits and the part of the household debt will be transformed in public/government debt. Actually, that is not a bad idea. Not bad at all for the following reasons:
- since the poor dumb suckers pay always taxes higher than top business earners, the public/government deficit will be mainly the burden of the poor (which will never be able to pay it).
-the high-priest got recently, some sacred tablets from Warburg-Morganus (the god of central banking). In those tablets there were precise instructions on how to set a separate private bank which is to deal exclusively with government/public debt while offering protection of his private bank. If the Government runs a deficit, it will have to borrow money with interest from this new Babylonian Federal Reserve Bank. The subjects of the kingdom (with the exception of the few wealthy elite) will be forever trapped in a web of debt. The average Babylonian will have to pay a private tax on his household debt and on one on the government debt. Crushed in between paying his own debt and the government debt, the average hard working Babylonian will never be able to escape the invisible chains of modern finance, becoming the perfect slave. After all, the Babylonian Empire was an empire based on slave labor.

Of course, in order for this to work, the government will have to always run ever increasing deficits. Therefore, no matter what king is on the throne and what prime minster is appointed to run the country, the high-priest have to make sure they will always recite loudly to the masses the Creed In The Babylonian Gods: "Deficits don't matter!"

If that is not possible at least they have to recite The Lie Of The Babylonian Public Servant :

"We have to increase deficit spending now, in order to get the country out of the economic crisis, but my stimulus plan will create a healthy economy, a balanced budget and we will reduce public debt in a few years."

Of course than in a few years there will be no balanced budget, the deficit will keep increasing, the public debt will keep ballooning and the slaves will remain slaves. The high-priests who wrote The Lie Of The Babylonian Public Servant, knew very well that when a man is left with , reduced to a debt slave, that will rebel. That is bad for business. Therefore, the high-priests of banking, every few years, have to give something to the slaves, in order to keep them obedient,... something that is worth nothing,... The high priests, using the puppet kings and officials, have to give them the illusion of ... HOPE!

Those who believe that what is happening now is the curse of the modern society, should read at least the ancient classics:

"The national budget must be balanced. The public debt must be reduced; the arrogance of the authorities must be moderated and controlled. Payments to foreign governments must be reduced, if the nation doesn't want to go bankrupt. People must again learn to work, instead of living on public assistance."
-- Cicero, 55 BC