Economic Farce Sifting through today's economic madness

Fractional Reserve Lending and the Dispute over Crises Causes between Ritholtz, Mish

Barry Ritholtz recently discussed What Caused the Financial Crisis, enumerating the following items from the FCIC report:

• Alan Greenspan’s malfeasance — his refusal to perform his regulatory duties because he did not believe in them — allowed the credit bubble to expand, driving housing prices to dangerously unsustainable levels; Greenspan’s advocacy for financial deregulation was a “pivotal failure to stem the flow of toxic mortgages” and “the prime example” of government negligence;
• Ben S. Bernanke failed to foresee the crisis;
• The Bush administration’s “inconsistent response” — saving Bear, but allowing Lehman to crater — “added to the uncertainty and panic in the financial markets.”
• Bush Treasury secretary Henry M. Paulson Jr. wrongly predicted in 2007 that subprime meltdown would be contained.
• The Clinton White House, including then Treasury Secretary Lawrence Summers, made a crucial error in “shielding over-the-counter derivatives from regulation [CFMA]. This was “a key turning point in the march toward the financial crisis.”
• Then NY Fed President, now Treasury secretary Timothy F. Geithner failed to “clamp down on excesses by Citigroup in the lead-up to the crisis;” Further, a month before Lehman’s collapse, Geithner was still in the dark about Lehman’s derivative exposure;
• Low interest rates brought about by the Fed after the 2001 recession “created increased risks” but were not chiefly to blame, according to the FCIC (I place some more weight on Ultra-low rates than they do);
• The financial sector spent $2.7 billion on lobbying from 1999 to 2008, while individuals and committees affiliated with the industry made more than $1 billion in campaign contributions. The impact of which an incestuous relationship between bankers and regulators, Congress and bankers, and classic regulatory capture by the industry.
• The credit-rating agencies “cogs in the wheel of financial destruction.”
• The Securities and Exchange Commission allowed the 5 biggest banks to ramp up their leverage, hold insufficient capital, and engage in risky practices.
• Leverage at the nation’s five largest investment banks was wildly excessive: They kept only $1 in capital to cover losses for about every $40 in assets;
• The Office of the Comptroller of the Currency along with the Office of Thrift Supervision, “federally pre-empted” (blocked) state regulators from reining in lending abuses;
• The report documents “questionable practices by mortgage lenders and careless betting by banks;”
• The report portrays the “bumbling incompetence among corporate chieftains” as to the risk and operations of their own firms:

In FCIC Investigation misses the "Pig Picture" Cause of the Crisis; Next Financial Crisis Brewing Already, Mike Shedlock (Mish) agrees with Ritholtz's points (as do I), but argues:

I cannot dispute any of those points. They are all correct. Yet every one of them happened as a failure "of" regulation, not a failure "to" regulate.

The actual cause of the financial crisis is easy to explain.
1. Loose monetary policies at the Fed
2. Fractional Reserve Lending
3. Congress willing to spend more money that it takes in

Had there not been Fractional Reserve Lending, and had the Fed not cut interest rates to absurd levels while fostering a "too big to fail" attitude at banks, this would not have happened. Perpetual Congressional budget deficits and the Fed's willingness to finance those deficits too cheaply is icing on the "what happened" cake.

To expect smart regulation from those who did not see it coming, the Fed and nearly all of Congress, is preposterous.

Moreover, had there been (by some miracle) regulation to prevent the housing collapse, liquidity would have flowed somewhere else and there would have been a bubble in some other thing.

I completely agree with Mish on these points. In an interesting follow-up to Mish's post, Ritholtz writes:

One of the stranger aspects of human nature — or is it just people with intense affiliations with ideologies? — is the tendency to see the entire world through a distorted lens.

The origins of the financial crisis are no different. It seems that all too many people are willing to use any event to pursue their own agendas, regardless of evidence or proof.

Hence, we have a steady parade of people who seek to blame or exonerate the precise wrong factors which nonetheless fit their preconceived notions.

Examples?

• Mish blames the crisis on 3 factors. While we agree about Ultra Low rates, his other two elements are simply incorrect. “Fractional lending” is his #2 cause. Never mind that this form of credit creation has been around for centuries, he is a vociferous critic of it. Naturally, it was the cause of the crisis. (See: Financial Crisis Brewing Already) Deficits are his #3 cause, which quite bluntly, is beyond my comprehension as a cause of the credit crisis.

I was very surprised by this Response from Ritholtz -- most specifically with regard to fractional reserve lending (FRL). Of all people, I surely thought Ritholtz would see the major influence that FRL has on nearly every bubble, but especially bubbles driven by credit.  Surely Ritholtz must agree that the housing bubble was driven by an over-expansion of credit?

Interestingly enough, Mish responded once more to Ritholtz:

Let' focus on Barry's main rebuttal:

Never mind that this form of credit creation has been around for centuries, he is a vociferous critic of it.

Yep, Fractional Reserve Lending is centuries old. However, what kind of logical rebuttal is that?

The fact is FRL has caused problems for centuries. The best example is the John Law Mississippi Bubble. However, FRL has arguably made every bubble in history worse.

The idea that something cannot be a problem because it has been around for a long time is preposterous. So why do we have it?

FRL has suited the interests of bankers and politicians. That is why it has been around for centuries. Indeed, inflation and credit expansion benefit those with first access to money: banks, the wealthy, and governments (via increased taxes, especially property taxes and sales taxes).

Those at the bottom of the economic totem pole get hammered.

I much enjoyed Mish’s response to Ritholtz’s statement that FRL is a “form of credit creation has been around for centuries.” Murderers and thieves have been around for centuries as well, so they must not be problems either. Even closer to the issue, fraud has been around for centuries, yet I think we all can agree that fraud played a large role in the current economic crisis and housing bubble, can’t we?

While I also agree with Mish’s other points that FRL has "suited the interests of bankers and politicians" and that “credit expansion benefits those with first access to money,” these points don’t do anything to show how FRL helped cause the current crisis. That is what I want to discuss further in this article.

Fractional Reserve Lending

Let’s start with a basic definition. According to wikipedia:

Fractional-reserve banking is the banking practice in which only a fraction of a bank's demand deposits are kept as reserves (cash and other highly liquid assets) available for withdrawal. The bank lends out some or most of the deposited funds, while still allowing all deposits to be withdrawn upon demand. Fractional reserve banking is practiced by all modern commercial banks.

When cash is deposited with one bank a fraction only is retained as a reserve and the remainder can be lent (or spent by the bank to buy securities). Thus, the money lent or spent in this way is subsequently deposited with another bank and increases the cash reserves of that second bank, allowing that second bank to keep a fraction of the new deposit and lend or spend the remainder. Thus the excess cash travels from bank to bank to bank creating new deposits as it goes. Although no individual bank does anything other than lend part of what is deposited with it, the practice of fractional reserve banking in a multi-bank system expands the money supply (cash and demand deposits) to a large multiple of the cash reserves in all banks.

In the U.S. we currently have a 10% reserve requirement for demand deposit (checking) accounts (lets ignore sweeps for now). When someone deposits $1,000 into bank A, bank A will loan out $900 of that money. The receiver of that loan will deposit the $900 into another bank, say bank B, and bank B will carry out the same process of loaning out $810. This process carries on throughout the system, eventually assuring that roughly 10 times the initial deposit is lent out and created out of thin air into the system. Economists have a friendly name for this expansion, and it is called the money multiplier. It doesn’t sound so bad that way, but you could easily call it the “inflator,” or “massive credit expander,” but I guess those don’t sound as nice. Alas, we see that from the initial $1,000 deposit, we will eventually (and usually in very short-order) have $10,000 of deposits created throughout the banking system.

These deposits will be based on money that doesn’t really exist. To really show this, let’s suppose that the government were to introduce a new currency called X, and it prints 1,000X into existence to pay for some construction project. Only 1,000X exist -- that is all that has ever been made. Now let’s assume the banks are told to accept these X notes, and the construction company deposits the 1,000X into a bank. The same process described above will carry on until there are now roughly 10,000X worth of deposits in various banks. But only 1,000X have ever been created! Clearly you can see the problem here. If every depositor tries to withdraw their deposits of currency X, there aren’t enough X’s in existence! This is fraud. Yes Barry, fraud has been around for centuries (likely longer than FRL!), but I still think it is a bad thing.

Above, I posed the question “Surely Ritholtz must agree that the housing bubble was driven by an over-expansion of credit?” Everyone should be able to see that FRL facilitates the extremely easy creation of credit (and essentially ‘money’) out of thin air by the banks. How can this possibly have not contributed (and in large part!) to the current financial crisis?

100% Reserve Banking

Let’s take a moment now to imagine a pre-crisis world without FRL -- or 100% Reserve banking. In such a world, banks would take on deposits, and be required to keep those deposits on hand at all times. Banks would not be allowed to lend out money in demand deposit accounts or sweep them into savings accounts. Depositors would know that their money was always there, and bank runs would not exist, nor would they be a problem if they did exist -- all the money deposited at the bank would always be there, untouched.

So how would the banks loan money?

Well, quite simply, they would have to save money, or borrow money from other savers. Let’s take the classic case of borrowing money from other savers. This is most commonly done through a Certificate of Deposit (CD). When a saver decides to invest in a CD with a bank, the saver is giving his money to the bank for a pre-determined period of time at an agreed upon interest rate. The bank knows that it will have this money for that time period, and can turn around and loan out that money at a higher interest rate for the same time period. The bank would make money on the difference in interest rates.

Notice that in this situation, no new money has been created. The saver does not have access to his money during the period he has loaned it to the bank (much unlike when he puts money into a checking account today). Additionally, the saver is actually taking on some known risk when he loans money to the bank. The saver would have an interest in the history of the bank to make good loans that it can repay. If the bank makes a bad loan with his money and can’t repay him, he stands to lose his savings. This is a risk that the saver must consider and be aware of.

So under this system, banks would not be able to create credit for free out of thin air, but would have to either save, or borrow money to loan out. Thus, when bad things happen and loans (mortgages) can’t be repaid, only individuals who have willingly taken on some risk with the bank through CDs (and other time deposits/loans) will be hurt.

Moreover, if a bank were to make many bad loans and bankrupt itself, depositors would still be able to get 100% of their money out of their checking accounts. This is because the bank is not allowed to take the money out of your account while you aren’t looking (as they are today under FRL). So we see that those who loaned their money to banks, and willingly took on some risk in hope of some reward, will be the only ones to lose any money. The depositors at the bank lose nothing.

This brings us to an interesting question.

Why did we bail out banks?

We were often told in 2008 and 2009 that if the government did not bail out the banks, we would have a “systemic collapse.” Everyone seemed to understand that without these bailouts, our banks would go under, and our deposits would be in jeopardy. Nobody wanted to lose their deposits!

As I have shown above, in the absence of a FRL system, there is no systemic collapse. Depositors cannot lose their deposits because deposits are required to be kept on hand, just like items that you keep in a storage unit are kept in the storage unit -- not lent out to others while you aren’t there.  If your mini-storage provider goes bankrupt, do you lose your lawn mower and furniture?!

Surely banks could still go under, but that would be due to bad decisions and bad loans on the banks part (just as it is today). The difference is that, in this world, bad decisions on the part of the banks only hurts the bank itself, and its investors. It cannot hurt its depositors (unless of course the bank is committing fraud, in which case they need to be prosecuted accordingly -- hopefully the link between FRL and fraud is becoming clearer?). This reality will encourage savers to be diligent when deciding which bank to loan their money to, which will, in turn, force banks to be prudent in their lending in order to receive more loans from more savers.

Alas, this is the crux of the matter.  Without FRL, banks have to borrow money from people in an open fashion (i.e. without taking it from their checking accounts while they arent looking). When investors loan out hard-earned money to banks, they will want to make sure they are going to get it back. This imposes restraint on the banks to make good loans to encourage more investors to loan them money.

But banks offer CDs today!

Some of you may mention that banks offer CDs today, so what is the problem? Well, banks do offer CDs today, but the vast majority of their loans comes from their depositors' (demand-deposit) money. In a quick search I couldn’t find any nationwide numbers to show the amount of time deposits (CDs are time deposits) vs. bank loans, but even if I could, the number would be muddled. It would be muddled because savings accounts are also time deposits, but savings accounts have zero reserve requirement, and are generally not locked in for a set period of time like a CD. Because savings accounts are not a loan to the bank like a CD is, I feel like such a number would represent many more savings accounts than CDs, and thus not tell us much. Suffice it to say that much, much, much more credit and "money" is being created from thin air by banks than is being backed by savings loaned to the banks.

Also, while banks do offer CDs today, the ability for banks to repay CDs is much higher than it would be if they could not simply repay the CD with money from its depositors (money that the depositors still think they have “on-demand”). If they were not allowed to touch demand deposits, they would have to find the money elsewhere (most likely by making good loans with the money borrowed, or by charging fees for their services). Because banks can so easily repay CDs without having to necessarily make prudent loans, it lessens the need for investors to be so diligent in picking a bank, which in turn lessens the restrain forced on the bank by its investors to make good loans.

Fractional Reserve Lending Contributed to the Crisis

Hopefully I have made the case that fractional reserve lending was, indeed, a major factor that contributed greatly to the current financial crisis. It is my strong belief that without FRL, banks would have been forced to make better loans (though some still would certainly do otherwise -- and go bankrupt), bailouts would not have been “needed” (I don’t think they were needed anyway), credit would not have expanded at anywhere near the rate it did, no depositors would have lost any money even without an FDIC, house prices would have risen more gradually and with inflation rather than bubbling out of control (due to easy loans facilitated by FRL!), and current government debt and deficits would be much much lower.

With FRL we verge on systemic collapse with every innocent citizen’s money at risk of disappearing overnight due to some remote banker’s bad decisions. Without FRL we may (at worst!) have investors losing money they chose to invest, while leaving uninvolved parties’ money untouched and safe. Even in the worst case, I choose no FRL. After reading this, I hope you do too.