Ever since the financial crisis there has been an onslaught of people who think we need to scrap the entire financial system and start over. The main source of angst has been private banks. Basically, people think banks lent too much money and leveraged up the financial system and then we got a financial crisis. This isn’t necessarily wrong, but that’s not really how banks work. Let me explain.
A bank is a lot like your water company. The water company supplies water through the pipes into your home and you can turn on the spigot whenever you please. Water flows as you need it and stops as you don’t need it. This is a good thing as it allows us to use water on-demand and to meet our specific needs. Banks operate in much the same way – they supply credit to the economy and when we need it we can tap into it. If the economy needs more liquidity there is an elastic money supply that can expand to take advantage of those new opportunities. (Read, the Basics of Banking).
Now, the financial crisis was an unusual beast. The majority of loans being issued were relatively low risk loans. The problem was that all of the loans were tied to an asset (housing) that was assumed to be fairly low risk. And just like the water company doesn’t decide how much water you put in the bathtub, the banks don’t decide how much home prices get bid up (and down). So as consumers irrationally bid up home prices the risks of the tub overflowing were growing. The strange thing about the financial crisis is that when the tub overflowed (ie, house prices collapsed) very few people blamed the homeowners who bid those prices up (ie, the people who filled up the bathtub in the first place).¹ But make no mistake, this was the crux of the problem. Blaming banks for rising asset prices is like blaming your credit card company when you pay $20,000 for a $1,000 iPhone.
Importantly, banks are private competitive entities that compete for our credit. If I have an income and good credit then I can shop around to access the cheapest line of credit available to finance future needs as opposed to having to access my current liquidity (which I might be able to put to a better use elsewhere). This elastic money supply makes our economy much more dynamic than it otherwise would be.
There’s a downside to private competitive banks – they must try to manage their risks so that they are also maximizing profits. In general, when times are good they take more risk (because their risk analysis looks better since everyone’s balance sheet looks better) and when times are bad they take less risk (because their risk analysis looks worse since everyone’s balance sheet looks worse). Banking tends to be procyclical in much the same way that stock market booms are procyclical (or that water usage is procyclical). So banks lend more during good times (sometimes exacerbating the boom) and lend less during bad times (sometimes exacerbating the bust). This procyclical tendency is just part of the economy’s natural ebb and flow. We can reduce the size of the booms and busts via better regulations and better knowledge, but it’s unlikely that we can eliminate it.
This brings me to this weekend’s vote in Switzerland on the Vollgeld Proposal. I touched briefly on this after my recent visit to Switzerland, but the basic gist is that the angst against private banks is so bad in Switzerland that their direct democracy raised enough votes to potentially end private banking and fully reserve the banking system with what they perceive as a “sovereign money” system. In essence, the control of the money supply would return to the government.
This is silly for several reasons:
- First, much of this is based on the myth of the money multiplier. (Read, the Money Multiplier and the Myth that Just Won’t Die). To people who have been reading my work for the last decade it’s almost unfathomable that this myth still exists, but here we are. Sigh. Anyhow, basically, most people think that banks take in deposits and lend them out in some multiplied fashion. Except that’s not at all how banks actually work. Banks actually create new loans from thin air by expanding their balance sheets. If they need reserves to meet a reserve requirement then they acquire them from another bank or the Central Bank after the fact. If you “fully reserve” the banking system then nothing actually changes there. It just means that the Central Bank will need to supply more reserves after loans are made. You see, this isn’t the government controlling the supply of money. It’s the government acting to supply reserves to meet a silly rule that they instituted.
- In order to control the quantity of reserves in accordance with new loans the government would have to control new loan issuance. Now, there’s no question that private banks are sometimes very bad at managing the money supply, but if you want to see true sovereign money systems work then take a look at almost any authoritarian regime throughout history and ask yourself why centralized money systems so often result in hyperinflation – the answer is because government bureaucrats don’t manage money to account for risk. So while private banking is far from perfect its decentralized nature removes control from the government in a way that creates a sort of hybrid system in which banks are regulated, but still competing to make loans in a risk managed nature. Would the government be a better steward of loan issuance than private banks? I guess we don’t really know, but I am highly skeptical.
- The Swiss people relish in their decentralized state of being relative to the rest of the world. They have great pride in the fact that they aren’t part of the EU or EMU. They also have widespread love for forms of money like Bitcoin. But we should be clear about private banking – private banking is highly decentralized despite the fact that the banking system is necessarily intertwined in the rest of the economy (just like your water pipes are necessarily intertwined in public waterways and your home). The point is, if you like decentralized money then private competitive banking is a dream come true because the real money supply is controlled almost entirely by private competitive entities and not the government. (If you think money comes from the government then read this piece).
- Interestingly, this proposal could result in a riskier banking system and one which moves more “off balance sheet”. Since banks are being paid interest on reserves the increase in the quantity of reserves necessary to meet a full reserve requirement would result in a massive handout to the banking system. This would be a de facto dividend of sorts that would divert money from households to the bankers. More interestingly, if the state began controlling loans directly then banks would operate “off balance sheet”. That is, the size of the shadow banking system would likely increase substantially as banks tried to offset their lost business in the deposit markets with other types of loans. These less regulated loans would be inherently riskier and could destabilize the financial system in the long-run. In other words, a centralized money supply could result in riskier government issued loans AND riskier shadow bank lending.
The bottom line is that the Vollgeld Proposal doesn’t solve the problem that the Swiss people think it will. If they fully reserve the banking system then the Swiss National Bank will be forced to issue more reserves to back all new loans. And if they centralize the issuance of loans then government bureaucrats will suddenly control all new issuance of credit.
Personally, I think this proposal is supported by people with a hammer who view everything as a nail. Hammering the banking system into submission won’t fix the actual problem. Instead, the Swiss people should advocate for better and smarter regulations that restrict how banks manage their risks and reduce the systemic risk they pose to the rest of the economy in the case that we decide to overfill our bathtubs.²
¹ – I am by no means trying to absolve the banks from any blame in the crisis. Yes, they definitely made too many loans to low credit borrowers. And they definitely leveraged loans into securitized products that made the crisis bigger than it should have been. But the key point here is that the kill mechanism in the financial crisis was house prices and the blame for booming house prices is widespread.
² – Not gonna lie. A warm overflowing bath sounds pretty nice right about now.
Mr. Roche is the Founder and Chief Investment Officer of Discipline Funds.Discipline Funds is a low fee financial advisory firm with a focus on helping people be more disciplined with their finances.
He is also the author of Pragmatic Capitalism: What Every Investor Needs to Understand About Money and Finance, Understanding the Modern Monetary System and Understanding Modern Portfolio Construction.