The Theory of Money, Part 37

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Last week, I summarized the control a government has over its country’s money when the money is 0% backed fiat money. And we saw that governments tend to leverage that control to try to help the country, but these efforts probably help us in the short term but harm us even more in the long term.

Now that we have a thorough enough background in how modern governments control money, let’s look at what the government might do when a bank is about to fail. This situation may be somewhat reminiscent of the U.S. in 2008 . . .

Let’s say that a bank is looking for the most lucrative places to lend money, and it finds that there is a particularly high demand for mortgages at that time. Maybe demand went up up as a result of some new government policies that are encouraging people to buy a house . . . they loosened the financial requirements for people to qualify for a mortgage, for instance. The bank sees this spiking demand for mortgages and recognizes it as a potentially lucrative investment opportunity.

Unfortunately, the new prospective borrowers were not allowed to get a mortgage before due to bad credit or too much debt, so even though now they can qualify for a mortgage, that doesn’t change the fact that they’re risky borrowers. But the bank is okay with this because higher risk means it will be able to charge higher interest rates. And, at this time, the economy is booming. Housing prices have been going up consistently for many years, and now they’re going up even faster due to the new policy. And with the booming economy, loan defaults are relatively low, and the few who are defaulting are able to sell their house for a higher price than what they originally bought it for even months before, meaning banks will most likely get their money back even in cases of default.

Taking all these factors into account, the bank feels like it can charge high interest rates and not have the default rate that such risky loans typically have. It’s a perfect opportunity to earn a ton of easy profit!

I hope by now you can see where this is going. These days with 0% backed fiat money, if there’s a relatively sudden abundance of wealth, you know it’s usually going to be from new money being created and injected into the economy, which means the perceived wealth is higher than the actual wealth. And in this perceived abundance, everyone jumps onto the speculation bandwagon to make some easy money. And then there’s an eventual correction as prices adjust to the new lower value of money.

As long as housing prices continue to rise like this, everything’s fine. All the parties–including the ones building houses, the ones getting mortgages, the ones doling out those mortgages, the ones flipping houses, the ones investing in repackaged mortgage investments from other banks, etc.–are counting on prices continuing to rise like this. And they are making investments accordingly, pushing their leverage as far as they can to earn as much as they can while there is still easy money to be made.

And then something changes. Maybe the influx of newly created money slows down, so prices finally start to adjust to this new lower value of money. The illusion of abundant wealth starts disappearing. The real price of a house starts to become clear as people realize their money isn’t worth as much as they thought. Demand starts to erode. Prices no longer look like they’ll keep increasing forever. Many businesses in the housing market were making big investments predicting continued rapid growth and big profits, but these investments no longer make sense given the slowdown, and many of them end up being lost. This puts some companies in financial trouble, and they start laying off workers. Things spiral from there, and soon the trickle of people losing jobs and being unable to pay their mortgage increases to a deluge. The tipping point has been reached, and tons of houses start going on the market as people are trying to get out before prices drop further.

Banks start having to foreclose on houses, and it’s them who are forced to absorb all the losses. How? Well, if they gave a borrower $800,000 to buy a house and then the market drops 50% and they foreclose on the house (becoming the new owner of the house), now they own a house that basically they bought for $800,000 and is now worth $400,000.

The banks all knew it was a risky market to invest in based on the risk evaluation of the people who were getting those mortgages, but they downplayed the risks based on the illusion of wealth and because of historical trends that they expected to continue. And who can resist investing in something that everyone else seems to be making huge profits investing in?

Part of the challenge here is the difficulty in pricing things like the land the houses are sitting on, which makes it easier for the prices in markets like this to lose touch with reality because there isn’t as reliable of an anchor to say what the things are actually worth.

Getting back to our bank, let’s say the required reserve is 0.2 and the bank has $20 billion in reserves, which means it is allowed to lend out $100 billion. This is a big bank! And of the $100 billion, it was pretty aggressive and invested (loaned) $40 billion of that money in the housing market.

We are back to the same situation Indie Bank was in way back in Part 17, except now it’s not a shortage of gold in a vault that is triggering panic. Let’s see how it works with modern banking in a 0% backed fiat money situation.

This can get confusing if I don’t make some simplifying assumptions, so I’m going to do that in the hope that it helps clearly illustrate the principle.

Let’s say the bank originated all $40 billion of its loans in the housing market at the same time, and immediately the bank had to foreclose all of those loans and then sell the houses. As long as it sells the houses for a total of $40 billion, it’s not a problem. The bank hasn’t lost any money. (Sure sure, there will be delays between loaning the money and getting it back after selling a foreclosed house, plus there will be a lot of bank employee time spent on all this stuff, but let’s ignore all that for now and say the bank breaks even.)

Now let’s say the bank makes the $40 billion in loans all at once and then it has to foreclose on all of them after 10% of the principal has been paid back. If the bank can at least sell those houses for 90% of the original purchase price, then it’s gotten 100% of the loans back (10% from the original borrower, 90% from the sale of the house), plus it earned interest while the loans were being paid on. This, too, is no problemo assuming inflation in the interim was 0%.

But what if the bank has to foreclose when only 10% has been paid back on the mortgages and then they can only sell those foreclosed houses for 50% of their original purchase price? The bank will only get a total of 60% of their loaned money back (10% from the original borrower, 50% from the sale of the house). So, of the $40 billion it loaned out, it got back $24 billion and lost the other $16 billion.

Where do you subtract this lost money? Does it come straight from the reserves?

Yes. Think about it this way. Before all this happened, the bank only had $20 billion of actual money. And this isn’t the bank’s money, remember. It’s customers’ money stored in the bank. Sure, the bank was lending out $100 billion, but that was money temporarily invented to exist until the loans get paid off, and then it disappears again.

The $16 billion that was just lost was actual money. So the bank’s reserve has now dropped to $4 billion. And remember that of the $100 billion in loans, $40 billion of that was in the housing market, none of which exists anymore, so it now only has $60 billion in outstanding loans.

Doing the math ($4 billion / $60 billion), this means that the bank’s reserve ratio just dropped to 0.07. To get its reserves back up to the 0.20 requirement, it’s going to need to borrow $8 billion. I doubt in this economic situation that the reserve-sharing central bank will have any excess reserves for sharing, so it’s getting all this money from the the discount window. Depending on what the discount rate is, the bank will very likely owe a ton of interest every single day until it gets back up to the minimum reserve requirement. So much interest, in fact, that its other revenues cannot cover this interest cost. And now we have a bank that is going down the drain quickly. It will have to declare bankruptcy.

And now it’s decision time for the government. Do they step in to help?

Remember, this bank is huge. It has an enormous effect on the economy. If it fails, this will hurt everyone in one way or another. And politicians don’t like to be seen as just standing by idly watching as things go bad. The public clamor will be for them to “do something!”

The government definitely has the means to bail out this bank with newly created money. So what is a rational politician to do? They know that actively working to help during a crisis will be very popular, and they can easily justify any bailout as being beneficial for the economy by deeming the bank to be “too big to fail.”

So of course that’s what they do. They end up creating a whole bunch more money, some of which will be a gift to this bank and some of which will be a loan to this bank with a very low interest rate (which is also a gift because it means the government is paying for the rest of the interest in one way or another).

As a result of this bailout, there has been a huge transfer of wealth. Wealth came from all people owning cash and it went to this bank (or, really, its owners). The cash-owning people just unwillingly and probably unwittingly had some of their wealth taken from them and given to this bank for the sake of helping the economy.

Just to make sure this is clear, the bank took a huge risk and initially made a lot of money. So they received the upside of this risk. But then, when things went bad, they got bailed out, so they experienced very little of the downside, and instead all the cash-owning people bore the downside of their risk. From a bank perspective, this is an amazing deal!

I don’t have the means of calculating how much this bailout would benefit the economy. But I suspect, based on all my other comparisons of similar situations (like in Part 15), the long-term cost of lost wealth to individuals and to the country as a whole will be much greater than the short-term economic benefit.

And this doesn’t even take into account the effects a bailout has on the future behaviour of competitors within the banking market. For every large bank, the incentives were just changed as soon as they saw that the government will bail out any bank that is big enough to hurt the overall economy if it fails. Large banks now know that they can make risky investments and not worry so much about major losses. This skews investment behaviour. It also skews bank merger decisions (“We gotta get too big to fail!”). Basically the government has incentivized mergers and is subsidizing risky investments, which leads to overinvestment in those risky investments and underinvestment in more solid investments.

And even if one bank wants to play it safe, they will be earning a lot less profit, and sooner or later their investment strategy will be changed to put them more in line with other banks.

I have a strong preference toward free markets, but I also believe government assistance to help markets run efficiently is important. Unfortunately, intervention in a market in this way does not help the market run efficiently; instead, it skews incentives and leads resources to being dedicated to different purposes than the market would otherwise direct them to, which leads to inefficiencies in ways that are often impossible to calculate. It’s the same principle as administrative pricing that I discussed last week.

So, for this reason, bank bailouts represent yet another way that the government leverages its control over our monetary policy in an attempt to help but that harms us financially. If we let banks fail, regardless of their size, the economy will hurt in the short term, but we will avoid all the adverse effects of creating even more money, and we will also foster the right incentives in the market, both of which will lead to greater wealth and financial security in the long run. Part 38 here.

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