Why there is a Credit Crunch and how Banks Work

Some people claim that the credit crunch and the banking crisis were caused by insufficient regulation of banks and “laisez-faire” capitalism or banking. This couldn’t be further from the truth. All of the problems have been caused because, to put it bluntly, banking is heavily regulated, and allowed to do things that normal businesses can’t get away with in the real world without their owners going to jail. Banking is a system where the government intervenes heavily in the free market and either distorts the market or rigs the laws to allow someone to do something that would normally be a crime. And I’ll prove it.

What exactly caused the financial crisis? Government bailouts, crony capitalism (where some people are able to operate businesses because of who they know or who they can bribe), moral hazard (where the laws encourage misbehavior and either don’t punish it or actually reward misconduct) and the “too big to fail” philosophy. In the real world, operating any business honorably does not guarantee you couldn’t make mistakes or go bust, but you can bet that if you dig deep enough, the problems in the financial markets are not the result of the free movement
of capital but because of restrictions on the same. Or because of Government rules which permit actions which would be criminal if the government didn’t give you a pass to get away with them.

If we had the same rules for running a bank as we do for other places that store things, like, say, your local self-service storage facility or moving and storage company, there would be no such thing as a credit crunch because we wouldn’t be pulling funny stunts with other people’s money the way we aren’t pulling funny stunts with their household goods.

If banks were run like ordinary storage facilities where people put their business records and household goods, anyone could open a bank and offer checking accounts. So in this fictional example, I’ll do that. I’d take in deposits, pay them as people wrote checks, and charge people $10 a month for handling their account. But their money is theirs, they can come in and take all or any part of it any time they want (except for the last $10; hey, I ain’t stupid, you don’t get to stiff me on my service charge.)

You do this and there is no way, whether you have a bank that has $50 in deposits or $50,000,000,000 that you can go broke, bust or fail (as long as your expenses are less than the fees you’re charging your customers, same as, say, a storage facility for household goods.) If there is a run on the bank, it don’t mean a damn thing except that if too many people show up they can’t get their money (right away), not because I don’t have it, but because if too many people show up to get it, it takes the tellers longer to pay them, just as if too many customers show up at Safeway the lines get longer because there aren’t enough cashiers to handle everyone at once.

But whether I have two dozen customers or two million, if they all come in and want all of their money all at once, eventually all of them will get 100c on the dollar, it’s just a matter of how fast the tellers can count their money back to them. As long as I run an honest bank, I have absolutely nothing to fear from a run on the bank.

It’s no more a problem for an honest bank to pay everyone all their money than a run on the post office causing a problem because everyone wants all of their packages at Christmas time that required signature and they weren’t home to get them. Everyone will get all of their packages as soon as their identity is checked (to make sure you’re getting your packages and no one else’s.) It will take time, not because your packages are gone, but because the clerks can only move them so fast. It’s not a problem, it’s simply an inconvenience. The post office has your packages, the clerk just has to go get it from the back, for you and everyone else who comes in.

In an honest bank, if there’s a run, it’s not a problem, it’s simply an inconvenience, the bank has your money (and everyone else’s), the teller just has to go to the vault to get it, for you and everyone else who comes in.

But just as the postal service can’t loan your Christmas packages to someone else, I can’t loan out the money in your checking account
to someone else to buy a house, car or the charge they made on a credit card I issued, any more than my storage facility can loan out my stuff to people who want to rent it from them. If I loan your money to someone else, that’s either conversion or embezzlement and it’s a crime. Unless the laws are rigged to allow it; if they are, it’s “legalized embezzlement.”

But it’s worse than that, banks don’t just loan out the money that depositors put in, they use fractional reserve. This is a very interesting concept and needs explaining. In an article I once wrote I explained how, in order to protect against runs on banks, the Federal Reserve requires banks to leave money with them. This money that banks have to leave with the Federal Reserve is available in case there is a run on the bank or otherwise is necessary. The amount is supposed to be 10% of the amount deposited, but can be more. And if it is more, there are some very interesting things a bank can do.

So under normal legalized embezzlement, if I get deposits equaling, say, $1000, I can put 10% of the deposits at the federal reserve, or $100 and loan out the other $900. That would at least be “honest legalized embezzlement”, but now, thanks to Fractional Reserve, I can turn what I deposit around, and deposit more than 10% of what I have. Then the Fed says I can loan out ten times whatever I leave with them. So if I put $500 into the Federal Reserve instead of $100, I’m allowed to loan out ten times the $500, or $5000. Even though I don’t have it. This is worse than “honest” legalized embezzlement, I’m actually stealing money that doesn’t even exist! So we’ll call this “dishonest legalized embezzlement.” So maybe I “loan” $1000 to five people, and I do this by opening checking accounts where I credit them for the $1000.

My books balance, I have “assets” of $6000 (the $500 in cash I have with the Fed, the $500 in actual cash I have on hand, and the $5000 that people have borrowed.) On the other side of the ledger, I have “liabilities” of $6000 (the $1000 originally deposited, plus the 5 checking accounts each containing $1000.)

Now if you’re paying attention, you’d say, “Wait a minute, all of your “assets” are money that someone else has, or that you created out of thin air, and your “liabilities” are either also created out of thin air – money you’ve supposedly loaned to them – and a small amount of cash that wouldn’t cover everyone if you had a run on the bank.”

You’d also be right on all points. And now you can understand why there’s a credit crunch, because if everyone actually starts pulling those deposits, most of them are fictional that I couldn’t pay unless they paid back their loans in full. But the money I loaned them doesn’t exist unless I close their account and set off their deposit against the loan they owe me. Then all the fictional entries disappear and everything would clear up. But chances are, those who could take money out have (without paying off their loan, of course, not because they’re dishonest, but because either they don’t owe it yet or I haven’t demanded repayment), and so, the only way I can cover those deposits is to demand repayment of the loans I have outstanding. The money for which does not exist or can’t be paid. So that means I can’t loan out any more money! (Presuming you believe I was loaning out money, or was I creating it out of thin air?)

So now, if you come to the bank, I can’t loan you any money, so there’s a credit crunch until people pay me and even at that I might need the money to increase my assets to cover depositors who want their money back. (Some of whom may not have loans with me and I actually have to give them money.) This is the result of dishonest legalized embezzlement.

You’ll also note we’ve turned the idea of assets and liabilities upside down, so that money we have on hand is a liability and debt people owe us is an asset!

In the real world, first you couldn’t do this (as badly) because first, you can’t loan two people the same sofa or recliner you “borrowed” (without asking) from “A” who stored it in your warehouse (clearly, if “B” has “A”‘s sofa in their living room, it’s
been borrowed from your storage, and “C” can’t also have it in their living room at the same time as well), and second, we usually refer to borrowing without asking as “stealing.”

But as long as money is treated as bookkeeping entries, where you simply make marks on a piece of paper, you can do it. Say I go work for a store, and it’s lunch time, so I go get a soda, and lets say the store is nice about it, I don’t have to pay cash, they will let me write them an IOU, when it comes time to pay me, they will take $1.00 out of my paycheck. Or I can pay them $1.00 in cash (or $1.25 if I didn’t use my employee ID.)

Allowing me to give them an IOU is the same thing as writing a check at a bank because I own the money in my checking account and that is money the bank owes me. In the case of the store, the amount of my future check is based on work I have done for them and is money the store owes me, I am a creditor of the store, same as the 7Up/Dr. Pepper Company; the store owes me for the work I’ve done. The store also owes the soda manufacturer for the (probably) 70c or so that the bottle of soda they sold cost them. (Might be less; the actual amount is irrelevant as long as it’s less than what they’re getting for it, or they have something else they’re making a big enough profit on to cover the loss leader.)

But the store can’t sell the soda to me and to a customer at the same time. Only one of us can drink it. But that’s what banks do when they accept demand deposits
payable immediately, and then loan them out to people who might (or might not) pay them back at a later date. They’re renting out money that belongs to depositors who can come back and ask for it at any time.

Now It’s even easier to play fractional reserve games when you have computers to manipulate the bookkeeping as opposed to the above example I gave where you can do everything on paper, you don’t need computers at all to do it. Because now you can have a webserver make a decision based on the numbers as to whether the person applying is a good credit risk, and deserves a credit card, and thus you can loan them money automatically (remember, when you run a charge on a credit card that is not a Check Card, you’re getting a loan from the bank) without a person ever even seeing them.

It also shows something else, too: the historic fallacy of borrowing short and lending long. If I’m taking in checking accounts, customers have the right to immediate repayment and are allowed to retrieve up to 100% of the balance in their account at any time. Checking accounts are not
time deposits; the technical term for a checking account is a “demand deposit” because checks are payable on demand. But if I loan out that money to someone who used it to pay for dinner on their credit card (and I paid the merchant who accepted that card from someone’s checking account) the borrower has 30 days to pay me without interest, or longer if they want to pay interest.

I took a checking deposit payable immediately and loaned it to someone who conceivably has 30 days to pay me back (plus their billing cycle), or even longer if they use their credit card as a credit card and carry a balance.

And if the checking account holder
writes a check to get their money, I’ve spent it; it went to the merchant who accepted the credit card. But that’s okay, I’ll just pay him with the money from *someone else’s* checking account.

And thus we have embezzlement or conversion and would normally be a crime. Unless you’re a bank, of course. Then it’s business as usual, because the laws allow it.

Now all we have to do is extend the time frame, like I take 90 day deposits, or 5-year or 10-year time deposits and loan them to people for 30-year mortgages, and if the guy who loans me money for 5 years comes back for it in 5 years, I can’t pay him back because his money is out for 30 years (with 25 remaining) in someone else’s house. Or I can just use someone else’s deposit to pay him.

And what you basically have is a Ponzi scheme. And most people don’t know it. And banks can only do it because the laws are rigged to allow it.

When your laws legalize theft, you don’t have laizez-faire capitalism, you have either crony capitalism or something else where the government has allowed people to get away with something that in the real world would get me five to ten in Baltimore’s Supermax Prison. It would probably have to be Supermax; not because we wanted to punish me the dishonest banker harshly (some would say it wouldn’t be harsh enough), but because once people found out what happened and tried to get their money and couldn’t (and in the real world there would probably be no deposit insurance, private insurance companies aren’t stupid enough to do what the FDIC does after the state deposit insurers
went broke trying to do the same thing), the prison would have to be secure to keep the depositors from getting to me and lynching me for stealing their money!