Expert Commentary

Lending vs. Banking

Every now and then EWT revisits the question of credit and the U.S. banking system. It is a difficult subject, and every time you can understand a little more of it, the clearer my long-standing argument for deflation becomes.

Let's start with a question. Suppose you owed title to $50,000 held at a safekeeping institution. Then a neighbor asks to borrow $40,000 from you on the promise of paying you back $42,000 a year later. You agree, so you go to the safekeeping institution, withdraw $40,000 and give it to your neighbor in exchange for an IOU for $42,000, payable in a year. If someone were to ask you, "How much money do you have in the bank?" you would say, "$10,000." Now let's change the scenario to the modern banking system. This time, you deposit $50,000 into a bank. Your neighbor calls the bank and asks it for a loan of $40,000, and the bank lends your money to the neighbor. Now if someone were to ask you how much money you have in the bank, you would say, "$50,000."

How is this possible? The bank is simply a middleman, brokering the loan between you and your neighbor, and taking a fee to do it, yet somehow you think you still have $50,000. Someone might point out that yes, $40,000 is gone from the bank, but the deposits are pooled, so the first person in the door can always get his money. You, for example, could go to the bank tomorrow and withdraw $50,000. That's true, but everyone in the pool thinks he has the money shown in his bank book, and that is obviously false. At latest count, U.S. banks report $6.942t. in deposits and $6.945t. in loans. In other words, the average bank in the U.S. has lent out 100 percent of its deposits. The money is not there. It is lent out. (Some banks have more loans than deposits, others less, because while deposits can move--so far, at least--banks can get stuck with illiquid loans. It used to be that when a large depositor left a loaned-up bank, the bank would sell of loan agreements to raise the cash to pay him. But today there is almost no market for mortgages. See the problem?) If your bank has a billion dollars on deposit but all of it is lent out, then it has no money. But if one were to poll all the depositors, their combined statements would indicate that, as a group, they think there is a billion dollars in the bank. So 100 percent of their belief is a fantasy. That is also the amount of potential deflation, if all the borrowers were immediately to default.

Confusion comes about due to a magical word: deposit. This word makes it sound as if you have placed your money in the bank for safekeeping. But what you have actually done--as courts have confirmed--is to lend your money to the bank so it can, in turn, lend your money to your neighbors and split the interest with you. It is a speculative business, not a safekeeping institution. In reality, a bank book should not list "money on deposit" but "money lent to our ban, to be paid on demand unless we run short."

Loan upon loan escalating through the banking system has created the bulk of the inflation in the system. But this inflation holds u only as long as all the loans backing the money listed in all the bank books are still good. If all the borrowers were to find that they could not pay back the banks, then the purchasing power that everyone thought he had would evaporate into the nothingness it truly was.

This outcome seems hard to grasp, so let's go back to the original scenario. Your neighbor calls you up after a year and says, "Sorry, chum, but I invested the money and lost it. I can't pay you back." O.K., how much money do you have in the bank? Answer: You still have $10,000. But you already knew your balance, so it's no big surprise. In the modern banking world, if 90 percent of borrowers were to default, the bank with $1b. on deposit would have to admit to having only $100m. worth of loans on hand. Most depositors would be shocked to discover that for every dollar they thought they had "in the bank," they in fact have only ten cents' worth of IOUs and not a penny of actual money. Contrast this outcome with the case of the direct loan. In that situation, you, the lender, knew the score every step of the way: You took a risk with his neighbor and it didn't pay off. Those are the breaks. In the modern banking system, almost no one knows the score. Even those who do understand the situation, from having seen "It's a Wonderful Life" a dozen times, rarely worry, because Congress, by creating the Fed as a lender and the FDIC as a supposed insurer, support the illusion that no losses are possible. This is a system with massive "systemic risk," which means in effect that huge illusions can melt away in a flash if the "system" fails. The modern banking system has no option but to fail. Its very design, in fostering the illusion of riskless lending, insures that ultimately a huge portion of the creditors someday will wake up broke.

In the direct-lending scenario, moreover, you consciously decided to take the risk. You could have chosen to keep your money safe. Indeed, because the risks are crystal clear and honestly represented, many would have done just that. But that option does not exist as an institutional service today, because with fiat money, holding is losing, at least for all but the rare, brief periods of deflation. So, almost nobody does it. People "keep their money in a bank" and think it's the same thing as "a bank keeping their money." But it isn't. To put it another way: The time-worn phrase "Money in the bank" really means "money not in the bank."

If a depositor were to ask a banker, "Where is my money?" the proper answer would be, "It's gone." If he were to press on and ask, "What, then, do I own?" the banker would say, "Shares in a bunch of IOUs." Deflation, then, simply makes manifest something that is already true--the money is gone--but the obligation to pay it disappears only in the case when borrowers can't pay up. That's a rare thing, which is why deflation is a rare thing.

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