The bank has some money it loans out. the depositor, who lent that money to the bank, has a right to claim it back from the bank. The borrower has the money, and owes the bank a debt. Where is the double ownership? Where is the fraud?
Further, this isn’t a problem–on average, borrowers repay, and any losses are covered by the interest charged. Universally, depositors can get money on demand.
There is a slight risk of nonrepayment if enough borrowers default, without having paid enough in interest first. To avoid this risk, so the depositors and borrowers–the bank’s customers–pay for insurance to ameliorate that risk. That’s not fraud.
So all we have is a loan from the depositor to the bank, a loan from the bank to the borrower, and insurance to protect against risks. To me, that seems to be quite kosher. What is fraudulent about a loan? What is fraudulent about using borrowed money? That’s all that’s going on here.
Isn’t history full of banks failing for this very reason? That people are not actually predictable, and don’t always act rationally?
You make it sound like there has never been a run on a bank.
Well, first of all, runs on banks do not make fractional reserve banking a fraud. History is also full of people who borrow money, and don’t pay it back, but that doesn’t make it fraud to get a loan.
Also, I’d say the number of runs on banks are vastly outweighed by the length of time the system has worked–bank failures are dramatic, but the vast, vast majority of the time, there isn’t a run on a bank.
Finally, this may have been a problem when banks were unregulated–when they could keep as little money in their vaults as they dared. Now that there are set reserve requirements, and mandatory deposit insurance, the risk is further reduced, and the risk of loss is hedged against.
ETA:
Nope. The people paying for insurance are the people who are at risk of loss were the bank to fail–the borrowers and depositors. They’re simply insuring against a remote risk of the transaction they’re participating in. I can’t think of anyone who would be more appropriate to pay for such insurance.
You do not add value to a house by getting a mortgage. You add value to your life, by getting a house. The mortgage is the cost of the extra value to your life. Indeed, lives are certainly better when lived indoors rather than outdoors, especially in inclement weather.
This is called utility. A man who does not have a house will find great utility in even a tent, while a man who has a house will only have utility for a tent if he goes camping.
(The difference between the two is marginal utility.)
Everything in economics rotates around the people involved, not the objects. Objects have no wants, no needs, and no desires.
I wish to add that the most important thing about the FDIC is psychological. Bank runs happen out of the fear that if you don’t withdraw your money right now it won’t be there. The FDIC, by guaranteeing that the money will be there even if the bank fails makes it unnecessary for depositors to withdraw their money, and thus prevents runs. I’d guess that the psychological aspects of the insurance are more important than the insurance aspects. With no FDIC, I bet a lot more banks would have failed.
ETA: I’ve lived through one example of a run, non-bank. During the Arab oil embargo of the '70s there were long gas lines and rationing. There really wasn’t a gas shortage, but people were convinced there was and so sat in lines topping off their tanks, just in case, and the lines made people think there was a problem. Almost all businesses are designed around an assumed customer behavior, not just banks, and when this gets violated trouble follows.
I asked, as the majority of loans are mortgages, how a house could add value. I am not questioning the value of having a house to live in. I am well aware that house > tent > street. Your first post implies that the majority of loans go towards something with increasing value. I asked how a house could increase value without spending more money on it. To which you gave me some condescending twaddle about the utility of owning a house vs not owning a house.
Care to elaborate?
Your argument is, as I understand it: (a) if you borrow money to buy a house, you have to pay back the amount you paid, plus interest. (b) This presents a problem unless the thing you bought increases in value.
Is that fair?
Now, let’s try a simple four-step process.
(1) Abandon your house. Don’t shower, don’t wash your clothes. Live out of a car on the side of the interstate–get very little sleep.
(2) Go to your job. See what happens. Interview for a job at a bank. See what happens.
(3) get a house. Live in it. Sleep well. Wash your clothes. Generally preserve personal hygiene.
(4) Repeat step (2). Observe greater success. Earn more money, use it to pay off the mortgage.
The point being made is that it is not essential that the money you use to pay off a mortgage, or the interest thereon, comes from an increase in the house value. It’s not even the most common way. There are plenty of ways that a house can help you create value that have nothing to do with its value.
How about another example?
I buy and mortgage a house. I then rent it out to you, and pay my mortgage with your rent payments.
Has the value of the house increased? No. Has owning the house given me a new source of income? Yep.
Can I pay my mortgage? Sure.
Most people buy houses to live in. The value they gain from owning a house is not that it increases in value–but that it is a place to live, which gives them benefits. Those benefits–having a place to live, being happy, etc, helps them earn money, i.e. creating value, which can be used to pay off their mortgage, including interest. That’s not even essential–I can hate a house I buy using borrowed money, never live in it, never rent it out, but still pay the mortgage as long as I have a job. There is no inevitable economic failure as long as that house isn’t my only way to create value.
Or to go even further back, where does the money go when you buy a new house?
Why, it goes to the people who build the house - who assemble a bunch of parts like wood, bricks, wires, glass, drywall, tiles, etc., and assemble them into something that is worth more than the parts were individually. In other words, the money went towards creating more value.
The consumer isn’t the one creating the value. The PRODUCER creates the value.
Fractional reserve banking and the system of central banks backstopping them as it evolved over the centuries up to the changes made after the 1929 crash worked fine for almost half a century, through all kinds of problems and some quite big wars. There were bubbles and bailouts but they were small scale stuff and the system worked just fine all things considered. Then starting 30 years ago we deregulated our way back to 1928 with the end result of that in 2008 and so we’re now having discussions about whether fractional reserve banking is sustainable. It is, QED. We just relearnt the lesson that it has to be effectively regulated. Or at least some of us did, some of us haven’t and one or two never forgot in the first place.
Ok, I’m sorry. I didn’t present my argument clearly. (Actually it’s not my argument, rather one I heard and found convincing, the validity of which I am now trying to determine.) It seems you’re talking about one person. I’m talking about the system as a whole.
Let’s go back to the beginning.
1: All (or the vast majority of) money that exists is created in the form of loans, which must be repaid. Lets say the total amount of these loans adds up to x.
2: Since all money is created as loans, the total money supply is also equal to x.
3: When the loans are repaid, interest must be paid as well (let’s call the total interest i)
4: Since the total amount to be repaid (x + i) is larger than the total money supply (x), surely it follows that it is impossible for all the debt to be repaid? As any increase to the money supply will create a corresponding (but larger) increase in the total debt?
It seems to me that the whole system relies on a time lag, and on not all the lenders demanding repayment at once, and an ever increasing money supply, with an ever increasing cycle of debt.
But the system is made up of individuals. So to put it another way, if we have 10,000,000 individuals, all of whom borrow money to buy a house, and all of whom have jobs that give them an independent source of income, how do you go from that to your “problem”?
I’m going to try to answer your questions–but I think they are fundamentally based on two false presumptions about the money supply, namely: (1) all money is created in the form of loans, and (2) money and value are synonymous. So while I’m going to try to address your questions in the context they were asked, my fundamental answer is that “that’s not how the money supply works”–but it would be clearer for me if you explain my question above: how your “problem” arises when the system is made up of individuals.
First of all, money is not in the form of loans. Loans are the mechanism through which banks multiply money created by the central bank–but money is not the same as a loan (for one thing, there is some money created by central bank issuance that is then multiplied–so the money supply inevitably exceeds the amount of all loans).
Again, only true if “all money is created as loans.” This is patently false–as the money multiplier only works if there is a source of M0–say, money created by a central bank. That money is not a loan.
Money is not the same as value. If I borrow $10,000 from you, I owe you $10,000, and $1,000 in interest. Also, I have a job. Let’s say I’m an overpriced lawyer (I could be a farmer, and create value by planting crops for each of ten seasons–the reasoning is the same). I work for an hour, make $1,000. I pay you $1,000. I then work for another hour, make $1,000, pay you $1,000. At the end of eleven hours, I’ve paid off my debt completely–but without any need for more than $1,000 in money at a time.
You don’t need an ever-increasing money supply, but if you don’t have an increasing money supply you’ll get deflation–that is, the value of money will increase relative to the supply of goods and services. That’s if the supply of goods and services is increasing, of course. If the supply of money increases faster than the supply of goods and services, then you’ll get the opposite–inflation.
Money is just any good facilitates the exchange of goods and services. Suppose we used cacao beans for money. But the minute you tell someone you’ll give them goods and services today in exchange for cacao beans tomorrow, you’ve created money that didn’t exist. For that one day, there is phantom money not represented by any actual cacao beans. And eventually if we have enough transactions of this sort, we don’t need to have any actual cacao beans change hands ever, just agreements to transfer virtual cacao beans.
So banking is just one example of how money can be created “from nothing” beyond the promise to pay tomorrow for value recieved today.
As for the question about how a mortgage on a house can create value, the answer is that the total of (house - mortage) is more valuable than (no house - rent).
But does it? I was under the impression that central bank money was multiplied by a relatively large number, does the money supply always exceed the amount of loans? That would clear up the confusion right there. . any chance you have figures for this? I can’t verify its accuracy, but Paul Grignon’s Money As Debt says the opposite.
Also, a lot of people are misunderstanding the point about the mortgages and increasing value - that was simply a response to E-Sabbath who said that “If it wasn’t possible to add value, then we’d never be able to get out of debt. But since a field of grain is worth more than some dirt and some seeds, it is possible to add value to things. Thus, debt can be canceled out.” - to which I responded by asking how a house could increase similarly, ie not every loan is taken out as an investment with expected returns higher than the original loan amount. Perhaps buying a car is a better example (although accounting for a far smaller % of total loan money, obviously)
This is a much smaller multiplier than you’d expect from the official minimum reserve requirements–which would suggest a multiplier of about 15 or 16.
Yes, the money supply is always greater than the amount of loans. Why? Two reasons.
Grignon’s video is better at polemics than economics–to give but one example, it seems to act as if banks lend out more money than they have, when the reverse is true.
Let’s think about how the money multiplier actually works. How it works is (in simple terms): you start with some money, call it M0. This is “printed” by the central bank.
Let’s think of that as a stack of 1000 dollar bills. I hope you can clearly see that there are no corresponding loans to those dollar bills, because the central bank just printed them. It then issued them, let’s say as payment for the paper, ink, and printers’ salaries. No loans there either.
So first reason: “strong” money. At time one, we have Money= $1,000. Loans =0.
Second, now let’s look at the multiplier. The printer takes his $1,000, and deposits it with citibank. Citibank loans out $900 to a baker and keeps 10%. Total economy: money, $2,000 ($1,000 in the printer’s demand deposit, and $1,000 in dollar bills, 900 held by the baker, and 100 held by the bank). Bank loans: $900.
Because the bank keeps a reserve (as is required by the fed), we have created $1,000 of money while only creating $900 in loans. Again, money > debt. That is the second reason.
So grignon’s point is wrong–there is not more debt than money. But let’s go beyond that–because his premise is wrong–you don’t have a problem if you have debts of X+I and a money supply of X. Why not?
Let’s think in commonsense terms. You own property valued at $1,000. You owe $500. Are you bankrupt? No–even if you have no money- you own stuff, and there are no dollar bills in your wallet. You may need to sell some stuff when your loan comes due to get some money, but the reason you’re not bankrupt is not because you have more money than debt, but because you own property with more value than your debts. That seems obvious, yes? Value does not equal money.
I think you misinterpret what we’re saying. E-Sabbath was pointing out that value was not the same as money–that you can (for example, by growing grain) increase the value you possess without any effect on the money supply.
You responded that not all assets can, or will rise in value. That is true–but it doesn’t really repudiate e-sabbath’s point that it simply isn’t a problem when you borrow money to buy an asset worth X, and have to pay back X+I.
Beyond that, I hope you see the point I and others have been making wiht respect to your response–that increase in asset value isn’t the only way to get out of the “problem” that when you borrow X to buy something, you have an asset worth X, and owe X+I. Increases in asset value aren’t the only way for people to create new value to pay off their debts. So it simply isn’t a “problem” that not all assets rise in value.
Yes, you’ll owe more than the asset is worth (in principal + interest) if you buy such an asset. But that’s only a problem if you don’t have a source of new value. In some cases, you gain value when the asset appreciates. In some cases, it’s because the asset lets you create new value in other ways. In even more cases, it’s because you have a more-or-less independent way of creating new value (say, a job).
In all of those three cases, you can pay off both principal and interest–and in the second and third, (as in your car example), you can still pay off principal and interest even if the asset depreciates dramatically.
Missed the edit window. Two points:
First, those numbers are in billions of dollars.
Second, of course, I mean the multiplier is just under 4. I forgot that M0 is counted in M1.
So to say it another way: There are $1712 billion dollars of “strong” money–in simple terms, dollar bills printed by the fed (or equivalent instruments).
This is multiplied through the banking system to create a total money supply of 8512 billion dollars, which includes about 6800 billion dollars of bank deposits that were created through fractional reserve banking.
So, (this is very much a rough estimation–it’s ignoring and simplifying a lot of things–but I think it makes the point), banks have loaned out about 6.8 trillion dollars–because creation of money requires the bank to loan out money. However, the total money supply is about 8.5 trillion dollars. Much larger. This is inevitable when (1) some of the money supply is based on "strong money’–money printed by central banks, not created by commercial banks, and (2) because banks cannot lend out money they don’t have, and because of the reserve requirement, don’t even lend out all the money they have.
Again, I also hope this makes it obvious that money does not equal value. There is, obviously, much more than 8.5 trillion dollars of value in the american economy–the amount of money in the economy does not limit the amount of value in the economy. We only reach a point where you can’t pay back loans if (as I point out earlier), you run out of value, not if you run out of money.
The return on a mortgage has two components, and one of them can be seen by looking at car loans. The value of a car depreciates, so the value will never be greater than the sum of principal plus interest at the end of the loan. However, the cost of the loan is balanced by the value of the car as transportation. Assuming we are rational actors, the value of the car after the loan is paid off plus the value to you of having it must be greater than the loan amount, or else you wouldn’t get the loan.
Now, for a house you get both the value of living there and a possible appreciation of value of the house after the mortgage is paid off. if the value of rental equal or exceeded the monthly mortgage payment, you’d get the loan even if the value of the house does not increase.
But the value can increase. For instance, new replacement houses might cost more than the house because of inflation, and thus the value of the house increases to match replacement value. If there is population growth, and your town is built out, more buyers chasing a fixed number of houses will increase the value. This might also happen if your house is near a desirable location, like easy commuting distance to a new major place of employment. And of course there are irrational market factors also, as we have seen, and the increase in value is not guaranteed.
What regulations did you have in mind? What was in place 30 years ago that would have saved us from the current financial crisis? For that matter, and anyone can jump in here, was there any deregulation that lead to the S&L crisis of the late '80s?
As far as the Savings and Loans crisis went, Reagan applied a free market solution to the problem S and Ls were facing, that their fixed loans weren’t making them enough money to cover the new high interest rates that they were haing to pay their savers. So Reagan scrapped the regulations on who they could loan to and they made a huge number of risky loans that went bad, resulting in a collapse of a lot of them.
As far as what we deregulated from 1980 onwards, we basically gradually stopped enforcing regulations that we had on the books. We allowed regulatory arbitrage, financial firms to shop around between the various regulators to find which one would regulated them the least. Actual banking, the process of taking deposits and making loans had been the way that we’d channeled funds from savers to borrowers. But the rise of the ibanks or shadow banking or whatever you want to call Wall Street’s takeover of the credit intermediation system took over this part of banking to a large extent. And these banks, Like Lehman and Goldman, didn’t have depository insurance, the insurance being one of the main reasons we didn’t have one single systemic crisis between 1929 and 2007 when they used to happen once every decade or so before that. And most of the shadow banks’ funding came from the overnight market, so when things started to go south in 2008 their overnight funding disappeared (like in the case of Lehman). We also didn’t regulate derivatives trades or derivatives themselves and eventually this market mushroomed to the extent that naked trades and trades not to hedge or insure against actual market fluctuations but trades just to bet on the direction of markets became a bigger chunk of the market than the original market. Basically the side action grew bigger than the actual action. If this kind of thing had been going on back in the 1920s you can bet FDR would have regulated it in the 1930s.
But the deregulation that allowed the housing bubble came after 2001. Here’s a big chunk of a previous post :
Firstly there had to be more mortgages to make securities out of, so in 2003 the Bush administration scrapped a huge stack of mortgage regulations, actually taking a chainsaw and tree shears to a paper stack of regulations at a press conference attended by a bunch of regulators, people who were generally banking lobbyists who’d spent their careers trying to get regulation scrapped and were now appointed by Bush to do the regulating in a fox/henhouse strategy to deal with financial regulation. Here’s a picture of the presser :
See the guy on the left of that photograph? He was responsible for regulating AIG, and the one person in his agency qualified to regulate insurance derivatives business did so from his office in the midwest. AIG’s derivatives operation being run in London, England, didn’t help effective oversight and neither did AIG telling the regulator that they didn’t want to discuss any aspect of their business with him (and the guy in the picture OKing that stance.)
Instead of mortgage originators having to hold mortgages to maturity, something that obviously encouraged mortgage originators to maintain sensible lending standards, they were now free to sell them as soon as they wrote them to a Wall Street desperate to get their hands on quantity to slice and dice for securities. The only requirement was that a borrower not default for 90 days.
So firms like Countrywide came up with new products that gave borrowers a cheap teaser rate for two or three years that was cheaper than renting. They were told “don’t worry when the rate resets as you can always refinance.” Whether they could or not didn’t matter as by then the mortgage had been sold to Wall Street and securitised and was somebody else’s problem.
You can see from this chart how the number of post-chainsaw deregulated supprime exploded. This graph shows when the mortgage interest resets happened, and as you can see they surged (and people stopped paying the new increased payments) just before when the banks started realising they had a problem and their funding dried up, precipitating the meltdown :
The vast majority of bad lending wasn’t even subprime. Losses from prime loans have already dwarfed subprime losses and there’s huge amounts of prime defaults yet to come, an impending commercial real estate crash not too far off as well. Subprime was just the canary in the coalmine and a handy way for the right to blame the meltdown on ethnic minorities.
But when mortgage companies went on a lending rampage of lending to people who shouldn’t have had mortgages, people who were previously known as “renters”, there was a mechanism to prevent it happening. We’d already had something very similar in the 1920s so a bunch of FDR-era regulations and regulators existed to prevent any wide-scale predatory lending from happening again. I’ll let the New York AG take up the story there :
*Several years ago, state attorneys general and others involved in consumer protection began to notice a marked increase in a range of predatory lending practices by mortgage lenders. Some were misrepresenting the terms of loans, making loans without regard to consumers’ ability to repay, making loans with deceptive “teaser” rates that later ballooned astronomically, packing loans with undisclosed charges and fees, or even paying illegal kickbacks. These and other practices, we noticed, were having a devastating effect on home buyers. In addition, the widespread nature of these practices, if left unchecked, threatened our financial markets.
Even though predatory lending was becoming a national problem, the Bush administration looked the other way and did nothing to protect American homeowners. In fact, the government chose instead to align itself with the banks that were victimizing consumers.
Predatory lending was widely understood to present a looming national crisis. This threat was so clear that as New York attorney general, I joined with colleagues in the other 49 states in attempting to fill the void left by the federal government. Individually, and together, state attorneys general of both parties brought litigation or entered into settlements with many subprime lenders that were engaged in predatory lending practices. Several state legislatures, including New York’s, enacted laws aimed at curbing such practices.
What did the Bush administration do in response? Did it reverse course and decide to take action to halt this burgeoning scourge? As Americans are now painfully aware, with hundreds of thousands of homeowners facing foreclosure and our markets reeling, the answer is a resounding no.
Not only did the Bush administration do nothing to protect consumers, it embarked on an aggressive and unprecedented campaign to prevent states from protecting their residents from the very problems to which the federal government was turning a blind eye.
Let me explain: The administration accomplished this feat through an obscure federal agency called the Office of the Comptroller of the Currency (OCC). The OCC has been in existence since the Civil War. Its mission is to ensure the fiscal soundness of national banks. For 140 years, the OCC examined the books of national banks to make sure they were balanced, an important but uncontroversial function. But a few years ago, for the first time in its history, the OCC was used as a tool against consumers.
In 2003, during the height of the predatory lending crisis, the OCC invoked a clause from the 1863 National Bank Act to issue formal opinions preempting all state predatory lending laws, thereby rendering them inoperative. The OCC also promulgated new rules that prevented states from enforcing any of their own consumer protection laws against national banks. The federal government’s actions were so egregious and so unprecedented that all 50 state attorneys general, and all 50 state banking superintendents, actively fought the new rules.
But the unanimous opposition of the 50 states did not deter, or even slow, the Bush administration in its goal of protecting the banks. In fact, when my office opened an investigation of possible discrimination in mortgage lending by a number of banks, the OCC filed a federal lawsuit to stop the investigation.* http://www.washingtonpost.com/wp-dyn…021302783.html
So now the banks hd huge piles of garbage mortgages. All they had to do was turn them into securities and sell them and they’d make serious money. Except to turn these crappy mortgages into AAA-rated paper would be impossible as the people responsible for rating them would never issue AAA ratings to crappy mortgages once they analysed the loan tapes and the other paperwork, right? You know what’s coming next, yes, ratings agencies had been left to self-regulate too. Analysts were actually fired if they refused to rate stuff they knew was garbage. Here’s one small piece of evidence that became public knowledge a while ago, an IM conversation between two analysts :
Rahul Dilip Shah: btw – that deal is ridiculous.
Shannon Mooney: I know right … model def does not capture half of the risk
Shah: we should not be rating it.
Mooney: it could be structured by cows and we would rate it.
Here’s another one :
Oct. 22 (Bloomberg) – Employees at Moody’s Investors Service told executives that issuing dubious creditworthy ratings to mortgage-backed securities made it appear they were incompetent or ``sold our soul to the devil for revenue,‘’ according to e-mails obtained by U.S. House investigators.
The e-mail was one of several documents made public today at a hearing of the House Oversight and Government Reform Committee in Washington, which is reviewing the role played by Moody’s, Standard & Poor’s and Fitch Ratings in the global credit freeze. http://www.bloomberg.com/apps/news?p…4Rc&refer=home
So now it was possible to create AAA-rated paper, the same credit rating s US bonds and stuff banks could describe as Tier 1 capital on their balance sheets, out of million dollar mortgages made to unemployed meth dealers. And then you had huge side-bets on these garbage securities via derivatives like credit default swaps which ended up a far bigger market than the value of the actual securities themselves.
And on top of that in 2005 you had the SEC allowing firms like Lehman and Goldman to lever up their debt:assets ratio from 10:1 to 30 and 40:1 because they had all this rock-solid unregulated paper to hedge all their risk down to negligible levels. So when the subprime reset problems started these firms were sitting on wafer thin capital ratios made up of garbage capital and once the overnight funding market started realising this we got our meltdown.
