Contagion.

This post is about Europe, banks, money supply and contagion. If you don’t think you care, now would be a good time to stop reading. But, honestly, you really should care, and this post will clear you up on why we are screwed.

It is a little wonky and slightly arcane, but it is highly relevant to the global financial quagmire we find ourselves in today. I honestly don’t believe Congress understands anything about finance. Most lawyers hate finance and generally got poor grades in whatever minimal finance courses they took as undergraduates. There are NO finance courses in law school (or at least, when I went to law school there weren’t) and I am sure the bankers are happy about that, because most Congressmen are lawyers.

I have known several congressional aides and congressmen. All of them swear they never read any of the legislation that crosses their desks, and then subsequently bears their vote as it passes thought Congress on its way to becoming a law. So, let’s assume that unfortunately for us, Congress doesn’t understand finance. After you read this piece, you will be better prepared than most Congressmen to vote for, or against whatever hopeful legislation is wheeled out in the final minutes, to ward off the impending financial disaster, as this year grinds to a close and we slide toward the fiscal cliff.

So, there are two fiscal concepts that affect our global crisis, because combined, they facilitated a large part of the current fiscal dilemma. One is known as fractional reserve banking and the other is called duration mismatch. The former is perfectly fine, both morally and economically (another post), but the latter is not so fine. Combined, as they are, they lead to fiscal disaster.

Fractional-reserve banking is a form of banking where banks maintain reserves (of cash and coin or deposits at the central bank) that are only a fraction of the customer’s deposits. Funds deposited into a bank are mostly lent out, and a bank keeps only a fraction (called the reserve ratio) of the quantity of deposits as reserves. Some of the funds lent out are subsequently deposited with another bank, increasing deposits at that second bank and allowing further lending. As most bank deposits are treated as money in their own right, fractional reserve banking increases the money supply, and banks are said to create money. Due to the prevalence of fractional reserve banking, the broad money supply of most countries is a multiple larger than the amount of base money created by the country’s central bank. All banks practice this form of banking and it is technically legal to a greater or lesser degree in all countries as determined by the rules of their central banking organizations. Depositors know this going in. (Don’t you?)

Duration mismatch is when a bank borrows short to lend long.  Unlike fractional reserve, duration mismatch is bad.  It is fraud, it is unfair to depositors (much less, shareholders) and it is certain to collapse sooner or later.  This is not a matter for statistics and probability, i.e. risk.  It is a matter of causality, which is certain.

In our paper monetary system, the dollar is in a “closed loop”.  Dollars circulate endlessly.  Ownership of the money can change hands, but the money itself cannot leave the banking system.  Contrast with gold, where money is an “open loop”.  Not only can people sell a bond to get gold coins, they can take those gold coins out of the monetary system entirely, and stuff them under the mattress. This is a necessary and critical mechanism—it is how the floor under the rate of interest is set.

This bears directly on banks.  In a paper system, they know that even if some depositors withdraw the money, they do not withdraw it to remove it altogether.  Depositors generally withdraw money to spend it.  When someone withdraws money in order to spend it, the seller of the goods who receives the money will deposit it again.  From the bank’s perspective, nothing has changed other than the name attached to the deposit.

The assumption that if some depositors withdraw their money, they will be replaced with others who deposit money may seem to make sense.  But this is only in the current context of irredeemable paper money.  It is most emphatically not true under gold!

Let’s say that Joe has 17 ounces of gold that he will need in probably around a month.  He deposits the gold on demand at a bank, and the bank promptly buys a 30-year mortgage bond with the money.  They assume that there are other depositors who will come in with new deposits when Joe withdraws his gold, such as Mary.  Mary has 12 ounces of gold that she will need for her daughter’s wedding next week, but she deposits the gold today.  And Bill has 5 ounces of gold that he must set aside to pay his doctor for life-saving surgery.  He will need to withdraw it as soon as the doctor can schedule the operation.

In this instance, the bank finds that their scheme seems to have worked.  The wedding hall and the doctor both deposit their new gold into the bank.  “It’s not a problem until it’s a problem,” they tell themselves.  And they pocket the difference between the rate they must pay demand depositors (near zero) and the yield on a 30-year bond (for example, 5%).

So the bank repeats this trick many times over.  They come to think they can get away with it forever.  Until one day, it blows up.  There is a net flow of gold out of the bank; withdrawals exceed deposits.  The bank goes to the market to sell the mortgage bond.  But there is no bid in the mortgage market (recall that if you need to sell, you must take the bid).  This is not because of the borrower’s declining credit quality, but because the other banks are in the same position.  Blood is in the water.  The other potential bond buyers smell it, and they see no rush to buy while bond prices are falling.

The banks, desperate to stay liquid (not to mention solvent!) sell bonds to raise cash (gold) to meet the obligations to their depositors.  But the weakest banks fail.  Shareholders are wiped out.  Holders of that bank’s bonds are wiped out.  With the cushions that protect depositors gone, depositors now begin to take losses.  A bank run feeds on itself.  Even if other banks have no exposure to the failing bank, there is panic in the markets (impacting the value of the other banks’ portfolios) and depositors are withdrawing gold now, and asking questions later.

And why shouldn’t they?  The rule with runs on the bank is that there is no penalty for being very early, but one could suffer massive losses if one is a minute late.

What happened to start the process of the bank run?  In reality, the depositors all knew for how long they could do without their money.  But the bank presumed that it could lend it for far longer, and get away with it.  The bank did not know, and did not want to know, how long the depositors were willing to forego the use of their money before demanding it be returned.  Reality (and the depositors) took a while, but they got their revenge.  Today, it is fashionable to call this a “black swan event.”  But if that term is to have any meaning, it can’t mean the inevitable effect caused by acting under delusions

Without addressing the moral and the legal aspects of this, in a monetary system the bank has a job: to be the market maker in lending.  Its job is not to presume to say when the individual depositors would need their money, and lend it out according to the bank’s judgment rather than the depositors’.  Presumption of this sort will always result in losses, if not immediately.  The bank is issuing counterfeit credit. In this case, the saver is not willing (or even knowing) to lend for the long duration that the bank offers to the borrower.

Do depositors need a reason to withdraw at any time gold they deposited “on demand”?  From the bank’s perspective, the answer is “no” and the problem is simple.

From the perspective of the economist, what happens is more complex.  People do not withdraw their gold from the banking system for no reason.  The banking system offers compelling reasons to deposit gold, including safety, ease of making payments, and typically, interest.

Perhaps depositors fear that a bank has become dangerously illiquid, or they don’t like the low interest rate, or they see opportunities offshore or in the bull market.  For whatever reason, depositors are exercising their right and what they expressly indicated to the bank: “this money is to be withdrawn on demand at any time.”

The problem is that the capital structure, once erected, is not flexible.  The money went into durable consumer goods such as houses, or it went into partially building higher-order factors of production.  Imagine if a company today began to build a giant plant to desalinate the Atlantic Ocean.  It begins borrowing every penny it can get its hands on, and it spends each cash infusion on part of this enormous project.  It would obviously run out of money long before the plant was complete.  Then, when it could no longer continue, the partially-completed plant would either be disassembled and some of the materials liquidated at auction, or it would sit there and begin to rot.  Either way, it would finally be revealed for the malinvestment that it was all along.

By taking demand deposits and buying long bonds, the banks distort the cost of money.  They send a false signal to entrepreneurs that higher-order projects are viable, while in reality they are not.  The capital is not really there to complete the project, though it is temporarily there to begin it.

Capital is not fungible; one cannot repurpose a partially completed desalination plant that isn’t needed into a car manufacturing plant that is.  The bond on the plant cannot be repaid.  The plant construction project was aborted prior to the plant producing anything of value.  The bond will be defaulted.  Real wealth was destroyed, and this is experienced by those who malinvested their gold as total losses.

Note that this is not a matter of probability.  Non-viable ventures will default, as unsupported buildings will collapse.

People do not behave as particles of an “ideal” gas, as studied by undergraduate students in physics.  They act with purpose, and they try to protect themselves from losses by selling securities as soon as they understand the truth.  Men are unlike a container full of N2 molecules, wherein the motion of some to the left forces others to the right.  How actual men in an open container behave is, as some try to sell out of a failing bond, others try to sell out also.  And they are driven by the same essential cause.  The project is non-viable; it is malinvestment.  They want to cut their losses.

Unfortunately, someone must take the losses as real capital is consumed and destroyed.  A bust of credit contraction, business contraction, layoffs, and losses inevitably follows the false boom.  People who are employed in wealth-destroying enterprises must be laid off and the enterprises shut down.

Busts inflict real pain on people, and this is tragic as there is no need for busts.  They are not intrinsic to free markets.  They are caused by government’s attempts at central planning, and also by duration mismatch. 

I have not really preferred the word “contagion.” When an effect happens, even in the monetary system, it has a cause. This is generally not merely that a similar thing is happening across a nearby border. The word contagion has connotations that because something is happening in Country X, then that by itself means it will somehow happen in Country B. I just do not think it works this way.

But something is going on in Europe today that I think fits the word “contagion” perfectly. It is becoming increasingly obvious that the Greek banks will collapse. The Greek government is too weak to prop them up much longer, and the Eurocrats are growing tired of throwing money into a bottomless pit. In addition, the Greek banks (like the others in Europe) were used to prop up the Greek government by buying Greek government bonds.

In Greece today there is a game dynamic that goes something like this. The first to withdraw their money from the banks gets out whole. Those who wait too long will lose something between part and all of their money, depending on how the government and other actors move the planchette on the Ouija board.

It is perfectly safe to withdraw a year early. Waiting until a minute too late could result in total losses. And of course a run on the bank will accelerate failure.

Contagion. n. When people in Portugal, Ireland, Italy, and Spain come to the same realization.

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