Where’d the Money Go?
By: BJ Lawson
Often when I talk to people, questions come up about the current subprime/mortgage crisis and just how serious its impact is on our banking and financial system. This recent CNN/Money article does a good job of summarizing the “writedowns” announced and projected by major commercial and investment banks, and the impact that those writedowns will have on the broader credit markets.
So what’s going on here? Why does the system seem so fragile, and how can some bad mortgage loans amplify into a “$2 trillion lending crunch”?
Quite simply, when you create money out of thin air, it can (and does) just as easily disappear back into thin air. It’s all about leverage — $100 deposited at the bank allows the bank to create $90 in new loans (assuming a typical 10% “reserve ratio”). Those new $90 then go into circulation through the bank’s customers, and most of those $90 are put on deposit again, which creates more reserves, and results in still more loans. Lather, rinse, repeat… and you end up with a tremendous pile of money on top of a tremendous pile of debt.
So that’s how a fiat currency and “fractional reserve” banking work in building up the money supply. What should also be clear, however, is how such a system will work equally aggressively in reverse. When a loan is made that is determined to be “bad”, or an asset listed on the books of the bank is found to be suddenly much less valuable then previously believed, then the bank has a problem. If its reserves decrease, then it needs to replace those reserves, or reduce its lending proportionately. That may mean restructuring, seeking additional investment, shutting off lines of credit to businesses, calling in loans, or begging for help from the Federal Reserve.
When a bank suddenly stops lending, businesses that need credit suffer. When a bank calls in loans, businesses really suffer. Suddenly reserves are being pulled out of the system, and the contraction ripples through the system in reverse. None of those things are good for sustained economic growth, or the health of the economy.
So what about the Fed? Ultimately, in a fractional reserve banking system, we need a central bank. The Federal Reserve’s ability to be the “lender of last resort” and be the ultimate source for creating fiat money out of thin air ensures that we won’t have obvious bank failures… but unfortunately the new money created to keep the inherently unstable system solvent causes inflation and the destruction of your dollars’ purchasing power.
Over the past 20 years, your dollar has lost 46% of its purchasing power, or equivalently, prices have run away from your dollar by 84%: $1.84 in 2007 is required to buy $1.00 in 1987, according to the Bureau of Labor Statistics’ Inflation Calculator. It’s not a mystery why this occurs, it’s a fundamental consequence of a system in need of help. There is a better way, however. Sound money, and sound banking, result in price stability and sustained, long-term, stable economic growth. Our nation doesn’t remember what that looks like, however, so it’s going to take some education to get there.
Addendum: When you’re ready to laugh about these events, check out this video:
March 30th, 2008 at 9:33 am
[...] http://blog.lawsonforcongress.com/2007/11/19/whered-the-money-go/ [...]
July 11th, 2008 at 1:27 am
[...] for their loans. Even worse, money that was created out of nothing through borrowing just as easily disappears back into nothing as asset values plummet — so when the music stops, the chairs start disappearing from the [...]
September 20th, 2008 at 11:57 pm
[...] for their loans. Even worse, money that was created out of nothing through borrowing just as easily disappears back into nothing as asset values plummet — so when the music stops, the chairs start disappearing from the [...]