When you put your money in a bank, the bank is now the owner of that money. You are an investor, that’s why you receive interest. Your current bank balance does not represent how much money the bank is holding for you, but rather how much debt the bank has to you. This is an important distinction, because you can have more debt than you have actual money, and so can a bank. What happens if you have more debt than money and you go bankrupt? Creditors line up in order to get whatever’s left of your assets to recoup their losses partially. But what happens when a bank goes bankrupt? First of all, usually people at the top already know and so do their compatriots with money in the bank. They know it’s going to end badly, so they move their funds. Then, as the news spreads, the smarter people will start withdrawing their funds as well. Because banks are part of a system of banks, the collapse of one affects all others negatively. This effect is so strong that it can undermine the trust in the currency these banks manage. That’s why these funds are usually converted into assets and other things that can protect these people from a drop in the value claimed by the currency. After all, a bread is a bread, but if you need twice the amount of currency to buy it compared to before, you’ve effectively lost half of your money. The opposite also holds true. If you have assets during a currency devaluation, you don’t lose value since if you sell your assets you have more units of currency claiming the same purchasing power.
After the big money withdrawal phase, the bank has a problem. Wealth is concentrated in the hands of the competent and through government, in the hands of the corrupt as well. Only a relatively small percentage of bank customers with big accounts need to move their money for the bank to suddenly lack the funds to cover even basic daily cash withdrawal needs. When the majority of people start to see the problems and they start to withdraw their funds in increasingly larger groups and amounts, a so called “bank run” occurs. The bank doesn’t actually have most of that money as cash. It’s mostly outstanding debt creating through a crime called fractional reserve lending, where debt is used to create more debt. To get an idea of how bad this is, these are roughly the steps that are repeated indefinitely:
1. Someone puts money in a bank
2. The bank keeps a small percentage “in reserve” and loans out the rest
3. Whoever borrowed the money either spends it or puts it in a bank
Usually it doesn’t take long before we’re back at step 1 again, if the money ever leaves the banking system to begin with as most payments these days are still from a bank to a bank. The problem lies in step 2. It relies entirely on the account holders to not withdraw more money than is held in reserve.
Let’s say the bank keeps 5% in reserve of a 100 USD deposit and loans out 95 USD to a second person, who puts that money in the bank. The bank keeps 5% of that 95 USD in reserve and loans out 90.25 USD to the next person. Already with just two deposits and three loans, there’s 195 USD on the accounts but only 5 USD covering it. This isn’t much of a problem while debt is being shoveled around between banks, but it completely relies on enough people keeping their money in the banking system. Since there’s a system of banks, and they’re all doing this, nobody actually knows how many units of currency are in circulation or how much money there actually is to cover these debts. This problem is only exacerbated by the privately owned Central Banks through printing unholy amounts of new currency, because that money is also put in a bank or worse, they buy assets like stocks with the newly printed money “to stimulate the economy“.
Once people realize this and start running to move their savings into something safer, the banks do the only thing they can do. They limit the amount of cash each individual customer can withdraw. This of course sends the masses in a panic, as they try to withdraw enough cash to secure their immediate future. Who knows if or when and how much the limits will be lowered further? This uncertainty only makes the existing problem worse.
The problems are exaggerated further through interest, because it creates more debt, which is no different from money in the banking system. Interest in itself is not a problem. Say we have two people, Alice and Bob. Alice has an extra 100 units of ‘currency c’. Bob wants to start a business and needs a 100c to start it. He promises Alice that if she loans him the money, he’ll pay 30c back every year for 5 years. Alice risks losing her money, but it’s a mitigated risk because Bob pays her back in part every year.
There isn’t a problem because Alice has to earn that money in order to be able to lend it to Bob. If Bob defaults because his business doesn’t pan out, then she loses her money. Alice has to carefully assess whether Bob is a trustworthy person capable of delivering on what he’s promising, and then she has to take the risk of losing her investment into account when determining how much of a reward she needs to make the deal worthwhile. So what if, hypothetically, Alice didn’t need to earn that money? She could just take it from other people? Would she be as careful in handing out loans? Unlikely.
Unlike this model, a Central Bank just creates more money. It prints it into existence, so there’s no reason to risk assess anything. Since there’s no need to convince the Central Bank to give out the loan, the Government has no need to be careful or even be responsible with spending. See Rand Paul’s rant on government spending, which is both hilarious and terrifying. Both Alice and Bob have been replaced by the people in power. Economic productivity and risk do not matter to these people, because they’ll just increase taxes or print more money.
But wait, it gets so, so much worse! Because there’s interest on these debts, there’s now a market to trade these debts. These debts are repackaged with fancy names and sold as a kind of bonds, where someone buys this debt under the expectation of receiving interest on them. This is what caused the collapse in 2008. A lot of these repackaged debts were actually mortgages, consumption loans to fund homes. Unlike production loans, there is no actual added value to the economy. Money is spent and it’s gone. No new permanent jobs are created, no new products or services are sold. It’s just taking money from the future and spending it now. Houses depreciate over time because they require constant upkeep. Only when the demand for houses in area exceeds the supply will the prices go up naturally. How then can there be a severe decline in people buying houses and yet the housing prices keep going up? It’s artificial. By encouraging people to take out huge unnecessary loans, the prices are driven up. When the housing prices crashed to the point where it became less expensive to default on the loan than to keep paying, people just bailed out and the banks were left with incredible losses and near-worthless property. The hedge funds and pension funds that bought all that bad debt suddenly had a lot less money coming in than expected as well. This time around, it’s not just a large amount of bad housing debt. It’s national debts from countries like Greece, repackaged and sold as “good investments” to the market. The scale of the next collapse is going to be something scary if I’m even remotely correct about what I’m expecting.
In 2008, a few banks fell and nearly dragged down the entire financial system. This time, all of them are in trouble. I just can’t see that ending well for us regular people unless we prepare. Keep an eye on those housing markets and remember you don’t have to outrun the bear market, you just have to outrun the slowest people.