The first thing you didn’t want to know about is something called “fractional reserve banking”. The sound of those three words is enough to make your eyes glaze over and your mind welcome sleep. Learning what they mean feels like it will make your teeth hurt. But “fractional reserve banking” has been at the very heart of our financial system for 95 years and it is arguably a primary source of the boom and bust cycle and a key contributor to the coming runaway inflation.
Here’s a simple example of how it works:
Let’s say the Federal Reserve loans $100 to Bank A. Through “fractional reserve banking”, Bank A is allowed to “create” $1,000 but must keep 10% or $100 in their vaults as a reserve. Instead of loaning the remaining $900 to a consumer, Bank A decides to loan it to Bank B. Bank B now “creates” $9,000 and can loan $8,100 to consumers while keeping $900 in reserve. So, $10,000 has been created from $100 and Bank A and B only have to keep a combined total of $1,000 in reserve in case one of them or the consumer defaults. This is all perfectly legal unless you or I try to do it – then it is called fraud.
The argument for this system is that it creates capital and drives growth. The supporters of this system argue that fractional reserves provide banks with money to loan to businesses to create jobs and the economy benefits. As long as there is growth, the serious problems with this system go unnoticed. In times like we are now living in, the system begins to fall apart.
Many of us have likely subjected ourselves to Frank Capra’s movie “It’s a Wonderful Life” at least once when it plays during the Christmas season. There is a chaotic scene in the movie where Jimmy Stewart is trying to convince the depositors in his bank not to take all their money out. He says that he has loaned it to their neighbors, that he doesn’t have it because he used it to help members of the community. Would that that was true these days. Many of the loans that the banks have made in the current crisis were mortgages either to people who could not afford them at the time they got them or who can no longer afford them given job losses and the inflationary cost of food and fuel. So we have a situation where banks have created money to make loans that aren’t being paid back and they are having to write off those loans.
But there is a more fundamental problem. We have what is called a “fiat currency”. That means that there is no gold or silver sitting in a vault somewhere that you can go to and redeem your paper money. A dollar is worth a dollar essentially because we said so; and for the past 30 years as we deregulated our financial system everyone bought into that idea. Now – not so much. Nations around the world hold a great deal of our debt in the form of Treasury bonds and they are seeing them decrease in value as the dollar weakens against the other currencies. Experts argue that none of them will start dumping those T bills because it is in their interest not to further degrade their value. This is the “too big to fail” argument and it has some merit. But it only takes one nation or one entity to start a crash and right now we are playing chicken with pretty much everyone else in the world.
The second thing you didn’t want to know about is that the federal laws against usury were repealed in 1980 during the Carter administration. Up until then there was a cap of 10% interest on any loans. States could have their own usury laws but could not exceed the federal maximum. Inflation during the years of the Carter administration provided the pressure to repeal the laws and increasingly states have modified or abandoned their own restrictions. You may have seen a reference to a recent attempt in Congress to cap credit card interest rates at 40% – it failed to pass.
So that is the situation that we are in these days. We have created money from nothing and we have agreed to pay whatever interest the market will bear. We have an economic proposition that requires a global belief system that seems to be fraying. The more money we pump into failing banks (whether it is through the Federal Reserve “creating” $29 billion to bail out Bear Stearns or the Congress approving a taxpayer funded $300 billion credit line for Fannie Mae and Freddie Mac) the more we push air into the inflationary balloon that drives up the cost of food and fuel and degrades the value of real estate as a result of foreclosures.
We are treating the symptoms these days. The problems seem so massive that the best the political class has been able to muster is a promise of greater regulation. Unfortunately, the problems are more fundamental than capping interest rates – if that even becomes possible. The only way to solve these problems is for all of us to understand the system that we have agreed to and determine if we want to continue to support it.
Don’t get mad – get educated.
Christian Bale, 34, stars in The Dark Knight, the Batman series, which broke all box office records when it opened in the US on July 18th. This should have been the crowning glory of his young life. He should be on top of the world, ready to take his career to the next level with tons more money for future roles (the first Batman movie that he did several years ago, Batman Returns was a blockbuster as well). But instead this may be a low point since his mother and sister filed assault and battery charges against Bale in London on Sunday, the day before his picture opened in England.
