Modern Banking: Creating Booms and Busts

0:00How many people have a bank account in the crowd? Yeah? Okay, so you already know about banking. I put this up here because there's a number of people in the country that are either unbanked, and that's 28 million people or 15 million households, and there are people who are underbanked. And I'm sure those who are underbanked really carry that burden around with them. But 24 million households just do not have enough banking in their life, at least according to the banking industry. And why does the banking industry want your money?

0:47Well, we're going to talk about that a little bit today. And I have to start with the idea that there's two kinds of banking. There's loan banking, and there's deposit banking. Now, I have to assume that most of you are engaged in deposit banking. In other words, you get a little money, or you get a lot of money, as the case may be, and you put it in the bank. And legitimate deposit banking would involve the bank honoring property rights, right? You've essentially hired them to keep your money for you. So that when you want to use it, you can go back and take it out, or write checks against it, or whatever you might want to do.

1:39Now, there's something else called loan banking. And that's straightforward enough. If you say, I want to save money and I want to start a bank, I raise some equity capital, and then the idea of my bank would be to loan the money out, loan the money out to people who had projects or a business or lend it to Mama Goldberg's next door so they could make sandwiches and make money, and then they would repay the loan, depending on their sandwich In which business? Of course the bank would be, bankers would be experts at where these loans should be made and who they should be made to.

2:26And so that'd be the idea behind loan banking. Loan banks would, they'd go bankrupt. If the loans didn't get paid off, the banks would go out of business. It's a very simple concept and pretty easy to understand. If you didn't run a loan bank correctly, loans didn't pay off, you'd be broke. Now there are types of loan banks out there, hard money lenders is what they're referred to as, or finance companies, or factoring companies. Factoring companies actually lend against a company's accounts receivable, and they would actually take title to those accounts receivable and instead of whoever owed that account receivable paying the company, they would pay the factor, they'd pay the finance company who had lent money against that receivable.

3:24And that's how those loans would be paid off. So loan banking is pretty straightforward and it's easy to understand. And also, deposit banking is pretty straightforward and easy to understand, right? You put your money in the bank and you expect that it's there waiting for you when you want it. You want to write a check to University of Auburn for tuition. If Cam Newton pays you for one of your term papers, you would deposit that check. Thank you. You know, it's a very cheap shot. I told a Cam joke in Greenville last week and barely got any laughs. So it's nice that you guys are up to speed on that. So anyway, you would put his check in the bank, presuming it would clear and be able to use that money Somewhere else.

4:31The problem has come with the merging of loan banking and deposit banking. And this started way back when the goldsmiths used to hold people's gold, and the goldsmiths figured out that, gee, people didn't come for their gold all the time, and they're holding in this gold and they thought, you know, I've given people receipts for their gold and they don't always come back to redeem their gold, so why don't I just issue more receipts than there is gold? And that's more or less how fractional reserve banking was born. And there is a series of legal cases in England that really unleashed fractionalized banking.

5:25Because when you think about the idea that when you put $100 in the bank, I got news for you, the $100 isn't there. They've lent it to somebody else. They've lent at least $90 of it probably to somebody else. In some cases, they've lent all 100 of it to somebody else. So when you put money in the bank, it's not sitting there. They say it's sitting there. You have a statement that says it's there, but it's not there. They've lent it to the person down the street. They've lent it to Mama Goldbergs, or they've lent it to Firehouse Subs, or Chick-fil-A, or whoever it may be. So you might ask, wow, how do bankers get away with this?

6:12Well, in the 1800s there was a series of three cases that I won't bore you the details on, but unfortunately the judge, at least in one case, said the money paid into the bankers becomes immediately part of his general assets and he is merely a debtor for that amount. In other words, they were treating deposits not as a bailment, not as money that the banker

7:09In the Comancheros, there is a circuit court judge named Thaddeus Jackson Breen, and he is played by Edgar Buchanan, and he says to Paul Regrat, who was played by Stuart Westman, Major here has told me what your troubles are, and I've been thinking it over, and in light of my 40 years experience in legal jurisprudence, I have come to the positive conclusion that there ain't no way to do this legal and honest, but being good sensible Texans will do it illegal and dishonest.

7:58Now that pretty much explains how fractionalized banking, or what we're going to talk about today, came into being. So, anyway, and how it's going to relate to bubbles and busts, which is the other part of the story here. So fractional reserve banks by themselves would be fairly contained if they were operating in a free market and there was no central bank to backstop them. Then if you had an account and you wrote a check to someone and they came to your bank to redeem that check, you can see very quickly that if the bank has loaned out all their for Money that the single bank would go under.

8:58So free banking, even in a fractional reserve system, would probably lead to 100% reserve banking, because it just couldn't survive, it couldn't survive operating under fractional and Reserves, but what glues this all together is the idea of a central bank. And the central bank, which in our modern terms, of course, are the United States, is the Federal Reserve. And the Federal Reserve essentially cartilizes the banking system and it makes all banks part of one system.

9:45And that way they are able to keep the fractionalized banking system alive. So when you put $100 in the bank, they can loan out 90 of it and stay in business because the Federal Reserve ties all the banks together and keeps the system going. And I want to show you how to do this, but the first thing I want to show you is a couple One thing, and it's the money supply, and the money supply has continually gone up over the course of many years, and that would be the M2 money supply.

10:41So you can see that banks are creating money at a pretty fast clip. If you look down here at 1970, right in there is where the President Nixon cut the last ties to the gold standard. And since the American dollar is not tied to gold anytime since then, you can see what's What's happened to the money supply? It's grown exponentially. You can see before that, it really was fairly stable for centuries, but then they cut the last ties to gold, and then through the fractionalized banking system that we're going to go into, it has created lots of money.

11:35So how do we do this? How does this happen? Well, the first thing here is, we'll kind of run through this. Oh, good. How does the commercial banking system inflate with the aid of the central bank? So, first of all, and you've heard about this QE2 thing recently, where the Fed buys as Treasuries say, in our case, from Citibank. So Citibank has bought, say in our case, $1,000 in Treasuries from Citibank. In other words, Citibank had $1,000 in Treasuries. The Federal Reserve bought $1,000 of those, and the $1,000 is reserves on Citibank's books.

12:27And then we have, in this particular situation, we've got demand deposits, this is a checking account from Mr. Jones over here, and on the balance sheet of the Fed, they now have the government securities that Citibank had, and then Citibank has the band deposits over at the Federal Reserve of a thousand bucks. Now you might ask, well, where did the Fed get the thousand bucks to buy the Treasury banks? Well, they created it out of thin air, out of nowhere, it's a record on their books. They don't have a thousand bucks, they never had a thousand bucks, they just created it out of nowhere.

13:12So that's step number one in our story, and that probably is not too troublesome. But then we'll see what happens next, because Citibank isn't going to just sit there and do nothing, Citibank's going to lend that money out. And in our case, they're going to retain a reserve ratio of 10%. In other words, we're going to assume that through the current banking rules that they can't lend out all these deposits, but they're going to keep 10% for a reserve ratio, and the rest they can loan out. So they've got this thousand in reserves, remember Jones had a deposit account, just like your deposit accounts over here, and they're going to make a loan to Donald Trump Because Donald Trump's a guy who always needs money, and he's a guy who knows how to borrow it.

14:15So you can see what happens. We've got the reserves of a thousand bucks, we've got the loan to Trump as an asset, and over here on the equity and liabilities, we've got the demand deposit for Jones. Now that's the money they lent. They lent Jones' thousand bucks, or 900 of Jones' thousand bucks, But Jones' money doesn't go anywhere. It stays. And then the loan they made to Trump, he deposits in his account at Citibank. So he's got a $900 deposit account there. So the total over here is $1,900, and the total over there is $1,900. Now, the next step then, and this will go pretty fast, But Trump, of course, is the kind of guy that he needs to borrow money, he needs to immediately pay money.

15:08And he owes his ex-wife, Ivana, some money, so he's got to write her a check. And Ivana, of course, she's well-to-do, and she has connections, and she banks over at Goldman Sachs. So we can see the balance sheet here of the loan to Trump for $900. So we've got Bank A over there, Citibank. We've got a loan to Trump for $900. We've got demand deposits to Jones for the $1,000 still. We're holding $100 in reserves, because we had to for our 10% reserve ratio. That's Citibank. Goldman Sachs now has $900.

15:56That's the money that Ivana put in her demand deposit account, and then reserves for $900 there. And the Federal Reserve's got $1,000 in government securities and demand deposits banks at $100 at Citibank and $900 at Goldman Sachs. Now, Goldman Sachs isn't going to sit on that $900. They need to immediately lend it out. And they have found another entity that needs to borrow money, and that's the state of California. They're in dire straits, I hear. So they're going to borrow of this $900, $810. So with Goldman Sachs, which is Bank B, we've got the loan to California of $800.

16:47We've got reserves of $900. We've got total assets $1710. demand deposit with Ivana, 900, we've got California's got 810 and we're at 1770. Of course, state of California is not going to sit on the money, they know CalPERS, CalPERS is the public pensioners who have worked their whole life slaving away as public servants for the State of California, and so what we have is Bank B at Goldman Sachs, the loan to California is on their books for 810 as an asset, they've got the reserves of 90 bucks, Ivana's still got her checking account over there at 900, we've got a new bank, it's Wells Fargo because that's where CalPERS does their business, they've got a checking account at at 810, and there's reserves at 810.

17:50And we're going to wrap this thing up with what's happened here with the three banks. So we've got Goldman Sachs, we've got Wells Fargo, and we've got Citibank, and then the The Fed, the city bank is being cut off here. But you can see very quickly that we've expanded through that $1,000 that the Fed injected in there. There was the $1,000 first and then $900 to Havana and then $810 to CalPERS. So our money supply has grown from $1,000 to $2,710 just in these three steps.

18:45And we can see if you play this out, it's this math right here. The thousand bucks that is injected by the Federal Reserve creates a money supply increase of Money, The Theory of Money and Credit of Money and Credit of Money and Credit of Money

19:29They've still got those deposits out there, but the loans that don't back them, and that's when banks go out of business, which we've had quite a bit of in the last few years. Now you can see how, you can see again, I'm going to put up this money supply chart. You were probably wondering, well, how is all this money being created? The Federal Reserve would stimulate monetary policy, and by doing that then the banking system takes over and creates money, essentially by lending, when they lend a Donald Trump money, when they lend state-of-the-art money, when they lend state-of-the-art money, when they lend state-of-the-art money, when they lend state-of-the-art money, California money, or what have you, or the business down the street, or the real estate developer money, then through this lending process, the money supply grows.

20:44Well the implications from this are pretty clear. What we've had is this kind of thing happen, and I'm going to push this up. You can't see, these are the years down here at the bottom, which you can't really see, but I'm going to point to about right there, and that's about 1971, again that was when Nixon cut the last ties to gold, and you can see ever since then, then the stock market went straight up, right, again driven by this deposit creation, this money creation, you can see it goes up, and then you've got this, a crash, and then another bounce, and then you have another crash.

21:42We've got a bit of a rebound going on, but who knows how long that will last. Also, you may have heard of this housing crash thing that happened. This is the history of home values. Again, the dates down there, hopefully you can make them out to some degree, But you can see where housing took off in the late 1990s, hit a peak in July of 2006, is what that says, and you can see what's happened since then. But again, that would correspond more or less with our money supply growth.

22:29It's led to a boom, not only in stocks, it led to a boom in housing values, which then of course has subsequently crashed. What happened with commercial property? Again, deposits are created. You can see the dates down at the bottom. This starts in 2001. and it peaked right around in 2007 up in here and has subsequently crashed. Again, it would more or less correspond with our money supply growth.

23:16Now, you might ask, well, maybe it wasn't this deposit growth you were talking about. Maybe people were really saving money. Have you thought about that? And I said, yeah, I thought about that. That's the savings rate, personal savings rate in the United States. The savings rate down here when the property market was peaking was almost zero. So as this boom took place, as the huge increase in the money supply was occurring, Actually the savings rate was going down, people weren't saving at all.

24:03All the money rushing into stocks, all the money rushing into real estate, commercial or housing wasn't driven by savings, wasn't driven by people delaying consumption and Investing in Capital Assets. It was driven by money supply growth, deposit growth at banks, again driven by lending.

24:35And if you want to see a picture of what But the total loans and leases at commercial banks, again, you can see it starts just after 1970 there, and you can see it peaks right in that period at about 2007 and it's backed off. So again, it wasn't savings that drove this, it was money creation through people taking out loans and creating money through the banking system. Now there isn't, money supply growth is backed off considerably and you can see why because banks aren't lending and total loans have dropped off, there's a little bit of a bounce but they're coming back down again as banks are licking their wounds and charging off bad loans and not making new ones.

25:43Now you might ask, well, okay, who cares about all that? We'll be okay as long as we, you know, everybody's wages will keep up with that, right? Well, this is hourly wages, 1964 roughly to October of 2010, and you can see the trajectory of nominal wages, yeah, in 64 average wage rate was a little over two bucks, and now it's 19 bucks. But when you average that out for inflation, that is this red line here. It's essentially flat. So while there's been an explosion in asset prices, booms and busts in terms of real estate and stocks, the average hourly wages fall behind that.

26:46And the reason is that wage earners tend to be one of the last people who receive money through this inflationary process. So I wanted to just put this up kind of at the end here. And I went to Wikipedia, and by the way, we have our own wiki now called Mises wiki, so please look for it on our site, all things Austrian. And I believe in two weeks we have 350 entries already. Yes. Amazing. Probably by this time next year we'll have 3,000 entries. So if you're ever looking for anything about anything Austrian by this time next year, we'll have it all on.

27:37But I pulled this off Wikipedia. And these are stock market crashes throughout history. And we'll start in 1720 with the Mississippi Bubble, then the South Sea Bubble. And anybody interested in that, I've written a little something about that in a book downstairs. But you can see that there were some crashes, some booms and busts in the 1700s. You can see that there are some booms and busts in the 1800s. Panic of 1819 is a wonderful book by Murray Rothbard, and some more in the 1800s, but when this thing really, really picks up, is really after, say, that 71 period.

28:30You can see the 73-74 stock crash, silver Thursday, black Monday. I've included a couple things. There was a commercial property crash in 1990, housing crash in 07, still ongoing. Commercial property crash probably in 08, still ongoing. But again, you can see this continual series of crashes that have occurred. And it's directly related to how money is created through the modern banking system. It's created through the loan mechanism, bankers overreach, they lend on property to the point, they may lend on stocks, they may lend on property, they may lend on commercial property.

29:22But you can see essentially through the modern banking system that these booms and busts are created. We have more and more of them in the modern era than we ever have. And I am afraid to tell you, as young people for the rest of your lives, as long as we Once we have the current system in place, you will live through a series of booms and busts that can make you very poor if you try to chase them on the way up and get caught at the top. And it's a very unfortunate thing. Bubbles are very seductive, and for people whose wages are not keeping up, you continually want to chase investments to make your lives better, but unfortunately, most people get caught directly in the crashes.

30:24So, unfortunately, I am going to leave you with that cheery note.