Cyprus, and what capitalists want

Mar 26, 2013

I haven't had much to post about lately, and for that I apologize. This particular post was inspired by a recent Twitter conversation I had with an acquaintance of mine. His initial post, based on an examination of the situation in Cyprus, suggested that there should be two types of banks: one that's fully insured for small savers, and one that has no insurance for so-called capitalist "gamblers".

I responded that there should only be one type of bank, one that has 100% reserves. The conversation continued from there, and I thought it would be good to put down my thoughts in full, rather than within the 140 character restraints of Twitter. So let's start from one basic truth that most self-proclaimed socialists don't, or refuse to see.

What we have now isn't capitalism

Maybe we used to have capitalism, some age ago, now lost forever in the mists. However, most people today see greedy, rich bankers making money hand over fist at the expense of poor savers and erroneously believe this must be capitalism. Presumably because it involves big wads of money. If you ask someone today for their definition of capitalism, the most common answers you'll probably get contain some mixture of the words "greed", "exploitation", "monopoly", "heartless billionaires" and/or "lobbyists" and probably all of the above.

Capitalism is not a dirty word. Capitalism is simply investment tempered by risk. That definition is important, so be sure to read it again: Capitalism is investment tempered by risk. Once you understand that, you can come to realise that the situation in Cyprus (and indeed the rest of the western world) has resulted from banks leveraging government to remove that risk, skillfully sold as protection for savers rather than what it really is: protection for banks and their profits. A small history lesson about banking will surely help here.

Banking reserves and the fractional reserve system

When banks were born, they were storehouses solely of coin, precious metals and other treasures. Soon after, banks discovered that they could then lend out these resources to entrepreneurs at interest and actually earn money for their depositors when the loans were repaid.

The problem was that it was risky. If the bank had $1,000 on deposit and someone asked for a loan of $500, approving the loan meant half the stake of their depositors was being risked, and could potentially all be lost. Because of this, bankers had to be shrewd, and research those they loaned money to. If it was determined that the person asking for the loan was too big of a risk, the bank could increase the rate of interest charged at their discretion, or deny the loan altogether. Of course, banks didn't like this. They made money by lending out money and charging interest, and the more loans the better! But making too many loans to too many risky entrepreneurs could potentially be disastrous for them and their depositors.

At this time there was no such thing as a government safety net for either banks or depositors. Everyone was on their own. Bankers making risky loans or depositors choosing risky banks could lose everything if things went bad. This risk was a brake on banking profits, but also a mechanism providing security for depositors. Smart bankers made fewer, and safer loans, and smart depositors avoided banks which loaned out too much of their gold and silver.

Another problem was that when a bank made a loan, it needed to physically give the gold, silver, or other items of value to whomever was asking for the loan. This made loans very vulnerable to theft, inconvenient to transfer over large distances, and depleted the physical reserves available to other depositors. Banks solved this problem through the use of banking certificates, later to be known as banknotes or paper currency. Instead of physically loaning out the precious metals, the banks would issue a certificate guaranteeing the holder that they could return to that bank and exchange the certificate for the specified amount in gold or silver. Eventually the certificates became so widespread that people used them directly for exchange. This was good for depositors because now their precious deposits could remain safely within the walls of the bank, while only their value was on loan in the marketplace.

However, banks soon discovered they could take further advantage of banking certificates. If people were using the certificates directly for exchange, why not just issue more of them, over and above the value of deposits held in the bank? The bank made money by charging interest on loans, and if the bank could make more loans, that meant more profits for the bank. For example, if the bank only had $1,000 worth of gold/silver on deposit, why not loan out $2,000 worth of certificates? That's $2,000 worth of loans the bank would be earning interest on, rather than $1,000! This is called "fractional reserve banking" (in this example, the bank has 50% reserve). The only problem with this was the potential risk of a bank run. If the bank kept 100% reserves, then every certificate that came through the door could be redeemed for gold or silver. Yet, if enough depositors lost faith in a bank with fractional reserves and came to withdraw their physical money, the bank might not have enough gold and silver to pay them all. This news would cause other depositors to demand their money back also, eventually driving the bank out of business. Or in other words: a bankruptcy.

For a century or two after banking certificates became the standard, no bank was entirely 100% reserve, but the risk of bank runs and bankruptcy was a check on fractional reserve banking getting out of hand. However, banks still wanted to make as much money as possible, and the only thing stopping them from making even more loans was this blasted risk. They constantly looked for ways to mitigate it.

Enter the Central Bank

It is important to note that every policy change advocated for by banks has been spun as protection for the saver, but in reality is protection for the banks. When banks began agitating for the creation of a central bank, the propaganda was no exception.

The story was that bank runs were becoming a big problem. People were too easily frightened by scary financial stories in the media, rushing to their banks and withdrawing their money and gold. When the banks (taking a gamble by running fractional reserves) ran out of money to give, since no deposits were insured, the hundreds or perhaps thousands of remaining savers lost all of their money when the bank was forced to go bankrupt. Think of the poor savers, the banks would say. No one wants people to lose all their money; what we need to do is to protect these savers from panics. The way to do that is to have a "lender of last resort", or a Central Bank.

The idea of the central bank was to neutralize bank runs by loaning banks what they needed during a bank run, then recalling it back once the run was over as depositors regained their confidence and returned their money to their accounts. Great news for all of the depositors, right? Now it was almost impossible for someone to lose all their money when saving it in a bank. Savers counted it as a victory for safe investment.

But it wasn't a victory for savers. It was in fact a victory for banks. With the creation of a central bank, it was now almost impossible (at the very least far more difficult) for a bank to go bankrupt. That blasted risk of making more loans was now far lower! Banks could now afford to have even fewer deposits on reserve, and make even more loans, and at far more attractive interest rates. If bank runs happened now, the bank itself could take out a low interest loan from the central bank, pay off its depositors, and continue operations.

By the same token, now that savers were relatively safe from losing all their money in panics and bank runs, it was no longer worth their time to examine whether or not a bank was prudent or careless with their depositors' money. All that mattered now was who gave the highest interest rates. And when we look back at the history of panics and bank runs in the US, we see that this is actually the case: while fewer individual savers lost their shirts in bank runs and panics after the establishment of the Federal Reserve (the US central bank), there were actually far more panics and bank runs. This is simply because both banks and depositors were now free to engage in far more reckless behaviour, with far lower risk.

And now Cyprus

After the establishment of the central bank, the banks continued to lobby government. The abandonment of the gold standard, national control of interest rates and federal insurance of deposits were all advocated for by banks, and spun as protection for depositors from the dangerous fluctuations of the market. In fact, when given more than a cursory examination, all of these policy changes allowed banks to engage in even more reckless behaviour by further lowering the risk of holding fewer and fewer reserves and of making more and more loans.

  • If there is no gold standard, banks don't need to hold physical reserves at all, just stacks of paper or bits in a computerised ledger.
  • If there is national control of interest rates, people will either take out loans when they don't need them, or be forced to pay usury, because there is no market pressure to adjust for levels of risk. A secondary effect is to give advantage to the larger banks which can afford to ride the distorted rates, crushing smaller banks out of business.
  • If there is federal insurance of deposits, then if a bank does happen to go bankrupt due to reckless behaviour, at least the taxpayers will shoulder a large part of the burden instead of the bank itself.

Capitalism is investment tempered by risk. The banks in Cyprus leveraged government to reduce that risk by claiming they were only trying to protect their depositors. In reality they were reducing that risk to protect themselves from bankruptcy when engaging in more and more reckless behaviour.

So my Twitter friend asked me: If 100% reserves are the answer, that means you advocate government regulation of banks. Hardly. Capitalists are advocates for a return to a system regulated by risk, not by government. If there was no government deposit insurance, no bank bail-outs, freely fluctuating interest rates and sound money, and you had a choice between a bank that offered you 3% interest holding 90% reserves and another that offered 20% interest holding 5% reserves, which offer would you take? The answer is: you'd choose the bank that offered a risk level you were comfortable with, no government regulation required. Millions of people making this assessment of risk before making a choice is the power of the free-market. When banks do their best to avoid this risk or pass the risk onto taxpayers, we end up with situations like Cyprus: untenable debt and now account haircuts.

I hope it's quite obvious by now why we aren't living in a capitalist or free-market society today. In a true capitalist society, these out-of-control banks in Cyprus would have gone bankrupt years ago and been replaced by sounder, less reckless competitors. True, many depositors would have lost their deposits, but the deposits of future Cypriots (and the economy of Cyprus) would be far safer for it.

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