Banking Truths

In last week’s post, I discussed the two-bucket approach to managing money.  Simply put, this management technique involves putting assets into two different ‘buckets of money’. 

One bucket contains assets that are stable.  This is the deflation bucket.  These are the assets that are invested with the objective as to not lose purchasing power in a market decline.

The second bucket is the inflation bucket.  These assets are invested in such a manner as to have purchasing power preserved in the event of inflation; massive inflation particularly.

That is my long-term forecast; although predicting timing is difficult.

This week, a piece published by Alasdair Macleod, a past guest on RLA Radio confirms that my forecast is likely going to come to pass at some point in the future.

As a side note, Mr. Macleod is a true pleasure to interview.  He is as gracious and gentlemanly as he is intelligent.

Here is a bit from Mr. Macleod’s piece:

“The legal formalisation of the creation of bank credit commenced with England’s 1844 Bank Charter Act. It has led to a regular cycle of expansion and collapse of outstanding bank credit.

Erroneously attributed to business, the origin of the boom and bust cycle is found in bank credit. Monetary policy evolved with attempts to control the cycle with added intervention, leading to the abandonment of sound money. 

Today, we face infinite monetary inflation as a final solution to 150 years of monetary failures. The coming systemic and monetary collapse will probably mark the end of cycles of bank credit expansion as we know it, and the final collapse of fiat currencies.”

There are some salient points in those few, short paragraphs.

Many, if not most, politicians today are of the opinion that the business cycle contains booms and busts.  These booms and busts are a natural part of the business cycle.  Mr. Macleod points out that that’s really not the case.  Boom and bust cycles exist because sound money policies are abandoned.

And, because of the economic conditions that exist in the world today and the easy money policies of central bankers, a.k.a. money creation, we now face ‘infinite monetary inflation’.  In other words, central bankers will continue creating money out of thin air because they don’t know what else to do.  And, frankly, they’re painted into the proverbial corner.

To provide a little context, it’s helpful to know how the fractional reserve banking system works.  It’s the money system under which the world now functions.

In fractional reserve banking, money is loaned into existence.

If you go buy a CD at your bank or make a deposit into your bank, that bank is required to reserve 10% of that deposit.  The rest of the deposit can be loaned out.  It is this process that creates money.

Perhaps an example to make the point clearer.

You go make a deposit into your bank of $100,000.  That banker reserves $10,000 and makes a loan of $90,000 to a customer who wants to buy an investment property.  The $90,000 borrowed ends up in the hands of the property seller who makes a deposit into her bank of $90,000.  That bank reserves 10% or $9,000 and makes a loan of $81,000 to another customer.

This process continues and money is created as money is loaned.

In the past, when central bankers wanted to jump-start the economy by increasing the money supply, they would reduce interest rates to make borrowing more attractive.  The more borrowing that takes place, the more money that is created.

However, after the financial crisis of about a decade ago, interest rates were reduced to zero percent.

But the massive borrowing that should have commenced due to the low interest rates never began.

Here’s why.

If you’re already up to your neck in debt, unable to afford another payment, does it really matter what the interest rate on the next loan is?

Collectively, that’s where the world was after the financial crisis.

Now, in an effort to keep the borrowing going, negative interest rates have taken center stage along with outright money creation. 

It doesn’t take a Ph.D. in economics or finance to ascertain that’s not normal nor is it sustainable.

And, that’s the point of Mr. Macleod’s piece.

Here is an excerpt from the article analyzing where we are today as a result of these policies (Source: (emphasis added):

Since the turn of the millennium there have been two global bank credit crises: the first was the deflation of the dot-com bubble in 2001-02, and the second the 2008-09 financial crisis that wiped out Lehman. It was clear from these events that the debate over moral hazard was resolved in favour of supporting not just the banks, but big business and stock market valuations as well. Furthermore, America’s budget deficits were becoming a permanent feature.

The cyclical rhythm of bank credit expansion and crisis was taking place against a background of increasing wealth transfer from the productive sector by means of an underlying monetary inflation. The beneficiaries have been the government and non-productive finance as well as large speculators in the form of hedge funds. The evidence of this transfer of wealth through the effect on the general level of consumer prices was increasingly suppressed by statistical method. While the official consumer price inflation indicator has been pegged between one or two percent, independent analysts (Shadowstats and Chapwood Index) reckon the true figure is closer to ten percent.

That being the case, the use of a realistic price deflator tells us that the US economy, and presumably others, in recent years have been contracting in real terms. Furthermore, GDP, nominal or real, is an appalling indicator of economic progress, being no more than a measurement of the increasing quantities of government funny-money inflating the economy. It does not tell us how that money is used and the benefits that actually flow from it, nor the degree of price distortion it generates.

Mr. Macleod concludes his article with some rather sobering statistics.

Global debt was about $173 trillion at the time of the financial crisis.  Today, global debt is an estimated $255 trillion. 

$17 trillion in global sovereign debt is negative-yielding.  There is no pain-free exit especially considering the massive government debt levels that exist worldwide.  (The United States continues to run trillion-dollar deficits.)

The repo market (overnight and short-term lending between banks) cannot operate without central bank intervention via newly created money.  Mr. Macleod indicates that this means the banking system is ‘in intensive care’.

Mr. Macleod concludes:

An extreme amount of monetary creation over the last ten years and the US-China trade war over the last two is horribly reminiscent of late 1929, when the combination of the end of the credit cycle and escalating trade protectionism combined to wreak financial destruction on a global scale. We face a possible repeat of the 1929-32 experience.

So, what should you be doing?

In my view, you’d be wise to seriously investigate using a two-bucket approach to manage money.

While the ‘when’ is difficult to predict, the ‘what’ is not.  The late economist Herbert Stein profoundly stated, “If something cannot go on forever, it will stop.”