What Went Wrong with Commercial Banking?

Part III

In Tuesday's post, Part I of this series, I told you about economist Edward C. Harwood's 1928 prediction of the 1929 Great Depression in published and unpublished articles. He saw imbalances in the banking sector that were leading us into a breakdown of the economy through a misuse of the banking system.

In Part II of the series, I gave Harwood's description of sound commercial banking, as read in an unpublished article entitled "A Sharp Distinction Should be Made Between Capital Funds and Commercial Credit." He uses the metaphor of characters in a play. Let me remind you of their names: The Earners, the Investor, the Manufacturer, the Retailer, and the Bank. I recommend that you read Parts I and II first, so that you can make better sense of what follows.


[Thanks to Dreamstime.com for the photo.]

I had described his understanding of the relationships among the players and how the Bank's main purpose is to facilitate the distribution of production into the hands of all who contributed to it and therefore deserve a share.

In Act I, the Bank's power to create credit is limited to an amount representing actual products or services coming to market. This is one of the essential characteristics of sound commercial banking, the foundation of any economy.

At the end of the last post, Earners had placed a small portion of their claims to production (otherwise known as purchasing power, or money) in savings accounts at the Bank. They did this for safety and convenience, and also to derive a little income from the Bank's judicial placement of these savings into the hands of proven wise investors like Investor, who is asking for some of these claims (money) to buy more stock from Manufacturer.

Manufacturer has seen that his products sell well and that he could profitably expand by issuing more stock. The savings department of the Bank agrees and offers a loan to Investor, holding Investor's stock as collateral. Note that the Bank's savings department does not create any credit here; quite the contrary. They extend claims already in existence (Earners' savings), taking only a conservative calculated risk on their return with interest.

So far, this Act I scenario represents the correct use of commercial credit and of capital funds. All's well that begins well in our sound commercial banking system.

Act II

Here the situation starts to go awry. We are 1913. Congress thinks it wise and useful to create a national entity that would have two functions: to apply modern technology to grease the wheels of check clearance, and to serve as a back-up reserve of funds to avoid the destructive effects of irrational, panicky bank runs.

Simultaneously, a war is brewing abroad and some in government foresee a need for a source of emergency financing for the military industrial sector should the US get involved.

They hit upon the formula of establishing a master bank that would have the two first functions, and a third function as well: to create credit--temporarily of course--by "monetizing debt," or "buying" US bonds with credit created out of thin air--claimless "money," if you will. (See how real money is actually claims on production in Wednesday's post.)

This extra claimless "money" would circulate throughout the economy and become indistinguishable from real money as it flowed first through those industries that would receive government checks to arm the military machine, and then on into the rest of the economy. Our master bank is named the Federal Reserve, Fed for short.

The formula works well. The war is won, thanks in part to this stimulus scheme. The Fed must now withdraw all that excess credit; but this causes a recession and pain, like withdrawal symptoms. Instead of taking his medicine and cleaning the toxic credit from the banking system, our Fed decides to relax his standards and allow the credit to remain in circulation.

In doing so, he loses control of the amount of credit he has created and finds himself in need of a less painstaking measuring stick. He settles on the price level. This, he thinks, will be just as good a measure of the supply of money, because it is well known that excess money creates general price inflation. This is not always true; but the Fed has good intentions and lots of faith in his knowledge of things monetary. (But we know what the road to hell is paved with, don't we?)

This illusion of wealth and the apparent stability of prices deceive all of our players. The Manufacturer converts his arms factory back into peacetime production. The Investor puts all his savings, plus as much as he can borrow from the now credit-stuffed Bank, into buying the Manufacturer's stock for further expansion. Optimism reigns.

Seeing the success of the Investor and plush with cheap "cash" (really only claimless credit) issued by the Fed, the commercial department of the Bank starts to think of new ways to make money. They begin to create credit accounts for Investor's investments, instead of letting the savings department lend real savings. This credit is not collateralized by sales documents as normal commercial credit would be, but is based only on a mutual appetite for risk-taking--not the commercial Bank's proper function. Leveraging creates more claimless "money" and makes the situation even worse.

(Note that there is a place for speculative investment, but it is not within a healthy commercial banking system. True speculators are fully informed of the risks involved and must be forced to withstand the full consequences of their actions, down to the last penny.)

A few Earners, seeing Investor becoming increasingly wealthy through his stock investments, begin to do likewise. They take their money out of the conservative savings account that now offers only a paltry interest, given that the Bank is flush with Fed "credit" and doesn't need Earners' savings anymore. Earners also start requesting loans from the Bank, and the Bank, now having lost itself in this adventure, begins to provide even more claimless credit "money," based on nothing but Earners' stocks, the Bank's optimistic and foolhardy assessment of risk, and also on the Fed's own example. Remember too that the Fed's mere existence has now "guaranteed" the banking system's equilibrium. (Economists call this "moral hazard.")

Times are good. Even Manufacturer and Retailer put a little of their profit aside to speculate in the stock market, sending stock prices sky high, even though general prices are stable. What's the first thing you think of when you get your first extra income? Buying a home, of course. Money (or this claimless credit hybrid it has become) turns towards the real estate market. A housing boom ensues.

More conservative Earners note that their wages seem to be stagnating, and that a good number of individuals around them are becoming extraordinarily rich. Manufacturers and Retailers are not expanding jobs like they used to, engrossed as they are in making it rich through speculation.

Once again, let's stop the carousel. This is starting to look like a game of musical chairs. When the drugged music of easy credit wears off, as it inevitably will (there being nothing but speculative and ephemeral gains to be claimed with all this claimless money), many Earners will be left chairless, and/or some will be sharing useless pieces of a chair when a rise in general price inflation sucks the value out of their real wealth.

Here we are in 1928, at the brink of the Great Depression.

"Act III remains to be played. Just when it will begin is a problem, but it is certain that the actors will not fail to appear. It must be confessed that this drama is a tragedy. The third act may be readily imagined by those who have seen depression before. It is unfortunate that this is what we must expect, but such will always be the price of inflation."

Harwood's phrases. "Inflation" as he uses it here refers to the inherently risky "claimless" credit expansion, to be contrasted with healthy expansion spurred by sound commercial credit creation as described in Part I.

Act III takes place one year later in 1929 with the collapse of a stock market bubble and a bursting real estate boom, much like the ones we find ourselves in today.

What makes today's situation worse than 1928 is that back then, the country observed the gold standard, which guaranteed the value of the dollar and limited the amount of risk-credit expansion that could occur. It was indeed the scarsity of gold that forced the Fed to retract credit in 1929. But both gold and the Fed were only doing their job, something the academic community dismisses today as primitive misguided meddling in free markets, which it was not. On the contrary, it was playing by the rules on a gentleman's playing field. Today, it's a game of Scoundrel Takes All, at least until the public wises up--not through more government intervention, but through a reestablishment of basic rules.

Standardization of the monetary unit referent to something of generally perceived and constant value is the second characteristic of sound commercial banking, whether it be gold or something better. (I know of nothing better.)

Today, we have no such disciplinary tools in place, and "claimless" credit expansion has been allowed to expand to a degree never before seen in history. What remains to be seen is whether the very people who allowed this expansion to take place can now persuade it to retract in an orderly manner.

(The public is not blameless. It is we who elected the 1913 Congress in the first place.)