The classical problem of banks

"The house is crazy, says a weary traveller to himself, and will not stand very long; but it is a chance if it falls to-night, and I will venture, therefore, to sleep in it to-night."

Today I shall endeavor to write a little bit about banking and interesting peculiarities of it which I came to overstand recently.

It is disappointing to see so much bickering on the television and misleading posts in bizarre websites which blandly twist presumed facts and inform us nothing about the fundamentals. So, this is an attempt based on classical sound economic principles, which are easy to understand and difficult to apply, since they are not meant to be always universally applicable and tackle all real-world scenarios. Rather, they are meant only to guide you with their invisible hand while you wander alone in the darkness.

We use money all day, but we rarely question the bluff history of paper promissory notes, which is a bleak blunder if you want to be economically literate and prudent.

Initially, instead of paper money, business was conducted by exchanging bulks of silver and gold. As indicated by the Scottish economist Adam Smith, during the course of English and Scottish economies in 17th and 18th century, due to the supply-demand relationships of the market (influenced by wars, acts of the Parliament and price of corn), the price of gold and silver (more precisely, the size of the consumer basket with goods) and the value which they could purchase varied. Stated simpler, one bullion of gold could buy you between 1 or 10 horses, depending on externalities aforementioned. However, it is more interesting to indicate, that the price of corn during that time was even more indicative of the actual state of the economy, since it was the chief commodity produced and traded - you can't necessarily eat the gold instantly, but you can eat the bread. It was also the fact, that corn was a primary commodity involved in many initial trading activities, therefore reflecting supply and demand of the market more throroughtly. Lastly, it has to be mentioned that prices of luxury items are high during peacetime, since wealthy people feel the desire to own them and promote their social status, while at times of war the demand for bread (as a primary source of food carbohydrates which feed the muscles and the brain) jumps sharply, while demand for luxury artifacts practically sink. Yet, you can't expect dramatic changes in the price of bread, meaning it has a somewhat fixed price, making it as if not the universal stable currency, which can reliably indicate how much there is to trade out there for a piece of bread. Thus, the price of it is determined by its actual value (how much human effort is required to bring it actually to the market).

Consequently, it is not money (paper, digital, gold or bank numbers) which define the GDP and wealth of an individual or society. It is actually the physical goods (fixed and circulating capital) which does, and the term 'money' is a bare approximating representation of that value. Note: Never consider the GDP of a country as a bare sign of its wealth, GDP PPP (GDP adjusted with Purchasing power parity) is a somewhat more accurate indicator.

With the above clarifying introductions made, I can proceed to my next notion which is that the amount of paper money (or just money) which circulates in a countries economy can not (must not) exceed the value of gold and silver (or whatever is used to serve as credit/trust for it). It is important to make it distinct here, that I am talking about value and not quantity.

Critical amount of money which can be absorbed by the economy:
The explanation behind this theory is, that there is a critical limit of amount of money which can be employed in the economy locally and globally. Money is used first to satisfy personal consumption requirements (food, bills, entertainment, others), then it is used by industrious entrepreneurs in order to invest in their business (primarily in their fixed capital needs). The thing is, both of these needs have a natural limit, which once reached, it becomes satisfied: it makes no sense to buy and eat further sausages since you can't eat more (even if you wanted to) and you cannot invest more dollars in your office, or hire more people, because it makes no more sense to do so (you will encounter losses and you can't expand your production chain further). That's the point, when local usage of money is satisfied, and money starts to look for its natural and prudent investment place abroad as this is an 'excess' money which cannot be utilized locally. Naturally, this money and its holders look for prospective investment opportunities abroad in locations where it can again become profitable and properly used once again.

It must be also mentioned the actual paper money is just a fraction of the actual value of all physical goods which exist in the world. The role of money is just to be used a tool for transactions. However, the whole paper money of any kind should not exceed the amount of all transactions. Otherwise, this money becomes belabored and "wasted" money as well.

Roles of banks:
It is appropriate to mention and clarify the roles of banks at this point too. Initially, banks were created out of the natural need to accumulate massive amounts of money for large projects which could be hardly funded by few (even though wealthy) tycoons. Besides, it was less risky and easier to borrow less from more people, thus decentralizing risk. This was practical for large infrastructure projects (such as railroads, architectural buildings, plants, etc.). We also know, that if there's one thing which the government is good at, this is building infrastructure. Thus, it was natural initially for banks to work closely with/for governments; as an example the Bank of England has been created by an act of the Parliament and it was used to fund the government. Fun fact: The first loan which the English government got from Bank of England was at 8% (with regular market interest rates floating between 5-6% at the time), denoting that in fact the English government had a low credit score at the time. Even more fun fact: The bank of England was not somewhat profitable until it had actually opened up to work with the public too, thus being actually able to make profitable loans.

So, what is a bank, in Layman terms? A bank is an entity with an accumulated pool of capital (usually money) which it lends to entities and then it expects the lent amount to be repaid back with some amount of interest. Banks also allow entities to deposit and store money in their coffers, often by paying them back an interest for storing their money with them. Of course, the banks use this stored money to lend it to others. Effectively, banks made use of "dormant" money by turning into "active" money, because money staying in your house is of no use to the economy. Your small game does not improve the world.

The main challenges of banks are two:


  1. To keep the aforementioned coffers full at all times in order to answer occasional withdrawal requests. It is important to note, that when someone take out their money, this effectively means the amount of capital which the bank can use in order to loan it, and therefore profit via interest, diminishes.

  2. To refill the emptied "coffers" as soon as possible when they are emptied by occasional withdrawal demands.

And yes, you know what happens when this refined equilibrium is not met: everyone discovers that the fractional reserve banking practically cannot guarantee 100% the safety of their money, so everyone rushes the bank to withdraw it. A bank run happens.

Now, with these simplistic, but required and important introductory clarifications made, I can proceed with the amount of circulating money which can be released into the economy.

If banks naturally release no more money in the economy than it can naturally absorb, utilize and use for real transactions (and to fund real business ventures), then naturally the economy is at balanced state (at least from monetary point of view) and there are no major reasons for inflation (diminution of the value of single money unit) to occur. If it happens so, that money can no longer be invested locally, it will be invested abroad in prudent and realistic ventures. However, if a bank decides to increase its capital (print money?), strange economic phenomenons start to occur. The excess money, which is released in the economy, first creates inflation, therefore reducing the purchasing power of the local currency and raising product prices. However, the subtle effect of that is also, that since - practically - this excess cannot (or more precisely is forced) to be employed in the economy, part of it starts to go back at the banks as deposits again. The amount of banking transactions increases. Since money is now also available to less prudent and careful entities, which now decide they will buy houses, buy cars, invest in ridiculous startups via crony funds or whatever with the new "lent money".

This means, that the banks has now to fill and empty their coffers with money much faster, because of the artificial supply of money which has been poured in the economy, resulting in profligate consumption-only transactions. The excessive money did not stimulate the natural rate of profitable investments, it has just bombastically increased consumption of goods mostly, which does not create new economic value, but only changes the owner of existing value much faster or worse - destroys it. Though the coffers of such banks have to be much larger in size, they are also filled and emptied much faster than before. The circulation of money has been increased to a much greater proportion, putting a burden on banks and their efforts to maintain supply in their coffers. Any excessive money which the bank issues, will be almost instantly returned back to it, because it cannot be absorbed (at least in natural profitable investments) or worse - it will be spent abroad. At this point, the bank will barely get anything, even by rising its interest rates, but will certainly lose additional funds for managing the excessive operations.

This phenomenon has been carried out by the Bank of England: by releasing too much paper money (the excess of which was always returned to the back instantaneously in order to be exchanged for gold and silver), the bank was forced to constantly coin new gold during the 18th century. Not even that, the bank was actually forced to purchase expensive gold bullions from abroad, incurring whopping losses.

During the same time, the Scotch banks, which also tried the same "trick" with excessive paper release were all forced to hire agents to procure and bring money from London banks, whenever their coffers would empty (back then there was no Western Union, PayPal or Internet), thus riding them horses with them coins on them wagons. It also goes without mentioning that these wagons were paid to be insured or sometimes raided by bandits. Must have been quite a hit for the Scotch and some good time for logistic companies and the mob. However, things became even more interesting. Since there was interest and commissions involved in the original sum which the Scotch banks have requested from London, in order to pay these too, they were required again to send another correspondent with a wagon to get even more money.

Let me illustrate, if the Scotch bank has requested 1000 pounds in cash from London since it can no longer refill its own coffers, and owing say 5% interest on them, later it would need to repay 1050 in cash. However, as often was the case, the 1000 pounds were instantly withdrawn by the person who wanted (or had to be paid with them) and since practically no real money (income) is made by the bank, and it now owes 50 pounds which it physically does not have. And it sends another wagon to get more cash, of course, masking the true reason for doing so and - of course - asking for a larger sum than 50 pounds.
In reality, the same correspondent often travelled back and forth with the same money, by just adding additional cash to it, with this additional cash being the interest and commission which was being paid back and forth between the banks. Do not be fooled, the example can be from the 18th century, but it is still happening, especially that now you do not need to pay for horses and you have more cash than ever to burn. Spectacular.

To get back to the role of banks, what a bank should really try to do is to facilitate the business, by preventing money to stay dormant in merchants, since this capital is neither truly required by them at all times, neither beneficial to the economy by staying locked up. This is just money which is "kept safe" for answering occasional demands. And this is what the banks can exactly do.

When a bank issues a bill from a real creditor towards a real debtor, which as soon as it is due is really paid, it only advances to the merchant part of the value which the merchant would otherwise keep all times unoccupied, thus preventing others to utilize this money better than him. A banking system working like that resembles a water pond, from which even though the stream of water is continuously running out, yet it is also continuously running in with the very near equally full. Little expense for the management and replenishment of the coffers of such a bank is needed.

The only problem in this almost equillibrium-like system is interest. Practically, interest measures the "risk" of someone not paying you back the money and it almost creates "new money" in the economy. And this new money most be procured from somewhere. There's a lot of people who have always condemned interest rates and the fact that banks do not keep all their owed money in their coffers at any time (just type "fractional banking" in YouTube and stare and wonder), but I come from the economic point of view that this creates (if used in reasonable bounds) a "healthy pressure" on the economy to innovate and constantly obtain new money. We would be certainly not better off - as Socialism has demonstrated numerous times everywhere - that money staying dormant does no good, and it is actually the young companies willing to innovate, optimize and risk which force push forward the economy into its next chapters. Pithily said, it's what Capitalism does.

It is no wonder that countries with liberal bank lending requirements and low interest rates, naturally result in the development of reckless buyers, who would be tempted to buy products - especially foreign - which they might not necessarily need, only to become legally - and economically - enslaved afterwards. This is infamously done with the mortgages with banks, with which the bank has a "win-win" scenario, but guaranteed only for itself: if you pay out your mortgage, the bank would profit from the interest, if you don't - it would perhaps profit by selling by now your lost house.

It is sometimes also expected from banks to lend to everyone, by implying this is their "duty" to the public, however in reality all banks are for-profit institutions, which prudently plan only their own outcomes. On the contrary, when a government decides to "force these expectations" a bank might be forced to overlend, flooding the economy with money beyond it can absorb, overstocking the circulation of public money. And this is where a central bank comes into play, with its role to monitor the monetary supply at all times. And this is also where 90% of our wet and naughty dreams with 90% of digital currencies fade out. It is not by increasing the capital of the country, but rather by making the sure the inactive "dormant" capital is "awakened" and taken into the hands of "active" entrepreneurs and businesses which would truly benefit the economy and would be one of the most judicious operations of a bank.

Breaking this principle has resulted us in living in an economy which has grew tremendous in absolute size relative to its active capital and is always prone to inflation and has 1% of the population control a disproportionate part of the capital and goods. It is worth here to say, that education also has a role in this paradox, since if we did educate the rest of 99% how to prospectively employ and profit from the capital which would otherwise would be offered to them, we would have a far more equal distribution of wealth. Yet, you cannot force everyone to be industrious, motivated and rich.

Now, as we have outlined some of the challenges which banks and nations face(both as government and cumulatively as private sectors), the good news are there are also solutions. One of this is the savings rate of a country. The basic notion would be the more you save, the more banks would be able to use your money in your bank account and lend it someone else. However, this is not exactly true. Excessive high savings rates are needed for countries which have poor infrastructure and will need large amounts of money for investments in those, hopefully with minimal corruption.

List of countries by savings rate percentage of GDP:
Graph: List of countries by savings rate percentage of GDP
Source: CIA: The World Factbook

If you take a look at the top 25 countries which highest saving rates as a percent of GDP, you would notice actually the top is dominated by countries with severely centralized governments (which are prone to corruption), primarily from developing countries. The only reason you don't see North Korea on the top of the list is because the CIA didn't manage to include them in the list at all. As you know, infrastructure projects are the easiest way to steal accumulate and steal public money and get away with it, somehow.
The only exception in this list is Singapore, which is a city-country ran by a centralized government which really knows how to spend its money properly, however this works only when your country is so small that it is so easy to monitor and manage. Therefore, savings rate, contrary on what one might presume are not the answer.

A country would need to save only some of its money it banks, once the base infrastructure has been established, the rest should be allowed for prudent investments abroad. And definitely, banks should not start lending freely more money than the local economy can absorb, or the entrepreneurs can utilize prudently in foreign direct investments. Therefore, for a developing nation, while the infrastructure is being built, slowly the banking system should be established, so people do not hold their money under pillows, but rather store it in banks, thus facilitating the economy by converting dead money into productive money.

Finally, I would like to write a little about the uncertainty of a currency. A currency is nothing more than promissory papers issued by the central bank of a particular country which (in the past) could be readily exchanged for their value in silver and gold (if you suddenly felt the desire to carry some heavy and hard to separate gold bullions in your pocket) or could be exchanged for goods. However, sadly the amount of goods this paper or gold can purchase you at a given time is not the same, because the dynamics of the economy change, therefore the supply (difficulty) to get the goods and the demand (price which is willing one to pay) for them, considering their condition. A currency is more valuable, when it is secure as an investment: gold hardly degrades, it is easily recognized and it can be only stolen or shaped into a jewel, but barely destroyed. This is not always the case with paper money.

A good historical example is with the infamous Optional Clause which was brought by the Scotch banks, which said that now, instead of being paid instantly, their gold and silver could be paid later (at the maximum of 6 months) with interest, depending on the decision of directors. Directors of the Scotch banks - of course - used this new clause as a tool to curb those who demanded large withdrawals of gold and silver by discouraging them with the possible delay, unless the customer would take a smaller amount. This practice was exercised between 1762 and 1764, with bills being paid with gold and silver in London and bills being exchanged with banknotes for which you were not sure whether you would be able to exchange properly for gold and silver back in the Scotch banks.

Distance between the banks in the cities of Carlisle and Dumfries (~60 km):
Distance between the banks in the cities of Carlisle and Dumfries (~60 km)
Source: Google Maps and own contributions

While the exchange between London and Carlisle was usual, the exchange between London and Dumfries would sometimes be 4% against Dumfries, despite it not being distant from Carlisle. But at Carlisle you could exchange your notes for gold and silver; but the uncertainty whether you could do the same using Scotch banknotes in Dumfries degraded them with 4% below the actual value of their money. And the distance difference between Dumfries and Carlisle is about only 60km.


The practical collapse of the Turkish lira (TRY) is an ongoing - and almost tangible - fact of the present, despite the 12th of January 2019 production version of the Wikipedia page stating it "was" after being edited (this, however should not make much differences for the citizens of the country, since Wikipedia is effectively blocked on DNS level in Turkey since April, 2017). The lira was historically one of the most prone to inflation currencies, which can be attributed to the cultural beings and the inherited "militarism" of the country's secular principles, since the founding father of modern secular Turkey, Atatürk, himself has appointed the military to be the "regulating force" should the country tilt in non-secular ways, which it numerous times (See military coups of 1960, 1971, 1980, 1993, 1997 and 2016).
If you read Wikipedia (remember, anyone can write almost anything on Wikipedia - and they do), you can even see that some reasons state it is due to "the tweet of Donald Trump", construction booms or whatever.
There's only a small sentence which indicates that the central bank was barred by the very president himself from adjusting their interest rates, and thus hamper the inflation and reckless construction boom in Turkey, particularly Istanbul which has been going on since 2003 and encouraged by the government and closely affiliated companies (as part of the scheme was revealed in the 2013 corruption scandals).
As of August 2018, 1/3 of homes in Istanbul remain unoccupied, with office space prices falling, and still being empty, hosting no businesses in them and 1 Turkish Lira being traded for 0.18 United States Dollars on international markets.

What others are saying...

?
?
?
?
Anonymous