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No Banks Means No Banking Crisis

2009 August 29
by Ian Welsh

Joseph Stiglitz, the Nobel Prize-winning economist, is suggesting we let banks fail.

This is a slightly more radical version of what I’ve been saying* for some time:

  • We don’t need the current banks.
  • If they won’t lend, let them go under.
  • If the Fed can lend to banks, it can lend directly to banks and consumers.

The following article was originally published Feb 2, 2009.  I am reprising it here because the reminder seems necessary.

No Banks Means No Banking Crisis

Banks exist to act as intermediaries between central banks and those who need credit.  Banks are given the ability to create (yes, create) money through fractional reserve money, and they also have the right to borrow money at rates that no one else can receive.

Image by Twolf

Image by Twolf

If you could take your money, multiply it by 10 (that’s not the exact number, but as an example) and lend it out, do you think you could make a profit?  If you could borrow money at 1- 5% and then lend it out for more than that, in some cases 15% more, do you think you could make money? That’s how banks operate.

Banks are thus given an incredibly valuable privilege by governments.  It’s really hard to overstate how easy it is to make steady returns as a bank as long as you don’t get greedy.

In exchange for the right to create money and borrow it at rates no one else gets, banks are expected to add some value to the equation.  Specifically, banks are expected to figure out who is a good credit risk, and where money should best be loaned and used.  There are two sides of this arrangement:

  1. Money should be loaned where it has a high return.
  2. It should also be loaned to people who can pay it back.  And it should be invested in the same way, return averaged with risk.

Banks have not been doing this.

Banks have been seeking out the highest return without taking risk into account .  Instead, they have been seeking out high risk for high returns.  They haven’t been adding value.  They also haven’t been performing the taks of getting money to the people who can use it best.  Banks took the money and invested in securities which were essentially fraudulent, in a bubble that any idiot could see would not last, in non-productive financial industries.  They didn’t invest in manufacturing, by and large, or new technologies or alternative energy, or anything particularly useful.  They didn’t use money to actually grow the economy—GDP was going up, and profits were going up, but the illusion of growth was based on multiple financial bubbles that weren’t sustainable and didn’t indicate any real prosperity underneath.

And when it came to loaning to ordinary people, in many cases, they were lending at usurious interest rates.  (What’s your credit card’s interest rate?)

In exchange for the very valuable privilege of creating money and borrowing at lower rates than anyone else get, banks weren’t creating value for the economy; they were destroying value.

Stiglitz is right.  There’s no reason to keep banks around, at least not this bunch of banks.  Let private investors take their losses, guarantee deposits, do a clean up as best you can and create new banks.  Or in the case of the US, maybe not…

Instead, what needs to be done is to just have the Fed lend directly to consumers and businesses.  Let everyone switch their credit card to a Fed card, and as a one time thing everyone can switch over up to a $10,000 balance.  The interest rate?  How about the top end of the Fed Funds rate +4%?  Right now, that would mean a 4.25% interest rate.  If people default, well, garnish their wages.  You’re the government.

Start lending to businesses.  Base lending it off credit ratings after you take over the ratings agencies, or force reform, because the rating agencies demonstrated they are worthless when they rated much of the junk that’s now imploded as great credit risks.

In time the central bank makes these loans conditional—you can borrow money from the Fed only for certain things:

  • Want to buy a house to live in?  Sure, you can borrow the money in one of 5 standard mortgage styles.
  • Want a vacation home or an investment home?  Go to a commercial lender.
  • On your credit card, want to buy food?  Great.
  • Want to put a vacation on your card?  Forget it.
  • Want to buy a fuel efficient car?  Sure.
  • Want to buy a gas guzzler? Get your financing somewhere else. (Not that this is much of an issue, given the low rates car companies give.)

Of course, the Fed may not want to be in the business of looking into too many things too deeply.  So something like banks is useful for when folks do want that vacation, or that second home, or to borrow money to start a business as opposed to just a credit line for one that’s ongoing.

Fortunately there is one group of financial institutions in the economy which has done a good job as banks, even though they aren’t called banks: America’s credit unions.

Help credit unions expand, offer them better credit, get them together to set up wide ranging ATMs so folks can get their money anywhere.  Use the one part of the system which, because they aren’t stock companies driven by quarterly results and don’t expect multi-million dollar bonuses, didn’t get involved very much in the greed driven stupidity of the last few decades.

As for the banks, if they can survive on their own, great.  If they can’t, nationalize the banks and slowly wind them down.  It may take years, but so be it.  Wipe out the shareholders completely (they took the money in the good years).  Give the creditors what they deserve, if there’s anything left for them.  Move the deposits over to healthy banks or credit unions.

Stop throwing good money after bad.  Something like $8 trillion has been spent, loaned and guaranteed so far and it hasn’t stopped the crisis.  Take the losses, find out where the bottom is and build a new system.

This will also lead to a more vibrant society in the long run.  Banks have been abusing the privileges they received and as a result credit for the things America really needs has dried up.  Wanted a loan for a hedge fund?  No problem.  Wanted a loan for a new company employing hundreds that would only make 5% to 8% a year?  Probably not.

But it was the hedge funds returns that were fake.  And it was the small businesses that never started because they could only make 5% a year which could have produced real value and lasting jobs.  If you want people to start new businesses, if you want consumers to spend, then giving them credit at reasonable rates, and making that credit available, is what has to be done.

At the same time, due diligence has to come back into the equation.  Everyone in America needs a credit card.  Might as well just give them one.  Without it you can’t rent a car, stay in a hotel or really interact in a modern society. But eveyone doesn’t need or deserve the same credit limit.  And everyone doesn’t need a home equity loan, in fact very few people do.  Let the Fed do the drop dead easy lending “you have an income of $50,000 a year, you want a mortgage where you will pay $10,000 a year, that’s under 30%, you can have it”.  Have the credit unions and the few remaining banks do the more speculative lending, but watch them like hawks.  And take the credit bureaus and the ratings agencies under government sway, and either nationalize them or regulate the heck out of them, so that the ratings they give mean something.

Add in some federal anti-usury laws (no interest rates above fed funds + 15%, on anything, including fees) and you’ve got yourself a full new banking system where credit is available to those who need it at reasonable rates, while reasonable oversight is occuring.  And because so many investors and lenders were wiped out, well, the lesson will have been learned, for a couple generations, that if you do really really stupid things, the government won’t just bail you out.

No more privatizing profits and socializing losses.

*For more on this topic

18 Responses
  1. August 29, 2009

    I’ve advocating turning the banks into regulated public utilities, but this idea seems more sensible: Abolish them in favor of credit unions. I wonder if regulation at the state level could do this?

  2. August 29, 2009

    The purpose of banks if financial intermediation. Simply, put this means taking one person’s deposit of money not currently being used, leveraging it, and loaning it at interest to other people who can put it to use. This keeps the economy flowing, and is is a valuable economic activity, and banks are compensated for it through the differential of interest paid on deposits and interest received from loans. This is banking as a utility.

    However, the financial system does not stop there. In addition to intermediation, the financial system also attempts to reduce risk through innovation, such as securitization, brokering bonds, and even speculative trading using leverage on OPM. Some of these activities have some economic value and some are of questionable value if not systemically harmful. They are chiefly rent-seeking measures that contribute little if at all to utility, and they often create disutility.

    Moreover, the largest and most powerful financial institutions control the creation and allocation of capital to an almost monopolistic degree. Their position also allows them to extract rent from productive enterprise, including labor, to an inordinate degree.

    In addition, their regulatory capture gives them extraordinary leeway in operations, and their influence essentially holds the entire economy hostage, resulting in government guarantees in case of losses, creating moral hazard.

    As a result the financial system has become parasitical on the economy, extracting much more value that it adds, and jeopardizing the system.

    The current bailouts have simply been feeding the parasites at the expense of the host, whose brain they have commandeered. Parasites act for their own advantage not for the host. In fact, to their own disadvantage in the end, they sicken and eventually kill the host. Then they find another host. (See Michael Hudson: The Financial Parasites Have Killed the American Economy, and They Are Sucking as Much Money Out as They Can Before Jumping Ship)

  3. Ian Welsh permalink
    August 29, 2009

    tjxfx, agreed on all points.

  4. August 29, 2009

    In the meantime, DeLong is telling the Chinese how lucky Obama is to have Bernanke. Official America considers the banks as they are to be essential and non-negotiable.

    I wonder if JP Morgan still gives its employees a new fresh set of workout gear every time they want to use the on-site gym? The cake, they may yet let us eat it.

    To be fair to DeLong, a lot of left-neoliberal thought comes from the perspective that these systems exist and continue to function, and all proposals to change them root-and-branch have no guarantee of success and a large risk of unintended consequence; and hence prudent management entails a responsibility to sustain the status quo for so long as it does not degenerate into chaos.

    This kind of dictionary-definition conservatism is not completely wrong-headed a sentiment.

    An interesting characteristic of modern-day neoliberal economics is its obsession with perverse results. I call it “Freakonomicism”.

  5. August 29, 2009

    Here is another article that is germane. Henry C. K. Liu is always incisive, but he cuts to the heart of banking, market fundamentalism, and economic neoliberalism:
    Money Markets and Commodity Markets By
    Henry C.K. Liu, Part I: Money Makets – Integrity Deficit Has Its Price”

  6. Ian Welsh permalink
    August 29, 2009


    that which can’t go on, doesn’t. The numbers I see indicate that the US has been liquidating itself since some time in the 70’s (72 or 76, probably). The pace of that liquidation is continuing. A large part of it is that capital is going into unproductive uses: so 5% of gpd is wasted on a health system in administrative costs and profits; money is drawn from the real economy into the financial economy where it fails to increase real productivity and drives out investment in non-financial activities while causing repeated crises, and not even creating any real profits (all profits from the last 10 or so years were eaten up, then more, by the crisis).

    Insanity is doing the same thing, with the same people, over and over again and expecting different results.

    As with every other time I’ve bet against DeLong, I’ll be very surprised if I lose this bet. I have nothing against classical conservatism (don’t fix it if it isn’t broke, and know what it was intended to do) but this is broke and it isn’t doing what the textbooks say it should do (properly allocate capital to the most productive areas.)

  7. August 29, 2009

    As with every other time I’ve bet against DeLong, I’ll be very surprised if I lose this bet. I have nothing against classical conservatism (don’t fix it if it isn’t broke, and know what it was intended to do) but this is broke and it isn’t doing what the textbooks say it should do (properly allocate capital to the most productive areas.)

    I don’t think he’s betting that this system will last forever. He is merely betting that upsetting the applecart at any point before it is ready to upset itself will have adverse consequences greater than the immediate forseeable benefit of major reforms.

    In other words, the market failure we all see now is greater than the short-term market failure (and hence suffering) that would occur if we permitted banks to fail, because investors would pull the rug out from under…something or other in short order, prisoner’s dilemma style. It’s kind of freakonomic.

    In the meantime, the LDP is apparently about to lose big in Japan. Speaking of market failures. I haven’t seen much about this, even though it’s kind of a world-historical circumstance.

  8. August 29, 2009

    Replace “greater than” with “less than” in the above. Oops.

  9. August 30, 2009

    Insanity is doing the same thing, with the same people, over and over again and expecting different results.

    Some quotes from the Liu article cited above expand on what Ian says:

    Market fundamentalism is the belief that the optimum common interest is only achievable through a free market equilibrium created by the effect of countless individual decisions of all market participants each freely seeking to maximize his/her own private gain and that such market equilibrium should not be distorted by any collective measures in the name of the common good.

    Yet market participants seldom act with equal information or full understanding of the effects of their actions. Market fundamentalism is a theory that suggests the right path to a watering hole can best be found by blind men pulling at different directions for uncoordinated reasons. The fundamental problem with market fundamentalism is the ability of market participants to maximize advantage by externalizing cost or penalties outside of the market onto the real economy. Free markets require regulation to remain free.
    Increasingly, it has become obvious that what is good for Goldman Sachs, a highly profitable global investment bank headquartered in New York, is not necessarily good for the US or for that matter the world. Thousands of Goldman Sachs do not add up to a healthy world economy, solid evidence that market fundamentalism does not work.
    Neo-liberalism, as summarized by Susan George in her paper: A Short History of Neo-liberalism: Twenty Years of Elite Economics and Emerging Opportunities for Structural Change (delivered at Conference on Economic Sovereignty in a Globalizing World
    Bangkok, 24-26 March 1999), is a belief that the market mechanism should be allowed to direct the fate of human beings. The economy should dictate its rules to society, not the other way around. Neo-liberalism is a movement in support of free market economics, globalized deregulated free-trade and anti-welfare reform.
    Financial neo-liberalism was born with the twin midwives of dollar hegemony and unregulated global financial markets, disguising economic neo-imperialism as market fundamentalism. The debasement of the fiat dollar, dragging down all other fiat currencies, found expression in the upward surge of commodities and equity asset prices, which pushed down global wages to keep US inflation low. This pathetic phenomenon of downward economic spiral was celebrated as economic growth by neo-liberals.
    Neo-liberal economists view money as a commodity, and only a commodity. Why then is its value fixed by fiat and not the way in which the values of all other commodities are fixed, by supply and demand in the market? The answer is that the issuing of money as a legal tender is a government monopoly that gives government pricing power over money. This makes money more than a commodity. Money is in fact a political instrument with financial dimensions.

    But the Fed, by its own definition of being politically independent, is not part of the government or even the democratic political process. The Fed, owned by its member banks, is a living example of a political institution with monopolistic monetary powers captured by a financial oligarchy. While the Fed claims that its monetary-policy measures are designed to sustain the health of the whole economy, it sees the maintenance of the health of the economy’s financial heart, the banks in the Federal Reserve System, as its paramount policy objective.
    Humphrey-Hawkins explicitly instructs the executive branch of the government to strive toward four mandated policy goals: full employment, economic growth, price stability, and a twin balance of trade and fiscal budget…. In a dynamic modern economy in which employment has replaced livelihood as a means of economic survival for the average individual, employment is a systemic political issue the responsibility for providing which lies with the institutions that operate the economy, not on individuals with livelihoods as in the static economy of the past. In the past, a baker or a blacksmith would inherit his trade from his father in a communal economy organized on cooperative principles. In the modern economy, workers are employed in piecemeal jobs defined by the division of labor in support of assembly lines in factories in a society organized on competitive principles.

    Only a small number of individuals are self-employed in a modern economy. Jobs are provided for workers by the economic system regulated by government. Unemployment then is the result of dysfunctional economic policy, and not the personal fault of the unemployed. Once full employment is reduced from a prime policy priority to merely one factor among many in connected government policy objectives, failed statehood will follow. In the modern economy, unemployment is a political problem with economic dimensions.

  10. Ian Welsh permalink
    August 30, 2009

    Mandos – what major reforms does DeLong see as likely in the current political environment/administration/congress? I’ve seen nothing meaningful coming down the line, and my take is that it’s better to upset the applecart now, than keep going till you get a crisis which can’t be fixed by all the king’s men. And that’s what I see coming.

    DeLong’s suggested course of inaction (and fundamentally, we are talking about inaction, since no meaningful changes to the system will occur) will lead to America having it’s Russia moment. A repeat of the 90’s in Russia, but in the US. When China gets internal takeoff and real decoupling (and they will) they will let the US survive on its own.

    Speaking of Japan: the incoming government has already states that they are going to diversify, hard, away from the US dollar. That’s a major support corroding out from under the US, and from the US point of view is the BIG news about the LDPs upset.

  11. August 30, 2009

    I wrote a lengthy response and then decided to delete it, because the answer is simple. DeLong has actually himself argued in favour of bank nationalization on more than one occasion. However, DeLong also knows that this is just like health care—any change to the system must protect the capability of Wall St. to make a profit. Bank nationalization does not do so, so it will not pass.

    Consequently, the choice is between “””undervaluation””” of toxic assets or private bank recapitalization. He believes the former option is Armageddon. Hence the latter option. And he probably correctly trusts Bernanke to handle that option. The “reform” he fears is any reform that allows a bank to fail.

    But what he actually fears is any attempt to change the fundamental structure of the US economy. He is a card-carrying neoliberal and opposes a policy that supports American industry and labour at an advantage to that of other countries, except insofar as preventing sudden failures, like GM. The banking system you propose, I suspect would count as one of those things, in that it would favour business lending but not consumer lending and hence hose foreign trading partners.

    In that sense, no significant reform at all is preferable.

    DeLong is betting on a situation in which—as America’s labour gets cheaper and cheaper—American exports will pick up, or (a neoliberal favorite) Americans will find niche markets no one else can do for cheaper. *waves hand and mumbles about retraining*

    I read a lot of blogs regularly and interestingly it was only the fringiest of liberal fringe blogs that brought that DPJ/LDP news to me.

  12. Ian Welsh permalink
    August 30, 2009

    Yeah…. The decline in the wages DeLong wants is exactly what I want to avoid. I also don’t think DeLong gets that labor (and carbon) arbitration can go on longer than the US can take it.

    To really work on his terms you need a significant devaluation of the dollar. But if you devalue the dollar that much, you get caught in the oil trap, leaving aside the living standard drop that it also implies.

    I’m not that impressed with liberal blogs these days, as a group. Stupider every year. Hope and “change” are bad for the brain, I’m afraid.

  13. August 30, 2009

    To really work on his terms you need a significant devaluation of the dollar. But if you devalue the dollar that much, you get caught in the oil trap

    Which is why the US military is being heavily committed to the Middle East (Iraq, and likely Iran) and Central Asia (Afghanistan). That’s were the energy is.

    The fundamental problem is that the US needs to reflate its way out of debt or risk falling into a deflationary spiral through massive debt destruction. However, reflating also risks increasing the cost of commodities, especially energy, as the dollar devalues.

    This is the rock and hard place for the Fed and Treasury, and there is no way out other than revamping the status quo, which is unacceptable to the ruling elite (oligarchy) that rents the government and owns the media. No one who wants to remain in the mainstream is going to oppose this in the end, neither DeLong nor Krugman, and even Roubini is going along with Bernanke’s reappointment. Folks like Chomsky, Hudson, etc., don’t have a public voice, being shut out of the debate. The more influential economic blogs that are getting this right are libertarian — Mish and Denninger, for instance, but their solutions are politically unworkable and pretty anti-liberal.

  14. August 30, 2009

    Oops. I forgot to close the final . Only the first paragraph should be emphasized.

  15. August 30, 2009

    I’m not that impressed with liberal blogs these days, as a group. Stupider every year. Hope and “change” are bad for the brain, I’m afraid.

    Well as DeLong goes, he’s been consistent with this line practically since he started blogging. I pay close attention to him because he is the clearest spokesman for the saner wing of the People Who Matter. Generally, even if his predictions of *outcomes* are wrong, his discussion of what policy will be implemented is right, at least in my experience. Except when Republicans are (rationally) protecting their constituents.

    As for stupider blogs, it is merely the case that a larger population of people have come onto blogs, and their political choices more closely match that of the population. I’m still not convinced that Obama wasn’t the optimal solution among solutions that would be permitted by the People Who Matter.

    To really work on his terms you need a significant devaluation of the dollar. But if you devalue the dollar that much, you get caught in the oil trap, leaving aside the living standard drop that it also implies.

    I think this is the core of the disagreement. One side says, we can’t wait for the dollar to devalue before structural reforms are made. The other side says that we can’t make structural reforms until the dollar devalues.

  16. August 30, 2009

    Jct: Sure, in a technical utopia where everyone gets a share of the robot paychecks as a dividend and may also bid on contracts to earn more credits, no one will need to count our money.
    But just like a poker game is more fun if you’re keeping track of your chips, an economic game is more fun if you’re keeping track of your chips won in the game. As long as there are enough chips for all, why should anyone care that others strive for excellence counted in chips. Elvis Presley would have earned millions of hours of chips without affecting anyone else’s right to buy in for new chips.
    So the real problem is only the interest. LETS banks lend credits interest-free to all based on time IOUs and collateral IOUs or even cash (Bershares, Toronto Dollars, etc.) A UNILETS could bank the whole game.
    So there’s no reason to get rid of banking, only reason to upgrade from interest-bearing chips to non-interest-bearing chips (paid for with a 1 time service charge.
    See Shift B inflation at youtube.

  17. Ian Welsh permalink
    August 30, 2009

    Dollar devaluation clearly needs a post of its own. Just wrote one, will post later tonight or tomorrow morning.

  18. masnoor h. khan permalink
    September 18, 2009

    A Radical Solution for America’s Insolvent Financial System
    The core problem of the United States’ banking system (and maybe the world’s banking system) is not liquidity but insolvency. The liabilities of the United States’ banking system exceed the value of its assets. The issue is not only the toxic assets (toxic mortgage backed securities, toxic commercial real estate loans, sub-prime mortgages, alt-A loans, adjustable loans likely to go bust, increase in prime mortgage default rates, etc) but also off-balance sheet liabilities (such as expected huge unaccounted for future derivatives losses).
    This means that bailouts are just beginning and will require bigger and bigger sums of taxpayer money as time goes on. The government will resort to borrowing more and more and eventually to printing money when treasury debt auctions start failing. The end result of this path is a currency collapse and probably total chaos as expected by gold bugs.
    One other way to deal with this issue is to stop the bailouts and let the dominoes fall. Defaults and cross-defaults will cause many, many depository institutions (even very large ones) to collapse leading to extreme decrease in money supply as bank deposits are destroyed. Deposits of failed banks cannot be used to pay bills, make purchases and/or service debts.
    Which will probably lead to even more defaults as unemployment increases and debtor’s are unable to service their debts. This process will probably cause extreme deflation as businesses lower prices in a bid to survive. This will also lead to wage cuts, increased unemployment and a deflation spiral and much chaos. But probably less chaos than a currency collapse.
    Is there a better way?
    Here is my idea:
    1) We essentially need an orderly bankruptcy and liquidation of the United States’ financial system.
    2) I suggest we create a government owned bank and transfer all deposits of the private commercial banking system to the new government owned bank. This “transfer” is really just new money creation. This new money will be digital cash (electronic version of physical paper cash). Very much like reserves at the FED.
    3) Note that the plan will not create net new money since we will be destroying all deposits of the commercial banking system in the process.
    4) All assets of the commercial banking system will be transferred to the government and auctioned off in an orderly manner over the next 10 years. The proceeds from the sale would go the United States treasury and not the commercial banks. The assumption here is that commercial banks deserve nothing since the entire industry would have been most likely destroyed any way. Even good banks would have been destroyed due to bank runs and defaults if the government had allowed the dominoes to fall. Of course bank shareholders, bank bond holders and counter parties of bank derivatives would not receive anything.
    5) After the transfer FDIC protection will be removed for any private bank which wishes to remain in business or any new private depository institution or bank. From that point on the government should make it absolutely clear that there will be no more bailouts and no more conversions. This will discourage (but not completely eliminate) fractional reserve deposit banking and private money creation that results from pyramiding of government created money. This will also limit debasement of the currency that results from fractional reserve deposit banking. In fact, we can have “free banking” from that point on and not even have reserve requirements or capital requirements. All depositors who use private banks will be fully at-risk. The industry will have to set the interest rate high enough to attract depositors.
    6) The new government bank will act as an electronic “piggy bank” only. All deposits will be 100% reserve and it will not make any loans. Loan making will be left to the private banking system (with no deposit insurance or a possibility of a future bailout). The new government owned bank exists only as a “safe” money storage and a payment clearing system so the public does not have to carry around physical paper cash to make purchases and pay bills.
    7) Of course this plan is not without pain or cost. Cost of funds for banks and borrowers will probably rise as bank deposits are a source of very low cost money for the banks. Nothing is free. We are just exchanging higher cost of funds for removal of systemic failure risk. Economically we are recognizing that when money is loaned there is always credit risk.
    8) We are just separating the payment and clearing transaction system which is absolutely necessary for day-to-day commerce (no credit risk) from the loan banking and investment system (has credit risk).

    Mansoor H. Khan

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