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Musical Chair Banking

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Hi Martin,

I read the Iceland proposal before you posted your comment about it.  I knew intuitively it wouldn’t work because they were putting government in charge of credit creation – like placing the wolf in charge of the hen house.  (I believe my conclusion came from your Education – thank you.)

I listened to your ‘Solution’ conference and you confirmed what I was thinking, which was government spending should be no more 5-10% of GDP (with tax revenue exceeding that amount so there is NEVER a deficit).

As you suggest, government is necessary in society as it fills a critical role, but that role should be clearly defined.  Credit creation by a bank fills a critical role in a society, so long as that role is clearly defined.

When I read that for every dollar deposited, banks can create 90 cents of loans with it, it strikes me as too much leverage.  Just as you defined that government spending should be no more than 5-10% of GDP, what leverage do you feel is appropriate for banks?  Is the current system too much or would it serve just fine as long as the credit went to loans that bettered the economy (as you state it, so long as the credit goes to relationship banking and not transactional).

Thanks again for all you do.


ANSWER: There are several problems with the whole credit picture. The reason we have banking crisis is because banks borrow short-term and lend long-term and that was the traditional relationship banking model. So they lent on property with mortgages and they held that on their books monitoring you and/or your business. That was the relationship banking model.

The transactional banking model was they securitized the loans and sold them. Under this model they became just brokers. They could care less if you paid off the loan – that was not their problem. It changed the entire incentive from conservative to just write the loans because they had people willing to buy.


Great Depression Land Auctions

The fractional banking people criticize was exaggerated by FDR during the Great Depression. Real Estate collapsed and he tried to revive the market. Without banks lending, that meant property fell to at best 10 cents on the dollar. ONLY people with cash could buy. FDR created the 30 year mortgage. By extending the time horizon, he was effectively bringing forward someone’s earning capacity to 30 years to spend now (leverage). It was government who extended that model – not the bankers.

The 30 year mortgage became the norm. In good times, it leveraged the entire real estate market. If you now eliminate that lending and say government will be now be in charge rather than the free market – OMG. You know who will get first dibs – their families.


The fractional banking is not the issue as much as manipulating the yield curve. Because governments are the largest single debtor, they drive the interest rates while they are stupid in still assuming they can raise interest rates to fight inflation. It has the exact opposite impact for the government spending will now automatically escalate to cover interest costs. Inverted yield curves wipe out the banking model and the current collapse in short-term rates expand the profits of bankers tremendously.

The NY Boys argued to drop Glass-Steagall so they could trade rather than keep loans on their books would reduce THEIR risk and strengthen the banking system. The blew up the world like Iceland, took no responsibility, and then told Congress if they were not bailed out then government could not sell its debt. The 2007-2009 Crash illustrated this model does not work and now they bribed Congress to repeal Dodd-Frank so it is back to the wild and crazy times. Politicians are not there to protect society, they are simply there to line their pockets with few exceptions who are the freshman typically since the longer they are there, the more corrupt they become.

The issue is not to hand banking to bureaucrats nor is it plausible to terminate banking. What is plausible is to restore Glass-Steagall, outlaw proprietary trading and restore relationship banking. The big money center banks are controlling government with effective bribes in form of campaign contributions to both parties and they have become traders, not bankers. Let them raise money and be hedge fund managers but not to trade with other people’s money where they keep the profits and hand the losses to government.

The wild times have come from the trading side and the collapse of relationship banking. Deal with the problem directly. Somehow we seem to just be dancing around in circles. This is like musical chairs. When the music stops, we are in trouble. We have to define the problem looking at every aspect, not just one. If we do not stop transactional banking, we are in for another crash that may be worse than the last one.