What Kind of System Is It?

April 7, 2008 – “Crises are endemic to financial systems.” So says The Economist in an April 3^rd editorial about the present credit crisis. But are they right? Or are they just an apologist for banking interests and offer what has come to be accepted as conventional wisdom in order to deflect blame away from the real culprit?

I think it is the latter. The real culprit is fractional reserve banking, and I am not alone in my thinking. Here is what Austrian school economist Murray Rothbard wrote during the brutal banking crisis that resulted from the nationwide collapse of the ‘savings & loan’ industry in the U.S. nearly two decades ago: www.mises.org

“What is the reason for this crisis? We all know that the real estate collapse is bringing down the value of bank assets. But there is no “run” on real estate. Values simply fall, which is hardly the same thing as everyone failing and going insolvent. Even if bank loans are faulty and asset values come down, there is no need on that ground for all banks in a region to fail.

Put more pointedly, why does this domino process affect only banks, and not real estate, publishing, oil, or any other industry that may get into trouble?…The answer is that the “bad” banks are vulnerable to the familiar charges: they made reckless loans…or their managers were crooks. In any case, their poor loans put their assets into shaky shape or made them actually insolvent. The “good” banks committed none of these sins; their loans were sensible. And yet, they too, can fall to a run almost as readily as the bad banks. Clearly, the “good” banks are in reality only slightly less unsound than the bad ones.

There therefore must be something about all banks…which make them inherently unsound. And that something is very simple although almost never mentioned: fractional-reserve banking…Only if all the deposits were backed 100% by cash at all times (or, what is the equivalent nowadays, by a demand deposit of the bank at the Fed which is redeemable in cash on demand) can the banks fulfill these contractual obligations.

Instead of this sound, noninflationary policy of 100% reserves, all of these banks are both allowed and encouraged by government policy to keep reserves that are only a fraction of their deposits…that results in our system of permanent inflation, periodic boom-bust cycles, and bank runs when the public begins to realize the inherent insolvency of the entire banking system.

That is why, unlike any other industry, the continued existence of the banking system rests so heavily on “public confidence,” and why the Establishment feels it has to issue statements that it would have to admit privately were bald lies…That is, everyone would find out that the entire fractional-reserve system is held together by lies and smoke and mirrors, that is, by an Establishment con…The banking system, in short, is a house of cards.”

It is indeed a house of cards, and we are now seeing just how fragile that house is. The accompanying table is from The Wall Street Journal on April 1^st.

Banks will soon be reporting their quarterly results, which we already know will not be good. So it is reasonable to expect that the $140 billion of sub-prime losses incurred by banks in this table will rise in the weeks ahead. As a result, banks – and their apologists – are now looking for potential saviors, namely, how to foist another bank bailout on taxpayers. It will be done under the guise of bank restructuring.

The Financial Times reported last week the 1998 mega-merger that combined Citicorp with the Travelers insurance and brokerage businesses was a “mistake”, according to John Reed, who masterminded with Sandy Weill the $166 billion deal. Reed went on to say that Citigroup turned out to be a “sad story”.

Yes>, indeed it did. I explained how sad it was in the last letter, which showed how over-leveraged and under-capitalized it was and pointedly asked whether Citigroup “will survive”.

Big banks never die – they just get merged, particularly those connected to ‘old money’, which is what Mr. Reed represents. Therefore, Mr. Reed’s comments this past week are instructive in my view. I read it as saying that Citigroup’s problems are too severe and the bank is too big to merge. So it will instead be split into two (or possibly more) entities, and this separation will therefore become the key to its survival.

Interestingly, the same strategy is apparently going to be used at UBS, the Swiss global banking giant. The Wall Street Journal this week reported that its chairman would resign as a result of another $19 billion write-down of low quality real-estate paper it owns, amid calls that the bank is too big and needs to be split into different parts. One of these would supposedly be a so-called “bad bank” created specifically to hold all of UBS’s inferior sub-prime assets. But it was Bloomberg that reported the really important news. Ironically, it was not from its own work, but that of Sonntag, a Swiss newspaper.

Here’s how Bloomberg put it: “Sonntag said UBS is suffering from a cash drain after customers in the Zurich area alone removed funds worth 700 million francs as of March 26.” In other words, this global banking giant has been undergoing an old fashioned, 1930s bank run like the one that hit Northern Rock last August. So one could reasonably ask the same question I posed in the last letter about Citibank – will UBS survive?