Going off the reservation on another financial rant/post today...

The other day I saw this great post explaining Fractional Reserve Banking in really simple terms.  It really lays the foundation for why our Federal Reserve and Treasury's policies not just now but over the last decade have helped lead us to where we are now and have actually been a main contributor to our worsening financial crisis.

Without going into the details of how it works (follow the link if you want a clear explanation), fractional reserve banking is the type of banking system that the US and pretty much every other country have operated under for hundreds of years.  There is nothing inherently bad about it, it's actually been very beneficial to society.  Without it banks could not lend money at rates at even close to the rates they do and still make money.  Many of the advances in society we've had, for example the industrial revolution may not have occurred without fractional reserve lending.  Certainly the concept of home loans, car loans and credit cards would not exist today.

Now like almost all good things, fractional reserve banking has some trade-offs.  The main one being that a cycle of boom and busts is mathematically inevitable within it.  As money is recycled through the banks, society becomes increasingly in debt and each additional cycle of lending generates less economic production, as more money is eaten up by interest costs.

You eventually reach a point in which the system becomes mathematically impossible and a "reset" is necessary.  The people who took on too much debt for unproductive uses like consumption (buying that new SUV, boat, 6 TV's) go bankrupt along with the banks who made the imprudent loans.  The total indebtedness of society is again reduced to a manageable level by defaulting debt.  These resets are an inevitable artifact of a fractional reserve banking system, and occur fairly regularly through things like recessions.  They need not be cataclysmic, society changing events and typically occur well before the mathematical brick wall is reached.

For more than a decade the US at all levels government, corporate and individuals have increasingly taken on greater and greater indebtedness, while at the same time the economic productivity from this debt has decreased.  Particularly over the last 6 years, the amount of debt we've taken on has been impressive but what was it used for?  Buying a house, and a new car is a great thing it really doesn't generate long term economic production in the same way building a factory does.  At the same time our manufacturing base has moved off-shore, most of our economic "growth" was not real nor sustainable.

Our fractional reserve banking system reached that point were a "reset" was needed to stabilize things and get back to productive ways.  Instead the geniuses at the Federal Reserve (yes I'm talking about you Greenspan) came up with the idea that could prevent an inevitable and needed business cycle through manipulating monetary policy, effectively lowering reserve requirements in banks and deregulation.  Instead of letting the system flush itself out and going through what probably would have been a fairly bad recession in 2002, they lowered rates and took actions that allowed increasing amounts of debt.  Deregulation occurred that allowed for banks to increase leverage and this debt trickled down to the consumer level via cheap lending.  Massive debt was added to society for things such as home loans and leveraged buy-outs in the corporate world, neither which generate lasting economic benefit.

Over the last two years this legacy has been carried to the extreme by Bernanke, Paulson and co. as they continued to do the exact opposite of what must happen to stabilize our financial system.  Remember the two things needed to “reset” a fractional reserve banking system and get it operating smoothly again is a reduction in total indebtedness through the default of bad loans, and the failure of those banks that made those loans.  So guess what they’ve done and continue to do.  Artificially hold down rates, increase total debt in the system via injecting massive liquidity, prevent the bad debt from defaulting and prop up banks that made bad loans.

It makes you want to bang your head against a wall, at least it makes me want to.  

Why do people continue to act like these guys are saviors steering our country through this crisis when their actions do the exact opposite, and are in fact some of the main perpetrators of this crisis?

Since the beginning of the financial crisis I’d get asked what my solution to the problem would be and my response would basically be “let them fail” and stop trying to artificially prop things up.  People would look at me like I was insane, that’s not a solution, it would create a disaster, lots of companies would fail, the government just needs to do more.  No, that is how you fix it and every attempt the government takes to intervene and prevent the needed reset, itself only creates a new, bigger problem.  The years of continuous government intervention and artificial attempts to circumvent corrective market forces is a primary reason this crisis has gotten so bad and continues to get worse.

Which brings us back to todays FED announcement that they are planning to purchase US treasuries to hold down long-term rates, but that’s for another post...