This now brings us to the primary question about central banks. They are simply
NOT all the same! There is a substantial difference between the Federal Reserve and the European Central Bank (ECB). The accounting at the Fed allows for it to CREATE money as needed and thus Ron Paul’s attempt to get into the books of the Fed created a firestorm. The Fed did not wish to open its books to allow the world to see how it is actually run. Now the fiat crowd will argue that the Fed can just create money in a very ELASTIC money supply. This is true and it was intended from the very outset that when economic declines appeared, the leverage within the system would implode and thus to ease that contraction, more money had to be injected to slow the collapse.
Banking began after the Dark Ages as simply a place to store your money. You paid a fee and they held it. The banks figured out that they could lend money and make a profit while it was just sitting there. This scam became the norm and then we ended up creating fractional reserves meaning if a bank held 6% of the funds on deposit it was enough to operate normally meeting the demands for people to withdraw their funds when all things remained equal.
In time of crisis, confidence in the banks collapsed and more people now wanted to withdraw their money that exceeded 6%.
BORROW short-term on a DEMAND basis and lend the money out long-term such as mortgages. During a crisis, if more people than the 6% wanted their money, the bank failed and thus created a “run” on the bank.
Bank runs still happen today as they have always taken place historically. Pictured here is a bank run from the Great Depression and an English bank run from 2007 in Birmingham. It is always the same event
– a collapse in confidence. This takes place because the fundamental structure of banks has been built upon this idea that they borrow short-term paying a lower rate of interest and lend long-term charging a higher rate. The structure is built upon this notion of a normal yield spread with the profit being long minus short-term rates.
The purpose of an
ELASTIC MONEY SUPPLY is to allow the quantity of money to increase when there is effectively a run on the banks. This was designed to prevent a depression where banks fail and their assets (loans outstanding) are sold for pennies on the dollar causing real estate to collapse in value as the leverage within the entire system implodes and collapses. If money supply were ELASTIC, it could then expand during such periods and contract as confidence returns and the panic subsides.
Because the Fed was designed with this ability to increase the money supply on an
ELASTIC basis, this has helped to ease the bank failures that would otherwise take place. The problem is not so much with this theory and design as it is with the political ineptitude of understanding what this mechanism true does and what are its limitations? Because of the fiat crowd ranting and raving about the Fed, they are only adding to the whole confusion about the design adopting the same mistakes made by the politicians who also clearly do not understand what the Fed was all about. This original ELASTIC MONEY SUPPLY idea was NEVER intended to be a permanent practice. The politicians assumed the Fed was designed to FIX the economy somehow (the details escaping them), and this has migrated transforming the Fed into now taking over institutions “too big” to fail and is somehow supposed to sterilize whatever bad effects may be created by the politicians spending more than they should. The ELASTIC MONEY SUPPLY was a good intension that if left alone meant TEMPORARY and that the expansion would then contract back to normal once the crisis was over. If it were restricted to that role, it would be helpful in easing economic contractions. But as politics goes, they never can leave anything alone for very long.
So how does this contrast with the
ECB? Here in lies the problem. The ECB is NOT authorized to create an ELASTIC MONEY SUPPLY. Consequently, the ECB cannot continue to just buy-in sovereign debt of member states as the market forces come down upon them. The ECB, unlike the Fed, will run out of money and then there will be a very public crisis whereby the ECB will have to be recapitalized. Now the fiat money crowd will argue that is the way it should be. The problem then becomes PUBLIC and now we introduce politics into the equation. This warns that the CONFIDENCE in the entire banking system in Europe may collapse because there is no automatic ELASTIC MONEY SUPPLY so bank failures and sovereign debt collapses cannot be dealt with immediately behind the scenes.
The fiat money crowd is fixed on this issue of money. That is
NEVER the problem. In the west, precious metals became a medium of exchange based upon their intrinsic value. In Lydia (Turkey), coinage began as a means of to solve a convenience. Instead of having to test and weigh the metal over and over again, the idea emerged where the city intervened and produced a standardized weight and imprinted the badge of the city (lion). This idea of money being intrinsic was pre-coinage. Once government began to get involved, the value rose relative to the actual cost to manufacture the coinage and like today, politicians always spent more than they had so they debased the coinage to make it spread out going further. Merely because the coinage was gold or silver did NOT stop the same process of fiscal mismanagement then as compared to today.
The problem is spending and debt, not what we call money. To solve the problem is to directly attack the issue. Imposing a gold standard and hoping somehow this will restrain government is wishful dreaming. It is like fining your wife because she failed to get you to take out the trash. We have to outlaw government borrowing except in times of war and then
ONLY if attacked! Anything shy of that is just not going to work; so right church – wrong pew.
This issue of how a central bank functions and the purpose of an
ELASTIC MONEY SUPPLY will come to the forefront next year. The ECB will have to be restructured since the European politicians refuse to address the structural problems in Europe and its almost single currency. Either the monetary system is revised, of the ECB will have to be recapitalized. Something will have to give in Europe.
European banks are now being forced to pay insurers and pension funds to take over their illiquid sovereign bonds in exchange for better quality ones because the ECB lacks this ability to create an
ELASTIC MONEY SUPPLY. European banks are desperate to secure much-needed cash and are having to turn away from the ECB. The ECB has now become the main provider of short-term funding in Europe as lending between banks is mostly shut down as everyone fears this debt game of musical chairs. They are scare to death what happens when the music stops. The European debt crisis is entering a new phase as banks are now running out of the good quality collateral to secure the short-term money.
The banks are now turning to the swaps market with institutional investors. But the
ECB is not a bottomless pit because of its structure and we may see the next crisis that will shock the hell out of everyone when the ECB requires recapitalization. This will give the impression Europe has completely FAILED, but it is a structural problem that would not have been an issue had the politicians simply consolidated the debt creating a single European debt cutting string that binds them together relegating all member states thereafter to whatever they issued would no longer be acceptable as reserves for banks. But no! The politicians have to bring down the whole damn financial system because they are stubborn and outright brain-dead when it comes to economics. So now we will have an ECB crisis and that will create the IMPRESSION Europe has failed and we could see wholesale bank runs throughout Europe.
The question becomes who long can these liquidity swaps continue? Will this cause a run on institutional investors if the European public understand what is going on behind the curtain this time? This is now no longer a REPO transaction that is a 24 hour swap market. We are now extending REPO in a quasi-central bank function. The
ECB is being marginalized because of its structure.
The major Italian banks met with the ECB officials in Frankfurt pleading with them to increase access to its borrowing for Italian banks. This is all a concern that goes to the problem of having to recapitalize the ECB. The emergence of this new market for liquidity swaps has led to the UK's Financial Services Authority (FSA), to issue a report last July pointing out the new risks in this development. Spreading the problem around, some U.S. banks are jumping into the market entering into these liquidity swaps with European banks in the tens of billions of dollars. In Europe, unsecured borrowing among banks was virtually non-existent. We are on the edge here of a very serious economic implosion and it is ALL driven by politicians ignorant of the risks who pray at the foot of their bed at night to just make it go magically away. They are ALL betting on just growing our way out AND THERE IS NO PLAN B!