Monday, February 23, 2009

Logical Whiplash

So I deigned to click on one of my "No Go" columnist's columns today, the oft-cheered-by-the-Left Paul Krugman... because, hey, I'm a reasonable man and I like to look at the spectrum of the ideas if only to know what they are. Besides, I know myself that the whole business of "creating" money is a bit more complicated than I (or maybe anyone) can actually understand.

This one is titled "Banking on the Brink", in which Krugman is in favor of Nationalization -- but hold on -- what he says he means here is the same kind of bank cleansing the FDIC does when it takes over a failed bank -- the bank gets re-privatized. So he came up with a term "pre-privitization" ... by which he really means "pre-re-privitization"... but that's awkward. At any rate, call it money laundering, or loan laundering, or whatever. And I don't know, maybe Paul's right on this one given the fact that the problem is, basically, that banks don't have enough assets to come close to covering the losses they may incur in a big recession/depression.

As an aside, here's my hand-waving description of how money works in this country. I'll start at the low level -- because that's where it all really happens. It's where the rubber meets the road. Then we'll work our way up.

Money represents productivity -- productivity of goods and services. It's a store, like a battery is for electricity. Or call it a "productivity conversion and transport device". I produce for 7-11 by working the Slurpee counter. 7-11 gives me some money for it. (Never mind where the bills physically originate for now.) I can't eat the money. But I want a Big Mac. I haven't done any work for McDonalds, but I can give them this "battery unit" representing my productivity for 7-11, and they'll do work to make me a hamburger (for which McDonalds pays them) and give it to me. And now maybe they can go rent a movie from Blockbuster with the money McDonalds gave them for making me a hamburger.

If I put drywall up in Bill's basement but he's got nothing I need, he can give me money he got for doing something someone else needed and I can go use that for something else in some completly unrelated venture. The money itself is a representation of the value Bill and I agreed putting the drywall up in his basement.

But that value was created by me doing the labor. So money cannot be finite. Somebody does the work - bang! New value. Means new money. Nobody does the work; No value created. It is not a zero-sum game. There's not just people with money and people without money. Things you and I do actually create money in an almost literal sense. But we don't get to print it up ourselves. That all gets done through the banking system. Call it a big standardization institution. A lucrative one, no doubt. But outside of a strict bartering economy, a necessesary one.

So how does a loan work? A friend once told me, and he was shocked -- that when a bank lends you money, they create the money out of thin air by giving it to you, and then saying you owe it back, plus interest. But that they never had it to begin with.

I knew deep down there was more to it than this at the time. If that were true, banks could just keep creating money out of nothing and transferring it to the banker's accounts. As much as they want. So what's stoping them? Risk. The activity is not without risk. (Not that it isn't still extremely lucrative and subject to abuse). They are placing a bet -- making a guarantee on the production of goods and services by their customers. It is tied to events, past, present, or (mostly, typically) future events which will guarantee the value the loans represent. And over time I came up with this model in my head that explains the whole thing pretty well in my head.

The bank does, in fact, have some money. Enough to, say, pay the former owner of a house you just bought completely off -- and to do that for many people per day. But the amount of money it has on hand and the amount on it's balance sheets are diffferent, because basically they are relying on you to go produce for someone and give some of that to them, plus some interest for their trouble, and they've got lots and lots of people doing this day in and day out. So they've always, in a sense, got what's coming in every day to hand out every day -- (and they're supposed to have reserve on hand too... but let's not get into that).

So what they're basically banking on is the fact that you're going to go produce something for someone -- enough that you can meet the obligations of your contract with them. With a house or car loan they have some element of a guarantee that the deal won't be a total loss for them if you walk away from it -- which most people won't -- because your house or car will be worth something. The contract will say that they get it in that event, and they can sell it to someone else and get some or all of the money back... maybe more depending on the market value.

So the bank is taking a calculated risk with each loan it makes -- and that risk is that you might not produce ... and thus add to the economy and give some of the value represented by that in money -- to them (both to pay them back and to "tip" them for their trouble).

So what it basically means is that you are the one that actually creates the wealth, represented by the money. If you don't create it, or get it from somebody else that created some, they don't get the money they guaranteed to someone on behalf of you.

Little banks, in turn, play similar roles as you and I do to those banks ... to larger banks that primarily lend to ... banks. Those are the big boys. Up at the top of the food chain is the Federal Reserve, where high-level monetary policy gets decided.

Right now what we have is banks looking at each other, wondering if they have enough assets to cover the loans one is asking another for.... banks worried about the risk of lending to one another. Big Bank A is worried that bank B is not going to be able to get the payments it needs from bank B's assets (which include its customers) to meet the obligation it's asking for. So it won't lend bank B the money it needs to lend money to Bob the Builder to buy the materials he needs to build the new shopping center and pay his employees before the shopping center owners pay them ... the shopping center owners in turn are banking on loans they're taking against future space rentals from businesses who will in turn take out loans they'll pay back depending on how flush their customers feel after they open. Including promises to pay their employees.

This has been caused basically by banks overestimating their assets -- which was fueled largely by runaway real-estate prices that were assumed to be perpetually heading upward, fast.

They stopped, making the risks in bad loans a bigger deal. And there is a very real domino effect that can easily be set off here unless somebody figures out a way to neatly pull a few dominoes out of the line near the top.

Anyway, what I'm saying here is that Krugman, a man I hate to read, may be right here about a method to do just that. I don't know.

But that's not what got me started on this, although I'm glad we went through that exercise. What got me thinking about it was this comment someone left on the article. It starts out coherent sounding enough... but wait until you get to the end:

The problem with the banking industry is not just banks that are effectively bankrupt, with deposits unable to adequately cover failing debt obligations or falling asset values. The underlying issue is liquidity and the structure of loan portfolios going forward. Nationalization or preprivatization should be a condition for the federal government providing liquidity to failing banks. However, there will be little economic value created in recapitalizing the banks, if these banks move forward and choose to make loans for uneconomic activities. Thus, the federal government's more important role with respect to the banking industry may be to institute regulations that encourage borrowing for needed projects that have a high economic return on invested capital (ROIC). Today, one of the most productive categories of high economic ROIC projects are those that decarbonize the economy - pull carbon out of industrial processes that emit CO2 into the atmosphere.
I was actually following the dude until that last sentence. Basically, he's saying that to fix the banking problem, we should address "global warming". Show me where decarbonization projects are going to give us a high ROIC! Where is the demand for that among people with capital to spend? How much of your income are you willing to give to such projects? Because ... that's where it would have to come from. The government. Barring some sudden formation of a private organization with lots of money to spend voluntarily. Private organizations that want to spend money on this stuff exist, for sure. But they don't want to spend their money. They want to use the coercive power of the government to force you to spend yours.

No comments: