What is going on?
Most people do not understand the banking crisis. In Chicago workers are picketing Bank of America because Congress gave the bank $25Bn and the bank still foreclosed on their employer and left them jobless.

As an investor you need to understand or else how can you invest sensibly?

To do that an investor needs to understand how the banking system creates money and why therefore the government had to rescue it.

Imagine that we have an economy with three people in it Housewife, Plumber and Banker.

Housewife has £1,000 and spends it on plumbing work.
Plumber then deposits that £1,000 with Banker.
Banker keeps 10% of it and lends £900 to housewife for more plumbing.
Plumber does the work and deposits another £900.

Banker continues to loan 90% of all new money and the money goes round and round. Eventually Banker has £1000 of cash, £9,000 of loans, and a debt in respect Plumber’s £10,000 of deposits.

This is fine as long as neither of two things happen
1. If plumber even takes just £1,000 out in cash the whole edifice crumbles because Banker has no liquidity (A bank with no money ceases to be a bank in any meaningful sense)
2. If housewife cannot repay the loan in full then the bank loses money and once Banker’s capital is exhausted Banker is insolvent and Plumber’s £10,000 balance is worthless.

In either event housewife has to repay her loans immediately and that she cannot do.

In practice of course we are all housewives and plumbers in this scenario and at different times in our lives we are both depositors and borrowers. There are millions of us and to the extent that we pay bills through the banking system, the amount of bank deposits remains constant. It is just the identity of the depositors that changes.

If £1,000 of cash supports loans of £9,000 and deposits of £10,000, the whole £10,000 sloshes round the economy as electronic money moving from depositor to depositor. The fact that loans rather than bank notes support 90% of it does not in practice matter. As long as everyone believes they can have cash if they want it.

Bankers expect to lose out on some loans anyway and it is allowed for in the interest rates charged. However if losses mount their own solvency is threatened and that trust is lost.

If money is withdrawn from the system, loans have to be called in to maintain bank liquidity ratios. If the banks need to maintain 10% liquidity it means that loans amounting to ten times the cash withdrawn have to be called in.

If debts are called in early, immediate repayment is frequently impossible. This turns a liquidity problem into a solvency problem. Depositors lose their money and are unable to pay their own bills causing more borrowers to default.

If the weakest bank goes to the wall, this causes more insolvencies, which in turn causes the next weakest bank to fail and so and so on.

Ultimately money is just destroyed and the economy grinds to a halt. You eat because the banking system works. You pay Tesco. Tesco pays its suppliers. Tesco’s suppliers pay their suppliers. For that to happen the banking system has to work.

When the housing market fell, this caused problems in the banking system and first Northern Rock had to be rescued and then so did the rest of the banking system. Banks could not raise money because of their solvency problems. The only option was for the government to do the borrowing and give money to the banks to prevent economic collapse such as happened in to 1920s and 30s.

If you go to Tesco much of the food is imported and so many of the ultimate suppliers are abroad. In addition as a broad generalisation people in Asian economies save and people in western economies borrow. This makes the problem international. Indeed another problem may well be that Asian savers are starting to spend. To the extent that deposits in Asia are supporting borrowing in the West, their cash withdrawals are forcing lending in the UK to contract and contracting money supply in much the same way as the withdrawal of cash would if the depositor were in the UK.

Although the implosion of the banking system has been prevented, confidence has been lost and mortgage defaults have soared. The system is in practice more fragile than it was before World War II. Then most people then were paid in cash at the end of the week. Shopping was paid for with cash. All that was cash money moving round the economy outside the banking system. Today we pay with a credit or debit card and so the money stays in the banking system and never sees the light of day. We use very little cash. A far greater percentage of the total supply of cash is now in the banking system, which has turned that into a much greater amount of electronic money. It is that electronic money that flows round the system.

Banks now have to do two mutually exclusive things. They need to repair their liquidity rations and in order to do that they need to reign back on their lending. However, they also need to expand their lending to stop the economy from contracting further.

It is not a happy situation to be in.

Standing back from the situation even further, many deposits by Asian savers are in practice backed by Western loans and this crisis has made those loans much more risky than they were. Our ability to repay has been damaged. The bright light in this situation is that it is very much in the best interests of the Asian economies that we do not default, as the pain will be felt there too.

It is notable that one bank that is rarely mentioned in this crisis is HSBC. Maybe its old name helps explain that "The Hong Kong & Shanghai Banking Corporation". Its a bank created to serve the empire. The empire is gone but the bank is still there with its savers all over Asia.

The balance of economic and political power has now shifted, probably irreversibly. In a small footnote to recent news item the Chinese government criticised the US government’s economic management.

Welcome to the new world economic order!

The Banking Crisis