When crashes happen, vast quantities of money are reported as being lost. But are they really? Or is it that they actually just cease to exist? It's an important question that needs an answer.
This is the audio only version:
And this is the transcript:
What happens to all the money that disappears in a crash?
It's a question that I am often asked, and it seems a reasonable thing to speculate upon, because, after all, most people think that money is, somehow, tangible and a real something that you can get your hands on, and the reality that money is only a debt, and that the debt can fail because it is just a promise to pay is something that most people find very hard to comprehend.
But it is that reality that is reflected in the fact that when a crash takes place, money can literally simply disappear. Money is quite simply a promise, and as we all know from experience in life, promises can be broken.
The promise to pay is something that we usually accept at face value because most of the time, most organisations, and especially banks, are quite good at keeping that promise. It is at the core of their business model.
But suppose there is a crash, then the promise to pay might fail. And we know that possibility exists because in the UK, for example, there is a guarantee provided by the government on every single person's bank account with every single institution with which they bank for a sum of up to £85,000.
In other words, a person who has, for example, £50,000 in a UK high street bank will get their money back from the government in the event that the bank in question cannot pay them. And if they have accounts with ten banks all with £50,000 in them, then they will enjoy a guarantee of all their money back - half a million pounds from the government - and nobody suggests that there is anything wrong in them arranging their affairs to ensure that is the case.
But why would they arrange their affairs in that way when it would, very obviously, be much easier to put all their money in one bank? That's because deep down people do not trust the promise that a bank makes to pay.
It is as simple and straightforward as that. And in the event of a crash, the sort of thing that we had in 2008, when we saw people queuing up outside Northern Rock, which actually was in 2007, and the precursor of the 2008 crash that followed - but the point remains valid all the same - people queued up outside Northern Rock, and they wanted their money back, but there was no guarantee that they would.
That is why the government had to step in, and in that case, they guaranteed repayments of all deposits to all people with money in that bank. And the day was saved, in a sense. The run on the banking system as a whole ceased to be a threat. The promise was maintained, not by the bank, but by the government.
Now, what happens in a crash? That promise was kept is under threat. It's under threat for all sorts of reasons. Most particularly in the event of a crash, asset prices fall. Let's be clear what I mean by that.
The assets we're talking about are the things that the banks take as security for their loans. The one with which almost all of us are familiar in some way or other, whether or not we've ever had one, is, of course, the domestic mortgage. The mortgage is what is called a legal charge, and what it means is that if you are not, as the borrower, able to repay your liability to the bank, then the bank can claim your asset - the property that you bought with the loan that the bank provided - and use the proceeds from the sale of that property to repay the loan that they provided you with.
It may not clear all your debt by the way, you might still owe money, but the point is that they use the property as security for the loan and this is also commonplace with regard to business loans. The assets that are used as security might differ, but in many cases they will still be property, but they might also be the debtor's book of a company, or all the property within the company itself. It could be a personal guarantee from a director, which is a problem for many small businesses, and is usually backed up by value of a property yet again. In other words, what the banks always look for are a means of recourse for the loans that they make.
And in some cases, they might use more esoteric assets as their security. They might, for example, lend money against the security of shares. When you're very large, you can get away with this. When you're an individual, it's highly unlikely that you can. But the point here is that, just like houses, the value of shares can fall. And once the value of assets is falling, in a crisis situation, markets tend to become intensely chaotic. Values might rise steadily over time. That is a feature of most markets. As people get confidence since the time elapsed since the last crash happened, then they begin to believe that prices will always rise.
And so they do, until the day when they don't.
And then, as happened in 1929, as happened in 1987, as happened at around the period when banks were falling over in 2008, the value of shares and other properties fall dramatically.
And as a consequence, we get a crash. There is no better word for it than crash because that is the way in which the prices fall.
And at that moment, the security available to a bank for the loans that it has provided vapourises in so many cases that it suddenly looks as though the value of the loans it has made on its balance sheet, which are its asset, because they have to be, because they are the borrower's liability, suddenly look to be worthless or unfounded. And unfounded in the sense that there is nothing to back up the asset value because the security that was provided to guarantee repayment either no longer exists or does not have sufficient value to cover the value of the loan that the bank made. And then the bank is vulnerable to failure.
This is what happens in a crash. The promise from the person to the bank to repay their loan has failed.
In turn, the promise from the bank to the depositor to repay the money that they owe to that person might also fail. And here another aspect of banking comes into play. You might say “Well, why can't the bank create more money to just make the repayment?” and of course that is true of the central bank.
But it isn't true of the individual bank because they do not now have another counterparty available to them to create the new funds by creating a new loan when what they're being asked to do is to is to repay an existing loan, and in this case the loan is from the depositor to the bank because it's an asset for you and therefore it's a liability of the bank. And they can't do that in the short term because they can't get their hands on the required assets.
Now, this situation has radically improved since 2008, because in 2008, the value of the central bank reserve accounts that the banks maintained with the government were tiny, little more than £20 billion in total. And now they are in excess of £700 billion in total, although the Bank of England is doing its very best to try to reduce this figure as fast as is possible, even though that threatens the stability of the banking system.
But what is clear is that those funds could, at that point of time, be used as security for making the repayment that is required to the depositor to provide stability to the system that would then be required.
So don't doubt that quantitative easing did, in this sense, provide significant new capital to the banks that bailed them out in 2008 and afterwards, but which now provides us with security that the banks may be able to repay us using, in effect, government created money because the system might provide for that.
And the government could itself, of course, create new money, as it did in 2008 for this very purpose. It disguised it through the quantitative easing process, but what happened in 2008 and 2020 was that new money was created to keep the economy going. It's as simple and straightforward as that, and it will happen again in the event of a crash.
That's necessary because the only person's promise to pay that has any value in the event of a crash is the government's. Nobody else's has any worth at all. The government can create money that still has value at that instant. And, therefore, they have to step in and it's because the rest of the monetary system has fallen into disarray because the promise to pay has failed.
It's not that the money has disappeared. There never was money. There was only a promise to pay and that promise to pay has now failed. And because it's failed, the government steps in.
But, and this is a video riddled with buts, the reality is that the greater the risk within the banking system because of the quality of the assets used to back up the promise to pay made by the customer, then the greater the risk is to the government that they will have to bail out the system.
And this is where Bitcoin comes into play. If people are using Bitcoin as security for loans from banks, and it seems possible that they are, then the likelihood that there will be a crash is increased because the possibility that the value implicit in Bitcoin might disappear at a moment, any moment, when a crisis occurs is very high indeed.
And that's why it creates risk of creating a crash. But in a crisis the money doesn't go anywhere. The money was simply a promise to pay, and that promise to pay was broken, and therefore the money disappears. It vapourises, because there is no tangible physical quality to money, and it doesn't go anywhere. It's just gone.
You have to understand that intangibility to understand how the economy works, how money works, how banking works, and why government has to be the provider of all money at the end of the day.
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Previously you told us that the banks don’t lend out your deposits to other people, but now you are saying that if the loans go bad depositors might not get their money back – both can’t be true.
If the money deposited was never lent anywhere else, how can it be at risk?
Because the bank’s liquidity fails.
Why not try engaging your brain?
A more detailed answer is that the banks don’t need deposits to lend. They create loans make making entries in their ledgers. Some of the money created will probably end up bank in their bank as deposits (although obviously it’s not distinguishable). If all the banks loans default then the depositors will lose their money unless the govt steps in.
Interestingly enough someone I knew who inherited money in 2008 had quite an ‘interesting’ time trying to find a secure home for it as it was several times more than the £85000 Government Guarantee.
The reason being of course that a lot of ‘financial institutions’ are subsidiaries of larger groups eg First Direct is a HSBC ‘Brand’ and you then have to look behind the scenes to try and discover if these brands or subsidiaries have their own banking licences – I think First Direct does, and hence its own £85000 Guarantee or are they part of the parent companies licence, in which case he could not then deposit £85000 with HSBC as well.
I suggest however that as far as the major UK clearing banks are concerned were one or all of them to collapse then we would be completely stuffed.
FDIC Deposit Insurance is $250,000.00 USD per bank in the USA.
If you have more than $250,000 that want you want insured, then you must open a second account in a second bank.
I’ve experienced the collapse of two financial institutions and one “currency”, and in one of them, the government lied to me that they “couldn’t afford” to pay me the compensation due.
Equitable Life (at the time the most “respectable” insurance/pension company in the UK) went bust, making their “guaranteed annuity” promise on a pension, worthless. After years of class action legal battles, the Gov’t wrote to me telling me what I was due as compensation, but that they “couldn’t afford it” so I would get several £000’s less.
Next, a local credit union, crippled by the constraints imposed by rules from Gov’t, failed, but FCA coughed up 100% of my small deposit.
Finally the “Bristol pound” stopped trading recently, but again there was no loss involved, the Bristol pounds became sterling pounds in the Great Western Credit Union.
I wouldn’t touch CRypto-currency with the proverbial bargepole, what do people think the CR stands for?
I know there are crooks-a-plenty in ordinary banks, but at least they have governments behind them.
But as I learned from Equitable Life, sometimes even the government lies, walks away, and leaves you in the lurch.
Money isn’t real, it can and does disappear into thin air. The guarantees of a government are also finite, even ephemeral, if the government goes rogue.
What IS real, is human solidarity, sharing, caring, organising together, as families, neighbourhoods, nations, and as a global entity. And that, it seems to me, is under threat today, like at no other time in my lifetime.
The irony is that the LEAST secure people, at a time of collapse, will be the VERY VERY rich, because they experience a poverty of caring community solidarity, at a time when that will be of great value. The very thing they have billions of, will be worthless. They can’t eat it, shelter under it, or wipe their tears away with it. I pity them.
“But as I learned from Equitable Life”
In the USA, Banks, Credit Unions and Savings & Loans are under a completely different set of rules than insurance companies, financial service companies and brokerage firms.
I have speculated that if there was a kind of debt jubilee, all the tangible wealth of goods, farms, mines, fish in the sea etc. , and services in the sense of people able to supply them, would all remain. What would be different is that many people would lose their demand on wealth.
In 1920s Germany the whole currency was replaced and in a few years, it was quite prosperous. My speculation is that it might be better than an unmanaged crash.
One needs to remember National Savings (NS&I). This is cheap borrowing for the Government. For instance, you can put up to £2m in the NS&I Direct Saver account which currently pays 3.75% gross interest, but that is reducing to 3.50% gross from 20 December. It can’t go bust. You can also put up to £1m in Income Bonds which pay pretty much the same rates.
Aside from NS&I, the only financial products with “100% Guarantees” under the Financial Services Compensation Scheme are life insurances, most pensions, and all annuities.
Agreed
The money disappears all but the 3% that is note or coin.
And that’s down the back of the sofa
Time to rewatch the 1961 Disney Classic “The Absent-Minded Professor” for change down the back of the sofa.
🙂
This part :
“But it isn’t true of the individual bank because they do not now have another counterparty available to them to create the new funds by creating a new loan”
completely lost me. Can you explain who is who and which way things are pointing here? This just totally floored me because I couldn’t follow it at all.
Thanks Professor.
What I mean is that money creation always involves mutual promises to pay.
The Bank of England can always do this with the government, so its capacity topographic create new money is inexhaustible.
A private bank can only do this when it can find someone to exchange promises with, as it usually can do with a customer because the customer presumes the bank will pay whoever they ask it to. But when the bank faces a liquidity crisis, meaning it cannot settle its short term debts e.g. to depositors, there will be no one it can swap promises with. No one will promise to pay the bank if they j is the bank cannot then pay whoever the customer asks them to name settlement to. So, in a liquidity crisis the capacity of a private bank to make new money disappears.
Does that make sense?
I was watching one of those histories on TV (BBC4) about the industrial revolution the other night.
The presenter was getting carried away with the role of private entrepreneurs building canals, railways etc., and I wondered what a documentary based on Christine Desan’s work might look like talking about how central banks – states – released the power of sovereign currencies to help those private entrepreneurs do what they did?
Or Perry Mehrling?
This is why I think I get what you are talking about.
The power of the central bank is simply awesome. No wonder there are those who simply want to deny that this power exists or want to monopolise it for themselves.
You get it.
I suspect I will need to try this several t8mes to get it right.
“But why would they arrange their affairs in that way when it would, very obviously, be much easier to put all their money in one bank? That’s because deep down people do not trust the promise that a bank makes to pay”.
This proposition seems to me, fundamental. Banks deal in money. It is conventional wisdom that Banks issue money; that is true only in the sense that there is a hierarchy of money, and Banks have a place in the hierarchy. For Stephanie Kelton State issued money is the ‘decisive’ money (following Minsky), or in Mehrling’s terms the hierarchy is ‘inherent’, and a function of the credibility of the promise the money represents. Not all promises are the same: “Farther down the hierarchy, bank deposits are promises to pay currency on demand, so they are twice removed promises to pay the ultimate money, and securities are promises to pay currency (or deposits) over some time horizon in the future, so they are even more attenuated promises to pay. Here again, the credibility of the promise is an issue, and here again reserves of instruments that lie higher up in the hierarchy may serve to enhance credibility. Just so, banks hold currency as reserve, but that doesn’t mean that bank deposits represent currency or are at the same hierarchical level as currency.” (Perry, Mehrling, ‘The Inherent Hierarchy of Money’, 2012; p.2).
But in this In this hierarchy, where is the dividing line between money and credit? Mehrling takes a relativist position, it depends where you are standing in the hierarchy, what you observe, and goes on to address the commercial Bank promise: “It is tempting to draw the line between currency (and everything above it) as money, and deposits (and everything below it) as credit. The source of this temptation is the institutional fact that currency is the final means of settlement for domestic payments. Just so, for a bank settling its accounts at the end of the day, currency or ‘high-powered money’ is certainly the means of settlement.
But things look different farther down the hierarchy. For ordinary people like us, bank deposits are the means of settlement. Hence we might be inclined to view deposits (and everything above them) as money, and securities as credit. This is more or less the practice of most modern textbooks when they speak of the money supply, although there remains some ambiguity which is reflected in the various definitions of money: M1, M2, M3 and so forth.” (Mehrling, p.2).
What looks like money and acts like money in everyday life, in a crisis, may turn out to be just vulnerable credit.
Just about everything to agree with.
Richard, I was delighted to see your post, because I had written making a similar case a few years ago. https://sussexbylines.co.uk/politics/the-mysterious-case-of-the-burnt-banknote/.
I suggest that the ability of money to disappear has several consequences:
1) A Government can never recover all the money it creates, if some of that money no longer exists. No matter how many “difficult choices” Rachel Reeves makes, it will not come back.
2) If you do the accounting, when a Bank creates money to make a loan and the loan goes bad, the bank makes good the difference with Government-created money. If some of the Bank-created money in the loan disappears, Government-created money is taken from the wider economy to replace it.
3) Since Banks charge the highest interest rates to to the least well-off borrowers, the drain from the economy is from where the money is most needed and is achieving the most. (http://www.progressivepulse.org/economics/a-perfectly-regressive-tax-a-guest-post-by-michael-green)
Sorry Michael, but nothing about this makes any sense at all. You really need to to stop making up this nonsense. It is not needed. Stop believing there is something tangible called money. There isn’t.
Sorry Richard. Like you, Like you, I have been under the weather last week with an infection. (Hospital waiting areas are a great place to let your mind go blank.) I must not have recovered as much as I imagined, because I thought we were on the same wavelength. Of course a £ is just an IOU, and like any IOU may get lost or destroyed. Bubbles are a plausible mechanism. If a bank loan goes bad and the £s have been spent back into the economy, no problem. The question is whether bubbles are only a problem when they burst? Or are Banks continually converting £s into Schrodinger £s, which may or may not exist? If Schrodinger £s do not contribute to the economy (except by encouraging Banks to create more £s), then disappearing £s may cause a continuous error in conventional economic models. I dread to think of the future if your work does not gain proper acceptance.
Get well!
My point is – all money is by definition temporary, excepting that the govenment chooses to create and leave in existence. Eeven that rotates. So why worry about this cause of money disappearing? All money disappears. It’s how we replace it that matters.