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July 13, 2019 - Freedomain Radio - Stefan Molyneux
16:59
The Truth About Banking, Busts and Bailouts
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Hi everybody, it's Stefan Molyneux of Free Domain Radio.
This is Banksters, Busts, and History.
The facts behind the recent financial crisis.
So the first thing I will say, get thee to school!
Look, if you want to diagnose an individual illness, like a doctor, it'd take like a decade of education and mentoring and study and internship in hospitals and so on.
If you want to diagnose general social illnesses, at least take a couple of years to study the facts and the history and the theory and so on.
Define your terms, research the evidence, get the facts, and reject propaganda.
So, let's start with some facts about the current history.
In 1989, bank CEOs earned 100 times the average salary of a worker.
But by 2007 this had risen to 500 times.
What could this mean?
Does this mean that in 1989 bank CEOs were only 20% as greedy?
No, they're always greedy.
They've always been as greedy.
The question is how could it raise so much?
Was it performance of the banks?
No.
Share prices of banks are lower in real terms than in the early 90s.
If you bought bank shares in the 90s, right now you're sitting on a net loss.
So how on earth could they make so much money when they're doing so badly?
During the crisis, 25% of the world's GDP was drafted, was forced by governments to prop up banks.
That is not good.
That is a significant risk.
All right, here's a general principle.
The greater the disaster, the longer it has been brewing, and almost always the more force has been used, usually in an attempt to, quote, solve the problem in the past.
Now the banking crisis has been brewing for 150 years and as I've argued on this show for it seems like 150 years it's because the returns or the profits have been privatized and the risks have been socialized.
So it's like in a casino you get to keep all the money that you win and if you lose money everybody else has to pay.
How long would you gamble and how well would the casino do?
All right, so 200, count them, 200 years ago, banking started, this was sort of the free market relationship, more or less, as an unlimited liability partnership.
What did that mean?
That meant that you were not shielded by corporate, quote, identity from the losses you incurred as a manager.
So if you lost money for your shareholders, if you lost money for your depositors, you were liable.
You could go all the way to debtors prison if you crashed your bank.
And this made managers and CEOs and executives, wouldn't you know it, quite conservative.
How did that look?
Well, in those days banks took very few risks.
Cash and equivalents were 30% of assets and equity, 50% of liabilities.
If you had a million dollars of assets, you had $300,000 sitting around in cash to shield you from the ups and downs of the market.
That makes good sense.
Compare this to recent exposures where cash and equivalents were only 3% of liabilities.
What that meant is that if your liabilities went up by 3%, you were wiped out as the bank.
That's not good.
How did it change?
Now remember, back in the day, 200 years ago, shareholders were also liable for losses.
So if you invested in a bank and the bank crashed, people would come after you for everything you had.
So shareholders had a very strong incentive to make sure that the banks weren't doing anything overly dumb and risky.
But governments wanted more capital for their own voracious moors and also to expand and to help fund expansions of things like railroads and so on, which wore things like that.
So governments wanted more capital.
So how do you draw more capital into the banking world?
Well, you limit liability.
So governments started to limit shareholder liability.
And that meant that since you couldn't be taken all the way to debtor's prison, if the bank you invested in went bust, more people wanted to invest in banks.
Banks got more money.
And banks were happy and all of that.
Now, interestingly enough, at the beginning and for the first couple of decades, almost a generation, banks mostly rejected this.
So governments offered it a limited shareholder liability, but banks rejected it because it was deemed unsafe.
And here's a quote from a banking expert of the time.
He said, a depositor would be much more likely to trust his money with the bank whose shareholders he knew must yield up to him the uttermost farthing.
And that's interesting.
This is something you see quite a lot.
People say, well, why did NASA do so well after it was first instituted and does so badly now?
Well, because for the first generation, you inherit all the people conditioned by the free market when you have a new statist environment.
So when you first socialize medicine, you get all of the doctors whose habits and discipline and work ethic have been developed in the free market.
And it takes a generation or two for the more sludgy people to come in.
So banks mostly rejected this offer of a limited shareholder liability.
In 1878 the city of Glasgow Bank collapsed.
No depositors lost any money but 80% of the bank's shareholders were bankrupted and they weren't happy and everyone who was invested in banks was terrified.
So they of course lobbied the government and a year later government started to really encourage limited liability and this began to turn the tide.
See, the shareholders get wiped out, the executives get wiped out, so you've got a huge cadre of politically connected wealthy people all trying to get limited liability across the board.
See, if banks aren't doing it voluntarily, then people want to pass a law that enforce it so that everyone has to do it.
Let's talk about reserve capital.
You know, get used to this topic because it's a good way to make sure that nobody sits next to you at a dinner table.
So the ratio is very interesting.
Again, this is centuries ago, but banks typically had liabilities three times their capital in both the US and the UK.
And that means, you know, 20-30% swing, you're still okay.
You can still survive.
And this was true in the US and the UK, though there was no formal relationship or legal relationship between the banking.
Now, once you limit liability, then banks get bigger.
And there was almost a 90% consolidation of banks.
So you went from like 700 banks to just a few.
And because there were so many shareholders, you didn't vet your shareholders anymore.
So before, if somebody wanted to come invest in your bank, the bank managers would vet that person to make sure they knew what they were doing.
They had the money.
They weren't idiots.
But now, when you've got so many more shareholders investing in far fewer banks, they don't vet the shareholders anymore.
Anyone can buy and sell shares.
And so by the 1930s, ownership and control were almost completely separate.
Ownership and control were almost completely separate.
Please understand, please understand, none of this is the free market.
None of this is the free market.
These are laws and regulations and goodies and favors and bribes and enforcements by the state.
This is not a free market situation.
And so reserve capital largely vanishes, as you would imagine.
So now we see a switch.
This starts to occur in the 1990s.
Most of the larger or many of the larger global investment banks switched from private partnerships to limited liability public companies.
This changes everything because when you have limited liability for losses you profit from volatility.
So picture this.
You're in a casino and some games pay off 2 to 1 and some games pay off 5 to 1 and everything you win you keep and everything you lose you don't have to pay for.
Of course you're going to go for 5 to 1 rather than 2 to 1 because it means that you're going to be more likely to make more money quickly.
Now, normally, the downside for volatility is increased risk, right?
So the 5-to-1 games, you have much less chance of winning than the 2-to-1 games, of course, right?
But if you win every time, or at least when you lose, you don't pay, of course you're going to go for 5-to-1.
And so because liability was limited, volatility becomes the bank's friend.
And we see this occurring statistically.
Asset returns were two and a half times more volatile between 1900 and 2000.
It only went up from there.
So if the market becomes volatile, that's because the people in the casino are betting on 5 to 1 rather than 2 to 1 because they don't take the same risks, increased risks of losses.
Right?
So this is why the stock market is going up and down so much.
Now over the past 30 years, UK bank assets have risen to over 500% of GDP.
This is why they're getting bailed out.
Because if they blow up, all that's left of the British economy is a smoking, drunken ruin.
Leverage growth.
So leverage rose from 3 to 4 during unlimited liability to 30 or more by 2007.
So if you're only lending out 3 to 4 times what you have in terms of assets, well that's because you have liability for your losses.
But if you don't have liability to your losses, you can lend out 30 or 40 times more than you have in assets.
And you'll make a huge amount of money.
And if there's a downside, Well, you've already made your money during the upswing, or you can short the stock or whatever, but this changes everything.
And remember, this has nothing to do with the free market.
This is the statist legal government environment.
And this we can see showing up in banks.
So in 1900, banks had single digit returns.
This had risen to 20% by 2000 and 30% in 2007.
And almost all of this can statistically be shown to occur from the increased leverage.
Of course.
I mean, if you're gambling at 5 to 1 rather than 2 to 1, you get to keep all your winnings and pay none of your losses.
Of course, you're going to make more money at 5 to 1.
The variability of returns was 600-700% higher.
Tax!
So bad laws are the first nail in the coffin of the banking system, and tax was the second.
All right.
Interest on debt tends to be tax-deductible, but equity financing is not.
So if you borrow to invest, the interest tends to be tax-deductible.
If you have money or some sort of equity you can use as collateral, it tends not to be tax-deductible.
And when you're talking 20, 30, 40 percent or more taxation, this is very significant because what it does is it means that debt becomes much more valuable to you than equity.
It's 30-40% cheaper to borrow than to have.
So of course banks are going to go into debt.
It would be crazy not to.
This is the regulatory environment that everyone's working in.
It's like changing the rules of a game and then saying the players are bad for following it.
So let's say in tennis you're allowed now to hold two tennis rackets so that you never have a backhand.
I mean could we then blame players who then start using two tennis rackets?
Of course.
I mean if you're allowed to win a golf game by dropping the ball into the hole, well who's not going to do that?
They're all going to do that.
So if you change the rules, don't blame the players.
I mean, you can, but I mean, there's not really any point.
And this is where we start to get too big to fail.
Look, if a bank starts to face trouble, they don't want to take the steps to reduce that trouble because that's a signal to everyone that they're in trouble, which means they might get an investor run or a deposit run or whatever.
So they're going to cover it up.
They're going to cover it up.
They're going to cover it up.
And remember, the bank executives do not face personal liabilities for anything they do to blow up the bank.
So how do we get too big to fail?
Well, in 1900, England's three largest banks were only 7% of GDP.
By 2007, they were 200% of GDP.
So if they failed, there would be minus 100% GDP.
That's not good.
So of course the government is going to bail them out.
So who's profiting?
Where is all this money going?
Well, there are two major groups who profit from the changes in rules to do with taxation and limited liability and some others, but those are the two biggies.
Who profits?
Well, shorter-term investors and bank executives.
Shorter-term investors, because remember, you make more money from volatility when you have limited liability.
For short-term investors, all volatility is good volatility.
If they time it right, they can short, they can long, they can make lots of money here and there.
And this is shown up by the data.
Bank shares, on average, were held for three years in 1998.
Only 20 years later in 2008, for only three months, for only three months at a time.
This gives executives, and again, I've argued for this over and over again, and I've actually lived through this, This gives executives a very short-term focus.
They're only looking at making money in quarterly banking.
Banking is no longer about investing and growing manufacturing and industries over many years.
It's about quarterly banking and this encourages short-term risk-taking behavior.
So, banks tended to focus on return on equity rather than return on assets as a whole.
Now, if they'd focused on return of assets rather than return on equity, bank CEO salaries would have actually fallen to about 68 times from 100 times median income rather than rising to 500.
Return on assets is a much longer-term view than return on equity.
So again, you got short-term focus, quick profitability, churning, buying, selling, and shorting, and really focusing on the short term.
But of course, banks really should be focusing on the long run.
So this is just a very quick overview as to why things have gotten so mental and why it is that people think this has anything to do with the free market is beyond me.
I can only assume that people have just not researched any of this or looked into any of this and you can see the sources for all of this below.
A big question to ask yourself is why do we have banks at all?
Why would we need banks?
Certainly the average person, why would he or she need banks?
There's a couple of reasons.
Inflation.
Inflation is driven by the government, right?
Inflation is the price increase that results from the overprinting of the money supply, which the governments love to do because it gets to bribe those closer to them with real money and then it dilutes as it goes out and out, mostly ending up as much less value to the poor.
So because of inflation, people don't want to put their money under the mattress because it's going to lose value.
So inflation drives money into banks that wouldn't otherwise be there.
Taxes.
Retirement savings plans.
RSPs in Canada, 401ks in the US, lots of other ones around the world.
But if you throw your money into the stock market or some sort of investment certificate or whatever, then you'll pay less in taxes.
Again, that drives a lot of money into the stock market that shouldn't otherwise be there.
I've called it the supercharged stock market.
Way too much money rolling around, trying to chase way too few profits, thus making everybody deal in short-term value, which then blows up long-term value.
Bad police!
Stuff gets stolen from your house, your money, your gold or whatever.
Police aren't going to do much about it and get it back for you.
So people want to put it in the bank because they lack personal security.
Fiat currency doesn't really have any individuation to it, right?
So you don't put your fingerprint on your money so anyone can use fiat currency.
And so because the government controls the currency, it's not personalized towards you like it should be.
And that's a problem.
That's another reason why people don't like to keep cash around.
It can just be stolen and used by anyone.
That's not a free market currency.
A free market currency with modern technology would have some sort of ID chip in it, something that would individualize it to use, even a micro thumbprint scanner or something.
There would be a way of making sure that it couldn't be used by other people.
But fiat currency doesn't have that restriction and therefore people don't want to keep it around so they throw it in a bank.
Laws, laws, laws, laws, laws.
So many laws just forcing you to basically put your money into a bank or into the stock market.
Of course everybody in the financial sector loves all of that stuff, but it's really really bad for individuals.
Statism as a whole, the role of the state, the corruption of the state in regards to finances has been going on since there was a state, since there was a tribal guy who began to first copy whatever was being used as currency at the time and thus promoted himself to the top.
The statism breeds this kind of corruption.
So I think it's really important to understand that if you go back 200 years, you see a much more free market system and you can see ratios of three to four.
You see executives who have total liability for their losses.
You know, anybody who loses money can come after them for everything that they have.
That makes people cautious.
You do not give people a blank check in a casino and expect good behavior out of it.
It's just really important to focus on because very few people understand any of this sort of stuff.
But it is essential to understand.
If you're going to diagnose, learn something about how the human body works.
Otherwise, you're just making noise and confusing people and leading people down the entirely wrong garden path.
So thank you, thank you so much.
It's Stefan Molyneux from Free Domain Radio.
If you don't know, you can check us out at freedomainradio.com.
Thank you so much for listening and watching and donating as always.
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