The most dangerous fallacy in modern economics

Young families must borrow heavily to buy property

There’s a simple and dangerous logic at the heart of modern-day economic thinking.

It’s exactly the kind of logic that led to the last crash and it seems we still haven’t learned our lesson.

The idea is that for every borrower, there is an equal and opposite saver. Put thus, the economy is in balance. That if things go wrong with the debt, then ultimately the problem spreads to the saver.

Stands to reason, right?

Looked at it in this way, the banking system is an elegant way of re-arranging wealth.

Well, it’s a nice idea. Pity the economy doesn’t actually work like that!

Here’s how it really works

It all comes down to a neat little thing – and I’m going to use some jargon here – called ‘fractional reserve banking’.

As with most terms in this business, fractional reserve banking can be explained simply. It’s where a bank holds smaller reserves than its customers have deposited – safe in the knowledge that it’s very unlikely all of them will want their money back at once!

This means that when a borrower takes out a new loan for a house, instead of being neatly transmitted through the banking system from saver to borrower, this money is effectively created.

So, when you take out a £100,000 mortgage, the bank creates an asset on its balance sheet – that is your mortgage. There is no need to find that full hundred grand from somebody else’s savings.

The banks can’t create money forever, of course, due to capital adequacy laws laid down by the regulators – but this setup means debt is tantamount to printing money. And what’s the problem with that, you might ask?

The very real danger to the indebted

Well, we’ve got an army of savers on one side and an army of borrowers, borrowing newly created money on the other side.

Low rates force the savers out of cash and into risk assets like equities and high-yield bonds. In fact, they’re even buying buy-to-lets in the very market the poor younger lot are desperately borrowing for!

Other than a sudden loss of confidence, technically, there’s no danger to the savings side of the equation.

On the contrary, much of the newly minted money actually ends up flowing straight back into financial savings (this is why stock markets continue to climb irrespective of whether there’s real value in them).

But of course, there is a very real and present danger on the other, indebted side of the fence.

The debt side of the economy is teetering on the edge. Half of borrowers are concerned that they may go bust.

Of course, we’ve been here before – in 2007 to be precise. The banking system almost collapsed as the markets got wise to the fact that US housing debt might not get repaid.

Stocks went down, but those businesses mostly kept paying the dividends – and ultimately shareholders remained the beneficiaries of many good businesses. In time, the markets bounced back.

So, who really lost? All of the mug punters, that felt forced into the debt markets to buy housing, cars and all those other nice, shiny things. And of course, anyone holding shares in the banks.

Could it all be happening again?

Debt is out of control… again

I could shock you with the cold, hard (and frankly dangerous) level of UK personal debt.
Or I could bore you with anecdotal evidence of how our continental European cousins simply don’t care for the debt obsession.

But the fact is, both government and its lieutenants at the Bank of England have done a great job of geeing debt back up to levels not seen since the great crash erupted.

Just this week, the council for mortgage lenders released data suggesting mortgage lending shot up 15% last year. Now, that even outstrips house price inflation, meaning homeowners are once again, using mortgages to realise cash from housing.

Meanwhile, mortgage lender Halifax decided to do some due diligence. The results its survey (also released this week) suggest that half of its customers are concerned that a higher bank rate will leave their homes unaffordable.

That’s right – borrowers aren’t worried about whether it’ll leave things tight, they’re worried they can’t even afford the monthly repayments.

What does it mean for your investments?

This is what to do

The dangerous group of economists at the Bank of England will tell you that anyone willing to take on the fantastic levels of debt required to square the circle is providing a much needed social function.

They tell the old that though low rates may hurt their savings, they have to put up with it. After all, the other side of the equation is more important, and that is ensuring enough of the population is willing to take on debt, and spur on the economy.

But the fact is, today a young family must borrow on a massive scale to buy a home, and all the other things needed to fulfil their lives. After all, you can’t have savings without somebody taking on debt.

When the dangerous debt side of the equation finally unravels, it’s the over-borrowed that will hurt the most, and of course, the dumb banks that created the money to give to them.

So what should you do?

Holders of real assets have usually done OK over the long run, so I think a diversified portfolio of companies with strong balance sheets, commodities and precious metals seems like the best place to put your money right now.

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  • DeeplyRealistic

    Sorry, but no. Reducing your example to the minimum case, a bank with 100k of savings from several folk and a single 100K borrower has no money in the till. As soon as one depositor wants out, they are in trouble. There is nothing in the till, and there will be a run on the bank. They have to find some more deposits or borrow from a kind uncle, who is almost the same as a depositor.
    When things go wrong, we all know Cash is King.
    A Bank can only hide the fact it’s broke by grace of Uncle Carney and his brood.
    Bottom line as far as I see it is that the money printer is presently buying his own debt back and lending cheaply as well.

  • Boris MacDonut

    Remember Bengt RBS had reserves of only 1.4% before the crunch. The ideal now is 10%.
    A bloke I know wanted £20 million in 2005 to buy some machinery. HSBC said no, Lloyds did 3 months due dliligence and said no, even Santander spent 2 months and only said maybe £10 million. RBS said yes the next day and the following week asked if he wanted more !

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