The Housing Froth
Column by Paul Hein.
Exclusive to STR
Complacency about the egregious defects in our monetary system continues to mystify me. If you bought an expensive watch that gained an hour each day, would you shrug it off because the minutes advanced every time the seconds reached 60? Or if you wore a size nine shoe, and bought a new pair plainly and clearly marked “nine” that were so big (or small) that you couldn’t wear them, would you ignore it? Yet vastly more often than you buy shoes or watches, you engage in transactions for money that does not, in fact, exist, in quantities (“dollars”) which are, of necessity, undefined and undefinable.
It’s not of just academic interest. Consider the collapsing housing bubble, or, as I prefer to call it, the housing froth, composed, as it is, of hundreds of thousands of individual bubbles. A local television station started running frequent spots a few years ago, when the crisis was news, advising viewers on ways of coping with the problem. It was good advice, but rather unimaginative: homeowners facing foreclosure should be wary of assistance that would prove very expensive, should consult some of the not-for-profit advisors who made themselves available, should meet with their banker to arrange more favorable terms, etc.
It seemed to me that this advice did not reach to the heart of the problem, which was the “money” itself. As a monetary realist, my interest is in the nature of the money, and the significance of that nature. So I wrote a letter to the TV station (I believe they solicited advice from viewers) with my recommendations that were, not surprisingly, never acknowledged.
If I faced foreclosure, I would look closely at my relationship to the bank, and the loan that existed between us. I would, for instance, be curious to know exactly what the bank had loaned me. The answer that I would get from the banker, and from most people, in fact, would be “money.” The Federal Reserve would agree with this. On page three of its booklet “Modern Money Mechanics,” published by the Federal Reserve Bank of Chicago, we read, “The actual process of money creation takes place in commercial banks. As noted earlier, demand liabilities of commercial banks are money.” That may be true, in a rather loose sense, but, as a matter of law, are bank liabilities money? If so, then private individuals--bankers--acting in their own interests, would be the source--the only source--of our nation’s money. Could that be? I don’t think so.
Just what are these “bank liabilities” that we are to regard as money? We find the answer, once again on page three. “Demand deposits are liabilities of the commercial banks.” So now we know, from the Fed’s own mouth, that the bank’s liabilities are money (if not by law, then by custom), and that the bank’s liabilities are its demand deposits--in other words, “checkbook money.”
Well, where do these deposits come from? This time the answer is on page four. “Then, bankers discovered that they could make loans merely by giving borrowers their promise to pay (bank notes). In this way, banks began to create money. Demand deposits are the modern counterpart of bank notes. It was a small step from printing notes to making book entries to the credit of borrowers which the borrowers, in turn, could ‘spend’ by writing checks.” (quotation marks in original) This is pretty significant! Note what the Fed is admitting: bankers make loans by giving borrowers their “promise to pay.” Today that “promise” is in the form of bank deposits--checkbook entries--rather than paper currency. Banks don’t loan existing deposits, they create new ones with every loan. Note also that money creation takes place in commercial banks. To create is to make out of nothing. Do banks simply create bank deposits (loans) from thin air?
If it isn’t already obvious that banks do precisely that, let’s look at another Fed publication, this one from the New York Federal Reserve Bank, entitled “Money: Master or Servant?” On page 12, under the heading “Creating Money,” we find, “Where did these demand deposits come from? The answer is that commercial banks created [that word again] the demand deposits by making loans….” The booklet gives an example of a businessman needing $7,000, and borrowing it from the bank. The bank does not give him 700 ten dollar bills, but rather, credits his account for that amount. Why is it willing to do that? On page 14: “It results from the bank’s belief we are almost certain to repay the debt, plus interest.” So the bottom line: when you borrow from the bank, it simply adds the amount of the loan to your account, and you can “spend” it by writing checks. Where did this amount come from? From the bank’s power to create money, although there is no law authorizing banks to do that.
Back to our original question: What, exactly, did the hapless homeowner borrow from the bank? He borrowed a bank deposit, which consists of the liabilities of the bank. The bank created the deposit out of nothing, but demanded collateral--actual wealth--from the borrower, in addition to his promise to repay. Indeed, the bank fully expects to be repaid, as the New York Fed has written. Without that expectation, there would be no loan.
But isn’t a liability, in effect, an IOU? The Fed makes it absolutely clear that the loan consists of the bank’s liabilities. And in promising to repay, does not the borrower tender his liabilities--or his IOU? So it would appear that, in borrowing to buy his home, the unfortunate soul facing foreclosure swapped his IOU for the bank’s IOU. Where is the debt? In return for the bank’s IOU totaling, let’s say, $150,000, the borrower tenders his IOU for the same amount--plus interest. Isn’t that even-Steven?
If the bank fully expects the borrower to make good on his IOU, shouldn’t the bank do the same? Since the bank has made itself liable for $150,000, should it expect to be repaid before it has actually turned over the $150,000? If it is claimed that the bank’s liability for $150,000 IS, in fact, $150,000, why can’t the borrower claim that his IOU, for the same amount, IS $150,000? Isn’t the borrower guaranteed equal protection under the law? How can there be discrimination between the bank’s IOU and the borrower’s? After all, the borrower’s IOU is listed as an asset of the bank, so it must have value--specifically the value of $150,000.
If a promise to pay--a financial liability--is, in itself, the payment which it promises (but only if promised by a bank), then we live in a topsy-turvy world indeed, where promises are their own fulfillment. And if it’s true for promises of one group of people, but not others, it’s an unjust, as well as topsy-turvy, world.
If I were facing foreclosure, these are some of the issues I would raise. I’m not naïve enough to think that justice would necessarily result, but isn’t it at least worth seeking? After all, the blessed are those who hunger and thirst for justice, not necessarily those who achieve it.