A key thing missing in last week’s coverage of the Cyprus crisis is that banks create a loan before they create a deposit. Almost all journalists and commentators all fall into the trap, believing that banks are true intermediaries between saver and borrower. Michael Kumhof, a former bank manager at Barclays, disposes of this myth in his article with Jaromir Benes called the Chicago Plan Revisited, and in subsequent lectures and papers. Kumhof, an IMF economist, says clearly; "The loan precedes the deposit. I know because I did it and if anyone like Paul Krugman tells you otherwise he doesn’t know what he is talking about.” I was explaining to a friend the other day that if banks have 100% backing for their deposits there is no risk of a run on the bank. Her reply was “But then they would have nothing left to lend out.” This friend was believing, as is fed to her in the daily media, that banks lend out their deposits. Kumhof goes further than this by saying “The chief function of banks is to create the nation’s money supply. They are solely in charge of it.” So when rich Russians deposit their money in the Laiki Bank in Cyprus the deposits are not lent out at all. The bank itself decides who will have loans, issues the loan and at the same time writes an equivalent deposit on the other side of the ledger. How do you think the size of the banking sector in Cyprus reached eight times the size of the economy in 2011? The banks made loans and were solely in charge of the credit blowout. And it is the same with the rapid expansion of the Iceland banking system. Banks made loans for houses, cars, aeroplanes, condominiums and seldom asked questions. In fact as Hordur Torfason the Iceland activist explained, he was called into the manager’s office and offered a big loan when he didn’t even want one. We know that the bank staff have incentives for issuing more loans. They are paid more if they do. The tragedy of all this is that the universities are not teaching it honestly to each generation of students of economics. The economists tell the journalists and so the myth continues. Hopefully Cyprus will help the public understand the whole horrible faults of the way we rely on banks to create and decide on the country's supply of credit. A transcript of the first seven minutes of Michael Kumhof's talk is here.
You will have noticed the banking crisis in Cyprus. It has absorbed my twittertime for 24 hours. I understand Iceland activist Hordur Torfason, currently on a speaking tour of NZ, is going to Cyprus after New Zealand. It should be interesting. As a condition for a massive loan from the ECB, their government is required to tax ordinary savers from 7-10%. This is ground breaking policy. ‘What is different this time is the nakedness of the Cypress heist’, writes Adita Chakrabortty in the Guardian. His article explains how the European powers pushed Cyprus into a politically suicidal pact. They demanded an impossible deal and it is no surprise when the politicians see how unpopular this measure is, they delay doing it. As I write this, the banks are closed in Cyprus for another two days and heaven knows what will happen when they open. See Guardian article, for example Senior bondholders (and it looks as though there aren’t many) will be exempt. This is not true in New Zealand, where Open Bank Resolution only touches deposit holders. As Geoff Bertram and David Tripe pointed out in their Victoria University article, there are at least six classes of creditors who are ahead of us in the queue to be reimbursed. They include holders of Covered Bonds held mostly by pension funds. These are illegal in South Africa and were so in Australia until recently. All this makes it doubly important for us to get behind our petition asking for a Parliamentary Enquiry into the best ways of making banks stable. We want a lasting durable banking system not one which gets into such crises. So why not write to your MP, the Minister of Finance and the Prime Minister about this? Jill Abigail has led the way in having her letter on the subject lead the Dominion Post letters today. Here it is: As a superannuitant dependent on interest from term deposits to top up my pension to a livable level, I am horrified to learn that the Reserve Bank is planning to set in place a process (called “Open Bank Resolution”) where ordinary bank depositors will – without notification and without our consent – have our savings used to bail out a bank in financial distress. If a banking crisis arises, your bank will be able to freeze your bank account overnight and release it the next day. But the account will have been “shaved”, and you will have less money than you had yesterday. A nameless amount will remain frozen while liquidators examine the financial state of the bank and then some or all of it will be used to bail out the bank. This process, which readers can check out on the Reserve Bank website, will all be in place by June 30. There has been no public warning of this undemocratic proposition. Is it legal? Isn’t it theft? Those of us who suffered loss of retirement savings in the finance institutions’ crashes in 2008 thought we would be safe by keeping the remainder in our banks, especially the Kiwi-owned bank. What a shock now for us to learn that our money is not safe after all. This is a terrifying prospect for those of us who have no means of replacing any losses because our days of being able to earn are long behind us. Jill Abigail