A Dollar in the Bank

Yesterday, I wrote a post about the inevitability that crypto is going to get a lot more support in the future (from my perspective) due to the mass transfer of wealth that will happen as the boomer generation dies away. One of the aspects I touched on and explained a little, was how the Bank of Mum and Dad (loans from parents) helping kids buy houses attributed to inflation.

Interestingly, it is also because of their help that people were able to afford houses that they couldn't otherwise buy, propping up the market and pushing it to the moon, as demand increased in Covid and people bought on increasing debt, including on guarantees from parents, so they could borrow even more. This means that even more funds were available to banks to print even more money through loans and interest, which on top of all the Covid loans from governments, injected even more money into the supply, pushing inflation harder.

I got a private message asking for a little more detail about how this works, so I thought I'd dive in a little further and explore it.

Essentially though (spoiler alert), governments don't print money - banks do. They do this through lending practices and interest repayments, and the greater the debt, the more currency inflation they will generate. I will keep the numbers really simple here, just to illustrate the processes.

For example,

Bank lends 1000 dollars @ 5% interest for 1 year.
This means that the borrower will have to pay the bank 1050 back, needing to find $50 more than what they bought with the 1000 was worth.

Then there is fractional reserve lending, which means that the bank can loan money out, but not have to back it 1:1 in their reserves. So, lets assume it is a 1:10 fraction and use the same numbers.

The bank loans 1000 @ 5% for one year to 10 people.
The 10 people would collectively pay back $10,500.
The bank only need 1000 "in the bank" to cover these loans, meaning they are effectively getting a 50% ROI on what they actually hold.

But, there is more to it than this as well, because at the start of the year, in reality, there was only 1000 dollars available in the economy, but once they lent it out to the ten people who spent it, they spent 10,000, which entered into the economy. Let's say they spent it with businesses who could make a profit of 10%, and they put it into the bank, meaning now the bank has access to 2000 at the base fraction, and can loan out 20,000 @ 5%, which gathers them 21,000 in repayments, with the 1000 being brought in from other parts of the economy. But, repeating the cycle means that at the start of year three, the bank will have 1000 from their starting fund, 1000 from year one businesses, 2000 from year two businesses and 1500 in interest payments from the debt takers - to have a new base of 5,500 - so they can loan out 55,000.

Still with me?

Now, what you should realize already is, this process has created a false demand, because it is spending the 1000 multiple times. If we were trading in gold for instance, it wouldn't be possible for a bank to give one gold bar to ten people, if they only have one gold bar to give. That gold bar can only be spent once at a time. However, with fractional reserves, it is possible to spend the same 1000 multiple times simultaneously - it used to be 27 times - so they could lend 27 dollars for every 1 dollar they held. Currently in the US, there are no reserve requirements.

This has ramifications.

But, well get to them soon. Before that, we will return to the Bank of Mum and Dad again and how this has a very direct impact on housing costs. Most countries in the world have deposit requirements for housing, so let's assume 20%. This means that to buy a 500K house it will require 100K cash in savings. But, during Covid for example, the demand on property was high from both live-in buyers and investors, so the prices climbed rapidly, but the cash on hand amount was static for the buyers, so they needed to borrow more. This came from the parents.

So, money that was previously "locked" in investments or in the bank earning interest (getting loaned out too, was loaned to children. If they add 100K to the kitty, it means that the kids can now spend up to 1 million on the house, which increasing bidding range phenomenally, for the same level of housing. Not only this, it means that instead of a 400K mortgage, they now have an 800K mortgage - which we are seeing the problems with now that interest rates have increased significantly. But again, this also means that the banks are earning interest on the loans, as well as people selling their houses for profits and pocketing the excess in the bank, or putting it into stocks of companies that the banks have a position in already.

See what is happening?

Or the size of their loans. The number of loans can mean that more people can compete, the size of the loans will drive the value upward for those willing to pay more than it is worth.

And, now let's finish with the ramifications of fractional lending, because they are quite interesting. As we know, fractional reserve lending will increase the money supply and the demand on goods and services. And it is this last part that I will mention in closing. When people borrow money, they aren't putting it into the bank, they are spending it on something they want.

So, if there is only 1000 dollars in the system and ten people have 100 each, they can each buy something up to the 100 limit. But, with fractional reserves, they will have 1000 to spend, but will be demanding similar items. This creates inflation in prices, because of the inflation in currency increasing the ability to demand. However, this "thin air" money is being injected into a business model that instead of having 1000 available, now have 10,000 available. If the profit percentage is 10%, instead of the economy making 100 profit from ten people, they are making 1000 profit from the same people. This is then injected into investing into the businesses that can make profits from people willing to take loans to buy them, which drives prices up further, but also increases money supply through interest payments, as well as generating more of a base amount for fractional lending practices.

What this does is, create an ever increasing wealth gap.

The people who take debt will get increasingly poorer.
The people who loan to them will get increasingly richer.

While "debt" is necessary under some conditions, when the entire economy is running on a debt model, the reality of the economy and the fantasy of the debt gets so out of alignment, that it can't be maintained. The entire system of "economic growth" is built on a fallacy that increasing money supply is growth, because companies are making more money, even though to do so, people are getting more into debt. It is unsustainable and will always end in collapse.

Ever known an economy not to crash?

Yes.