Gold News

So Are the Banks to Blame?

The root cause of this banking crisis runs much deeper than "bonus culture"...

MUCH has been made of the recent appearance of Bob Diamond, the Barclays Chief Executive, before the Treasury Select Committee, writes Robert Sadler, a business professional working for banks and other financial institutions for over ten years – primarily in real estate lending – at the Cobden Centre.

Diamond attempted to defend the British banking industry from various charges such as "casino banking", "bonus culture" and more simply "not lending". The fundamental accusation that has been laid against the banks is that they are responsible for the financial crisis and all of the problems that have occurred as a result.

It is often far easier to pick a scapegoat and punish them rather than face one's own responsibility for personal failure. But are banks a scapegoat or are they indeed to blame?

As usual with questions of this kind, the answer is complex, more complex that one might discern from reading the front page of a tabloid. But the truth is out there, and it has its roots in the special privilege awarded to banks by the State.

What is clear is that the State has established the legal structure within which banks operate. This government-mandated legal structure is a privilege granted exclusively to banks and it allows them to violate the property rights of their depositors by lending out their money while at the same time guaranteeing to return their deposit upon demand.

The bank's unethical legal privilege (as explained by Jesus Huerta de Soto in his excellent book Money, Bank Credit and Economic Cycles, 2009) has authorized banks to operate in a fraudulent manner, laying the groundwork for the current depression. And as if this were not enough, the British government has acted to increase the severity of this latest depression by taxing the population to pay for the failure of the banking industry.

To add further insult to injury, the government has reduced benefits for the poorest in society and increased them for the wealthiest (i.e. the banking bailout) in a bizarre reverse socialism. In order to convince the population of the necessity of this unjust punishment, the message from the government, oft repeated through the media, is that this bailout is necessary because we "need" banks.

This is close to the truth but not quite true. The government "needs" banks in their current form. Everyone else would be far better off without them. It is questionable just how beneficial such an industry is when the cost of it is increased taxes and an increased debt burden which has the potential to ruin the government. But government officials operate with a short-term vision. The crises of tomorrow are an issue for the government officials of tomorrow. Today, the government needs banks to buy their debt so they bail-out the banks with future taxes to be levied on less important members of society. Bringing bankers before the Treasury Select Committee is merely a dog and pony show to placate the confused and angry masses. The bankers are yelled at, an angry finger is waived, the bankers make one or two token concessions and the primary problem – fractional reserve banking backed by a central bank – is ignored.

Indeed, the government had previously established a red herring for the masses to cheer by targeting banker's bonuses. So we are told that the "bonus culture" is the reason for the "excessive" risk taking of bankers. All that need be done is that bonuses be reduced to a token amount, say, £2000, and the problem of banking crises would go away.

If only all complex problems in economics could be solved so simply. Unfortunately for the government, the banks have made it clear that the bonuses will not be cut. This emphasis on bonuses and bankers pay (or the banking crisis more generally) is much like the global warming hysteria; yet another excuse for increasing the size and power of government and for increasing taxes. After all, what has been the end result of the bail-out but increased taxes?

Some may argue, with some justification, that an increase in taxes is necessary to cut the budget deficit and reduce the debt. An alternative view is that is that is entirely unethical to impoverish one group of people in society to repay a debt to which they are not a party. A staunch libertarian might argue that the only ethical approach would be for taxes to be made entirely voluntary and what debt the government is unable to repay it would be forced to repudiate. The functions that the government currently arrogates to itself would be returned to private hands and the government would return to doing what it does best – as little as possible.

Realistically, in the short term this is simply not going to happen. The government is not yet at the point of capitulating to economic reality. So in the first instance it continues its strategy of slaying the goose that lays the golden egg by raising taxes. This is in line with the expectation that changes in government spending are a predictor of changes in tax rates. The government increased its spending most recently with the bail-outs, so taxes are now raised to cover this increased spending. Thus one group in society is plundered for the benefit of another.

To be fair, the banks are not alone in participating in this plunder as a visit to any council estate will illustrate. However, banks are the most important recipient of state aid because their operations impact all other participants in the economy. Virtually everyone interacts with banks at some level, but more importantly the operations of fractional reserve banks set into motion the business cycle. This occurs because of the special privilege awarded to banks by the state. It is in fact a powerful form of state subsidy that allows banks to effectively lend money they do not have. This process creates a supply of money at an artificially low interest rate for which there is no prior saving. This can only lead to a distortion of the capital and property markets. Projects are commenced to create products for which there will be no buyers and mortgages are made en masse to borrowers who will not be able to repay them. Initially, businesses will prosper and people will feel wealthier. However, the net result of this process is the bankruptcy or default of homeowners, businesses and ultimately banks, as we have seen most recently.

Banking failures prompted the establishment of the central bank as a lender of last resort to bail-out troubled and valued banks when needed. The recent financial crisis has shown that even this is not enough and now we have the British government supplanting the Bank of England as the lender of last resort in directly bailing out the banks. It is likely that during the next, inevitable financial crisis the British government itself will need to be bailed out as it has been in the past and as the Irish government has been recently. It is clear that no matter how big or how often the bail-outs are made we eventually reach a point at which the system will fail absolutely. We will reach a point at which there is no willing lender of last resort, at least on favourable terms. This is the key danger of allowing this system of fractional reserve banking to exist.

To return to our initial question, are the banks to blame? Yes they are, but they share the burden of blame with the architect of the current legal structure of our financial system, the British government. The State has permitted this special legal privilege that allows the existence of fractional reserve banking. Fractional reserve banking allows banks to make loans not backed by savings at artificially low interest rates. This in turn leads to the business cycle as described by Austrian Business Cycle Theory. The State has created the system and the banks are willing participants in it. Together, they share the burden of blame for the continuing crisis.

Buying Gold today...?

Built on anti-Corn Law radical Richard Cobden's vision that "Peace will come to earth when the people have more to do with each other and governments less," the Cobden Centre promotes sound scholarship on honest money and free trade. Chaired by Toby Baxendale, founder of the Hayek Visiting Teaching Fellowship Program at the London School of Economics, the Cobden Centre brings together economists, businesspeople and finance professionals to better help these ideas influence policy.

Cobden Centre articles

Please Note: All articles published here are to inform your thinking, not lead it. Only you can decide the best place for your money, and any decision you make will put your money at risk. Information or data included here may have already been overtaken by events – and must be verified elsewhere – should you choose to act on it. Please review our Terms & Conditions for accessing Gold News.

Follow Us

Facebook Youtube Twitter LinkedIn



Market Fundamentals