Banking Blunders

Imagine this.

We are only weeks away from the biggest spending period of the year: Christmas.

You had plans to use the time to relax, to do a little holiday shopping, spend time with family and friends. Perhaps even a trip to the coast, to enjoy the summer vacation.

Now everything’s changed. Something’s ruined your plans, and now the holidays are the last thing on your mind.

In fact, you are not alone. The whole country is in the same boat with you.

The banks are taking a holiday

The ‘something’ that’s changed is that the banks — and not you — are the ones taking a holiday. They’ve closed their doors, taking your savings along with them on a break.

But you don’t need to imagine this, it happened.

In 2001 there were fears that Argentina was going to default. So, in a move to prevent a bank run, the government closed the banks.

People couldn’t take their money out of the bank, but instead there was a weekly withdrawal limit in place so people could cover their expenses.

It was something that would later be known as ‘corralito’ Spanish for pen, or the enclosure where farmers usually keep animals.

With no money flowing, the economy went into a standstill and the currency collapsed against the US dollar.

It was a time that scarred the country, with the memory of the corralito is still alive and well in Argentina.

Argentina’s history is an extreme case. But it shows you how crucial to our system it is to keep confidence up and money flowing through the economy.

The corralito’s spectre came rushing back this August after Argentina saw a surprise result in the primary elections.

The Argentinean stock market collapsed close to 40%, and the peso quickly devalued against the US dollar.

In the chart below, you can see how the US dollar leapt from 45 pesos to 60 pesos in one day.

USDARS Grafico de Forex - 14-09-19

Source: Trading view

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The plunge meant that people rushed to exchange their pesos for US dollars to preserve their wealth.

To stop the haemorrhage, the government placed restrictions on how many US dollars people can now buy. The fear now is that this loss of confidence could spread, leading to another bank run.

A bank run is something that the system can’t afford, because of the fractional system.

What I mean by fractional system is that banks are only required to hold a fraction of their deposits in the bank.

When they lend money out, they don’t take it out of your savings and give it to the borrower. Instead, with a few keystrokes your money stays in your account and the borrower receives their loan. This is how commercial banks create new money.

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This leaves the whole banking system exposed…

The fractional system allows banks to lend more money than what they actually hold in deposits. The problem is that this leaves the whole system exposed if there is a loss in confidence. That is, if everyone went to the bank at the same time to ask for their money, the bank would not have enough cash to honour the deposits it holds.

The whole system is based on confidence, if we see a collapse in confidence then…well, the whole system breaks down, like we saw in Argentina.

But it is also based on lending.

As you can see, the whole system is based on debt. The available amount of money expands when banks give out more debt. And this debt makes the economy flow. If banks stop lending then the whole economy could stop.

It’s the way the system works.

Now, hold that thought for a moment.

The European Central Bank (ECB) has just lowered rates further into the negative territory. They are also looking at restarting bond purchases.

It’s no secret that US President Donald Trump wants some of the same for the US. Check out some his recent tweets:

USDARS Grafico de Forex - 14-09-19

Source: Twitter

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USDARS Grafico de Forex - 14-09-19

Source: Twitter

[Click to open in a new window]

I mean, I get it.

Every developed country is trying to stimulate their economies to create inflation. But monetary stimulus doesn’t seem to be working anymore. Things aren’t getting better, and inflation isn’t picking up.

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The system is not designed to work like this

We already have too much debt. And all that debt is taking us to even lower interest rates, with less to show for it. Debt is now becoming a burden instead of stimulating the economy.

Central bankers may be looking at lower interest rates to keep stimulating the economy, but negative rates don’t do much for building up confidence on the banks…or the whole system of fractional banking and lending.

As I wrote before, the lower the rates go the more people will want to save. But if deposits are paying negative rates, it encourages people to save outside of the system.

Negative rates also mean that if banks need to pay to lend money out…well, then they won’t want to lend, which means less investment in the economy. Negative interest rates affect bank profitability.

We are already seeing the effects of this in Europe. Banks are in the doldrums, their shares have been flat lining for years.

The system is not designed to work like this. The whole system is based on keeping lending going, and in confidence.

But negative interest rates could turn the whole system upside down.


Selva Freigedo Signature

Selva Freigedo,
Editor, The Rum Rebellion

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Selva Freigedo is a research analyst for The Rum Rebellion.

Born in Argentina, her passion for economic analysis started at a young age. Her father was an economist for the Argentinean governments and the family used to discuss politics and economics at the dinner table.

Argentina is a country with an unusual economic history. Growing up there gave Selva first-hand experience on different economic phenomena such as hyperinflation, devaluation and debt default.

Selva has also lived in Brazil, Spain and the USA.

Back in 2000 she was living in the US as the dot com bubble popped…
And in 2008 she was in Spain as the property market exploded and then collapsed…

She has seen first-hand what happens when bubbles burst.

Selva joined Fat Tail Investment Research’s team in 2016, as an analyst. She now writes from her vantage point in Australia, where she settled in 2015.

The Rum Rebellion