On the Pointlessness of the Moai

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Whoosh! US markets flew up in the last session. Mr Market likes what he sees when it comes to the midterm election result.

They say that the market climbs a wall of worry but hates uncertainty.

The US action is proof of that right now.

All you need to know is that the Wall Street Express is chugging along again. Hold on for more bouts of volatility as we climb higher.

But it’s Australia that preoccupies us today. And with good reason.

The banking regulator is opening his toolbox and wants to tinker with the system. I’ve no doubt the intentions are good. But you know where those lead, don’t you?

Here’s the story. The Australian Prudential Regulation Authority (APRA) just put out a discussion paper. It wants to lift the capital requirements of the banks.

APRA thinks this will help the Aussie financial system cope if the bankers get themselves into another mess. They’re going to sell it to you that Australia’s banks will become ‘unquestionably strong’.

Indeed. And the ancient people of Easter Island thought spending scarce resources to construct hundreds of Moai heads was a good idea too.

Here’s a picture in case the name doesn’t ring a bell…

Source: Pixabay.com

Both APRA and the Eastern Islanders appear to believe something that achieved nothing the first time might benefit from being replicated in the hope of a different outcome.

Capital adequacy rules are a dud from the get-go. APRA can raise and lower them and never change this basic fact. History is unequivocal on this point.

The idea behind banks setting aside a portion of their own money to back their loans stems from the ‘Basel Accords’ – the international framework for banking.

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These appeared in the late 1980s. I’m afraid banks have been going bust regardless ever since. 2008 was wonderful proof of that. But like our Eastern Islanders, the regulators keep reiterating the same uselessness.

That is because these restraints do not address the ‘procyclicality’ of the banking system…

Banks create money out of nothing

You need to know how the modern financial system works to get this. Economics taught for years that banks merely ‘intermediate’ money from savers to borrowers.

This is not how banks work. Bank lending creates deposits and injects new money into the economy. The Reserve Bank of Australia just released a paper explaining some of this, which you can read here.

The more banks lend, the more the economy heats up. If they lend for property transactions, real estate goes through the roof. If it’s for shares, the stock market booms. If it’s for consumption, you get inflationary pressure in consumer goods.

Now, capital can come from two sources: retained profits or investors. Neither of those are hard to find when times are good.

That means banks can hit whatever level they need…then get on with the lucrative business of making loans. This means capital levels don’t restrain the overall level of credit creation.

Capital is designed to absorb losses. If you think it through, it makes far more sense to regulate what brings on the bad debts in the first place. The most vicious banking crisis usually stem from property booms.

Don’t be lulled into a false sense of security

These get out of hand because banks create credit out of nothing and drive new money into the market, sending prices soaring.

But there’s very little productive activity backing this credit creation. That means no new source of income to pay off the incurred debts. This is where the instability of the whole shebang comes from.

The right solution – if the regulators really wanted to stop the boom bust cycle – is to ban banks from credit creation except for productive activity.

That doesn’t mean you can’t borrow to buy a house. It just changes how its financed. Using existing money would remove the extreme inflationary pressure that builds up when property booms really get going.

That’s because there’s a natural limit to how much money is available at any one time…if it’s sourced from the non-bank sector.

Alas, our system is not designed as such. So don’t be lulled into a false sense of security. There’ll be more bank bankruptcies in the future. APRA even concedes this regardless of its new rule.

That’s not to say it’s going to be a problem anytime soon. But it’s clear now that the ‘lessons’ of 2008 have been completely ignored.

There’s been no genuine reform anywhere in the world that eliminates the boom bust nature of the economy. APRA’s ‘reform’ is just another Maoi head.

Regards,

Callum Newman Signature

Callum Newman,
Editor, Profit Watch

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