The Bank Bubble

December 26, 2007

Financial institutions are supposed to help connect people who need capital with those who have excess capital for the purpose of generating economic activity. Banks don’t create wealth, they don’t produce anything of value to the world. They are middlemen, and when they take too large a piece of the pie the system fails because those who actually work and produce are not being properly compensated for their labor. Our bubble is not in real estate, it’s in banking.

This is not a liquidity problem, it’s a solvency problem. It was not caused by real estate speculators, it was caused by ignorant and irresponsible bankers. The banks don’t need a temporary injection of money, they need to admit that central planning in money is just as ridiculous as central planning in anything else — it doesn’t work because nobody is smart enough or honest enough to do it right.

Let’s not be coy, what’s at stake here is the entire financial system on which the western world is built. Never before in American history have people been able to purchase homes with no money down. The sub-prime debt has been re-packaged and re-sold so many times that nobody even knows where it is, but we can estimate the aggregate amount — about $900 billion. A credit bubble of this size can not be cleared in a few months, it could take years.

“The kind of upheaval observed in the international money markets over the past few months has never been witnessed in history,” says Thomas Jordan, a Swiss central bank governor.

It didn’t have to be this way, there was a time when banks actually made an effort only to give loans to those who could realistically be expected to pay them back. But in the end, greed and faith that the Federal Reserve would have the ability to print as much money as necessary to bail the financial industry out of any conceivable crisis overruled common sense. It is somewhat ironic that the Federal Reserve system which was installed by banks to ensure their infinite profitability could ultimately be the cause of their downfall.

We don’t know how long it will take for the surplus inventory of homes to sell and we don’t know how this will affect consumer spending, but I would argue the greater problem is that we don’t know how many banks are at risk of bankruptcy and we don’t know how much inflation we will experience when the banks finally have enough free money to resume their old habits. We don’t know what sort of dirty tricks these people are willing to play in order to save their empires. The fact is, we have very little information and in this case, our ignorance is not bliss.

However, the greatest fear, I believe, is a growing realization that those in power don’t know any more than the rest of us.