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As
the title of this essay suggests, a loan is an exchange of wealth for
income. Like everything else in a free market (imagine happier days of
yore), it is a voluntary trade. Contrary to the endemic language of
victimization, both parties regard themselves as gaining thereby, or else
they would not enter into the transaction.
In
a loan, one party is the borrower and the other is the lender.
Mechanically, it is very simple. The lender gives the borrower money
and the borrower agrees to pay interest on the outstanding balance and to
repay the principle.
As
with many principles in economics, one can shed light on a trade by looking
back in history to a time before the trade existed and considering how the
trade developed.
It
is part of the nature of being a human that one is born unable to work,
living on the surplus produced by one’s parents. One grows up and
then one can work for a time. And then one becomes old and infirm,
living but not able to work. If one wishes not to starve to death in
old age, one can have lots of children and hope that they will care for their
parents in their old age. Or, one can produce more than one consumes and
hoard the difference.
One
discovers that certain goods are better for hoarding than others.
Beyond a little food for the next winter season, one cannot hoard very
much. One of the uses of the monetary commodity is to carry value over
time. So one uses a part of one’s weekly income to buy, for
example, silver. And over the years, one accumulates a pile of
silver. Then, when one is no longer able to work, one can sell the
silver a little at a time to buy food, clothing, fuel, etc.
Like
direct barter trade, this is inefficient. And there is the risk of
outliving one’s hoard. So at some point, a long time ago, they
discovered lending. Lending makes possible the concept of saving, as
distinct from hoarding. It is as significant a change as when people
discovered money and solved the problem of “coincidence of
wants”. This is for the same reason: direct exchange is replaced
by indirect exchange and thereby made much more efficient.
With
this new innovation, one can lend one’s silver hoard in old age and get
an income from the interest payments. One can budget to live on the
interest, with no risk of running out of money. That is, one can
exchange one’s wealth for income.
If
there is a lender, there must also be a borrower or there is no trade.
Who is the borrower? He is typically someone young, who has an income
and an opportunity to grow his income. But the opportunity—for
example, to build his own shop—requires capital that he does not have
and does not want to spend half his working years accumulating. The
trade is therefore mutually beneficial. Neither is
“exploiting” the other, and neither is a victim. Both gain
from the deal, or else they would not agree to it. The lender needs the
income and the borrower needs the wealth. They agree on an interest
rate, a term, and an amortization schedule and the deal is consummated.
I
want to emphasize that we are still contemplating the world long before the
advent of the bank. There is still the problem of “coincidence of
wants” with regard to lending; the old man with the hoard must somehow
come across the young man with the income and the opportunity. The
young man must have a need for an amount equal to what the old man wants to
lend (or an amount much smaller so that the old man can lend the remainder to
another young man). The old man cannot diversify easily, and therefore
his credit risk is unduly concentrated in the one young man’s
business. And bid-ask spreads on interest rates are very wide, and thus
whichever party needs the other more urgently (typically the borrower) is at
a large disadvantage.
Of
course the very next innovation that they discovered is that one need not
hoard silver one’s whole career and offer to lend it only when one
retires. One can lend even while one is working to earn interest and
let it compound. This innovation lead to the creation of banks.
But
before we get to the bank, I want to drill a little more deeply into the
structure of money and credit that develops.
Before
the loan, we had only money (i.e. specie). After the loan, we have a
more complex structure. The lender has a paper asset; he is the
creditor of the young man and his business who must pay him specie in the
future. But the lender does not have the money any more. The
borrower has the money, but only temporarily. He will typically spend
the money. In our example, he will hire the various laborers to clear a
plot of land, build a building and he will buy tools and inventory.
What
will those laborers and vendors do with the money? Likely they will
keep some of it, spend some of it… and lend some of it.
That’s right. The proceeds that come from what began as a loan
from someone’s hoard have been disbursed into the economy and
eventually land in the hands of someone who lends them again! The
“same” money is being lent again!
And
what will the next borrower do with it? Spend it. And what will
those who earn it do? Spend some, keep some, and lend some.
Again.
There
is an expansion of credit! There is no particular limit to how far it
can expand. In fact, it will develop iteratively into the same topology
(mathematical structure) as one observes with fractional reserve banking
under a proper, unadulterated gold standard!
Without
banks, there are two concepts that are not applicable yet. First is
“reserve ratio”. Each person is free to lend up to 100% of
his money if he wishes, though most people would not do that in most
circumstances.
And
second is duration mismatch. Since each lender is lending his own
money, by definition and by nature he is lending it for precisely as long as
he means to. And if he makes a mistake, only he will bear the
consequences. If one lends for 10 years duration, and a year later one
realizes that one needs the money, one must go to the market to try to find
someone who will buy the loan. And then discover the other side of that
large bid-ask spread, as one may take a loss doing this.
Now,
let’s fast forward to the advent of the investment bank. Like
everyone else in the free market, the bank must do something to add value or
else it will not find willing trading partners. What does the bank do?
As
I hinted above, the bank is the market maker. The market maker narrows
the bid-ask spread, which benefits everyone. The bank does this by
standardizing loans into bonds, and the bank stands ready to buy or sell such
bonds. The bank also aggregates bonds across multiple lenders and
across multiple borrowers. This solves the problem of excessive credit
risk concentration, coincidence of wants (i.e. size matching), and saves both
lenders and borrowers enormous amounts of time. And of course if either
needs to get out of a deal when circumstances change, the bank makes a liquid
market.
The
bank must be careful to protect its own solvency in case of credit risk greater
than it assumed. This is the reason for keeping some of its capital in
reserve! If the bank lent 100% of its funds, then it would be bankrupt
if any loan ever defaulted.
What
the bank must not do, what it has no right to do, is lend its
depositors’ funds for longer than they expressly intended. If a
depositor wants to lend for 5 years, it is not the right of the bank to lend
that depositor’s money for 10! The bank has no right to declare,
“well, we have a reserve ratio greater than our estimated credit risk
and therefore we are safe to borrow short from our depositors to lend
long”
Not
only has the bank no way to know what reserve ratio will be proof against a
run on the bank, but it is inevitable that a run will occur. This is
because the depositors think they will be getting their money back, but the
bank is concealing the fact that they won’t behind an opaque balance
sheet and a large operation. So, sooner or later, depositors need their
money for something and the bank cannot honor its obligations. So the
bank must sell bonds in quantity. If other banks are in the same
situation, the bond market suddenly goes “no bid”.
The
bank has no legal right and no moral right to lend a demand deposit or to
lend a time deposit for one day longer than its duration. And even
then, the bank has no mathematical expectation that it can get away with it
forever.
Like
every other actor in the market (and more broadly, in civilization) the bank
adds enormous value to everyone it transacts with, provided it acts
honestly. If a bank chooses to act dishonestly (or there is a central
bank that centrally plans money, credit, interest, and discount and forces
all banks to play dirty) then it can destroy value rather than creating it.
Unfortunately,
in 2012 the world is in this sorry state. It is not the nature of banks
or banking per se, it is not the nature of borrowing and lending per se, it
is not the nature of fractional reserves per se. It is duration
mismatch, central planning, counterfeit credit, buyers of last/only resort,
falling interest rates, and a lack of any extinguisher of debt that are the
causes of our monetary ills.
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