Inflation and value

This is a meditation on business practices I wrote a while back, that I thought would be fun to post here. I'm not sure I still feel the same way, but I'll throw it out there and see what kind of feedback we get. Caution: It's a biggun.

Way back in the day you could put your money in a bank, and come back to said bank at any later date and be sure that you're money would be safe in vault somewhere. These days, that's just not the case. If you go to your bank right now, they can show you an account statement, maybe even liquidate it for you (depending on how much you have in your account), but if you ask them to see the actual cash safely locked away in the vault, they'll laugh you out of the building.

The reason for this is something we call "fractional reserve banking". Basically that's where a bank only has to hold (or keep on reserve) a fraction of the money entrusted to them at any given time. The rest of it can be on loan to other people (the hope being that those people will pay back the loan with interest, and the bank owners get money). The system works pretty well as long as everyone doesn't ask for all their money all at once -- we call that a "run on the bank". It also encourages people to own and operate banks, because there is a way to make money off of it.

But what happens if everyone tries to get their money all at once? In that case, there are central reserve banks that keep a metric ass-load of money on hand that they can give out to a bank that gets "runned" on. These central banks are owned by the Federal Reserve, and private banking conglomerate with board members appointed by the federal government. The idea with the central reserves is that not all the banks in the entire country will have a run on them all at once, so they can cover a few at a time. Sounds good, right?

Well, kind of. The idea is nice. All the banks are covered, so that people can know that their money is safe even though it's not technically in a vault somewhere. At the same time there's a reason for people to open banks, and competition is good for us all. Or so they say. It's important to remember that in the grand scheme of things, capitalism is a pretty young experiment, still in it's early stages. Because of that, there are a lot of unintended consequences of seemingly good decisions.

Because banks only have to keep a fraction of their entrusted money on hand (10% in the US), they make money off of interest on loans, and they have a grand bail-out bank making sure that they won't get totally boned by over-zealous bank members there is a strong incentive in a competitive market to give out loans to as many people as they possibly can. Even if some of that money is lost because of defaults, they central reserve banks got them covered. Mean-while, they maximize their potential gains by riding close to the line (most banks keep EXACTLY 10% cash on hand, the other 90% is on loan all the time). Another funny thing about the way that capitalist institutions keep their books is that money that they have given out to other people is actually an asset, even though they don't have the money any more! They have the promise of a lot more money, though. They can take out loans of their own on this promise, or even sell the promise for face-value to other banks before that promise has ever been realized (effectively turning a potential gain into a realized gain -- without anyone ever giving any money back).

So, we have a bank give 90% of it's money away to anyone who asks for it, and then sell the piece of paper that says "I'll give it back. Scouts honor" to someone else for a profit. Rinse, repeat. Because everyone knows that the reserve banks have their backs, there's no reason not to just run that as far and as fast as you can, which of course leads to a lot of the problems we are seeing now with the credit crisis, collapse of financial insurance companies, people losing their houses (and not paying back their loans -- 90% of which is your money), etc etc.

But the fed has them covered, right? Well, kind of. The fed can bring the money into existence to cover them. That's right; the fed invents money as it's needed. As the fed issues more and more money, there is more in the market, bringing the value of any given piece of money down relative to the rest. We call that inflation. Which means that every time money is given out by a bank and not given back, the overall value of money eventually goes down. That's why banks give interest on some accounts; to try to get people in the doors with a counter-trend to inflation (although savings account interest rates are never as high as inflation...).

So, see if you can follow this:
1) Banks go nuts giving out money.
2) Any money they make, 90% goes right back out the door again
3) Any money that they lose gets conjured into existence anyway, and
well all lose. In other words, capitalism, in this case, guarantees that we all LOSE purchasing power -- the exact opposite of what capitalism is supposed to provide.

It's not some conspiracy, though. There's no one at the top wringing their hands and cackling in the night at your expense. Quite the opposite: they're losing out, too. That's why they come up with more and more investment vehicles, in the hopes of finding the magic thing that makes them not lose out anymore.

It's all a funny artifact of the fact that at one point we decided that banks were good, and to make them better, they needed to be able to compete within a market. Both good concepts, but with some odd, unintended consequences.

So, here's what I propose: We still need banks, and no one will run them if they aren't going to make money, so the bank still needs to be able to run on a fractional reserve. However, we just need to get rid of the backing. Make a bank stand on its own decisions, and rise or fall as their business practices dictate (what capitalism is supposed to be). Check it:

1) Take away federal reserve backing of banks.
2) Drop the required reserve to 1% (so that banks can decide for themselves what makes the most sense for their business)
3) If a bank fails, or gets "runned on", only a small group of people lose out, instead of all of us.

Of course, this will make the federal reserve angry, because they are invested in making money as well. To keep them going, just move them to a government bank (still privatized, though). Here's the thought:

1) If banks rise and fall on their own merit, they won't want to give out loans to dodgy people
anymore (good)
2) The dodgy people need the money for things like food though (bad)
3) Let the government gives out and absorb those loans, and back them with the fed

This will keep the fed in business, allow for a healthy amount of inflation to allow for economic
growth, and keep the government from having to nationalize anything. Everybody wins -- in theory. Also, the government already has the debt-collection part in place with the IRS to cover people who take out a government loan and default. A bank can't come to your house and take your stuff. The feds can, though. So the government has less risk in giving out loans to bad customers than private banks. Private banks can focus on intelligent business practices like giving out loans intelligently, running their margins at a reasonable level to support their customers, and giving out interest that actually matters, and is relevant to how well they do in a competitive market.

We get the benefits of capitalism, without all the stupid by just getting out of the way and actually letting the market decide.

So, that's my idea. What do you think? Can you think of any unintended consequences of this kind of plan, or can you think of a whole new plan that would do even better?