Economics for Dummies #4: Time Travellers

Why do we repeatedly see banking induced financial crisis? In poorer countries, and countries where a small group has inordinate control, one can see that the political top bosses force bankers to lend to their cronies, regardless of the viability of the loan. But banking induced financial crisis are a phenomenon of the West too. What exactly is the problem with banking?

 

Yanis Varoufakis answers the question in Talking to My Daughter About the Economy. It is all rooted in something we discussed in an earlier blog in the series – the need for debt (loans). Quick recap: One needs money now to build a factory, to pay for raw materials and employee salaries on a continual basis, in order to make a profit in the future. So how does one get that money now? By taking a loan. From the banker, of course.

 

Put differently and vividly, Varoufakis says one can almost think of the entrepreneur as a “time traveller” –He goes into the future and gets money for his needs in the present. And who is his “travel agent” in this trip to the future? The banker.

 

While the time travel analogy may be appealing (and entertaining), it still doesn’t answer the question – how did the banker get money from the future? The way most people assume banking works is as follows –folks deposit money in the bank, and the banker lends parts of these deposits to others. Yes, that is part of the answer. Notice though that in this scenario, there is no time travel.

 

But there is also another way bankers facilitate loans – and that other way is where time travel really happens. With the stroke of a pen (or keyboard), the banker can issue a check to the entrepreneur for money that he doesn’t even have today! Huh? How does that even work? In effect, the banker is borrowing money from the future entrepreneur to give it to the present entrepreneur. While this may seem like magic (or illegal), it is standard banking practice all over the world. The assumption, of course, is that the entrepreneur can repay the loan in future, at which point the accounts will tally.

 

Of course, even without frauds, businesses are risky. Things can fail for many reasons. At which point, the banker’s accounts can’t be tallied anymore. One might naively think that the banker should be allowed to go, er, bankrupt. But it isn’t as simple as that – if the banker fails, the bank shuts down, and with that everyone with deposits in the bank loses money. No government can allow that, and so bank bailouts are all too common.

 

This compulsion of the government to bail out banks only encourages bankers to be even more rash in their actions. And so the cycle repeats itself. (In recent financial crisis in the West, the banks even sold these loans to other entities via complex deals. In effect, that meant when the loans couldn’t be repaid, the entity losing money isn’t even the bank anyone, but whoever had bought those loans from the banks. But that is a complex topic, and not the scope of this blog).

 

Before you get all worked up and decide to shut down banks altogether, remember how debt (loans) are indispensable to entrepreneurs, for the modern industrial system to work (this is true regardless of capitalism or communism)? And so, as Varoufakis writes:

“The very same process that generates wealth and profit generates financial crashes and crises.”

 

If you want to be philosophical about it, banking is like the yin and yang – it contains the seeds of its next phase within itself.