Thursday, August 15, 2013

Paying interest to lenders who don’t risk losing their principal misallocates resources.

Inflation apart, your money is virtually risk free if you lend to a responsible government: e.g. most North European governments. Plus if government stands behind bank deposits, so your “loan” to a bank when you deposit money there is virtually risk free.
But there’s a problem with all that, as follows. In the case of banks, the investments and loans that banks make are not 100% safe: a point that has become glaringly obvious in the recent crises. Though given the never ending stream of bank failures over the last few centuries, it was obvious all along.
In short, the only way of attaining complete safety is to do NOTHING with your stock of money. I.e. lending is INHERENTLY risky, even if the risk is small.
As for loans to government, the fact that such loans combine interest and zero risk is a mirage. As to loans to government which government uses to make investments, if those investments are incompetent and the investments don’t pay for themselves the risk or loss does not vanish into thin air: all that happens is that taxpayers foot the bill for the incompetence, while those lending to government don’t pay a penalty.
And as to loans to government which government spends on current consumption, there is no justification for that. Such lending is simply a ruse that enables incumbent politicians to ingratiate themselves with the electorate, while future politicians have to sort out the mess, as I explain in more detail here.
Indeed both Warren Mosler and Milton Friedman advocated a “zero government borrowing” regime.

Bank leverage.
Another form of risk free lending might seem to be involved where a bank has such a conservative leverage ratio that there is no realistic prospect of it failing. Let’s say a ratio of 50%.
Isn't that better than insisting on full reserve or 100% leverage? The 50% ratio on the face of it induces people who don’t want any risk to lend their money, doesn’t it?
Well the answer to that is that if 50% leverage really does bring 100% safety, then there’s no need for government backing for deposits – in which case depositors become quasi shareholders. Alternatively, if government backing for deposits IS OFFERED, then that is quite clearly a subsidy of banking!!!
In short, the argument for anything less than 100% leverage is plain illogical. It’s self- contradictory. It’s in check mate. Or in the words of Money Python, it’s a dead parrot.

Loans which are apparently risk free are a mirage. They are a confidence trick. All lending involves risk. That risk can be artificially transferred to parties other than the lender, but that’s simply a cheat. It’s fraud. It’s a misallocation of resources.

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