The Next One could be Even Worse

According to the International Monetary Fund (IMF), there have been 147 banking crises since 1970. As you can see in the graph below, 2008 was by far the year with the largest number of crises.


Source: IMF
[Click to enlarge]

As you can see from the graph, these crises happen in waves.

Many bank crises happen because of excessive lending and taking too many risks. As the IMF reports, out of the 129 banking crises for which they have credit data available, a third were led by a credit boom.

That is, because of banks lending too much.

In a way, booms and busts in domestic economies are normal. The economy creates imbalances during a boom that usually get corrected and reversed in a bust.

Yet the last bust in 2008 went much deeper than that. The 2008 crisis shook people’s confidence in banks.

The government saved the banks, but, it made many question them.

Recovery since 2008 has been very weak. In fact, we are still feeling the effects of the latest bust.

As we wrote recently, a crisis can also leave scars. That is, a recession can lead to a country’s permanent loss of output. Since the 2008 crisis, the US has been constantly revising their potential output estimates down.

And people are still weary of banks.

For this reason, Switzerland’s citizens are going to the polls this Sunday.

They are looking to vote on a proposal called ‘Vollgeld’ or Sovereign Money Initiative (SMI).

If the referendum becomes law, it would stop commercial banks from having the ability to create money.

You see, commercial banks create money by lending it. That is, when you deposit money in your account, the bank keeps a part of it and then lends the rest.

Banks are required to hold a fraction of their deposits, something that is called fractional reserve banking.

When they lend money, they don’t take it out of your savings and give it to the borrower. Instead, with a few keystrokes they create new money.

Let me give you an example. Let’s say you deposit $100 and the bank is required to keep in reserve 10%. The bank would keep $10 and loan the rest. Now there is an extra $90 in the system. At some point, those $90 will end up in another bank, who will also keep 10% and lend the rest, and so on…

About 90% of Switzerland’s money is created this way.

As you can see, the whole system is based on debt. The available amount of money expands when banks give out more debt.

With SMI, money creation would go through the central bank.

SMI proponents say Vollgeld will make the system safer. For one, it could put an end to the fractional reserve system.

Supporters argue it would also mean the end of booms and busts.

During a boom, banks lend out more, which can increase risk taking and can boost asset prices. When the economy slows, banks usually tighten up credit, which can make the slowdown even more severe.

I saw this during the 2008 property bubble in Spain. During the early 2000s, banks were lending excessively. It created an illusion of wealth.

Yet once the 2008 crisis came, everything came crashing down. Banks tightened credit for years, which made the recession even worse.

And they also argue that it would put an end to bank runs. If you are not familiar with them, a bank run is when all depositors go to the bank at the same time to ask for their money back.

As the bank only holds a fraction of the deposits, they cannot honour them, and default.

The whole fractional reserve banking system is only backed by confidence. A confidence that the system won’t crumble…that bank depositors will not ask for their money back all at once.

In our system today, currencies can be multiplied easily and they are not backed by anything.

Yet think about the older currencies, they were all backed by something.

The British pound got its name because it was equal to one pound of silver. The German mark comes from the German Goldmark, which was tied to gold.

Today, there are no limits to how much money we can create. And, as we saw in the graph above, crises are getting worse and more violent.

We are creating more and more debt to spur the economy.

World debt has increased from US$142 trillion to US$233 trillion in the last 10 years. That is, the world has added US$91 trillion or 64% more debt.

That’s why I think the next crisis will be even worse than the one in 2008.

Will the Vollgeld law go through?

According to the polls, it’s not likely. They expect that about two thirds of voters will go against it.

While, in my opinion, giving even more power to the central banks is not the solution, I do agree that our current system needs to change.

And, as the referendum shows, 10 years after the 2008 crisis people are still very much weary of banks.

All the best,

Selva Freigedo,
Editor, Markets & Money


Selva Freigedo is an analyst with a background in financial economics. Born and raised in Argentina, she has also lived in Brazil, the US and Spain. She has seen economic troubles firsthand, from economic booms to collapses and the ravaging effects of hyperinflation, high unemployment, deposit freezes and debt default. Selva now writes from her vantage point here in Australia. She is lead Editor at the daily e-letter Markets & Money. And every week, she goes through each report and research note produced by our global network of trusted advisors to find the best investment opportunities for you in Australia and overseas. She packages these opportunities for you in Global Investor.


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