Perverse Banking Incentives

According to political consensus, it's because of the wrong incentives that we have arrived at the current financial crisis. Too many excessive bonuses have been given to bankers, to reward huge short term profits, causing huge long term losses. Naturally, these bonuses are perverse incentives, which despite all discussion we still have.

Yet, there is a much more perverse incentive in our current banking system. It's a deeply anchored incentive, which costs not just many millions, but it actually devours all of our money. Does this sound strange? I'm talking about the way our bank balance sheets now are organised. The problem forces us to go into debt continuously, just to keep the economy going.

How?

Suppose, I get a mortgage to pay for my house. I'd like to borrow three hundred thousand, but I have thirty thousand of my own. Fine, the bank tells me, because the bank can lend out more than ten times its cash reserves. My thirty thousand will be a reserve, and with the flick of a computer keyboard my thirty thousand is inflated to three hundred thousand of bank credit. That's ten times as much as I had. It's just bank credit, but it's as good as money – or in fact, it currently is our money.

On one side of the balance sheet it now says “credit to lender: 300,000”. On the other, nicely balanced, it says “to be repaid by lender: 300,000”. To be repaid with interest, by the way, but that's another thing. My autograph, and my promise to pay have enabled the bank to create 270,000 of new money. That's 270,000 to be used in the economy to invest or speculate, buy things, hire people, and pay taxes.

Virtually all our money is continuously being created this way. Once someone promises the bank to pay back the money, and the bank wants to believe it, then the money can be created. It's rather bizarre when you think about it, but that's what our money is now: bank debt tokens.

But what happens when I pay back my mortgage? In that case the loan is extinguished, and not only the debt, but also the money disappears! On one side of the balance sheet my debt to the bank is crossed out, but on the other side the money I used to pay back is also crossed out. The two hundred seventy thousand I borrowed are taken out of circulation. We cannot use this money any longer, and nobody has it any longer. It's taken out of existence, and can't be used for investing, nor for buying stuff, nor for paying interest.

So our economy loses out, when we pay back (too much) of our debts, at least in the sense that we'll have less money to go around with. That's a rather strange and counter-intuitive incentive. It also means that in this system some kinds of austerity will be deadly to our economy.

The bankers also do not really want me to pay back my loans. They don't get the money that I pay back, because it's crossed out against the debt. At the most my paying off unburdens their balance sheets a bit. Instead, the bank makes its money from the interest I pay on my loans. Interest does not have to be extinguished on the balance sheet. Interest is much more “real” to the bank, as they can keep it as their profit. It's much more interesting – pun intended.

If the bank could choose, we would pay interest for eternity. If we want to keep our money in the economy, we'd never pay off our debts. If we would, we would shrink the money supply – which we are currently doing. So, if we want to keep the economy going we will have to borrow money forever. Yet we can't. Even if we learn not to worry about insane debt levels, we can't.

The way our bank balance sheets work now, we have to borrow until the system bursts. One day the interest we have to pay, just to be able to use our money, will be more than what we can collectively earn.

That day may already have arrived.