Skyscrapers And Business Cycles

By Dan McLaughlin, on February 18th, 2009

A recent Forbes article listed the ten “tallest cities”, those with the most buildings over 700 feet tall. The current record holder for tallest building is the Burj Dubai in the Arab Emirates, at 2684 feet, scheduled to open this fall. It is more than 1000 feet taller than the previous record holder, the Taipei 101 in Taiwan. There are plans to build a couple of skyscrapers over 3000 feet tall.

The article brings to mind a concept introduced in 1999 by Andrew Lawrence, called the “Skyscraper Index”. The index highlights a fairly strong correlation between new world record buildings and the onset of recession. While correlation isn’t causation, and tall buildings certainly don’t cause economic downturns, it is quite interesting and can help to shed some light on the workings of business cycles.

Business cycles can be more aptly described as banking or monetary cycles. They arise in conjunction with inflationary credit bubbles, the responsibility for which lies with the central banks and the fractional reserve banking system. The relative regularity of the bubbles is linked to the fact that the actions taken to mitigate the deflationary effects of an economic downturn, when the bubble bursts, actually plant the seeds for the next bubble.

The root of the matter is that central bankers use incentives to spur rapid economic growth. The interest rate is artificially reduced to below the market rates and the market is flooded with money. Fractional reserve banks greatly leverage the money supply, and it expands like an accordion. The banks use deposited money to make loans, and the leverage of fractional reserves transforms a billion dollars of new reserves into ten billion dollars of new money, created out of thin air.

When interest rates are artificially lowered, business ventures that might not make sense under normal conditions suddenly look profitable. The beginning of the bubble is actually the end of the previous bubble, so costs look favorable. The prior shakeout means that there are lots of resources available at cheap prices. Business really does look good, and entrepreneurs make rational decisions to start projects which look profitable. The money entering the system makes it appear that business is booming for everyone. High spirits and lots of cash stoke the fires for bigger and bigger projects. At times like this, record breaking skyscrapers start to materialize. The thesis of the Skyscraper Index is that when world record building projects get rolling, it is likely that the end of the bubble is near.

The problem is that real resources are limited in the short term. More money pouring into the system does not make any more steel, concrete or lumber available. It does not make more people available to do the work. As the market heats up, the limitation on real resources becomes apparent and costs of production are bid up far beyond expectations. It turns out that entrepreneurs have been fooled. Projects that once looked like big winners now become losers.

The downhill side of the bubble occurs when businesses and individuals can’t pay and the loans go bad. The accordion of fractional reserve banking starts to contract as the leverage is reversed. A billion dollars in bad loans will cause a contraction of 10 billion dollars, as money made from nothing disappears into the ether from whence it came.

As the bust progresses, the real productive resources are still there. Skyscraper owners may go bankrupt but deflation should make prices come down. Productive assets, or overpriced homes in the present case, should become more affordable and realistically priced. If that was allowed to happen, the efficient entrepreneurs would take over productive assets and prospective homeowners would finally be able to afford the homes that they were responsible enough to avoid when they were overpriced.

The reaction among politicians today is to flood the market with “stimulus” to prevent prices from falling and to prop up failed banks and businesses. Aside from the glaring moral hazard of supporting failing businesses and irresponsible homeowners at the expense of those who were responsible, the actions prevent the adjustment that is needed for the economy to become productive again. Skyscraper owners are bailed out, while Average Joe drowns.

Eventually, we may wake up to the reality that the present banking system is the problem. Real banking reform may make the bailout mentality obsolete. It is probably not a good idea to hold your breath waiting, though. Big banks and skyscraper owners with political clout have become addicted to bailouts.



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The End Of Fractional Reserve Banking?

By Dan McLaughlin, on December 11th, 2008

United States Treasury Notes were recently auctioned off for a yield of 0%. That means that very smart people running mutual funds, brokerage houses and other very large organizations were willing to invest lots of money and get nothing in return other than a return of their principal. We can probably rule out the motives of benevolence or Christmas spirit. There must be some other reason.

Those smart people are investment managers, who’s job it is to make money for the organizations through their investing. With the extreme volatility of the stock market, those people would rather sit on their cash than risk it on companies that will likely lose a significant portion of their share value. That is not irrational. However, considering the fact that there are brokerage commissions and fees involved in buying treasury notes, those managers are losing money for their organizations by investing at 0%. Why would they not just keep their cash at 0% and not pay the commissions? It doesn’t seem to make sense.

An organization that has $100 million of cash doesn’t have a room full of twenty dollar bills. They have a bank account with some accounting entries. With all of the turmoil in the banking industry, it is not unreasonable for these money managers to feel a little queasy about leaving that money in a bank. FDIC deposit insurance only covers the first $250,000. The other $99,750,000 is unsecured. If the bank goes belly up, they may or may not get all of their money back, and if they do, they have no idea how long they would have to wait.

With that in mind, it makes sense that large scale investors would rather own treasury notes that appear to have a high level of safety, even if they lose a little money on the transaction. It sounds perverse, doesn’t it? If you understand fractional reserve banking, you can understand why it actually is so perverse.

When you put your money in a checking account at a bank, you do so with the understanding that it is still all your money. You have a right to withdraw it in any amount, at any time. This is opposed to investing in a Certificate of Deposit at the same bank. With the CD, you are actually loaning the bank your money. You do not have a right to withdraw it without penalty before the due date.

Banks have figured out that, on average, their depositors will not be withdrawing all of their money. Only a fairly small fraction will be taken on a given day. The bankers believe that all of that money should not be just sitting around collecting dust. They say “Someone should be making money from it, it might as well be me.” So they take a portion of that money and lend it out to other customers at interest to be paid over time. That’s pretty clever. In any other setting, that is called embezzlement, but in banking it is called generally accepted business practice.

At any point in time, every bank is technically bankrupt. Most of its liabilities, the deposits due to customers, are very short term. Most of its assets are very long term, such as loans. Mortgages that a bank lends out for 30 years are balanced by a checking deposit that is due today. In normal times it is not an issue because people are pretty predictable. In abnormal times, like now, people aren’t so predictable. They may have very valid reasons for pulling out their cash, such as believing that the bankers won’t have their money when they need it.

Unfortunately, that is a very valid concern. The underlying problem has nothing to do with market psychology or confidence or any such nonsense. The core issue is that, due to the bank’s systematic embezzlement, they do not have the cash available to meet their contractual obligations.

Using taxpayer money and the FDIC to secure a portion of deposits against banker fraud is not the solution to the problem. The solution is not to use billions, or even trillions, of taxpayer dollars to bail out banks who did stupid things with the money they embezzled. The solution is to make the embezzlement illegal, to stop the fraud.

The fractional reserve system allows banks to leverage reserves and rapidly expand money and credit. We witnessed that with the current housing bubble, the 1990’s stock bubble and every other bubble market before that. Rapid credit expansion is a two edged sword. Once the bubble bursts, there is a rapid deflation as irresponsible loans go bad and reserves diminish. They can’t hide the embezzlement in the downside of the bubble, because people want their deposits and banks don’t have them to give.

There is a very simple way to prevent future bubbles and economic crises, or at least minimize them. If banks were forced to live by the laws that everyone else must live by, bank runs would be very unlikely, even in the worst economic conditions. People could always get their money because it would always be there. There is a fairly simple cause and effect relationship. A simple policy change of requiring 100% reserves for all banks would prevent a meltdown like we are suffering through today.

It would be a fairly easy policy to implement, if there was the political will to do so. Given that the banking industry is one of the most wealthy and powerful lobbyists in Washington, that is not likely until taxpayers and voters connect the dots, and get fed up with footing the bill and bearing all the pain.



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