How Fractional Reserve Banking Leads to Booms and Busts

The seeds of an asset bubble

The seed of a boom is very often a clear and sustained rise in the price of some asset class (typically shares or houses), usually for a genuine fundamental reason to do with supply and demand. For the sake of argument, in the coming parts of this discussion we shall refer to this initial rise as being caused by “Reason X”. This is the first of the two components that drive the price rise. The second is more complex, and requires a little digression before it can be introduced.

Trading on margin and its cousin, the mortgage

The next ingredient in the recipe for creating bubbles, concerns a mechanism used by speculators known as trading on margin and an economically similar device, the mortgage. Trading on margin is a trick employed to make greater profits from a successful investment. It works as follows:

Trading on marginImagine a speculator is confident that the price of an asset is going to rise strongly over the next year. As an example, say that the asset is shares in Tesco Plc. Let us also say that he has £1,000 to invest. The speculator can profit from this prediction by simply using his money to purchase the asset, wait a year, then sell up and pocket the difference. If the shares rose by 15% he would have a profit of £150.There is, however, a way to boost his earnings. What he can do is borrow some money for his investment. Say he borrowed £10,000 at 5% interest. Now he would have £11,000 to buy Tesco shares.

One year later he can sell the shares for 15% more, i.e. £1,650.

Now he has to pay the 5% interest on the loan. This will be £500.

So the net profit over the year will be £1,150, far greater than the £150 without the loan.

This method of magnifying your potential profits is a form of financial leverage. The degree of leverage is expressed as the ratio of the amount of loaned money to the amount of money the investor has available himself for the investment, so in this example the leverage is 10:1.

Note that for trading on margin to work profitably, the increase in the price of the asset must outstrip the interest rate being charged for the loan. So increases in interest rates will reduce the propensity for investors to employ this technique.

Getting a mortgage in order to buy a house for investment purposes has very similar economic characteristics to trading on margin. The investment in this case is the house. The investor’s contribution is the deposit and the remaining money is made up by the loan. If the price of the house rises at a faster rate than the interest on the loan then the profit that the householder can make on their investment can be far greater than that which they could make had they only been able to invest their original deposit.

Both trading on margin and buying houses as an investment can be summarised as follows:

People who are confident in the rising price of an asset may like to borrow money in order to invest it in that asset.

The word “may” in that sentence depends on how confident the investor is that the price of the asset will rise faster than the rate of interest on the money that needs to be borrowed. We can now make a more accurate summation of the situation:

People who are confident in the rising price of an asset may like to borrow money in order to invest it in that asset. The greater their confidence in the rise and the lower the interest rate, the greater the enthusiasm for this process.

Readers of this blog will already be aware that loans create money. So we can further modify the summation as follows:

When people are confident that an asset can rise in price at a rate greater than the current interest rate then fresh new money will be created for the purposes of purchasing those assets. The greater the confidence in the rise and the lower the interest rate, the greater the enthusiasm for this process.

Simple supply and demand will tell you that the more money there is chasing an asset, the higher the price will go. We can now state that:

More money being created for the purposes of purchasing this class of asset pushes up the price. This in turn creates more confidence that the price will continue rising.

This constitutes a positive feedback loop in the asset price. As discussed at the start, an asset bubble can get started when there is a sustained rise in the price of an asset for a fundamental reason but people observe this rise for a long enough period, their confidence in its continued rise will grow. This will give people the confidence to trade on margin and the feedback loop can then kick in. The bubble will grow. Sadly so few people know of the feedback loop that many commentators will ascribe all of the rise to Reason X even though this was merely the seed.

The bust

One can consider the price of an asset as being made up of two components:

1. a price based on the inherent desirability of the asset on its own merits

2. a premium over and above “Price 1”, based purely upon expectations that you will be able to sell the asset at a higher price at some future point.

During an asset bubble the second component will grow and grow while the first component may remain relatively unchanged. This is what we have seen time and time again, either in the form of unsustainably high share prices, house prices, or more recently, in the price of derivatives.

As many economists have pointed out, “If something cannot go on forever, it won’t.” When the price of an asset class has been rising steadily for a considerable time, it is only natural that many people begin to assume that it is likely to continue rising and they will merrily invest in the asset, thereby raising prices in the bubble. But there will eventually, possibly years after the start, come a point where the price of the asset becomes so obviously unsustainable that more and more people begin to become sceptical that it can go any further. At some point the sceptics will begin to outnumber the “believers” and the prices will turn around. As soon as this starts to happen then the aforementioned “Premium over Price 1” will vanish. The positive feedback loop then acts to accelerate the price change in the opposite direction, i.e. people see the prices falling and they no longer want to hold on to the asset so they sell, or at least are reluctant to buy. This signals prices to go down… and so on and so on.

An end to the rise at some point is guaranteed but there will always be some event that people will claim was the cause, even if it was merely the straw that broke the camel’s back.

At this point let’s remind you of the two phenomena discussed earlier:

• Borrowing causes money creation (via fractional reserve banking).

• Speculators like to borrow in order to invest in assets that they think will rise in price (trading on margin).

Obviously the price of the assets involved in the bubble are no longer expected to rise; quite the opposite, they are expected to fall. We now need to introduce the corollary to these phenomena:

• Paying back loans/defaulting causes money to disappear out of existence.

• Speculators who had recently been doing a lot of borrowing will now no longer have that desire. Indeed speculators whose investments have fallen in price dramatically may default on their loan repayments.

You should be able to see now that this scenario will naturally lead to a significant shrinking of the money supply which has a host of disastrous side effects.