The Banking System is Fine, Part Two

October 31, 2023

It’s been over two months since several large US Banks (and Credit Suisse) closed their doors. Over that time, the S&P 500 is up over 10%, the bond market is down a few percent, and the feared pandemic of bank failures has not (yet) fully materialized. For many, this suggests the banking system is fine, and the economy is on its way to the promised land of a “soft landing”. If you believe that, I still have that bridge I can sell you.

The Problem With Banks

As discussed in the previous article, the root cause of virtually every banking crises over the past 500 years can be found in the structure of the banking system itself. Fractional reserve banks (from here on, we’ll just call them “FR banks”) blur the distinction between time deposits and demand deposits, lending dollars they don’t actually have. In a sense, they create new money out of thin air.

Defenders of fractional reserve banking argue that this money-creation process is necessary to grow the economy. As far back as the 18th century British philosopher David Hume, the argument has been made that without bank credit, entrepreneurs would not be able to obtain capital to build new businesses, create new jobs, and raise the standard of living. So, to oppose FR banks would be to oppose economic progress. This notion, however, is mistaken. Bank credit is the driving force behind the very destructive business cycle – a phenomenon that has plagued modern economies for generations.

How Banks Create the Business Cycle

While banks create money (in the form of credit), they do not create wealth. Wealth is the result of increasing production. But this wealth cannot be measured merely in terms of output, which means that a bank can’t just loan money to anybody who wants to build something. Loans are only productive (and sustainable) when they are lent to businesses that make a profit.

The Chinese have famously built ghost cities by lending dollars to builders for the sake of “increasing production.” However, since that production was not funded by real savings, many of these building have remained empty, and are now crumbling from neglect. This is not wealth creation, but the wasting of scarce resources.

Similarly, the Soviet Union famously sought to increase their official steel production by ordering their civilians to melt items they found in their homes (like bikes, appliances, etc.). This did result in an increase in steel production, but it did not add wealth. The steel they produced came at the expense of worsening the lives of their civilians, who gave up useful items to make poor quality steel. Steel that was then remade into…appliances and bikes, among other things.

Production must be measured in terms of profits, which is the only way for a company to know if they are adding value (i.e., increasing productivity). When banks create money by extending credit, they create illusory profits. Entrepreneurs then undertake projects that will almost always end up operating at a loss. This process actually destroys wealth over time. Perhaps most confusing, this wasting of resources can occur even if the economy continues to grow.

Miscounting Coconuts

Suppose a man on a deserted island wants to build a net to catch fish, and this net would take approximately 5 days to build. If he doesn’t want to starve to death, he must first save 5 days’ worth of coconuts to “spend” while he builds his net. If he only saves two days’ worth of coconuts, then he can’t take five days to build the net – he will run clean out of “savings” on day three and begin to starve.

Now, don’t push the analogy too far – I understand that some guy on a deserted island could conceivably just stop building the net for a few days, save some more coconuts, and then finish the project later. But in an infinitely more complex modern economy, large and complex projects that take months or years to complete cannot simply be paused when resources run dry. Not completing big projects on time often invites a high risk of foreclosure if not outright bankruptcy. Regardless, the main point is this: projects that increase productivity cannot be completed without prior savings.

Counting Our Coconuts

In a FR banking system, the banks are essentially telling entrepreneurs that they have more coconuts than they actually do. The banks lend out more savings than they have received, encouraging entrepreneurs to build projects they cannot complete.

This problem, however, is entirely avoidable without FR banking. In a system without FR banking, entrepreneurs always know how many coconuts are available. When individuals save money instead of consuming their income, those saved funds end up in the financial system. That supply of money (as long as it isn’t increased by banking gimmicks), combined with the demand for loans in the economy, are what determine the “natural” interest rate. The cost of borrowing those funds (i.e., the interest rate) is a key component in determining if any project is profitable. If the interest rate is too high to make a product profitable at its expected sales price, then the plans are scrapped and loans are not made. If the interest rate is low enough to earn an expected profit, however, the loans will likely be made.

Global FR Banks and the Current Problem

Over the past 75 years, FR banks began expanding the supply of dollars all over the world. This was not only occurring inside the US – as had been the case for well over a century – but increasingly outside the US after World War II. British banks were lending dollars to banks in South America. Japanese banks were lending dollars to banks in China. Korean banks were lending to banks in Australia. The list goes on and on. The amount of dollars (in the form of bank credit) created in this system is estimated to be in the hundreds of trillions. Yet, the real savings available in this system are grossly insufficient to maintain the number of corporations that have borrowed this credit. There simply aren’t enough coconuts in the system.

This results in increasingly unprofitable and economically weak corporations, sometimes referred to as Zombie companies. According to the Bank for International Settlements, “zombie corporations” have been on the rise since at least 1980. The BIS discovered the percentage of publicly traded companies that qualify as zombies (i.e., they don’t earn enough to pay even the interest on their debt) have increased from around 4% in 1980 to over 15% in 2017. This percentage is likely much higher in the private corporate landscape, as private equity firms are notorious for playing accounting games to obtain higher valuations even if it means hurting long-term profitability.

In short, at least one in six companies globally are so unprofitable that they can’t even earn enough to pay the interest on their debt. This is, by the way, scraping the bottom of the barrel. There are many weak and unprofitable companies that do not technically qualify as zombies but are nonetheless highly likely to fail sooner or later. To top it all off, the latest statistics from the BIS were published before the pandemic, when the global economy was arguably much healthier. It is safe to conclude that the percentage of companies that are unprofitable today is much higher than one in six.

The Banking Crisis of 2023

The banking crisis is far from over for a variety of reasons. First, as the above analysis suggests, banks have increasingly been struggling to find good collateral (i.e., real wealth) to sustain their credit structure. This is a much bigger problem globally (specifically in China and the rest of the emerging economies), but it is a problem in the US as well.

Second, this struggle to stabilize their balance sheets has been exacerbated over the past 12 months as the Federal Reserve has taken the interest rate on short-term, risk-free credit from 0% up to over 5%. This has encouraged depositors to take their funds out of savings accounts at banks (which can only pay 0-1% in many instances) and deposit those assets into money market funds that now generate close to 5%.

As deposits flee, banks are increasingly concerned about having to liquidate assets that have lost market value. This is the Silicone Valley Bank (SVB) story being played out among many other small and regional-sized banks. In order to avoid this, these banks are utilizing the recently created Fed facility that is designed to avoid another SVB-type scenario. This facility just hit another record this week, having now received over $100 billion in bank assets in just three months. Although this facility may help to avoid another SVB, it doesn’t fix the credit crunch that this represents.

Third, these higher rates have affected both credit supply and demand, as has been strikingly obvious from the Dallas Fed survey of banking conditions. From the beginning of April to the middle of May demand for loans declined by nearly -50%. Don’t fall for the stock market’s rally – the effects of the banking failures in March and April are just getting started.

On the other hand, the SLOOS survey, which tracks the supply of credit on the banking side, found that roughly 45% of banks were tightening credit conditions before the banking crisis began! We don’t yet have the data for the second quarter of 2023, but if you believe credit supply improved after SVB’s collapse, then I’ll give you a 15% discount on that bridge.

Fourth, the increase in interest rates has spread into the mortgage market, the commercial real estate market, and soon it will likely start showing up in the high yield (i.e., zombie-type companies) debt market. If many of these zombie companies were struggling to survive at low-interest rates, they won’t stand a chance at higher interest rates.


It’s important to understand how banking crises play out. But it’s also important to understand why they play out. In short, an insufficient supply of wealth to support issued debt leads to a boom in economic activity, followed by an inevitable bust. The bust is often referred to as a recession. We are heading into one now, if we’re not already there. The banks know it. Does your portfolio?