First, let's start by looking at the text of the proposed bailout at this handy-dandy
provided by SkepticOverlord
The relevant section I'm speaking of is:
SEC. 127. ACCELERATION OF EFFECTIVE DATE.
Section 203 of the Financial Services Regulatory Relief Act of 2006 (12 U.S.C. 461 note) is amended by striking "October 1, 2011" and inserting
"‘October 1, 2008".
So something from another piece of legislation is being pushed forward, in simple English.
That legislation in full can be found at this link
The specific section amended is as follows:
SEC. 202. INCREASED FLEXIBILITY FOR THE FEDERAL RESERVE
BOARD TO ESTABLISH RESERVE REQUIREMENTS.
Section 19(b)(2)(A) of the Federal Reserve Act (12 U.S.C.
461(b)(2)(A)) is amended—
(1) in clause (i), by striking ‘‘the ratio of 3 per centum’’
and inserting ‘‘a ratio of not greater than 3 percent (and which
may be zero)’’; and
(2) in clause (ii), by striking ‘‘and not less than 8 per
centum,’’ and inserting ‘‘(and which may be zero),’’.
SEC. 203. EFFECTIVE DATE.
The amendments made by this title shall take effect October
So whatever this mumbo jumbo is authorizing, it's going to go into effect in Oct 2008 instead of October 2011. But what does it mean?
Right now, a bank does not hold every dollar you deposit with them in some big vault. If you deposit $1000, they are only required to physically keep
a percentage of that in cash available for withdrawal. The remainder of the deposit is loaned out to other customers - credit cards, mortgages, etc.
This is called fractional reserve banking. The banks only keep a FRACTION of what you deposit into your account in RESERVE on hand for
This works because, in normal times, the demand for withdrawals rarely exceeds what a bank holds in reserve. If a bank has, let's say, $1million in
deposits, it may only keep $200k in cash on hand. If, over the course of a year, withdrawal requests only average $150k in cash, then the bank is
operating normally and keeping up with customer demand. In abnormal times, such as the current environment, the demand for withdrawals can and will
start outpacing what a bank holds in reserve. People get nervous and take their money out of the bank - also known as a "bank run." If that
happens, the bank physically does not have the cash to meet its depositors' demand. They may be able to raise cash by taking a loan from another
bank or selling assets, which keeps the bank afloat...but if they can't do this, then we see an IndyMac situation.
But what does this have to do with the text in the bailout bill?
Well, that ratio of about $.80 loaned out for every $1 in reserve not only protects the bank (somewhat) in normal economic times, but it also prevents
an excess of credit money (or commercial money) being created. Let's say a bank loans out $800k of its $1million in deposits. It has effectively
released an extra $800k into the market via credit.
This tends to balance out as loans are paid back....but what happens when loans aren't paid back? The bank can seize assets (foreclose on a house)
and try to resell them to recoup their depositors' money. What happens if they can't resell the asset (a foreclosed house, for example)? The bank
now has lost its depositors' money and must find another way to honor withdrawal requests. Again, in normal times this tends to balance out as banks
make profit in other ways, but when huge numbers of loans are in default, we start to see banks collapse.
Now. The root of this massive issue comes down to that ratio. There's a cap on how much a bank can lend out, based on how much it holds in deposits
What this amendment in the bailout bill does is allow for a bank to hold zero in reserve. It removes that cap. If a bank holds $1million in deposits
and this bill passes, as of October 1st the bank can loan out all $1million of those deposits. It can loan out more than that.
It allows a bank to create money
by loaning out more money than it physically can back!
What happens when money is created at an explosive rate with nothing to back it? We're seeing it happen in
right now. It's called
- only this money isn't being created by the Fed. As things stand,
it will be created by the banks by removing any controls they previously had on issuing credit.
THIS is how they want to save the economy???