Why the Swedish are to blame for the credit crunch

The explanations for the current financial situation are wide ranging, but none so far seemed to have blamed the Swedish. So here goes.

Up until the formation of the Swedish Riksbank in 1656 the concept of what now is called "fractional reserve banking" didn't really exist. Most banking that had taken place up until that point was done where any loans were matched 1-for-1 against a metallic reserve (gold, silver etc.) whose price was typically pretty constant or fixed. The Spanish Conquistadors for example had pillaged and looted their way through the Inca Empire in the 16th century because precious metal was the only way in their minds to expand economically. The Spanish monarchy were the main beneficiaries of the conquests, but the way the gold and silver "money" was spent provided the entire continent with a stimulus. Precious metal had become the store of value, and the Spanish "pieces of eight" coins were the world's first reserve currency. As such, it allowed the Spanish to finance its empire building, it's wars in Europe and it's trade flows between Europe and Asia. Nevertheless, as an empire they were still limited by the amount of precious metal they could plunder; in modern banking terminology - the "money supply" could only grow as fast as they could plunder gold and silver.

The Swedish Riksbank a century or so later had figured that they could overcome this issue. They realised that they didn't really need gold or silver as "collateral" to match 100% against any deposits they had. They could profitably lend money that had been left on deposit, and since it was highly unlikely that depositors would ask for their deposits back en masse, only a fraction of the deposits would need to be left on reserve at any one time. This was the first large scale attempt of any bank to introduce the concept of credit creation.

Other banks followed over time, but even by the late 18th century many banks were still yet to transition to fractional reserving that made the Riksbank successful. By way of example, the Amsterdam Exchange Bank by 1760 still had close to a 100% ratio between its deposits and reserves of precious metal. In that year they had deposits of 19 million florins versus metallic reserves of 16 million. Any modern bank would call this ludicrous inefficiency, as they were missing out on a large quantum of lending and earning opportunities, but as is oft ignored, commensurately more liquidity risk (the risk that all of the depositors come looking for their funds at once - a bank "run"). Say for example that the Riksbank operated a 10% reserve policy, and received a deposit of 100 from the central bank. They would place 10 on reserve with the central bank, and lend on 90 to the Volksbank. The Volksbank also operated a 10% reserve ratio so they reserved 9 and lent out 81 to the Peoples Bank. After 3 rounds of lending the money supply has reached 271.

Two of the core definitions of modern monetary theory are covered above. M0 (known as the monetary base), is equal to the total liabilities of the central bank, that is, cash plus the reserves of private sector banks on deposit at the central bank, and M1(known as narrow money) which is equal to cash in circulation plus deposits at private sector banks. Prior to the Riksbanks move into the unchartered territory of fractional reserve banking, the difference between M0 and M1 would have been almost nil. In the example above, M0 is 100 and M1 is 271.

The point here is that with the spread through the Western world of fractional reserve banking the very nature of money changed in a profoundly important way. Now money represented the sum total of specific liabilities (deposits and reserves) incurred by banks. The newly established concept of credit, was quite simply the total of banks' loans. Some of this money might still consist of precious metal, though a rising proportion of that would be held in the central bank's vault (no longer in the UKs case, as Gordon Brown sold most of the UKs gold a few years ago at a terrible price versus where the market is today), but most of it would be made up of those banknotes and coins that made up legal tender along with the invisible money that existed only in deposit account records.

Was this progress? In many senses, of course this was progress. Credit creation has been essential in the process of capital formation, which drives entrepreneurship, creates jobs, and has been responsible for pulling literally billions of people out of poverty the world over. Good risk taking achieves the positive aspects to credit creation outlined above. Bad risk taking on the other hand will make it more likely the borrowers will go bankrupt, and consequently that a bank cannot make new loans, or that depositors will worry that there isn't enough in the kitty to pay them back, and might induce a bank run. In the US in 2007 98% of bankruptcy filings were classified as "non-business" (i.e. personal/ consumer debt). The principal driver of bankruptcy therefore was not failed attempts at entrepreneurship but personal indebtedness, not backed by corporate endeavour, but by hope. In 2007 US consumer debt hit $2.5trillion. In 1959 average mortgage debt was 54% of personal income and by 2007 it was 140%. That is not necessarily a bad thing, but it just makes any liquidity shocks that much more painful.

In the 1946 film It's a Wonderful Life, which has become Christmas-time staple viewing, we are led to feel a great deal of sympathy for the plight of George Bailey (Jimmy Stewart) as he tries to sustain the Building & Loan Association that he has taken over from his dead father. The loans made to the local working class are critical to the local economy, whom the Baileys treat with a greater respect and dignity than their competition. The film is set from 1928 onwards, so the fractional reserve system is universal at this point. At various points through the story-line, George Bailey is close to seeing his bank collapse, firstly through a bank run and secondly through a sizeable misplaced deposit, which I'm sure the Daily Mail wouldn't have been too sympathetic towards. In the end he is saved from committing suicide by Clarence, his guardian angel, as God thinks that George essentially is a good man with the right attitude towards people and life. The blasphemous alternative take on George Bailey's situation is that he was undercapitalised and too careless to operate under the fractional reserve system, though it would spoil what is such a magical film.

Since the Swedes embarked on their revolutionary banking model in 1656 the inescapable reality seems to be that breaking the link between money creation and a precious metal anchor has led to an unprecedented monetary expansion - with a credit boom the likes of which the world has never seen. The pace of the expansion has increased exponentially in the past 20 years, with technological innovations that have made global markets instantaneously accessible. At the same time the capital reserves (or "adequacy") of banks in the developed world has been steadily declining. In Europe bank capital is now equivalent to less than 10% of assets, compared with around 25% at the beginning of the twentieth century. Today banking assets (loans + deposits) in the world's major economies are equivalent to around 150% of those countries combined GDP. This figure doesn't take into consideration "the shadow banking system", whereby many banks assets aren't recorded on balance sheet, but they may become liabilities at some distressed point (like now) in the future. According to the Bank for International Settlements, total international banking assets (loans + deposits) were equivalent to around $30 trillion, which is roughly 63% of world GDP. $30 trillion was also the total value "credit crunched" off world stock markets this year. And all of this is the fault of the ambitious Swedish, circa 1656. Well at the very least that gives us someone to add to the list of who's to blame.