Tuesday, 21 January 2014

Share prices with fractional reserve banking

The textbook explanation of share prices revolves around basic “supply and demand”. If the price of something has gone up it must mean that either its supply has diminished, or its demand has increased. It’s all part of a natural stable system. Wise investors are carefully evaluating companies and buying and selling shares accordingly. The government, who claim to believe in free markets, sit on the side-lines and let them get on with it.

Most people would make two assumptions when considering this market:

1.    People normally buy shares with their money.
2.    If they spend say, £1000 on shares, they will have £1000 less money to spend on other things.

If both these things were true, then share prices may be well behaved and act in the way textbooks may have you believe. But many economists have observed that share prices behave in strange ways. At least part of the reason prices appear so strange is the fact that neither assumption is correct. They are incorrect because shares are often purchased with borrowed money, or to be more accurate, part borrowed. Readers of this blog should know by now, that when £1000 is “borrowed” from a bank, that money is created out of nothing. There is nobody else in the economy that is deprived of £1000 of spending power. You should get the idea straight away that now something is screwy about the demand side of the supply and demand balance.

Textbooks say that the price of something is what you are willing to give up in order to get something, i.e. the amount of money you will pay for something equals the amount of money you are willing to have disappear from your spending power on other stuff. But if you are going to buy that thing with 10% your money and 90% borrowed money (a process known as trading on margin) then the textbook concept is busted. Now the amount of money you are willing to pay for something is enormously sensitive to the interest rate you will be charged for the money you borrow to buy that something!

So now the role of government becomes crucial in setting share prices. Instead of standing at the side-lines observing these wise investors analysing the companies, the government is now the dominating factor. The wise investors are sitting watching the government! If they lower interest rates, then the enthusiasm for borrowing to buy shares increases, this increases demand and their price will rise… and conversely If they raise interest rates, then the enthusiasm for borrowing to buy shares decreases and their price will fall. By implementing super-low interest rates for such a long time, the government is now stuck in a situation, where returning to normalised interest rates would almost certainly cause a crash in the stock market. Note that I could have made almost exactly the same argument about the housing market too.

The near-zero interest rate policy is in force precisely because of fractional reserve banking and would be entirely unnecessary had we a full reserve system.

Changing to full reserve banking is a key ingredient for making our economy work properly. If I were in charge, I would ban the practice of trading on margin too. It serves no purpose that I can figure out for the economy as a whole.