Debt II: Financial Panic

Debt rests on trust, usually trust backed up by threat, but trust nonetheless. A financial panic occurs when it turns out that a lot of money people thought they had really doesn't exist - when it turns out that a whole bunch of debtors really can't pay.

The modern bank is one of the chief institutions of the modern world, but it's also that nightmare of Polonius, both a borrower and a lender. Probably the most fundamental characteristic of a bank is that it borrows short and lends long - it takes in short term deposits from savers, subject to recall on demand, and lends them out for longer terms.

Financial panics always involve a bank - or in modern times, a whole bunch of banks, because they do a lot of borrowing from each other. In a modern economy, financial transactions are only possible if people can trust banks to safely hold their money. If banks can't be trusted, we become a world of hoarders, and the market grinds to a halt.

Bad debt becomes a panic when savers find that the money they put in banks is gone. The scary part of the Greek financial crisis for non-Greeks is that German, French and other savers will wake up some morning and find the money in theri savings accounts was in a bank that no longer exists.

Moralists may point fingers at banks for lending foolishly, or at borrowers for borrowing foolishly, but realists prefer to worry about how can these paired evils be prevented, or, once they have occurred, be ameliorated.

We have 5000 years of human experience to prove that borrowers will indeed borrow more than they can afford if given a chance, and that lenders will lend out other peoples' money more freely than they would lend their own, so if we really want the market to function, [Wolfgang doesn't like the rest, and on second thought, he might be right]we should tell the market purists to STFU and regulate.

But I still believe that failure to regulate doesn't work.

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