David French | 2/03/2009 12:33:08 PM

This article was originally published in The Morning Bulletin as "Dogma debates show the better times returning" on 7th February 2009.

How does a bank work? Say a bank attracts a $1.00 deposit. It might keep $0.10 in reserve and lend out the other $0.90. That $0.90 goes round in the economy and is eventually re-deposited in the banking system. Of that $0.90 the banks keep $0.09 in reserve, and lend out $0.81. If nothing adverse happens, this goes on and on until there is no more to lend. Reserves underpin the system and consequently are normally invested in highly rated securities.

Problems arise when the value of the reserves is compromised. Say a bad investment reduces bank reserves by $0.02. That 2 cents is actually supporting $0.18 in loans. Since a relatively small level of reserves props up a large amount of loans, the absence of those reserves necessitates a winding in of a large volume of loans. Banks simply cannot continue lending if the level of reserves is compromised.

After many piecemeal attempts to reinstate the integrity of bank reserves, we might be about to see the most convincing and historically successful measure implemented soon. The creation of a special purpose bank to hold troubled assets would involve the US Government taking the risk of the “bad bank”, while swapping bad assets for clean capital. Switzerland, Sweden and in the early 1990’s, the USA, have all successfully used this measure. The argument that the creation of a “bad bank” amounts to privatising profits and nationalising losses misses two important points. First, historically, and given time, the “bad” assets have been found to have significant value. Second the cost to the public will be much, much greater if the system is not fixed.

Notwithstanding a generally tough economic environment, things in financial markets might be about to get better. In overseas debt markets, January saw $A380 billion in company bonds issued, the most since the credit crisis began (source AFR, Friday 6 February). Domestically, someone with a mortgage of $300,000 is saving $9,750 per annum in interest even allowing that banks retained some of the reductions (they did that to boost reserves). Falling fuel prices probably save another $1,000, and every man and his dog is entitled to something under the latest stimulus proposal.

Finally we have the Prime Minister lambasting what he calls “neo-liberalism”. The return of meaningless, dogma laden debates to parliament is probably the most encouraging sign yet that things are returning to normal.

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