The Corruption of Banking

Towers of Mammon
Originally uploaded by seadipper.

Banks perform essential functions in society. They provide people with a place to leave their money. And they give credit. Farmers, for instance, need credit so that they can live between the time they plant their seeds and when the crop has been harvested and sold, when the credit is extinguished.

Trouble has arisen because banks lend money for land purchase, or proxies for land purchase, and do it on the basis of using the capital value of the land as collateral for the loan.

The effect of this is to stoke up land prices. And the more land prices rise, the happier the banks are to advance money, again using the land as collateral. This leads to periodic land price bubbles. Then things go bad. The real value of land it its annual rental, which is not subject to the bubble effect to anything like the same extent. Yields, as a percentage of selling prices, gradually drop, which is acceptable to investors only so long as people think that prices are going to keep on growing. Eventually, the realisation dawns that the growth has come to an end, and then there is a crash. It seems to happen every 18 years or so. An economic depression follows. It can last five years or so before confidence starts to return and the cycle begins again.

We are now in the feverish stage of the cycle. Bank have been doing all sorts of stupid and barely honest things, like lending to people who cannot pay the money back, imagining that it does not matter because of the security of the rising value of the land being used as collateral, and then selling-on the bad debt. Both the borrowers and the banks are going to be in trouble.

The underlying problem is that the rental value of land is retained by the owner instead of being taxed away. This is how capital values attach to land in the first instance, as land purchase is the purchase of a rental stream. Once that happens, land prices froth up as they reflect the expectations of a larger rental stream in the future. Then land becomes a speculatively traded commodity. And that is the whole problem. The corruption of the banks is a side-effect.

Under a system where land rental value was taxed away, land would have no significant selling price. Banks would have no option but to make their loans on the basis of the credit-worthiness of the borrower. And competition would make prices fall. There would be no necessity to charge interest because charges for credit would need to be no more than was required to cover the cost of administration and to cover the possibility of default - a kind of insurance premium. This is the key to an honest banking system.