How Banking Works

I was surprised at the normally astute FT.com for taking an old joke, and getting it wrong. Let’s see if we can help the FT find their sense of humor.

First, the old joke:

Bail-out blues

The rain beats down in a small Irish town. The streets are deserted. Times are tough. Everyone is in debt and living on credit. A rich German arrives at the local hotel, asks to view its rooms and puts on the desk a €100 note. The owner gives him a bunch of keys and he goes off for an inspection.

As soon as he has gone upstairs, the hotelier grabs the note and runs next door to pay his debt to the butcher. The butcher hurries down the street to pay what he owes to his feed merchant. The merchant heads for the pub and uses the note to pay his bar bill. The publican slips the note to the local hooker who’s been offering her services on credit. She rushes to the hotel to pay what she owes for room hire. As she puts the €100 bill on the counter, the German appears, says the rooms are unsuitable, picks up his €100 note and leaves town.

No one did any work. No one earned anything. Everyone is out of debt. Everyone is feeling better. And that is how a bail-out works.

Well, not really.

To begin with, the proper punchline to the joke is: “And that is how banking works.”

Next, there was no bailout. If the rich German never came along, the town would not have defaulted, nor would it have have caused a global meltdown. Instead, we see an economy that thrives on credit. All of the local services were purchased on credit, by solvent, responsible, employed debtors who promptly paid off their debts as soon as they were liquid.

Indeed, this is an economy town suffering from a liquidity issue, not a solvency problem.

Here is how a bailout works: The financial sector ignores traditional capital requirements, imprudently leverages itself to the hilt, then blows up. The recklessness makes these banks insolvent, and the resultant collateral damage threatens the broader economy. A bailout is accomplished by transferring money from local taxpayer to the banks that caused the problem. Wait a decade or two, and repeat.

None of that is present in the above situation.

Last, the statement “No one did any work. No one earned anything” is actually false. Everyone did work and earned something: The hotelier was in debt to the butcher because he had guests whom he fed; the butcher raised and slaughtered his herd. He obviously worked with the feed merchant, who had sold his wares. The merchant purchased goods from the bartender in the pub. The pub owner had purchased services from the hooker, who in turn had purchased the services of the Hotelier. That seems to be a fairly robust economy, with a minor liquidity issue and credit squeeze.

As I have said in the past, Economics is easy . . .  comedy hard.