Below is an excerpt from a commentary originally posted at www.speculative-investor.com on 23rd May, 2010.

Apart from the tiny fraction of the US population that understands economics, everyone was content while the private-sector credit bubble was inflating. The Fed chairman was hailed as a "maestro" for keeping interest rates at artificially low levels and thus ensuring that the prices of most investments -- especially high-risk investments -- remained on upward paths, while politicians of all stripes were happy that the market for home mortgages was the greatest 'beneficiary' of the Fed-sponsored inflation of money and credit. Actually, politicians didn't leave much to chance, in that regulations were passed to encourage the provision of mortgage-related credit to anyone with a pulse and government-sponsored enterprises (Fannie Mae, etc.) worked tenaciously to increase both the supply of and the demand for mortgages. The banking industry played its part to the hilt by inventing new ways to expand credit (think: Residential Mortgage-Backed Securities and Collateralised Debt Obligations), but it is important to understand that the banks would not have had an incentive to create these new credit-related products unless there existed huge demand for such products. The demand came from large investors -- hedge, bond and pension funds, for example -- that were desperately searching for yield in a world where yields had been kept artificially low by various central bank and government manipulations.

The main problem with credit bubbles is that they result in a massive transfer of resources to activities that would not be economically viable in the absence of the artificially low interest rates and the monetary inflation. Consequently, although they temporarily create the feeling of prosperity, they deplete real savings and lessen the economy's long-term growth potential. The recession or depression that inevitably follows the bursting of a credit bubble is caused by the ill-conceived investments made during the bubble rather than by the bursting of the bubble itself. Think of it this way: once the bubble bursts and the supply of new credit is curtailed, a light is suddenly shone upon the terrible mistakes that were made during the bubble.

During the giant credit bubble that ended in 2007, the banking industry made more than its fair share of investing errors and was thus eventually left with enormous holes in its collective balance sheet. Some of the largest US banks should have gone under, which would have resulted in the holders of bank equity losing all of their money and the holders of bank bonds losing most of their money. It would NOT, however, have resulted in bank depositors losing any of their money or in the cessation of the traditional banking businesses (the taking of deposits and the making of loans). Unfortunately, the government deemed that the banks were "too big to fail", and arranged for hundreds of billions of dollars to be siphoned from the rest of the economy to prevent the large banks from collapsing. Note that the banks were not actually "too big to fail". They should have failed, and the US economy would be in far better shape today if they had.

Further to the above, the banks certainly played a role in creating the current mess, but it was a supporting role. The lead roles were played by the government and the Fed. However, now we have the ridiculous situation of US policy-makers passing legislation that grants themselves greater power and crimps the activities of the banks, with the stated aims of mitigating the risk of another financial crisis and preventing banks from becoming "too big to fail". If they are serious about mitigating the risk of another financial crisis then they should pass legislation that abolishes the Fed and severely crimps the activities of the government.

The attacks on the banks are nothing if not predictable. Throughout history the ends of giant credit bubbles have invariably been followed by periods of recrimination, when politicians looked around for someone other than themselves to blame. In the current case the banking industry is the most logical target because it is blatantly obvious that the large banks have profited handsomely at the expense of taxpayers over the past 18 months. But isn't it bizarre that the finger of blame is being self-righteously pointed at the banks by the very same people who arranged or approved the gargantuan wealth transfer from taxpayers to banks?

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