Bank Leverage, Fractional Reserve Banking and Central Banks - the US vs. Europe

The gold standard put a check on governmental plans for easy money. It was impossible to indulge in credit expansion and yet cling to the gold parity permanently fixed by law. Governments had to choose between the gold standard and their — in the long run disastrous — policy of credit expansion. The gold standard did not collapse. The governments destroyed it. It was incompatible with etatism as was free trade. The various governments went off the gold standard because they were eager to make domestic prices and wages rise above the world market level, and because they wanted to stimulate exports and to hinder imports. Ludwig von Mises

If the situation in Cyprus has accomplished one thing, it has raised the issue of fractional reserve banking.  Moreover, it appears that governments, the Troika and central banksters everywhere have shed the false benevolence of statist theft as they now clearly and resoundingly assert that  YES, they fully intend to steal the deposits of ordinary folks to save and subsidize failed banks and banksters.  The plundering masks have finally come off.

This is truly EPIC.

However, what is confounding and confusing is why European banks are in so much trouble yet US banks are proclaimed healthy, at least by comparison to European banks.  This phenomena has a lot to do with leverage.

Leverage increases when bank assets grow at a faster rate than equity capital, such as common stock, which acts as a cushion against losses.  Allbusiness.com 

In other words, banks don't gamble with their own capital, they use the money of depositors.  Anybody who deposits money in a bank is giving the bank permission to gamble with their money however they want - there are ZERO restrictions on the banks and banks effectively become casinos.  Such is the fatal flaw of fractional reserve banking, here.

Zero Hedge zoomed in on the issue of bank leverage.

Guess Who’s Even More Leveraged Than the European Banks?

The US banking system as a whole is leveraged at 13-to-1. While this is not horrible relative to Europe’s banking system (more on this in a moment), these levels still mean that an 8% drop in asset values wipes out ALL equity.

Then you have Europe’s banking system, which is leveraged at 26-to-1. Anecdotally, this is borderline Lehman Brothers (30 to 1). At these levels, even a 4% drop in asset prices wipes out ALL equity.

Japan’s banks are leveraged at 23 to 1. France’s are 26 to 1. Germany is 32 to 1.

You get the idea.

However, worse than any of these the US Federal Reserve. With $2.8 trillion in assets and only $52 billion in capital, the Fed is leveraged at 53 to 1. Yes, 53 to 1.

The only reason US banks have some semblance of sane leverage ratios is because the Federal Reserve created a ton of "out of thin air fiat money" to recapitalize US banks and they did it by largely buying bad assets that included $1.3 trillion in bad mortgage paper.

Of course the next logical question is:  why didn't the European Troika just do what the Federal Reserve did?  Moreover, printing money out of thin air doesn't solve the myriad of problems associated with the scourges of fractional reserve banking but for some reason the Troika has opted to take a different path than the US.  It's entirely possible that European banks were always way more leveraged than US banks and that printing was a nuclear option that would immediately result in inflation on steroids, Weimar Republic style, here.

While many who try and follow Austrian economics do indeed scratch their heads in bewilderment over the fact that the US has managed to escape the stone cold reality check that is descending upon Europe, one of the most fascinating and enlightening explanations came from the Ludwig von Mises Institute that actually argued in favor of the Euro in that it was a rudimentary form of a disciplined free market currency despite its vast and numerous flaws.

An Austrian Defense of the Euro

The Euro as a "Proxy" for the Gold Standard (or Why Champions of Free Enterprise and the Free Market Should Support the Euro While the Only Alternative Is a Return to Monetary Nationalism)....

The introduction of the euro in 1999 and its culmination beginning in 2002 meant the disappearance of monetary nationalism and flexible exchange rates in most of continental Europe. Later we will consider the errors committed by the European Central Bank (ECB). Now what interests us is to note that the different member states of the monetary union completely relinquished and lost their monetary autonomy, that is, the possibility of manipulating their local currency by placing it at the service of the political needs of the moment. In this sense, at least with respect to the countries in the eurozone, the euro began to act and continues to act very much like the gold standard did in its day. Thus, we must view the euro as a clear, true, even if imperfect, step toward the gold standard.

Moreover, the arrival of the Great Recession of 2008 has even further revealed to everyone the disciplinary nature of the euro: for the first time, the countries of the monetary union have had to face a deep economic recession without monetary-policy autonomy. Up until the adoption of the euro, when a crisis hit, governments and central banks invariably acted in the same way: they injected all the necessary liquidity, allowed the local currency to float downward and depreciated it, and indefinitely postponed the painful structural reforms that where needed and that involve economic liberalization, deregulation, increased flexibility in prices and markets (especially the labor market), a reduction in public spending, and the withdrawal and dismantling of union power and the welfare state. With the euro, despite all the errors, weaknesses, and concessions we will discuss later, this type of irresponsible behavior and forward escape has no longer been possible.

It it possible that Europe and the Euro are well ahead of America in addressing its monetary problems? It's hardly likely that the EU anticipated or welcomed the situation of collapsing banks and it's doubtful that the EU bureaucrats have any goal except to hold the economic, political and monetary union together, whatever the cost.

Meanwhile, the Federal Reserve continues to purr along oblivious to its own fatal flaws as the political class in the District of Crime (DC) grows even more arrogant and smug, as if America is somehow exempt from the problems that plague the rest of the world and the mountain of debt created by fiat monetary systems.

When reality finally strikes America, it will be far more painful and devastating than anything the profoundly suffering southern Europeans are experiencing.