As you know, the biggest banks worldwide have owned up to enormous losses, now more than US$300 billion and still counting, over the last year. That includes the failure and bailout of the fourth largest U.S. investment bank, Bear Sterns.

But against this background of staggering losses by the big banks, only five small banks have failed in the last 12 months. These are…

1. Metropolitan Savings in Pittsburgh
2. Douglass National Bank in Kansas City, Missouri
3. Miami Valley Bank in Lakeview, Ohio
4. NetBank in Alpharetta, Georgia
5. Hume Bank in Hume, Missouri

It Only SEEMS like the Banking System is Relatively Sound

In truth, that number is deceptively low compared to crises of the past. In fact, the list of possible problem banks remains at historically low levels. There are only 76 institutions on the FDIC’s “watch list.” In 1990, as the S&L crisis unfolded, there were close to 1,500 banks on the list, and 800 failed between 1990 and 1992.

However, while it might seem that the banking system is sound, federal banking regulators are gearing up for potential problems. The FDIC announced that it plans to hire at least 140 new employees to deal with a possible increase in bank failures over the next year.

You Have to Treat the Disease – Not the Symptoms

Dealing with economic problems is like treating a disease. Treating your symptoms without finding the cause of the symptoms can lead to disaster.

You could treat a mild headache with aspirin. But if an undetected brain tumor is causing your headache, then failure to identify and treat the cause will be fatal.

What is the cause of the recent failures of both large and small banks? Simply put, it is the monetary policies of central banks, the very entities that now are struggling to solve the crisis. Unfortunately, they are prescribing exactly the same medicine to cure the problems that caused the problems in the first place.

Central Bankers Are Passing Out Placebos to Cure This Crisis

This past week Mervyn King, Governor of the Bank of England, announced that the bank was prepared to swap £50 billion (US$100 billion) in government bonds for securities backed by mortgages and credit card debt. On this side of the Atlantic, Ben Bernanke has loaned triple that amount, US$360 billion, to troubled banks again, against collateral made up of securities backed by sub-prime IOUs.

The Federal Reserve was the first central bank to begin discounting the sub-prime securities that triggered the widespread banking problems of the past months. But now, other central banks are following suit as the ripples of the crisis spread in ever-widening circles around the world. Some observers suggest that these loans secured by sub-prime debts will rise above US$1 trillion. That could be just the beginning.

So what caused this credit crisis disease? It’s simple. But to fully understand it, you have to step back and view the evolution of the U.S. dollar over the past 200 years.

The Evolution of the Falling Dollar…
That Led Us to This Mess

In the 19th century, the dollar was defined as 1/20th of an ounce of gold. At the time, banks simply took deposits in gold and issued their own private IOUs in the form of banknotes redeemable in gold on demand. This process naturally restricted credit expansion, because you had to have tangible gold to back your dollars.

Then Congress created the Federal Reserve in 1913. Congress gave the Fed a monopoly on printing U.S. dollars. Also, initially, the Fed held reserves of gold to back its issues of Federal Reserve Notes.

However, eventually, the U.S. government wanted to break free of the restrictions on credit expansion. So they gave the Fed the authority to “discount” commercial paper from banks. In other words, the Fed could buy IOUs and pay for them with newly printed dollars.

Eager for profits, banks made loans, then sold the IOUs to the Fed, and then made more loans. The federal government financed its expenditures for World War I through borrowing from banks. Banks sold enough of those federal IOUs to the Fed to keep the credit supply growing.

The banks also loaned to businesses, investors and speculators, ultimately financing the asset frenzy called the Roaring Twenties.

As loan demand grew, the amount of notes rose against the fixed amount of gold the Fed held in reserve. Eventually, the speculative frenzy drove stock and real estate prices to unsustainable levels, and the bubble popped in 1929.

A credit contraction ensued as borrowers began to default on debts they shouldn’t have held in the first place. This should have turned into a short-lived economic correction that purged bad loans and punished those that made them. But the government stepped in to stop this healthy correction and wound up seeding the Great Depression.

So Similar it’s Scary

Today’s credit crisis is essentially identical to the 1930s. It’s a consequence of failed monetary policies. Just like the Roaring Twenties, those in power refuse to allow the bad loans to be purged from the system. The federal government allows central banks to buy these loans for newly printed money.

And meanwhile, Mervyn the Magician and Helicopter Ben ensure that their currencies will drop in value and the economy will suffer.
As mentioned, a century ago the dollar would buy 1/20th of an ounce of gold. Today it will buy only 1/950th of an ounce. In truth, it should buy less than half of that. Gold is underpriced. This is clear when we recognize that the dollar has lost far more purchasing power in terms of other goods.

The dollar today will buy what a nickel would buy at the turn of the last century. If you factor in productivity growth from advances in technology, then today’s dollar is worth less than 1% of what it was then. This is all the consequence of 10 decades of relentless credit expansion.

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