Peter Lyons: Pity the farmers whose misery is theirs alone

Dairy farmers should not expect a government bailout or government guarantees for their debts. Photo / Getty Images

Dairy farmers make milk. Banks provide loans. Dairy farmers are part of the private sector. The banks are the same. Dairy farmers are motivated by profit. Banks are the same. Dairy farmers take risks and gain returns. The banks are the same.

Dairy farmers should not expect a government bailout or government guarantees for their debts. In 2008, the Labour Government provided banks with a guarantee for their depositors to ensure they did not fail when things turned ugly in their industry. National continued the scheme for several years after it gained power. Why is banking so fortunate compared to dairy farming?

The banking sector has always been the Achilles heel of market economies. That is because their survival is entirely based on the confidence of their customers. If a large dairy farm goes bust, its customers will buy milk from another dairy farm. If a large bank goes bust, this creates fear for people with deposits in other banks. They start demanding their money back.

The money is simply not there to be paid out to everyone on demand. If one major bank fails this can cause other banks to fail. It can cause a domino effect. This can decimate economies, as occurred in the 1930s in the United States.

In the 19th century, banking in the United States and Australia and New Zealand was a largely private business. Anyone could start a bank. They could take deposits and issue loans, even issue their own currencies or bank notes.

After a major banking crisis in 1908, the US established the Federal Reserve to prevent periodic widespread bank collapses when people lost confidence in private banks. The initial function of central banks, such as the Fed and our own Reserve Bank, was to act as a lender of last resort to the banking system to prevent systemic bank failures.

This original function has been forgotten in the mists of time. Prior to the establishment of central banks, private banks had a long history of stuffing up in their lending habits and causing widespread economic pain.

The story of modern banking contains a further hidden secret. Private banks can create money largely out of thin air. This increases their ability to stuff up the wider economy when they get it wrong. If I walk into the local bank and ask for a $2 million mortgage to buy a weatherboard shack on the slopes of Mount Albert, the loan is entirely divorced from the number of deposits the bank receives that day.

If the loan is approved, my account is credited with $2 million of newly created money. The money has been created by a simple accounting entry by the bank. I can now buy the house. When I buy the house the payment may be credited to the seller's account at another bank. It does not require any actual notes and coins being paid between the banks. It is all done electronically with debits and credits between the banks. But the effect on demand for houses is that $2 million of extra money has been created. This huge rise in house prices in New Zealand in recent decades has been accompanied by a huge rise in bank debt - effectively new money.

This is a simplified example, but only slightly. If the prices of assets such as houses or dairy farms are rising, this allows banks to increase lending which effectively creates more money. So as the banks increase their lending, it leads to further increases in asset prices, which allows further lending. This is a very profitable process unless asset prices start falling and bad debts start rising.

Dairy farmers are unlikely to receive a government bailout or a government guarantee for their debts. They are private business owners who have taken a risk with the aim to make a profit. Since the slump in international dairy prices, some farmers are likely to go bust. That is how a free-market system works.

But when banks get it wrong they can wreck an entire economy. They are the only industry that has a lender of last resort in case they stuff up. After the Great Depression, they were tightly monitored in most countries because of the broad awareness of the misery they could cause when they get it wrong. This lesson of history has been largely forgotten.

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• Peter Lyons teaches economics at Saint Peter's College in Epsom and has written several economics texts.