Banking will always trump dairy farming, writes Peter Lyons.
Dairy farmers make milk.
Banks make 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 the returns.
The banks are the same.
Dairy farmers should not expect a government bail-out or government guarantees for their debts.
In 2008 the Labour government provided the banks with a government 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.
Dairy farmers are unlikely to gain such a privilege.
Their debts are unlikely to be guaranteed by the Government.
Why is banking so fortunate compared to dairy farming?
The banking sector has always been the Achilles heel of market economies.
This 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.
Widespread bank collapses in the United States led to a severe drop in lending and the money supply.
The fall in lending caused a huge drop in demand in the economy.
Firms were unable to sell their output so they cut staff and dropped their prices.
They also cut wages.
This caused further falls in demand.
This created a vicious downward spiral.
It caused the Great Depression.
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.
Banks could even issue their own currencies or bank notes that could be used to pay for stuff.
The acceptability of a bank's own currency depended entirely on the reputation of the bank.
But if one bank failed, this usually resulted in a string of bank failures.
Panicked depositors would quickly demand their money back.
After a major banking crisis in 1908, the United States established the Federal Reserve to prevent the periodic widespread bank collapses when people lost their 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.
The 1930s Depression has often been blamed on the Fed's failure to perform this role properly.
This original function of central banks set up in the 20th century has been forgotten in the mists of time.
Before the establishment of central banks, private banks had a long history of stuffing up in their lending habits and causing widespread economic pain.
If one large bank failed this jeopardised all the other banks.
But the story of modern banking contains a further hidden secret.
The 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.
I could walk into the local ASB and ask for a $2 million mortgage to buy a weatherboard shack on the slopes of Mount Albert.
The lending officer will check my income and my credit history and the estimated value of the house I intend buying.
The loan would then be approved or declined.
The loan is entirely divorced from the amount 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 slightly simplified example but only slightly.
If the prices of assets such as houses or dairy farms are rising this allows banks to increase their lending, which effectively creates more money in the system.
So, as the banks increase their lending, this leads to further increases in asset prices, which allows further lending.
This is a very profitable process for the banks unless asset prices start falling and bad debts start rising.
Dairy farmers are unlikely to receive a government bail-out 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.
This is how a free-market system works.
Banks make money by lending.
When they get it wrong they can wreck an entire economy.
They are the only industry that has a lender of last resort specifically created for them in case they stuff up.
After the Great Depression they were tightly monitored and regulated in most countries because of the broad awareness of the widespread pain and misery they could cause when they get it wrong.
This lesson of history has been largely forgotten in recent decades.
● Peter Lyons teaches economics at Saint Peters College in Epsom and has written several economic texts.
