The velocity of money

When I wrote at the PPS of the foregoing blog about the velocity of money, so many things went through my head that I stopped short. It needs a post of its own.
Remember the scene in Frank Capra's classic "It's A Wonderful Life"? George Bailey (Jimmy Stewart) has not gone on his honeymoon to prevent a run on the Bailey Building and Loan. Facing a crowd of frightened depositors he describes banking perfectly.
To paraphrase slightly, George says "You're thinking of this all wrong. It's not like I've got the money back there in the safe. Your money's not here - it's in Joe's house right next to yours - or in Mr. Kennedy's house or Mrs. Mecklin's or a hundred others. "
That's what banking is about. The bank lends your money out. But only if someone borrows - that's the velocity of money.
Suppose you deposit £1000 in an account whilst the Banking Reserve requirement is 15%. That means the bank can lend £850 ( it keeps back the remaining £150 as a reserve.)
A farmer comes in and borrows money to buy stock, all £850 of it. But the person he buys the stock from puts that £850 back into a bank. They reserve £127.50 ( 15% of £850) and lend out the remaining £722.50. So it goes on. In effect £1000 eventually does the work of about £7000.
New scenario - the reserve requirement drops to 10%. That means instead of £850 the bank can lend £900. Eventually that means some £10,000 is " created".
But suppose the person who borrowed the £722.50 goes bust or doesn't pay it back. That bank still has to give its depositor back the £850 he deposited. That bank can only do it if another bank lends it the shortfall. This is what is meant by the interbank market has seized up. Every bank is too afraid to lend to any other when they might have to repay their depositors. This, in effect, is what has pulled down the various banks over the last week or two. HBOS is classic - it was lending not 85% of its deposits - it was lending 180%. This is all compounded by the fall in house prices, which is what the banks have used as collateral. Even supposing house prices were steady there would be a serious recycling problem, but with the collateral falling faster than anyone can make sense of, the only response is get your money somewhere safe.
So at the moment, instead of the velocity of money being say 7 ( £7000 divided by £1000) its probably already down to 4 and still heading south. Effectively, if house prices fall say 25% for a cumulative loss in the UK of about £300 billion ( I'm ignoring the non-mortgaged ones) that's actually about £2,500,000,000,000 that just disappeared from the banking system. To give you an idea of how big a number that is, if every £1 was 1 second, then 1million would be about 11 .57 days. 1 BILLION would be about 32 years. 2,500 BILLION would be 80,000 years.
Which is why all the talk is of only $700 billion to fix the problem. Putting that back into the equation means those banks that have a problem with illiquid assets can get cash - and it also explains why Washington Mutual was taken over. Its deposits were melting as people realised it was effectively over lent. JPMorgan bought the good bits, paying $1.9billion, gets all the deposits and mortgages, banks, people etc etc, but NOT the money being rolled over in the markets that had virtually dried up anyway. Bank of America must be a touch sore they had to shell out $50billion for Merill Lynch, when just by waiting they might have got it for free. Dimond at JPM has shown himself the savviest of all the bankers. In both cases, BofA and JPM, the Fed is effectively standing right behind them saying we will give these two ANYTHING they need immediately.
In the same way, the Bank of England, despite not saying it, has learnt its lesson from Northern Rock, and is standing behind Lloyds TSB over the HBOS position. My belief is Lloyds will have to write off billions not only from the Halifax mortgage book, but from all the equity stakes and funding they took in various ventures ( like Tom Hunter).
So what needs to happen? Actually, Hank Paulsen's solution is fine - remove the bad bits and let everyone get on with the good bits (which is what Dimond has done) - but the banking supervision system needs beefed up. Perhaps there needs to be a cap on now much any one bank can borrow interbank. In effect, banks make their clients sign covenants as to how much they are borrowing against their assets ( JJB sports today is a classic banking squeeze) so why should the Fed or the BofE not do the same with banks? We could do the same over here. Instead of running down Northern Rock, let it buy all the duff mortgages at 80% loan to real value. The whole system would leap to life almost overnight.
Although I've been predicting this for quite a long time, it's much much worse than I expected. It's also quite a different thing to protect fully against it. I thought we might be through this by next spring. At the moment I wouldn't bet on anything getting any better until spring 2010.
In the meantime, I am battening down the hatches and buying agricultural land.
At least I will be able to eat.
PS
I have heard it all now. Someone paying off their credit card referred to "deleveraging" their position. Like it