Expand transfers, not credit
I have a little secret. Please don’t tell anyone. I am glad that the banks, for all the hundreds of billions of dollars we are giving them, are not lending. That is not because I want banks to improve the quality of their balance sheets. On the contrary, I don’t want banks at all, at least not banks anything like what we’ve had. I don’t want to “use all of our resources to preserve the strength of our banking institutions“. Since we have already bought and paid for our nation’s banking institutions, we are within our rights to, um, transition them to a different business model. Let’s do that.
But credit is the lifeblood of a capitalist economy, right? I keep hearing that line. It’s a dumb line.
Credit, also known as debt, is one of several arrangements by which a party with the power to command resources but lacking aptitude or interest in managing a productive enterprise delegates wealth to another party who is capable of creating value but unable to command sufficient resources. You would be forgiven for not noticing, given how habitually we misuse credit, but supplying credit is really just a subspecies of the practice that used to be called “investing”. There are a variety of other arrangements that serve the same economic function. Perhaps you have heard the terms like “common stock” and “cumulative preferred equity”? In fact, credit is to investing what heroin is to painkillers: Unusually appealing, in a certain way. Hard to kick once you’re on it. Almost certain to, um, cause problems, eventually. Our overall goal ought not be to kickstart the credit economy, but to kick the habit and move towards financing arrangements that are more equity-like than debt-like. That’s going to be hard to do, because historically, we’ve subsidized the hell out of debt financing, especially bank credit, and alternatives are underdeveloped. But with the exception of war, no still-practiced human institution provokes catastrophe as regularly or as grandly as the misuse of debt. We ought to phase out banks as we’ve known them since before Bagehot’s time, and move to a regime of what are lately referred to as “narrow banks” (banks that lend only to the government that issues the currency of their deposits). We should encourage the development fine-grained equity markets and local-market investment funds to replace bank financing.
The rush to ramp up “consumer credit” is particularly dumb. Usually, financial investing involves funding wealth generating projects in exchange for a share of the anticipated wealth. Consumer credit funds current consumption in exchange for a share of, um, what exactly?
In theory, there’s a good answer: consumer credit funds current consumption in exchange for a share of anticipated future wealth that is believed to be endowed already. Economists talk about consumption smoothing, how it may be optimal for a consumer whose income is volatile to borrow during periods of low income and repay (or save) during periods of high income in order to maintain a constant standard of living. That’s very well in models where consumers know the true distribution of their future income, where the spread between borrowing and lending interest rates is not very large, and where consumer preferences are time-consistent. In practice, none of these conditions hold even approximately. As we are learning, the future is a very uncertain place. Consumers, like Wall Street quants, may inadequately extrapolate the distribution of their future income from recent observations. They have no access to the true distribution. The interest rates consumers pay for unsecured credit (think credit card rates) are often several times what they receive on money they save. In the world as it is, consumers ought to borrow only to counter severe downward shocks to income, pay off borrowings quickly, and build buffers of precautionary savings, since the cost of dissaving is much less then the cost of borrowing. (You lose 4% interest on your CD, rather than paying 12% interest on your credit card.)
Some consumers behave this way, but very many do not, suggesting that consumers are myopic, overvaluing consumption today in a manner that they themselves will come to regret in the future. If consumers are myopic, if self-today has different preferences than self-tomorrow, then whether taking on credit is a good idea is beyond the comfort zone of positive economics. Credit availability creates winners (self-today) and losers (self-tomorrow), while interest payments reduce the size of the overall pie available to the time series of selves. In the way that economists suggest “free trade” to be good — winners, losers, gains overall — myopic consumers imply that the absense of a credit constraint is bad. Thank goodness the banks aren’t lending!
There are obvious wrinkles and objections — What about credit for cars, or home mortgages, or education? The analysis changes when the borrowing is exchanging one pre-existing long-term liability for another. (We are born short basic shelter, and, in much of America at least, short a cheap car as well.) Education can be viewed as an ordinary, wealth generating investment project that in theory could be equity rather than debt financed, but that might be too tricky in practice. It’s not my intention to suggest that consumer credit is always bad, only to defend the commonplace notion that for many people and under many circumstances, even loans that will be never be defaulted can be positively harmful, and as a matter of policy we should not be exhorting banks to issue or consumers to accept credit.
But if we let consumer credit contract, and if investment demand is derived from consumption demand, doesn’t that spell macroeconomic disaster? There is an alternative. It is called “transfers”. What’s good about credit from a simple Keynesian perspective isn’t that loans get repaid tomorrow, but that they get spent today. If what consumers would do with funds would be better for the economy than what banks are doing with funds, we ought to stop the massive transfers of funds from buyers of government debt to banks, and transfer the funds directly to consumers. If you think that Americans consume too much, and that we need to grit our teeth and endure a “reduction in our standard of living”, fine. I disagree, strongly, but at least you’re consistent. Then the government shouldn’t transfer to anyone, banks shouldn’t be encouraged to lend, consumption, investment, and GDP should be allowed to fall until we find a new level. I think that’s foolishly pessimistic, though. Americans may need to change the mix of our consumption, but overall I think our standard of living is not only supportable, but improvable, and that our goal should be to get the rest of the world to live as well as we do, rather than to reconcile ourselves with some pseudomoral poverty. The world is full of human want, which we should strive to meet by working to increase our capacity to produce. Problems arise when want and purchasing power are misaligned. We can improve that by redistributing some of the purchasing power from those with lesser to those with greater use for current consumption. If that sounds Commie to you, note that is precisely the function that consumer credit traditionally serves, just without all the residual claims, a large fraction of which will prove to be illusory (at least in real terms). That is, transfers are just a more honest way of doing precisely what a credit expansion does, except without the trauma that comes from learning that much of the money lent to fund current consumption will never be repaid.
I’m trying to come up with a reasonable opposing view, a case for pushing consumer credit but opposing transfers. Perhaps you can help, because I just can’t do it. One might argue on philosophical grounds against coercive transfers, but coercive transfers are a precondition of restarting bank lending, and we’ve already made transfers to banks on such a scale that banning them now would be like robbing a jewelry store, then piously arguing future looters should be shot. One might argue that bank lending is “smarter” than public transfers would be, that the patterns of consumption and investment that result from private sector credit allocation will lead to superior productive capacity and more sustainable patterns of consumption than direct transfers. Given the awful quality of aggregate investment this decade and the volatility now faced by consumers who were recently credit flush but who under any reasonable lending standard must now be credit constrained, it is hard to be enthusiastic about the special wisdom of bank-mediated credit allocation.
Of course, once we start redistributing purchasing power, there’s the thorny question of who gets what. I have an answer to that, it is my new mantra. Transfer flat. Cut checks to every adult in the economy of interest, regardless of whether they pay taxes or have a job. Flat transfers are easy to understand and they pass the smell test for “fair”. As an income source unrelated to work, flat transfers increase workers’ bargaining power with employers by reducing the cost of refusing a raw deal. (Supplementary income is a better means of enhancing labor bargaining power than unionization, which serves the same purpose but may limit the flexibility and efficiency of production.) Finally, flat transfers align purchasing power in the economy with the problem that we want markets to solve — We want an economy that serves some people dramatically more than others, in order to preserve incentives to produce and excel. But we also want an economy that meets every person’s basic needs, even those of people who are unable or unwilling to offer marketable goods or services. We won’t let people starve, so why not fund a basic income, however miserly, rather than relying on an inefficient social services bureaucracy or taxing the virtuous by relying on charity?
Tax Pigou and progressive. Transfer flat. Encourage equity. Contain the banks.
I wonder if I’m missing something. Why limit banks to the “narrow” definition you used when we can simply restrict them to only lending money they actually possess (i.e. no fractional reserve lending?) That still allows for what traditionally qualified as prudent lending/borrowing and also helps the economy by imposing discipline on the process. Sure, there will still be abuses, but there will be many more incentives and corresponding disincentives to limit these.
If that is accompanied by elimination of interest rate manipulation (effectively price controls on money) then good price signals will also help with discipline. The various forms of investing, as you broadly defined it, will then form a competitive landscape for distribution of money from those that have a temporary surplus to those that have a temporary shortage.
Re. flat transfers, I hadn’t thought of that previously, but on first read it does strike me as far superior to the current highly inefficient mechanisms. We still have to be cautious not to create an incentive (and/or the means) to withdraw from productive endeavor, which our economy, of course, depends on.
Kudos for overcoming the very common failure of the imagination in such matters. I am so tired of hearing that improved living standards over the centuries must be a result of the various and sundry statist economic policies we’ve had when it’s so much more likely *in spite* of those. It seems silly to think that if someone completes a marathon with a backpack full of sand then sand must be necessary for runners, yet in economics the equivalent seems to be the prevailing view.
January 18th, 2009 at 2:57 am PST
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This is a great point. And leads to many other interesting thoughts.
Have to agree with BSG; why hasn’t the media even touched the fractional reserve banking as something that might be worth analysing? In my common sense, central banks are investing (lending) in commercial banks with lower rates of return than market would, and then these banks create new money, which leads to lower risk investment possibilities. This cannot be sustainable economy.
January 18th, 2009 at 7:11 am PST
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“It is well enough that the people of the nation do not understand our banking and monetary system, for if they did, I believe there would be a revolution before tomorrow morning.”
— Henry Ford
I agree with you 100% on consumer debt. For 99% of people, it doesn’t make sense to take on debt except in the case of car loans, home mortgages, and student loans, and even in those situations, more restraint should be exercised than is commonly seen. Using credit cards to finance the purchase of (generally nonessential) consumption goods is a trainwreck waiting to happen at both the level of the individual and of the economy.
On the business side, I have mixed feelings. One of Minsky’s primary departures from neoclassical economics was his model of production. In neoclassical economics, production is simply the instantaneous exchange of factors of production (labor, capital) for finished goods and services, given a particular set of technology constraints, in the face of known consumer demand. In Minsky’s model, there is a temporal sequence with decisions made under uncertainty each step of the way. Production cannot take place until capital investment (specific to the intended production) has occured and that capital investment generally must be financed before it can occur.
If the world had to rely on bootstrapping to launch new business enterprises and retained earnings to finance growth, there are entire classes of businesses that simply never would have existed – automobiles, airlines, computers, etc.
As for equity financing, I’m attracted to the idea, and I certainly believe that, in theory, the economic cycle would become much smoother if equity financing replaced debt financing. Again, however, I have my doubts as to whether it could ever replace bank loans, bonds, and other forms of debt finance.
The financing of real capital investment under conditions of uncertainty will always be at the heart of fundamental disagreements between various schools of economics, and unfortunately will also always be at the heart of some of the most pressing problems a modern capitalist economy will face.
January 18th, 2009 at 8:10 am PST
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Business credit is essential. You could go back to the early basics of banking and restrict credit to seasonal needs, and financing the movement of goods between businesses, but why tie up equity in such short term needs?
And even for medium term loans. Equity participation means a voice in management. Should a successful manufacturer be obliged to share management decisions with outsiders, if he needs to buy new machinery, for example. It seems to me that a medium term bank loan is a more efficient way to handle this.
On the other hand restricting loans for mergers and acqusitions seems a good idea.
January 18th, 2009 at 9:10 am PST
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I had fun reading your take on credit and such and I don’t blame you to want to have a change in the lending and borrowing process since the principles that were supposed to be followed as guidelines did not really work and led us to this mess of economic turmoil. I hope the powers-that-be who have a say on changing the logistics of borrowing and lending will listen to you and give your post a hard long thought so they can make changes for the better.
Evelyn Guzman
http://www.debtchallenges.com (If you want to visit, just click but if it doesn’t work, copy and paste it onto your browser.)
January 18th, 2009 at 9:18 am PST
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Steve:
Welcome aboard. Again. “Destroy the banks or destroy the dollar”. It’s that simple. Unless our idiot “economists” like Paul Krugman understand they are inviting a hyperinflation, they are fools. Or worse. How can a bank “supply credit”? Explain it to me. Where are the real savings? If you haven’t yet, go to the Fama/French website. Eugene Fama is discussing a topic which will interest you. Got gold? Get more!
January 18th, 2009 at 9:50 am PST
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Islamic finance in theory is supposed to do equity rather than debt financing. In practice, it apparently usually ends up as a debt-like financing anyway: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=845
January 18th, 2009 at 10:02 am PST
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I like the clarity of your philosophy on what debt is, though I reach a different conclusion. My response is “More debt please” at Knowing and Making.
Interesting that a posting like this brings out the fractional-reserve-goldbugs in the comments. You can’t genuinely eliminate fractional reserve currency in an economy that allows free contract. I can simply write you an IOU and, as long as my credit is good, you can use it as money to buy things. Suddenly the money supply has expanded, as if by magic. Fractional reserve banking is no different.
And it’s quite amusing to see gold-standard people agreeing with substantial fiscal transfers. Not two positions that usually go together! Surely it couldn’t be that they didn’t read the whole article….?
January 18th, 2009 at 10:35 am PST
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Brilliant as usual.
BTW: A friend of mine is going back to China for a couple of weeks. I have asked her to report back on how the Chinese will feel about a yuan revaluation and the central bank reserves.
January 18th, 2009 at 12:04 pm PST
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Leigh Caldwell – your IOU, unlike a bank loan, would not automatically be as good as cash and it would not increase the total amount of cash outstanding (if the recipient sold it, that cash would come from someone else.)
Without central banks to accommodate FRB, it likely would have collapsed of its own weight long ago (as it did repeatedly, bringing about the creation of central banks.) It would then be the equivalent of pyramid schemes today (if they were legal, I suppose.)
What does a gold standard (which I happen to be skeptical of) have to do fiscal transfers? Regardless of the financial system in place, governments would have revenue and in a democratic society voters ultimately get to decide how it is best spent, including transfers.
BTW, your dismissive tone does not contribute anything useful, IMHO.
January 18th, 2009 at 12:23 pm PST
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BSG — I’m not sure what you mean by “lending money they actually possess”. If you put cash in a bank, and they lend any of it, you are in a fractional reserve system. If you try to take your money out, they do not have it. The apparent magic of fractional reserve, whereby banks “make money form thin air” or “lend money they do not have” comes from the fact that they tell depositors they effectively still have the money (it’s available on demand), while at the same time they’ve lent it out. Both depositors and borrowers think they have money, and what they have usually works as money, so voila “money” has been created. Banks might do more complicated things, e.g. crediting accounts with money they don’t have in cash when they make a loan. But that’s unnecessary — both the fragility and “money creation” of fractional-reserve banking occurs as soon as banks lend while still promising depositors full access.
January 18th, 2009 at 4:17 pm PST
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Lasse — Criticizing “fractional reserve” banking has become taboo, for reasons more sociological than rational, I think. Since banking as we know it can only be “fractional reserve”, I find it more convenient just to criticize banking. Banks are to economies really are what heroin is to bodies: once you have them, for both economic and political reasons, it is difficult to get rid of them. But if I were on heroin, I’d try to kick that too.
January 18th, 2009 at 4:20 pm PST
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RTD — The crucial question are the terms of financing. Lending is attractive to borrowers because earns some real return with little uncertainty over future cash flows: Over a wide margin of scenarios viz the underlying investment, they achieve predictable sure cash flows. Borrowing is attractive to entrepreneurs because it is cheap and does not require sharing control. However, subsidies are required to make both those things true: The state reduces the cost of debt financing by virtue of deposit guarantees, preferential tax treatment, and assuming some costs while dispersing some losses during bankruptcy enforcement.
The challenge is, can we come up with less destructive financing arrangements that require subsidies at least no greater than the subsidies we already provide. Note that good scenario cash-flow predictability is easily included in equity arrangements — consider cumulative preferreds, which pay out like bonds, but which are equity in the sense that investors cannot enforce payment via bankruptcy. If managers who wished to retain control had to raise cash via cumulative preferreds, funding would be more expensive, and that’s all. A lot of bond issues could be replaced by cumulative preferreds at modest cost if we equalized the tax treatment, i.e. if we made dividends on cumulative preferreds deductable. The lack of enforceability via bankruptcy, along with governance norms that don’t treat cumulative preferreds as risk-free or cash-equivalent, is all that would be needed to dramatically reduce the systemic risk associated with what is in some ways a very debt-like form financing. Cumulative preferreds will still be more expensive than bonds, but not by very much for well capitalized companies, and the explicit riskiness makes it more likely they will be actively priced rather than rule-of-thumbed as either money or junk, or else branded by ratings agencies.
I don’t mean to suggest that cumulative preferreds are a particularly great form of financing either. My only point is that within the universe of possible financing vehicles, we want to find instruments that maximize discrimination of good from bad projects, that minimize the temptation to treat potential future wealth as certain wealth today, that minimize disruption of the operating concerns they fund as long as they are medium-term profitable, and that locate control with the parties with the greatest incentive to maximize infinite horizon value creation. Whatever we invent can’t make raising finance very much more expensive than it is now (or it’ll never happen), but we can consider state subsidies in various forms (as debt financing already has). I don’t think it’ll be that hard to come up with much better financing vehicles according to these criteria. Whether “we need debt” to finance businesses becomes semantic. Our present financing arrangements frequently interfere, sometimes catastrophically, with the operating value of good projects (and frequently fail to interfere promptly in the operation of very poor projects). Can we come up with better arrangements?
I agree that self-financing/bootstrap and financing from retained earnings would be way insufficient. Financial investing is a good idea. But there are devils in the details, and it’s time we slay a few of them.
January 18th, 2009 at 4:45 pm PST
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Farrar — I agree that hard debt will always have some role in business finance, but I think it should be restricted almost entirely to transactional purposes, and should occupy a very small fraction of a firm’s balance sheet. If I order a part from a supplier and they ship it, my obligation to pay should be straight debt. To treat all counterparties as “investors” would be to create huge frictions to commerce.
But debt financing of a significant hunk of the capital structure is like treating investors as business transactors. We ought to insist that those providing a large share of the capital of an enterprise evaluate and manage the firm’s operations more closely than a vendor or customer. That is, or ought to be, an important role of capital providers.
That doesn’t mean that all capital providers should have a vote — there are lots of kinds of nonvoting equity. But it does mean that capital providers should be sufficiently at risk that the value of their stake is significantly sensitive to the operation of the firm. Straight debt tends to have a very low sensitivity over a wide range of real economic scenarios, before falling off a cliff during a liquidity crisis or as balance sheet insolvency approaches. I claim that our collective experience demonstrates that this sensitivity profile, while theoretically as evaluable as any other, in practice leads to frequent poor decisionmaking, overconfidence and underdiligence in good times, panic that harms viable concerns in bad. It’s not some great moral issue, just a technical problem, poor system design given the observed behavior of human agents. (There are some great moral issues too, though within the banking sector and with respect to agency costs generally. A social system that rewards people for destructive behavior (rather than seducing and than punishing them, as in the dynamic above) is not only broken, but bad. The structure of financial intermediation is bad, as a moral matter. But debt as a vehicle is not morally bad, just dangerous, like a car with its accelerator stuck too close to the brake pedal.
January 18th, 2009 at 5:00 pm PST
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Evelyn — Thanks.
IA — There’s no such thing as real savings. There are only real resources. My election not to consume, but to hold money or gold or anything else instead, doesn’t create wealth I can consume in the future. Banking systems are a trick that are supposed to reduce the price of capital goods by dissuading you from consuming them, while increasing real investment by giving a lot of purchasing power to a class of investors known as bankers. In theory, this kind of thing might not be a bad idea, although I don’t think we need all the trickery. But the most crucial problem is that the agents to whom we transfer purchasing power are have skewed incentives and are poor investors, so they often destroy wealth with the purchasing power with which they are entrusted. They do so not only by accident, but also by the moral equivalent of theft. Institutions to which vast resources are entrusted and that function poorly and encourage theft by trusted agents are bad. One might try to fiddle with the incentives, we always try to fiddle with the incentives, but if the structure of an institution is very poorly adapted to its purposes, small reforms won’t do. I think we’ve learned that, or should have learned that, about banking systems.
Fama’s stuff is interesting, but it all depends on how one values alternative uses of resources. One can establish by definition that there is no such thing as an idle resource. Then by definition, no transfer or government stimulus does anything but shift from one use to another. Still, if you think that some uses of resources are much more useless than others, ie if the 10th hour of television is a poorer use of a human’s time than an hour of work somewhere, then transfer or stimulus can help. But if you think the government in question will impinge on TV time to dig and backfill ditches, that might not be so good. The overall question is how we can encourage “good” uses of resources and discourage lesser uses, but that’s inherently normative and value-laden: if the government banned television and conscripted people to genuinely productive work for 12 hours a day, that might genuinely increase the marketable wealth of the economy and measured GDP. But it would still be bad. At least let me see The Office.
January 18th, 2009 at 5:18 pm PST
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Itamar — I’m very interested in Islamic financing, and disappointed that it must become like debt financing in a world where it must compete with debt financing.
This touches on ta point made by Yves Smith…
I think that in a world of competitive states, governments will need means of subsidizing and skewing investment to match competitive threats by other states who do the same. Transfers and central direction are hidden when they is mediated by a banking system connected to the organs of the state. So they are attractive to politicians who wish to direct economic activity without owning up to it. That politicians sometimes use this power for necessary purposes (matching a competitive threat) doesn’t eliminate the fact that it can be put to corrupt or foolish purposes. Just as we need to develop better vehicles for financing enterprises if we eliminate banking, we’ll need to develop better means of meeting the needs of states in a competitive world. We should do both.
A propo, I really liked this piece from the Islam and Economics blog… There are interesting questions about to what degree “economic growth” is good because it makes us better off, vs the possibility that change is harmful but forced by a competitive dynamic. I’m overall optimistic on this question, I think a lot of change is for the good, and that a dynamic society can be equitable as well, so I can ignore the trade-off. But I could be wrong, and it’s certainly worth considering whether the machinery of economic growth, financial or otherwise, is our invention and our servant, or whether we are caught up in economic arms races that do more harm than good, but from which we are unable or too blind to escape.
January 18th, 2009 at 5:43 pm PST
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Leigh — Thanks for the very thoughtful comment at your blog. I like that you put things in terms of promises. I think promises are the best way to think about most financial arranegements.
I tried to address two distinct questions about consumer credit: First, will the debt be repaid? If not, I assume it’s bad for the lender, and not so good for the borrower either, given the consequences of default. That is, I assume nonrepayable debt is uncontroversially not something we should encourage. You think that the nonrepayable debt will turn out to be less than 5%. Unless we inflate, I think we will find it to be much larger than that (and would have found it much larger without all the government intervention we are still up to). But let’s put that aside. The second question, is credit good for the borrower who does repay is trickier. You point out that giving from richer to poorer can be utility increasing, so borrowing from a future richer self might be overall good. That’s the general argument for consumption smoothing: borrow when you’re poor, repay or save when you’re risk. But it loses force if the interest rate on savings is much higher than the interest rate on borrowing. If I am very poor now but will be rich next year, it might make sense to borrow even at a high interest rate (that also depends on how I value future wealth). But the optimal strategy over time becomes to build up a cushion of savings, because the cost of spending savings is much less than the interest rate.
The “winners / losers / bad overall” argument is about when you are myopic. If you do not care (or you care too little) about your future self, you will borrow as much as you can (or too much), despite that the harm you do to future you exceeds the benefit you experience now. If borrowers are not myopic, the availability of credit can never hurt them — they’ll income smooth when it’s wise or not when it’s unwise, and present and future self will agree with one another’s choices. But if borrowers are time-inconsistent, then they are in a fight. Credit availability lets’ self now win at the expense of self future, by borrowing more than his fair share under income smoothing and shoving not only the bill but a high rate of interest on the fund onto the future. There is a legitimate, everybody wins case for consumer credit. But there’s also a darker plausible story, and which best captures the real state of affairs is arguable.
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You are right that some of what is bad about debt happens as soon as you write an IOU, if the state is willing to enforce the contract. If the state is not willing to enforce, than it’s an equity arrangement — you have to monitor those to whom you give money, and give only to those whose promises are good. As BSG pointed out, even if the state will enforce your debt, an IOU will not be money. It will have limited liquidity, and holders will not treat it as certain cash. Banking systems hurt both ways — they create the brittleness and distress costs that come when operations are at risk of bankruptcy, and they create overconfidence on the part of holders who make poor choices under the assumption that IOUs from banks represent certain wealth.
January 18th, 2009 at 6:04 pm PST
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brian — on the first point i think you are mistaken. but thanks. on the second, i hope you’re friend has an amazing trip, and will be interested to know her impressions.
January 18th, 2009 at 6:06 pm PST
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Words after my own heart, Steve, as you know.
Unfortunately, Hank Paulson, the Darth Vader of finance, got to help out his friends (read: welfare for greedy multi-millionaires) before Bushie left office–sort of the like the tax break he got on his Goldman stock when he took the gig–he thought he’d share the wealth a bit.
At the very least, Treasury might have split the difference, helping out homeowners and banks equally. That probably would have worked as well as what they’ve done.
How can more debt help when it was too much debt that got us into this mess? We were already living way beyond our means as a nation. American living standards should not return to where they were in 2005 until we can pay our own way.
But this is the War Party’s parting shot. Their feeling is probably that the reserve army of the unemployed can join the military. Increasingly the USA resembles Germany in the late 1930s, stagnant, highly indebted, over-muscled, spoiling for riches. When will we finish the real job in Iraq and take the oil fields for good? When we begin to inflate and our offshore financiers jack up our rates? And how about occupying Iran while we’re at it? The hawks at Stratfor have been saying we could do that too, if we felt like it.
When I was young, it was the Democrats who got us into stupid wars and busted the budget. Recently it’s been the Republicans.
I do hope President Obama focuses on helping the people, and avoids the path leading to war. The military-industrial complex will be of no help to him in this regard. (Hank Paulson’s resemblence to Daddy Warbucks has been noted elsewhere.)
P.S. Note that there are thousands of prudent banks still making good loans, who were never greedy enough to make the bad loans or stupid enough to hold the toilet paper containing them. Most of these banks neither want nor need TARP funds. Credit is still flowing to creditworthy borrowers, although the standards are understandably tighter due to the recession.
January 18th, 2009 at 6:51 pm PST
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Benign,
I mostly agree, unfortunately.
Re standards of living, I think a lot of people who were living on asset-bubble appreciation will need to adjust. But broadly, I don’t think there’s anything that implies that we have to live worse, or be poorer. Undoubtedly, there are things that were artificially cheapened and will have to change: exurban America cannot survive without the subsidy of home appreciation and very inexpensive gas. It will have to shrink. But the “reduction of standard of living” talk suggests that good things about how we’ve come to live will have to disappear, like we’ll be unable to eat out, Target will turn back into Woolworth’s, and kids will have to work at 14. That’s just not true. Most of what is called economic growth derives from technological and organizational innovation, and we only lose that if we fuck up big. That’s not impossible — I’m much less confident in the quality and sustainability of our institutions than I was a decade ago. But the fact that our replacement cycle on furniture, cars, and televisions may grow longer as we insist upon a balanced current account (please!) does not imply a significant fall in our standard of living.
(The eating out thing really bugs me… fingerwaggers often suggest we’ll have to live like our grandparents, eating out only on special occasions, otherwise pulling out the Wonder bread and meatloaf. In aggregate, if you believe in opportunity cost, comparative advantage, and specialization, we should be wealthier when people eat out then when people don’t — for many people, eating-in is an expensive luxury! As trade economists forget, there’s more to life than opportunity cost, comparative advantage, and specialization, so big grain of salt. But I really think those of us who don’t like to cook, can in the aggregate, afford to eat out.)
January 18th, 2009 at 8:40 pm PST
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Leigh,
You can’t genuinely eliminate fractional reserve currency in an economy that allows free contract. I can simply write you an IOU and, as long as my credit is good, you can use it as money to buy things. Suddenly the money supply has expanded, as if by magic. Fractional reserve banking is no different.
While I admit that there are many specious arguments against FRB, there is one that is not. And one is all it takes.
The catch is in your phrase “as long as my credit is good.” In a world without FRB (more specifically, without formal or informal sovereign deposit insurance), banks will still exist. But a bank’s credit will not be “good” unless the maturity of its assets matches that of its liabilities.
Therefore, you will not be able to write me an IOU that matures tomorrow but is backed by a mortgage payment which is spread over thirty years. And who’s going to stop you?
Your friendly local regulator, certainly, in any transitional period. It is a bit rich for any defender of our present monetary regime, especially in a debate with sound-money advocates, to suddenly metamorphose into a paladin of free and unhampered exchange.
However, in a steady-state economy with free and unhampered exchange, checking that neither a bank nor the banking system around it exhibits systemic maturity mismatching is ultimately the responsibility of whoever has the due-diligence responsibilities for accepting your IOU.
January 18th, 2009 at 8:48 pm PST
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Steve – yes, of course our standard of living can go up, especially if you’re at all geeky and get excited by shiny buttons (Moore’s Law, etc.).
And I’m sure my wife would agree with you on the eating out thing, although I find that some Indian or Greek for $50-$60 for two is preferable to haute cuisine Americaine for $200, which still sticks in my craw after all those years teaching.
The point I was making is that sustained, bloated trade deficits matter.
January 18th, 2009 at 10:10 pm PST
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Whereas I would agree that there are problems with debt financing through bank loans and bonds, there would equally be problems associated with equity investment, (e.g. limited liability and agent/principle corporate governance problems). The problem is less the extension of credit/debt, than its over-extension and excess accumulation, and is less one of commercial banking than of the off-loading of debt beyond commercial banking onto the unregulated “shadow banking” system. (I do agree that the favored treatment of interest tax deductions does distort capital structures, and, more specifically, encourage the construction of rent-seeking and tax-evading structures by the financial system). Which is to say, that the dangers of excess credit require robust and vigilant regulation.
However, factional reserve banking has been baked-into-the-cake before the very origins of industrial capitalism, and it’s a dubious proposition that all the failures and defects of the latter can be laid at its feet, as if there were little reason for its emergent evolution. Aside from their crucial role in the system of payments facilitating commerce and industry, and their function of aggregating highly dispersed savings into a pool of loanable funds to be allocated to “best” uses, through valid underwriting of loans, the plain fact of the matter is that, without credit availability, particular capitals would be preoccupied with their self-conservation and would not extend production to the fuller extent of potential demand. By sharing the risk through the extension of credit between the “operational leverage” of equity capital and the financial leverage built into the banking system, real production is extended, smoothed and optimized, compared to what otherwise would be the case. And more speculative financing through investment banking helps to bring about the futural development of innovations in production techniques, though obviously not without glitches and higher levels of risk. There is always an element of risk and uncertainty, since interest and principal must be paid out of future returns from the realization of productive investments in increased rates of productivity and output, which is never know ex ante. Hence there is always a gap and even a contradiction between the uncertainties and coordination difficulties and adjustments of long-run real productive investment and the liquidity demands of short-run financial “investment”, but it is a superficial view of the former that regards its problems as entirely rooted in the excesses of the latter, rather than understanding the cross-implication between the two and the “origins” of the latter in the real difficulties of realizing, coordinating, and adjusting investment in the real productive economy, which lies at the root of the transformations of techniques of production in the business cycle.
Leaving aside the obsessiveness of the concern for “hard money, “Austrian” claims that the whole root of the evil lies in fractional reserve banking, and excessive credit, which itself can be subject to regulation and limitation in terms of reserve and capital ratios, ignores that a full reserve system would require much high stores of financial capital or much higher rates of interest or both, which, far from being “natural”, would be an unnecessary limitation on both the extent and efficiency of production. And the idea that maturities could somehow be ideally matched ignores both the possibility of transferring maturities through the relative liquidity of financial implements in secondary markets, which facilitates the willingness to support real investment, and the fact that production is an ongoing, continuous objective process, whatever the phase-shifts in levels of activity, and not a matter of subjective “time preference”, to which interest rates will respond in a similarly on-going fashion. (None of the foregoing though counts as a defense of the monetary policy of the Fed).
As for consumer lending, to the extent that it is not basically vendor financing, to support large-scale production, (which could be criticized under the auspices of “planned obsolescence”, encouraging excessive and wasteful consumerism), or a means of providing liquidity to long-run durable goods markets, (where “time preferences” do matter), then it amounts to a substitution of debt for an adequate distribution of productive surpluses to wages and salaries, rather than profits, with respect to output potential and adequate effective demand. Unions, far from being an inefficiency in a “pure” market system, are precisely a prime vehicle for identifying productive surpluses and rents in the production system and ensuring their “fair” distribution through equalizing otherwise grossly unequal bargaining power, though, to be sure, government regulations and social insurance schemes might provide alternate, though not necessarily mutually exclusive, “functionally equivalent” solutions to corporate rent-captures blocking an adequate distribution of incomes and gains-to-productivity.
January 19th, 2009 at 12:23 am PST
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Steve – it seems to me that your inferences are correct only with demand deposits and/or maturity mismatching. So, to express the idea more clearly, banks should only be able to lend money they possess *and* for which they have explicit authority to do so (i.e. its owner agreed to the arrangement and can therefore not demand the money until the authorized loan matures.) For demand deposits they can use vaults.
Now, I realize much mischief is still possible and as a practical matter your perhaps more direct approach may be necessary. On the other hand it may very well be that without government to prop it up and try to profit from it, as it has almost universally done to date, a stable system may evolve. One way or another I think the inherently unstable and destructive system bankers have effectively created for us (for their own benefit, at our expense) needs to end if we are to enjoy broad and sustained prosperity without virtually inevitable crises.
January 19th, 2009 at 1:50 am PST
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John C. Halasz – you state that 100% reserve banking would be an “unnecessary limitation on both the extent and efficiency of production” and yet I didn’t notice in your post a discussion of the costs of FRB.
We are now witnessing (and have witnessed before) a large scale destruction of wealth. Some of it was illusory to begin with and should very well get “destroyed” (though the Fed tries to turn ever more non-existent profits into cash.) It’s difficult to doubt that there is also much collateral damage.
An objective analysis may demonstrate that the higher interest rates likely without FRB would in aggregate cost much less than the destruction FRB brings when the bubbles it blows burst. Unfortunately, the advocates of FRB seem uninterested in objective analyses. Instead, I routinely encounter an almost blind faith in the alchemy of converting fake wealth (money created out of thin air) into real wealth. Then, when the stuff hits the fan, we see the hoocoodanodes and discussions of the mysterious vagaries of the business cycle, typically accompanied by calls for more bubble blowing to counteract the bursting of the previous one.
An element that makes this debate far more challenging than many is the massive asymmetry of interests. The progenitors of FRB make almost unimaginable profits from it and through the centuries have fought tooth and nail to retain and expand their exorbitant privilege, especially through a massive propaganda campaign that by now has deep roots. Those crying foul have traditionally been, at best, dismissed as “obsessive” heretics. If there was a huge pecuniary interest in the 17th century for the flat earth at the center of the universe theory, I wonder if it wouldn’t still prevail. I prefer to hope for – and advocate – improvement.
January 19th, 2009 at 2:36 am PST
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BSG:
If not entirely lacking a category of “fictitious capital”, you’re severely under-estimating its potential, -(and now actual),- extent, and its contradictory “origins” in the reproductive dynamics of the real productive economy,- (which is not entirely reducible to the operations of market equilibria),- as an effort to prolong and evade the difficulties engendered therein, in order to artificially maintain the accustomed or entitled rate-of-profit, over against the re-distributions of income/real wealth required to re-balance the economy in the light of its own productive gains. The destruction of fictitious capital is not the same as the destruction of wealth, but rather the destruction of excess claims on the real distributable surplus product, due to the blockage of an adequate re-distribution of productivity/output gains. In case you don’t get it, I am not any sort of apologists for the over-financialization of the real productive economy. To the contrary, I’ve been a strong advocate,- (having googled myself recently, since 4/5/08, where I called it the “Norwegian solution”)-, of public recapitalization/nationalization of the banking system, indeed, of its over-capitalization, in order to take down the “shadow banking” system and re-regulate and de-concentrate the financial economy. But I don’t think that “FRB” is the root-cause of the problem. Indeed, I think it requires a strong public-regulatory hand to limit its potential damages and dysfunctions, but the basic notion of “FRB” is self-limiting in terms of regulatory capital and reserve ratios, provided the structural transformations of both finance and real productive markets are not lost sight of. In 1900, unvarnished capital ratios were at 20%; nowadays, with VAR tier one ratios, actual leverage ratios are at best 4%, though probably recently much worse. Counter-cyclical regulation of capital and reserve ratios, and strict policing of the boundaries between regulated lending and speculative ventures would be in order, as well as restrictions on the size of financial entities to avoid the too-big-to-fail-or-succeed syndrome, combined with a general down-sizing of the financial economy as a whole, in order to bring the destruction of fictitious capital in line with real productive capacities and incomes/revenues, (which would also entail the real “destruction” and re-alignment of excess production capacity). Your “unimaginable profits” are my “financialized rent-seeking schemes”. But then again, there is no such thing as a “steady state economy”, as referenced by a commenter above, let alone one due to the entire “autonomy” of market equilibriating processes, independent of the emergent evolution of production systems, business organizations, (which tend toward oligopolistic rent-seeking), and political institutions. If there were such a thing as a “steady state economy”, it would be undesirably pre-modern, (which is not entirely far from the reactionary market utopianism of the Austrian school).
One thing I forgot to mention about the fantasy of doing away with central banks and regulated banking above is that it would result in severe information assyemmtries and huge costs imposed on ordinary savers, to monitor they accumulated “wealth”, (which is never identifiable with the fantasy of “hard” currency, but rather concerns claims upon real distributable surplus production). A plumber, say, is much better off improving his skills or working more over-time, than investing his efforts in financial research and monitoring. Believe it or not, something of what banks and financial professionals do might actually be functional and, indirectly, productive.
January 19th, 2009 at 4:15 am PST
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Surprisingly, I agree 100% with your policy prescription, but also think Americans consume too much and need to have a reduction in their standard of living, via a reallignment of terms of trade.
January 19th, 2009 at 4:45 am PST
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I suppose, the key point is who precisely the “Americans” in the quote above are.
January 19th, 2009 at 4:46 am PST
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BSG
I don’t see the difference between banning FRB and allowing it. The key point is that some definition of money is controlled somehow. I tend to think that financial innovation will continually find ways around any obstruction, so the authority seeking to maintain the controls needs some powerful tools and to be quick on its feet.
But in the mean time – how would we manage the transition to world as you imagine it?
January 19th, 2009 at 4:50 am PST
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Farrar,
Steve didn’t pick up, but there was a gem in your first post. Get rid of leveraged takeovers! YES!
January 19th, 2009 at 5:15 am PST
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John C. Halasz –
It is exceedingly difficult, if not impossible to avoid destruction of real wealth as fictitious capital is destroyed. I don’t see how you can know that said fictitious capital is simply the result of “blockage.” If useless products and productive capacity for same are encouraged by banks and shadow banks creating money out of thin air, then we do indeed have little or nothing to show for all of that money. Since that new money dilutes the “real” money, wealth is effectively destroyed, or at least its creation is forgone.
While in theory the newly created easy money could be used for truly productive enterprise, in which case no damage would be done, in practice this rarely happens and when it does, it’s only to a limited extent. This is to be expected since people tend to be much more cavalier about “investing” easy money and productive endeavor takes a lot more effort than chasing the latest financial fad (see e.g. LBO for a particularly pernicious use to which easily borrowed money is put.)
While I’m no market fundamentalist, I find your apparent faith in the prowess of regulators to prevent the inherently unstable FRB system from imploding surprising given the extraordinary failure of regulation we are witnessing. It seems to me that with the massive rents beckoning, any discretionary regulatory system will inevitably be corrupted. This is especially true of a system constructed by, and for the benefit of, financiers. While no regulatory system is perfect, the less opportunity for abuse, the more likely it is to hold up. The current system is one massive bundle of opportunities for abuse.
What you deride as “undesirably pre-modern” seems to me to have a much sounder analytical intellectual basis than the current system with its recurring hoocoodanode laden crises. That it hasn’t really been meaningfully tried is, I think, the result of the combination of propaganda and the failure of the imagination I mentioned in a prior comment above.
You mention that the “fantasy of doing away with central banks and regulated banking above is that it would result in severe information assyemmtries [sic] and huge costs imposed on ordinary savers”. In fact, our central banks and regulators are helping financial institutions hide their true condition, making it almost impossible even for those who were willing to make the effort of financial research and monitoring to get good information. Perhaps the fantasy is that regulators would serve anyone other than the financiers (to whom some regulators even refer as “clients.”)
I also think it’s ironic to refer to hard currency as a fantasy when the current system produces so many fictitious (and destructive) instruments.
I agree that doing away with the current system will be very difficult – like overcoming a heroin addiction, as Steve puts it – but that doesn’t mean it isn’t worthwhile. Quite the contrary.
January 19th, 2009 at 5:32 am PST
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reason – Wow! As far as I can tell, you’re the first anywhere to ask, apparently in earnest, “But in the mean time – how would we manage the transition to world as you imagine it?”
That’s a big and important question and while I do have some thoughts on that (surprise, surprise :-) I’m sure Steve has (or can come up with) much better ideas and I, for one, hope he gives it a go (hint, hint :)
January 19th, 2009 at 5:43 am PST
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“If you put cash in a bank, and they lend any of it, you are in a fractional reserve system. If you try to take your money out, they do not have it.”
Aren’t banks basically investment companies? Depositers should not be able to withdraw their cash but ‘lock in’ like a CD. They should be earning a high interest yield for the risk the banks take with their deposit.
It should be clear to the depositer: The bank is loaning this deposit and risking loss.
If they want safety, their money should be ‘stored’ and not be available for loans, and available anytime to the depositer. Their interest rate would be 0% or negative for the use of the banks services.
The bank would have to offer higher interest rates for longer term depositers.
People would split their deposits between ‘risk’ interest bearing bank account and with the ‘risk free’ 0% ‘storage’ money, as with an investment portfolio.
Instead, banks lend out all the money (at pathetically low interest rates for the depositer) and losses are socialized to the depositers by bank failures, or government bailout.
But the cry is “the system needs credit” “credit must flow” which means credit losses need to be pushed onto unaware depositers or the government, otherwise no one would want to lend money or it would be too expensive for entrepreneurs to pay the actual interest rate depositers feel they need to be compensated for their risk? Isn’t this just a big case of private gains / socialized losses?
January 19th, 2009 at 6:00 am PST
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Above was not Steve Randy Waldman. :) I need to think of a handle
January 19th, 2009 at 6:12 am PST
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Yves Smith weighs in:
naked capitalism
January 19th, 2009 at 6:32 am PST
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Steve W.
By the way what you saying sounds a lot like what I actually should be done, and have consistently pushed. It sounds a lot like what Chris Dillon is pushing, although I tend to have big differences with him (and have great difficulty discerning how serious he is).
January 19th, 2009 at 6:36 am PST
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oops
… what I actually think should be done …
January 19th, 2009 at 6:37 am PST
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One half way house that I have heard wispered elsewhere, is that we should limit banking to partnerships, and so break the deadly combination of limited liability and leverage (which is also one of my main reasons for opposing leveraged takeovers).
January 19th, 2009 at 6:40 am PST
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From reason’s post above: Chris Dillon = Chris Dillow
Stumbling and Mumbling Blog
Or his posts on what he calls
Citizen’s Basic Income
I also tend to have big differences with him, but I believe him to be very serious and often a refreshing thinker.
January 19th, 2009 at 9:22 am PST
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John, you write:
One thing I forgot to mention about the fantasy of doing away with central banks and regulated banking
While I appreciate your lengthy responses, I think you will create a more productive discussion if you are more courteous with those who disagree with you.
Bear in mind, Mr. Halasz, that sensible financiers such as (I’m sure) yourself were the party most strongly committed to “sound money” and what used to be called “orthodox economics,” until a certain political revolution in this country. While it’s true that the “sound money” of the pre-Federal Reserve era was not, in hindsight, quite all that – even the so-called “classical gold standard” centered on the Bank of England was considerably diluted with paper, with the predictable results – it remains the case that, from when Jesus was a little boy until roughly 75 years ago, sound money was orthodox by definition, and monetary debasement and paper-money schemes were considered the department of cranks, politicians, and schizophrenics.
In our enlightened era, of course, that perception has reversed. As I recall, the “New Economics” came into office with the promise that, either by fixing interest rates (Fisher-Friedman) or printing money and spending it (Keynes), they would “stabilize the economy” and there would be no more business cycles. How’s that workin’ out for ya? So, please, a little more politeness.
to monitor their accumulated “wealth”, (which is never identifiable with the fantasy of “hard” currency, but rather concerns claims upon real distributable surplus production).
By definition, money is the best “claim on real distributable surplus production” there is. The question for the saver is not whether he wants to save in money, but whether he needs to be able to spend his money right now. If so, he can invest it, exchanging return for time. If not, he can’t.
A plumber, say, is much better off improving his skills or working more over-time, than investing his efforts in financial research and monitoring. Believe it or not, something of what banks and financial professionals do might actually be functional and, indirectly, productive.
Banks and financial professionals are extremely productive and necessary. A plumber should not be picking stocks. The essential task of a banker is to judge risks and diversify across them. This job will never, ever go away.
What a banker should not be doing, however, is mismatching maturity – borrowing short and lending long. When you run a maturity-mismatched balance sheet, you are issuing IOUs that you cannot repay. If you have the only maturity-mismatched balance sheet on the planet, you can sell your long assets for cash to redeem your short IOUs. If you don’t have the only maturity-mismatched balance sheet on the planet, the result is a systemic maturity crisis – ie, a bank run. Ie, what just happened.
Our basic problem is that the modern financial system, as a whole, has a wildly maturity-mismatched balance sheet. This is an extraordinarily dangerous structure, obviously, and I think the authorities should be taking much more drastic and aggressive steps to unwind it. Basically, what needs to happen is that the government needs to buy all the banks with freshly-issued dollars, assume all their liabilities, and auction all their assets.
(I certainly do not favor the consensus Austrian solution of just letting it self-liquidate. Austrian economics is a method and a diagnosis. It is not a prescription, and neither it nor those who expound it are infallible. Once you get out of the mainstream, you realize that you have to be much more careful about thinking through everything for yourself.)
January 19th, 2009 at 11:42 am PST
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Steve,
I can do nothing more than mostly agree with your philosophy regarding debt-based consumption. I would even go further and state that automobiles should not be financed either since there is no shortage of cheap, used cars.
However, your stance regarding capital finance is confused/incoherent. There is nothing inherently wrong with debt financed capital in the form of bonding. Indeed, such bonding is the ideal arrangement in that it completely maturity matches the lender and the borrower. I infer, from a reply you wrote in the thread, that you seem to think this is not the case, but you would be wrong. As the lender, I can sell the bond to regain my immmediate claim to real goods and services, but then someone else has given up theirs to buy my bond. The maturity match holds.
I agree, there is nothing wrong with equity financing. Again, it is a maturity matching operation. I would agree that the government should not be favoring one over the other via tax policy. Let the two mechanisms compete on their own merits.
So, where are the problems? The problems lie in maturity mismatching. This problem always arises with fractional reserve banking. Banks exist so that the owners can borrow short and lend long. This always ends in a bank run. The entire history of fractional reserve banking is a story of creating ever larger lenders of last resort, but the runs still eventually take down the last lender. The Federal Reserve is next on the list, and if this crisis doesn’t result in it’s failure, the next one likely will.
Leigh is correct, fractional reserve banking is a result of mostly free contracting, but the government tilts the playing field through it’s guarantees of the deposits and the debts- something that can’t actually be done indefinitely. If the guarantees of government were removed, then fractional reserve banking would have to compete with full reserve and banks with higher but still fractional reserve lending. In other words, regular failures would steer us into a more stable financial system.
January 19th, 2009 at 1:33 pm PST
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Mencius said: “What a banker should not be doing, however, is mismatching maturity – borrowing short and lending long.”
Banks, by definition, will always have mismatched maturities. This is because both demand deposits (checking accounts) and time deposits (savings accounts) effectively have a maturity of zero (can be withdrawn at any time). Even a narrow bank, as Steve describes in the post, will have maturity mismatch, as the Treasuries it buys will have maturities from one month to 30 years. The only way around this is to eliminate checking and savings accounts altogether and replace them with a sort of CD whose maturity is matched to the maturity of the loan that is made with the funds and not allow it to be redeemed early. At that point, however, we’re no longer dealing with a bank because these aren’t really deposits, they’re non-marketable bonds of varying maturity. Just as with moving from fractional reserve to full reserve (in which case banks no longer are lending institutions but rather just payment clearinghouses) implementing such a step essentially means eliminating the concept of a bank as we know it.
January 19th, 2009 at 1:41 pm PST
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“Leigh is correct, fractional reserve banking is a result of mostly free contracting, but the government tilts the playing field through it’s guarantees of the deposits and the debts- something that can’t actually be done indefinitely. If the guarantees of government were removed, then fractional reserve banking would have to compete with full reserve and banks with higher but still fractional reserve lending. In other words, regular failures would steer us into a more stable financial system.”
This is counterfactual and confused.
1. We had free banking in the US from 1837 to 1862. It was an abysmal failure. There was no tendency towards stability. Half of all banks chartered during that era failed and the average lifespan of a bank was only five years. There was also no stop in the financial panics and economic crises under that system.
2. How exactly does a full reserve bank compete with and draw customers from a fractional reserve bank? A full reserve bank has to make money by CHARGING it’s customers a fee for depositing their money there. It cannot pay them interest because you can’t loan out deposits under full reserve banking.
January 19th, 2009 at 1:49 pm PST
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Rue the Day,
We had no national banks from 1837 until 1862, but we had plenty of state supported/manipulated banks.
As for how a full reserve bank competes with a fractional reserve one- it competes by being more likely to not lose your demand deposit, unless, of course, government steps in and guarantees the demand deposits of the fractional reserve banks. It is the risk of loss that balances the fee charged.
Yes, not guaranteeing deposits and debts requires a rethinking of the way people view banking. No one is denying this, but the path we are on ends in collapse. You cannot create multiple claims to the same property without it blowing up. The government backing only means the blow up is systemic when it occurs. I am under no illusions- we will continue this path to it’s designated endpoint. I only hope I am dead by then (after a nice long life, that is).
January 19th, 2009 at 2:18 pm PST
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Also, yes, a full reserve bank could accumulate timed deposits of various maturities from 1 day to 30 years, for example, and lend those with matching maturities. Interest could be paid on those types of deposits depending on the interest income on the lending minus fees and losses.
January 19th, 2009 at 2:23 pm PST
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RTD,
Obviously, if you define a “bank” as a financial intermediary that mismatches maturities, no maturity mismatching means no banking. But why not just define a “bank” as a financial intermediary? We’ll still need those.
The set of profitable investments at maturities under 30 days is likely to be quite small, so the natural interest rate on loans of this length is probably zero. If you can’t make a profitable lending transaction, just hold the cash. Your friendly local financial intermediary is likely to provide this service as a freebie, in order to obtain your other business.
Yes: this means a lot less lending. As Steve notes, the problem is too much debt, which means we did too much lending. We need to restructure the financial system to make this debt payable. We don’t need to add more debt. With 100%-reliable deposit insurance in a fiat-currency maturity-mismatched banking system, long lending of short deposits is economically equivalent to having the Fed print money and lend it out – an absurdity the system seems to have done quite well at reducing itself to.
But, just as there is genuine demand for loans at long maturities, there is genuine supply. Our plumber should go to his financial advisor and explain his retirement plans. If he is actually saving for retirement 15 years from now, he should lend that money out for 15 years. Of course, we need not call this “banking,” but is it really necessary to invent another word? (In fact, there is already an accepted term: “narrow banking.”)
January 19th, 2009 at 4:14 pm PST
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Yancey – There was no federal deposit insurance in the United States until 1933 (6 states offered limited deposit insurance from the mid-1800’s on), yet there were plenty of banking panics and economic crises prior to that time. You’re falling victim to the libertarian fallacy – that everything would always be ok if not for government interference, and the historical evidence simply does not support such a position. On the contrary, central banks and deposit insurance were established BECAUSE an unregulated financial system is so unstable and crisis prone.
January 19th, 2009 at 4:24 pm PST
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Mencius – Banks are a very specific type of financial intermediary; not all financial intermediares are banks. The key characteristic of a bank that distinguishes it from other financial intermediaries is that banks, and only banks, can accept deposits.
January 19th, 2009 at 4:27 pm PST
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RueTheDay – central banks and deposit insurance were established by big financiers for their own benefit. What you cite is their propaganda.
Check out “The Creature From Jekyll Island” by G. Edward Griffin or google it for a summary to learn the sordid details.
As for your fallacious “libertarian fallacy” (you do seem to like straw men), how about the fallacy *you* seem to fall victim to – that everything the government does would always be OK (yes, I set up a straw man of my own to illustrate the point.) How about dispensing with such nonsense, at least on this forum?
January 19th, 2009 at 6:08 pm PST
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BSG: I do not believe the government (or any other institution created by and run by people) to be perfect. Far from it. I do, however, take issue with the notion that in the _absence_ of government all would be fine. We have had financial crises for as long as we’ve had a financial system, regardless of the degree to which the governments of the time were involved with them.
January 19th, 2009 at 8:02 pm PST
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RTD, I surrender to your command of the English language.
The absence of formal deposit insurance does not imply the absence of informal deposit insurance. (Eg, the phenomenon now known as “too big to fail.”) There has never been a libertarian paradise in which there is true separation of bank and state. This is true especially for the so-called periods of “free banking” in both the US and Scotland. The former, especially, was corrupt as the day was long.
At least in the last two centuries, the rare cases of a completely sound monetary system have been in international entrepots with little effective government. Condy Raguet, in his 1837 treatise on money and banking, mentions one:
Such being the theory of this branch of my subject, I have the satisfaction to state in regard to the practice under it, upon the testimony of a respectable American merchant, who resided and carried on extensive operations for near twenty years at Gibraltar, where there has never been any but a metallic currency, that he never knew during that whole period, such a thing as a general pressure for money. He has known individuals fail from incautious speculations, or indiscreet advances, or expensive living; but he never saw a time that money was not readily obtainable, at the ordinary rate of interest, by any merchant in good credit. He assured me, that no such thing as a general rise or fall in the prices of commodities, or property was known there; and that so satisfied were the inhabitants of the advantages they enjoyed from a metallic currency, although attended by the inconvenience of keeping in iron chests, and of counting large sums in Spanish dollars and doubloons, that several attempts to establish a bank there were put down by almost common consent.
Believe Raguet and his informant or don’t, but suffice it to say that this does not read like a description of any US state in the postcolonial era. (And note that he is using your definition of “bank” – he’s certainly not saying that there is no borrowing and lending in Gibraltar.)
January 19th, 2009 at 9:55 pm PST
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Wow! This is great! This gives me hope. I haven’t seen a post on the econoblogs in months that’s this encouraging. Just to see people talking about these things, no matter how far off they may be or how much creative destruction will be involved. I have a 16 yr old daughter who knows something is “wrong,” and I just say something like “Oh, we’ll be alright,” but she also asks, wistfully, “Will there be anything like the ’60s in my life?” I can tell her “Hey! People are thinking. And starting to talk. There are big changes in store, you’ll have an interesting fight to be part of for the rest of your life.”
Sorry to wax emotional. But really…
January 19th, 2009 at 10:45 pm PST
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Mencius (Moldbug, I assume):
I gave my account of the business cycle here in a comment on the 12/27 post on Krugman’s response to “hangover theory”. The upshot is that I don’t believe it possible to eliminate business cycles, nor permanently “stabilize” the economy, but rather it is a matter of managing its transitions and phases. Without repeating much, the point was that the “origins” of the business cycle lie in the dynamics of the real productive economy, the “sphere of production”, which is cross-implicated with the “sphere of circulation”, to which financial intermediation belongs, but not reducible to it, not to issues of the mere over-extension of credit in the financial economy. Further, to view the financial economy as “prior” and as somehow a transparent reflection of the real economy is, in my view, a highly inverted perspective on economic reality. The main points I raised here were, in a quasi-Darwinian, quasi-pragmatic, emergently evolutionary vein, to point out some of the functions of the credit/banking system and its practices, under the assumption that such practices would never have taken hold and endured, if they had not solved real underlying problems and held “good”, for much of the time. (This is not to deny continuing economic evolution, nor that those practices might involve dysfunctional potentials that might need to be addressed, but only involves the claim that understanding the intrication and benefits of credit/banking/finance with the real productive economy is required to adequately address such issues, rather than taking the financial economy superficially as primary). But, of course, the specific points I raised were not answered, or even recognized by BSG, but, instead, pointing to the current debacle, which I’ve long anticipated, he franticly, with self-referential loopiness and self-righteous self-insistency, not untypical of latter-day “Austrians”, claims that it is all due to the failure of the “free market” to be “free” enough and to the innate evils of “FRB” and central banking, (which emerged as an effort to resolve some of the dysfunctions of the former), rather than to the failure of adequate regulation by the very same governmental agencies, due to the ideological hegemony of their own “free market” ideology, (and, more functionally described, to the regulatory capture of governments by the rent-seeking corporate oligopolies, especially financial ones, in the hypocritical name of “free market” competition). I’m sorry, if I get irritated by the blatant ideological hypocrisy and fallacious petitio principii of such contentions. In fact, due to economies of/increasing returns to scale, large-scale production becomes concentrated in the hands of market-dominating oligopolies, which renders the idyllic vision of perfectly competitive markets of petty goods producers nugatory, (if it ever existed, and then only in an economy still largely dominated by pre-capitalist formations). That, of itself, negates claims that prices are set at the margin by “competitive equilibrium”, since market dominating oligopolies are “imperfectly” competitive, to say the least, but also since, both due to the high, long-run fixed capital costs, which need to be managed at great uncertainty across business cycle conditions, and due to the quasi-rents and rents that accrue to such market dominant positions, which help to cushion the management of such high fixed costs, prices are in some considerable degree set administratively and manipulatively. Which is not due to governmental interference in the markets, but is due to the evolving tendencies of industrial capitalist markets, but which provokes the countervailing regulatory “force” of governments. Which also goes to the need for long-term financial maturities and government supports for long-run investments and the management of such financial commitments.
So, no, the current impending debacle is not due to “FRB”, which properly regulated to guard against its potential dysfunctions, is self-limiting, nor to the mere existence of central banks, nor to maturity transformations and mismatches, (since in a proper financial market, there is a wide range of maturity mixes and matches), nor even to the evils of “fiat currency”, (since even a commodity currency is really just a symbolic cypher). (The problem referenced by complaints about “fiat currency” are really much more those of trade imbalances and inadequate forex mechanisms). The supposed “market-based” alternatives would, in fact, by any realistic reckoning, be even more functionally deficient and sub-optimal, which was my basic point. Rather, it’s due to the huge over-extension of the financial economy beyond the banking system, wherein huge amounts of leverage has been built up outside its regulated bounds, and the global financialization of the real productive economy, at the expense of balanced (re-)productive investment. In short, a proliferation of financial schemes extracting rents from the real productive economy and the household sector, with the full complicity of the regulatory “authorities”, even to the point of financialized looting, (cf.the Akerlof and Romer paper on corporate looting or bankruptcy for profit, which, while prescient, underestimated by far the full potential scope of the problem). That is not the result of interference in “free” markets, but rather the stagnation of the productive economy, at once caused and furthered by the upward mal-distribution of income evident in financial asset inflation, which has been furthered and championed by captured government policies all in the name of “free markets”.
As for “sound” money, it certainly doesn’t go back to Jesus. (If you’re alluding to the money changers in the temple, IIRC that concerned a God vs. Caesar issue, since they were not merely minting money from money, but changing Roman coin into coin acceptable for temple offerings). No, a uniform monetary medium arose largely as a function of the need to pay taxes, just as FRB emerged from medieval times, not just from intermediating growing trade, but more especially from loans to sovereigns, with their taxing and seigniorage powers. Like I said, all that was baked-into-the-cake, in ways that it’s fruitless to subsequently subtract out in terms of some idealized model of “pure” markets. Even the “gold standard” refers merely to less than a century of British hegemony. But then: “By definition, money is the best “claim on real distributable surplus production” there is.” Really? The monetary medium of itself effects such a guarantee? In which case, I suppose, any manner of taxation would accord with such a “best claim”. But more to the point is that “sound” money is not somehow a permanent store-of-value, nor would its long-run “neutrality” somehow guarantee the long-run self-regulation of a market system, since “currency” is always attached to an underlying system of production and circulation. Put bluntly, a given level of nominal relative prices and a corresponding hoard of money now is not the “same” as a set of prices and hoard of money ten or twenty years hence, in terms of both its composition and “value”, since changes in both the ratios and level of productivity across business cycles, barring “secular stagnation”, alter the structure of an economy, beyond what can be accounted for in terms of chained indexes. And, of course, it is precisely the extension of credit for real investment, “productive consumption”, that not only anticipates such changes, but brings them about, both through the immediate spillover effects of such expenditure on current activity and through the subsequent improvement of capital stocks, which is what “guarantees”, though not quite, its repayment with interest. So “hard” money is tantamount to a metaphysical fantasy of “eternal being”. Similarly, both the vertical integration of production supply-chains, converted into a “round-aboutness” of production in terms of “time preferences”, and the notion of “subjective utility”, are subjectivistic abstractions from reality, more conducive to the subjectivistic metaphysical f
antasies than practicable economic theory, since both production and utility are ongoing temporal and social processes. (That market processes are somehow the perfect abode for the realization of human agency,”freedom”, let alone human community, which is closely linked to the former, to my mind, does not even begin to approach the level of philosophical “seriousness”. Von Hayek, at least, was more honest, since he emphasized that the outcomes of market processes were the frustration of most human purposes).
The Austrian school needs to be put back into its historical context, which is one of “classical” liberalism and not the libertarianism that its latter-day acolytes imagine. There was perhaps no more hierarchical, bureaucratically infested, and lazily, “comfortably”, deferentially, inefficient society than Austria, whether as the polyglot empire or the later rump state, at least by the ruthlessly efficient standards of Prussian bureaucrats. The Austrian school began as a school of neo-classical marginalist economic analysis, but when it ran into difficulties, after the effort of Boehm-Bawerk and the Swede Wicksell, to work out its “time theory of production”, it retreated into the insistence on the heterogeneity of capital goods, (which is really no different than that of consumer goods), and the denunciation of quantitative “scientism”, while extolling market processes as a unique medium of informational discovery, any interference with which would vitiate its irreplaceable knowledge. (That the reflexive and mutual self-monitoring of agents’ interactions with their environments might be a more general feature with other possible venues is not to be considered. No, the limitations of human knowledge are such that market exchanges must be mystically unique, since they so obviously can not be “transparent”). The collapse from analysis back into ideology of the Austrian school is two-fold: on the one hand, an arch-conservative adherence to social hierarchy itself oddly rooted in a more-than-Humean moral skepticism, and on the other, the adoption of “Manchester liberalism”, since Anglophilia was a fashionable pose in Austria, unlike Germany, into a utopian vision of “pure” free markets, all too bitterly at odds with actual Austrian reality. Hence an ideology of “free markets” as reactionary utopianism, which somehow has had a recurrent appeal equal to its functional irrelevance. (Er, like I said, the Austrian “solutions” to the problems of banking and credit are far more deficient and sub-optimal than what they would claim to criticize). But just in case you don’t understand my point about the reversion to subjective metaphysical fantasy, you might consult that other Austrian, IIRC a cousin by marriage to von Hayek, L. Wittgenstein.
Are bankers and financiers productive? Well, in terms of Adam Smith’s invidious distinction between productive and non-productive labor, they are not. But they have their function. Still, I think the whole financial sector has become excrescent and needs to shrink by at least half. It has long since failed to intermediate the real productive economy, but rather has disintermediated itself from it, as an “autonomous” subsystem. Not just in terms of the labor and investment that the financial sector has drawn away from the real economy, but in terms of the the malinvestment and maldistribution it has induced in the real economy, it has been anything but productive and functional.
The current crisis is one of both over-indebtedness and excess production capacity, both of which need to be reduced. But they are geographically separated, with the latter located in China/East Asia, and the former in the U.S., U.K. et alia. Again the problem is less about “fiat currencies” than trade imbalances and forex mechanisms. I would trace the current debacle back to the collapse of Bretton Woods in 1971-1973, and the eventual response of Reagan/Thatcher in unleashing financialized de-regulation in response to the perceived crisis in profitability. But then that collapse was foreseen as the “Triffen dilemma”, and, to go back to the origin, you can google the 1948 Havana Charter. If any good can come of this, it would involve the formation of a new trade and forex regime, which, of course, however unlikely, would require international cooperation. There is no market resolution, nor mere adjustment of nominal rates or prices that could correct the huge imbalances involved, without government “intervention”.
January 20th, 2009 at 1:12 am PST
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Without repeating much, the point was that the “origins” of the business cycle lie in the dynamics of the real productive economy, the “sphere of production”, which is cross-implicated with the “sphere of circulation”, to which financial intermediation belongs, but not reducible to it, not to issues of the mere over-extension of credit in the financial economy.
After such a spectacular credit-bubble collapse, it’s difficult for me to understand how anyone can still believe in real business-cycle theory.
Of course the stablest, best-equilibrated economy will suffer from unexpected events, seasonal cycles, etc. If an asteroid suddenly flies out of space and destroys the Western Hemisphere, you’ll see a real business cycle. One of the original motivations for the establishment of the Fed was seasonal fluctuations in interest rates as the result of agricultural borrowing. And since I work in the software industry, I see companies and even sub-industries disappear all the time as the result of technological changes.
But comparing these “natural” price changes, which under normal circumstances are produced by the inevitable changes in all human affairs over time, to the effect of a bank run or other maturity crisis, is like comparing a wind wave to a tsunami. The existence of waves caused by wind, even large waves caused by wind, does not cast any doubt whatsoever on the existence of tsunamis, the fact that they are caused by earthquakes, and the fact that our lives would be better without them.
It is of course a matter of speculation what prices, interest rates, etc, would look like in a hard-money environment without systematic maturity mismatching. But I’d be quite happy to bet that they would exhibit the same level of aggregate stability described by Condy Raguet’s correspondent in my previous comment above.
Basically, IMHO, a hard-money financial system is a financial system without multiple equilibria. Which is a financial system in which the EMH should actually be true. Which is one in which it is actually safe for quants to use highly levered arbitrage to try to damp the “wind waves.”
Obviously this does not describe the US financial system at present. Nor the Anglo-American financial system at any point in the past. Since 1694 the Bank of England has been diluting the British coin, and US monetary affairs (despite an attempt at one of the best designs ever, the pre-Civil-War Independent Treasury System) have been a running disaster since the Continental dollar.
No, a uniform monetary medium arose largely as a function of the need to pay taxes, just as FRB emerged from medieval times, not just from intermediating growing trade, but more especially from loans to sovereigns, with their taxing and seigniorage powers.
The theory that money emerged to pay taxes (chartalism) is no more historically credible than the theory that government emerged when people all got together and voted to have a government. It imagines prehistoric Eurasia as somewhat more, um, orderly than it was. Money emerged as a store of purchasing power, ie a mechanism to defer consumption.
Try De Soto’s treatise for a history of FRB. It has emerged repeatedly throughout European and classical history, generally either as a mere private fraud or in (as you say) a pattern of collusion between sovereigns and financiers. (While unlike most Austrians I don’t think of FRB as inherently fraudulent, covert FRB is obviously so, and often FRB begins as a corruption of a full-reserve bank.)
But then: “By definition, money is the best “claim on real distributable surplus production” there is.” Really? The monetary medium of itself effects such a guarantee?
In a stable system, absolutely. If some other good has a lower net cost of storage than the good which is presently used as money – if, to be exact, including storage costs it can be expected to appreciate relative to the present monetary good – rational hoarders will switch to the new money, and the old money will return to its industrial price (ie, the price of the good assuming zero monetary demand). Thus the claim is a tautology.
But more to the point is that “sound” money is not somehow a permanent store-of-value, nor would its long-run “neutrality” somehow guarantee the long-run self-regulation of a market system, since “currency” is always attached to an underlying system of production and circulation. Put bluntly, a given level of nominal relative prices and a corresponding hoard of money now is not the “same” as a set of prices and hoard of money ten or twenty years hence, in terms of both its composition and “value”, since changes in both the ratios and level of productivity across business cycles, barring “secular stagnation”, alter the structure of an economy, beyond what can be accounted for in terms of chained indexes.
You are committing the ubiquitous fallacy of believing there is some such thing as “value,” which the saver intends to “preserve.” This abstraction is sufficient for a blurry view of the monetary transaction, but it is not precise.
Precisely, the saver’s goal is not to preserve his purchasing power at the point in time at which he spends his savings, but to maximize it. This is why, given the choice of any two goods A and B, he would rather save in B if he expects the price ratio B/A to increase over the hoarding period. Of course this may be difficult to forecast, especially since the price ratio B/A may depend quite critically on whether other savers choose to hoard A, B, or neither. But it is the only question he has.
Most importantly, this decision has nothing to do with the price of any other article C, whether expressed in B or A. Thus, there is no need for indexes.
The Austrian school needs to be put back into its historical context, which is one of “classical” liberalism and not the libertarianism that its latter-day acolytes imagine. There was perhaps no more hierarchical, bureaucratically infested, and lazily, “comfortably”, deferentially, inefficient society than Austria, whether as the polyglot empire or the later rump state, at least by the ruthlessly efficient standards of Prussian bureaucrats.
Historically you are certainly right, though I don’t know how many of today’s Austrian economists make the mistake of seeing the Dual Monarchy as some libertarian utopia. They generally reserve that mistake for 19th-century America.
Still, I think the whole financial sector has become excrescent and needs to shrink by at least half. It has long since failed to intermediate the real productive economy, but rather has disintermediated itself from it, as an “autonomous” subsystem. Not just in terms of the labor and investment that the financial sector has drawn away from the real economy, but in terms of the the malinvestment and maldistribution it has induced in the real economy, it has been anything but productive and functional.
Well, I think that much is certainly clear!
The financial deregulation of the ’80s and ’90s looks pretty fraudulent in retrospect. Its effect was to privatize profits and socialize losses within the basic framework of a centralized, New Deal-era financial system, which it had no ambition to reform. It pretended to be increasing productivity through Hayekian decentralization, and no doubt it did a little bit of that, but for the most part it was just printing money.
Again the problem is less about “fiat currencies” than trade imbalances and forex mechanisms. I would trace the current debacle back to the collapse of Bretton Woods in 1971-1973, and the eventual response of Reagan/Thatcher in unleashing financialized de-regulation in response to the perceived crisis in profitability. But then that collapse was foreseen as the “Triffen dilemma”, and, to go back to the origin, you ca
n google the 1948 Havana Charter.
The problem is that these days, a man has a broad conception of history if he can see the events of the last five years in the light of the last fifty. But the Anglo-American political system is considerably more than fifty years old – and so is its financial arm. I think extending your historical pattern recognition past WWII would add quite a bit to your perspective.
If any good can come of this, it would involve the formation of a new trade and forex regime, which, of course, however unlikely, would require international cooperation.
International trade and monetary exchange existed for quite a few millennia before people even contemplated the possibility of international institutions. Perhaps they could go back to existing that way again. It’s certainly hard for me to see our present institutions as a success. So why reinforce failure.
There is no market resolution, nor mere adjustment of nominal rates or prices that could correct the huge imbalances involved, without government “intervention”.
That is certainly true. The mistake that most Austrians make, generally because of their political associations, is the failure to apply the simple principle of “you broke it, you bought it.”
Ie: 20th-century governments, having in some way foisted this clearly broken financial system on us, must assume the responsibility for figuring out what’s wrong with it, and using their sovereign powers to unwind it in a way that is fair to everyone, and replace it with a new financial system that is not broken. Sadly, our current regime seems quite unequal to this task. But the modern Austrians, for all their accurate diagnoses, are hardly doing much to assist it.
January 20th, 2009 at 2:35 am PST
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RBC? LOL! Mencius, you missed the point entirely. Credit extension is endogenous to the unfolding of the production cycle, and when that cycle reaches its technical limits, further credit extension, based on past expectations, but increasingly compensating for the lack of further productive/profitable investment opportunities, blows up into a bubble. That’s roughly Minsky, not RBC. (And that’s what happened in the 1922-29 cycle, in which productivity rate increased by 4+% per year, the employment-to-population ratio greatly expanded, but wage rates rose little, such that profits from the boom prolonged into a speculative financial bubble until not. Then huge debt deflation and a depression). But thus far there have been this time no bank runs, (except Northern Rock), as opposed to bank collapses, (many more to come), but rather there has been a huge run, well deserved on the external, unregulated financial system.
For the rest, yes, there has “always” been money and trade and hoarding of wealth, but so what? Rome had a balance of payments problem with China, but so what? Somehow you miss the distinctiveness of what happened in 18th W. Europe, when an expanded mercantile capitalism ran into a contingent cascade of technical innovations and the industrial revolution occurred. (And arguably there have been a few reiterations of such revolutions since). Suddenly, credit no longer just financed transport of goods from areas of abundance to scarcity, but rather the increase in real output from ever diminishing means/resources. Which is the increase in the real distributable surplus product, the total output minus that consumed in the process of its production. And such an increased real output of goods and services is real “wealth”, not a hoard of money.
The stalling of growth since the 1970’s stagflation and the resort to financial deregulation to lower costs-of-production/increase distributions to profits has subsequently, with good reason, been called a “super-bubble”. Chickens are now coming home to roost, but not because of the “sins” of the New Deal regime, let alone the founding of the Bank of England!
And there are no possible conditions in which the EMH is true. Financial markets are never perfect aggregators of information from the real productive economy, let alone clairvoyant prognosticators, which is part of why they require regulatory restraints.
For the rest, you complained of my lack of courtesy, but, sorry, I think my diagnosis is correct: you are absorbed in archaic fantasizing, rather than any realistic mode of analysis.
January 20th, 2009 at 3:44 am PST
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john c. halasz
wow.
I tend to agree about the disfunctionality of the international financial regime and the need for reform.
As for deposit insurance, isn’t enough to point out that deposit insurance supports the depositors (and gives them the opportunity for risk free interest bearing savings that they otherwise wouldn’t have) but not the banks (who can still fail if they lend unwisely). And as for the threat of eventual failure, what evidence does he have. Doesn’t for instance the experience of the US in the 1980s and Japan in the 1990s actually point the other way? Failure is only a serious threat when the issue of Fiat currency either borrows in another currency or allows the money supply to balloon without control.
January 20th, 2009 at 5:08 am PST
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… issuer or fiat currency …
January 20th, 2009 at 5:09 am PST
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“The reason that England was able to punch above its weight in the 1700s and 1800s was that it was able to borrow more cheaply than France, even though France was the bigger economy.”
The power of fractional reserve lending? Was this at the cost of banking stability? I would imagine a moderate loss magnified by fractional reserve leverage would wipe out the deposters occasionally. All the cheap funding available for English expansion was at the cost of the occasional wipeout of depositer’s savings? (I don’t know the history but it would seem logical- the money has to come from somewhere)
If they had deposit insurance the loss could have been distributed more thinly across the taxpaying public but the same principal applies – private gains socialized losses. no?
January 20th, 2009 at 6:28 am PST
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Look I would point out that mismatching term structure is just one risk in banking (and not necessarily the biggest). And there is more than one degree of freedom for banks, who can use various strategies to change their portfolios and can also vary the interest rate spread that they offer.
And banks with no mismatching term structure can invest badly or be ponzi schemes. You still have an information problem for depositors.
January 20th, 2009 at 10:19 am PST
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I sometimes get the feeling that this is a general problem with Austrian economics, it picks some particular feature of the world (from the mass) and says THAT is the important feature and doesn’t even do the empirical analysis to see if its right.
January 20th, 2009 at 10:20 am PST
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John,
You’re the one who brought up real business cycles. Laugh at yourself all you want.
But since you mention Minsky, he describes the cycle quite well. What he does not understand is the cause of the systematic error.
Reason,
Mismatched term structure is the only kind of risk that banks handle which is not susceptible to diversification via the central limit theorem. This is because the risk of a mismatched term structure is the risk of a transition between two equilibria in a multiple-equilibrium system: ie, the bank run. This is perfectly orthodox neoclassical economics: google “Diamond Dybvig.”
Reason, you might want to consider the possibility that the particular feature of the world that the Austrians are picking is, in fact, the elephant in the living room. That’s certainly how it appears from their perspective. Also: accurate deduction beats empirical analysis. Every time. By definition.
January 20th, 2009 at 2:56 pm PST
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mencius
accurate
Are you sure you want to stick by that. It rather depends on
1. what you mean by “beats”
2. what your axioms are
3. how stochastic the world is.
It sounds though like a typical fundamentalist creed.
January 21st, 2009 at 6:12 am PST
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Assuming the bible is literally correct, then the world cannot be older than 6,000 years. Deduction is sound but there sure are some empirical problems.
January 21st, 2009 at 6:14 am PST
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Not to mention that central banking with Lender or last Resort facilities has pretty much controlled the bank run problem. It just that Austrian’s don’t like that solution. But Banks still fail for other reasons.
January 21st, 2009 at 6:19 am PST
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Now what I really is the biggest problem with the banking industry at the moment. Agency problems and a disfunctional incentive structure. It is not a mismatched term structure (although that was the problem in the S&L crash).
January 21st, 2009 at 6:22 am PST
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I agree with transfer flat. I maybe agree with “tax Pigou.” But I disagree with “tax progressive.”
For the sake of efficiency, we should have a flat income tax. To capture business income in the tax base once and ONLY ONCE, all businesses (from the gardener with a truck and lawnmower, to GM) should distribute 80% of all cash-flow profits to shareholders, who would then pay tax on it at the flat rate. The other 20% would go into an escrow that would build up and be used for debt repayment and additional distributions to shareholders. That way, shareholders get dominion over profits, instead of management, which will blow them on (leveraged) empire-building. It also avoids the perversity of taxing the returns to a poorer person’s savings at 35% and then another 15%. To the extent a business borrowed for equipment and property, they would deduct principal and interest when paid, instead of interest and depreciation, which for real business property, on a 40 year schedule, is a joke (as would be allowing immediate expensing, for businesses that borrowed 90% to buy a building).
Instead of the personal and dependent exemptions in a flat tax, transfer flat for each adult and child. Tax flat from the first dollar and make the transfer refundable, to boost the working poor. Better yet, cancel social welfare programs (HUD, Medicaid, Food Stamps, other welfare) and use 80% of the savings to boost the flat transfers, so that everyone gets something, without having to wait in line to dance before a bureaucrat.
I would also cancel FICA, and choose a flat tax rate sufficient to pay Social Security and Medicare. Those with average taxed earnings averaging $40,000 per year or less would get benefits equivalent to what they get now (except Medicare would be a flat cash amount deposited into and HSA, instead of a blank check). To add some progressivity to the system, require that 12.5% of earnings over $40,000 be saved in a Roth-style account (no deduction now, no taxes on withdrawal), and those with fat accounts at age 67 or older get deferred as to how much old-age benefit they get. That way, no one who consistently earns $150K+ per year will ever be a charge on the state.
Government would also become easier and less corrupt, because there will only be 2 levers for politicians to play with — the tax rate, and the transfer amount. No more pork barrel, picking winners and losers, etc.
And as for credit, simply establish some universal controls — whenever credit is taken out, for anything, require 25% down from the borrower, and limit overall debt to a certain portion of a person’s rolling average income over the past 5 years. Debt from related parties would not be counted against that limit, but would also be automatically last in line in any bankruptcy.
February 3rd, 2009 at 11:53 am PST
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February 5th, 2009 at 12:34 am PST
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