no third solution

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A Belated Reply on Fractional Reserve Banking

April 17th, 2009

A long, long time ago, most likely in response to this statement: “[T]he current system of fractional reserve banking is nothing short of fraudulent. There may be some bad apples among the borrowers, but they are dwarfed in number by the bad apples among the lenders,” Tony inquired:

As you understand it, how much of the problem with fractional reserve banking is the concept and how much is the people who practice it? How, if at all, is your objection tied in with fiat currency?

Let me answer a part of the first question pertaining to “the people who practice it” immediately, I’m working on an essay to address the remainder of Tony’s inquiry which should be finished shortly.

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My primary objection is with the concept of fractional-reserve banking. The people who practice it are a much smaller concern, because unfortunately as my Public Finance professor used to say, “People respond to incentives.” People respond to incentives, no matter how perverted the incentives are made by government. And it is the concept of fractional-reserve banking in government which perverts the incentives. A good many of these people don’t know that it’s wrong. But most of these people can’t think critically.

Case-in-point: over the last decade or so, many brilliant young minds were drawn into what appeared to be lucrative careers in finance, banking, real estate, etc. Many of them are also now out of a job. I know smart people who took jobs in banking or wealth management, or whatever. They took those jobs because they were the best available sources of income at the time. A friend of mine was a real estate agent, he made over $100k/year back in 2003. Bought himself a nice house, had a couple kids, etc. Can’t sell houses any more. Can’t bring home commission checks anymore. I know people in wealth management, now unemployed because there’s no more “wealth” for them to “manage”. They were responding to the bubble that eventually burst.

Given the choice, individuals don’t want to subsidize Wall Street, and see their savings decimated by inflation. That is why governments make sure that individuals don’t have that choice! Despite some arguments based on a misapplication of Gresham’s Law ¹, in any free system where unbacked notes compete with specie, the latter will supplant the former. In some instances, “bad” money may trade side-by-side with good money, but not for long.

The root of that problem is the concept and the implementation of fractional-reserve banking, and its corollary, fiat money, which causes real inflation, and creates inflationary bubbles, which are the illusion of profit that many people chased, exploited, and cashed-in on over the early part of the past decade.

Fractional reserve banking must cause inflation and malinvestment, not necessarily price inflation which is what most mainstream economists mean when they say “inflation,” but real inflation, which is an increase in the supply of un-backed currency or currency substitutes. The very fact that a bank arguably loans (this much is debatable – in fact banks don’t usually operate this way) my deposits to someone else, in order that they may affect a purchase immediately, while simultaneously maintaining the assertion that my money is all still there, is kind of proof by definition. Fractional reserve banking permits banks to profit at the expense of depositors, just as any common counterfeiter profits at the expense of everyone who accepts his fraudulent notes, and everyone else who pays higher prices than they otherwise would’ve, as a result.

On this subject, I’m very Rothbardian. Rothbard argues essentially that interest rates on deposits can not exist, because money deposits are warehouse receipts and not loanable funds. Money doesn’t grow in warehouses any more than it grows on trees in your backyard.

A loan implies transference of ownership in exchange for consideration: either future consideration through interest payments, or current consideration in the form of collateral, or a combination of the two. In exchange for these considerations, the lender forsakes his title, for the duration of the loan, to that amount of money, and accepts the risk that the borrower may default, in return he receives collateral (or not) and a claim against the borrowers future productivity. A deposit, on the other hand, does not imply any transference of ownership. When you place your valuable jewelry in a safe-deposit box, the bank does not pretend to own those belongings. A deposit-banker is merely a custodian², and compensated accordingly for the safeguard of deposits.

For the time being, let me attempt to do a Cliff’s Notes tie-in with fiat currency, the defining characteristic of which is its legal tender status, mandated and enforced by the Government. An individual, having no right to print or otherwise create legal tender³ money from thin air, no group or collective of individuals may be said to have that right, whether they call themselves “The State” or “The Mafia”. This doesn’t mean that you can’t offer anything in exchange, like liberty dollars or doughnuts, but it does mean that you can’t force the other party to accept it in lieu of your obligation. Fiat money, on the other hand, has to be accepted on the white market. It’s backed by nothing (except debt and promises), and redeemable by nothing. This is the medium in which banks trade.

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1. Succinctly, “Bad money drives out good money.” This assertion can only hold where bad money must trade at a face value in excess of its true value in exchange, that is, with the help of legal tender laws.

2. If you drydock your boat for the winter, the warehouse does not pretend to own that boat for any amount of time, he does not claim your boat as an asset in his ledger. He can not sell it and use the proceeds on a business venture, in the hopes that he will earn enough of a return to replace your boat when you come knocking in the springtime.

3. For all debts, public and private. Mandate enforced by a government gun.

Why Diversification Fails During a Credit Bubble

March 4th, 2009

John Plender’s recent article in the Financial Times discusses the failure of diversification with regards to the current economic bust. I thought it was interesting because his thesis has an “Austrian” element¹:

A more fundamental point is simply that diversification cannot work well in a credit bubble because virtually all asset categories are driven up by leverage. Then when the bubble bursts, deleveraging affects asset categories indiscriminately.

I tend to agree that diversification cannot work well in a credit bubble, although I’m not sure “indiscriminate” is the appropriate way to describe the havoc wrought. When Plender says “indiscriminately”, what he means is that no amount of entrepreneurial insight was sufficient to avoid losses, and that only dumb luck could’ve kept investors above water.

But losses aren’t exactly “indiscriminate”, instead, effects of deleveraging ought to be strongly correlated with the amount of leverage, so highly levered “assets” should experience the largest losses; this much is elementary. Although not stated explicitly, Rothbard touches on the apparently “indiscriminate” nature of losses during the bust phase, while describing the “cluster of error” characteristic of capitalist boom/bust cycles²:

How, then, do we explain the curious phenomenon of the crisis when almost all entrepreneurs suffer sudden losses? In short, how did all the country’s astute businessmen come to make such errors together, and why were they all suddenly revealed at this particular time? This is the great problem of cycle theory.

Expanding on Hayek’s framework, Rothbard concludes that the eventual “bust” is “generated by monetary intervention in the market, specifically bank credit expansion to business,” and that the “’crisis’ arrives when the consumers come to reestablish their desired proportions [of savings and consumption]” and the banks can no longer credibly augment the money supply.

The last point is key: as long as the money supply can be continually and credibly expanded (i.e., no risk of hyperinflation), banks can continue to increase the amount of credit available, and business borrowers will remain “one step ahead”, able to bid prices ever higher, further exacerbating the eventual bust. At some point, however, credit is no longer issued in sufficient quantities or at the right time, and this is the point in time where the house of cards is revealed for what it is.

It’s of paramount importance to understand that although an economic “bust” destroys, dislocates, or otherwise consumes some real wealth through malinvestment, mostly, what’s happening is that the Ponzi-scheme illusion of wealth, credit, is being destroyed, and consequently every asset the “value” of which was determined (in whole or in part) by credit, needs to be reassayed.

Wherever economic growth is not driven by previous savings and capital accumulation, but instead mortgaged by future productivity, a “bust” is inevitable.

Plender, John. Investment and the crisis: an error-laden machine, Financial Times, March 2, 2009.
Rothbard, Murray N. How the Business Cycle Happens.

Re: the Austrian Delusion

February 26th, 2009

I read an interesting blog post a while back called the Austrian delusion. I think the criticism are, for the most part either without merit altogether, or haphazardly miscast as applicable to any “Austrian”, when the plain fact of the matter is that there are people of many different political creeds that are associated with Austrian economics.

So, in other words, “Austrian” economics is right — no matter what evidence can be presented — because it is based logical deductions from axioms which are, by definition, true. Capitalism is great because 2+2=4

It’s not that vulgar, is it? No, it’s not. If you read things like Jim Davies’ most recent post on STR (Misallocation), you’ll see that what many “Austrians” or near-Austrians mean by “capitalism” or “free markets” is markedly at odds with either the Marxist conception thereof, or the current state of affairs. Without getting into a semantic debate, I think it’s more than fair to ask that people stop relying on intentionally misrepresentative assumptions and/or loaded, emotionally charged definitions.

any problems we face now are due to the state and most definitely not due to the profit seeking activities of business men — unless they are bankers, of course, but even then it is all the fault of the central bank…

So, variations on that theme. Also, of course, they will be stressing that the state should do nothing, that wages should be cut (although the impact of that may not be what they hope), that people should be thrown out of their homes if they cannot pay the rent or mortgage, and so on. Once the collapse if finished, then the economy will bounce back better than ever but the pain is good for the economy — and serves you right for not worshipping at the idol of von Mises!

This is not a flaw specific to “Austrians”, it’s a deductive error committed by a great deal of right-libertarians no matter what school of economic thought with which they self-identify. It’s an inadvertent, but obvious error, to paraphrase: the state is the cause of all the problems, but they take for granted (and often apologize for) a great deal of the institutional inequalities that are likely byproducts of the State, assuming that these same institutional arrangements would persist in the absence of a State or neglecting to account for any other possibilities.

As an example, suggesting that people should be “thrown out of their homes if they cannot pay the rent or mortgage” presupposes that the creditor has a superior and morally justifiable claim to the property in question. In many, if not most, if not all circumstances, it is not at all the case, that the creditor has a superior claim based on the no-interest nature of the fiat money loan “contract.”

The key problem with the “Austrian” theory is that it bases the crisis in banks artificially lowering the rate of interest from its equilibrium (“natural”) price. This has three major problems:

1. It is in contradiction with their normal claim that equilibrium is a meaningless concept and unlikely to exist in reality. Except, apparently, in the banking industry (where it can be used to demonise the state for the failings of capitalism) and in the labour market (where it can be used to bash unions and such like).

A “natural” price is not the same as an “equilibrium” price. A “natural” price occurs in the absence of state intervention. An “equilibrium” price does not exist because circumstances are in constant flux.

2. It is in contradiction with their defence of entrepreneurial activity within capitalism. After all, why do banks artificially lower interest rates? To make money by meeting customer demand! It seems hard to blame the government when (as Minsky argues) such activity is a natural part of the entrepreneurial activities of the banks seeking profits.

I respectfully disagree. Banks loan money into existence in order to earn a profit without putting any of their own skin in the game. As long as they continue to loan money, they make a nominal profit which is realized before prices have fully risen as a result of the increased MS. If for some reason they can’t print/loan any more money, they have to call in their loans—a painful process which allows the banks to take title to real assets for which they risked nothing, in the first place. The entrepreneur always has his own skin in the game.

Anything else is rent-seeking. Stop calling it “entrepreneurship”.

Such activity which would be otherwise intolerable, is encouraged by the government. The artificial lowering of interest rates is predicated upon a foundation of fractional reserve banking, which permits(among other things) certain individuals/institutions to create pure debt obligations out of thin air, which the market is forced to accept at par value with legitimate money. Morally flawed, corrupt or corruptible individuals are far more likely to prosper in any system that tolerates or encourages the extraction of unearned rents. The State is such a system.

3. It is also ignores that an interest rate, firstly, does not reflect the time preference of individuals and, secondly, even if it did, it is also the source of income for banks! Hence they have a market interest to act as they do, regardless of whether there is central banking or not.

I do not think you know what “interest” is (especially in regards to originary/natural interest derived as a function of time preference). The interest rate is not the source of profits for banks, rather it is the yield spread between what they pay to borrow money, and what they charge to loan money. This would conceivably be true for an individual capitalist, except he is rarely in a position (on a free market) to borrow low and sell high, pocketing the yield spread. Instead, in order to earn interest, he has to forsake a certain amount of income or property that he has already earned, for a period of time. His “cost of borrowing” is actually a his opportunity cost — that which he might’ve otherwise earned, or that consumption he might’ve otherwise enjoyed.

For further reading, I have a particularly detailed post about the Malinvestment, as a consequence of fiat money inflation, suffice to say that “these same institutional arrangements” would not be long for this world in a truly free market. I’ve also got a lengthy post about Entrepreneurs, the Firm, and the Knowledge Problem, which in my experience is the syndicalist-left’s favorite free market whipping boy.