JohnL

Looting Goes Mainstream: The Trouble with Government-Backed Risk

Looting has become endemic, even in good times, for many years. When banks can legally borrow a large portion of their funding from the central bank at a low interest rate and then loan it out to the public at high interest rates, that is looting -- plain and simple. It is a huge transfer of wealth from the public to the bankers and it's been taking place in plain sight for decades. There is not a word from the press, politicians or academia. The public is almost entirely ignorant of the whole scheme. I'm sorry, but looting went mainstream a long time ago.

Rethinking Subsidized Finance

Aristophanes,

I need to end our little debate here. You are not convincing me and I'm sure the feeling is mutual. I do appreciate your time; you provided some interesting historical commentary. That said, you refused to rebut my specifc arguments and you provided no references for the historical claims you made. When I made theoretical arguments, rather than countering with your own logic, you just said that I was stuck in ideology. Well, Austrian Economics is no more an ideology than Keynesianism, Monetarism or any of the other schools of economic thought. Frankly, I thought most of what you said was from some leftist monologue rather than an economic argument. I'm afraid the impasse is just too wide. Too bad, really.

Take care.
JohnL

Obama and Bush: Different Objectives, Same Results

-- President Bush thought common shareholders in financial institutions should be massacred to preserve Darwinistic capitalism. --

What other kind of capitalism is there? I thought that capitalism was a system in which those that are less successful at satisfying customer wants in a profitable manner, lose money, lose business and eventually lose their investment. The resources at their disposal get picked up by someone more successful. I'm confused (again).

Rethinking Subsidized Finance

Aristophanes,

I really appreciate your quick reply and the obvious effort you took in responding. Unfortunately, while you tell a compelling story, none of it is backed up by source references. And frankly, I had a hard time following your logic. Also, you did not respond to most of the points I raised, so I’m left with more questions than when I started. Here are some specific points that for which I would love a response, if you’re so inclined:

I provided multiple references showing that deposit banking and full-reserve banking were established by legal precedent in classical Greek and Roman law. Are you disputing them?

I provided multiple references showing examples of full-reserve banking practiced in Europe. Are you disputing them?

How does using gold as money lower the saver’s risk tolerance or raise his liquidity preference?

How can an unwillingness to lend be attributed to commodity-backed money or full-reserve banking?

Requiring loan collateral does not result from full-reserve banking, but from poor credit risk. Most loans in our fractional-reserve system require collateral, do they not?

How does full-reserve lending make worse the consequences of debt default for the borrower?

Investment risk-taking by borrowers increased primarily due to changes in bankruptcy laws.

How does full-reserve banking cause corruption?

Full-reserve banking eliminates systemic failures caused by bank panics and debt deflation.

Increasing the supply of “credit” or fiat currency produces only the illusion of an increase in available capital. This leads to entrepreneurial error.

Commodities generally increase at the same rate as the population.

With regard to your latest comment, you talked a lot about the extensive use of barter. I’m not defending barter systems, I’m not proposing that we go back to them and I’m not convinced that using gold-backed money leads an economy back to them. I'm afraid you’ve lost me on that one.

You state “There has never been a full deposit system that survived into modern times because the systems cracked under the stress of capital expansion, vastly outrunning the input of depositors.”

First, I never claimed that deposit banking or full-reserve lending survived from ancient times to the present. In fact, I understand that most all banking ceased during the Middle Ages.

Second, are you saying that growth of tangible wealth outpaced that of the money stock, leading to deflation? I don’t think that is historically accurate. There are numerous examples of inflation caused by credit expansions in early fractional-reserve economies. Among them: the inflation in Florence that preceded the banking collapse of 1341-46 and the inflationary policies of the Medici bank from the 1460s until its collapse in the 1490s. There were deflations and collapses, but I think they were all preceded by credit inflations that could not be sustained.

And can you demonstrate that deposit banking caused this “stress” which led the “system” to “crack?” As a counter example, the Dutch flourished during the period when their banking system was dominated by the Bank of Amsterdam – from 1609 until after 1800. This bank, as was described appreciatively by Adam Smith and David Hume among others, operated as a full-reserve lender until at least the late 1700s. In 1699, the French ambassador described the city: “Amsterdam is without any doubt the foremost in greatness, wealth and the extent of her trade. There are few cities even in Europe to equal her in the two latter respects; her commerce stretches over both halves of the globe, and her wealth is so great that during the war she supplied as much as fifty millions a year if not more.” Their full-reserve banking system does not seem to have been a problem.

-- You have it entirely backwards when you assert that the state "participated" in its formation. These merchants were running away from the constraints of the state. --

Did not the state provide the banks their charters and licenses? Did they not set up and enforce the laws which permitted fractional-reserve banking to flourish, counter to legal precedent handed down from Greek and Roman law? And I think state participation can be seen directly when the government entered the banking business itself. Examples: the Taula de Canvi (Barcelona’s Bank of Deposit) in the 15th century; the Bank of Stockholm in 1668; the Bank of England in 1694, which was effectively a government bank.

-- Historically, fractional reserve banking is an unqualified success. The history of Western progress is absolutely linked with this evolution. --

The list of inflations, deflations, bank failures and disruptions of commerce under fractional-reserve banking is as long as your arm. I’ll be happy to provide a list if you like, but there’s no secret on this point. Yes, there has been Western progress, but you’ve not shown causality between it and the banking system, and I don’t think anyone can (given all the social, political and scientific variables at work).

I look forward to your response. Thanks.

Rethinking Subsidized Finance

Aristophanes,

Long post alert! My comment is really too long for a blog, but I don't have your email address, so here goes...

First of all, like most Austrian economists, my arguments are primarily theoretical and not based on empirical evidence. I’m sure you know that the Austrian school believes that most historical economic data is influenced by too many concurrent variables to draw “scientific” conclusions. In short, national economies are not good laboratories so you can’t run good experiments. To call economics a science is generous at best. Nonetheless, I’ve attempted to respond to your empirical claims.

-- Today, collateral and commodity-based neighbourhood banking systems dominate the developing world at the local economic level...The collateralized and 100% commodity system is awful, responsible for much of the severe corruption i the third world. --

You seem to be suggesting that the developing world offers us many examples of full-reserve banking to examine, and that the record is one of failure. I believe there are many more likely causes for the economic issues of the developing world, as described below.

How does full-reserve banking cause corruption? Indeed, the Austrian position is that fractional-reserve banking is in fact a form of legalized embezzlement, since money supposedly available to the depositor “on demand” has in fact been loaned out for profit by the banker. This system offers tremendous opportunities for corruption as the elite has access to tremendous amounts of credit prior to the average person. Indeed, in Barcelona of the 14th century the penalty for a banker caught engaging in fractional-reserve lending was beheading.

-- None of them (commodity systems) create economic progress. In fact, they severely inhibit progress because unless the commodities increase at the same rate as population then there is redistribution tension, and always violent conflict. --

First, commodities generally do increase at the same rate as the population, and gold is no different than others. The amount produced is self-correcting: when the price gets too high it stimulates mining and when the price gets low it depresses mining. Second, a little variation in the amount of gold is insignificant compared to the wild swings (mostly upward) we face with fiat money and fractional-reserve credit.

-- There are very few deposits to draw upon so in order to borrow, you must have equivalent collateral...There are no bank deposits in a system where barter is as valuable as monetary transactions. --

I agree. We both seem to agree on the need to encourage saving and the investment of those savings which the saver is willing to put at risk. Our disagreement seems to center on what constitutes available savings and the factors which encourage their prudent investment.

-- Using it (gold) as a standard to underwrite currency as with a gold standard risks all deposits to the aforementioned corrupt government, or invader, etc. This lack of risk taking is severely inhibiting to commercial development. --

If the government is corrupt, there is no protection for the citizen in any case. Using a different type of money does not change the protection level. And if invaders come to loot the country, they will take the gold whether you call it money or not because it is valuable. Indeed, corrupt governments have always favored fiat currency over gold because it is easier to counterfeit…eh…I mean easier to create.

-- Putting their gold up as collateral for a paper "note" is risking the family's entirety…Indians store gold as a safeguard against crop failures and infertility (generational support), not as currency --

So Indians, based on the variability of their farm income and their risk tolerance, keep a large portion of their savings in a liquid form (gold), rather than taking on the credit and liquidity risks of investing those savings. How can that be attributed to fiat money or the lack of fractional-reserve banking? It seems to be more the result of cultural differences and the unpredictability of the monsoons. Would changing their money system increase their risk tolerance or smooth out the rains?

-- That is why it is personally held as jewellery. --

This may actually be as much a result of religious doctrine pertaining to a woman’s right to own property or investments, as it is to fear of investment risk.

-- There are very few deposits to draw upon so in order to borrow, you must have equivalent collateral --

Why would full-reserve banking discourage deposits by savers? Indeed, the primary reason for a “bank run” is a fear that the fractional-reserve bank can’t honor your withdrawal request; this doesn’t occur with full-reserve banking.

The lack of good banking in the third world today is not proof that such banking has never existed or cannot exist; there are many other factors, like the lack of respect for the rule of law and political instability, to account for their unwillingness to deposit savings and their economic troubles.

-- …and debts are carried across generations (as a result of commodity-based banking) --

Aren’t you ignoring the role played by modern bankruptcy laws and the legal construct of limited liability in encouraging risk-taking? I don’t see a (negative) relationship between full-reserve lending and the frightening consequences of debt default. If anything, full-reserve banking eliminates the systemic failures (debt deflation) that we are currently experiencing, since defaults don’t contract the money supply.

-- The lack of faith in fractional reserve banking kills their fiat currencies and they drop down the ladder swiftly to bartering their collateral (working capital really) rather than depositing it…Fractional reserve lending builds in a risk tolerance towards default with the expansion of credit, roughly based on demographics and human productive ingenuity, not how much of a precious metal is mined in some far off place. --

As explained above, the increased risk tolerance comes from legal protections – not from a greater willingness to risk paper money than to risk other forms of wealth. Increasing the supply of “credit” or fiat currency produces the illusion of an increase in investable capital. This illusion causes entrepreneurial error because there is actually insufficient capital in the economy to complete many investments started as a result of the illusion. Full-reserve banking ensures that all credit represents truly investable savings.

-- In a fractional reserve system it is entirely possible to lend with no collateral (almost unheard of in developing countries until micro-lending came along) because the risk pool is evaluated against the possibility of future earnings. --

Credit risk is always evaluated against the borrower’s prospect for future earnings and requiring loan collateral does not result from full-reserve banking. It results from the lender lacking sufficient confidence in the borrower’s future income stream and his ability to repay the loan principal and interest. We have many loans in the fractional-reserve world that still require collateral: mortgages; auto loans; small business loans. I don’t see that you’ve demonstrated causality on this point.

-- If they know cows and have no collateral, you can still lend them money because they know cows. --

Even in a full-reserve banking system, a banker will be willing to make a loan if there are good prospects for future earnings. Why wouldn’t he lend investable savings to a borrower with a good business plan? The form of money loaned doesn’t change his risk, does it?

-- The barter trade in gold usurps the fractional lending system to the point where the articles of value circulate but cannot be leveraged… gold is not leveraged for risk, but is hedge against risk. It is insurance. --

If gold is acting as a medium of exchange, then that economy is not based on barter. If it is a barter system, then there is no banking system – fractional or otherwise.

And are you claiming that society resorts to barter because of the acceptance of gold as money? I don’t believe this is historically accurate. Precious metals, because they were so good in their role as money, eliminated most barter systems thousands of years ago, where political conditions were sufficiently conducive.

Also, savers in all financial systems face the decision of how much of their wealth will be kept in liquid form and how much will be committed for longer terms. They also must choose a spot on the investment risk-reward spectrum. I don’t see how using gold as money alters those decisions. If anything, knowing that they will be repaid in a stable currency will reduce one of their primary risks. If they are less willing to loan gold perhaps it is because they know gold is more valuable than fiat currency.

-- The lack of faith in fractional reserve banking kills their fiat currencies… --

On this we both agree. It is one of many reasons for abolishing fractional-reserve banking; it undermines faith in any type of currency placed on deposit.

-- Fiat currencies and fractional lending liberate transactions from physical repercussions…tying repayment to anything more than a fiat currency leads to the abuse of physical labour as collateral... --

I don’t see how the currency specified in the loan contract impacts the repercussions of default for the borrower. Whether or not the creditor can lay claim to the borrower’s collateral is a function of the legal system and the contract terms – not the specified currency of payment. If the laws allow it, a borrower can be equally wiped out in fiat currency, gold or cattle. Debtor prisons went away because of changes to debtor laws – not because of the move toward fiat currencies or fractional-lending.

-- There has never been a banking system as we know it that has been anything but fractional reserve. A full reserve system is purely hypothetical. The entire concept of bank deposits was started because of fractional reserve lending opportunities. You've got it backwards. --

First of all, you can’t describe at length why a full-reserve banking system is “awful” and then claim one has never existed. Conversely, if there are important differences between a full-reserve banking system and a “collateral and commodity-based system” then the failure of the latter can’t be used as evidence against the former. I operate under the assumption that you hold them to be different in important respects.

Secondly, I will confess that I’m not an academic researcher with access to primary source documents, so I’m relying heavily on the research of others.

We know that banks and the state have cooperated in their pursuit of fractional-reserve banking for centuries. This helps explain why there are few long-running examples of full-reserve banking in modern times. That said, we know that bank deposits and full-reserve banking have existed, at various times and places, for more than two-thousand years.

We know that full-reserve banking was established and protected by early legal precedent. The ancient Greeks conducted deposit banking in the temples and deposits could not be loaned out by the bankers. In 293 B.C. the legal scholar Isocrates describes a trial of a banker in “On a Matter of Banking,” p. 114. The client testified that his banker “cried and said he had been forced by economic difficulties to deny my deposit but would soon try to return the money to me; he asked me to take pity on him and to keep his poor situation a secret so it would not be discovered that he had committed a fraud.”

Todd, in “The Shape of Athenian Law,” p. 251, indicates that “banks were not seen as obvious sources of credit…out of hundreds of attested loans in the sources only eleven are borrowed from bankers; and there is indeed no evidence that a depositor could normally expect to receive interest from his bank.”

Rostovtzeff in “The Social and Economic History of the Hellenistic World” p. 1279, indicates that bankers in Ptolemaic Egypt accepted both demand deposits and interest-paying time deposits.

We know from classical Roman law that the concept of a demand deposit was well-established in Rome. Section 3, book 16 of the “Digest” of “The Corpus Juris Civilis” is entitled “On Depositing and Withdrawing.” In it Papinian declares of deposits that a banker must “return them to you immediately, whenever and wherever you wish.” In the same book

Ulpian describes the legal protections for depositors: “Whenever bankers are declared bankrupt, usually addressed first are the concerns of the depositors; that is, those with money on deposit, not those earning interest on money left with the bankers.“

It may very well be that the Greeks and Romans tried and eventually rejected fractional-reserve lending, but there can be no doubt that full-reserve banking was established practice in the western world a long time ago.

After the fall of the Roman Empire, Europe fell back into a system of barter for many centuries. But when banking finally returns late in the Middle Ages, it follows Greek and Roman legal precedent.

Piquet in “Bankers of the Middle Ages: The Templars, a Study of their Financial Operations” tells us that the order of the Templars provided deposit banking services throughout their area of influence starting in the 12th century and that they did not loan out demand deposits.

Usher in “The Early History of Deposit Banking in Mediterranean Europe” indicates that the move from full-reserve lending to the use of fractional-reserves does not become widespread in Europe until the 13th century. On p.63 he states that banks in 12th century Genoa made a clear distinction between demand deposits and time deposits, and recorded the latter as loans or “mutuum” contracts.

The Bank of Amsterdam, founded in 1609, operated exclusively on gold and gold certificates, and did not loan out on-demand deposits. It operated profitably for hundreds of years.

It is clear that with the protection and participation of government, full-reserve banking has gravitated toward fractional-reserve banking. This is not in dispute. The central questions are whether full-reserve banking, in which demand depositors are protected, ever existed and whether it is a good or bad thing.

-- Historically the pulses of gold and silver discoveries have been sporadic though quite common and generally very, very unsettling contributing greatly to conflict. --

Today, gold has an extremely high stock-to-flow ratio. Such disruptions are undoubtedly a thing of the past. Thus, the parallel drawn with oil, which has an extremely low stock-to-flow ratio, is not warranted in a monetary context. Most of the events that you cite are political in nature and could just have easily occurred with any form of money. In any case, I would not dictate that only gold or silver can be money, but that they be allowed to compete freely in the marketplace, unfettered by governmental restriction.

-- Currencies liberated from commodities are far superior to those tied down. --

I believe you have it reversed. In playing its role as a reliable store of wealth, a currency tied to commodities is superior to a fiat currency. When government can (and they always do) print currency without restraint, that currency is not a reliable store of value. This causes a society to lose faith in the currency and revert to barter in an attempt to gain protection from inflation. An unstable currency also increases the risk associated with credit contracts, particularly for the lender. Both factors diminish capital formation and economic progress.

Again, my apologies for the length of this posting. If you want to continue the discussion, perhaps email would make more sense. jlafer at yahoo dot com

Rethinking Subsidized Finance

Aristophanes,

Could you please clarify your meaning for a "collateralized and 100% commodity system?" Are there any differences between that and a "100% reserve banking system" or are they equivalent in your mind? Some of your comments might imply that the former suffers from a lack of available deposits and loan contracts that impose oppressive terms on the borrower (even liabilities passing to the heirs of the borrower).

Rethinking Subsidized Finance

Agreed! Thanks Aristophanes, for a credible argument on this subject. Guys it will take me a day or so to respond properly, but I will so please check back.


On Mar 05 09:57 AM Chris B wrote:

> Excellent discussion JohnL and Aristophanes. A rare example of Austirans
> and non-Austrians having a smart, civil discussion on SA!

Rethinking Subsidized Finance

ChrisB,

I really appreciate your response. You made some good points, but I want to clarify a couple misunderstandings.

-- In a non-fractional reserve system, the person with $100 would have to just directly lend it out. The difference would be that having a third party to arrange loans would be illegal. --

No, under a 100% reserve banking system lenders can still make loans via a bank. In fact that is one of the traditional services provided by a banker -- he acted as a broker between savers and borrowers. The traditional vehicle was the "time deposit" which paid interest to the saver for a fixed period of time. The only requirement was that the saver couldn't access the money until the term expired, while the funds were loaned out to another party. Credit risk was borne by the banker or the saver, depending on the terms of the contract.

The banker makes money by collecting a brokerage fee or from the margin between the two interest rates. The only difference between our system and 100% reserve banking is that in our system bankers loan out "demand deposits" as well as time deposits. There is nothing to prevent both saver and borrower from accessing the same funds. And this divergence between true savings and credit is what enables the boom-bust cycle.

-- When the dollar was pegged to gold, its value was also more volatile, and impossible to control compared to the value of things like food, other commodities, housing, services, etc. The 19th century featured multiple sharp waves of inflation/deflation that wiped out farmers, industries, and lenders alike. --

Many observers of that period (and earlier ones) recognized that the volatility was not caused by gold backing -- but the fractional-reserve lending that was layered on top of gold reserves. The growth in the supply of gold has been quite stable over the centuries with only two exceptions: Spanish gold imports from the New World and big gold discoveries in CA and AK. Those disruptions are behind us an unlikely to repeat. I would refer you to almost any book on monetary history to see that this is true. One I enjoyed was "A Short History of Paper Money and Banking in the United States" by William Gouge.

-- Overall, economics is an evolutionary process. More successful systems end up with a larger percentage of global GDP and systems based on failed ideas end up with a smaller percentage (For example, communism). --

I agree completely, if all systems are allowed to compete fairly. But politicians and bankers are able to achieve local maximization of benefits (their own) because they are in power. They use their laws (e.g. confiscation of gold by FDR; tax on purchases with gold; legal tender laws) to prevent the adoption of gold as a currency.

-- If a non-fractional reserve, commodity based currency economy would lead to higher economic growth and better stability, why hasn't a country with such a system ever outgrown the US? --

I'm not aware of a country that has allowed such a monetary system. Politicians and bankers throughout the world have been united in their opposition to such an economy for 500 years or more.

Rethinking Subsidized Finance

On Mar 04 01:01 PM Chris B wrote:

-- There is no way to prevent bystanders from being hurt by an out-of-control financial system. --

That is why I think we need a financial system that is not out of control.

-- Depositors, in a pre-FDIC world, lost their savings when banks lost money. In a post-FDIC world, taxpayers lose money to make them whole and prevent bank runs. --

FDIC is necessary only because of fractional-reserve lending. If you remove that fradulent practice, there is no need for deposit insurance because depositors are already protected from all but fraud or theft.

-- Companies lose access to loans when the financial system collapses. --

This is yet another problem that results from a credit system that can expand and contract (i.e. an elastic money supply). All resulting from fractional-reserve lending.

The constitutional and Austrian solution: end fractional-reserve lending and fiat money. Most all of the problems you cite go away as booms and busts are all but eliminated. Your thoughts?

Rethinking Subsidized Finance

-- A lot of people are willing to risk being seen as horrible risk managers in exchange for multi-million dollar bonuses. Because the downside risks belong to outsiders as we have seen, outsiders have the right to impose rules on the financial industry. --

Or perhaps the downside risks shouldn't belong to outsiders in the first place -- only the investors. This is why I call for an end to all public subsidies of the banking system; the public's money would not be put at risk and we wouldn't need yet another layer of regulation. I would argue that most of the laws in this country have been written to regulate all of the co-mingling of public and private interests, subsidies, restraints on trade, tariffs, etc.

Rethinking Subsidized Finance

As always Steve, a great article, and I agree we need to try something new in banking, but I don't understand this one statement: "We want investment decisions to be driven by economic value rather than political diktat, but at the same time capital formation has positive spillovers so we'd like it to be publicly subsidized."

I would think that pursuing purely economic values would dictate capital formation free of public subsidy. What are these positive spillovers? We don't want more or less capital formation than that amount which is sustainable, based on our true desire and capacity to save out of income. If you subsidize capital formation, don't you trick investors into thinking there is an availability of capital which can't be sustained?

In fact, because of credit created via fractional-reserve lending, isn't it true that much of the supposed "capital" doesn't even exist, thus causing many of the painful swings that you mention? Could not these be the true causes of the "low frequency, high amplitude breakdowns?"

I appreciate your thoughts.

Visceral Loathing for AIG's Failures

I share the author's sentiments, but I think they could have been expressed without resorting to vulgarity.

The Economy, And Why It's Taking So Long to Fix It

--There have been half a dozen government programs to stem foreclosures and help stabilize the housing market. But too much help would falsely subsidize prices once again, and prolong the problem.--

So a little help only prolongs the problem a little?

--For the most part, bubbles need to work themselves out.--

For the most part? You mean we should try to keep them a little inflated?

I'm struggling to follow this line of thinking.

Too Big to Bail: Lehman Brothers Is the Model for Fixing the Zombie Banks

"Thus, its not worth the risk to dismantle these banks. If Lewis and Pandit are able to keep their businesses going with a few injections here and there, that is by far the better option."

Who is providing the injections? The bondholders or the taxpayers? Yeah, I thought so. To borrow from the Iron Lady, the problem with bailouts is that you eventually run out of other people's money.

Can the Public-Private Plan Work?

Excellent summary of the fundamental issue, which doesn't change no matter how creative one gets with the "partnership" options: the pricing of these securities is a zero-sum game. The banks' gain is the taxpayers' loss.