History

Who Owns the Fed?

Warren Gibson Economics, History, Liberty , , ,

Have you heard? The Federal Reserve System raked in profits of $79.3 billion last year, almost triple what runner-up ExxonMobil made. The Fed’s business model is a snap—just print money—and unlike poor beleaguered Exxon, the Fed has no competition to worry about. This means a gigantic windfall for the big banks because, although they don’t like to admit it, they actually own the Fed.

Or not. These are all half-truths and distortions, all too easy to find on the Internet. Bloggers like to begin with the discovery that commercial banks hold shares of Fed stock and those shares pay an annual dividend. A further discovery that the Fed makes big profits is all it takes to send some of them off on a conspiracy tangent. Because shareholders in a profit-seeking corporation are its owners, so it must be with the Fed, they think. Profiteering, world-government schemes, and who knows what else, must surely follow. As I will show, these half-baked ideas are distractions from the serious issues that surround the Federal Reserve System.

Yes, commercial banks hold shares of stock in their local Federal Reserve branch, but these shares do not confer ownership in any meaningful sense. Ownership is defined as the legal and moral right to use and dispose of some asset. Ownership can be conditional or temporary, as when you lease an apartment and acquire the right to occupy it for a limited time, but not to run a business in it or do major renovations. Your purchase of shares of stock in a public corporation gives you rights to vote in shareholder elections, receive any dividends declared, and sell your shares—but that’s about all. You may not walk into the corporate offices and start giving orders; on the other hand, you may not be held liable for any misdeeds of corporate officers or employees. If you acquire shares in a nonpublic company like Facebook, you accept additional restrictions on when and to whom you may sell your shares.

Member banks receive a fixed 6 percent annual dividend on their Fed stock and enjoy limited voting rights. But there the resemblance to ordinary shares ends. The banks are obliged to acquire shares when they become members of the Fed, and they may not sell their shares or pledge them as collateral. An initial issue of stock was seen as a good way to capitalize the Fed when it began, but there has been no need for additional capital and those shares are no longer significant.

Each branch has a board of directors with six members elected by local member banks and three appointed by the central board of governors. However, board members are not all bankers. Moreover, under a rule recently enacted by Congress, only nonbankers may serve on committees that select Fed bank presidents. This new rule is one way in which the ground has been shifting under the Fed recently; more about this below.

In the beginning the Fed was quite decentralized. A dollar bill in my wallet is imprinted “Federal Reserve Bank of San Francisco,” a remnant of the formerly dispersed power. The headquarters operation was initially a modest one, operating out of an office in the Treasury Department, but it now has its own imposing building, greatly expanded powers, and a correspondingly larger staff. With so much power now centralized, the branches engage mainly in monitoring local conditions and passing recommendations up to the board of governors. They have also become known for differing interests and points of view. The St. Louis Fed, for example, has an excellent collection of data available to the public. The Cleveland Fed is known for innovative research.

The Fed is a nonprofit institution, but that designation means only that profits are not its primary mission. The Red Cross is also a nonprofit, and like the Fed, it does earn a profit during any year in which gross income exceeds expenses. From an accounting point of view, such profits are essentially the same as those earned by firms in competitive markets, but not from an economic point of view. Competitive profits serve the vital function of directing scarce capital resources to the most urgent unmet demands of consumers. The Fed’s profits serve no such function.

Its income consists primarily of interest earned on its securities portfolio. Until recently the portfolio was made up almost entirely of Treasury securities. It has expanded greatly since 2008 to include mortgage-backed securities, loans to such pillars of the financial system as Harley-Davidson, and other assets including direct real-estate holdings. It incurs operating expenses of the usual sort: salaries, buildings, supplies, and more.

Remember that $79.3 billion profit? The 2010 figure, far higher than the $47.4 billion recorded for 2009, did not benefit the Fed’s managers or member bank shareholders because the money was remitted to the Treasury. That’s the law. It happens every year. If any private firm earned that much in a year it would be headline news and a boon to stockholders. For the Fed this is just an interesting statistic.

Who Calls the Tune?

The answer to the question “Who owns the Fed?” is that it’s the wrong question. Instead, we should ask: Who calls the Fed’s tune? That’s not such an easy question, yet it’s the only way to reach an understanding of why the Fed acts as it does and why it has done so much economic damage.

First and foremost, the Fed was created by Congress and can be modified or abolished by Congress. Clearly Congress is the Fed’s most important constituent.

The U.S. president also holds substantial sway over the Fed. He appoints the seven-member board of governors subject to Senate confirmation. The powerful Open Market Committee, which makes monetary policy decisions, consists of those seven plus the president of the New York Fed and four seats that are rotated among the 11 regional presidents.

But even though it exercises ultimate control, Congress has given the Fed a degree of independence that no other federal agency enjoys. Although its profits are swept back to the Treasury, the Fed enjoys a sweet deal that is unavailable to ordinary Federal agencies, which must plead with Congress for an annual appropriation. The Fed spends whatever it wants on operations, constrained only by the necessity to keep up appearances—not to look like fat-cat bankers. Its profit is whatever remains after all expenses have been paid, and, in contrast to ordinary corporate accounting, after dividends have been paid.

The Fed’s vaunted independence is a good thing, the thinking goes, because we don’t want the stewards of our money to be caught up in the swirl of day-to-day politics. But independence trades off against accountability. After all, in a democracy the bureaucracies are supposed to be accountable to Congress. The purse strings are the primary means of accountability among the other agencies, but there are no such strings tying Congress to the Fed.

Such control as commercial banks exert is not so much a function of their nominal stockholdings as it is of their connections through the network of good ol’ boys that weaves through government and “private” financial institutions. The Fed surely looks out for the interests of major private institutions, especially big banks, insurance companies, and securities firms. It does not want big-bank failures or a stock-market crash. It must be cognizant of foreigners who hold $3 trillion in U.S. Treasury debt and are keenly aware of the Fed’s actions and pronouncements.

These incentives have little to do with the Fed’s official dual mandate: stable prices and high employment. That mandate was established by the Employment Act of 1946 and the Humphrey-Hawkins act of 1978. These were times when no one questioned the Keynesian idea that inflation and unemployment always trade off against each other (the Phillips curve) and that monetary and fiscal policy must steer a course between two extremes. If the proponents of the mandate could see the relatively stable prices of recent years coupled with high unemployment, they would call for major Fed “easing.” If they then found out how much easing we have already had and the consequent monstrous increases in debt, they would surely be speechless.

Swift Changes

Some congressmen are calling for reassessing the dual mandate. This is just one way in which things are changing fast for the Fed. This once-staid institution is under increasing attack and is finding it necessary to defend itself, as when Chairman Ben Bernanke came out of his cloister to appear on 60 Minutes, a decision he may regret given the reaction to his astonishing claim that further “quantitative easing” will not increase the money supply.

New rooms are being added to the Fed mansion even as the sand shifts under it. Congress has given it extensive new powers unrelated to monetary policy, most notably a new consumer protection agency. The idea is that the Fed’s independence will ward off regulatory capture, something that always seems to happen to ordinary regulatory agencies. We shall see.

Rep. Ron Paul is the Fed’s most prominent critic. Last year his bill to require an audit of the Fed garnered a great many cosigners in the House. He reintroduced it at the start of the 2011 session, this time with his son Rand Paul on hand in the Senate to file the same bill there.

But in some ways the Fed is already quite transparent. Its website has extensive reports, updated regularly and more detailed than any releases from commercial banks or private corporations. And while deliberations of the powerful Open Market Committee are secret, detailed minutes are now made available shortly after each meeting.

In other ways it is quite secretive. For example, the Fed refused to disclose the names of banks that got loans during April and May 2008, denying Freedom of Information Act (FOIA) requests filed by Bloomberg and Fox News. Responding to lawsuits, the Fed did not claim it was a private institution and therefore exempt. Instead it cited potential harm to the banks that had borrowed, but the court sensibly ruled against a “test that permits an agency to deny disclosure because the agency thinks it best to do so. . . .” The information was released.

“End the Fed” has become a rallying cry for Ron Paul and his supporters. His little book by that name will not earn any academic awards, but as a mass-market polemic it does a good job of making his case without conspiracy theories or private-ownership sideshows. There is, however, room for honest debate about fractional-reserve banking, which he opposes.

About the Fed, though, Ron Paul is right. Whatever good intentions its managers may have, the Fed, like all central banks, exists ultimately as an enabler of ever bigger government. My colleague Jeffrey Rogers Hummel may be right when he says the Fed is becoming the central planner of the U.S. economy. But when we argue for replacing the Fed with market institutions, we must take the time and effort to get our facts straight and to expose the complex network of special interests that supports the Fed. Wrongheaded and simplistic arguments only hinder the cause.

[Editor’s note: this essay first appeared in the Freeman on April 21 2011] 

The Beltway Consensus: Iraq Edition

Brandon Christensen Current Events, History , , , , , ,

The illegal invasion and occupation of Iraq undertaken by the Bush administration is one of the American republic’s darkest moments. I rank it as the fourth-worst policy in our history, just after slavery, the extermination of the Indians, and the invasion and occupation of the Philippines and just before Jim Crow and the New Deal. Invading and occupying Iraq rejected the American notions of liberty and justice, individualism, republican government, and free trade. It also further damaged American credibility in the eyes of the world.

For the most part, populations have been okay with Washington’s antics since the end of World War 2. There are certain expectations that everybody has of a world hegemon, and the Cold War atrocities that Washington committed were largely understandable. But attacking a third world despot in the middle of the Islamic world – for no apparent reason except to “bring democracy” to the region – not only undermined the US’s claim to be defender of the peace, but it exposed the extent of the republic’s intellectual decay that has been going since the New Deal. Not only does nobody believe our claims when we attack a helpless state, but they don’t think we have the intellectual capacity to do the job, either.

My own perspective on the crimes against humanity that Bush and his cronies committed are much more superficial, of course (I live in LA, after all!): we have basically copied the British imperial model. Not only are my taxes being spent on killing innocent people abroad, but Washington is not even doing it creatively! The following article in Foreign Affairs illustrates my point perfectly. Continue reading →

Adamson’s Book Signing

Brandon Christensen Books, Current Events, History

Dr. Adamson’s new book just came out two weeks ago, and he has passed along a couple of photos from his book signing event. More below the fold. Continue reading →

What’s Up with Inflation?

Warren Gibson Current Events, Economics, History, Liberty

Inflation as measured by the Consumer Price Index (CPI) has been almost nonexistent for several years, though it started creeping higher in the first half of 2011. Yet many prices have been rising at double-digit percentage rates. Are official figures trustworthy? And what of expectations? There is a great deal of buzz right now about inflation but also talk of renewed stagnation with the Fed’s QE2 program having ended in June. Could renewed stagnation trigger enough deflation to counter inflation? Or might we get the worst of both worlds—stagflation—as in the 1970s?

We can’t get anywhere with these questions until we agree on the meaning of inflation. At one time the word referred to an increase in the money supply. Over time it came to mean a general increase in prices, an unfortunate turn of events not just because we lost the nice metaphor of an inflating balloon, but also because the shift in meaning tended to obscure the relationship between the two phenomena. Some free-market authors hold out for the old definition, but I suggest this is wasted effort. In my classes I use the phrases “price inflation” and “money inflation” to keep the distinction alive without getting too sidetracked by semantics.

In 1970 Milton Friedman said, “[Price] inflation is always and everywhere a monetary phenomenon.” This is not entirely true but understandable because he was writing at a time when the causal relationship had nearly been forgotten. We can have price inflation without money inflation when there is a supply shock. An overthrow of the Saudi government, for example, might well disrupt the flow of oil from that country. A surging oil price, because it is so important to our economy, would likely pull up the price level with it. In this situation the monetary authorities can help things by doing exactly nothing—letting higher energy prices do the work of encouraging marginal users to cut back. Supply shocks, as such one-time events are called, do not of themselves generate sustained price increases and are therefore not classified as inflation by some economists. Continue reading →

Inside Insider Trading

Warren Gibson Economics, History, Liberty

Insider trading is something we hear a lot about these days. To most people, the practice smells of foul play, and federal law restricts it. But the inside story of insider trading is something very different, as we shall see. The alleged ill effects on shareholders in particular and on the economy in general are mostly illusory, and in fact insider trading produces benefits that are little understood.

If I may first indulge in a little personal history: I was once a corporate insider. Two friends and I started an engineering services firm in 1982, and we set it up as a corporation. The paperwork required to register the corporation was minimal, but the law allowed us to offer shares only to specially qualified individuals, in addition to ourselves and our employees. Actually this rule wasn’t binding on us. We didn’t want to be answerable to strangers so the only “outsiders” we sold to were a couple of relatives, whom we later bought out.

Most Silicon Valley firms like ours aim to “go public” at some point—that is, sell shares to the general public to raise additional capital and reward early investors. We had no such ambition. We did not want to jump through all the hoops required in an initial public offering, nor did we want the continuing hassle of running a public corporation. (Since that time hassles have been multiplied by Sarbanes-Oxley.) However, we might have benefited from something short of a full public offering, where we would have offered shares to a wider but still limited set of shareholders.

Yet SEC rules allow only a very restricted offering or a full public offering, and nothing in between.

What if we had gone public? The law would have restricted our ability to trade our own shares for reasons roughly as follows: Insider trading would violate our fiduciary responsibility to our shareholders. As managers of a public corporation we would have placed ourselves under a board of directors answerable to shareholders. Our job would be to watch out for shareholder interests, not subordinate them to our own private gain.

There is some truth in these arguments. Shareholders can never be totally sure that management is looking out for their interests. Corporate regulations and employment contracts can do a lot to minimize these “agency problems,” as they are called, but perfection is not possible. Purchasers of shares should be aware of the risks they take and act accordingly. But none of this justifies insider-trading restrictions. Continue reading →

Environmentalism and Property Rights

Brandon Christensen Current Events, History , , , ,

The horrible air in Beijing has been making the news again, and for good reason. Check out these pictures for reasons why. The topic of environmentalism and its compatibility with liberty has been brought up before here at the consortium, but I’d like to briefly use this opportunity to point out something on property rights.

Conservatives and, lamentably, some libertarians often attribute environmental destruction to “the tragedy of the commons,” but this is short-sighted. Anthropologists have long pointed out that land and property held in common is actually governed quite well. Political scientists and economists have recently begun to come around to this point as well, with Elinor Ostrom (a political scientist by training) winning the 2009 Nobel Prize in Economics for her work on how some societies govern the commons.

Common land and its use often requires an informal set of rules for maintaining a harmonious balance between man and land, and is also a characteristic feature of societies that we would variously label, rightly or wrongly, as stateless, pastoral, foraging, tribal, or my personal favorite: undeveloped. In other words, common land is often exploited by poor people who do not have the resources to institute a regime based largely on private property. With this in mind, just think: would you want to be the party that is found guilty for violating an agreed-upon set of rules for a specific area of land? Even if there were no formal state apparatus charged with enforcing a society’s rules? Not only would you have to face justice, but you’d also be held responsible for the possible suffering of many other people depending on the land, which could lead to other forms of punishment besides fines or violence; punishments that could affect the lives of your loved ones and your loved ones’ loved ones. Continue reading →

Don’t Forget

Brandon Christensen Books, Current Events, History

Michael Adamson’s new book, A Better Way to Build…, comes out on the 15th of this month. You can check out more of Dr. Adamson’s (bad ass) work in the ‘recommendations‘ section of the blog. He’s got stuff on Native American property rights (or lack thereof), US foreign policy, and the decline of Argentina just hanging out online waiting for curious minds to read and process.

Dr. Adamson is a historian by trade, and we’re lucky to have him on board here at the consortium. Also, check out his demolishing of the rationales used by the Bush administration to go to war in Iraq (the second time around).

The Holy Roman Empire was…

Brandon Christensen History, Law, Liberty , , , ,

…_______________ (fill in the blank!).

I’ve been meaning to link to a fascinating article in the Economist on the parallels between the Holy Roman Empire and the European Union, but travels, getting ready for school, and other stuff has gotten in the way.

Among the gems:

The empire faced the same problem as today’s EU, only worse. The EU currently has 27 member states. During its final 150 years, the empire had more than 300 territories (the number varied). Should each member get one vote? If so, any hillbilly could block progress. Or should votes be weighted by territory? If so, big princes could bully little ones. Should decisions be taken by simple majority, qualified majority or unanimity? The empire answered these questions as the EU does: with a characteristically decisive it-all-depends.

Do read the whole thing.

My only critique of the article is that it misses a huge piece of the puzzle: the presence of the US military, as a conquering power, on the continent. As long as Uncle Sam is around, Europeans don’t have to worry about descending into yet another war. None of them will ever admit this, though. Europeans would rather spend their time ignoring this point while simultaneously assaulting the very political and economic system that enables the US to provide for Europe’s security.

I’ve written about this before, but due to the inevitable fiscal constraints of empire I think American military policy towards Europe needs to go one of two ways: 1) either withdraw our troops completely or 2) start implementing trade policies that would make living, working, and traveling between the US and Europe much, much easier. Like moving to Louisiana from Languedoc should be as easy as moving from California to Connecticut.

Taking the second route would pay for itself and much, much more. Unfortunately, there are too many isolationists and too many reactionaries (mostly on the Left) on both sides of the pond that would oppose such a policy no matter how much it would benefit themselves and everybody around them. The second route might be the one we need to take. Both, as I mentioned, are going to have to be necessary if the US is going to get its fiscal house in order.

Federal Deposit Insurance: A Banking System Built on Sand

Warren Gibson Economics, History, Law, Liberty ,

Federal deposit insurance grew out of a turbulent time in American history: the Great Depression. During two waves of bank failures in the 1930s an astonishing 9,000 banks closed and millions of depositors lost some or all of their savings. The Federal Deposit Insurance Corporation (FDIC) began operations in 1934, insuring deposit accounts up to $5,000 per person (roughly $80,000 in today’s money).

The bank failure rate then dropped dramatically and never again rose anywhere close to the level of the 1930s. And such bank failures that have occurred have cost insured depositors nothing; many uninsured depositors were made whole as well. Bank runs are a distant memory, revived occasionally by reruns of It’s a Wonderful Life.

Yet it may be premature to pronounce deposit insurance a success. It can take a long time for an unsustainable program to unravel: Witness Social Security and Medicare. Seventy-five years after the start of Social Security and 45 years into Medicare, it’s common knowledge that both programs are headed for a financial cliff. A closer look at deposit insurance will show cracks in its edifice, raising questions about its sustainability as well as the distortions that it has introduced into the economy.

Before we take that closer look we might ask whether, as is widely assumed, the bank failures of the 1930s were an example of unregulated free markets run amok. During that time, as Milton Friedman and Anna Schwarz pointed out in their classic, A Monetary History of the U.S., the number of bank failures in Canada was exactly zero. Canada is closely linked to the United States economically and culturally, making this episode as near to a controlled experiment as any macroeconomist could wish for.

The difference? Canada had just ten nationwide banks with about 3,000 branches, while branch banking across state lines, and often within states, was prohibited by U.S. law. Thus smaller communities could only be served by relatively weak, poorly capitalized banks. A hailstorm might be enough to topple the local bank in a small farming community as surely as if it were built from straw.

The banking system was also caught in the downdraft of a plummeting money supply. When banks hold only a fraction of their liabilities as reserves, deposit inflows cause the money supply to multiply, but the reverse happened during the Depression as worried depositors began to cash out their accounts. The economy could have adjusted to a declining money supply in one of two ways: either by lowering prices and wages or by Federal Reserve injection of new money. Hoover’s jawboning and Roosevelt’s New Deal legislation precluded the first solution, while the Fed, out of ignorance or confusion, failed to inject new money. With economic adjustment prevented by government policies, a vicious cycle of souring bank loans, liquidation of deposits, further declines in the money supply, and more business failures took hold.

Interestingly, Milton Friedman and Murray Rothbard, both free-market economists, reached opposite conclusions about the declining money supply. While Friedman blamed the Fed, Rothbard celebrated what he saw as the people’s attempt to overturn fractional-reserve banking, which he believed is inherently fraudulent. Either way, the fingerprints of government were all over the bank failures of the 1930s and the Great Depression generally.

With the failure of so many banks, U.S. Representative Henry Steagall vigorously pushed deposit insurance legislation. Franklin Roosevelt was among his opponents. Indeed, when asked about guaranteeing bank deposits four days after his inauguration in March 1933, Roosevelt said he agreed with Herbert Hoover:

“I can tell you as to guaranteeing bank deposits my own views, and I think those of the old Administration. The general underlying thought behind the use of the word ‘guarantee’ with respect to bank deposits is that you guarantee bad banks as well as good banks. The minute the Government starts to do that the Government runs into a probable loss. . . . We do not wish to make the United States Government liable for the mistakes and errors of individual banks, and put a premium on unsound banking in the future.”

FDR was right. Deposit insurance generates moral hazard: an incentive to engage in more reckless behavior when one’s misdeeds are covered by someone else. Bank managers tend to make riskier loans than they would without insurance, and depositors don’t worry about the lending practices of the banks they patronize. Currently many people, including me, buy bank certificates of deposit through online brokers, perhaps not even learning the name of the bank that got our money. The magic letters FDIC are all we look for.

Savings & Loan and Moral Hazard

The savings and loan crisis of the late 1980s saw a catastrophic explosion of moral hazard. Deregulation had lifted interest rate caps for S&Ls and allowed them to expand from residential mortgages into commercial and consumer lending. Competitive pressures sent managers scrambling into these markets, which were mostly unfamiliar to them, while at the same time they had to compete vigorously for deposits. With deposit insurance offered to all chartered institutions regardless of risk, S&Ls made many preposterous loans. When the dust settled, roughly half had failed. A massive taxpayer bailout followed and, as very rarely happens to failing government agencies, the Federal Savings and Loan Insurance Corporation was abolished in 1989—though its responsibilities were shifted to the FDIC.

Moral hazard is an aspect of all insurance, public or private. But private insurance companies, if they wish to survive and prosper, must find ways to limit policyholders’ risky behavior. Deductibles, copays, threats of cancellation, and rewards for prudent behavior return some monetary incentive to policyholders. In addition, insurance companies try to educate policyholders about prudent behavior. Crucially, in a free market private insurance companies’ profit-and-loss statements tell whether they’re getting it right. Government agencies lack profit-and-loss discipline and are inevitably subject to political pressure. The FDIC’s legally mandated requirement to hold reserves to back its liabilities may resemble market discipline, but as we shall see, when the mandate was violated, no one lost his job and no investors lost any capital.

Private insurance companies invest most of their reserves in productive activities such as corporate securities or real estate. They count on earnings from these investments to balance low or even negative returns on their pure underwriting activities. The FDIC, by law, holds its reserves in the form of Treasury securities. Any alternative would certainly be riskier and more politically charged. Yet we must recognize that this arrangement, as with the Social Security Trust Fund, is merely a pass-through of the FDIC’s liabilities to U.S. taxpayers.

The FDIC reserve fund is called the Deposit Insurance Fund (DIF). For most of its history, the DIF was kept within its statutory limit, which has varied over time but is currently a range of 1.15 to 1.25 percent of insured deposits. At least, that’s the statutory range. It’s actually essentially zero. But are the statutory numbers the right ones? No one can be sure, but again, the FDIC lacks a profit motive to help get it right.

A spate of bank failures in 2008 and 2009, while far less severe in number and magnitude than in the 1930s, left the DIF with no unencumbered assets at all. The pace of bank failures continued during the first three months of 2010, while the number of problem banks on the FDIC’s secret list jumped 27 percent in the fourth quarter of 2009, to 702. In short, the FDIC is in trouble.

A restoration plan has been proposed to get the DIF back to 1.15 percent of insured deposits by about 2017, a date that has been pushed back more than once. The plan relies heavily on an assumption that the economy will soon resume robust growth and that “only” about $100 billion in failure costs will be incurred between 2009 and 2013, with most of those costs coming in 2010. For the shorter term, the proposal calls on commercial banks to prepay their deposit insurance premiums through 2011. When they do so, a new asset will appear on their balance sheets: a prepaid expense. To gain their acceptance and cooperation, the FDIC proposes that this prepaid expense be counted as an asset that is just as safe as U.S. government securities and therefore does not require additional capital backing. This shuffle will be pretty much a wash for the commercial banks, and the upshot is that the FDIC will indirectly borrow its own future premium income, hoping that income will materialize in amounts sufficient not only to cover future bank failures but also to rebuild the DIF. We shall see.

The DIF is not the FDIC’s only problem. When closing a failed bank, the agency tries to sell as many of the bank’s assets as possible, including branches, loans, and securities holdings. The FDIC’s goal is usually to make all depositors whole, not just insured depositors. It sometimes takes possession of assets for which it can’t get an acceptable bid. In doing so it acquires assets that are difficult to evaluate and thus greatly complicate estimates of future liabilities.

Disguised Risk

Now let’s take a longer look at the business of banking. The very words we use, like “bank” and “deposit,” can distort our thinking. The word “bank” comes from the bench or counter where medieval money changers did business. The word “deposit” suggests something like an ore deposit in the ground: the minerals are there and can be gotten out. We think of banks as custodians of our money, keeping it safe for us and making it available whenever we need it. But present-day banks are not deposit banks, locking our money away in a vault as the term would suggest, but rather loan banks. Most of our deposits are loaned out and not all of them could be redeemed on short notice. This works fine as long as there is no large and sudden short-term demand for withdrawals. But we have come to believe, in part due to misleading terminology, that we can have rewards without risk. Interest paid on bank deposits is now essentially zero but as depositors, we still reap benefits such as ATMs and online banking with no fee and no apparent risk. In short, as in so many areas of contemporary life, we have been led to expect something for nothing.

Thus proper labeling could help rationalize banking. Those who want utmost safety in the form of true deposit banking should be free to pay for it with fees for storage of their currency or gold. Liability insurance for true custodial service should be very cheap. Those who wish to entrust their money to loan banking should accept the risk, and if they want insured accounts, they—not taxpayers—should be prepared to pay for the insurance, at least indirectly.

While there is nothing inherently wrong with loan banking, we get too much of it when it is disguised as deposit banking and backed by mispriced and politically motivated government insurance. The result is a banking system that is more highly leveraged than it otherwise would be. This in turn increases the severity of business cycles—booms and busts.

FDIC Incentives

Back to the FDIC. As we have seen, banks pay for its service in the form of insurance premiums. Coverage is not mandatory, so the organization looks somewhat like a private business. But in fact it is a monopoly supplier to banks (with a parallel institution serving credit unions). Private competitors are locked out, perhaps not by statute, but by the FDIC’s implicit and explicit backing by the Treasury (explicit in the form of a line of credit). Without a profit motive, the FDIC lacks the incentive to serve its bank customers and its indirect depositor customers by offering innovative services with effective moral-hazard controls.

Though the FDIC lacks market incentives, it is awash in political incentives. Thus in 2008 Congress voted for an increase in deposit coverage from $100,000 to $250,000 with little or no discussion of the costs of this move. This “temporary” increase has been extended once and will likely become permanent. Members of Congress are of course motivated by the campaign contributions of bankers and others, and may not know or care about the long-term consequences of such actions.

Private Options

How might private firms handle bank deposit insurance? Before the government takeover of the banking system, private clearinghouses sometimes provided mutual aid among member banks. The Suffolk Bank in Boston was a notable example in the early 1800s. It supported country banks in New England for many years by clearing their transactions and accepting their currency at par. It earned a profit doing so.

But could private firms ever be big enough to provide bank deposit insurance in today’s multitrillion dollar economy? Reinsurance firms offer evidence that they could. As their name indicates, General Re and other such firms insure insurance companies. Who insures the reinsurance companies? No one. Absent government intervention, these firms would experience diseconomies of scale when they grow too large, provided it is clear that they would not be in line for a government bailout should they get into difficulty.

Failure is an important aspect of the free market. Economist Joseph Schumpeter’s pithy phrase “creative destruction” captures this notion and reminds us that failures, which will always be with us, should be liquidated so that others can pick up the remains and apply them to more promising enterprises. Shouldn’t this idea apply to banks as well? Rothbard actually celebrated occasional bank runs as a way of putting the fear of God into bank managers and depositors alike. Amazingly, Roosevelt’s initial response to the deposit insurance proposal echoed Rothbard’s: “There are undoubtedly some banks that are not going to pay one hundred cents on the dollar. We all know it is better to have that loss taken than to jeopardize the credit of the United States Government. . . .”

Washington-Wall Street Banking Cartel

Make no mistake, our current banking system is, and has long been, a cartel run for the mutual benefit of Wall Street financiers and their regulator friends in Washington. Case in point: Goldman Sachs and Morgan Stanley were allowed to convert to bank holding companies so that they could receive federal bailout money. The $180 billion AIG bailout provided Goldman with 100 cents on the dollar for its holdings of AIG credit default swaps.

Let us not be so naive as to believe that government deposit insurance is any different. Any benefit this system provides to small depositors is incidental to its real objective: to serve the cartel.

The banking system is in need of real reform. More regulation? More virtuous regulators? Only the naive, the ignorant, or the disingenuous can believe these answers in the face of regulation’s long history of failure, the practical impossibility of detailed oversight, and the perverse political incentives that always operate. The solution lies not in wiping out risk—there can be no real economic growth without risk. Instead, we need rational incentives: Let risks be borne by those best able and willing to take them.

[Editor’s note: this essay first appeared in the Freeman on May 20 2010]

GDP: Who Needs It?

Warren Gibson Current Events, Economics, History, Liberty

“For so it is, oh my Lord God, I measure it, but what it is that I measure I do not know.” –St. Augustine

Gross Domestic Product (GDP) gets a lot of attention these days. It’s fair game for bloggers, talking heads, perhaps your local barber.  While most agree that higher GDP is better than lower, there are problems, some better-known than others. Some theorists have considered the concept hopeless, such as Austrian economist Oskar Morgenstern, who called GNP (the predecessor to GDP) “primitive in the extreme and certainly useless.” Lamenting the idea that the whole of a nation’s economic activity could be captured in a single number, he said that “very few men, even few economists, or should I say regretfully, especially economists, have a real appreciation and understanding of the immense complexity of an economic system.”

Let’s get the formal definition out of the way. GDP is the market value of all final goods and services produced in a particular country in a given year. The federal Bureau of Economic Analysis computes this number and releases it quarterly. The level of GDP is used as a basis for evaluating other things, like the national debt, which currently stands at about 85 percent of one year’s GDP in the United States. GDP growth rates are closely followed. These are inflation-adjusted, seasonally adjusted, and annualized, and are of course supposed to tell us how well the economy is doing.

Simon Kuznets gets credit for the first serious attempt to calculate national income figures, publishing his first work on the subject in 1941. Following in his footsteps, calculation of GDP and other “national income accounts” has become a core area of the economics profession. The explosion of economic and financial news has thrust GDP into the limelight in recent years. Continue reading →

From the Comments: Militias and the Second Amendment

Brandon Christensen Current Events, History, Law , ,

Longtime reader (and blogger) Hank Moore has been on a roll lately. In response to a condescending (and fact-free) comment made by a Leftist concerning gun rights, Hank responds with this:

That is very interesting that you would bring up the militia. Were you sincere and knowledgeable on this matter you might know that THIS, the militia, more properly to keep the militia from becoming a rabble and to circumvent the need for a standing army, was the main point of the Second Amendment. Not gun ownership.

The right to own whatever you could legally acquire without causing harm to someone by way of that acquisition was (and is) already an inalienable right, protected not only by the Constitution’s very structure (negative law) but by the Ninth and in a sense Fourth and Tenth Amendments as well.

The Second Amendment threw in that much-hyped line about the right to bear arms precisely so people like you wouldn’t interpret “well-regulated militia” as anything other than what it was (FYI, it had absolutely nothing to do with “conquering the frontier”). That is, a group of local men banding together when the need arose to protect what’s theirs (including their guns). But that is exactly what you have done. Misinterpreted it. But not because the language of that particular Amendment is so unclear (although I do wonder if their is a language barrier between collectivists and people who like to mind their own business, and no I don’t refer here to that obnoxious limey Piers Morgan’s pretentious accent), but because as a whole, the document the Constitution has fallen into disuse. In the era of positive law and positive rights, why even have one?

The answer is so that you (the politician or the lobby or the activist) can appeal to people who know deep down that arbitrary power is morally reprehensible, and thus bitterly cling to some semblance of a social contract; but who still have stupid ignorant ideas (by this I mean gun-control) that they want to shove down everyone else’s throat. Oh, and our founders wouldn’t know what you meant by military style weapons. Do you mean the military-style weapons that they used to defeat the British and would have been mercilessly slaughtered without? Or do you mean today’s military-style weapons that only certain classes of benign uniformed government-employees are permitted to own under your reading of the Second Amendment?

Anybody out there care to answer Hank’s questions? Well done! Here is Hank’s blog one more time. Do check it out.

America and Firearms (Explained to Overseas Readers)

Jacques Delacroix Current Events, History, Law, Liberty, Politics , , , , , , , , , , ,

The other day, I am watching the news on TV5, the international French language network. I am doing this to get away from the spectacle of the impending economic disaster in the US where I live. This is shortly after the massacre of school children in Connecticut. One item draws my attention: The cute, airhead French female announcer (or “anchorette”) states that last year about 28,000 people in the US lost their lives to guns.

Here we go again, I think. More half-assed information that is worse than no information at all. I have witnessed European media disseminating misleading information about the US for more than forty years. This time again, I have to intervene to help overseas of observers of the international scene who want to know about reality and who might happen to read this blog.

I can’t tell you how often I have witnessed the following: European commentators making sarcastic, superior comments about some American event or custom, or some American way of doing things and then, their society adopting uncritically the same American event, or custom, or way of doing things ten years later, or even later. Right now, for example, I would bet you anything that one of the novelties on French radio is 1990s American popular music. That would be especially true on the channel that calls itself without batting an eye-lash, “France culture.”

The tendency of Europeans to copycat the United States is so pronounced that it even affects social pathologies, the last thing you should want to imitate. Accordingly, it seems that the French expression for “serial killer” is: “serial killer.” N.S. ! (Would I make this up?) Continue reading →

The Mystique of Hedge Funds

Warren Gibson Economics, History , , , , , , ,

Hedge funds are controversial these days. Though it’s unlikely that the average citizen or the average congressman could say just what hedge funds do, many are certain they must be reined in by additional regulation because they can—and do—cause widespread damage to our financial system. Almost everyone takes it for granted that regulation of some sort is the solution, ignoring the possibility that at least some of the problems are actually caused by regulation.

What is a hedge fund? The name implies hedging, a strategy that reduces risk. If you bet on several horses in a race, you are hedging your bets—spreading your risk. You can buy gold to hedge against inflation. You can sell interest-rate futures to hedge the risk that rising interest rates would pose to your bond portfolio.

The first hedge fund was created in 1949 by Alfred Jones. He believed he could pick stocks that would outperform and those that would underperform the overall market. But Jones didn’t know where the overall market was going, so he would buy his expected outperformers and sell short the expected underperformers. He thereby insulated his portfolio from general market moves, which would affect about half his holding positively and half negatively.

Most present-day hedge funds don’t do much hedging, but the name persists. Instead, they engage in a bewildering variety of trading methods, including buying on margin (using borrowed funds) and selling short (selling borrowed assets so as to profit from a price drop). They trade stocks, bonds, options, currencies, commodity futures, and sophisticated derivatives thereof. Some try to anticipate global political or economic events, while others seek opportunities in specific industries or companies. Continue reading →

Forward to the Failed Past

Fred Foldvary Current Events, History, Politics , , , , , ,

Some politicians like to use the slogan, “forward.” Sometimes it is more emphatic: forward!

But one may well ask, forward to what? Time and the current of events are always moving us forward already, so evidently the forward-seekers want to change the existing flow sideways. The slogan “forward” has often been used by those who seek greater state-imposed collectivism. As propaganda, “forward!” sounds better than “leftward!” or “towards ever greater statism!”

Several publications of socialist parties during the 1800’s were titled “Forward.” Lenin continued this tradition when he founded the Bolshevik newspaper “Vpered” (or “Vperyod”), which is “forward” in Russian. German socialists had already published the periodical “Vorwärts,” and the German national socialists continued the use of the slogan. Several communist and socialist parties still use “Forward” as the title of their publications. Continue reading →

Race and Ethnicity

Jacques Delacroix History , , , ,

My Facebook friend, VXA who is a disgruntled Afghan immigrant but quite smart some of the time asks this question: What’s the difference between race and ethnicity?

I am a sociologist by trade and I think I know the answer.

Both are vague terms. Race is a well established habit to classify people according to certain selected physical characteristics. The physical features are selected generally according to their usefulness within a given social agenda. Thus the presence or absence of  hair on the second knuckle of the index finger never is selected because it’s not useful. Skin color and hair shape often are because they allow for quick classification.  Medieval Europeans had no category “negro.” They would describe people in physical terms without assigning them to a  social category “Du Guesclin, the Marshall, was very dark of skin and hair.” It turns out that famous French historical figure was probably a man of some African blood. He would have been considered “colored” in Georgia in 1850. Same goes for Pushkin, the Russian national poet. Continue reading →