Fractional Reserves in Free Banking

by Fred Foldvary

A bank is a firm that accepts funds as deposits. The generic term “bank” includes various institutional types, such as credit unions. The bank is an intermediary between savers and borrowers. The interest paid by borrowers pays the expenses of the bank, and what remains is paid to the depositors.

There are two ways to organize a banking system. The first is with central banks, such as the Federal Reserve (the “Fed”) in the USA. The central bank issues the currency and regulates the private banks. In the USA, the Fed includes regional Federal Reserve Banks, which are the bankers’ banks. The private banks hold accounts with a Federal Reserve Bank; the funds are called “reserves.” The Fed creates money by buying bonds: it pays the seller a check, the seller deposits the check into a bank, the bank presents the check to the Federal Reserve Bank, and the Federal Reserve Bank covers the check by increasing the reserves of that bank, thus creating money out of nothing. The interest income from bonds pays the expenses of the Fed, and the remaining interest is paid back to the US Treasury.

The other method of banking is with free-market banking, or “free banking,” whereby there is no central bank; the private banks issue their own currencies and are not restricted other than by laws that prohibit fraud. The banks would usually use the same unit of account, such as the dollar or euro.

There are two ways to do banking. The first is called “one hundred percent reserves” or “full reserve” banking. In that method, the bank may not loan out the funds that are deposited. One of the challenges of banking is that with checking accounts, also called “demand deposits,” the account holders may withdraw their money at any time. In contrast, loans are typically long term, such as for mortgages or business loans or car loans. So if depositors suddenly want to withdraw much of their funds, the money will not be there. With full-reserve banking, the money is always there, but the bank get no interest payments. The depositors pay a fee to have their money stored at the bank.

The workings of a banking system also depend on the money system. The three basic types of money are 1) commodity money, where a commodity such as gold or silver is used as a general medium of exchange, 2) a fiat money system, in which the currency has no fixed convertibility to any natural commodity, and 3) an artificial-commodity system, where the unit of account is constructed in a way that limits the supply.

With commodity money, banks create money substitutes convertible to the real money at a fixed rate. For example, if gold is the real money, banks issue paper currency convertible into gold, so that, for example, a $20 paper note can be exchanged for a $20 gold coin with $20 worth of gold. All government-created money today is fiat. With fiat money, the real money is paper currency and coins, and bank deposits are money substitutes. The prime example of artificial-commodity money today is the bitcoin, an electronic currency created by computer programs.

The other method of banking is called “fractional reserve banking.” With that method, a bank holds only a small fraction of deposit funds in its reserves. Governments typically impose some minimum of required reserves. The remainder are “excess reserves,” which may be loaned out.

For example, suppose Samantha deposits $100 of currency into her account, and the required reserves are ten percent. The bank keeps $10 in reserve, and loans out the other $90 to Ralph. The loan consists of an account created by the bank. The loan therefore creates $90 in new money, since Samantha still has her $100 in the bank. With the $90 account, the bank again keeps 10%, or $9, and loans out $81. This money creation can continue until all the excess reserves are fully loaned out, in which case the original $100 deposit is multiplied into the creation of $1000.

With all reserves loaned out, if the depositors seek to withdraw their money, the bank will not have sufficient currency. A bank can deal with this liquidity problem in several ways. One is to have most of the funds in time deposits, funds that are held for a fixed period of time, unless the account holder pays a large penalty. Another method is for a bank to be able to borrow funds from other banks or from a central bank. A third way is for the bank to have contracts that state that the bank may not be able to provide withdrawals at times when it has insufficient funds.

Critics of fractional reserve banking claim that the private banks are a private monopoly cartel that inflates the money supply by making loans and obtains interest that robs the economy of money and goes to privileged bank owners.

With fiat money and central banking, there is indeed a potential for inflation, as there is no limit to money creation. The main problem with central banking is that there is no scientific way to know in advance the optimal money supply, and historically, the Fed created destructive deflation in the 1930s, high inflation in the 1970s, and the cheap credit that generated the real estate bubble and the Crash of 2008.

Some critics of central banks want the government to directly issue money. But if the Treasury or Finance department can issue money at will, political influences can induce inflation, and even hyperinflation as happened in Zimbabwe.

However, with free banking and commodity money, these problems do not arise. Banking would not be a monopoly cartel, since new banks, including credit unions can be created. The convertibility of money substitutes into real money prevents inflation, as the quantity of money substitutes is limited by the demand by the public to hold them. Competition among banks limits their profit to normal returns, as the rest of the debt service paid by borrowers goes to interest payments to depositors. Fractional-reserve free banking generates a flexible yet stable money supply. Free banking does not generate inflation, because new deposits into the banking system come from additional real money, such as from gold mining, which is costly to produce.

The failures of central planning in the economy include the failure of central banks to successfully manage the money supply and optimally manipulate interest rates. Free banking worked well where tried, such as in Scotland until 1844, when the Bank of England took over its money system. A pure free market would let the market determine both the money supply and the natural rate of interest. In Scotland, the banks formed an association to lend funds to banks that needed more liquidity. With free banking, the market’s natural rate would avoid the distortions that arise from either cheap credit or a shortage of credit.

The boom-bust cycle will only be eliminated by the prevention of the fiscal and monetary subsidies to real estate. Sustainable economic progress requires both the public collection of land rent and a free market in money and banking.

Note: this article appeared as “Fractional Reserve Banking” in the Progress Report.

From the Comments: Populism, Big Banks and the Tyranny of Ambiguity

Andrew takes time to elaborate upon his support for Senator Elizabeth Warren, a Native American law professor from Harvard who often pines for the “little guy” in public forums. I loathe populism/fascism precisely because it is short on specifics and very, very long on generalities and emotional appeal. This ambiguity is precisely why fascist/populist movements lead societies down the road to cultural, economic and political stagnation. Andrew begins his defense of populism/fascism with this:

For example, I still have more trust in Warren than in almost anyone else in Congress to hold banks accountable to the rule of law.

Banks have been following the rule of law. This is the problem libertarians have been trying to point out for hundreds of years. See Dr Gibson on bank regulations and Dr Gibson again, along with Dr Foldvaryon alternatives. This is why you see so few bankers in jail. Libertarians point to institutional barriers that are put in place by legislators at the behest of a myriad of lobbying groups. Populists/fascists decry the results of the legislation and seek a faction to blame.

If you wanted to be thought of as an open-minded, fairly intelligent individual, which framework would you present to those who you wished to impress: the institutional one that libertarians identify as the culprit for the 2008 financial crisis or the ambiguous one that the populists wield?

And populism=fascism=nationalism is a daft oversimplification. I’ll grant that there’s often overlap between the three, but it’s far from total or inevitable overlap. Populists target their own countries’ elites all the time.

Sometimes oversimplification is a good thing, especially if it helps to clarify something (see, for example, Dr Delacroix’s work on free trade and the Law of Comparative Advantage). One of the hallmarks of fascism is its anti-elitism. Fascists tend to target elites in their own countries because they are a) easy and highly visible targets, b) usually employed in professions that require a great amount of technical know-how or traditional education and c) very open to foreign cultures and as such are often perceived as being connected to elites of foreign societies.

The anti-elitism of fascists/populists is something that libertarians don’t think about enough. Anti-elitism is by its very nature anti-individualistic, anti-education and anti-cooperative. You can tell it is all of these “antis” not because of the historical results that populism/fascism has bred, but because of its ambiguous arguments. Ambiguity, of course, is a populist’s greatest weapon. There is never any substance to be found in the arguments of the populist. No details. No clarity. Only easily identifiable problems (at best) or ad hominem attacks (at worst). Senator Warren is telling in this regard. She is known for her very public attacks on banks and the rich, but when pressed for details she never elaborates. And why should she? To do so would expose her public attacks to argument. It would create a spectacle out of the sacred. For example, Andrew writes:

Still, I’d rather have people like Warren establish a fuzzy and imperfect starting point for reform than let courtiers to the wealthy and affluent dictate policy because there’s no remotely viable counterpoint to their stances […] These doctrinaire free-market orthodoxies are where the libertarian movement loses me. There are just too many untrustworthy characters attached to that ship for me to jump on board.

Ambiguity is a better alternative than plainly stated and publicly published goals simply because there are “untrustworthy characters” associated with the latter? Why not seek plainly stated and publicly published alternatives rather than “fuzzy and imperfect starting points for reform”?

Andrew quotes a man in the street that happens to be made entirely of straw:

“Social Security has gone into the red, but instead of increasing the contribution ceiling and thoughtfully trimming benefits, let’s privatize the whole thing and encourage people to invest in my company’s private retirement accounts.”

Does the libertarian really argue that phasing out a government program implemented in the 1930s is good because it would force people to invest in his company’s private retirement accounts? I’ve never heard of such an example, but I may just be reading all the wrong stuff. Andrew could prove me wrong with a lead or two. There is more:

This ilk of concern trolls (think Megan McArdle: somewhat different emphasis, same general worldview) is one that I find thoroughly disgusting and untrustworthy and that I want absolutely no part in engaging in civil debate. Their positions are just too corrupt and outlandish to dignify with direct responses; I consider it better to marginalize them and instead engage adversaries who aren’t pushing the Overton Window to extremes that I consider bizarre and self-serving. They’re often operating from premises that a supermajority of Americans would find absurd or unconscionable, so I see no point to inviting shills and nutters into a debate […].

Megan McArdle is so “disgusting and untrustworthy” that her arguments are not even worth discussing? Her name is worth bringing up, of course, but her arguments are not? Ambiguity is the weapon of the majority’s tyranny, and our readers deserve better. They are not idiots (our readership is still too small!), and I think they deserve an explanation for why McArdle is not worthy of their time (aside from being a shill for the rich, of course).

I think populism/fascism is often attractive to dissatisfied and otherwise intelligent individuals largely because its ambiguous nature seems to provide people with answers to tough questions that they cannot (or will not) answer themselves. Elizabeth Warren’s own tough questions, on the Senate Banking Committee, revolve around pestering banks for supposedly (supposedly) laundering money to drug lords and terrorists:

“What does it take, how many billions of dollars do you have to launder from drug lords and how many economic sanctions do you have to violate before someone will consider shutting down a financial institution?” Warren asked at a Banking Committee hearing on money laundering.

Notice how the populist/fascist simply takes the laws in place for granted (so long as they serve her desires)? The libertarian would ask not if the banks were doing something illegally, but why there are laws in place that prohibit individuals and organizations from making monetary transactions in the first place.

Senator Warren’s assumptions highlight well the difference between the ideologies of populism/fascism and libertarianism: One ideology thinks bludgeoning unpopular factions is perfectly acceptable. The other would defend an unpopular faction as if it were its own; indeed, as if its own freedom were tied up to the freedom of the faction under attack.

Around the Web

  1. A university in Malaysia has awarded an economics doctorate to North Korea’s communist dictator
  2. Ian Bremmer asks, in the pages of the National Interest, if China is in the middle of a big bubble
  3. The Diffusion of Responsibility: a short piece on government employees, the rest of us, and some implications of the drug war
  4. How laissez-faire made Sweden rich by Johan Norberg
  5. Why do banks keep going bankrupt? Kirby Cundiff answers this question in the pages of the Freeman
  6. Mud People and Super Farmers: Creatively adapting to the lack of land rights in Africa

Cognitive Blocks and Libertarianism

Last year Brian Gothberg, who was lecturing at a summer seminar I attended in 2009, left the following comment in response to a post about media coverage and Austrian economics:

I think there’s a perceptual or cognitive block, that simply makes it hard for many people to see government activity in the foreground of the story, as an actor which actively and (often) arbitrarily changes outcomes. It reminds of the recent Brian Greene programs on cosmology on PBS. In one, he compares the treatment of space, through most of scientific history, as simply being the unadorned theater stage, upon which the truly interesting things actually happen. It’s only later that Einstein (using Riemann’s math) described space as having positive, unambiguous characteristics. After Einstein brought space itself into the foreground, you could make statements about particular things that space did do, and other particular things that space did not do.

Another example: at a gathering of friends with children, my wife and I were observing a small boy (3-ish) who kept biting the other children. When it came to tears, parents would come in and intervene, and scold him. Later, we watched the same parents — who were baffled at the boy’s biting — laugh and giggle as the father playfully bit his son. Apparently, nobody had ever brought the father’s behavior into the foreground, for their scrutiny, as a possible influence on the son’s problem. Sometimes, the obvious does stare people in the face. I think that the way we describe the role and actions of government, in the press and schools, goes a long way to explain this cognitive block. Libertarianism is nothing like common sense; not nearly.

I was reminded of this as I read the following 2008 piece by Roger Lowenstein in the New York Times, where he documents the regulatory regime that was built by the state in the years leading up to the Great Recession. Check this out: Continue reading

Cyprus, the EU and Competing Currencies

There have been many critiques over the European Union from many different quarters over the decades since its inception. With the seizure of cash from customers of banks in Cyprus, the worst threat imaginable has now come to pass for Euroskeptics. Economist Frederic Sautet explains how the heist has so far gone down:

Some depositors at Cyprus’ largest bank may lose a lot of money (e.g. see article in FT). Those with deposits above €100,000 could lose 37.5 percent in tax (cash converted into bank shares), and on top of that another 22.5 percent to replenish the bank’s reserves (a “special fund”). Basically “big depositors” are “asked” to pay for (at least part of) Cyprus’ bailout (the rest will be paid by other taxpayers in the EU).

I cannot think of a faster way to completely destroy a banking system than to expropriate its depositors. This is the kind of policies one would expect from a banana republic, not from a political system that rests on the rule of law. But this is the point: the EU does not respect the principles upon which a free society is based.

An economist over at ThinkMarkets also has a good piece on the Cyprus heist. The EU has taken an incredibly good arrangement – free trade throughout Europe – and turned it into an attempt to unify Europe into a single behemoth of a state. And all under the auspices of “federalism.” This is a bad development for a number of reasons. Continue reading

Free Banking Beats Central Banking

In “More Bits on Whether We Need a Fed,” a November 21 MarginalRevolution blogpost, George Mason University economics professor Tyler Cowen questions “why free banking would offer an advantage over post WWII central banking (combined with FDIC and paper money).”  He adds, “That’s long been the weak spot of the anti-Fed case.”

Free banking is better than central banking because only in a free market can the optimal prices and quantities of goods be determined.  Those goods include the money supply, and prices include the rate of interest.

There is no scientific way to know in advance the right price of goods.  With ever-changing population, technology, and preferences, markets are turbulent, and there is no way to accurately predict fluctuating human desires and costs.

The quantity of money in the economy is no different from other goods.  The optimal amount can only be discovered by the dynamics of supply and demand in a market.  The impact of money on prices depends not just on the amount of money, but also on its velocity, that is, how fast the money turns over. The Fed cannot control the velocity since it cannot control the demand for money, that is, the amount people want to hold. Also, even if the Fed could determine the best amount of money for today, the impact on the economy takes several months to take effect, and so the central bankers would need to be able to accurately predict the state of the economy months into the future. Continue reading

The Volcker Rule

Paul Volcker is a man of considerable stature, and not just because he’s six feet, seven inches tall. He gained a reputation for courage and plain talk as chairman of the Federal Reserve System under Presidents Carter and Reagan because he broke the back of the 1970s inflation. He did so by (mostly) sticking to a tight monetary policy even though that meant sky-high interest rates and sharp back-to-back recessions before the economy could enter its vigorous recovery. Now 84, he has enjoyed a comeback in recent years as an adviser to President Obama. His Volcker Rule, prohibiting proprietary trading by banks, was heralded as one way of preventing a repeat of the recent financial crisis, and it became part of the Dodd-Frank Act signed into law in July 2010.

Dodd-Frank’s full title, incidentally, is the Wall Street Reform and Consumer Protection Act. Like most current legislation its name reflects hoped-for outcomes, not its actual provisions. Reading the act (the PDF is available here) is not for the faint of heart. There are 16 titles consisting of 1,601 sections for a total of 848 dense pages. Only a lawyer could love sentences like this:

Any nonbank financial company supervised by the Board that engages in proprietary trading or takes or retains any equity, partnership, or other ownership interest in or sponsors a hedge fund or a private equity fund shall be subject, by rule, as provided in subsection (b)(2), to additional capital requirements for and additional quantitative limits with regards to such proprietary trading and taking or retaining any equity, partnership, or other ownership interest in or sponsorship of a hedge fund or a private equity fund, except that permitted activities as described in subsection (d) shall not be subject to the additional capital and additional quantitative limits except as provided in subsection (d)(3), as if the nonbank financial company supervised by the Board were a banking entity.

Volcker initially outlined his proposal in a three-page memorandum. It came to life as Section 619 of Dodd-Frank, expanded to 11 dense pages. This section is supposed to prevent banks from buying and selling securities for their own accounts, in contrast to brokering customer trades. It also prohibits banks from holding interests in hedge funds or private equity funds or from sponsoring such funds. These prohibitions are supposed to lessen the need for future bailouts like those that were provided to financial institutions in 2008 and 2009. Continue reading

Free Banking Explained

Free Banking is free-market banking. In pure free banking, the money supply and interest rates are handled by private enterprise, there is no restriction on peaceful and honest banking services, and there is no tax on interest, dividends, wages, goods, and entrepreneurial profits. Free banking provides a stable and flexible supply of money, and allows the natural rate of interest to do its job of allocating funds among consumption and investment, thereby preventing inflation, recessions, and financial panics.

To understand free banking, we first need to understand the relationship between capital goods and interest rates. Capital goods, having been produced but not yet consumed, have a time structure. Think of it as a stack of pancakes. The bottom pancake is circulating capital goods, which turnover in a few days, such as perishable inventory in a store. The higher levels take ever longer to turn over. The highest pancake level consists of capital goods with a period of production of many years, the most important type being real estate construction.

Lower interest rates make the pancake stack taller, while higher interest rates make it flatter. Think of trees that take 20 years to mature. Suppose the trees are growing in value at a rate of three percent per year. If bonds pay a real interest rate of four percent, and the interest rate is not expected to change, then the trees will not be planted, since savers will put their funds into bonds instead. But if bonds pay a rate of two percent, then the trees get planted. So the lower interest rate induces an investment in long-lived trees and steepen the capital-goods pancake stack. Continue reading

Credit Booms Gone Wrong

Recent research by economists Moritz Schularick and Alan M. Taylor have confirmed the theory that economic booms are fueled by an excessive growth of credit. They have written a paper titled “Credit Booms Gone Bust: Monetary Policy, Leverage Cycles and Financial Crises, 1870–2008“, published by the National Bureau of Economic Research.

A major cause of the Great Depression was a credit boom, as analyzed by Barry Eichengreen and Kris Mitchener in their paper, “The Great Depression as a credit boom gone wrong” (BIS Working Paper No. 137). Eichengreen and Mitchener cite Henry George’s Progress and Poverty as providing an early theory of booms and busts based on land speculation. They also credit the Austrian school of economic thought, which in the works of Friedrich Hayek and Ludwig von Mises, had developed a theory of the business cycle in which credit booms play a central role. Henry George’s theory of the business cycle is complementary to the Austrian theory, as George identified the rise in land values as the key role in causing depressions.

An expansion of money and credit reduces interest rates and induces a greater production and purchase of long-duration capital goods and land. The most important investment and speculation affected is real estate. Much of investment consists of buildings and the durable goods that go into buildings as well as the infrastructure that services real estate. Much of the gains from an economic expansion go to higher land rent and land value, so speculators jump in to profit from leveraged speculation. This creates an unsustainable rise in land value that makes real estate too expensive for actual uses, so as interest rates and real estate costs rise, investment slows down and then declines. The subsequent fall in land values and investment reduces total output, generates unemployment, and then crashes the financial system.

We can ask whether this theory is consistent with historical evidence. One strand of evidence is the history of the real estate cycle, which has been investigated by the works of Homer Hoyt, Fred Harrison, and my own writings. Another strand is the history of credit booms, as shown by Schularick and Taylor, who assembled a large data set on money and credit for 12 developed economies 1870 to 2008. They show how credit expansions have been related to money expansions, and how financial innovations have greatly increased credit. Because economic booms are fueled by credit expansion, Schularick and Taylor note that credit booms can be used to forecast the coming downturn.

Followers of Henry George have focused on the real estate aspect of the boom and bust, while the Austrian school has focused on credit, interest rates, and capital goods. A complete explanation requires a synthesis of the theories of both schools, but these recent works on credit booms have not recognized the geo-Austrian synthesis. In order to eliminate the boom-bust cycle, both the real side (real estate) and the financial side (money and credit) need to be confronted.

Current Austrian-school economists such as Larry White and George Selgin have investigated the theory and history of free banking, the truly free-market policy of abolishing the central bank as well as restrictions on banking such as limiting branches and controlling interest rates. In pure free banking, there would be a base of real money such as gold or a fixed amount of government currency. Banks would issue their own private notes convertible into base money at a fixed rate. The convertibility and the competitive banking structure would provide a flexible supply of money along with price stability. The banks would associate to provide one another with loans when a bank faces a temporary need for more base money, or a lender of last resort.

Both the members of the Austrian school and the economists who have studied credit booms have not understood the need to prevent the land-value bubble by taxing most of the value of land. That would stop land speculation and eliminate the demand for credit by land buyers.

But the credit-bubble theorists have not understood that financial regulation and rules for central banks cannot solve the financial side of credit bubbles. Credit booms always go wrong. As the Austrians have pointed out, there is no scientific way to know the correct amount of money or the optimal rates of interest. Only the market can discover the rate of interest that balances savings and borrowing, and only the market can balance money supply with money demand.

Thus the remedy for the boom-bust cycle is both land value taxation and free banking. Land speculation would not be as bad without a credit boom, but will still take place as land values capture economic gains and land speculators suck credit away from productive uses. But also, a credit boom with land-value taxation will still result in excessive construction and the waste of resources in fixed capital goods, reducing the circulating capital need to generate output and employment, as Mason Gaffney has written about.

Economic bliss requires both the public collection of rent and a free market in money.

[Editor’s note: this essay first appeared on Dr. Foldvary’s blog, the Foldvarium, on April 4 2010]

Gold, Interest, and Land

Three seemingly unrelated variables are in fact deeply connected. Gold has been the most widely used money, and in a pure free market, gold would most likely come back as the real money. Free-market banking would mostly use money substitutes such as bank notes and bank deposits, but these could be exchanged for gold at a fixed rate. Free banking would combine price stability with money flexibility.

Interest is ultimately based on time preference, the tendency of most people to prefer present-day goods to future goods, due to our limited lifespan and the uncertainty of the future. In a free market, the rate of pure interest would be based on the interplay of savings and borrowing. Interest is not just income and payment, but has a vital job in the market economy. The job of the interest is to equilibrate or make equal the amounts of savings and borrowing. This also equalizes net savings (subtracting borrowing for consumption) and investment. Investment comes from savings, and the job of the interest rate is to make sure that net savings is invested. Continue reading

Federal Deposit Insurance: A Banking System Built on Sand

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]

Around the Web

  1. What if there really were mutants, X-Men style?
  2. Adam Smith’s anti-imperialism. Grab a cup of tea or coffee.
  3. More environmental destruction in China. We saw the same type of thing happen in eastern Europe and Russia during the Cold War. This destruction is also rampant in post-colonial states that have largely adopted a Leninist approach to state-building. This may just be part of a harsh learning curve that comes with economic development. After all, the property rights regimes that the West now has in place took hundreds of years to develop, and they could all be much, much better. On the other hand, it seems as if Beijing is undertaking many projects without even thinking about the consequences, much less the claims to property by its citizens that are already in place.
  4. Has the Fed Been a Failure? If you read one thing this weekend, let it be this.
  5. More on militias and the second amendment, by –Rick (check out his blog here)

How to Make the New Year Better

Many economists and financial analysts are making conjectures about when the recession will bottom out and how strong the recovery will be. The speed of recovery depends on the policies of government world wide. With the best policies, the economy could recover within three months. With bad policies, such as occurred during the Great Depression, the economy could stay down for years.

One bad policy that made the depression worse was the erection of trade barriers. The US enacted a high tariff in 1930, and other countries also restricted imports, and world trade broke down. Companies that sold goods abroad could no longer stay in business. Farmers suffered as foreigners could not buy their crops.

Unfortunately, many countries today are repeating this policy error. The German philosopher Hegel was right when he observed that governments do not learn from history. Indonesia is requiring new licenses and taxes for imports. Russia has raised tariffs on imported cars and food. India has levied a tariff on imported soybean oil. The chiefs of each country think that they are protecting their home industries, but they are ignoring the lessons of the Great Depression, as trade limitation is contagious. If political pressure induces them to do something, a money subsidy is preferable to a trade barrier, since that does not distort prices as much. Continue reading

“Gold and Money”

That’s the title of this piece in the Freeman by our very own Dr. Gibson. In it, he suggests:

Let’s turn down the heat a bit and look into some propositions about gold. That should lead us to some reasonable ideas about whether or how gold might return.

Indeed. I’m  tempted to copy and paste the whole thing, but just check it out.

PS I’ve been a very busy man lately, but I’ve got a bunch of almost-finished writings in the works. Stay tuned!

Around the Web: Nobel Prize Edition

I just got three of them.

  1. Why we need to separate the central bank from the monetary authority.
  2. “Market Design”
  3. Noble Matching.

Maybe one of our in-house economists can share their thoughts on the award this year as well…