James, I guess we are not completely out of the
woods yet. Perhaps a fire is necessary in order
to clear the ground for new growth.
James C.W. Ahiakpor wrote:
>The purpose of insuring the public's deposits
>against loss -- up to a certain amount, per
>account type -- is to prevent panics against
>certain banks from turning into a contagion on the banking system as a whole.
>The U.S. hasn't had a banking contagion since
>the establishment of the FDIC. So in what sense has the FDIC failed?
I know the purpose. However, I don't think that
panics and contagion are appropriate terms for
describing the phenomena that occur when
transaction depositors converge to withdraw their
deposits or when savings depositors begin to
worry about the safety of their deposits. A pure
financial intermediary that borrows short and
lends long must face the discipline of the market
for the saved funds to be used efficiently. No
kind of deposit insurance can substitute for this
discipline.On the other hand, a bank that uses
transactions deposits as a basis for making loans
of newly-created money must face the discipline
of the market if it lends purchasing power that
depositors are not willing to have lent. No kind
of deposit insurance can substitute for this
discipline either. We can all think of situations
in which a bank's money creation is a good thing.
For example, it may enable inventions to occur
that would otherwise not occur. But without
discipline, there is no way to assure that the
research financed by new money will result in
worthwhile inventions or that the value of the
inventions is worth the sacrifice. For that
matter, there is no way to assure that the money
will not be used to finance a tower of babble or
a bridge tournament (;Lehman Brothers). To stop a
run on a financial institution at the expense of
enabling these functions to be performed seems to
me to be a silly tradeoff, since the worst
effects of bank runs can be prevented by blocking bank money creation..
An FDIC or FSLIC cannot succeed in removing the
uncertainty from either the intermediation of
loans or money creation. It can only distort the
bearing of uncertainty that would otherwise be
chosen by providing insurance for deposits. What
you call bank panics and contagion are quite
inconvenient for banks; bank stockholders; and,
because employees and stockholders can avoid
bearing the harmful effects of their actions, for
a general public that must suddenly adjust to a
reduced quantity of money that occurs after a
bank run. Government-guaranteed insurance can
avoid bank runs so long as the government has
plenty of gold under a gold standard or so long
as it controls the issuance of currency under a
dollar standard. But it is not possible to avoid
the disruption to the economic system that occurs
when the insurer becomes insolvent. Because
deposit insurance would be unnecessary to avoid a
bank run under a 100% reserve system, what's the
complaint against this system?.
The FDIC failed in the sense that if the FED and
national government had enforced its own rules of
the game, the reserve fund of the FDIC would
have been only a drop in the bucket of what was
needed for the FDIC to make good on its insurance
commitments. (As I recall, this fund was under 6
billion in 2007, although my recollection may be
wrong). The choice faced by the coalition of the
FED, FDIC, and Treasury was to create money to
pay off depositors of bankrupt banks as they
failed or to save the major banks from going
bankrupt in the first place. A similar choice
situation occurred in the early 1980s, although
it was the FSLIC that most obviously failed to
maintain a sufficient reserve fund. Whether the
FDIC failed at that time is a matter of
interpretation. It certainly prevented enough
bank failures to avoid a threat to its reserve
fund. But it did not achieve this through insurance.
>Thus, the growth of M2 is more relevant to the
>"state of the economy" than that of M1.
This is not theory, James; it is statistics. I
have no way to evaluate such statements. My view,
based on non-mathematical neoclassical economics,
is that M2 itself is completely irrelevant to
growth. Only savings that are channeled to
producers whose action ultimately cause the
production of goods valued by consumers
contribute to growth. As for M1 itself, the
specific amount of it is completely irrelevant to
growth. Growth could occur to the same degree
whether M! was billions or just a single dollar.
But I am sure that you know this. The forest is
full of positivists and empiricists who, not
realizing that they are in the forest, have no clue about what causes what.
>I think it is too bad that some analysts,
>particularly some Austrians -- Pat included
>here, do not appreciate the benefits of a
>fractional reserve banking system as Adam Smith
>well explains -- creating a highway through the
>sky! They think a 100% reserve banking system
>would serve an economy best, including preserving individual liberty.
>Now anyone who wants to store up their non-spent
>dollars could use the safety deposit box
>facility of banks to achieve that aim. And they
>will pay a fee for that safety service rather
>than receive interest from a bank.
100% reserve banking would eliminate the need for
the FED as an entity that tries to control the
quantity of money. That is all. In the early
1960s and for the about the next two decades, the
FED accommodated a series of budget deficits. In
the past 28 years or so, as it gradually moved
toward a policy of inflation targeting, it has
merely introduced additional unnecessary
instability to the purchasing power of the
dollar. In reference to your point about
Austrians, I don't see any point in or
possibility of a gold standard, which is what I
presume you are referring to. I would love,
however, to hear someone defend. rather than
assume, fractional reserve banking. I suspect
that it is best in explaining history to conceive
of the fractional reserve banking system in the
US today as a kind of compromise that was reached
by politicians who wanted to regulate banks and
banks who tried to position themselves to take
advantage of the new regulations. If you can
discern any benefits for the general public, I would love to know them.
It is obvious that the interest that transactions
depositors receive under a fractional reserve
system is due entirely to the (competitive)
lending of newly created money. As a receive of
this interest, a transaction depositor tends to
see fractional reserve banking as a good thing.
Such a depositor is a bit like a union worker who
sees higher wages in his company during an
expansionary monetary policy as a good thing.
Both move among the trees, while ignoring the
fact that they live in a forest that could catch
fire. Money creation, magnifies the ordinary
market economy cycles that result from periodic
over-reliance on financial intermediaries. Cycles
would occur even in 100% reserve banking.due to
adverse incentives resulting from corporation law
and bankruptcy law. But they are magnified by a
fractional reserve system because depositors, as
a group, are "tricked" into thinking that their
wealth is greater than it really is. They only
find out their true wealth when the businesses
supported by their non-existent savings begin to fall like a house of cards.
Yes, transaction depositors receive a payment for
providing resources to banks in a fractional
reserve system. But practically everyone ends up
paying every few years when the exaggerated
crisis occurs -- e.g., the savings and loan
crisis, the dot.com bubble, the global financial
crisis. Or they pay when the FED finances
government deficits, as it did before Paul Volker
and as we can expect it to do in the not-to-distant future.
Finally, your highway through the sky is
supported by "Dædalian wings." At least, this is
how I interpret the presumed passage from Smith
to which you refer. It does not strike me as an
approval, in any way shape or form, of a
fractional reserve system. But then I am not an
expert on Smith. So perhaps I have misread the
passage or perhaps he says something about this issue elsewhere.
>Secondly, locking up our dollars in safety
>deposit boxes would simply deprive borrowers the
>funds they otherwise could have received from
>financial intermediaries to invest, hire
>workers, and increased production in the
>economy. Indeed, it is really not our dollars
>that are lent but our savings. The dollars are
>simply the "deed of assignment," the means of
>extending savers' purchasing power: "By means of
>the loan, the lender, as it were, assigns to the
>borrower his right to a certain portion of the
>annual produce the land and labour of the
>country, to be employed as the borrower pleases" (Smith /WN/, 1: 373).
Deprive borrowers? As if borrowers have a right
to funds? Let's keep in mind that the function of
financial intermediation is not to get money from
savers to investors, like a Keynesian might
argue, but to enable the purchasing power of
savers to be employed in the directions that most
satisfy consumer wants both in the near and more
distant future, as a good Austrian would argue.
If you really know the basis for the Austrian
theory of the cycle, then you realize that a
crisis is a sign that this function has not been
adequately performed. Savers lose their shirts
and many employees lose their jobs because funds
have been used to finance firms whose
profitability cannot be sustained in light of
real consumer wants. A redirection of resources
is required for this function to be performed adequately.
Of course, this is not only part of Austrian
economics. It is also a part of non-mathematical neoclassical economics.
Again, it seems to me that your reference to
Smith, while amusing, is irrelevant. The loan to
which Smith refers is not a loan of bank-created
money based on paper dollars. He writes of that
kind of money, it seems to me, in his discussion
of John Law (Book 2, Chapter 2).
Pat Gunning
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