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Societies for the History of Economics <[log in to unmask]>
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Pat Gunning <[log in to unmask]>
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Sun, 22 Mar 2009 22:05:33 -0400
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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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