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On avoiding a repeat of the financial crisis

Via the Cobden Centre, a relatively new think tank that focuses on banking and money from the “Austrian” point of view, here is a nice article by James Tyler. He sets out how to avoid past problems and what to do about banking and money.

I still think that fractional reserve banking, so long as it is openly stated and so long as legal tender laws are scrapped, is not necessarily an evil. If a person deposits money in an FRB that advertises itself as such and if he takes out commercial insurance to cover a potential disaster, then in a free market based on consent, I am not sure that FRB should be made illegal. For sure, a bank that claimed to be a 100% reserve bank that was in fact, not fully covered, should be prosecuted for running a fraudulent business. But that is simply a case of obtaining money by deception, an offence covered in existing law.

As is so often the case, I think that some of our current woes could be ameliorated, if not solved, if we enforced the basic Common Law of this realm rather than endlessly creating new rules instead. But then I guess that would give politicians nothing much to do, would it?

30 comments to On avoiding a repeat of the financial crisis

  • But then I guess that would give politicians nothing much to do, would it?

    What if we all agreed to pay them for doing nothing? Would still be much cheaper.

  • ESCP Europe is hosting an honest money colloquium at the end of this week in association with The Cobden Centre at which we hope to move forward the 100% reserve/FRFB debate.

    James and I met Nassim Nicholas Taleb on Monday where he made the point that banking should be “the most boring business in the world” with all the excitement in the hedge funds. He pointed out that about 1800 hedge funds have failed and “no one noticed”. Perhaps deposit taking institutions should do just that, on strict legal principle, while hedge funds operate FRFB for those who understand the principles in play and the risks.

  • Paul Marks

    There is still the point of the violation of the principle that borrowing must be 100% from real savings (i.e. from money that some other person or persons has chosen not to consume).

    This is really an Aristotelian logic point – the money must come from somewhere, it must not be just created “by magic”.

    However, all that means is that will continue to be booms and busts under fractional reserve banking.

    J.P. can, quite fairly, turn round to me as say the following:

    “Paul, I do not believe in any government support for banking what-so-ever – and I do not believe that contracts should not be enforced during a bank run. If a bank has not got the gold (or paper Pounds and base metal coins – if that is what it promised) to honour all its cheques and drafts and so …….. well then it goes backrupt, end of story”.

    And I would have a hard job replying to J.P. if he said that.

    I would just hope that after the next great banking collapse people would take seriously the warning signs on bank doors saying “Warning this is fractional reserve bank – we pay interest on what other banks call “deposit accounts” but to finance this interest we lend out the “deposites” indeed we lend out ten times more money than is actually “deposited” with us [do not ask how we manage that] so you may lose every bit of money you put in here”.

    Although I do accept that the other bank down the road is a rather grim place.

    “I want to put some money on deposit”.

    “That will be….”

    “What you are CHARGING me – I want interest”.

    “Oh you want an investment account – why on Earth did you say you wanted a deposit account, of course we have to charge for protecting the money and giving you convienent access to money that is just laying about here on deposit”.

    “Will I have access to my money in the investment account”.

    “What do you mean “access” – the money is not going to be here, we are going to lend it out it is not going to be physically in the building till when, and if, it is paid back. Look you are clearly mentally unbalanced and I have other customers to deal with – so bugger off”.

  • Johnathan Pearce

    Paul, agree with your reply, absolutely!

  • lucklucky

    I am surprised by some of this 100% reserve talking…What is the interest for a bank to have your money if it can’t lend it? Unless it puts a fee to get your money there is no reason.

  • lucklucky, historically banks had two functions: one was to look after people’s money (security), the other was lending. The idea is that these two functions need to be completely separated.

  • “What if we all agreed to pay them for doing nothing?”

    I wouldn’t care – I would still want my minority vote.

  • Mike: I think this can be arranged, but I’d like to think that you would cast your vote to the man’s face.

  • Jim

    Denninger (http://market-ticker.denninger.net/) waxes lyrical on fractional reserve banking, and has convinced me (as if anybody cared…) that it’s a good thing. The two codicils being:

    - the money IS REALLY STILL THERE. The bank lends your money out to others to buy stuff, like houses, which are collateral – the bank holds a note until it’s paid-off – so if they default, the bank seizes it, sells it off and gets the money back. Needless to say, protective gov’ts outlawing foreclosures / banks lending against boom-properties that depreciate to a tenth of what they cost, play hob with the system; and

    - the bank MAY NOT LEND UNSECURED; i.e., no collateral, no loan. Denninger rightly holds that banks who lend unsecured for greater amounts than they possess, should be closed and their officers flung in jail. Can’t argue with that…

  • “…but I’d like to think…”

    That wouldn’t be important to me, I’d be concentrating on getting the job done. Pest extermination, nothing more.

    In reference to the topic, it’s interesting to me that Mr Tyler leads with this:

    “In October 2007 the Federal Reserve briefed a secret congressional committee that the US economy had, at one stage, been only a few hours away from a total meltdown in the financial system.”

    If it was so secret how has he gotten to know about it? He hasn’t posted any links.

  • Richard Thomas

    I have been confused about fractional reserve banking. I read it was one thing (banks lending several times their deposits), was told it was something else (banks only having to keep a fraction of their deposits in reserve which apparently has much the same affect but to me is morally different).

    Seeking clarification from wikipedia, it seems that banking is based on lies and deceits and “convenient untruths” and therein lies the problem. Wikipedia gives this example: A customer deposits $100, the bank then lends $80. This somehow means the money supply has been increased from $100 to $180.

    This really doesn’t make much sense to me (and I’ve studied quantum physics). Surely the depositor should be told that they have $20 liquid deposit but that their $80 has been lent out? Or otherwise they should get an account with lower (no?) interest?

    It seems that the banking world is plagued by cluttered thinking which allows those who are able to exploit it to cause us worlds of hurt.

  • Surely the depositor should be told that they have $20 liquid deposit but that their $80 has been lent out? Or otherwise they should get an account with lower (no?) interest?

    I’m sure it is somewhere in the small print.

  • That wouldn’t be important to me, I’d be concentrating on getting the job done. Pest extermination, nothing more.

    Why am I not surprised.

  • “Why am I not surprised.”

    Because you understand, as I do, that such people cannot be persuaded by reason to refrain from forcibly arrogating my life and mind to their direct and indirect subjugation of civil intercourse to the petty glory of their political fame.

  • Richard Thomas

    I’m sure it is somewhere in the small print.

    That’s the point, apparently it’s not. Which is the problem.

  • Richard: have you checked? Seriously, because I have no idea.

    Mike: no, that’s not the reason, but let’s leave it at that, since this thread is not about you or me.

  • Alice

    What if banks were required to invest their Fractional Reserves increased money supply in Land Value Tax futures repayable in gold?

    Sorry. Please ignore. Don’t know what came over me there.

  • Yes, now you’ll have to go wash your mouth fingers with soap Alice!

  • lucklucky

    Banks should upfront tell how much % fractional reserve they have. Of course tracking it is dificult if they invest the money and do not put it in a vault.

  • Ivan

    Jim:

    - the money IS REALLY STILL THERE. The bank lends your money out to others to buy stuff, like houses, which are collateral – the bank holds a note until it’s paid-off – so if they default, the bank seizes it, sells it off and gets the money back.

    Unfortunately, this is a horrible fallacy, because it fails to take into account the aggregate effect of everyone practicing FRB. To put it as succinctly as possible, the problem is that when a system-wide bank run occurs — and it may occur at even a slight hint of uncertainty, perhaps even prompted by false rumors — the banks will have to liquidate their assets en masse, thus introducing a surge in supply and dramatically lowering their price. A bank’s balance sheet may look perfectly solvent in good times because the demand deposits it owes are balanced with the value of the long-term loans it has made, which are valued at their present market price (i.e. the amount of money people are willing to pay right now for the right to the future cash flow). But in a bank run, banks will massively start liquidating (i.e. selling) these assets, thus dramatically lowering their price and pushing each other into insolvency. (You can also look at this as interest rates going through the roof because everyone is struggling to exchange future money for the present.)

    Basically, the problem is that future cash flows under FRB are priced in a way that generates a false impression of solvency, because the system can be easily tipped away from the barely stable “good times” equilibrium into a mass fire sale that dramatically lowers the price of future cash flow assets. (This is what really makes the fabled “toxic mortgages” toxic, not just the risk underestimates. Their owners are trying to convince us that the past FRB-inflated price of these assets is somehow the true “just price” that they deserve, and the government must step back in to restore it. These shameless crooks then complain that their problem is just some nebulous “illiquidity,” whereas in reality they’ve driven themselves into true insovency.)

    The only thing that can stabilize the system is the government guarantee on deposits coupled with its ability to print as much fiat money as it wants to bail out the banks, so there is no need to even bother lining up for a bank run. But when the big players start practicing FRB-like manipulations without formal government guarantees, relying only on the informal and uncertain “too big to fail” guarantees, you get… exactly the mess we’re in presently.

    By the way, this is probably the best analysis of FRB I’ve ever read (the author of the blog also has some very eccentric ideas, which I don’t endorse at all, but this post is a true gem):
    http://unqualified-reservations.blogspot.com/2008/09/maturity-transformation-considered.html

  • Ivan

    Richard Thomas:

    This really doesn’t make much sense to me (and I’ve studied quantum physics). Surely the depositor should be told that they have $20 liquid deposit but that their $80 has been lent out? Or otherwise they should get an account with lower (no?) interest?

    You’re forgetting that along with the $20 physical deposit, you also get the government guarantee for the full $100, backed by its printing press. Thus, FRB + fiat money + government deposit “insurance” = no need to worry at all, as long as you believe that the dollars you eventually get won’t be inflated into worthlessness. (And if you don’t believe that, then you shouldn’t hold anything dollar-denominated in the first place.)

    You can form a basically accurate picture of the modern FRB/fiat system by viewing banks as for-profit quangos specially licensed to print money and lend it, where the amount of money they are allowed to print is determined by the amount of deposits they hold and the regulatory minimum reserve rate. Even though the physical banknotes don’t come into being through the process of FRB, what does appear out of thin air are implicit, but 100% real and guaranteed claims against the printing press. Thus, your remaining $80 are still there in a very real sense — to the extent that you can consider any form of fiat money as “real” in the first place!

    The whole abominable structure is in fact quite stable in the short to medium run, as long as the government guarantees are clear and properly observed. In the long run, of course, it turns the entire financial system into a malignant pit of corruption. One way this happens — not the only, but a major one — is that the informal “too big to fail” guarantees are also in place, but they are much more erratic and uncertain, and thus capable of generating mass delusions that eventually come crashing down in a spectacular wreck.

  • The only kind of bank that is not “fractional reserve banking” is a bank funded entirely by share capital and retained profits, and which is not allowed to take deposits or issue bonds at all. Which sounds “safe” but their is no pressure to keep things liquid; it can’t go bankrupt (by definition) and so the managers could really take the proverbial with shareholders’ money.

    If you think that such banks would be run better than HBOS or Lloyds TSB et al, well, think again.

    The least-bad kind of bank is the old-fashioned Building Society which is funded almost entirely by deposits. The fact that the source of all their funding might be withdrawn on a whim in the next few days keeps the bankers on their toes.

  • Ivan

    Mark Wadsworth:

    The only kind of bank that is not “fractional reserve banking” is a bank funded entirely by share capital and retained profits, and which is not allowed to take deposits or issue bonds at all. Which sounds “safe” but their is no pressure to keep things liquid; it can’t go bankrupt (by definition) and so the managers could really take the proverbial with shareholders’ money.

    That’s not true. As long as a bank balances all of its liabilities with assets that mature at the same time, there is no FRB. If a bank issues a one-year certificate of deposit or a five-year bond, this instrument needs to be matched with the same amount of money it has loaned to other customers for a year or five years, respectively — and to make a profit, the bankers must figure out a way to do this so that the risk-adjusted interest rate is higher on their assets than their liabilities. This isn’t easy to do, but making money is hard work in any honest trade.

    Of course, this doesn’t make that banks would be immune to failure due to badly estimated risk, incompetent management, unforeseen disasters, etc. But this risk would be similar as for other businesses, and individual failures would be localized, rather than causing a devastating nationwide and worldwide chain reactions of bank runs and cascading failures that happen under a FRB regime.

    By the way, I’m not sure I understand what exactly you mean by “there’s no pressure to keep things liquid.”

    The least-bad kind of bank is the old-fashioned Building Society which is funded almost entirely by deposits. The fact that the source of all their funding might be withdrawn on a whim in the next few days keeps the bankers on their toes.

    Trouble is, it also keeps the customers on their toes in constant fear for their deposits, thus making the bank run a constant threat that can be easily triggered by a mere rumor of problems. As long as there are on-demand deposits that aren’t backed by actual cash reserves, and there is no printing press-backed government guarantee for deposits, this horrible instability is inevitable. This is in fact a recognized phenomenon in mainstream neoclassical economics — just google for the “Diamond-Dybvig model.”

    I don’t know much about the British building societies, but they certainly aren’t exempt from the same iron law.

  • Richard Thomas

    Ivan, good points and pretty much reflects the impression I have.

    It seems like banking is very much like a magician’s trick of cups and balls. I’m reminded of this little stumper my father told me as a child. The astute will recognize the fallacy immediately (it works better as a told story, possibly with beer), others may need to write it down but I think it illustrates nicely the kind of traps there can be in dealing with such things.

    Three old ladies go to buy a radio. They go to the shop and buy a radio for £30, each contributing £10. After they have left the shop, the manager realises there has been a pricing mistake and the radio should be £26. So he gives his assistant £4 and sends them off after the old ladies. The assistant catches up with the old ladies. Not having change for £1 and being a bit sneaky, he gives each of the old ladies £1 each and pockets £1 himself.

    So, if you add up the £9 each the three old ladies paid, the £1 each the assistant gave them and the £1 the assistant pocketed, you get £31. Where did the extra £1 come from?

  • Richard Thomas: I suppose I shouldn’t spoil the game, but it’s not as if people won’t know how this works. But basically, you’s is counting sifferent things.

    The ladies paid $27 ($9×3, sorry, no pound sign on my keyboard, and I’m too laxy to CnP or Alt-NumPad). The radio cost $26, the assistant stole $1, which adds right back up to $27. Balanced. Or, you can consider that the ladies paid $30, $26 of which was for the radio, $3 of which was given back to them in change, and $1 which was stolen from them. Again, balanced.

    The mess which is FRB is now even more interesting, because now bank runs don’t need to be in terms of physical cash. If I have two accounts; one with a local bank and one with an offshore bank, and the local bank looks squirrelly, I can simply issue a TT (or local equivalent term) to shift my funds from the local to the offshore.

    And because this is just a bunch of electrons, the offshore bank can just turn back and lend the funds to the local bank. As long as nobody (or only a minority) actually withdraws the money from the electronic banking system completely, the whole house of cards remains remarkably intact.

  • It’s a fast-talk trick: ‘So, if you add up the £9 each the three old ladies paid, the £1 each the assistant gave them’ They paid 10 each, not 9, and then the assistant gave them 1 each. How do I make a pound or euro sign, BTW?

  • Paul Marks

    In case anyone ever reads this who does not understand what I meant……

    The nasty, grim bank (with the very rude bankmanger) – is how I would run a bank. You want to “deposit” money on me – fine but I will charge you for protecting it. And you want to invest money with me – fine but do not expect the money to be here, I will lend it out. You do NOT have the money – the people who borrowed it do (the same money can not be held by totally different bodies at the same time). At the end of your investment you hopefully get your money back (plus interest) IF the people I have lent out the money to pay me back.

    “Well it is just as well you do not. run a bank…”

    There would be a good side.

    Like Mr Brown I could say “no boom and bust” – but unlike Mr Brown I would not be deluded.

  • Richard Thomas

    It’s a fast-talk trick

    Exactly my point :) Things should be as Paul Marks suggests.

  • Richard Thomas

    Oh, and to do the pound sign, I do alt-156 which is not really good html but works well enough for most purposes

  • Richard: obviously. Oh, and thanks for the tip:-)