Free Banking
A cool article today from Mises.org about the inflationary nature of the central bank. As usual, the post-Keynesians have, with some enthusiasm, taken up the task of defending the state from its critics. As usual, they are wrong. I'm going to take the opportunity to talk about my views on the nature of fractional reserve banking and of free banking.
FRACTIONAL RESERVE BANKING:
Most people are aware of the basics of the current system of banking that we have in place. Joe Average takes his savings to Steve's Bank, and gives it to them as a deposit. They credit his account with the amount of money he has given them. They then take the majority of that money, we'll say 60% as an example, and loan it out to borrowers, charging an interest rate. If Joe should return to collect on his deposit before the bank collects on the loan, they will pay it out to him either through their takings from interest rates on other loans or from the accounts of other customers of the bank. This system is why economists say that savings and investment are so closely linked. Without savings, placed in the hands of fractional reserve banks, there could be no loans, and without loans, there could be no large scale investment.
This system does not work too badly (we'll get to that later) in the absence of a federal bank and fiat currency. However, in our current system, it is an inherently inflationary process that serves to distort the structure of production and cause what economists call the business cycle.
Suppose that there is a sudden increase in the demand for loans in our current system. Banks, of course, oblige this desire for loans. However, since the supply of money has remained the same, they react by raising interest rates. Interest rates, are, essentially, the price of borrowing money. So, of course, they obey the laws of supply and demand like any other price mechanism. However, the government has in place a price control on interest rates. It takes the form of the federal reserve, which will respond to rising interest rates through pumping money into the economy, in an attempt to keep rates at what the fed has set as its target. The result of this, is of course, inflation. Anytime the demand for loans is increased, money is simply taken out of thin air and placed into the economy by the fed!
Like any policy that refuses to let markets clear, the fed's policy of trying to control the interest rate is misguided and has ill effects. By refusing to allow interests rates to function properly, and keeping them artificially low via the creation of new money, the fed encourages malinvestment. Investors who believe that interest rates will be always be (relatively) low have much less reason to invest carefully. Why not take big risks? After all, you can always take out more loans, its not as if the price of loanable funds is liable to change just like the price of anything else in a market. Of course, eventually this malinvestment boils over, and the demand for loanable funds begins to skyrocket. Sometimes, the fed responds by bailing out banks (remember that they keep only a fraction of actual savings) through loaning them large amounts of money. The result is large scale inflation. Sometimes it chooses not to, believing it is best to stick to a tight money policy. The result is bank runs. With the federal reserve in charge, you are damned if you do and damned if you don't!
FREE BANKING:
So, clearly, this is a problem. It traps us in a constant state of boom-bust capitalism, the business cycle always nipping at our heels. Is there nothing we can do? There is an answer, however politically infeasible it seems currently. The answer is a complete end to government monopoly on the money supply. We should instead institute a system of free banking, whereby banks print and compete with their own notes.
Before we discuss this, it is important to understand the nature of money, and what it really is. Everybody knows how a primitive, barter based economy works. If I have wheat, and I want meat, I take my wheat and I find someone who A.) Has meat in the quantity I want, and B.) Wants wheat in the quantity I have. We can then trade. For obvious reasons, this gets very inconvenient very fast, especially when more complex trade enters the scenario. The result is that some good appears in the barter economy, which is widely traded enough, that it actually becomes the standard of trade itself. Everyone is confident that everyone else will be willing to accept it in trade. In the history of the west, and indeed of all advanced economies, this has near universally been gold. So let us assume that, in the absence of the dollar, gold becomes our standard of trade (though really it could be anything). Of course, just as nobody wants to lug all of their dollars around with them in cash, nobody wants to lug all of their gold around with them. That would be even more inconvenient!
So people pay to have the gold deposited in banks, and are issued receipts, in the form of bank notes, to use as trade. Now, obviously, banks are going to want to compete to have the best notes. After all, banks want to get the most deposits. The result will be that banks will try to minimize the risk a consumer takes by depositing with them of a run on the bank. This could either spell the end of fractional reserve banking altogether, and the creation of a seperate market for loanable funds independent of banks. It could also mean that fractional reserve banking will continue, but, in the absence of a price control (federal reserve) interest rates will set themselves according to the actual demand for loanable funds. It will likely be some mix of the two, with some banks engaging in fractional reserve, but using other perks to get savers to deposit with them instead of with other banks. In any event, it is the end of inflation, and it minimizes the risk of bank runs (since investors will be much less likely to malinvest if they know that interest rates might change rapidly). Fractional reserve banking with a central bank structure is the cause of the business cycle and of boom-bust capitalism. Free banking is the cure.
FRACTIONAL RESERVE BANKING:
Most people are aware of the basics of the current system of banking that we have in place. Joe Average takes his savings to Steve's Bank, and gives it to them as a deposit. They credit his account with the amount of money he has given them. They then take the majority of that money, we'll say 60% as an example, and loan it out to borrowers, charging an interest rate. If Joe should return to collect on his deposit before the bank collects on the loan, they will pay it out to him either through their takings from interest rates on other loans or from the accounts of other customers of the bank. This system is why economists say that savings and investment are so closely linked. Without savings, placed in the hands of fractional reserve banks, there could be no loans, and without loans, there could be no large scale investment.
This system does not work too badly (we'll get to that later) in the absence of a federal bank and fiat currency. However, in our current system, it is an inherently inflationary process that serves to distort the structure of production and cause what economists call the business cycle.
Suppose that there is a sudden increase in the demand for loans in our current system. Banks, of course, oblige this desire for loans. However, since the supply of money has remained the same, they react by raising interest rates. Interest rates, are, essentially, the price of borrowing money. So, of course, they obey the laws of supply and demand like any other price mechanism. However, the government has in place a price control on interest rates. It takes the form of the federal reserve, which will respond to rising interest rates through pumping money into the economy, in an attempt to keep rates at what the fed has set as its target. The result of this, is of course, inflation. Anytime the demand for loans is increased, money is simply taken out of thin air and placed into the economy by the fed!
Like any policy that refuses to let markets clear, the fed's policy of trying to control the interest rate is misguided and has ill effects. By refusing to allow interests rates to function properly, and keeping them artificially low via the creation of new money, the fed encourages malinvestment. Investors who believe that interest rates will be always be (relatively) low have much less reason to invest carefully. Why not take big risks? After all, you can always take out more loans, its not as if the price of loanable funds is liable to change just like the price of anything else in a market. Of course, eventually this malinvestment boils over, and the demand for loanable funds begins to skyrocket. Sometimes, the fed responds by bailing out banks (remember that they keep only a fraction of actual savings) through loaning them large amounts of money. The result is large scale inflation. Sometimes it chooses not to, believing it is best to stick to a tight money policy. The result is bank runs. With the federal reserve in charge, you are damned if you do and damned if you don't!
FREE BANKING:
So, clearly, this is a problem. It traps us in a constant state of boom-bust capitalism, the business cycle always nipping at our heels. Is there nothing we can do? There is an answer, however politically infeasible it seems currently. The answer is a complete end to government monopoly on the money supply. We should instead institute a system of free banking, whereby banks print and compete with their own notes.
Before we discuss this, it is important to understand the nature of money, and what it really is. Everybody knows how a primitive, barter based economy works. If I have wheat, and I want meat, I take my wheat and I find someone who A.) Has meat in the quantity I want, and B.) Wants wheat in the quantity I have. We can then trade. For obvious reasons, this gets very inconvenient very fast, especially when more complex trade enters the scenario. The result is that some good appears in the barter economy, which is widely traded enough, that it actually becomes the standard of trade itself. Everyone is confident that everyone else will be willing to accept it in trade. In the history of the west, and indeed of all advanced economies, this has near universally been gold. So let us assume that, in the absence of the dollar, gold becomes our standard of trade (though really it could be anything). Of course, just as nobody wants to lug all of their dollars around with them in cash, nobody wants to lug all of their gold around with them. That would be even more inconvenient!
So people pay to have the gold deposited in banks, and are issued receipts, in the form of bank notes, to use as trade. Now, obviously, banks are going to want to compete to have the best notes. After all, banks want to get the most deposits. The result will be that banks will try to minimize the risk a consumer takes by depositing with them of a run on the bank. This could either spell the end of fractional reserve banking altogether, and the creation of a seperate market for loanable funds independent of banks. It could also mean that fractional reserve banking will continue, but, in the absence of a price control (federal reserve) interest rates will set themselves according to the actual demand for loanable funds. It will likely be some mix of the two, with some banks engaging in fractional reserve, but using other perks to get savers to deposit with them instead of with other banks. In any event, it is the end of inflation, and it minimizes the risk of bank runs (since investors will be much less likely to malinvest if they know that interest rates might change rapidly). Fractional reserve banking with a central bank structure is the cause of the business cycle and of boom-bust capitalism. Free banking is the cure.
posted by Ben-T | 11:15 AM
0 Comments:
Post a Comment
<< Home