Can Banking Reform End the Boom and Bust Cycle?

|Peter Boettke|

Toby Baxendale argues in the Telegraph that bank reforms which eliminated the special status of banks and made banks behave just like other businesses in the market place would end the possibility of credit-induced boom and bust cycles. There is actually a proposal based on these ideas that has been put forth in the British Parliament.

What do you think?

Comments

[Jerry O'Driscoll]

Details are lacking, but it appears to be a proposal for a variant of narrow banking or 100% reserve banking. There have been many variants of narrow banking proposed in the past, most notably the Chicago Plan of the 1930s.

Milton Friedman updated the Chicago Plan in 1960. He recommended that the Fed pay interest on reserves, and banks could thus pay interest on deposits. (Othwerwise banks would need to charge for taking deposits.) Since the Fed does in fact now pay interest on reserves, one might say that a needed step has been taken to make narrow banking feasible.

The knock on narrow banking is that other forms of financial institutions would arise to compete with commercial banks. These competitors would be able to offer higher returns by investing deposits in assets riskier than accounts at the central bank. Hence, the risk of the current banking system would be reintroduced.

To solve the latter problem, Kotlikoff has advocated making ALL financial institutions into mutual funds. Mutual funds take no risk, only the holders of their shares do. Kotlikoff solves one problem by eliminating banking as we know it. His plan also comes with a hefty increase in federal government regulation.

Then there are the free banking advocates.

So here are the proposals for fundamental banking reform: free banking, narrow banking or no banking. The latter two are designed to eliminate the elasticity in money and credit that Hayek identified as the source of booms and busts. Free banking advocates argue their system would avoid booms and busts. It is not clear that Hayek thought they would, but certainly there should less scope for booms and busts than with central banking.

[Richard Ebeling]

Well, it is perhaps of interest to know Ludwig von Mises' view on this matter. He explained it in the following way in his 1928 monograph, "Monetary Stabilization and Cyclical Policy":

"In any event, the practice of intervening for the benefit of banks, rendered insolvent by the crisis, and of the customers of these banks, has resulted in suspending the market forces which could serve to prevent a return of the expansion, in the form of a new boom, and the crisis which inevitably follows.

"If the banks emerge from the crisis unscathed, or only slightly weakened, what remains to restrain them from embarking once more on an attempt to reduce artificially the interest rate on loans and expand circulation credit?

"If the crisis were ruthlessly permitted to run its course, bringing about the destruction of enterprises which were unable to meet their obligations, then all entrepreneurs -- only only banks but also other businessmen -- would exhibit more caution in granting and using credit in the future. Instead, public opinion approves of giving assistance in the crisis. Then, no sooner is the worst over, than the banks are spurred on to a new expansion of circulation credit."

First, notice that Mises clearly understood the danger of "moral hazard" and how destabilizing expectations can be generated on the part of issuers and users of bank credit due to government "bailouts" and support.

Second, he also explains part of the direction that any reform should take to, if not eliminate cyclical fluctuations, than at least possibly reduce their frequency and severity:

"If the knowledge of the Currency Theory had led to the conclusion that fiduciary media should be deprived of all special privilege and placed, like all claims, under the general law in every respect and without exception, this would probably have contributed more toward eliminating the threat of crisis than was actually accomplished by establishing rigid proportions for the issue of fiduciary media in the form of notes and restricting the freedom of banks to issue fiduciary media in the form of checking accounts. "

Thus, Mises concurs that a useful reform would be to make banks fully liable for their obligations and their actions.

And, also, Mises gives an answer to the question, Would not such "ruthless" allowance of the crisis to just follow its course be a cure worse than the disease? Mises suggests:

"It may well be asked whether the damage inflicted by misguiding entrepreneurial activity by artificially lowering the loan rate would be greater if the crisis were permitted to run its course.

"Certainly many saved by the intervention would be sacrificed in the panic, but if such enterprises were permitted to fail, others would prosper. Still the total loss brought about by the 'boom' (which the crisis did not produce, but only made evident) is largely due to the fact that factors of production were expended for fixed investments which, in the light of economic conditions, were not the most urgent. As a result, these factors of production are now lacking for more urgent uses. If intervention prevents the transfer of goods from the hands of imprudent entrepreneurs to those who would now take over because they have evidenced better foresight, this imbalance becomes neither less significant nor less perceptible."

Thus, such intervention during the "downturn" stage of the cycle merely delays and prevents the reallocations and readjustments without which longer-term sustainable balance and coordination in the service of consumer demands cannot occur and in the shortest period of time.

Richard Ebeling

[Pietro M.]

The article is not much informative about the contents of the proposed bill. Probably this is better:

http://online.wsj.com/article/SB10001424052748703376504575491611740494630.html

It looks like it's about 100%-reserves.

However, two different issues are confused: government pro-banks interventions and fractional reserve banking.

I'm convinced that most of the instabillity of financial markets comes from expectations of future bailouts and interest-rate cuts in case of trouble. This implies the policy rule that outside money shall not be created discretionally, and banks shall be allowed to fail whenever markets believe they deserve it.

This problem is likely to be much more important than fractional reserve issues. In fact, if, paradoxically, we had fiat money 100%-reserve banking with discretionary creation of outside money, we would have as much boom/bust cycles as we have today. Thus, fractional reserve cannot be the source of the problem, although it is likely its main transmission channel.

So, what should be the focus? Forcing banks to pay the consequences of their mistakes, as Mises said in "On the manipulation of money and credit", or restricting one of the many - although the most important - sources of systemic risk in financial markets (i.e., fractional reserve banking)?

I believe that without solving the main problem, systemic risk would arise in other ways. Regulations can always be circumvented.

A reform may save us, but it needs to tackle the issue of the countercyclical creation of outside money, not its consequences, i.e., unrestricted credit creation.

[Pietro M.]

Ops, I didn't want to repeat O'Driscoll's incipit and cite the same paper as Ebeling. I was writing my comment when they were posted. :-)

[Stephan Kinsella]

I discuss it on Mises Blog here. More details forthcoming.

http://blog.mises.org/13868/british-proposal-for-banking-reform-fractional-reserve-banking-versus-deposits-and-loans-2/

The Bill would not stop private fractional-reserve banking (freebanking). It's aimed at the current centralized FRB system, deposit insurance, and disclosure.

[Jerry O'Driscoll]

James Buchanan has recently made an incisive point about frational reserve banking. The argument for the system is that it economized on costly commodity reserves. With a fiat money supply, there is no case for fractional reserves.

As Pietro suggests, the government could still print money and create booms and busts. But the additional base money would not be leveraged through the banking system. Bank runs would be stopped and the payments system protected.

According to Ronnie Phillips, 100% banking was considered in the 1930s as an alternative to deposit insurance. Instead, FDR went with preserving the unit banking system; preserving fractional reserves; and instituting deposit insurance. That is inherently unstable combination of policies.

[George Selgin]

There most certainly _is_ a vcase for fractional reserves under fiat money, Jerry: it is that private savings get intermediated by commercial banks, and not just by the central bank. The consequences for development are in essence the same as those Adam Smith pointed out when speaking of a specie-standard system. It's a big mistake to overlook the consequences of having all money balances supporting central-bank intermediated investment when the opportunity lost is that of investment by commercial banks. The difference is evident enough from inspection of the sorts of assets central banks typically invest in.

On this matter Bill and I have a paper, Banknotes and Economic Growth that shows some pretty serious costs of merely preventing banks today from issuing their own fractionally-backed notes.

Jim Buchanan has done lots of good stuff, but on the matter of fractional reserves he is quite wrong. It isn't just about saving gold: it's about investing savings efficiently.

[Jerry O'Driscoll]

@George,

Buchanan's argument was made in the larger context of the recent financial mess. Jim always starts from where we are.

In today's world, banks are highly privileged institutions with the backing of the US Treasury -- made explicit for the large banks by recent policy and Dodd-Frank. In effect, we now have about 20 Fan and Freds.

We're not in the 19th century. There is a securities market now.

What is the best route out of the moral hazard morass in which we find ourselves? We need to clamp down on the moral hazard before the next bubble-and-bust. Even if abolishing the central bank were the ultimate goal, what is the first step?

In other words, what do you recommend we do tomorrow?

[George Selgin]

As stated, Buchanan's argument says nothing about the special circumstances of the crisis. It says: fiat money=no savings from fractional reserves. My point is that, as a matter of theory, that's wrong. I would be happy nonetheless to have the places in Buchanan's text were he points out the context you refer to pointed out to me.

But to answer your question: if we let the government's screwing up of the banking industry justify it's wiping out of that industry, think what the precedent means. For starters, other countries will treat the U.S. "solution" as a first-best one--as they did with deposit insurance, for instance (and despite their lack of developed securities markets). Eventually the conventional wisdom will be that banking just can't be left, even partly, to the market, but must be regulated to the point of being prohibited.

If this is a position that even champions of markets must acquiesce to in the name of being practical, I'd rather be considered a dreamer!

As for the way out of the present morass: for me, it consists of insisting, as you do, on the harm done by implicit and explicit guarantees, and on finding ways to limit them, instead of simply destroying the industry they've crippled. Instead of narrow banks, let's have banks with living wills that are expressly denied access to guarantees. _Then_ we can narrow the rest to death far as I'm concerned.

[Stephan Kinsella]

The video and full text of Carswell's speech in Parliament arguing for "honest money and sound banking" may be found at http://blog.mises.org/13912/uk-parliament-speech-invokes-mises-institute-re-honest-money-and-sound-banking/

[Pietro M.]

I think that the problem is that moral hazard makes the distinction of good and bad intermediation impossible. Banks respond to incentives, but both the good and the bad ones, coming from the safety net. The net result is the financial mess in which unregulated banking is not feasible and regulations are welfare improving, although probably worse than removing the cause (moral hazard).

There is a paper by Rajan (I may be wrong) about the usefulness of banks in intermediating credit. I don't remember the argument, but I think that the "plus" of banks is that they use nominal liabilities to fund inherently illiquid investments, thus enhancing the efficiency of intermediation, but at the cost of being inherently fragile and prone to systemic disasters.

I don't know to what extent this argument is valid, considering that non-bank financial institutions may perform roughly the same function without the Achilles' heel of commercial banks, as probably O'Driscoll suggests. Valid or not, the intermediation efficiency argument appears to me more relevant than Buchanan's argument on bullion costs.

So, is there a necessary link between being efficient in lending and being exposed to severe maturity mismatch, with nominal liabilities and financial leverage?

I still think that the best route is to remove safety nets, discretional monetary policy included. But this, in the short run it would cause a financial mess, and in the long run it depends on how well banks learn to constrain their lending, reducing leverage and maturity mismatch.

[Jerry O'Driscoll]

George states that he prefers to be a dreamer, but provides the start of an answer to my question in his last paragraph. The bankruptcy code is the living will for nonfinancial corporations. It's difficult to apply to institutions with current obligations that constitute the payments system. But it's worth more thought. How about immediate receivership.

Any banking reform must address the problem of time inconsistency. How does one prevent a future Congress from reneging on the promise of a prior Congress for "no more bailouts?"

The immediate problem is that many banks are likely insolvent or close to it because they have not sufficiently written down assets related to housing and commercial real estate. They are reluctant lenders and that is inhibiting recovery.

Along with I assume everyone else contributing here, George wants maximum liberty in banking. But we have a corrupt corporatist fiancial system. As Pietro suggests, the road from here to there may involve some less than perfectly classical liberal reforms.

For instance, we have a number of institutions recognized as "too big to fail." If they are too big to fail, they are too big. What is the laissez faire approach to forcing firms to donwsize?

[Bill Stepp]

@Jerry, who writes:

"We're not in the 19th century. There is a securities market now."

True enough, but small businesses, including mom & pop stores can't access them by issuing shares or (junk) bonds--and not just because of their small size, but also because many of them are S corps and therefore limited to something like 75 shareholders. Their banker of first resort is a commercial bank.
I'm in the free banking/fractional reserve/abolish central banking camp.

[Jerry O'Driscoll]

I think advocates of any particular banking reform must grapple with the sad historical record presented in This Time is Different. It seems that asset booms and busts occurred with little regard to monetary systems or banking structure.

The UK did have a better record on bank runs (none) than the US from around the 1870s until Northern Rock. It was not free banking.

Maybe you must get both the monetary standard and the banking system right. If so, that is the answer to the original question. Banking reform by itself won't end the boom and bust.

[Richard Schulman]

Jerry O'Driscoll writes: "I think advocates of any particular banking reform must grapple with the sad historical record presented in This Time is Different. It seems that asset booms and busts occurred with little regard to monetary systems or banking structure....Maybe you must get both the monetary standard and the banking system right....Banking reform by itself won't end the boom and bust."

Good point, but let's make that a trinity:

* good money (producing a stable or slightly falling price level, in line with productivity increases);

* good credit (matched maturity lending, no leverage);

* stable limited government, which keeps its fingers off the scales.

I can't recall any historical episode recounted in This Time Is Different that didn't violate at least one of those three conditions.

[Jerry O'Driscoll]

Richard Schulman has opted for limited government, the gold standard and narrow banking. He should read Kotlikoff's book, Jimmy Stewart is Dead, and decide whether narrow banking is what he really wants.

I offered up the alternatives and didn't say which I preferred. I do think there is one unworkable combination: free banking plus fiat money.

[Pietro M.]

Among the reform alternative, Kevin Dowd proposed to convert banks' monetary liabilities into standard equity.

A bank with financial troubles would just be forced to convert his deposits into equity. This is an extreme version of the option clause (standard clauses convert money into lonter term debt).

This would increase the banks' clients incentives to monitor banks, it would turn bad banks into widely public owned companies, diluting the ownership rights of old stockholders, would rapidly reduce financial leverage to sustainable levels, would avoid banks crises.

Banks would be as bankruptcy proof as money funds, and the worst danger for money holders would be to "break the buck" by selling equity shares subpar.

The only think I'm not so sure is if it would align banks' (especially banks' managers) incentives with reasonable decision-making. But at least depositors and stockholders would have some incentive to check their behavior.

And how to organize the transition from money debt to equity liabilities? Who should be long on that option? The SEC, the Fed, the banks? This is not clear to me, but I know nothing about receivership or conservatorship.

He also proposed ending limited liability. The discussant of my conference paper on perverted financial innovation insisted on this point, too. However, I believe it would be difficult to implement: how to force foreigners to pay for additional capital?

http://mises.org/daily/4218

[Mikeikon]

Needs more Monetary Equilibrium Theory.

[Bill Stepp]

Pietro M. writes:

"And how to organize the transition from money debt to equity liabilities?"

What the heck are "equity liabilities"? Could you explain the accounting behind this concept?

[Pietro M.]

no, it's not accounting, it's bad english, I think. I meant equity.

[Richard Schulman]

Jerry O'Driscoll writes:
"Richard Schulman has opted for limited government, the gold standard and narrow banking. He should read Kotlikoff's book, Jimmy Stewart is Dead, and decide whether narrow banking is what he really wants."

Actually, I didn't opt for those three as the One True Policy Proposal but just put forward the trinity of good money (insuring a stable or slightly declining price level), unleveraged matched-maturity credit, and limited government as conjoint conditions not met by any of Reinhart and Rogoff's historical examples of financial folly in This Time Is Different.

Also, there may be better ways to achieve a stable or slightly declining price level than through a gold standard.

I *have* read Kotlikoff's Jimmy Stewart Is Dead. It has its virtues, but he would have a giant regulatory agency, the FFA, riding herd on banks and mutual funds, and the federal government still printing all the money. That's a lot of unwarranted trust in government.

Any reforms that get the federal government out of money and credit -- whether White-Selgin free banking, Kotlikoffian limited-purpose banking, or Rothbardian strict banking -- would arguably reduce the frequency and severity of financial crises. Indeed, the best way forward might well be to let the market sort out the winners among all three.