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Where We Went Wrong

The real genius of progressivism is that it is progressive.  The effect of this approach is that over generations, people completely lose touch with what a reasonable alternative to progressivism looks like.  At each step we are forced to choose between the existing progressive system which we know to be flawed and an alternative, even more progressive system which we don’t yet realize is even more flawed.  This leaves those of us who would advocate for true freedom the difficult task of explaining what a real free market would look like to people who have never seen anything like it.  This I will attempt here. 

The only way to break the cycle is to take a historical perspective and ask questions like “what could we have done instead at some point in time and what would likely be the effect?”  These questions are not very appealing to academic economists because it involves analyzing a system that either hasn’t existed in generations or hasn’t existed ever, so it may not seem to be of much practical importance to the American Economic Review.  It should, however, be considered of the utmost importance to people who have any hope of returning to a system which relies on personal liberty.

There is a common blueprint for basically all progressive schemes.  First, you take an individual problem and turn it into a collective problem.  Then you take it for granted that it is a collective problem and use this as justification for using the government to “fix” it and claim you are doing so in defense of freedom and liberty.  As congress prepares sweeping new financial regulation, I will identify where and how we first caused the problems we now have with the financial system (at least some of the problems) and go through a thought experiment regarding what might have happened had we embraced individual instead of collective responsibility.

As usual with this stuff, we go back to the early days of progressivism.  In this case it was 1913 when the Federal Reserve System was created.  The main reason for the Fed was to stave off bank panics.  A bank panic happens because banks lend out more money than they keep on hand and the contract depositors make with banks (theoretically) allows them to withdraw it at any time.  If you put $100 in the bank, they are contractually obligated to give you $100 at any time if you come in and demand it.  But if they don’t expect you to come ask for it in the near future, they may not want to have that money just sitting around doing nothing.  If they loan it out, they can make some interest on it.  So they will keep some on hand to deal with the people who do happen to come demand their money and lend the rest out.  Currently they are required by the Fed to keep 10% on hand.   

Now the problem is that, while the bank may have assets of greater value than its liabilities at any given time,  it does not have sufficient liquidity to settle all the demand which could be made on it.  If the bank remains financially sound and everyone believes it is financially sound, this is not likely to cause a problem.  The problem comes if something happens which makes people concerned about the long-run health of the bank.  Imagine that you have your money in such a bank and you know that it has loaned a large amount of money to a property manager constructing a large resort casino and halfway through construction, the building burns down and the owner has no insurance.  He will certainly default on the loan.  And imagine that this is such a large part of the portfolio of the bank that the loss causes the actual value of their assets to be less than their liabilities.  One of their liabilities is to you.  And your contract with them requires them to pay you in full on the moment that you present yourself at their bank and ask for your money.  You also know that every other depositor has the same contract and eventually someone is going to have to bear the loss incurred by the bank from the fire.  What do you do?  Of course, you run down to the bank and try to get your money out so you won’t be left holding the bag.  Naturally everyone else does the same thing and the bank doesn’t have enough money to pay everyone because they loaned most of it out.  This causes additional losses due to the manner in which the bank collapses.  It also may cause an otherwise healthy bank to fail if people “panic” for some reason which is unfounded.

Before investigating the possible solutions to this situation, we must consider the purposes which the banking system serves.  The first is the safe storage (and sometimes transport) of money.  Originally, banks were nothing more than places where you could put your gold or other valuables and be more comfortable about their security than if you had them under your mattress.  There are two important things to point out about this.  First is that the risk of losing your valuable assets is a reality of nature that exists with or without banks.  The purpose of this sort of bank is that it reduces that risk.  Second is that in exchange for this reduction in risk you would pay them

The second purpose of a bank is to be a middleman between investors and borrowers.  If you had a certain amount of money that you wanted to invest in a productive activity and you had to find such a thing yourself, there would be some difficulties.  First would be that you would have to find a project of a size and risk level which was suitable for you and every borrower would have to find lenders in a similar way.  This requires every investor and borrower to spend a lot of resources engaging in activities which they don’t necessarily have a comparative advantage in.  Banks act as a specialist in this area.  Also, if you invested all your savings in one project and it failed you would lose everything.  Since people seem to be risk averse, this is probably not ideal.  By borrowing from many investors and then lending to many borrowers, a middleman can spread the risk in a way which is more beneficial.

A bank engages in a pure form of this function when it issues a certificate of deposit in some amount to be paid on a specified date.  The important difference here is that you cannot just walk in and demand your money whenever you want.  This allows the bank to plan and manage the inflow and outflow of cash.  The risk of loss still exists but there is no incentive for a bank run.  This risk may likely be increased compared to storing your money under your mattress and even if it is not it requires you to give up some liquidity.  Because of this, the bank pays you

Now the bank run is a symptom of banks pretending that they can provide the best of both worlds.  If the deposit banker who had promised to keep your gold in a safe place where you could get it whenever you want decides “hey, I have all this money lying around. I may as well lend it to someone and make a little extra profit, but I won’t tell anyone because it might scare them to know that I couldn’t really pay back everyone who deposited here if they all wanted their money,” this would be considered fraud.  The complicating issue is that by the early 1900s banks were all doing this and had been doing it for a long time, depositors knew it was happening, and the price of bank deposits had been competed down to a level which reflected this behavior (that is, the bank was paying the depositor rather than the other way around). 

The progressives solved the problem of bank runs by federalizing the banking system.  The basic argument is that bank runs are irrational (which they may or may not be) and that by ensuring people that they will get their money, they can be avoided.  This allows banks to continue engaging in fractional reserve banking without having to pay a rate of interest which compensates people for the risk.  The risk still exists but it is assumed by the government.  This is the check that came due in 2008  and it is why the “health” of the financial system is now a collective problem.

Murry Rothbard, who deserves credit for much of the explanation above, argues in The Case Against the Fed that the way to eliminate bank runs is to eliminate fractional reserve banking.  I take a somewhat more moderate (though even more liberty-minded) approach which is to say that fractional reserve banking is not necessarily a bad thing, the bank runs of the 19th and early 20th century were the result of a failure by individuals to recognize flaws in a contractual relationship.  The flaw was that they failed to recognize that there is a real risk associated with depositing money in a fractional reserve bank which is greater than that of depositing money in a safe deposit box and they failed to anticipate this and provide for it in the contract.  This could be easily fixed without any government intervention.

Consider a contract between a depositor and a bank similar to the following:  Depositor deposits Y dollars in the bank and the bank pays r% interest as long as the money remains in the bank.  The bank will maintain a minimum reserve ratio of X% of all deposits on hand for withdrawals and will pay withdrawals up to the full amount of a depositor’s account upon demand so long as their reserve ratio exceeds X%.  The current reserve ratio will be disclosed at all times to the public.  If the reserve ratio falls below X%, or if the manager of the bank anticipates that it will fall below X%, then the bank will be considered insolvent and will freeze all withdrawals for a period of Z days/weeks/months during which time the assets of the bank will be liquidated at the most favorable terms possible.  At the end of this period, the remaining assets of the bank will be distributed among depositors in some specific way. 

The only difference between this contract and the one that existed between banks and depositors is that it recognizes the existence of a real risk and provides for dealing with it in a specific way which would eliminate the incentive for a bank run.  Once people observe that bank runs are a potential problem, this is how thoughtful people could be expected to deal with it in a country of individual freedom, property rights, and rule of law.  The only “problem” with this is that it prevents people from pretending that the risk doesn’t exist.  You would have to acknowledge that you might not be able to get your money under certain circumstances.  This means you would likely demand a higher rate of interest to induce you to deposit there.  It also means banks would compete on both r (the interest rate) and X (the deposit ratio).  If you didn’t want to bear any risk you could deposit it in a “traditional” bank which does no lending (as Rothbard wanted) but then you would have to pay them.  If you wanted maximum profit and weren’t concerned with liquidity you would get a CD.  If you wanted some intermediate combination of risk, liquidity and return, then you would choose a bank with the appropriate X and r for your taste. 

The only thing preventing this was the delusion that we deserve maximum liquidity, with no risk and the bank should pay us.  In a free market, people who continue to cling to this mistaken belief would continue to get burned by bank runs and people who realized it was mistaken would form and seek out banks which offered more realistic agreements and would not get burned by bank runs.  In this case it would not be a collective problem.  Only people who were too ignorant to recognize that just because a risk isn’t provided for in a contract does not mean that it doesn’t exist would be susceptible to it.  In this case, it probably wouldn’t take long for everyone to come around because it wouldn’t be in their interest to continue to deny the reality of the situation.

Instead of allowing this to happen, we decided to institutionalize the delusion.  The government said that if we just let them take over the banking industry we could continue to have the maximum liquidity with no risk and a high rate of return that we had mistakenly believed was possible.  It wasn’t particularly in anyone’s interest to figure out the flaw in this plan so nobody did (or if they did they were a sufficiently small portion of the population that they couldn’t stop it) so we went forward with this solution.  Because of this, there is an inherent moral hazard problem in the banking system since banks don’t bear the risk of insolvency.  This means the Feds have to regulate them.  Also it turns what was an individual problem into a collective problem, so that they can eventually regulate anything even relating to it (but don’t worry not much is related to the financial system).  And, perhaps most importantly, it removes the incentive for anyone to figure out a free market way to fix the problem.  This means that generations later, we just take it for granted that this is a reasonable thing for government to be doing and we can’t even imagine what a free market would look like.

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