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Consider the process
thus far. A miner has mined $5,000 worth of
gold and, after having it struck into coins,
deposits it in Bank A. The new $5,000 of
gold has been converted into a new demand
deposit of $5,000 and the money supply has
increased by $5,000. Because banks keep only
a fraction of their deposits in reserves,
Bank A lent the excess reserves and those
became a new demand deposit of $4,250 at
Bank B. Bank B then had excess reserves,
which became a new demand deposit of
$3,612.50 at Bank C. In a fractional-reserve
banking system, the "hard money" of $5,000
(i.e., the gold the miner found) has set in
train a process that has thus far increased
demand deposit money by $5,000 + $4,250 +
$3,612.50 = $12,862.50.
But the process is not finished because Bank
C now has excess reserves. This process of
expanding the money supply through the
creation of demand deposits can continue
until all of the $5,000 in gold is
transformed into required and precautionary
reserves. Given a reserve ratio of 15%, the
miner's production of $5,000 of money would
eventually increase the money supply by
$33,333.33 (i.e., $5,000 ÷ 0.15). Fractional-reserve
banking always changes – and virtually
always increases – the supply of money; in
other words, it almost inevitably
manufactures inflation. Further, the smaller
the reserve fraction the greater the
resultant change of the money supply (which
equals the rate of inflation) Given this
leverage, relatively small changes in
reserves typically create much larger
changes in the supply of money. Keynesians
discount or ignore the supply of money; in
sharp contrast, Austrians diagnose these
changes of reserves and of money supply as
the ultimate causes of the business cycle.
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Fractional
Reserve Banking and Monetary
Disturbances in 1907 |
Let's revisit an
historical example that illustrates the
problems – namely outbursts of volatility
and instability – that necessarily accompany
fractional reserve banking. Almost exactly a
century ago, on 14 October 1907, an
unusually large number of the depositors of
five banks in New York City began to convert
their demand deposits into currency. Their
preference for currency over deposits
exceeded the banks' ability to convert
deposits into currency: trouble therefore
brewed. On 21 October, the Knickerbocker
Trust Co. experienced a severe "run" on its
deposits and failed; and on the 24th,
depositors at the second largest trust
company in the City began a run on their
deposits. Worried depositors at other banks
began to convert their deposits into
currency; in a chain reaction, concerned
banks outside New York that held deposits
with banks in the City now began to convert
those deposits into currency and gold; and
depositors at banks in other Eastern cities,
observing the unfolding panic in New York,
also began to convert their deposits into
currency. By late October, a nation-wide
banking panic (subsequently dubbed the
"Panic of 1907") had developed.
JPMorgan & Co.'s huge balance sheet, and
the confidence it (and he) inspired, saved
the day and eventually halted the panic.
Thanks to Morgan's reserves, reputation and
encouragements ("There's the deal," J.P.
reputedly told the heads of other banks. "I'll
let you out of my library when you've signed"),
banks were able to stem the redemption of
deposits into currency and gold. They
continued to clear cheques and borrowers
continued to repay their loans. Just as they
had ended previous banking panics, these
actions ended the Panic of 1907. But in its
immediate aftermath, and as a safety
precaution, banks increased the percentage
of their deposits they kept as cash reserves.
And depositors, for a while, held more of
their capital in currency and less in demand
deposits.
Notice that, in order to rebuild their
reserves – for example, to increase the
percentage of deposits held as reserves from
15% to 20% – banks must reduce their supply
of net loans outstanding. In other words,
they must reduce the money supply and thus
implement a policy of deflation. If
borrowers repaid $100,000 of their
outstanding loans, for example, then banks
might create only $85,000 of new loans.
Having reduced the supply of loans, they
could also reduce the demand for loans by
increasing interest rates or the terms and
conditions of collateral and repayment, or
by "calling" (i.e., demanding immediate
repayment of) loans. Under these conditions
the demand deposits destroyed by the
repayment of old loans would be larger than
the deposits created by new loans.
Increasing the fractional reserve ratio thus
tends to decelerate, halt and eventually
reverse the growth of the money supply. The
miner's new $5,000 in gold would result in "only"
$25,000 of new demand deposits at a 20%
reserve ratio versus $33,333.33 at a 15%
ratio. At a 20% ratio, each dollar that a
depositor converted into currency rather
than held as a demand deposit would require
that the banking system destroy $5 of demand
deposits. At a 15% reserve ratio, each
dollar of demand deposits converted into
cash necessitates the destruction of $6.67
of demand deposits.
Under a régime of fractional reserve banking
– which, remember, is not a creature of the
free market but is a government-imposed
phenomenon underwritten by banks' exemption
from the normal laws of bankruptcy – small
changes in reserves beget large changes in
the supply of credit. Sudden changes in the
supply of credit, in turn, create
instability in Wall Street and (eventually)
booms and busts in Main Street. Fractional
reserve banking not only fuels inflation and
booms; the logical consequence of inflation
and boom is deflation (a reduction of the
money supply) and bust.
In 1907, banks responded to October's runs
by accumulating (i.e., not lending) excess
reserves. The money supply subsequently
stagnated and eventually shrank, the pace of
economic activity (which had hitherto
depended upon debt finance) decelerated
sharply and prices (including the price of
labour) fell precipitously. The rapid
decrease of many prices, which was unrelated
to the preferences and demands of consumers,
drastically but temporarily weakened the
ability of the price mechanism smoothly,
accurately and efficiently to co-ordinate
the actions of capitalists, producers and
consumers. Only when the structure of
production adjusted to these new and
chastened conditions could prices transmit
accurate signals, growth resume and
prosperity return.
In 1907, then, fractional reserve banking
(the ultimate cause) and a monetary
disturbance (the consequence of banking
arrangements and the immediate cause of the
crisis) transformed what might otherwise
have been a brief and relatively minor
contraction into a rapid and severe decline
of economic activity that persisted until
June 1908. During the late 1920s and early
1930s, much more severe, complex and
extended monetary disturbances occurred.
This turmoil, together with politicians' and
policymakers' utter unwillingness to let the
price mechanism operate freely, transformed
what might have been a short and sharp
contraction of the type that occurred in
1907 (and again in 1920-21) into a
depression of unprecedented severity that
lasted throughout the decade.(2)
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The Panic of
1907 and the Credit Crisis of
2007-08: Plus Ça Change … |
Is the cause of a
particular malady, the business cycle, known
or unknown? Keynesians simultaneously claim
two things. First, an "excess of aggregate
demand" causes the upward leg and a "deficiency
of aggregate demand" causes the downward leg.
Businesses and consumers who seek to consume
more than the government desires allegedly
cause the boom, and businesses and consumers
who obstinately decline to consume as much
as their rulers demand cause the bust. The
cure, they say, is interventionist monetary
and fiscal policy, which allegedly lessens
the severity of upswings and downswings.
Second, say the Keynesians, no rational
cause but rather the "animal spirits" of
businessmen, underlies the business cycle.
Because these animal spirits are
ineradicable, palliative treatments (such as
imprisoning businessmen in regulatory cages)
are the most that can be expected. During
the 1930s and 1940s Lord Keynes expressly
denied, and today his heirs emphatically
disavow, that monetary and institutional
factors – particularly fractional reserve
banking – cause financial and economic
perturbations (see in particular Paul
Krugman, The Great Unravelling, Penguin,
2005 and the excellent "Oh Keynesian, Where
Are Thou?" by Mateusz Machaj).(3)
Since the late 19th century, Austrian School
economists have emphasised that in a
fractional reserve system banks cannot
quickly return cash to large numbers of
depositors because the bulk of the deposits
reside in an illiquid form, i.e., loans and
income-earning securities rather than
currency and gold. In an emergency, banks
must turn to the strongest and most solvent
among their ranks, if such a beast exists,
in order to obtain cash quickly. In 1907
they turned to JPMorgan & Co., and in
2007-2008 they have turned to the Federal
Reserve. If banks sell loans and securities
in order to obtain cash for their panicky
depositors, as they did a century ago and
are doing again now, they depress the prices
of the loans and securities. Under these
circumstances the banks have even fewer
assets to cover their liabilities, and risks
to their liquidity (i.e., ability to convert
assets into cash) and ultimately solvency
(i.e., the ability to repay debt and other
liabilities) rise.
Hence the Fed's actions since August 2007:
it has lent reserves to banks in exchange
for collateral. The Fed is lending more
reserves for longer periods of time, and is
prepared to lend at lower rates of interest
and in exchange for ever less pristine
collateral. These actions give the banks
time to purge and repair their balance
sheets, i.e., to recognise bad loans and
raise new capital, and thus to rebuild
depleted shareholders' equity. The Fed, in
effect, is underwriting the banks' day-to-day
and least-risky transactions. As it did in
the early 1980s and again in the early 1990s
(and later reversed), it is undertaking a
nationalisation-by-stealth of parts of the
U.S. banking and mortgage industries.
Critically, however, the Fed cannot increase
assets relative to liabilities: it cannot,
in other words, create shareholders' equity.
Only savings can do that. Keynesians have
always rejoiced that central banks routinely
conjure money out of nothing; but they have
never grasped that nobody can contrive
savings from a vacuum. These days, where do
savings reside? Not, by and large, in the
U.S., U.K. or Australasia. To some extent
they dwell in Canada and the Eurozone; but
they mostly congregate in Asia and the
Middle East. Americans flatter themselves
that they are the world's most powerful
nation. But aircraft carriers and military
bases around the world may avail Americans
little when Arabs and Asians finance them –
as well as American banks and mortgages.
The juxtaposition of the Panic of 1907 and
the "Credit Crisis" of 2007-08 shows that
the "American sub-prime crisis" is not a
cause of the recent and current ructions in
credit and stock markets. It is a symptom
(and hence a consequence) of bad policies,
namely Keynesian economics and fractional
reserve banking. The sub-prime bust, the
credit crisis and stock market ructions, in
other words, are not "free market" phenomena:
they are the consequences of meddling
government. The correct prescription for
these ills is not more government,
legislation and regulation. Quit the
contrary: it is drastically less of these
harmful things.
Alas, politicians, bureaucrats and market
participants are so strongly addicted to
interventionist medications that they simply
do not recognise the harm these elixirs have
done, are doing and (unless reversed) will
continue to do. The mindset of one of
Australia's most prominent financial
journalists is typical. Noting on 4 April
that "the collapse of the long-running bull
market is revealing a series of errors of
judgement that leave a nasty taste for all
concerned," he concluded "we obviously will
need extra regulations." Just as inanely, a
former head of the Australian Stock Exchange
and of a forerunner of the Australian
Securities and Investments Commission was
quoted in The Australian (also 4 April,
which was clearly a great day for socialists
in Oz), "the regulator needs to do more to
prevent market manipulation by cowboys who
believe they can drive a market down for
their own benefit." Left unsaid, but implied,
is that market manipulation by the Coalition
for Inflation (which includes governments,
central and commercial banks, regulators,
borrowers and speculators), which believes
it can drive a market up for their own
benefit, is quite OK. Because they were
clueless about the weakness of the Gilded
Era from the mid-1990s, and are now
oblivious to the causes of the crisis and
ructions, the herd is demanding medicine
that will exacerbate rather than ameliorate
the problem. The trouble is that bad policy
caused this mess. So how can more of the
same resolve it?
The most idiotic comments of all were
uttered by folks who sought to ban one or
another or all types of
short-selling.
During February and March, short-sellers
played the same role in Australian (and to a
lesser extent British) financial markets as
witches did in colonial Salem: that is, they
were scapegoats and innocent pawns.
Fortunately, sane articles about short-selling
appeared amidst the dross (see in particular
"Tighter Shorts May Put the Squeeze on Those
They Are Supposed to Protect" and "The March Against Shorting"). A letter to the editor of
The Australian (2 April) about short-selling
was unintentionally very wise. "There should
be an immediate Government declaration that,
pending enquiries, all parties are on notice
that for every dollar lost a dollar will be
demanded from those who have benefited. And
that there will be no legal loopholes, that
there will be severe penalties for those who
do not return their undeserved gains." Why
not apply this admirable rule to the
government and its henchmen, and to
politicians and their mascots, as just
desserts for their lying, stealing, cheating
and killing?
From the foregoing
analysis emerge seven major points for
investors:
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1) Many journalists, market
commentators and the like are manic-depressives.
Their sudden and diametric changes
of mood, together with their sheer
contempt for logic and evidence,
should be taken no more seriously
than Commies' and fellow-travellers'
demented twists and turns during the
late 1930s and early 1940s. Like
politicians, Redshirts and
Brownshirts, so too mainstream
economists and commentators: regard
them alternately as evil and as
objects worthy of nothing but
ridicule.
2) In order to comprehend what has
happened, is now occurring and may
eventually transpire in Wall Street
and Main Street, it is imperative to
remove distorting Keynesian
spectacles and diagnose the world as
our forefathers did – that is,
through unimpaired (i.e., Austrian
School) eyes. This allows us to see
something that the manic-depressive
herd cannot or will not see: namely
that sub-prime mortgage lending in
the U.S. has not caused the ructions
in credit and stock markets. The sub-prime
fallout is a symptom (and hence a
consequence) of destructive policies,
namely Keynesianism and fractional
reserve banking.
3) Modern banks, i.e., fractional
reserve banks, lend depositors'
funds. They cannot repossess these
funds instantly, yet depositors can
demand their funds any time they
wish. Such banks cannot meet its
obligations if they fall due.
Accordingly, they are always
technically bankrupt.
4) Fractional reserve banking links
Wall Street to Main Street. It not
only ignites the boom that causes
the bust: it spreads the virus from
financial to the real world. It did
so in 1907, and also in every
subsequent exclamation of the
business cycle including 2007-2008.
During today's bust, the Fed can buy
commercial banks some of the time
they need in order to repair their
wounded balance sheets. But it
cannot increase banks' assets
relative to liabilities: it cannot,
in other words, create shareholders'
equity. Only savings can do that.
5) In order to restore their
finances to order, banks must raise
billions of dollars of capital.
Their demand for savings will raise
its price, and their caution will
increase the price and stiffen the
terms of loans. These actions will
put downward pressure upon corporate
earnings (including banks' profits),
and therefore upon the prices of
securities and financial assets.
6) The next decade will resemble the
1970s rather than the 1930s. It may
well include recession and falling
asset prices, together with rising
consumer prices and interest rates
("stagflation"). The poor policies
of the past decade are once again
coming home to roost, and the
growing clamour for more
intervention will simply add to the
downdraught.
7) Fractional reserve banking is not
a creature of the free market: it is
a government-imposed phenomenon.
Hence the sub-prime bust, credit
crisis and stock market ructions are
not free market phenomena: they are
the consequences of interventionist
government. The correct prescription
for these consequences of bad policy,
therefore, is not more of the same
bad policies. Quite the contrary: it
is drastically less government
expenditure, financial legislation
and regulation. The abolition of
corporate regulators and central
banks would provide a good start.
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Where are stock market
indices heading? I don't know, but the
analogy of Daniel Turov ("Mixed Message,"
Barron's 21 May 2001) makes much more sense
than the relentless cacophony emitted by
most journalists, "market strategists" and
other babblers. "Bear markets don't act like
a medicine ball rolling down a smooth hill,"
said Turov. "Instead, they behave like a
basketball bouncing down a rock-strewn
mountainside; there's lots of movement up
and sideways before the bottom is reached.
During the Great Bear Market from 1929 to
1942, the Dow Industrials had rallies of 48%
(from November 13, 1929, to April 17, 1930),
94% (July 8, 1932, to September 7 of that
year), 121% (February 27, 1933, to February
5, 1934), 127% (July 26, 1934, to March 10,
1937), 60% (March 31, 1938, to November 12
of that year) and 28% (April 8, 1939, to
September 12 of that year). Yet, on April
28, 1942, the DJIA was still at only 92.92,
76% below its September 3, 1929, high of
381.17."
Turov adds "when the bulls stop asking 'is
this the bottom?' and instead are explaining
to their friends why 'this time it's
different, and the market really is a
bottomless pit,' then it will be time for me
to pen 'Buy Signal, Part 2.' But we're a
long way from that." His conclusion applies
just as much to Australia as to the U.S. As
such, it should – but probably won't – give
the Australian herd pause: "the Dow first
reached the 100 level in January 1906. It
traded above and below that level for more
than 36 years; it wasn't until May 1942 that
the market left 100 behind for the last
time. The Industrial Average first reached
1,000 in February 1966. It traded above and
below that level for the next 17 years,
leaving that figure behind for the last time
in February 1983. The Dow first reached the
10,000 level in March 1999. Considering the
unprecedented gains of the past several
years, would it be that unusual for this
benchmark to take a decade or even two
before leaving 10,000 in the dust for the
last time?"
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