Another incentive for banks to maintain adequate reserves is that the other banks that use the same clearinghouse—the banks’ partners in that clearinghouse association—will be willing to accept any particular bank’s notes and checks only as long as they are confident that that bank can meet its obligations to redeem those notes and checks as promised. A bank that lets its reserves at the clearinghouse fall too low would risk being suspended from the clearinghouse. That could be the road to ruin because it might shake its customers’ confidence in the bank and motivate them to take their business elsewhere.
On the other hand, no bank wants its reserves to exceed the amount necessary to cover its normal redemption obligations, because that would mean missing the opportunity to earn income by lending out more notes and checking balances.
In short, any bank must discover through experience a safe but not excessive level of reserves to hold, and try to maintain that level. It is this effort by each bank, along with the public’s actual behavior in spending or holding each bank’s notes and checking balances, that keeps the money supply “right” in a free market.
To see how the feedback system works, consider what happens when a bank tries to expand too aggressively, lending more of its notes and checking balances into existence when the public is already holding all of that bank’s money it wishes to hold. It might do this by attracting new borrowers with slightly lower interest rates on loans and then lending those new borrowers notes it has newly printed or checking account money it newly creates in the borrowers’ accounts. When some bank does this (let’s call it Bank A for “aggressive”), people to whom its borrowers pay the excess Bank A notes will spend them away (because by assumption they are already holding all they want to hold). As those notes are spent, they will eventually be deposited in various other banks and go from there to the clearinghouse. Similarly, people paid by checks drawn on the new checking accounts at Bank A will deposit those checks in their own banks, from where they will go to the clearinghouse.
Eventually (perhaps quickly) all the new notes and checking account money Bank A has issued in excess of what people wish to hold will come back to Bank A through the clearinghouse. Thereupon Bank A will have to redeem the notes and checks in base money (gold, silver, or whatever). The bank will thereby experience negative net clearings, “adverse clearings,” which reduce its reserves. Low reserves will mean losses for Bank A on the next day it has unusually large negative net clearings at the clearinghouse and runs out of reserves. When that happens, the bank will have to borrow reserves from a sister bank or from the clearinghouse itself at a penalty rate of interest. That’s costly. It reduces the bank’s profits or causes a loss. That feedback gives the bank an incentive to stop over-issuing money and, indeed, to issue less than normal for a time, while it replenishes its reserves.
Of course, not all banks will necessarily learn the right amount of reserves to hold and money to issue. People (including bankers) make mistakes. From time to time, on account of their persistent over-issuing of money and the large expenses and diminished reputation that would result, some banks would go out of business or be taken over by a more capable rival. Driving bad banks out of business is one way in which the Profit-and-Loss Guidance Principle regulates the quality of banking.
If a bank (let’s call it Bank T for “timid”) is over-cautious and issues less in notes and checking balances than the public wishes to hold, the process works in reverse. The public will try to get their holdings of Bank T’s notes and checking balances up to their desired levels by saving (not spending) them. Hence fewer will return to the clearinghouse. With less of its notes and checks to redeem at the clearinghouse, Bank T will experience positive net clearings—its reserves will increase. Observing that increase, Bank T will learn that it can safely lend out more.
Not all banks will avoid being over-cautious, of course, but market forces tend to weed out timid banks. Those banks make smaller profits than they could, or they make losses overall because their income is so low, and therefore they become attractive targets for takeover by better-managed, and hence more profitable, rivals. There’s the Profit-and-Loss Guidance Principle again.
Each bank regulates the quantity of notes and checking balances it issues to the public based on the changing levels of its reserves. Profit and loss force each bank to do this pretty well or go out of business. With each bank regulating its own portion of the money supply more or less correctly based on its feedback from the clearinghouse, the system as a whole tends to provide the amount of money the public wishes to hold. As with pencil making, no mastermind is necessary to plan or comprehend the process as a whole. Free banking would regulate the money supply well in an entirely decentralized fashion.
Why Central Banking Cannot Keep the Money Supply Right
Under a regime of central banking, in contrast to free banking, no feedback mechanism operates to tell the central bank how much money the public would like to hold at prevailing prices. When the central bank upsets monetary equilibrium by creating too much money, it has no competitors returning its notes and checking account money through the clearinghouse for redemption in the underlying reserve commodity. There is no underlying reserve commodity, so the notes and checks are not redeemable. The money a central bank creates does not come back to it from the clearinghouse; there is no independent clearinghouse (in most countries, the central bank clears commercial banks’ checks). The new money stays out in the economy, unless and until the central bank intentionally removes it (see open market sales in Appendix A). A bank that receives the new central bank money holds it as reserves instead of gold, silver, or some other commodity. In a fiat system, central bank notes and checking account money become reserves for that bank as soon as the notes hit the teller’s drawer and the checks clear. All banks are happy to acquire more reserves; accordingly, banks are willing to accumulate indefinite quantities of central bank money. Thus, in all central banking regimes in which the central bank has a legal monopoly on issuing notes, the central bank’s fiat money serves as reserves in place of an underlying commodity.
Hence, when more fiat money is issued than the public wishes to hold, the central bank experiences no depletion of its reserves (the money it created is reserves!). The erring central bank faces no losses, embarrassment, or expulsion from its clearinghouse association (clearinghouses for notes no longer exist).
This difference in the nature of reserves is fundamentally important. In free banking, reserves consist of quantities of a physical commodity valuable in its own right; increased quantities can be obtained only by expensive mining operations. In central banking, reserves consist of printed paper and bookkeeping entries that can be created with the click of a mouse. With underlying (“base”) money so easy to create, there is great danger, all too often realized in history, that the central bank will create too much of it.
When too much money is issued, spending rises. That is true under central banking or under free banking. The public spends away the excess on a variety of consumption and investment goods. But because this new money stays in the economy in a central-banking regime (as it would not in free banking), this extra spending serves not to punish the over-issuing central bank (as it would a free bank) but to drive up prices. Prices tend to rise most in the sectors of the economy where the money is most freely spent. It might, for example, be spent most freely on housing and drive up housing prices. When prices rise, the buying power of money falls. Prices tend to rise until the buying power of money has fallen enough so that the new, larger quantity of money has only the buying power that people wish to hold.
So, in the absence of feedback from a clearinghouse, how does the central bank know how much money to create? It doesn’t know. It can’t know.
Because a central banking system lacks the natural, decentralized regulation provided by clearinghouses in free banking, there is no systemic limit to how much money the central bank can produce. In the face of political and social pressure on
the central bank authorities, the public has little to rely on to restrain excess money issue other than the understanding, independent judgment, good intentions, and good luck of the bank authorities themselves.
Unfortunately for the public, even with the best of intentions to get the money supply right, central bankers lack the information and understanding necessary to do so. This is no slander of them: The world economy is too complex for anyone to understand well enough to intervene in it and reliably get good results. As I said above (and discussed in Chapter 2), this is another instance of the knowledge problem—a problem that free market processes solve, if they are allowed to. Unfortunately for the public, sometimes central bankers lack the best of intentions. After all, they are human beings. Like all of us they respond to the incentives at work on them. In a central banking system, impersonal profit-and-loss incentives (as well as, in the extreme, the unanswerable compulsion of bankruptcy) are replaced by a host of other incentives. Those incentives range from a magnanimous desire to do a good job and win the esteem of a grateful population (perhaps years in the future after the public comes at last to appreciate the wisdom of policies they once decried), to a selfish desire to pacify at once a clamorous public and legislature, to the desire to exercise yet again the intoxicating power to lower (short-term) interest rates and create new money and credit out of nothing at all.
I fear that, most often, political incentives prevail. This certainly seems to be what happened in 2001-2004, when the Fed created so much new money that it kept its target interest rate at historical lows, thereby enabling hundreds of billions of dollars of over-investment in housing.
Intervention #5 - Rescuing Lenders
Another major government intervention into the economy that stoked the boom is the federal government’s regular rescuing of the creditors of big institutions that have gotten into financial trouble. Such rescues obstruct the operation of the Profit-and-Loss Guidance Principle by shielding lenders from the losses they have earned, and which they need to suffer, if saver/lenders are to discover—and learn and remember—the kinds of investments they should avoid. The government has been rescuing lenders for decades. Its doing so has led creditors of big financial institutions to expect to be rescued in the event of trouble. This expectation in turn has led lenders both to lend more freely and to reduce (or quit entirely) their monitoring and curtailing of the risks their borrowers take.
Such carelessness and free lending allowed (even induced) major financial intermediaries—Fannie and Freddie, Bear Stearns, Merrill-Lynch, Citibank, Bank of America and others—to invest huge amounts of borrowed money in housing. These bad investments fed the housing boom.
The government’s habit of rescuing lenders is harder to identify as an intervention than other culprits we’ve considered because it is implicit policy, nowhere explicitly written on the books and not consistently followed, as we shall see. The exemption of housing from capital gains tax, Fannie and Freddie’s “affordable housing” goals, and the Basel capital adequacy rules (to be discussed in the next chapter) are all explicit policies “on the books.” On the other hand, the government’s strong tendency to rescue lenders over the last thirty years has shaped the expectations and decisions of lenders and borrowers.
I am indebted for my understanding of this problem to Russell Roberts. In discussing this intervention, I digest and quote extensively from his paper, “Gambling With Other People’s Money, How Perverted Incentives Caused the Financial Crisis.”
We already touched on the basic problem Roberts describes when we discussed the U.S. government’s once-implicit, now-explicit guarantees to those who have loaned Fannie Mae and Freddie Mac money by buying their bonds or their mortgage-backed securities. In the next chapter we discuss guarantees in the form of government-provided deposit insurance for those who have loaned banks their deposits. The law promises to rescue these depositors from any losses on their deposits up to the amount specified by law (now $250,000).
Roberts discusses not only these guarantees—he discusses Fannie and Freddie at length—but also the government’s record of rescuing lenders to institutions not “sponsored” by government and depositors whose deposits were not insured by the FDIC.
Roberts makes his point with a metaphor of a very good poker player who borrows most of his stake from a friend at an agreed rate of interest. His illustration merits quoting at length:
Imagine a superb poker player who asks you for a loan to finance his nightly poker playing. For every $100 he gambles, he’s willing to put up $3 of his own money. He wants you to lend him the rest. You will not get a stake in his winning. Instead, he’ll give you a fixed rate of interest on your $97 loan.
The poker player likes this situation for two reasons. First, it minimizes his downside risk. He can only lose $3. Second, borrowing has a great effect on his investment—it gets leveraged. If his $100 bet ends up yielding $103, he has made a lot more than 3 percent—in fact, he has doubled his money. His $3 investment is now worth $6.
But why would you, the lender, play this game? It’s a pretty risky game for you. Suppose your friend starts out with a stake of $10,000 for the night, putting up $300 himself and borrowing $9,700 from you. If he loses anything more than 3 percent on the night, he can’t make good on your loan.
Not to worry—your friend is an extremely skilled and prudent poker player who knows when to hold ’em and when to fold ’em. He may lose a hand or two because poker is a game of chance, but by the end of the night, he’s always ahead. He always makes good on his debts to you. He has never had a losing evening. As a creditor of the poker player, this is all you care about. As long as he can make good on his debt, you’re fine. You care only about one thing—that he stays solvent so that he can repay his loan and you get your money back.
But the gambler cares about two things. Sure, he too wants to stay solvent. Insolvency wipes out his investment, which is always unpleasant—it’s bad for his reputation and hurts his chances of being able to use leverage in the future. But the gambler doesn’t just care about avoiding the downside. He also cares about the upside. As the lender, you don’t share in the upside; no matter how much money the gambler makes on his bets, you just get your promised amount of interest.
If there is a chance to win a lot of money, the gambler is willing to a take a big risk. After all, his downside is small. He only has $3 at stake. To gain a really large pot of money, the gambler will take a chance on an inside straight.
As the lender of the bulk of his funds, you wouldn’t want the gambler to take that chance. You know that when the leverage ratio—the ratio of borrowed funds to personal assets—is 32–1 ($9,700 divided by $300), the gambler will take a lot more risk than you’d like. So you keep an eye on the gambler to make sure that he continues to be successful in his play.
But suppose the gambler becomes increasingly reckless. He begins to draw to an inside straight from time to time and pursue other high-risk strategies that require making very large bets that threaten his ability to make good on his promises to you. After all, it’s worth it to him. He’s not playing with very much of his own money. He is playing mostly with your money. How will you respond?
You might stop lending altogether, concerned that you will lose both your interest and your principal. Or you might look for ways to protect yourself. You might demand a higher rate of interest. You might ask the player to put up his own assets as collateral in case he is wiped out. You might impose a covenant that legally restricts the gambler’s behavior, barring him from drawing to an inside straight, for example.
These would be the natural responses of lenders and creditors when a borrower takes on increasing amounts of risk. But this poker game isn’t proceeding in a natural state. There’s another person in the room: Uncle Sam. Uncle Sam is off in the corner, keeping an eye on the game, making comments from time to time, and, every once in a while, intervening in the game. He sets many of the rules that govern the play of the game. And sometimes
he makes good on the debt of the players who borrow and go bust, taking care of the lenders. After all, Uncle Sam is loaded. He has access to funds that no one else has. He also likes to earn the affection of people by giving them money. Everyone in the room knows Uncle Sam is loaded, and everyone in the room knows there is a chance, perhaps a very good chance, that wealthy Uncle Sam will cover the debts of players who go broke.
Nothing is certain. But the greater the chance that Uncle Sam will cover the debts of the poker player if he goes bust, the less likely you are to try to restrain your friend’s behavior at the table. Uncle Sam’s interference has changed your incentive to respond when your friend makes riskier and riskier bets.
If you think that Uncle Sam will cover your friend’s debts . . .
you will worry less and pay less attention to the risk-taking behavior of your gambler friend.
you will not take steps to restrain reckless risk taking.
you will keep making loans even as his bets get riskier.
you will require a relatively low rate of interest for your loans.
Free Our Markets Page 26
