I have written a number of
pieces on fractional reserve banking and duration mismatch. I have argued
that the former is perfectly fine, both morally and economically, but the
latter is not fine. I have dissected the arguments made against fractional
reserve banking, and pointed out that it is nothing more than a bank lending
out some of the money it takes in deposits.
I have debunked the most
common errors made by opponents of fractional reserve:
- Banks print
money
- They lend
more than they take in deposits
- They inflate
the money supply
- Money is the
same as credit
- Fractional
reserves banking is the same thing as central banking
- It is the
same thing as duration mismatch
Duration mismatch is when a
bank (or anyone else) borrows short to lend long. Unlike fractional reserve,
duration mismatch is bad. It is fraud, it is unfair to depositors (much less
shareholders) and it is certain to collapse sooner or later. This is not a
matter for statistics and probability, i.e. risk. It is a matter of
causality, which is certain as I explain below.
This discussion is of
paramount importance if we are to move to a monetary system that actually
works. Few serious observers believe that the current worldwide regime of
irredeemable paper money will endure much longer. Now is the time when
various schools of thought are competing to define what should come next.
I have written
previously on why a 100% reserve system (so-called) does not work. Banks
are the market makers in loans, and loans are an exchange of wealth and
income. Without banks playing this vital role, the economy would collapse back
to its level the previous time that the government made it almost impossible
to lend (and certainly to make a market in lending). The medieval village had
an economy based on subsistence agriculture, with a few tradesmen such as the
blacksmith.
But I have not directly
addressed the issue of why duration mismatch necessarily must fail, leading
to the collapse of the banks that engage in it. The purpose of this paper is
to present my case.
In our paper monetary system,
the dollar is in a "closed loop". Dollars circulate endlessly.
Ownership of the money can change hands, but the money itself cannot leave
the banking system. Contrast with gold, where money is an "open
loop". Not only can people sell a bond to get gold coins, they can take
those gold coins out of the monetary system entirely, and stuff them under
the mattress. This is a necessary and critical mechanism--it is how the floor
under the rate of interest is set.
This bears directly on banks.
In a paper system, they know that even if some depositors withdraw the money,
they do not withdraw it to remove it altogether (except perhaps in dollar
backwardation, at the end. See:
http://keithweiner.posterous.com/dollar-backwardation). They withdraw it to
spend it. When someone withdraws money in order to spend it, the seller of
the goods who receives the money will deposit it again. From the bank's
perspective nothing has changed other than the name attached to the deposit.
The assumption that if some
depositors withdraw their money, they will be replaced with others who
deposit money may seem to make sense. But this is only in the current context
of irredeemable paper money. It is most emphatically not true under gold!
There are so many ills in our
present paper system, that a forensic exploration would require a very long
book (at least) to dissect it. It is easier and simpler to look at how things
work in a free market under gold and without a central bank.
Let's say that Joe has 17
ounces of gold that he will need in probably around a month. He deposits the
gold on demand at a bank, and the bank promptly buys a 30-year mortgage bond
with the money. They assume that there are other depositors who will come in
with new deposits when Joe withdraws his gold, such as Mary. Mary has 12
ounces of gold that she will need for her daughter's wedding next week, but
she deposits the gold today. And Bill has 5 ounces of gold that he must set
aside to pay his doctor for life-saving surgery. He will need to withdraw it
as soon as the doctor can schedule the operation.
In this instance, the bank
finds that their scheme seems to have worked. The wedding hall and the doctor
both deposit their new gold into the bank. "It's not a problem until
it's a problem," they tell themselves. And they pocket the difference between
the rate they must pay demand depositors (near zero) and the yield on a
30-year bond (for example, 5%).
So the bank repeats this trick
many times over. They come to think they can get away with it forever. Until
one day, it blows up. There is a net flow of gold out of the bank;
withdrawals exceed deposits. The bank goes to the market to sell the mortgage
bond. But there is no bid in the mortgage market (recall that if you need to
sell, you must take the bid). This is not because of the borrower's declining
credit quality, but because the other banks are in the same position. Blood
is in the water. The other potential bond buyers smell it, and they see no
rush to buy while bond prices are falling.
The banks, desperate to stay
liquid (not to mention solvent!) sell bonds to raise cash (gold) to meet the
obligations to their depositors. But the weakest banks fail. Shareholders are
wiped out. Holders of that bank's bonds are wiped out. With these cushions
that protect depositors gone, depositors now begin to take losses. A bank run
feeds on itself. Even if other banks have no exposure to the failing bank,
there is panic in the markets (impacting the value of the other banks'
portfolios) and depositors are withdrawing gold now, and asking questions
later.
And why shouldn't they? The
rule with runs on the bank is that there is no penalty for being very early,
but one could suffer massive losses if one is a minute late (this is
contagion http://dailycapitalist.com/2012/05/30/keithgr...tagion-defined/).
What happened to start the
process of the bank run? In reality, the depositors all knew for how long
they could do without their money. But the bank presumed that it could lend
it for far longer, and get away with it. The bank did not know, and did not
want to know, how long the depositors were willing to forego the use of their
money before demanding it be returned. Reality (and the depositors) took a
while, but they got their revenge. Today, it is fashionable to call this a
"black swan event." But if that term is to have any meaning, it
can't mean the inevitable effect caused by acting under delusions.
Without addressing the moral
and the legal aspects of this, in a monetary system the bank has a job: to be
the market maker in lending. Its job is not to presume to say when the
individual depositors would need their money, and lend it out according to
the bank's judgment rather than the depositors'. Presumption of this sort
will always result in losses, if not immediately. The bank is issuing
counterfeit credit target="_blank"(http://keithweiner.posterous.com/inflation...nterfeit-credit).
In this case, the saver is not willing (or even knowing) to lend for the long
duration that the bank offers to the borrower.
Do depositors need a reason to
withdraw at any time gold they deposited "on demand"? From the
bank's perspective, the answer is "no" and the problem is simple.
From the perspective of the
economist, what happened is more complex. People do not withdraw their gold
from the banking system for no reason. The banking system offers compelling
reasons to deposit gold, including safety, ease of making payments, and
typically, interest.
Perhaps depositors fear that a
bank has become dangerously illiquid, or they don't like the low interest
rate, or they see opportunities offshore or in the bill market. For whatever
reason, depositors are exercising their right and what they expressly
indicated to the bank: "this money is to be withdrawn on demand at any
time."
The problem is that the
capital structure, once erected, is not flexible. The money went into durable
consumer goods such as houses, or it went into partially building
higher-order factors of production. Imagine if a company today began to build
a giant plant to desalinate the Atlantic Ocean. It begins borrowing every
penny it can get its hands on, and it spends each cash infusion on part of
this enormous project. It would obviously run out of money long before the
plant was complete. Then, when it could no longer continue, the
partially-completed plant would either be disassembled and some of the
materials liquidated at auction, or it would sit there and begin to rot.
Either way, it would finally be revealed for the malinvestment that it was
all along.
By taking demand deposits and
buying long bonds, the banks distort the cost of money. They send a false
signal to entrepreneurs that higher-order projects are viable, while in
reality they are not. The capital is not really there to complete the
project, though it is temporarily there to begin it.
Capital is not fungible; one
cannot repurpose a partially completed desalination plant that isn't needed
into a car manufacturing plant that is. The bond on the plant cannot be
repaid. The plant construction project was aborted prior to the plant
producing anything of value. The bond will be defaulted. Real wealth was
destroyed, and this is experienced by those who malinvested their gold as
total losses.
Note that this is not a matter
of probability. Non-viable ventures will default, as unsupported buildings
will collapse.
People do not behave as
particles of an "ideal" gas, as studied by undergraduate students
in physics. They act with purpose, and they try to protect themselves from
losses by selling securities as soon as they understand the truth. Men are
unlike a container full of N2 molecules, wherein the motion of some to the
left forces others to the right. With men, as some try to sell out of a
failing bond, others try to sell out also. And they are driven by the same
essential cause. The project is non-viable; it is malinvestment. They want to
cut their losses.
Unfortunately, someone must
take the losses as real capital is consumed and destroyed. A bust of credit
contraction, business contraction, layoffs, and losses inevitably follows the
false boom. People who are employed in wealth-destroying enterprises must be
laid off and the enterprises shut down.
Busts inflict real pain on
people, and this is tragic as there is no need for busts. They are not
intrinsic to free markets. They are caused by government's attempts at
central planning, and also by duration mismatch.
