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On Friday, May 1, 2012, JPMorgan
Chase said it suffered a $2 billion trading loss. Some commentators have
suggested that the huge loss emanates from so-called proprietary trading or
placing risky bets using the bank's money. The loss raised the credibility of
the Volcker rule, which restricts banks from trading their own money. Despite
JPMorgan Chase's large loss, the opponents of the Volcker rule are of the
view that the rule, if it is introduced, will only destabilize the financial
markets and make things much worse. Hence they would like to allow market
forces to do their job.
Do Fewer
Banking Controls Always Equate with a Free Market?
The proponents for less control in
the banking industry hold that fewer restrictions imply a better use of
scarce resources, which leads to the generation of more real wealth.
It is true that a free banking
environment is an agent of wealth promotion through the efficient use of
scarce real resources, while controlled banking stifles the process of real
wealth formation. However, it is overlooked by the opponents of the Volcker
rule that the present banking system has nothing to do with free banking and
thus a free market.
What we have at present is a
banking system within the framework of the central bank, which promotes monetary
inflation and the destruction of the process of real wealth generation
through fractional-reserve banking. In the present system, the more
unrestricted the banks are, the more money "out of thin air" can be
generated and hence greater damage inflicted on the wealth-generation
process. This must be contrasted with genuine free banking, i.e., the absence
of a central bank, where the potential for the creation of money out of thin
air is minimal.
Elsewhere we have shown that in a
free-banking environment with many competitive banks, if a particular bank
tries to expand credit by practicing fractional-reserve banking, it runs the
risk of being "caught." So it is quite likely that in a free-market
economy the threat of bankruptcy would bring to a minimum the practice of
fractional-reserve banking.
The Existence
of a Central Bank Encourages Fractional-Reserve Banking
This is, however, not so in the
case of the existence of the central bank. By means of monetary policy, which
is also termed the reserve management of the banking system, the central bank
permits the existence of fractional-reserve banking and thus the creation of
money out of thin air.
The modern banking system can be
seen as one huge monopoly bank that is guided and coordinated by the central
bank. Banks in this framework can be regarded as "branches" of the
central bank.
For all intents and purposes the
banking system can be seen as being comprised of one bank. (Note that a
monopoly bank can practice fractional-reserve banking without running the
risk of being "caught.")
Through ongoing monetary management
— i.e., monetary pumping — the central bank makes sure that all
the banks engage jointly in the expansion of credit out of thin air. The
joint expansion in turn guarantees that checks presented for redemption by
banks to each other are netted out. By means of monetary injections the
central bank makes sure that the banking system is "liquid enough"
so banks will not bankrupt each other.
The Myth of Financial Deregulation
Prior to the 1980s financial
deregulation we had controlled banking. Banks' conduct was guided by the
central bank. Within this type of environment bank's profit margins were
nearly predetermined (the Fed imposed interest-rate ceilings and controlled
short-term interest rates); hence the "life" of the banks was quite
easy, although boring.
The introduction of financial
deregulation and the dismantling of the Glass-Steagall Act changed all that. The deregulated
environment resulted in fierce competition between banks. The previously
fixed margins were severely curtailed. This in turn called for an increase in
volumes of lending in order to maintain the level of profits.
In the present central-banking
framework this increase culminated in an explosion in the creation of credit
out of thin air — a massive explosion in the money supply. (In the
deregulated environment, banks' ability to amplify the Fed's pumping has
enormously increased.)
Rather than promoting an efficient
allocation of real savings, the current so-called deregulated monetary system
has been promoting the channeling of money out of thin air across the
economy. From this it follows that, in the framework of the present monetary
system, in order to reduce a further weakening of the real wealth-generation
processes, it is necessary to introduce tighter controls on banks. Murray Rothbard wrote,
Many free-market advocates wonder:
why is it that I am a champion of free markets, privatization, and
deregulation everywhere else, but not in the banking system? The answer
should now be clear: Banking is not a legitimate industry, providing
legitimate service, so long as it continues to be a system of
fractional-reserve banking: that is, the fraudulent making of contracts that
it is impossible to honor. (Making
Economic Sense, p. 279)
Bear in mind that we don't suggest
here suppressing the free market but suppressing banks' ability to generate
credit out of thin air. Please note that the present banking system has
nothing to do with a true free-market economy.
It must be reiterated here however
that more controls within the framework of central banking can only slow down
the pace of the erosion of real wealth formation. It cannot prevent the
erosion. (Remember that the Fed continues to pump money to navigate the
economy.) More controls will suppress banks' ability to significantly amplify
the Fed's pumping, so in this sense it is preferable to a so-called
deregulated banking sector.
Summary and Conclusions
According to some commentators, the
huge $2 billion loss by JPMorgan Chase, caused by the risky bets placed using
the bank's money, raises the need to implement the Volcker rule — more
controls on banks' activities. Critics of the Volcker rule are of the view
that it will only make things much worse by stifling the efficient allocation
of scarce real resources. Our analysis holds that as long as we have a
central bank, in order to minimize the damage its policies inflict, it makes
sense to impose tighter controls on banks. It is the central bank that
enables banks to practice fractional-reserve banking, thereby polluting the
economy with money out of thin air. A better alternative is of course to have
genuine free banking without the central bank.
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