Radio Free Market

Re: Irish Try to Eradicate Ghosts of a Housing Crash

Lord Keynes famously said that paying people to dig holes and fill them back up was necessary for recovery.  His disciple Paul Krugman wants Martians to attack earth so that we can spur the economy via war spending.

Read the above NY Times report, if you have a strong enough stomach.  Keynes would have applauded the Irish housing boom, and von Mises would have explained that such malinvestment leads to bankruptcy and poverty.  I would add that it leads to despair, as the wealth, hopes, and dreams of hard working people are shattered.

Patrick Barron

Introduction

This paper deals with the steps that are required to cover bank demand deposits 100% by reserves.  We will deal with ending the ability of the banking system to pyramid reserves into new money, created out of thin air, and will show the steps necessary for the banking system to transition from a fractional reserve system to 100% reserves without creating new reserves and without shrinking the money supply.  The paper will discuss the feasibility and the method to successfully transition to this new banking structure. Monetary expansion via the banking side would end, as would inflation and the boom/bust business cycle. (See note #1)

Summary of expected outcomes

Banking services would be divided into two separate businesses as described in chapters six and seven of Murray N. Rothbard’s The Mystery of Banking.  Bank demand deposits (checking accounts) would be backed 100% by reserves, housed in new Deposit Banks that provide payment services only.  Bank savings and time deposits would be backed by loans and securities, housed in new Loan Banks.  A Deposit Bank customer who wishes to earn an interest return on his excess demand funds opens an account at the Loan Bank.  He transfers ownership of his excess demand funds to the loan banker, who further transfers ownership of the demand money to his borrowing customer.  In other words, the original demand account holder “lends” his money to the loan banker, who further lends it to his (the loan banker’s) customer.  The loan banker acts as a financial intermediary, finding good credits and managing them in order to pay interest to his depositors (who actually are lenders to the Loan Bank).  He must earn enough from the loans he finds to pay interest to his depositors, fund his lending operation, and set aside a reserve for bad debt.  Notice that no new money is created anywhere in  this process.  The Loan Bank’s borrower takes temporary possession of the money originally in the Deposit Bank.  The possessor of the same money has changed temporarily, but no new money was created.  This paper will discuss the feasibility and method to successfully transition to this new banking structure.

Enough cash to cover demand accounts but not savings and time accounts

Here is the aggregate balance sheet (trillions of dollars) for all US banks as of November 2013 per Federal Reserve Data:

Notice that bank total cash assets exceed bank demand accounts by $1.151 trillion ($2.630 minus $1.479).  However, bank total cash assets are well short of covering total bank deposits by $7.116 trillion ($2.630 minus $9.746).  Therefore, it is technically possible at the present time for banks to maintain 100% reserves against demand (checking) deposits but not against total deposits.  In other words, if all bank depositors, including savings and time depositors, chose to exchange their deposits for cash and accept any contracted penalties, the banks would be $7.116 trillion short.  Total bank deposits are $9.746 trillion, of which $1.479 trillion are demand deposits, leaving $8.267 trillion in non-demand deposits; i.e., savings accounts and time deposits.

Morphing the current banking system into a Rothbardian banking system

But is this really a problem?  The banks do have loans and securities of $10.076 trillion, well in excess of the amount needed to secure their savings and time deposits in the Loan Bank.  Would not these depositors prefer to keep their funds invested rather than decide to “cash out” their savings and time deposits, accept the penalties, and place all or most of their money in the Deposit Bank where they not only would not receive interest but would pay fees to boot?  Let’s take a look at how the new Deposit and Loan Banks might be constructed after the split and what might entice savings and time depositors to keep their money in a new Loan Bank.  Here is what the new aggregated Deposit Bank and Loan Bank would look like:

Here’s how I divided the assets, liabilities, and capital:

1.  I moved all of the demand deposits into the Deposit Bank and all of the non-demand deposits into the Loan Bank.
2.  I gave the Deposit Bank enough of the cash assets to cover the demand deposits 100%.  I gave the rest to the Loan Bank.

3.  I gave the Deposit Bank the loans, securities, and the other half of the Other Assets.
4.  I divided the Other Assets equally between the two banks, assume these to be mostly fixed assets and office equipment.
5.  I gave the Deposit Bank enough Capital to balance its Liability side with its Asset side.  I gave the rest to the Loan Bank.
5.  I gave the Loan Bank all the Borrowings and all the Other Liabilities.

Here are the results:

1.  The capital ratio of the Deposit Bank is 30.1%; the capital ratio of the Loan Bank is 7.5%.
2.  The Loan Bank’s liabilities of $10.974 are secured by cash, loans, and securities of $11.227.
3   The Loan Bank has cash equal to 11.7% of its loans and borrowings, meaning that almost 12% of the non-demand depositors would have to ask for their money before the Loan Bank would be forced to sell some of its securities.

4.   The Loan bank has securities equal to another 24.6% of its non-demand deposits, so, in total the Loan Bank has cash and securities equal to 35.1% of its non-demand deposits to pay for deposit withdrawals.

5.  For individual Loan Banks that nonetheless find themselves short of cash and securities, the only answer is to sell their loans in the market at whatever discount is required to raise the funds necessary to honor their current deposit contracts.  Now the issue becomes one of simple market forces.  How much of a discount will these banks be forced to accept?

If customers wish to hold more demand accounts, secured by 100% fiat money, they will pay for the privilege in the form of fees at the new Deposit Bank, because the Deposit Bank will not be allowed to invest the cash, as is currently allowed by fractional reserve banking laws.  Banks who run out of excess reserves to back their redeemed savings and time deposits will be forced to sell some of their loans to banks with excess reserves.  They may be forced to offer discounted prices to these investors, which means the purchasers, presumably the new Loan Banks, will receive a higher return.  This will give a great incentive for current savings and time deposit customers to keep their deposits in a new Loan Bank rather than hold all their money in the form of demand deposits in a new Deposit Bank and pay fees for the privilege.

Individual banks that  cannot raise enough cash to honor all of its demand deposits must declare bankruptcy.  Their depositors will be paid out of the FDIC insurance fund.  This is a one-time occurrence, for after the banking system has been split into Deposit Banks and Loan Banks, the FDIC will be dissolved.

Regardless of whether banks make a profit or loss on securing their demand accounts 100% by cash, the accounting equation is fairly straightforward:  the Deposit Banks credit their loan accounts on the asset side and debit their savings and time deposits accounts on the liability side to the extent required so that the Deposit Bank holds only demand accounts, all of which are backed 100% by cash.  The loans will be debited to the asset side of the Loan Bank, securing the savings and time deposit liabilities that were credited to the liability side.

The look of the new Loan Banks

We can assume that some investors will want packages of highly rated loans and will be willing to accept a lower return for a more secure investment.  At the other end of the market will be packages of riskier loans offering higher rates of return as compensation for the increased risk.  We can expect great market diversity in the quality of loans within the same Loan Bank and among the many new Loan Banks.  For example, a new Loan Bank may offer several loan funds of differing risks and returns, or there may be many Loan Banks that specialize in only one or a few loan funds of the same kind of risk, ranging from silk stocking funds that pay low returns to high flyer funds that pay higher returns.  The market will determine the true value of the funds.  We should expect a great deal of market volatility at first, as the banking market reshapes itself.

Conclusion

The banking system has more than enough reserves to back its demand deposits 100%.  Even assuming that some current savings and time depositors would decide to accept deposit contract penalties and move their funds to one of the new Deposit Banks, there seem to be enough excess reserves to cover anticipated redemptions of this kind.  If not, those banks with insufficient reserves would be forced to sell loans at whatever rate the market requires to those banks with excess reserves.  In the end, all demand deposits held in the new Deposit Banks would be backed 100% by cash.  Savings and time deposits held in the new Loan Banks would be backed by some cash, some securities, but mostly loans.  These savings and time deposits would not be insured; the only insurance available to depositors would be the bankers’ capital accounts and their reputations for finding good loans.  The marketplace of Loan Banks would be very diverse, composed at one end by long standing, very safe banks with lots of capital, silk stocking loans, and offering low savings rates.  At the other end of the market would be start up banks with higher risk loans, less capital, and offering higher deposit rates.  The age of vanilla banking would be over as well as the age of moral hazard created by government deposit guarantees.

Assuming that the Fed is not allowed to increase reserves ex nihilo, this process of establishing the new Deposit Banks and new Loan Banks will result in a fixed money supply of notes, coins, and reserve balances at the Fed that can be converted into cash at any time.  Today we call this the “monetary base”.  The banks always must maintain reserves in an amount not less than their demand account balances.  Their reserves must be some mix of cash in their vaults plus balances at the Fed that can be converted to cash.

At this point the banking system will no longer be able to create money out of thin air via the lending process, which it was able to do under the fractional reserve banking system.  The banking side of the US monetary system will be placed on a sound, non-inflationary basis and this source of periodic boom/bust business cycles will be eliminated.

Patrick Barron

Note #1:

At this point we are discussing fiat money reserves and, as such, it is still possible for the Fed to manufacture reserves out of thin air by several means.  Although preventing the further expansion of fiat reserves is vitally important and many may consider it to be the logical first step to monetary reform, limiting the Fed’s power to do this is the subject of another paper.

Note #2:

According to Fed statistics for commercial banks as of November 27, 2013

Cash assets in commercial banks (cash and reserves held at the Fed): $2.630 Trillion

Bank loans:                            $7.337 Trillion

Bank securities:                     $2.698 Trillion

Bank loans and securities: $10.076 Trillion

Demand accounts in banks:          $1.479 Trillion

Non-demand accounts in banks: $8.317 Trillion

Total deposits in banks:                 $9.796 Trillion

Re: Hardships linger for a mending Ireland

and

Re: E.U. ministers stagger toward banking deal

Dear Sirs:
In her recent report on the so-called recovery in Ireland Ms. Liz Alderman makes the mistake of defining success in terms of saving the Irish welfare/regulatory state rather than its people who must live in the real economy. For example, she reports that Ireland now can borrow for ten years at 3.5% rather than 14.5% and Its budget deficit probably is improving, etc. due to higher taxes and some budget cuts. EU leaders are hailing this as success. Yet it is the very same EU policy of monetary expansion and excessive government borrowing that caused the problem in the first place. While the ECB is fighting the false evil of “deflation”, meaning lower prices for Irishmen trying to make ends meet, through its zero interest rate policy, it is fueling even more banking moral hazard that already has cost the Irish 10,000 euros per citizen. Mr. Andrew Higgins and Ms. Melissa Eddy report that E.U. ministers are forging a new banking union to “catch bank problems early” and provide a new 55 billion euro bailout fund. There is no way that the EU can catch bank problems early, for the simple reason that it causes them. Furthermore, its new fund will cause even more capital destruction through the process of moral hazard, whereby the banks will take increased risk, knowing that they will benefit from any successes and be compensated for their failures. Patrick Barron

Re: Dwindling Tools to Raise Wages, by Eduardo Porter

Dear Sirs:
Economic law is a deductive and not empirical science, meaning that market research cannot determine the effects of raising the minimum wage.  We know by the laws of logical deduction that if the marginal utility of labor is below the cost of labor, which includes ALL costs not just the objective salary, unemployment will exist.  Mr. Porter should ask himself why the New York Times pays him more than the statutory minimum.  I’m sure that Mr. Porter is worth more than the minimum and if the Times failed to pay him what he is worth, he would go to work for someone else who would pay him more.  This application of economic law pertains to low wage workers, too.  Mr. Porter says that “the most compelling argument for raising the minimum wage is simply this: It is worth a try.”  I suggest that we try something that works every time–free market capitalism.

Patrick Barron

Re: US Ends Bailout of GM

Dear Sirs:
Mr. Bill Vlasic and Ms. Annie L. Lowrey report that “Taxpayers lost about $10 billion on their $49.5 billion investment in (GM).”  Their story is full of pride in achievement all the way from President Obama to current GM executives to so-called “automotive specialists”.  According to Mr. David E. Cole of the Center for Automotive Research, which gets half of its funding from governments and corporations, the federal government’s purchase of GM stock saved 1.2 million jobs.  Although I do not believe this nonsense for one minute–government cannot create or save jobs, but it certainly can destroy them–let us assume, just for grins, that Mr. Cole is right.  So the government spent $8,333 per saved job.  Please spare us taxpayers any more such success stories.  Patrick Barron

From today’s Open Europe news summary:

Germany cedes ground on eurozone banking union The FT Weekend reported that, at a meeting with other eurozone decision makers on Friday, German Finance Minister Wolfgang Schäuble ceded ground on banking union plans. Officials suggest that he has now accepted that the current EU treaties provide a sufficient legal base for the majority of the banking union project, and that the European Commission can play a role in any bank resolution. However, disagreements remain over the bank resolution fund, with Germany maintaining its view that this should, at least initially, be a network of national funds rather than a single combined eurozone fund. FT Weekend Süddeutsche

A eurozone banking union is simply another means for the successful to subsidize failure.  All socialist enterprises eventually fail because, unlike capitalism, socialism rewards failure and punishes success, resulting in capital destruction and not capital accumulation.

Of course, Germany will assume the lion’s share of the cost of this new union. Schauble’s capitulation on these points is a valuable lesson to those who will see; i.e., that being a member of a socialist organization eventually means that your wealth will be confiscated by others…all perfectly legal, of course.  That is what the organization is all about…not free trade, not enhanced protection of life, liberty, and property…no…it is about confiscating and consuming wealth.  Patrick Barron

Re: EU seeks “time for reflection” after Vilnius summit failure

I found this statement by EU Commission President Manuel Barroso to be particularly insightful:

“This Agreement would save Ukrainian business some €500 million a year just in  import duties,” Barroso underlined after the summit…

By this statement Barroso admits that the EU is a closed shop; i.e., a supposedly free trade zone inside the EU but with high tariffs to imports from outside the EU.  If Barroso and the EU really wanted to help the citizens of Ukraine and provide another source of goods for citizens of the EU, then the elimination of trade barriers would be an easy and important first step.  But then Barroso and the EU would have no leverage on keeping current EU members.  Why belong to a high regulatory, high tax, socialistic transfer union when one can trade freely with its members anyway?  This demonstrates that the EU really provides no additonal value whatsoever that a country cannot achieve simply by unilaterally declaring itself to be a free trade nation.  Patrick Barron

Re: Jim Rickards: Decline of the Petrodollar System is Good for Gold Any event that diminishes the value of the dollar as a reserve currency can trigger hyperinflation in the US as trillions of overseas dollars are repatriated to the US economy. Here is a frightening excerpt from the above interview with Jim Rickards by Casey Research (my highlighting in red):

Jim Rickards: All of the developments you mention, a GCC central bank, a BRICS multilateral bank, and the increasing use of the yuan are significant straws in the wind all pointing in the same direction—the decline of the dollar as the global reserve currency. Other similar developments could include a regional ruble zone on the Russian periphery and the creation of a true Eurobond backed by the full faith and credit of all members of the European Monetary System. While no one of these developments is decisive, each one of them represents an alternative to the dollar for a specified set of transactions. Cumulatively these developments could push the dollar past a tipping point, where it collapses suddenly and unexpectedly after an initially slow decline.

Nick Giambruno: Do you think the US has any aces up its sleeve or will otherwise be able to somehow pull a rabbit out of a hat and prevent the diminution of the dollar’s role in the international monetary system?

Jim Rickards: There is a set of policy choices the US could make that would preserve and even strengthen the dollar’s role as the leading global reserve currency. These include lower taxes, higher interest rates, breaking up big banks, reduced regulation, repeal of Dodd-Frank, reinstatement of Glass-Steagall, banning most derivatives transactions, improved educational outcomes, smart investment in infrastructure, reduced entitlements, and other structural adjustments. I see little prospect of any of these things happening, let alone all of them. As a result, one must conclude that the dollar is heading for collapse even thought that outcome is not inevitable. It is not too late to make structural adjustments, but it is extremely unlikely.

GCC is the acronym for Gulf Coopertation Council, whose members include Bahrain, Kuwait, Oman, Qatar, Saudi Arabia, and the UAE.  The BRICS is an association of emerging economises, which include Brazil, Russia, India, China, and South Africa.  The nations in these two groups hold 31% ($1.755 trillion) of the total foreign-held US debt of $5.653 trillion.  As a point of reference, the current US money supply of cash and checking accounts is $2.576 trillion (M1).  The larger measure of the money supply adds savings accounts and short term small certificates of deposit to the M1 total to obtain M2. Currently M2 stands at $10.800 trillion.  So, it is clear that any substantial repatriation of US dollars to our shores would result in a huge increase to our money supply, whether measured by M1 or M2.  Patrick Barron