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June 16, 1933. President Roosevelt signs Banking Act
of 1933. To FDR's immediate right and left are Sen. Carter Glass of Virginia
and Rep. Henry Steagall of Alabama.
At the end of January, President Barack Obama
announced that he is planning to introduce new regulations for the banking
industry, to prevent excessive speculation. According to the president, no
bank or financial institution that contains a bank will own, invest in, or
sponsor a hedge fund or private equity fund, or have proprietary trading
operations unrelated to serving customers for its own profit. The driving
force behind this plan is the former Federal Reserve Board chairman Paul
Volcker who, it seems, wants to resurrect the Glass-Steagall Act of 1933.
Instead of the separation of commercial and investment banking, we will now
have a separation of banking business from proprietary trading, hedge funds,
and private equity. In his testimony to the Senate on February 2, 2010,
Volcker said,
The specific points at issue are ownership or
sponsorship of hedge funds and private equity funds, and proprietary trading
— that is, placing bank capital at risk in the search of speculative
profit rather than in response to customer needs.
Some provisions of the Glass-Steagall Act, such as
Regulation Q, which allowed the Federal Reserve to regulate interest rates on
savings accounts, were repealed in 1980. The provisions that prohibited a
bank-holding company from owning other financial companies were repealed on
November 12, 1999. The repeal enabled commercial banks to underwrite and
trade instruments like mortgage-backed securities, and establish structured
investment vehicles (SIVs) that bought those securities.
Most experts are of the view that the repeal of the
Glass-Steagall Act contributed to the global financial crisis of
2008–2009. They believe the repeal of the act was instrumental in the
creation of the subprime-loans bubble, which they see as the driving force
behind the financial crisis. The year before the repeal, subprime loans were
around 10 per cent of all mortgage lending. By 2005 they were approaching 21
per cent.
From this way of thinking, it would appear that a
reform along the lines as suggested by Volcker could stabilize financial
markets and prevent boom–bust cycles. The opponents of the Volcker
plan, such as the Federal Reserve Board governor, Kevin Warsh, are of the
view that the plan may only stifle the economy. In his comments published in
a Financial Times opinion piece (February 2, 2010), he said,
We must resurrect market discipline as a complement
to prudential supervision. Otherwise, the spectre of government support
threatens to confuse price signals and create a class of institutions that
operate under different rules.… The US economy runs grave risks if we
slouch toward a quasi–public utility model.
According to opponents, the best way to fix the
problem is to allow the market forces to do the job.
Do fewer banking controls always mean a more free
market?
The proponents for less control in the banking
industry hold that fewer restrictions imply a better use of scarce resources,
which will lead 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, whilst controlled banking stifles the
process of real-wealth formation. However, the opponents of the Volcker plan
overlooked that the present banking system has nothing to do with free
banking or 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 they can generate "out of thin air," and
the more damage they can inflict upon the wealth-generation process. This
must be contrasted with genuine free banking, i.e., the absence of the central
bank, where the potential for the creation of money out of thin air is
minimal.
Fractional-reserve Banking creates money out of thin
air
Through fractional-reserve banking, banks can create
money out of thin air. We suggest, however, that in a genuine free-banking
environment the likelihood of banks practicing fractional-reserve banking
would be minimal. Here is why. Take, for instance, Farmer Joe, who sells his
saved 1kg of seeds for $100. He then deposits this $100 with Bank A. Note
that the $100 is fully backed up by the saved 1kg of seeds. Also, observe
that Joe is exercising his demand for money by holding it in the demand
deposits of the bank. (Joe could also have exercised his demand for money by
holding the money at home in a jar, or by keeping it under the mattress).
Whenever a bank takes a portion of Joe's deposited
money and lends it out, it sets in motion serious trouble. Let us say that
Bank A lends $50 to Bob by taking $50 out of Joe's deposit. Remember that Joe
still exercises his demand for $100. No additional saving backs up this $50.
Once Bob uses the money, he in fact engages in an exchange of nothing for
something. This amounts to nonproductive consumption of real wealth. What we
have here is $150 that is backed by $100. (Remember that $100 is fully backed
up by 1kg of seeds — real savings).
Now, Joe demands money, not to hold it as such but
to use it as the medium of exchange. So let us say that Joe decides to use
his $100 to buy goods from Sam, who banks with Bank B. On the following day,
Bank B will present the check on $100 to Bank A. In short, $100 is shifted
from A to B. No more money is now left at Bank A. Let us say that Bob, who
borrowed $50 from Bank A, also buys goods from Sam, who keeps his money with
Bank B. This will pose a problem to Bank A since it doesn't have the $50 to
pay Bank B once the check on $50 written against A is presented by B. In
short, Bank A is "caught," so to speak.
As the number of banks rises and the number of
clients per bank declines, the chances that clients will spend money on the
goods of individuals that are banking with other banks will increase. This in
turn increases the risk of the bank not being able to honor its checks if
this bank practices fractional-reserve banking — i.e., lends fictitious
claims or money out of thin air.
Conversely, as the number of competitive banks
diminishes, that is, as the number of clients per bank rises, the likelihood
of being "caught" practicing fractional-reserve banking diminishes.
In the extreme case, if there is only one bank, it can practice
fractional-reserve banking without any fear of being "caught,"
since it will always clear its own checks. Thus Sam, who sold goods to Bob,
would simply deposit the check with Bank A.
All that would happen in that case is that the
ownership of the deposit would be transferred from Bob to Sam. If Joe decides
to spend his $100 on goods from Tom, then again we would have a transfer of
the ownership of the deposit.
We can thus conclude 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 will 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 a central bank. By means of monetary policy, the central bank
protects fractional-reserve banking and thus the creation of money out of
thin air. If Bank A is short of $50, it could borrow from the central bank.
Where does the central bank get the money? It actually generates it out of
thin air. The modern banking system can be seen as one huge monopoly bank,
guided and coordinated by the central bank. And as we have seen, one monopoly
bank can practice fractional-reserve banking without running the risk of
being caught.
Through ongoing monetary management, i.e., money
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 that banks will not bankrupt each other.
The myth of financial deregulation
Prior to the financial deregulation of the 1980s, we
had controlled banking. Banks' conduct was guided by the central bank. Within
this type of environment, banks' profit margins were nearly predetermined,
because the Fed imposed interest-rate ceilings and controlled short-term
interest rates. Hence, the life of the banks was quite easy, albeit boring.
The introduction of financial deregulations 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. This increase culminated in an explosion in
the creation of credit out of thin air. Indeed, in the deregulated
environment, banks' ability to amplify the Fed's pumping has enormously
increased. Note that the AMS-to-trend ratio hovered very close to 1.0 from
1959 to 1979. Since the early 1980s, this ratio has been rising visibly,
climbing to 1.77 by November 2008.
We suggest that it is this massive explosion of
money that has severely damaged the pool of real savings and laid the
foundation for the present economic crisis. Rather than promoting an
efficient allocation of real savings, the current "deregulated"
monetary system has been channeling money created out of thin air across the
economy. From this it follows that in the present banking system, what is
required to reduce a further weakening of the real-wealth-generation process
is to introduce tighter controls on banks. As Murray Rothbard put it:
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.
Pay attention that we don't suggest suppressing the
free market, but suppressing banks' ability to generate credit out of thin
air. The present banking system has nothing to do with a true free-market
economy. It must be reiterated here that more controls in the framework of
central banking can only slow down the pace of the erosion of real-wealth
formation. They cannot prevent the erosion. (Remember, the Fed continues to
pump money to navigate the economy). More controls will simply suppress
banks' ability to amplify the Fed's pumping. In this sense, controls are
preferable to a so-called deregulated banking sector.
Would more controls, i.e., keeping the
Glass-Steagall Act intact, have prevented the current economic crisis? We
suggest that the crisis wouldn't have been as severe, since controls would
have prevented the massive monetary explosion since the early 1980s, which
put the pool of real savings under severe pressure. The financial
deregulations have sped up the erosion of the real-wealth-generation process.
Consequently, instead of having a severe crisis in 20 years' time, we have it
now.
Why the Volcker Plan cannot prevent boom-bust cycles
Now, if controls were the answer for economic
instability, then why, prior to financial deregulation in early 1980s, did
the US economy experience vicious economic swings? The chart below depicts
sharp swings in the growth momentum of US industrial production during the
period of the Glass-Steagall Act. For instance, after peaking at 11.6 per
cent in November 1972, the yearly rate of growth of industrial production
plunged to −12.3 per cent in May 1975.
In the present setup, the policy makers of the Fed
are of the view that they can somehow navigate the economy toward the path of
stable economic growth. Their navigation via money pumping leads to
fluctuations in the money supply's rate of growth. This in turn leads to the
boom–bust cycles that the Fed supposedly is trying to smooth out or
eliminate all together.
Conclusion
At the end of January, US president Barack Obama
announced that he plans to introduce new banking-industry regulations in
order to prevent excessive speculation. The driving force behind this plan is
the former Fed chairman Paul Volcker, who seems to want to resurrect the
Glass-Steagall Act. Instead of the separation of commercial and investment
banking, we will now have a separation of banking business from proprietary
trading, stock broking, and hedge funds.
The US president is of the view that this will help
stabilize the financial system. Some critics of the proposed plan 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 the key reason
for financial instability is not the repeal of the Glass-Steagall Act as such
but the existence of the central bank. It is the central bank that enables
banks to practice fractional-reserve banking and thereby pollute the economy
with money created out of thin air.
As long as we have a central bank, it makes sense to
impose tighter controls on banks in order to minimize the damage the central
bank's policies inflict. A better alternative is, of course, to have genuine
free banking without the central bank.
Frank Shostak
Frank
Shostak is a former professor of economics and M. F. Global's chief economist.
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