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Building A Sustainable Financial System
Beyond a shadow of a doubt, this ongoing crisis has illuminated a set of specific underlying problems with the current financial set-up. Hereafter, I attempt to distill the three most broken features thereof and pose generalized solutions.
1) The Federal Reserve must be abolished and the price of credit must be determined by market forces, even in times of stable "inflation" in terms of consumer goods . Nominal interest rates must always consist of the real rate of interest plus the expected rate of inflation. If it is too low, people interested in preserving purchasing power against excessive inflation will be forced into risky assets and excessive leverage just to stay ahead of the curve. As leverage intensifies and the money supply expands, this reinforces a positive-feedback loop toward further credit and purchasing power destruction. If interest rates are too high, investment is unsatisfactorily crushed.
The Federal Reserve, like all market price-fixing private entities, usually has no idea what they are doing and/or portend to act in the interest of the People while really only acting as slave to special interests and the status quo. Electing a cabal of egotistical insiders to control the price of the most important asset class (money/credit) is nothing but an ill-fated attempt to achieve systemic stability while ironically and always instigating previously unforeseen pockets of instability. Bernanke has been categorically wrong virtually every time when predicting where the economy is headed and even when describing the current state of affairs. There is ample evidence to suggest that recessions have turned into depressions all thanks to Fed manipulation ever since its inception.
Further, more access to cheap credit is not going to lead us out of this mess. There is no easy way out (THERE IS NO FREE LUNCH IN ECONOMICS, something monetarists like to forget), but continuing to prop up failed investments will do nothing but delay the pain for when the next asset or credit bubble pops. Which it will.
2) The FDIC / Fractional Reserve banking system distorts risk-taking behavior by socializing losses and rewarding bankers with massive bonuses as the Fed and its tag-team partner Irrational Exuberance work together to blow dangerous bubbles.
In today's day and age of venture capital, private equity, small cap and large cap stocks, bond markets and mutual funds, it really doesn't make much sense to allow our nation's savings to be lent to what are often very risky prospects. Hell, one of the reasons banks resorted to increasingly riskier activies over the past decade was because alternative and more flexible and specialized lending entities began significantly encroaching on their traditional territories anyways.
The only reason this lending system still exists is that savers are content to have access to banking liquidity and other services while not personally absorbing any risk even though the banks are massively leveraged and often taking too many risks with capital. Why? Because the risk has been socialized via the FDIC and now the Fed's money printing machine (since the FDIC is broke). Talk about moral hazard... Classic free-rider problem, everyone does it because they think the risk won't come back to haunt them personally. Unfortunately, it eventually and indirectly will affect each and every one of us.
And thanks to the fractional reserve system, banks can take $100 of savings and turn it into $400 quite readily as new borrowers spend money, which gets deposited in a bank, which lend money to new borrowers who spend it, which then gets deposited in a bank only to be lent out and....
So when the moral hazard, malinvested and low interest rate chickens come home to roost, the result is magnified ten-fold, especially because many banks have become so interconnected precisely due to reserve banking! The systemic risks are simply enormous. If banks that guaranteed savings could only invest excess capital in risk-free assets, more rational savings decisions could be made.
Let's face it, the dinosaur that is fractional reserve FDIC-backed banking needs to be made a thing of the past.
3) The derivatives market must have full transparency and probably leverage regulation. Much like the Fed, the FTCC operates enshrouded in deep mystery. The complete derivative book of every large corporation and large hedge fund should ideally be made available for all to see. Sure, competitive advantages may be lost, but without fully understanding the counterparty risks in the system, and since derivative positions can be absurdly leveraged positions, this information can be of such systemic importance that it should be clearly revealed and documented wherever possible. Just think AIG or LTCM.
Not to mention it would shed more light on potential market manipulation and abuses. With the amount of leverage involved in derivative contracts, it is easy to goose markets with a limited amount of capital.
There should also probably be regulation ensuring that no one single entity is exposed to obscene levels of risk, the likes of which they could not even remotely absorb in a rapidly falling market.
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Thanks for another piece of callow, clever irony. Very droll
You guys are getting very good at this.
It's time to remind your credulous fans you're just pulling their leg (again).
donations has paid off - judge rules in Bloom's favor..Cheers to alan grayson as well..
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p: finance news & finance opinions
Please. You need to go back to the drawing board. This is the same old market-knows-best pablum. The US banking system has been in tatters many times under a gold standard and private ownership. You need to dig deeper. There are substantially better solutions than the same old diatribe.
the market and people do know best....any
centralized planning solution such as central
banking is complete pablum...
the gold standard is not about protecting
economic activity but about protecting wealth...
myriad forces conspire to derail healthy
economies regardless of the currency system
and banking structure....those are all non
sequiteurs when discussing the role of currency
which is a proxy for wealth.....
i would suggest that you dig deeper into economics.
monetary science, politics, property rights,
and finance....there are better solutions than
your tired socialist, communist, totalitarisn
utopias...
I agree with absolutely every word in #1. The notion of a group of men (and women) being smart enough to manage, and capable of managing, an economy made up of 300 million souls is ludicrous on its face. This notion was completely refuted by Mises in a short paper titled "Economic Calculation in the Socialist Commonwealth," a paper which was proven to be correct by the collapse of the Soviet Union, and again by the collapse-in-progress of the U.S.
Re: #2, I personally entertain a strong but unproven suspicion that the decreasing marginal utility of debt is directly related to constantly increasing (cumulative) leverage in the fractional reserve banking/credit system. In essence, the fractional-reserve system lends out "credit", not money; this credit can actually be used as capital, but it is capital that has been diluted by the fractional-reserve process. You rightly point out the circular nature of fractional-reserve banking; the "deposits" that come back from lent credit (when it is spent) are not actually money, they are credit, yet they become deposits on which still more fractional-reserve lending can be based. I also view the well-documented cases of leverage increases approved by Congress / regulators as conscious efforts to keep a bubble going that was know to be about to collapse.
Credit default swaps are another example of a leverage-enhancement, suborned by the lenders and securitizers, and enabled by the ratings agencies. The idea of buying credit insurance only provided cover. Early in the crisis one credit insurer, ACA Capital, was effectively levered at 180:1, guaranteeing $61 Billion on loans on its $326 Millon capital base. Under circumstances like these, the idea of a credit insurer keeping its AAA rating, and thereby passing its AAA rating to everything it ensured, is revealed to be a falsehood. But again, no one asked during the bubble, as it meant allowing the bubble to continue, tax revenues to rise, foreign wars to continue, natives to remain calm, and Greenspan to go about being the "Maestro".
http://seekingalpha.com/article/43538-loan-insurer-aca-capital-may-be-to...
Courts opening up the Federal Reserve -
http://www.bloomberg.com/apps/news?pid=20601087&sid=a7CC61ZsieV4
Here is my vote for #4:
Require a minimum of 20% owner equity for any residential property loan, whether that means a 20% downpayment for a purchase mortgage or limiting HELOCs to 80% of appraised value.
There would be cheating, for sure, but it would be a start.
Nice article, and a good start.
However , the money created from FRB with regards to deposits is more like 1:100 (as opposed to 1:4)!
Also (and I put this forth with trembling hand), a little inflation is a good thing (assuming it grows at the rate of population increase), so basing currencies partially on metals is a likely solution. Hey, the Swiss Franc was the 'gold standard' of currencies for generations... And it was only backed 40% by gold.
Imagine if countries instead of competing with each other to debase currencies were competing with each other to be the safest (backed by a higher percentage of gold) currency?
there are regulatory standards for reserve ratios
and it is not 100:1
monetary inflation is a bad thing always...it
is a tax and an arbitrary transfer of wealth...
#1 and #2 are perfect. Abolish the Fed, FDIC and all other bailout mechanisms. Without moral hazard, #3 wouldn't be necessary. Regulation never has the intended consequence, and invariably does more harm than good. Who do you think writes the laws anyway?
The reason for a central bank is because the politicians would be in control of the money supply, otherwise. They would find the forces of inflation impossible to resist. The problem with what we have is that without prudent lending practices and the regulations to enforce them, bankers will expand credit as much as possible. When the resulting bubble pops, it creates deflation.
Money functions as a public utility. You exchange your resources for drawing rights on the community resources. The problem is when these resources are wasted or stolen by those managing the system issuing an excess of drawing rights and using them for personal gain. The idea that money is a form of private property is promoted by those with the most of it.
If we understood it is a function of government to provide this medium of exchange, then it becomes a public responsibility to use the resources it controls wisely. We all live on this finite planet, but think if we issued infinite amounts of money, we can all be rich.
It is the nature of patent law that after a sufficient amount of time, ideas revert to the public. It is time for banking to revert to the public. When the Rothschilds first invented private banking, they were responsible for the value of the gold certificates they used as currency. With the development of central banking, responsibility for the stability of the currency was made a public function, yet private banks maintained the profits from managing it. The next step is to develop a public banking system and feed the profits back into the communities which created the wealth in the first place. Rather than one huge system, banking would function at the lowest level possible, with each level of incorporated community having its own bank and the profits generated going back into that community.
The currency would still be a national responsibility, but since people understood money is a form of public wealth, they would be less inclined to turn personal resources into money and would leave value in the ground as much as possible, so to speak.
the people should be in charge of their own
money - not the politicians and not an elite
group of bankers. both groups have proven
unreliable and inherently incapable of managing
money just as we saw that central planning does
not promote economic growth or prosperity.
It's a sad thing -- nay, a depressing thing -- that with increasing popularity of zero hedge, the quality of comments deteriorated so rapidly and fundamentally.
Welcome to the casino/gulag/insane assylum that is the USSA.
Now quit your whining and get back to that gaming table.
BULLETIN: Obama to reappoint Fed Chairman Ben Bernanke: WSJ
8/24/2009 9:16:15 PM EDT
Visit http://marketwatch.com/r.asp?g=6B66B9EA113946D2A80C28AF92AFC1BA&d=bnbt
mornin '
Well well , guessing is over , same path , markets will love this .
the article is provacative while displaying large blind spots....
yes the fed should be abolished because the people should control the price of money and its supply just as our nation's founders intended having seen the arbitrary powers of the bank of england exercised in deleterious ways. they also went one step further by specifying that the dollar consist of so many grains of gold. only gold preserves wealth and freedom. the fed is a stealth central planning committee - a politburo....it is axiomatic that the market must establish prices - not a board of self important quacks...
the fed must create monetary inflation and thus transfer wealth from the have-nots to the haves....this is a by product of open market operations which were precluded by the original federal reserve act.
however, the indictment of fractional reserve banking is not sound. the problem is not with fractional reserve banking but with the regulators who failed to oversee it in two significant ways. 1. leverage was allowed to rise from its traditional 10:1 to as high as 50:1 in many cases. 2. regulators failed to take prompt corrective action when the banks became insolvent. these two factors conspired to magnify the financial crises we currently have but did not cause the crisis.
now one could argue that it is inherently impossible to properly regulate fractional reserve banking in which case it should be abolished. but i am open to the idea that it can be managed. it has a very powerful ability to leverage capital and foster economic prosperity if indeed it is properly regulated. unfortunately we have seen going back to the 1980s that the regulators are bought and paid for whores (hos) who caused the debacle of the s&l crisis and the crisis today.
derivatives without a doubt must be regulated and in some cases abolished especially where an incentive to create a credit event exists. all derivatives should be required to operate under publicly visible clearing, registration, and reporting. derivatives which cannot be traced back to their source asset should be illegal as well....
any firm which cannot demonstrate competence in the creation, management, and dissolution of derivatives should be barred from trading all financially engineered products.
this is a broad topic and there are some reasonable counter views to details of central banking but in the main do not justify the existence of such an arrangement.
the argument that economic stability is greater with central banking is groundless but i will not develop it here...the argument that elastic currency is better able to deal with economic crises is a canard as is the notion that absent central banking or fiat currency that depressions must be worse. again i will not develop that idea now.
finally one should be careful to distinguish between currency management and central banking. i believe strongly in a gold standard but that could exist with or without central banking....
Is there not an enourmous difference between "fractional reserve banking" and "The FDIC / Fractional Reserve banking system"?
i use fractional reserve banking in a generic
way....i am not aware of any difference between
that and the other term you mention....
fractional reserve merely specifies a system
in which it is permissible to maintain less
than 1:1 ratio between assets and liabilities...
The quality of the posts on this site is just getting lower and lower, with each new hack they let contribute. Although I agree with the spirit of the article, the arguments presented are just nonsense. Fractional reserve banking isn't the problem. It's simply a reflection of the fact that there is no need to hold 100% of depositors' money in reserves, because they don't all need access to it at the same time. You could get rid of the system entirely, and force banks to keep all money in reserve, and then you'd just have to adjust the price of everything to essentially reflect a new dollar.
The difference between the status quo, and such a system, is not merely a wash, because of the fact that it actually costs money to print money, and costs money to protect hard currency. Those costs are not the same for 10% of the money supply vs. 100% of the money supply, for example.
I want the system overhauled, too, but don't bring up silly ideas like this.
I think that you have different misconceptions to those of the author, that's all.
The problem is that we are accustomed to monetising credit issued by credit intermediaries "deficit-based" upon a minimal amount of regulatory capital. In a 100% reserve deficit-based system, there can be no new money=credit, merely the recirculation of existing money.
Credit has no cost at the time of creation, whether it is a seller giving "time to pay" to a buyer; a private bank, creating credit; a Central Bank as intermediary between Treasury and citizen; or even the Treasury directly to the citizen (cf the Social Credit movement).
In the former case the "cost" is the opportunity cost of receiving value at a later date; in all the others, the cost is:
(a) system operating cost (including unjustified levels of compensation to baroque management hierarchies);
(b) defaults;
(c) (private banks) profit to shareholders.
There is no reason why Treasuries could not issue credit interest-free directly to anyone who needs it.
All that is necessary is a (performance-based) service charge to a service provider consortium, and a provision (guarantee charge) into a default pool held by a custodian.
The consortium would manage the system;set "guarantee limits" / credit limits; and deal with defaults.
In such a "Credit Clearing Union" the credit needed for the circulation of goods and services and the creation of productive assets.
The long term finance of productive assets IMHO requires a new approach to equity - "unitisation". This is essentially the creation of Units redeemable in value such as energy, or the right to occupy property. to all intents and purposes such units are undated credits.
http://www.policyinnovations.org/ideas/innovations/data/000085
energy and rights are extremely poor forms of
money as they fail to meet the criteria of good
money...it's just another method for conning
people out of their wealth....
the cost of money production and management is
negligible - almost a triviality....especially
when considered against the benefits if one is
talking about hard money....
in a 14t usd economy and a 3-4 t usd federal budget
it is laughable to argue the costs of money
management as an objection to anything...
again costs are only meaningful in terms of
benefits and lost opportunities....
i do not advocate abolishment of fractional
reserve banking...that is an entirely different
issue.....
Hi anon,
Objecting to "the dinosaur that is fractional reserve FDIC-backed banking" is not the same thing as objecting to "fractional reserve banking."
Maybe the author objects to FRB as well, but it wasn't adressed in the piece.
http://en.wikipedia.org/wiki/Amsterdamsche_Wisselbank
this reminds me of Credit Unions. I used to belong to a Credit Union - actually I've belonged to 3 over time. I've found them to be extraordinarily good and very useful.
It wouldn't be a bad thing to impose a "Glass Steagall" type of wall between banking and investing again, and to subject banking to terms more in line with Credit Unions.
I've found them to have lower interest rates, better service, and easier to work with.
The downside, of course, is that they are not EVERYWHERE like BoA or Citi. Naturally, this can be remedied in the day of the ATM.
End the Fed video:
www.youtube.com/watch?v=VGlP6Vlnd9I
The fed needs to be ended but you could stop 90 percent of the monkey busniess just by eliminating leveraging. People love to talk about how the american consumer has to deleverage but that's just a mask. The American consumer doesn't leverage it borrows. Leveraging is when Hedge Funds and ETF's go into EVERYONES bank accounts and use that money as security to gamble with. It makes a false shadow economy because while you think your moneys sitting in a bank account being quiet and good it's out raping and pillaging throughout the stock market. The games supposed limit the losses to only what the hedge fund brings to the table but it still doesn't keep EVERYBODIES money from running all over the place voting on what something should cost. It's like voter fraud. One dollar one vote. Not 1 dollar 40 votes.
/agree
"Nominal interest rates must always consist of the real rate of interest plus the expected rate of inflation."
Except there would be no inflation in the absence of the Federal Reserve.
????!!
I would figure that no matter the monetary system there would be inflation simply due to the rising scarcity of resources.
The EROEI for all the energy we consume, net-net, is cliffdiving so just that should be able to force prices higher no matter what currency those prices are based on. Unless of course you make an energy based currency, which would be boss.
Ah....but changing the money, changes EVERYTHING. For instance we might not need oil at all if the market forces, rather than political connections, were allowed to work and determine the correct. Think whole-istically.
By now we would have found a better way.
Inflation is the result of an increase in the money supply, not due to an increase in demand or decrease in supply. Prices may rise or fall based on supply and demand, but over time the general PRICE will remain consistent.
Inflation, as a matter of course, has always been driven by the increase in specie. When Gold was the specie of choice, and Conquistadors returned with massive loads of it, inflation was rampant throughout European nations. By the same token, as that same Gold left national boundaries due to payments resulting from finance of war or trade, deflation would occur.
The increase in supply of money(s) will always create "inflation". Today, we should be seeing our prices fall to a point which is commensurate with demand - arguably much lower than prices are today. But "inflation" is occurring due to Fed intervention, and thus keeping prices "stable" as opposed to letting them find a normal, typical level.
At Minyanville, another site I enjoy, the issue of price discovery, time, and debt reduction remain themes of ongoing importance. Price discovery cannot occur during times of massive Fed interference, because you can't know what the real value of something is if more paper money is flooding the system. You're making a "guess", at best.
Were the Fed non-existent, you would have less of a problem making that decision on value, because you can gauge demand and supply more effectively rather than trying to figure out how many assets the Fed is purchasing and storing in a closet somewhere.
"Inflation" based on scarcity or increased demand is not true "inflation". It's price discovery, which is the first goal of a market. Once price discovery occurs, prices may rise and fall based on supply and demand, but bubbles are likely to be non-existent or at least less painful.
HOWEVER, and this is important, the removal of a fiat (fractional reserve) system means that growth will be much slower and sluggish. Of course, in a mature economy that's to be expected.
This is just an issue of semantics. I would argue that the natural tendency is for price discovery to constantly seek a higher price since demand will always outpace supply. I would call that inflation and there is nothing wrong with it. When this inflation is driven by changes in the monetary supply then I would call it monetary inflation but in the end it seems to me it is also a process of price discovery, albeit not the healthy kind.
In the colonial south tobacco was used as a currency. Naturally the supply kept increasing and so did prices in terms of tobacco. If we have a monetary system where specie is 'everything', that is the value of all the money out there was backed by total purchasing power, the level of specie would be in constant flux and would hence lead to inflation or deflation by your definition.
Again I'm sure this is a question of semantics and we both agree that artificial inflation is definitely not the way to go. The value of money should be a function of real world supply and demand not the other way around.
we should expect better
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this is utter nonsense....your use of terms and
defintions is most unfortunate to say the least...
semantics has EVERYTHING to do with any discussion...
the classical gold standard period was characterized
by resonably stable to slightly declining prices
as a whole...
i won't even comment on the statement about
price discovery always seeking higher prices....
the poster who commented about the fed's interference
in price discovery is correct.
the emphasis on price is a bit unfortunate as it
obscures the real issue - the content of the
money.....
your example demonstrates why some assets are
better forms of money than others...
money should never be valued based upon supply
and demand....money should have it's own
intrinsic worth...
Gold's value is 99% extrinsic. Its only intrinsic value comes from the fact that it does not rust and some other uses it can have in circuitry. When money was based on the gold standard it was just dependent on faith as it is today. The difference is that now we have faith in the value of piece of paper while previously we had faith in the value of a shiny metal that did not spoil. That was and is very convenient since as Locke says, and I agree, the main function of money should be to prevent spoilage. But it is still only an extrinsic advantage for the value of gold since all the absence of spoilage leads to is the reassurance of faith in gold. It has very few intrinsic uses in the real world.
On the other hand, an energy based currency, which I recommended in my original post, would be much closer to having intrinsic worth...for obvious (I hope) reasons.
It's hard to agree - I don't think anyone has any faith in neither a piece of paper nor chunk of gold. I use the paper money not because of faith, but because of convenience. Everybody stands ready to accept it at any given time - there are significant eceonomies of standardisation to be gained here.
Concerning the energy currency argument - the fact that it has more intrinsic value does not make it a better candidate for becoming a medium of redemption and account. What makes a commodity good money, is its marketability. How easy it is to transport, to store, to divide and merge, to check quality, does it spoil? Wood or wheat or water are all comodities that I find more useful than gold, but somehow it was gold that emerged as the standard for money.
Your surprise only indicates the level of ignorance prevalent in today's society regarding monetary affairs.
Thanks for assuming my surprise was due to ignorance and not engaging in any meaningful discourse. Your original statement is questionable and assuming at best. Maybe you meant to say artificial inflation instead of just inflation. Otherwise I can point to several examples of when there was inflation with the absence of a Federal Reserve or any central bank. Off the top of my head: in the colonial south when tobacco was used as a currency, during the Roman decline when the bronze coins were devalued, the United States note was also inflated for a certain period of time after several contractions in the initial supply.
Inflation is not exclusively a central bank monetary system function. What kind of inflation we speak of is a whole different matter however. There is the healthy market driven inflation, then the inflation that is currently being stuffed down our throats.
your statements are exceedingly confused....
there is no such thing as "inflation" vs
"artificial inflation" vs "healthy market driven
inflation"
part of the problem is that inflation is a
nebulous term. the dictionary definition is
not helpful either.....
my interest is monetary inflation
which is an increase in the currency
supply via a debasement of the currency....it's
effects may include price increases...
"inflation" and price increases are not
synonyms....prices can change for innumerable
reasons - thus this is a wholly inadequate way
of discussing the phenomenon of inflation....
Ok Ok I get it, you think of inflation/deflation solely as changes in monetary supply and demand while real life changes in supply and demand have nothing to do with inflation. I simply use a different definition. I believe it is possible to debase a currency in other ways other than tinkering with the supply. If I had a wheat field of 100 acres and a 100 dollars and I burned 10 acres I have accomplished the same debasement of the currency as I would have if I increased the money supply of the dollars that are out there by approximately 11.
Granted...of course there is a difference, but in a dynamic system it is too hard to distinguish clearly. That is why I don't have the confidence in having my definition of inflation be as clear cut as yours. Some would say that we are in an inflationary requirement because the FED (which I don't like so don't think I'm arguing in their favor) is trying to increase the money supply but we are actually in a deflationary environment since even with the printing (which matters little compared to QE in the end) the amount of money that is out there is diminishing due to real world supply and demand factors.
When I say 'inflation' I mean deflation or inflation, each of which may arise out of supply/demand shocks over any given period of time.
that's why these discussions are always confused
and misinformed....
price changes due to supply and demand apart
from changes in money supply are non sequiteurs...
prices can change for innumerable reasons one
of which may be a change in the money supply....
Nope, not in a non-fractional reserve, commodity backed currency.
This is not necessarly true - with a commodity type money (gold probably being the best one) prices could accomodate through the market of altenartive uses of the commodity. The lower value of monetary gold (i.e. higher prices for everything else) would incentivize lower supply (less gold mining)and higher demand for non-monetary gold. These effects would work in the direction of keeping the 'value of gold'-'value of everything else' relation more or less stable. But, obviously, this is not a continuous nor perfect mechanism.
the rise of prices due to scarcity of resources
is not inflation....it's merely a change in price....
the subject of interest is not price changes
which could be caused by myriad factors but
monetary inflation. monetary inflation may cause
price rises depending upon where the money flows...
the change in the value of the currency through
proliferation is of utmost concern because it
does not affect all actors uniformly...
it represents an arbitrary change in the value
i own without my consent and usually without my
knowledge.