Best of the Week
Most Popular
1. The Trump Stock Market Trap May Be Triggered - Barry_M_Ferguson
2.Why are Central Banks Buying Gold and Dumping Dollars? - Richard_Mills
3.US China War - Thucydides Trap and gold - Richard_Mills
4.Gold Price Trend Forcast to End September 2019 - Nadeem_Walayat
5.Money Saving Kids Gardening Growing Giant Sunflowers Summer Fun - Anika_Walayat
6.US Dollar Breakdown Begins, Gold Price to Bolt Higher - Jim_Willie_CB
7.INTEL (INTC) Stock Investing to Profit From AI Machine Learning Boom - Nadeem_Walayat
8.Will Google AI Kill Us? Man vs Machine Intelligence - N_Walayat
9.US Prepares for Currency War with China - Richard_Mills
10.Gold Price Epochal Breakout Will Not Be Negated by a Correction - Clive Maund
Last 7 days
Learning Artificial Intelligence - What is a Neural Network? - 20th Sep 19
Precious Metals Setting Up Another Momentum Base/Bottom - 20th Sep 19
Small Marketing Budget? No Problem! - 20th Sep 19
The Many Forex Trading Opportunities the Fed Day Has Dealt Us - 19th Sep 19
Fed Cuts Interest Rates and Gold Drops. Again - 19th Sep 19
Silver Still Cheap Relative to Gold, Trend Forecast Update Video - 19th Sep 19
Baby Boomers Are the Worst Investors in the World - 19th Sep 19
Your $1,229 FREE Tticket to Elliott Market Analysis & Trading Set-ups - 19th Sep 19
Is The Stock Market Other Shoe About To Drop With Fed News? - 19th Sep 19
Bitcoin Price 2019 Trend Current State - 18th Sep 19
No More Realtors… These Start-ups Will Buy Your House in Less than 20 Days - 18th Sep 19
Gold Bugs And Manipulation Theorists Unite – Another “Manipulation” Indictment - 18th Sep 19
Central Bankers' Desperate Grab for Power - 18th Sep 19
Oil Shock! Will War Drums, Inflation Fears Ignite Gold and Silver Markets? - 18th Sep 19
Importance Of Internal Rate Of Return For A Business - 18th Sep 19
Gold Bull Market Ultimate Upside Target - 17th Sep 19
Gold Spikes on the Saudi Oil Attacks: Can It Last? - 17th Sep 19
Stock Market VIX To Begin A New Uptrend and What it Means - 17th Sep 19
Philippines, China and US: Joint Exploration Vs Rearmament and Nuclear Weapons - 17th Sep 19
What Are The Real Upside Targets For Crude Oil Price Post Drone Attack? - 17th Sep 19
Curse of Technology Weapons - 17th Sep 19
Media Hypes Recession Whilst Trump Proposes a Tax on Savings - 17th Sep 19
Understanding Ways To Stretch Your Investments Further - 17th Sep 19
Trading Natural Gas As The Season Changes - 16th Sep 19
Cameco Crash, Uranium Sector Won’t Catch a break - 16th Sep 19
These Indicators Point to an Early 2020 Economic Downturn - 16th Sep 19
Gold When Global Insanity Prevails - 16th Sep 19
Stock Market Looking Toppy - 16th Sep 19
Is the Stocks Bull Market Nearing an End? - 16th Sep 19
US Stock Market Indexes Continue to Rally Within A Defined Range - 16th Sep 19
What If Gold Is NOT In A New Bull Market? - 16th Sep 19
A History Lesson For Pundits Who Don’t Believe Stocks Are Overvalued - 16th Sep 19
The Disconnect Between Millennials and Real Estate - 16th Sep 19
Tech Giants Will Crash in the Next Stock Market Downturn - 15th Sep 19
Will Draghi’s Swan Song Revive the Eurozone? And Gold? - 15th Sep 19
The Race to Depreciate Fiat Currencies Is Accelerating - 15th Sep 19
Can Crypto casino beat Hybrid casino - 15th Sep 19
British Pound GBP vs Brexit Chaos Timeline - 14th Sep 19
Recession 2020 Forecast : The New Risks & New Profits Of A Grand Experiment - 14th Sep 19
War Gaming the US-China Trade War - 14th Sep 19
Buying a Budgie, Parakeet for the First Time from a Pet Shop - Jollyes UK - 14th Sep 19
Crude Oil Price Setting Up For A Downside Price Rotation - 13th Sep 19
A “Looming” Recession Is a Gold Golden Opportunity - 13th Sep 19
Is 2019 Similar to 2007? What Does It Mean For Gold? - 13th Sep 19
How Did the Philippines Establish Itself as a World Leader in Call Centre Outsourcing? - 13th Sep 19
UK General Election Forecast 2019 - Betting Market Odds - 13th Sep 19
Energy Sector Reaches Key Low Point – Start Looking For The Next Move - 13th Sep 19
Weakening Shale Productivity "VERY Bullish" For Oil Prices - 13th Sep 19
Stock Market Dow to 38,000 by 2022 - 13th Sep 19 - readtheticker
Gold under NIRP? | Negative Interest Rates vs Bullion - 12th Sep 19
Land Rover Discovery Sport Brake Pads and Discs's Replace, Dealer Check and Cost - 12th Sep 19
Stock Market Crash Black Swan Event Set Up Sept 12th? - 12th Sep 19
Increased Pension Liabilities During the Coming Stock Market Crash - 12th Sep 19
Gold at Support: the Upcoming Move - 12th Sep 19
Precious Metals, US Dollar, Stocks – How It All Relates – Part II - 12th Sep 19
Boris Johnson's "Do or Die, Dead in a Ditch" Brexit Strategy - 11th Sep 19
Precious Metals, US Dollar: How It All Relates – Part I - 11th Sep 19
Bank of England’s Carney Delivers Dollar Shocker at Jackson Hole meeting - 11th Sep 19
Gold and Silver Wounded Animals, Indeed - 11th Sep 19
Boris Johnson a Crippled Prime Minister - 11th Sep 19
Gold Significant Correction Has Started - 11th Sep 19
Reasons To Follow Experienced Traders In Automated Trading - 11th Sep 19
Silver's Sharp Reaction Back - 11th Sep 19
2020 Will Be the Most Volatile Market Year in History - 11th Sep 19
Westminister BrExit Extreme Chaos Puts Britain into a Pre-Civil War State - 10th Sep 19
Gold to Correct as Stocks Rally - 10th Sep 19
Market Decline Will Lead To Pension Collapse, USD Devaluation, And NWO - 10th Sep 19
Stock Market Sector Rotation Giving Mixed Signals About The Future - 10th Sep 19
The Online Gaming Industry is Going Up - 10th Sep 19

Market Oracle FREE Newsletter

Nadeem Walayat Financial Markets Analysiis and Trend Forecasts

The Myth of Financial Deregulation, Volcker Cannot Prevent Boom-Bust Cycles

Politics / Market Regulation Feb 16, 2010 - 08:35 AM GMT

By: Frank_Shostak

Politics

Diamond Rated - Best Financial Markets Analysis ArticleDoes It Make Sense to Resurrect the Glass-Steagall Act?

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% of all mortgage lending. By 2005 they were approaching 21%.

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 Less 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.[1] 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.[2]

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% in November 1972, the yearly rate of growth of industrial production plunged to −12.3% 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 is an adjunct scholar of the Mises Institute and a frequent contributor to Mises.org. He is chief economist of M.F. Global. Send him mail. See his article archives. Comment on the blog.


© 2005-2019 http://www.MarketOracle.co.uk - The Market Oracle is a FREE Daily Financial Markets Analysis & Forecasting online publication.


Post Comment

Only logged in users are allowed to post comments. Register/ Log in

6 Critical Money Making Rules