Comments (11)

• olmedo

  great article!!.

  at last Austrians are taking notice of financial events around us.

  one issue i like to underline is the issue of "default risk insurance" which is becoming one of the pillars of modern financial architecture.

  credit risk insurance, a descendant of the "black and scholes model" which tells that risk can be "priced" therefore you can take out "risk" out risk taking.

  can human stupidity be priced????

  
  one implication of this notion is that with this business of derivatives, financial markets fool themselves in the sense that they have made risk disappeared out of planet earth when the only thing they have done is to transfer it to people all too happy to receive the premiums but with serious questions on whether they can support a general market collapse.

  worse still,is the fact that, with this, money managers has been relieved of their fiduciary responsibility of protecting the money they manage from "risk".

  
  this is all too ugly!!

  another interesting subject of research is what happened to the traditional notion of fractional reserve banking after the repeal of the glass steagal act in 1981. a big factor shaping todays financial world.

  
  olmedo

  Published: May 16, 2007 11:00 AM

• Richard

  While I remain convinced of the correctness of the Austrian analysis, one potential aspect of a 100% reserve system troubles me.

  Let's assume that I wish to purchase a house costing $100,000 and take out a mortage with a 1% interest rate so I owe the bank $101,000. Under a 100% reserve system prices and wages will be falling so that although the real value of my earnings increases, the nominal value will decrease. How can I therefore afford to pay the sum of $101,000 is the amount I earn is going down year by year.

  Published: May 16, 2007 1:33 PM

• Scott Monroe

  Some constructive criticisms of the article:

  In point IV you mention the creditor’s net wealth (as you define as an increase in net present value [NPV]) rising by $10 by purchasing a $100 bond. Actually, the creditor’s NPV ought to remain unchanged, since the discount rate will discount future cash flows to the present value of the security, which is $100. If the NPV were positive, the lender could take the $10 arbitrage profit, and turn around and sell the bond immediately for $110 with no risk. Given the huge and relatively efficient market for debt securities, that’s an unlikely scenario. On average, it’s appropriate to assume that the market discount rate equals the average investor’s discount rate when purchasing a marketable security. To do otherwise throws out the basic mechanisms of financial analysis, particularly because you’re drawing conclusions in the aggregate.

  Also, in point IV, you say that the lender records a liability of $110. That’s also not true. Borrowers record the market value of their debt securities on their balance sheets, which would be $100 in this case, though the future value of the loan may be $110. Furthermore, while you’re correct that lenders try to invest borrowed funds at rates higher than borrowing costs, they must also exceed the expected market rate of return _on top of borrowing costs_, which significantly reduces the possibilities for investments, and therefore borrowing. When you mention that the borrower merely needs to earn a return in excess of the borrowing costs, it dramatically exaggerates the implied demand for credit.

  In point V you write, “the growth of the credit derivative market might also be a direct consequence of rapid government-sponsored credit growth”. You then reference in a chart the huge growth of credit derivatives between 2004 and 2006. What you don’t mention is that Central banks all around the world have been hiking interest rates during the same period- in the U.S., UK, the ECB and significant parts of Asia, which has significantly slowed the growth of money supply. That seems to directly contradict your point. Rather, the huge increase in credit derivatives ought to have happened between 2000-2002, based on your point that there’s a correlation between the money supply and credit growth. However, no such relationship has occurred in reality.

  Further, in point V you suggest that another arbitrage profit is created by the writer of a credit protection contract assuming that a $5 premium will be smaller than the expected losses (you assume $3). Actually, the experience of insurance companies over the long run has been that premiums are approximately equal to expected losses, and that the profits they make are typically from how they invest the float- which is the money they hold between the time the premium is collected and the time they have to pay out claims. One can view it as an interest-free loan. It seems that your examples are consistently assuming a badly-priced, inefficient market full of arbitrage opportunities at every turn- little of which occurs in reality.

  Rather than explaining the growth of the credit derivatives market on inefficiently priced debt securities and fiat money, perhaps you should consider the very real value the market adds to individuals, companies and governments, the world over, and how it would likely exist in any monetary system. Your fear seems little more sensible than a pessimistic man railing against the existence of the insurance industry—warranted in some manner, but proceeding from the wrong assumptions, overall.
  

  Published: May 16, 2007 2:06 PM

• Mark Humphrey

  I had just time to scan rapidly "The Dark Side of the Credit Boom" and Scott Monroe's comment. I think Mr. Monroe is mistaken to attribute the growth in credit derivatives primarily to authentic market demand for risk mitigation, because the scale of intervention provided by the Fed--and foreign central banks--is very large.

  For example, our Fed has let it be known to speculative players that it stands ready to bail out any player "too big to fail"--a description that takes in ever larger numbers of big speculative institutions with each passing year. In the absence of this destructive policy, with its attendant moral hazard, it is doubtful that financial derivatives could exist on any scale approaching today's collossus.

  Moreover, the idea that the Fed's moderate tightening for the past couple years must produce results in the markets that mechanically reflect this development is a misconception. The Fed's interventions spur various wealth-destroying financial activities--from speculation in stocks and real estate to malinvestment in costly, interest-sensitive financial derivatives. Players make bets based on a primary underlying conviction: the Fed will always be there to boost investment prices, depress yields, and bail out big overextended players. So almost no one goes short, which is seen as a fools errand; the smart money counts on easy money. This bias shows up in the promiscuous expansion of financial derivatives.

  Finally, the operations of foreign central banks have a substantial influence on US investment prices and financial activity. The modest tightening by our Fed over the last 2 years has been partly offset by the central banks of Japan and China, which have printed yen and yuan with which to buy dollar assets. The effects of foreign inflating have partly mimicked Fed inflating, by depressing US yields.

  Published: May 16, 2007 3:17 PM

• Scott Monroe

  Mr. Humphrey- Excellent points! I have to admit I got a bit of a chuckle about your comment on overpriced real estate, considering your career (Though, it only serves to make you wealthier, which is a good thing). I’d say I generally agree with you about some of the facts you’ve stated, but with different conclusions.

  The main point I would respond with is that if market participants believe the Fed makes investments inherently _less_ risky, by lowering interest rates to artificially prop up asset prices (or by directly bailing out failed companies), the need for a credit derivatives market should be relatively smaller than if the Fed didn’t provide the perceived safety net. Credit derivatives, after all, serve to re-distribute risk, so if the outlook for risk, overall, is smaller, then the market for credit derivatives ought to be smaller, as well. Also, the market for credit derivatives may be smaller than it appears, because contracts are usually based on notational amounts (Say, $1B worth of debt), but many are cashed in on price movements (say, a 5% drop, leading to a payment worth $50 million). So, the premium paid on a $1B contract is nowhere near $1B, and a range of likely payments (if any) are also nowhere near the notational values of the contracts, even under extreme circumstances. So, to compare the notational values of the derivatives market to the market value of fixed income securities is misleading.

  Also, you wrote that “almost no one goes short”. But in the typical derivatives contract, there is precisely one party going short to every one party going long, whether you’re talking about currency swaps or derivatives based on interest rate movements or defaults. The intervention of the Fed may change the prices involved, but it cannot fundamentally change the composition of shorts vs. longs- they must always be equal. This isn’t true of the stock market, on the other hand, because there are market makers who will provide the opposing side of a trade from their inventories when there isn’t an opposing trader to deal with (which can happen in a rapidly rising or falling market).

  I agree with you that the Fed can cause distortions in traders’ outlook for risk, but I think it’s more subdued than Austrians suggest, because the market has an advanced understanding of what results from excessive monetary easing compared to, say, market participants in the 1920’s.
  

  Published: May 16, 2007 5:07 PM

• SF Mechanist

  Thank you for the article which I read with great interest and agree with the vast majority of points made.

  One area of disagreement I have is with the relative power of the government versus the central banks.

  The article implies that central banks are a pawn of the government so that credit and money supply come under the control of politicians, rather than being subject to free market forces.

  I am of the belief in the opposite: that the central banks (i.e. the Fed) coerced governments into allowing their existence, and they are their own private corporations serving their own profit motive, and fund all relevant political parties enough such that they can persue their policies of financial self interest.

  The recent runnup in credit, in America and the world over the last few years, serves the profit margins of the financial industry and the central banks in terms of: (1) services fees and (2) interest when the debts are paid back, and possibly (3) any markup in sales on securitized loans. In essence, the whole financial industry made out like bandits over the past few years. Credit excesses from low interest rates served them well.

  Eventually the time comes when an economic system is "credited out". In other words people, businesses, and governments either cannot, or do not want to, accept any further debt. Are we there now? I suspect we are close, but only time will tell.

  To satisfy their profit motive, when no further credit can be lent, the central banks and financial industry would want to ideally persue a policy of dollar tightening. As inflation equates with debt forgiveness, so too would deflation equate with debt maximization. However, this is a tricky game. Tighten the dollar too much and the economy collapses in depression and people and businesses foreclose and thus profits would be lost that are otherwise reaped in interest payments.

  So in other words, the Fed would increase interest rates if it could; but it might lower them, out of necessity. In either case it would be motivated by corporate self-interest.

  In this scheme, the government plays a relatively small role, other than to allow the Federal Reserve to happen by enforcing the dollar as legal tender.

  Now, if democratic processes truly ruled the national economy, in terms of interest rates and money supply, then yes, I would fear the possibility of hyperinflation-- enacted by congress using its constitutional right to print currency. Congress certainly could hyperinflate the economy by the printing of currency if it wanted to. Debtholders would love to see that happen, and would likely vote for any politician that promised it.

  However, in my belief that the Federal Reserve is NOT a pawn of the government, but its own force which controls its own politicians--for them hyperinflation would reflect a loss of wealth and power. I sleep well in the belief that hyperinflation will not occur in the present system, but rather we will continue to see credit expansions and contractions which serve the corporate profiteering of the Federal Reserve well.

  In any case, I belief there is benefit to viewing the government and central banks as two distinct economic and political forces.

  Published: May 17, 2007 12:36 AM

• TLWP Sam

  I thought the interest rate on a loan WAS the hedge against inflation (and opportunity lost) for a lender. Hence if you get a variable-interest rate loan, you tend to cringe when you hear interest rates go up and have a bit of sigh of relief when they go down. Or if you get a fixed-interest loan, you gloat when interest rates go up and kick yourself when they go down. No?

  Published: May 17, 2007 1:12 AM

• SF Mechanist

  In regard to Richard's comment: I read Human Action cover to cover and recall a discussion from Mises on fractional reserve lending as an acceptable part of a free market system of banking.

  Published: May 17, 2007 1:14 AM

• Paul Marks

  To Richard.

  Prices fell for decades in the late 19th century and people still bought houses.

  Also wages need not go up (in money terms) for them to buy more stuff each year.

  To SF Mechanist.

  Ludwig Von Mises did not support government subsidies to banks and other financial institutions (perhaps apart from in the extreme situation when he was fighting either a Nazi or a Communist take over in Austria).

  With a fractianal reserve system the banks (and so on) will need subsidies (in various complex ways) from time to time in order to prevent them getting into trouble - how is that the "free market"?

  I am not shy of being on the other side of an argument to the late Murry Rothbard - but I would certainly not oppose him on the basic economics of fractional reserve banking (and other credit expansion games).

  Borrowing (whether for investment or consumption) must not just be based on savings it must be 100% financed by them - and they must be real savings (i.e. people choosing not to consume) not so called "savings" (which allow people to have their cake and eat it as well).

  What fractional reserve banking (and other complex practices) really are is an effort to reduce interest rates (for borrowers) below the level that would exist by time preference.

  Look at what Ludwig Von Mises says about such efforts to "reduce interest rates".

  Credit expansion may or may not be "fraud" (as Murry Rothbard said it was), but it certainly is not good practice.

  Credit bubble finance distorts everything and is the basis of the boom-bust cycle.

  Published: May 17, 2007 10:05 AM

• RogerM

  Richard: "How can I therefore afford to pay the sum of $101,000 is the amount I earn is going down year by year."

  Good question. This troubles a lot of people, especially Fed governors, which is why they insist on a positivie inflation rate. But a 100% reserve banking system wouldn't necessarily cause prices to fall. Fractional reserve banking is only one way to increase the money supply. If we used gold as money, gold mines would contribute about 3% annually to the money supply and if production in the rest of the economy increased by the same amount, prices would stay about the same. Using paper money, as we currently do, the Fed could purchase bonds from the public and increase the money supply by 3% annually and keep prices constant.

  But you're right that if we had a fixed money supply (no gold production and no purchasing of bonds by the Fed), prices would fall each year by the amount of the increase in production (2-3%) under a 100% reserve system. In that case, you wouldn't want to borrow money to buy a house since your salary would decrease each year while the amount of the loan would remain fixed. Renting would make more sense. The only people who would borrow money are businesses who could get a higher return on their investment that the cost of borrowing money.

  On the other hand, the value of money would increase at the rate of deflation (say 3%) plus an interest rate (say 3%). That would make it much easier to save money and people would tend to pay cash for houses instead of borrowing. Borrowing for housing only makes sense in an inflationary environment.

  Finally, although prices in general would fall, not all prices would. For example, even in our inflationary environment, not all prices are rising. The prices of manufactured goods, especially computers have fallen for over two decades. So I can imagine that housing prices might remain fixed because of supply and demand. In that case, housing would be an even greater investment for people under deflation than under inflation. So how would you make the fixed payments when you're salary is falling? The fixed housing payment would take a larger percentage of your income each year, so you would have to get raises in your salary to make up the difference.

  Wages probably wouldn't fall as much as prices because productivity increases raise wages. Productivity would increase because mild deflation would encourage savings and therefore increase the pool of money available for businesses to invest in new plants and equipment. So workers would become wealthier each year. The relative increase in wages might make up for the fixed house payments.

  All of this is speculation, because the periods of deflation in the US have been very short. But we can look at Japan's experience in the 1990's and see that they did just fine. But as you can see, an environment of mild deflation would turn our economic system upside down and would be very disorienting for a while. People would tend to save rather than borrow and consume. That might even leave more money for charities.

  Published: May 17, 2007 10:08 AM

• RogerM

  Richard: "How can I therefore afford to pay the sum of $101,000 is the amount I earn is going down year by year."

  Good question. This troubles a lot of people, especially Fed governors, which is why they insist on a positivie inflation rate. But a 100% reserve banking system wouldn't necessarily cause prices to fall. Fractional reserve banking is only one way to increase the money supply. If we used gold as money, gold mines would contribute about 3% annually to the money supply and if production in the rest of the economy increased by the same amount, prices would stay about the same. Using paper money, as we currently do, the Fed could purchase bonds from the public and increase the money supply by 3% annually and keep prices constant.

  But you're right that if we had a fixed money supply (no gold production and no purchasing of bonds by the Fed), prices would fall each year by the amount of the increase in production (2-3%) under a 100% reserve system. In that case, you wouldn't want to borrow money to buy a house since your salary would decrease each year while the amount of the loan would remain fixed. Renting would make more sense. The only people who would borrow money are businesses who could get a higher return on their investment that the cost of borrowing money.

  On the other hand, the value of money would increase at the rate of deflation (say 3%) plus an interest rate (say 3%). That would make it much easier to save money and people would tend to pay cash for houses instead of borrowing. Borrowing for housing only makes sense in an inflationary environment.

  Finally, although prices in general would fall, not all prices would. For example, even in our inflationary environment, not all prices are rising. The prices of manufactured goods, especially computers have fallen for over two decades. So I can imagine that housing prices might remain fixed because of supply and demand. In that case, housing would be an even greater investment for people under deflation than under inflation. So how would you make the fixed payments when you're salary is falling? The fixed housing payment would take a larger percentage of your income each year, so you would have to get raises in your salary to make up the difference.

  Wages probably wouldn't fall as much as prices because productivity increases raise wages. Productivity would increase because mild deflation would encourage savings and therefore increase the pool of money available for businesses to invest in new plants and equipment. So workers would become wealthier each year. The relative increase in wages might make up for the fixed house payments.

  All of this is speculation, because the periods of deflation in the US have been very short. But we can look at Japan's experience in the 1990's and see that they did just fine. But as you can see, an environment of mild deflation would turn our economic system upside down and would be very disorienting for a while. People would tend to save rather than borrow and consume. That might even leave more money for charities.

  Published: May 17, 2007 10:08 AM