Short-Sale Restrictions Are an Exercise in Naked Power
Short selling is a beneficial process that allows anyone to participate in the market's evaluation of share prices. So long as contracts are enforced, even naked short selling can be a beneficial process that allows the quickest possible adjustment in mispriced stocks. The government's recent efforts to "protect" nineteen favored firms from naked shorting will do nothing but raise transaction costs. Beyond that, it provides a sobering hint of future, more significant innovations in federal government support for particular financial giants. FULL ARTICLE
Comments (55)
jeffrey
Prof Murphy, I've thought about the supposed connection between naked short selling and fractional reserve banking but I just don't see it. In fractional reserve banking, the banks is creating for use something that really doesn't exist: money that is owned by one person that is used by two or more people simultaneously. It is weaving an illusion that more property exists than really does, and it works only so long as the money substitutes aren't actually cashed in.
In naked short selling, we have nothing but a promise of a future delivery. As you say: "the brokerage is responsible for delivering the proper number of shares to those who purchased them in the initial short sale." So we have a promise at work. It is the same as any loan agreement but the brokerage is acting in the position of a speculator in the market for future income streams.
Whereas fractional reserve banking is effectively lying about the present state of things, naked short selling is speculating about an uncertain future and promising real property that can in fact be delivered.
Published: August 11, 2008 8:23 AM
Bob Murphy
Jeffrey,
Yeah, I'm not saying the connection is real, just that some of the objections against naked shorting sounded like the objections against FRB.
Published: August 11, 2008 8:54 AM
Curt Howland
I don't see how a naked short sale is actually fraud.
I sell 200 shares of MSFT, because I think their price will drop between when the sale is made and when I have to deliver the shares.
I then buy those 200 shares however I have to, and deliver them in time. It matters not how much profit or loss I make on the transaction, it is my responsibility because it is my contract to sell.
The short-seller may very well be putting themselves in danger, but it is a deliberate choice. I'm sure that those who practice this particular style are adrenaline-junkie types.
The only way I see the brokerage being involved is if part of their contract (with buyer or seller) includes specific protections against such a transaction falling through. However, doing so would put the brokerage in a contractual bind, but if they left it entirely up to the buyer and seller then they could step back and let the chips fall where they may.
What would really put a damper on this would be if there were a flag put on sales where the seller did not already own the shares. Such a rule would be enacted by the exchange, I assume, since that is where the transaction is taking place.
So would you knowingly buy shares that someone was selling naked? Interesting question.
Published: August 11, 2008 9:25 AM
David Ch
Curt Howland said:
'I don't see how a naked short sale is actually fraud'.
Me neither. Its not. Neither is FRB where theres no central bank involved and the banks do it openly without misrepresentation. Sure, if they miscalculate and cant meet a deposit when it falls due, that might trigger a collapse of confidence in that bank. But thats the exact threat that would ( absent a central bank nanny with a poop-scoop) motivate any bank to assure that just such an eventuality does not occur, so banks that persist will be those who do it particularly well.
This seems to be a big Austrolibertarian blind spot which baffles me, frankly. For some reason, those who are so vehemently against ( free market) FRB seem to think that banks have to play by different rules from all other market participants*. It's as if their faith in the market is not strong enough to be universal, and fails them as soon as they see banks in their sights. As if they are not just another form of trade, with mutually-agreeable benefits for themselves, depositors, and borrowers alike, all done with some acceptance of risk. Wheres the fraud?
* One, I forget who, even declared in a different thread in this blog that if FRB was allowed in a free market, the banks would push the money supply to infinity. Thats rubbish, because the very motivations mentioned above will place a firm ceiling on how much banks lend out: A bank is only going to lend to a borrower who demonstrates a robust ability to repay when the debt is due, and it will constantly match its maturing deposits with maturing loans ( and will also likely have some of its own capital as a buffer, and have some level of liquidity in hand as well ( the fraction). No bank is going to do it blindly, and who better than a bank concerned with its own viability to determine what the reserve fraction would be. Without a central bank, No bank is going to create unlimited money without regard for consequences.
Fractional reserve banking is only perverse where central banks are involved. take them away, and FRB will emerge all by itself. And if it does, let it be.
Published: August 11, 2008 11:08 AM
Joe Stoutenburg
jeffrey, let me get this straight. You've compared a free market practice of naked shorts with a government managed money system and found similarities lacking. Are you surprised?
Take away the government interventions from the money system and see if it might not act quite like the stock brokerages. Take away the central bank. Take away legal tender laws. Take away the power to monetize government debt (i.e. future tax collections). Render the banking system a matter of contractual agreements between willing parties. Do you imagine that it would act anything like the monster that it is today?
Professor Murphy implies that people drawing the parallel would use it to attempt to ban naked shorting. I use the parallel to criticize people who would ban any peaceful free market practice - including FRB absent the government interventions.
Published: August 11, 2008 11:41 AM
Person
If I were an entrepreneur whose firm went public, I would be bursting with glee if speculators were rablidly shorting my company. That would be a stellar opportunity for me to cheaply increase my share of the enterprise, since *obviously* they are undervaluing it.
Btw, has there ever been a case where a speculator borrowed shares and sold them, after which the existing shareholders were few enough (and those outside, passive enough) to form a cartel such that they could charge obscenely high prices (i.e. more than full net worth of speculator for each share) for the shares, making the speculator unable to cover his position, and making the price jump far too quickly for the brokerage to cover it with the assets the speculator put up?
Published: August 11, 2008 11:41 AM
rube goldberg
The real issue is the failures to deliver. the FTDs are a fraud. the reg SHO list is full of stocks with large percentages of FTDs. naked shorting is not problematic as long as the FTDs are addressed. The problem is that parties failing to deliver are not forced to fulfill their contractual obligations by the SEC or DTCC.
Published: August 11, 2008 2:24 PM
Francisco Torres
For some reason, those who are so vehemently against ( free market) FRB seem to think that banks have to play by different rules from all other market participants.
The problem is not the existence of Fractional Reserve Banks, which can appear in a free market (at their stock holders' risk), but the fact that they are de facto protected against risk by the government, through the Federal Reserve. This protection creates the distortions we see in the form of boom-bust cycles. It is the protection racket itself rather than the existence of this form of banking which finds no love with Austrian economists and libertarians. As long as the FRBs are allowed to fail and their clients allowed the hardship of learning the lesson, then they can exist in a free market.
Published: August 11, 2008 2:37 PM
Atlanta Gold North
The problem with Naked Shorting is Failure to Deliver. I would not have a problem with legal shorting, that is when the sold stock is delivered to the buyer within the three days allowed by the SEC. Then the legal short seller is on the hook to whoever loaned the stock. And at a price and terms of settlement determined between the loaner and the loanee.
The Naked Short seller is committing fraud! There are stocks where over 1,000,000 shares that do not exist are in someone's account. These buyers believe they have legal shares of stock that do not exist. The naked short seller does not deliver within the 3 days allowed and may NEVER deliver that stock. An individual is not the seller that is creating the large number of failures to deliver. It's the large hedge fund that is mounting an attack on a legitimate stock and is pushing the stock down by selling shares that do not exist. If it was a legal short sale, as the loaned shares became unavailable, short sales would decrease and an equilibrium would be found. When the loaned shares do not exist, there is no equilibrium.
Overstock, Inc has claimed with some degree of support that the total number of shares in the hands of buyers was over two times the number of shares issued. That is patently impossible with legal short sales. This is what I mean by lack of equilibrium.
When sold stock is not delivered within three days required by the system, the stock should be supplied AT THE SELLING BROKER'S COST AT MARKET. That would make the system work properly.
Published: August 11, 2008 2:51 PM
rube goldberg
you are correct AGN. more problems with naked shorts are revealed by Patrick Byrne, CEO of Overstock, at his site dedicated to the issue...
http://www.deepcapture.com/did-someone-say-world-historic/
Published: August 11, 2008 3:02 PM
rube goldberg
you are correct AGN. more problems with naked shorts are revealed by Patrick Byrne, CEO of Overstock, at his site dedicated to the issue...
http://www.deepcapture.com/did-someone-say-world-historic/
Published: August 11, 2008 3:02 PM
Andras
Robert Murphy: "So long as contracts are enforced, even naked short selling can be a beneficial process that allows the quickest possible adjustment in mispriced stocks."
Isn't stealing and selling the loot to a pawnshop also beneficial? It decreases the market price very efficiently!
AGN and RG correctly realizes what is the problem with naked shorts: They pretend to own or have legal rights to what they don't. Try to approach the problem from the other side: why don't we have naked longs? It sounds even more exciting.
What makes naked shorts more attractive are the asymetric rules. E.g.,
1) you don't have to deliver if the stock is delisted. (With a little stamina you can drive the stock down to pennystock status which soon triggers delisting.) By stamina I mean the broker/mutual fund does the dirty with, up to recently, almost unlimited resources. When the price goes up they just roll it over to the next three days, indefinitely if necessary.
2) If the company wants to make countermeasures it has to apply for permissions from the SCC (which takes months) and can have say permission for 20% buybacks. It will not even make a dent on the outstanding stocks of which only 10-50% is legitimate. (In other words, 20% against 200-1000% stocks.)
You can frequently get voting rights with your fraudulent stocks and also affect corporate decisions to your favor. The great pretenders!
So I would say shorts (and longs) are good. Naked shorts are very BAD!!!
Published: August 11, 2008 9:28 PM
David Ch
Francesco Torres said: The problem is not the existence of Fractional Reserve Banks, which can appear in a free market (at their stock holders' risk), but the fact that they are de facto protected against risk by the government, through the Federal Reserve. This protection creates the distortions we see in the form of boom-bust cycles. It is the protection racket itself rather than the existence of this form of banking which finds no love with Austrian economists and libertarians. As long as the FRBs are allowed to fail and their clients allowed the hardship of learning the lesson, then they can exist in a free market'.
This is exactly my point. the axe I have to grind is that some of us in the Austrolibertarian world do not accept this, and would love to outlaw it . Which is weird, frankly.
Published: August 12, 2008 12:39 AM
Bastiat
I have the impression that the real problem here is that some brokers indeed collude to operate on a fractional reserve, perhaps because they can't afford to come clean with previous bad bets, because they hope to profit from delisting, or some other reason.
Wouldn't a centralised system of fractional stock reserve pose the same systematic risks as a centralised system of gold stock reserve?
Personally, if I were FREE to choose which stock market to trade on, I would choose one that has a stricter enforcement of FTDs. Thus, I would be careful about claiming that the current fractional reserve free-for-all better represents the "free market" position.
Published: August 12, 2008 3:35 AM
newson
to francisco torres:
well, i think your compatriot, jesus huerta de soto, makes a very compelling argument that frb is anti-libertarian, because it promotes ambiguity and deception over property titles.
it's a great read. "money, bank credit, and economic cycles".
Published: August 12, 2008 10:39 AM
Joe Stoutenburg
Any person or institution that "promotes ambiguity and deception" may be rightly condemned. What some of us here are defending is the possibility of an open, honest free market fractional reserve bank. As a caveate, I personally believe that a free market banking system would certainly have some form of physical convertibility (gold or silver) even if every unit of money wasn't backed by the physical asset.
To illustrate, suppose that a bank offers notes that may be redeemed for a certain amount of gold. It publicly reports the number of notes outstanding. It publicly reports the amount of gold in reserve. It also makes public the collateral held and its exchange value in gold. Ideally, all of these amounts would be independently audited.
From a liberty perspective, there can be no issue. You may choose to bank only with an institution that holds a 100% gold reserve. Alternatively, you might accept notes for which you are satisfied that the appropriate amount of gold may be settled according to whatever contract you agree upon with the bank (perhaps including possible delays for the bank to sell its claim on the collateral for gold). You could even accept notes from a bank that offers loans without physical collateral - accepting only IOUs. If the credit of those borrowers proves to be bad, you should suffer the consequences along with the bank. In a free market, firms would undoubtedly arise to help people assess the soundness of the banks.
Now, we could address interesting questions of money supply, inflation and interest. From the answers to those questions might arise some preferred banking system that we might advocate. But this should not be a matter of liberty.
Published: August 12, 2008 11:56 AM
Mike D.
Curt said
I don't see how a naked short sale is actually fraud.
It comes under the "free riding" restriction. Suppose I call my broker and buy 1,000,000 shares of Microsoft at $20 per share. Suppose immediately Microsoft immediately goes up $2 and I sell for $2,000,000 profit. Is there anything wrong with this transaction? Reg T requires that I have at least $10,000,000 in my account before I do this transaction. Otherwise, it is deemed to be "free riding". Now, my broker would normally stop me doing this. But a floor trader, who buy and sells all day, could easily do this during the day. However, even brokers are required to comply with Reg T. However, it is very difficult to enforce.
A similar rule same applies to short sales. In principle, when the trade is placed, you should be able to deliver the stock. However, most positions get closed out before delivery occurs. This is what the SEC does not like.
Do we need this rule? Why can you short the S&P 500 futures without going through this rigmarole? If you want to see what happens when you can't sell short, because nobody is lending any more stock, pull up a 10 year chart of Goodyear Tire (GT) . At a point in the downward drop, there was no stock left to borrow. The stock kept moving down, but much more slowly than it would have if naked short selling had been allowed. All the SEC decision will do is to give the financial markets a "time out". They hope that "things will turn around". They'd do a lot better if they just let the markets find there own level - sort of like the way that a lion picks off the weak animals in a herd of gazelle - better for both species in the long run.
Published: August 12, 2008 1:45 PM
newson
to joe stoutenberg:
there is no such thing as a open, honest free-market frb. precisely because there can be no honest way of allocating the same property to two or more valid title holders without disappointing someone, in the case of a run.
there is no problem with clients making short-term loans to a bank, for interest, just that demand accounts shouldn't be mixed up with loans.
want a higher return? invest in a hedge or mutual fund. deposit accounts with banks should live up to their name. deposit = safekeeping. i recommend de soto, whose work on frb is the most comprehensive that i'm aware of.
Published: August 12, 2008 6:47 PM
joebhed
Sorry for being here.
The rest of us, you know.
The ones without the money.
The ones without what Martin Van Buren wrote as THE MONEY POWER.
We are the ones on the receiving end of the consequences of the activities and actions of those with THE MONEY POWER.
To a glaring few of us, the notion that the government should not be involved to the highest degree in matters involving the use of the money system in this country is nothing less than a joke.
Having watched as the actions of “jokers” in the financial markets have caused the greatest of financial calamities of the only world that any of us has ever known, the days of more freedom in the market of capital itself is drawing to a close.
There will be a period of regulation of the financial industry as it appears after the coming reforms.
But the basic case has already been made by the situation and circumstances in which we find ourselves that the future economic well being of this country can no longer be left in the disastrous hands of the risk-taking, free-marketeering, debt-creating capitalists.
The people are demanding of the only power that can provide them any comfort from this financial collapse. That of government.
The primary driver of our financial downfall has been the “money-centric” nature of the development of the American economy by the financial capitalists. It is an ignominious failure.
It has ignored the good of the American people by using our nation’s capital, and by that I primarily mean our nation’s debts, for the purpose of creating more capital and more services and structures, more vehicles and tools for the financial services industry.
It ignores funding the productive use of the American worker and American resources. In fact, it sees only one productive use favorably, that of producing more money.
As a sovereign nation, the people of the United States of America possess the rights to determine every aspect of the money system that facilitates the national economy. It is by the Act of Congress on behalf of those people that the private Federal Reserve System came into being.
It is a private franchise that has a perfect right that has been created for it by the Congress to create the nation’s money supply. In return for that lucrative favor from the Congress, the FED is supposed to be responsible to the people and the government by keeping the economy going and growing, and by providing for jobs for the American work force.
That private franchise and its debt-money system have ruined this nation financially. It was bound to do so because the notion of creating “rents” on the capital that is needed to make productive use of our human and natural resources is essentially self-defeating and impossible to sustain.
And so, the government must step in and it must un-do the private debt-money banking system and replace it with a new system of creating the nation’s money without issuing debts for its use. That’s how money should work.
As in creating the private Federal Reserve System, it is up to the government to act in the best interest of all the people, and in doing so it must maintain a strong deterrence against allowing money to again become the commodity that it has been for almost a hundred years, and turn it again into a debt-free medium of exchange.
The bankers can lend their own money. The bankers and the traders can risk their own money. There will never again be anything like a fractional-reserve private banking system running the economy of this country into the ground.
So please don’t pretend to me that the FRB is the government of this country sneaking its clammy little paws into the pockets of those defenseless stockholders. The FRB(FED) is the private partnership among the nation’s commercial banks and bankers that makes the rules that determine the economic well-being of all the American people.
You know, the rest of us.
Right now the FED is running as fast as it can to keep the shit from hitting the fan before this administration comes to a close. In so doing, they said. “Hey, we gotta stop those short runs or we’re dead”.
We cannot ever repay the debts that this FED and its complicit government agencies have allowed.
Yes, it’s a power play.
But it’s not a private, debt-money-issue FED power play.
It’s a people power play.
Published: August 12, 2008 9:06 PM
Joe Stoutenburg
newsom:
there is no such thing as a open, honest free-market frb. precisely because there can be no honest way of allocating the same property to two or more valid title holders without disappointing someone, in the case of a run.
It seems that when it comes to "property" in banking, only precious metals meet the definition for you. Let me try this again. A bank issues notes for which it will exchange a certain amount of gold. In reserve, it holds some gold for relatively small redemptions of a portion of the notes outstanding. It also holds other assets that it believes that it can exchange for enough gold to redeem all of its notes. It places restrictions upon large redemptions in order to allow it to sell the assets in orderly transactions.
All of this is done openly and contractually. As I wrote before, we could certainly talk about the consequences of this type of arrangement versus a 100% reserve gold standard. However, your contention that such a system constitutes claim on the same property simply doesn't hold water. Every note is backed by gold or by an asset of sufficient value to exchange for the agreed upon amount of gold.
Perhaps we are talking at cross terms? In a way, what I have just described is 100% reserve banking. I just admit that different assets than precious metals may be admitted as backing as long as doing so is openly understood and agreed upon.
I'll heartily agree that issuing notes without even the pretense of backing is fraudulent. This may occur in a system of financial convertibility (asset values are insufficient to redeem enough gold) or in a system of strict physical convertibility (bank issues more notes than its gold supply). Fraud may even occur when no notes are issued if the mint tampers with the weight or purity of coins.
Published: August 13, 2008 8:04 AM
newson
to joe stoutenberg:
deposit banking can only honour its implicit commitment if it can guarantee safekeeping of all the money entrusted to it, at the same time ensuring constant availability for withdrawals to all depositors.
this doesn't mean the bank can't offer time deposits, the maturity of which will be offset against their loan portfolio.
for deposit accounts, anything less than 100% reserve implies an aleatory contract, not a custodial contract.
even if it were perfectly explicit, the safekeeping aspect for deposits is contractually unable to be maintained under frb. fraud (as in promising something knowing that it is not deliverable, and knowing this in advance) isn't legitimized by being open.
download the mises.org pdf of de soto's magnum opus (take a look at the first three chapters, the legal and moral arguments against frb). he argues the point in greater depth than mises or rothbard, though he builds on their positions.
assuming the austrian business cycle theorem is correct (were it not, why would anyone hang around this site?), then freebanking is going to deliver the boom-bust cycle that we experience now. only the amplitude of the waves will be much smaller, and the frequency presumably much greater, and the busts localized.
cancerous doctrines like marxism were greatly assisted by the regular and devastating and demoralizing effects of the business cycle, and capitalism has wrongly borne the blame. only 100% reserved deposit-banking can obviate this.
Published: August 13, 2008 11:11 AM
Joe Stoutenburg
I'll take a look at de Sota's "magnum opus". At best, I may learn something. Maybe I'm error. At the least, I'll know the points to which you so stringently cling or may be able to discern whether you have even accurately understood your source. You should realize though that by presenting it in that manner you are increasing my perception that you are repeating dogmas without fully comprehending opposing arguments or perhaps even your own.
You have not demonstrated how my illustrative bank fails to deliver its promise (your argument by assertion notwithstanding). Should I repeat one more time? You sign a contract. You realize that large gold redemptions may require a delay in order for the bank to exchange non-gold assets for gold on the market. You submit a request to exchange all of your notes for the agreed upon amount of gold. In fact, everyone does. A run on the bank occurs. According to contract, the bank exercises its right to delay redemption in order to obtain gold. Within the specified time, the bank delivers gold to every note holder.
Where is the fraud???
de Soto may argue for the desirability of one system over another. In that question, I remain open. But if you or he tries to tell me that fraud is occuring in which every party satisfies its obligations, I'm not buying it!
Published: August 13, 2008 12:50 PM
newson
to joe stoutenberg:
the 100% reserve means 100% gold backing against current account deposits. when the bank has other assets redeemable against current accounts, it's offering you an investment account.
it's important that words have precise meanings. if i go to a hospital, it's expected that i'm checked out by a medical doctor. i don't have to read the fine print to find that if a doctor's not on the wards, i'll not be seen by a vet! it's part of the meaning of hospital. likewise, if i take fido for his shots, i expect the service of a vet, not a doctor (if there's a vet shortage at that time). i shouldn't have to ask what a "veterinary clinic" means.
when i buy a banana cake, i don't want to find in exceptional circumstances it becomes a hazelnut cake. i might have an allergy and might die. blah, blah, blah.
it's probably clearer if you follow the modern evolution of frb, described in detail by de soto, particularly where the law diverged regarding warehousing grain vs. warehousing money.
the mere signing of contracts (even if it's informed consent) doesn't give an accord legal validity (and de soto goes into this at length).
if you sign a contract with me that says i grant you ten extra years of life through my magical powers, it doesn't matter whether you're happy with the various disclaimers, the contract is null because i cannot possibly know i can honor my side of the bargain.
you've also missed my criticism about frb and the business cycle. i find it difficult to reconcile the abct with frb, when it's precisely frb that causes it (the fed only immeasurably aggravating the problem, not originating it).
Published: August 13, 2008 7:38 PM
jp
"if you sign a contract with me that says i grant you ten extra years of life through my magical powers, it doesn't matter whether you're happy with the various disclaimers, the contract is null because i cannot possibly know i can honor my side of the bargain."
Your comparison of Joe's simple contract in his previous post to someone's granting of extra life is ridiculous. Joe's contract with the bank was simple and realizable - if the gold is not available upon a request for redemption, other assets are sold for gold, this being delivered by the bank when it becomes available. He never claimed that he was warehousing the money with the bank. If he wanted to warehouse he would have put it in a security deposit box.
Joe's contract is not a tough contract to understand. And it's not an impossible contract for the bank to uphold, not anywhere near the granting of extra life you use. You're really reaching to the bottom of the barrell on this one Newson.
Published: August 13, 2008 9:16 PM
newson
to jp:
then perhaps you'd like to explain how the business cycle occurs?
Published: August 13, 2008 9:32 PM
newson
to jp:
"warehouse" in the sense that he can be sure his gold, or an identical amount of someone else's gold is still set aside for him.
demand accounts offer checking services, something safe deposit boxes can't.
Published: August 13, 2008 9:45 PM
jp
To tell the truth I'm still trying to learn exactly how the business cycle occurs.
I'm going to read De Soto though. It's not really fair to criticize him without giving him a shot. I hope he makes good holiday reading.
If you have time, I'd suggest you read Larry White's "Free Banking". It gives a far better defence of fractional reserve banking than I can. George Selgin's book on Free Banking is good too. If they can't convince you of the legitimacy of frb at least they'll give you a good foil against which to test your knowledge about traditional austrian econ.
Published: August 13, 2008 11:34 PM
newson
to jp:
it's a long read, but the beginning is especially insightful.
he also critiques selgin's arguments, which may prove interesting to you.
no, i haven't read larry white's book. is it available pdf? i find this format good whilst doing my exercises. plus i'm a skinflint.
Published: August 14, 2008 2:42 AM
David C
absent central banks and bailouts for commercial banks, we do need to distinguish between a deposit and safe custody. Many here seem to insist that any bank that takes a deposit must keep 100% cash reserve against my deposit. this is not banking, its a mere safe custody service.
If I go to a bank and place my cash with them for safekeeping with an absolute guarantee that they will retain it safely until I want it back, I can expect to pay for the service, and they must ensure that my deposit with them is NOT lent out. Their reserve is in fact the very cash I placed with them.
If I go to a bank and deposit cash with them on the basis that they will pay me interest, I must accept that they will lend th ebulk of my deposit out to borrowers where they can earn interest in turn from the borrower, and that they expect that when I want my deposit back, they will have the liquidity to pay me out. Its not a guarantee. there remains some risk that th ebank will not be able to collect the loan by the time I want my deposit back. However I will choose to do this because
1. the bank is more skilled than me at assessing the creditworthiness of the eventual borrower.
2. By aggregating a portfolio and deploying its capital and reserve margins ( note, held prudently by the bank voluntarily and in regard for my confidence in them as a customer, not prescribed by some authority), the bank protects ME from the default of any particular borrower. the bank funds th einevitable proportion of bad debts from the differencebetween what they charge the borrower and what they pay me.
this arrangement suits borrowers and depositors and banks alike, because each gets to do what it does best, and risks are apportuioned in accordance with appetite of each party. .
THAT's banking, and it cant be done at all if 100% reserves are compelled against all deposits as some of our more zealous brethren seem to want.
Published: August 14, 2008 4:08 AM
Joe Stoutenburg
I've begun reading de Soto. I won't comment until I've at least read the first three chapters.
In the meantime, while latter de Soto chapters will address this, it's time to take up the Austrian business cycle theory. One of the appeals of Austrian economics is that it bridges the artificial divide between micro and macro economics. Yet in this debate, focus seems resolutely focused on the macro level. I would like to briefly develop a micro level view of the business cycle that builds up to the macro level.
Individual households undertake activities in the pursuit of wealth. Upon the start of a new enterprise, there is a boom. Optimism abounds. The household is spending money to develop the budding business. Economic activity is booming.
In time, the project proves to be a failure. The business runs out of capital. The household is obliged to cease its activities. There is a period of slower economic activity as its members try to figure out what to do next. A bust has ensued.
In an unhindered market, it should be expected that individual booms and busts will tend to cancel each other out. However, it is not unreasonable to suppose that the failure of large companies or industries could cause a general slow down in economic activity until entrepreneurs can decide upon how to best utilize the now idle resources. If new technology has displaced the defunct companies, it is quite within expectation that a boom could ensue.
Now, let's introduce monetary effects upon our household. Suppose that the amount of money in circulation exceeds the wealth that is supposed to back it. This could occur in a 100% gold standard in which significant amounts of paper money are fraudulently printed with no backing. It could also occur in a banking system in which other assets are admitted as backing that proves of inadequate value [1].
From here, we follow the official Austrian theory. The increased supply of money pushes down interest rates below the true cost of capital. Our household sees more profit potential than might actually be available. What's worse, this misinformation affects all households together. This general boom is indeed artificial.
A time of reckoning must occur. Either real capital is found lacking, or the banks are found out for their error and/or fraud. The malinvestments are liquidated. A bust ensues as people adjust their activities to take on new productive enterprises.
If the misinformation is perpetuated by the intervention of a central bank or government fiat, the time of reckoning may be delayed but its effects amplified. Without question, our socialized monetary system is to blame for the amplitude of the business cycle. A free banking market would see less of the boom/bust cycle. However, booms and busts are simply effects of misvaluation. Banking systems that result in inadequate reserves amplify them but are not the base cause.
[1] A case could be made that a 100% gold standard would be more immune to such monetary effects. I would probably come to agree. My point though is that the monetary effects could conceivably occur in any system as long as errors or fraud are possible.
Published: August 14, 2008 10:12 AM
newson
to david c:
i agree that demand accounts should attract fees for safekeeping and checking facilities, indeed any safekeeping facility that pays interest is a contradiction in terms.
the second part, which is the frb bit, i disagree with. apart from the fact that this process is the driver of the boom/bust cycle, it ignores the impossibility of predicting bank runs. as de soto mentions, they is no probabilistic model which can help here, unlike insurance for natural risks.
again, the investment house you've described is fine with me, as long as it's not called a bank, and as long as the account is called a checking account, demand deposit, or current account, which would be an untrue description of the product.
the bank of amsterdam was an historical example of how well 100% reserve banks can operate. in the end, it too gave in to the temptation to loan out depositors money, and from there its fate was sealed, like all frb institutions. the only unknown is timing.
Published: August 14, 2008 10:27 AM
newson
oops, please read:
"...and as long as the account is notcalled a checking account, demand deposit, or current account..."
Published: August 14, 2008 10:31 AM
newson
to joe stoutenberg:
naturally, even if 100% reserve bank were mandated by either governments or courts, it's inevitable there will be those who infringe. to the extent that this is not curtailed, the business cycle will still be with us.
absent monetary factors, as you say, business failures will be offset by business successes. there would be no endogenous cyclicality. in biblical times (where money-lending was 100% reserve banking), economies would flourish or wither depending on taxation, fair laws, natural disasters or war.
Published: August 14, 2008 10:53 AM
Joe Stoutenburg
newsom:
the investment house you've described is fine with me, as long as it's not called a bank, and as long as the account is not called a checking account, demand deposit, or current account, which would be an untrue description of the product.
Are we just arguing semantics then??? Let's expand this. Suppose that the "investment house" gains a reputation for reliably exchanging its notes for gold. People start trading those notes for goods and services. Is that okay as long as we don't call it money?
Really, what are we arguing?
Published: August 14, 2008 11:18 AM
Joe Stoutenburg
newsom:
the investment house you've described is fine with me, as long as it's not called a bank, and as long as the account is not called a checking account, demand deposit, or current account, which would be an untrue description of the product.
Are we just arguing semantics then??? Let's expand this. Suppose that the "investment house" gains a reputation for reliably exchanging its notes for gold. People start trading those notes for goods and services. Is that okay as long as we don't call it money?
Really, what are we arguing?
Published: August 14, 2008 11:22 AM
David C(h)
To Newson, who said:
'the second part, which is the frb bit, i disagree with. apart from the fact that this process is the driver of the boom/bust cycle, it ignores the impossibility of predicting bank runs. as de soto mentions, they is no probabilistic model which can help here, unlike insurance for natural risks.
again, the investment house you've described is fine with me, as long as it's not called a bank, and as long as the account is called a checking account, demand deposit, or current account, which would be an untrue description of the product.'
Response:
This is where things get fuzzy around the edges. whatever the nomenclature, and absent the jackboots of law, where voluntary economic activity gives rise to claims between participants, institutions will emerge to facilitate trading in those claims. Presto, these tranferable claims start behaving like money, whatever the 'base' money might be, and you have a variable money supply that expands and contracts in lockstep with the net volume of claims being created and settled.
Where we disagree is the cause of the boom/bust cycle: You say it is a result of FRB, period. I say it is an artefact of central bank intervention within a context of FRB.
Let me explain myself. economic participants, producers, consumers and bankers alike, do not have perfect vision into the future. They guess, and forecast, and respond to pricing signals all over the place in making their choices. They inevitably are sometimes going to make mistakes, and the outcomes of their choices may well undershoot , or match, or overshoot their expectations. But in a free banking market without a central bank and without a lender of last resort protecting banks from the adverse consequences of their decisions, interest, or the price of money, AND the prices in the real sector, both inform alll participants decisions. Mistakes made will sometimes overshoot and sometimes undershoot expectations, so every participant might face a personal boom or bust or a neutral 'as expected' outcome, and in this way successful ventures will flourish and unsuccessful ventures will be flushed out, leaving the most optimal fulfilment of the demands of society at large.
When a central bank enters the picture and siezes control of interest rates, making money cheaper ( or, less often, more expensive) than the rate that freely emerges from th evoluntary interactions between borrowers and lenders ( whose borrowing and depositing decisions are informed by their view of th e investment and consumption opportunities in the real goods markets, the nexus between prices in the real sector and the prices in th emoney sector is distorted. Ans it is this distorted signal that SYNCHRONISES the various mistakes made by all the participants at large. So instead of a range of undershooting and overshooting more or less balancing one another, the sequential overshooting and undershooting generates an economy-wide rollercoaster - the boom bust cycle. Take away the central bank, and this will move out of sync while reducing the genreal propensity to make mistakes because at least everybody is making decisions based on honest pricing signals.
I have no problem with a banking-sector facilitated money supply multiplier, which will inevitably emerge in properly free conditions one way or another, particularly in conditions of expanding economic activity or growth. I have a problem with the result being hijacked by a central 'authority'. And of course, banks are still limited in how much they can lend, becaUSE they still cant lend out more than what has been deposited with them at the outside. those that try to will swiftly die and leave the more prudent ones to prosper and marry idle cash holdings to where they can be deployed for investment most beneficially.
I hope that makes some kind of sense.
I rather suspect that this view has something in common with Mr Sproul's real bills doctrine, but I dont know enough about RBD to be sure.
I have to confess that I havent read De soto either.
Published: August 14, 2008 1:10 PM
newson
to joe stoutenberg:
the semantics of this question is important. "deposit" means leave in safe custody. it's hard to imagine how iou's would circulate more readily than gold, but i don't have any problems with people trading any sort of paper.
it's unlikely people would entrust large amounts of their personal or commercial funds in such iou's. they're not going to become a rival money to the precious metals, and so the effect on prices is going to be small. (history shows paper always attracts a discount, barring legal tender laws).
Published: August 14, 2008 8:48 PM
newson
to david c(h):
"And of course, banks are still limited in how much they can lend, becaUSE they still cant lend out more than what has been deposited with them at the outside."
fractional reserve banking encourages banking aggregation and centralization, in order to minimize the risk of runs (and subsequent deflation), inevitable because of the inflationary effects that fractional reserve banking sets up in the economy. this effect is present even without a central bank (though the cycle is different in amplitude and frequency). before the austrians, the business cycle was thought to be a necessary evil of capitalism, and inspired marx and others to come up with a better system. and the rest is history...
real bills doctrine - it's got such a long history of failure, but i guess hope springs eternal.
Published: August 14, 2008 9:32 PM
Joe Stoutenburg
newsom:
history shows paper always attracts a discount, barring legal tender laws
I don't know about history one way or another. I think that statement is reasonable though. In units or gold, people will tend to prefer gold over claims to gold. No matter how small, there is always the risk that the obligor may default on the claim.
I will try to sum up:
1. You have no problem with the exchange of paper for goods and services. In other words, you would not use force to deter people from entering into those voluntary exchanges.
2. You take exception with calling institutions 'banks' that offer notes redeemable in gold but that hold other assets of exchangeable value. You prefer to call them 'investment houses'.
3. You believe that it is unlikely that the notes of such institutions would broadly circulate as money.
4. You warn that "fractional reserve banking encourages banking aggregation and centralization." You therefore favor banking institutions based upon 100% gold reserves.
If those points accurately reflect your positions, I have the following reactions:
1. If it is true that you would not ban any sort of voluntary exchanges, then we have no material disagreement. I don't think that you ever explicitly called for such a ban. However, calling non 100% gold reserve depositories "fraudulent" certainly makes one think that you would do so.
2. It seems that our agreement turns upon careful definitions of institutions. I think that you insist too heavily upon this. To me, an investment house is a firm that receives money with the expectation of paying a return (whether by fixed agreement or according to the investment performance). The institutions that I have described perform every function of a 100% gold reserve bank except that they probably must require some kind of delay to allow them to redeem their assets for gold. In exchange for this restriction, it is probable that they might have to offer somewhat different terms (perhaps slightly higher rates of interest on time deposits and lower rates on loans).
3. I don't know one way or another for certain. Mankind has exchanged many strange things as money. I wouldn't rule out anything.
4. You may be right on this point. Whether "aggregation and centralization" are bad in themselves may be debated. I won't enter that debate here. I believe that the primary thing is to forbid fraud and violence. If such institutions do result in fraud, it is simply critical to not employ another fraud or act of violence to bail them out. In that manner, if you are correct the market will naturally shun them.
Published: August 15, 2008 8:15 AM
newson
to joe stoutenburg:
first, sorry i mangled your name.
second, regarding my contention that fractional reserve banking is a fraudulent practice - i'd be happy to see it go ahead under a name that doesn't include "banking".
even in a minimal state or stateless society, chosen authorities would presumably still be charged with outlawing fraud. to go back to the cake example, i can make a hazelnut cake and sell it as such, but i can't pitch it as a banana cake because that would be toknowingly deceive purchasers (and could have disastrous consequences like an allergic reaction). even when you buy cakes that have a disclaimer about ingredients on the packet, this doesn't mean there is no potential for legal liability. there is a duty of care.
if you believe the abct, then you recognize the disastrous effects that the boom/bust cycle has on society, so the pedantry you remark on is warranted.
aggregation and centralization are the natural outcomes of frb, as this tactic lessens the chance of ruinous bank runs. so frb's nature is to encourage cartelization of the banking sector. now what is the logical final move after banks have cartelized? to form the ultimate cartel through the creation of a central bank, thereby enabling all of the banking cartel to inflate simultaneously without risking runs (and knowing the reserve bank is there to you out if things go awry).
all of which is said with greater erudition by de soto, so i commend you to him, and welcome any lacuna you're able to find in his logic.
Published: August 15, 2008 10:54 AM
jp
"history shows paper always attracts a discount, barring legal tender laws"
In his history of Free Banking Larry White shows how people voluntarily began to use bank notes in place of gold in Scotland in the 18th and 19th centuries. There were no laws requiring this, indeed the Scotch system was remarkably free of regulation.
Furthermore, notes circulated at their gold value as they were redeemable in gold on demand, although banks retained an option to delay redemption by up to six months. The same phenomenon of paper replacing gold occurred in Canada.
So empirically it's untrue to claim that paper always circulates at a discount. It also makes no theoretical sense. In a free banking world, if you held a note redeemable for an ounce of gold that was only being accepted by merchants at a discount of 0.9 ounces, you'd immediately bring it to the bank for redemption to get the full ounce. At some point enough notes would be withdrawn from circulation that supply would return to demand and the one ounce note would be worth one ounce again.
Either that or the bank would run out of reserves and have to delay redemption. Good banks would of course ensure that they never overissued in the first place, preventing any discount in their notes from appearing. Under competition, it would be the good banks that dominated the system. My point is that notes trading at a discount would be the exception and not the rule, opposite of what you seem to think.
About Larry White's book, it is not available on pdf but well worth purchasing or a trip to the library. Larry Sechrest's Free Banking is available as a pdf here on Mises.org, but I'd suggest White's book as a better starting point, since it was the first to reintroduce the topic of free banking.
Published: August 15, 2008 11:05 AM
jp
"aggregation and centralization are the natural outcomes of frb, as this tactic lessens the chance of ruinous bank runs. so frb's nature is to encourage cartelization of the banking sector. now what is the logical final move after banks have cartelized? to form the ultimate cartel through the creation of a central bank, thereby enabling all of the banking cartel to inflate simultaneously without risking runs"
Now here your contradicting Rothbard. One of the great insights of Rothbard was his observation that only governments could create monopoly. In a free system, such cooperative attempts at controlling markets were doomed to failure. In his own words... "The cartel form is bound to be highly evanescent and unstable" and there's plenty more of that in Man Economy and State.
Why does Rothbard say this? The most efficient producers always have an incentive to avoid quotas and set out on their own. If the cartel does somehow manage to survive internal discord, their monopoly profits will attract outsiders to form their own competing firms. If it survives all this it's because the cartel is providing a real service to consumers who have no incentives to look elsewhere.
Newson, you have to run through a bunch of hoops before I'll buy your theory that there is one evil business out there that is able to get around the Rothbardian limits to cartel and that business is named FRB.
The problem with the Austrian critique of FRB is it leads them to trample over key Austrian insights. Gone is the freedom to contract, and now Newson wants to contradict Rothbard's key insights on monopoly. Our job as critics is to point out how the Austrian frothing-at-the-mouth denunciation of "sinful" FRB doesn't make any sense, that it makes Austrians look confused and contradictory, and it betrays many important Austrian insights.
Published: August 15, 2008 11:33 AM
newson
to jp:
nowhere did i contradict rothbard, nowhere did i mention cartels were stable or viable, but as you'll also find from rothbard, there will always be attempts at cartelization. the incentives to cartelize are greater in frb than in other industries, because the model is inherently unstable. so you can understand the strong desire on the bankers part to get the state involved and form a genuinely viable cartel.
by the way, if you want to start quoting rothbard to me, he was for the 100% reserved bank. perhaps you're thinking of mises, who was more favourably disposed to freebanking. "man, economy and state" page 810 (p909/1541 pdf version) and page 1013 (p1112/1541 are the ones to consult.
or he makes his case for 100% reserve banking in this article http://mises.org/daily/1829.
have you come up with a business cycle theory yet? absent monetary elements (thank you frb), you're just left with the keynesian "animal spirits".
Published: August 15, 2008 11:41 PM
jp
Good, so you don't claim that in a free system, aggregation to the point of cartelization is the inevitable ending point for FRB?
Published: August 16, 2008 1:19 AM
newson
no, i don't. cartelization is the dream of most businessmen, destined to fail.
a fractional reserve bank's survival hangs solely on the public's confidence in the ability to retrieve their demand deposits at a moment's notice (an impossible task to satisfy all comers).
given this uniquely fragile business model (show me one other industry with a greater intrinsic fragililty), it's not surprising how aggressively bankers have lobbied to get the state to give a helping hand (frustrating or suspending payments in specie etc).
rothbard shows how rigged the game was even before the fed (see"the case against the fed" for a good pre-fed synopsis).
sure, the fed has made things much worse, but frb prepared the way.
as for paper not trading at a discount, absent legal tender laws, show me one paper currency that has the same purchasing power now as in 1908.
history is one long story of paper money failures, starting with the chinese in the 9th century.
Published: August 16, 2008 4:49 AM
jp
"as for paper not trading at a discount, absent legal tender laws, show me one paper currency that has the same purchasing power now as in 1908."
I wouldn't even try to defend paper currency after 1908 for the same reason I wouldn't try to defend government run health care, education, or defence. Government monopolies are reprehensible and all currencies since 1908 have been run by these institutions.
I'm more interested in defending FRB in a free market context. There were systems prior to 1908 that, on a scale of free to controlled, were far more free than anything we have today. The Scottish system in the 18th and 19th centuries had no central bank, no barriers to entry, no mandated reserve requirements, and no legal tender laws, yet private FRB notes emerged and circulated spontaneously, trading at par no less. Due to their convenience, cost, and the trustworthiness of Scottish banks, notes entirely replaced gold as the circulating medium.
An FRB note trading below par is a market signal that the issuing bank may be experiencing problems. Some noteholders will redeem their notes for their full gold amount. If many noteholders are inspired by the market signal to redeem, the bank will run out of reserves. This would destroy the bank's credibility and its competitive position. Any bank seeking to preserve itself will ensure that its notes trade at par. The bank can only do this by issuing notes judiciously and ensuring its assets are of pristine quality.
Thus, contrary to your position, FRB notes trading below par are the exception and not the rule. Furthermore, a note trading below par is not a bad thing. This is the market's way of disciplining a poorly performing bank.
Published: August 16, 2008 12:49 PM
newson
to jp:
i'm no expert on scottish free banking, but do recall reading this article of rothbard, which was a counterpoint:
http://mises.org/journals/rae/pdf/RAE2_1_15.pdf
i'll read sechrest's book shortly.
Published: August 16, 2008 7:35 PM
newson
to jp:
actually, i don't think i'm going to be reading larry white. not only does his work get panned by rothbard, it gets the thumbs down by sechrest, who shows how scottish "free banking" was a misnomer. here's his critique:
http://mises.org/journals/rae/pdf/RAE2_1_16.pdf
Published: August 17, 2008 6:19 AM
Ireland
Hello Joe Stoutenburg,
very interesting debate, thank you. As you spelled it out under #1, the tipping point is whether FRB should/could be called fradulent. This may be tough question, so let's approach it from the other side:
How about finding something that we all could agree on labeling "fraud". First example that comes to mind are Ponzi schemes. It is possible to setup such pyramid operation in peaceful market conditions and see people join it on their own will, knowing what they are doing.
Yet it's clear to some that it has to fail, as the future liabilities mount and each next iteration needs more new money enter the system to cover them. When the moment of crash comes, the net result is that early players are better off at the expense of latecomers. From the liberty viewpoint it would be a tough task to ban such operation, I for one would speak for allowing it.
Yet it is useful and needed to be able to discern it from other operations, that also take your money and promise to return more, making that happen by real economic growth via capital investment, inventions and increased effectivity of production.
It's common to use word "fraud" when distinguishing between the two, and that's the other side of the liberty equation: we should be allowed to mark fradulent schemes with appropriate label.
If we can agree that Ponzi schemes are fraud, then we can get back and nitpick on various techniques of banking, bookkeeping and share-selling, uncovering if they do share something with these schemes or with real economic growth.
Published: August 18, 2008 1:54 AM
efletch1220
Can I reel us back in?
"Fortunately, the market allows short selling, where someone who has zero shares of a stock can, in effect, sell shares and hold a negative position. Suppose stock XYZ is trading at $50, but Jim the Speculator believes tomorrow's news will contain something very unfavorable for the stock — and the rest of the market isn't seeing things the way Jim is. Jim can borrow, say, 100 shares of XYZ from a stockholder, sell them today for $5,000, and then wait for the news to hit. When it does, and the stock sinks to $40, Jim buys back the 100 shares for $4,000, and returns them to the stockholder. The stockholder is no worse off (he hadn't planned on selling the shares), and Jim has netted $1,000 from his superior foresight."
So the lending shareholder freely allows the short-seller to borrow his shares? What's up with that? It is an investment the lender has made. Does he charge interest? Let's please get this out in the open. Every definition of short-selling includes the word "borrow." Borrowing always has some cost -- except in this circle of traders.
Published: September 20, 2008 7:25 AM
Joe Stoutenburg
Leaving aside our tangent on banking, those of us seeing this reposted at LRC need to give props to Prof Murphy for his prescience. We can not be certain whether the naked short prohibition was part of some grand master plan. But plan or no plan, it turned out to be a small step on the way to more outrageous interventions.
Published: September 25, 2008 10:16 AM
Eric
The problem with FRB's is NOT fraud, provided everyone knows that what they are promising is not true. If a depositer knows he might not get his money back, but is offered an interest payment for taking a risk, then I don't think there is fraud, per se.
Nobody would deposit money at a zero or a negative interest rate (equivalent to paying a warehouse fee) if they thought there was still a risk of losing their money. This would happen only if the alternatives were riskier still, for example, hiding a $1 million in cash under the bed.
But the most important issue with FRB's is that of legal tender. This is what makes FRB's truly evil. If we didn't have to be forced to use the same medium of exchange as the FRB's then we could avoid the risks associated with holding onto the currency of an FRB (from inflation).
Equivalent in damage to legal tender laws is government bailouts. Both of these use force to make people participate in risky investing and that is the key issue. As always, follow the force.
Published: September 25, 2008 1:01 PM
jeff krup
A very detailed, very thorough explanation of the mechanics of illegal/manipulative naked shorting is described here:
http://counterfeitingstock.com/CS2.0/CounterfeitingStock.html
This is an incredibly confusing and difficult concept to grasp, but it is worth the time.
Short selling is fine.
Some naked short selling is arguably fine (for liquidity)
Illegal/manipulative naked shorting is absolutely insidious.
Published: September 26, 2008 2:51 AM
canbyte
I can't believe this R Murphy is able to post such rubbish on the Mises Inst blog. Naked shorting creates phantom, counterfeit shares as noted by many writers. Do these shares vote? What did the buyer get? Obviously not what he expected any more than with counterfeit money or forged art. Undermines the whole system and any writer stupid enough to support such mayhem should not be respected by anybody. One wonders though what kind of inducement encouraged Murphy to do so. Commissions maybe, grants maybe. Professor of what? Who knows. Waste of time.
Published: November 17, 2008 11:12 PM
Julien Couvreur
canbyte,
I tend to agree with you. There should only be one owner and one vote per share at any given point.
At the same time, it is fine to sell something that you don't have yet, as long as it is identified as such to the buyer.
In that sense, I think Bastiat's question above is pertinent: each market comes with a set of rules, and if I can choose which market to participate in, I can pick one that offers stricter rules if I want. What prevents this today? Does the state have monopoly power over new markets?
Finally, I am intrigued as there seems to be a very interesting market design and technical problem here. As a software engineer, I can't help but imagine there should be a way to automatically find willing lenders, reserve the shares, make digital claims and contracts, etc. using a secure protocol. It all seems solvable.
Published: October 23, 2009 11:50 PM