Good and Bad Credit
The best policy is for the Fed to do nothing and permit interest rates to reflect reality. By doing nothing, the Fed will enable wealth generators to accumulate real savings. The policy of doing nothing will force various activities that add nothing to the pool of real savings to disappear By impoverishing wealth generators, the current policies of the government and the Fed run the risk of converting a short recession into a prolonged and severe slump. FULL ARTICLE
Comments (56)
Manuel Castro
We have witnessed the housing bubble burst and one can argue that the stock market bubble is on its way to correction. Could you give an example of what other bubles activieties may go belly up if the artificial manipulation of rates and pumping of money continues?
Thank you.
Published: October 16, 2008 8:23 AM
BrentR
As one generally uneducated in economics, someone please humor me with a little 101. This article does a great job of explaining real savings and how a bank should theoretically work in a non-fractional reserve system. But the section on how fractional reserve lending was "stealing" was a little under-developed. Can someone expound on this a bit more for me? Thanks.
Published: October 16, 2008 8:43 AM
jdavidb
The best policy is for the Fed to do nothing
Yes! The word for this is salutary neglect. Salutary neglect is what originally made America great, and it is the only policy for steering us out of the mess we're in.
Ask your congressman to support a policy of salutary neglect.
Published: October 16, 2008 8:52 AM
Miklos Hollender
BrentR,
The way I see it: you deposit $1000 in a bank on a current account/ Get a debit card. The money is yours and you expect to be able to spend it any time. But because you won't instantly spend all of it and the bank knows it, they'll loan a part of it to someone else. Say, $500. So you have $1000 on your spendable debit card and someone has $500 spendable on a credit card. And a year later you wonder how did everything get 50% more expensive when you still don't have much more than that $1000, plus, you earned $100. But because of the inflation, the purchasing power of that money is still less. But at least the bank made a nice profit. This is why it borders on crime.
When you have a savings account: a contract that you that you leave that money for a year, then it's OK for the bank to re-lend it. In such a case the bank is just a middle man between a creditor and debtor, a perfectly OK thing. But on a current account, you have not lent the money to the bank, just put there for safekeeping. That's a huge difference.
Published: October 16, 2008 8:54 AM
fundamentalist
Don’t know if the Ricardo effect still holds much credibility with Austrian economists. I have recently been reading about it in Hayek and it seems that it might be ready to kick in, though in reverse. The Ricardo effect says that when prices rise, real wages fall and producers higher more laborers at the expense of equipment, causing falling employment in the producers goods industries. In reverse, lower prices make real wages high and profits low, so producers start buying labor saving equipment. Prices are slowing their growth and some have actually fallen. This should make real wages higher relative to the costs of production. I got these from the Economist’s Free Exchange blog:
And headline consumer price inflation in America was flat in September, while core prices rose a tiny 0.1%. Year-over-year inflation fell to 4.9%. The dramatic easing of price pressures can be attributed in part to falling commodities prices, as well as the related slackening of economic activity.
The most spectacular reflection of falling activity has been the Baltic Dry Index (BDI), which traces prices for shipping bulk cargoes such as iron ore from producers such as Brazil and Australia to markets in America, Europe and China. The index has plunged by 85% after hitting a record high of 11,793 points in late May. It is a leading indicator of international trade and, by extension, of economic activity. In the past couple of years the index has been driven up by the boom in China, as that economy sucks in raw materials in bulk-carrying ships and pumps out finished products, which are exported in vessels.
The weakness is because of the slowing of world demand and the arrival of new capacity following the recent boom in shipbuilding. There are also signs of slowing demand for the container ships that take China’s manufactured goods to Western markets. The latest forecasts show growth in container demand falling from 15% a year to barely 5%.
Steel prices have also been falling fast from record highs. In America the price of coil steel, used to make cars and white goods, has fallen by 20% since May. The price of steel billets, which are traded on the London Metal Exchange, has tumbled by 70% since May. Steelmakers, including ArcelorMittal, the industry leader, and Russian and Chinese firms, are moving to cut production.
Published: October 16, 2008 8:59 AM
Jim Mulcahy
"(Milton Friedman and Anna Schwartz wrote that the key factor behind the Great Depression was the failure by the Fed to pump large doses of money.)"
To be accurate they charged the Fed with causing the money supply to shrink by 1/3 between 1929-1932.
Published: October 16, 2008 9:07 AM
Chad Rushing
On a side note, I must say that whoever picks out the accompanying pictures for these articles deserves some sort of special recognition for their great, ongoing work.
The image of a man in a business suit representing a short-sighted CEO, over-confident central banker, or foolishly ignorant politician sent to the corner with a dunce cap after having wrecked the U.S. economy sums up our current situation perfectly and is tragically hilarious at the same time.
Published: October 16, 2008 9:13 AM
BrentR
Miklos,
Thanks. I thought he was referring to inflation, but he didn't go out and say it, so I wanted to be sure.
Published: October 16, 2008 9:14 AM
J D
That Central Banking (Fractional Reserve Banking) exists is the problem.
Read George Bancroft's explanation at:
http://www.constitution.org/gb/gb-plea.htm
(Mr. Bancroft wrote in opposition to paper being declared LEGAL TENDER but PAPER is what central banking IS.)
His Introduction:
A PLEA FOR THE CONSTITUTION OF THE UNITED STATES
Wounded in the House of Its Guardians
by George Bancroft
1884
--------------------------------------------------------------------------------
Introduction
Good money must have an intrinsic value. The United States of America cannot make its shadow legal tender for debts payable in money without ultimately bringing upon their foreign commerce and their home industry a catastrophe, which will be the more overwhelming the longer the day of wrath puts off its coming. Our federal constitution was designed to end forever the emission of bills of credit as legal tender in payment of debts, alike by the individual states and the United States; and it will have that effect, if it is rightly interpreted and firmly enforced.
The supreme court of the United States was endowed by our fathers with a peculiar tenure of office and high powers of jurisdiction, that it might be able to keep watch over the life and integrity of the constitution. On the third of March, 1884, without having listened to any public argument on the case which was made the occasion of its utterance, it pronounced before a crowd of listeners an opinion in these words: "The power to make the notes of the government a legal tender in payment of private debts being one of the powers belonging to sovereignty in other civilized nations, and not expressly withheld from congress by the constitution; we are irresistibly impelled to the conclusion that the impressing upon the treasury notes of the United States the quality of being a legal tender in payment of private debts is an appropriate means, conducive and plainly adapted to the execution of the undoubted powers of congress."
The opinion thus confidently expressed, if it should be accepted as law, would be a death blow to the constitution; in defiance of which it not only gives a sanction to irredeemable paper money, but clothes the government with powers that have no defined limit in its relations to the people. Of the nine who composed the court, Stephen J. Field alone gave a dissenting opinion; but there stood at his side, invincible vouchers for the rightness of his dissent, James Wilson, Oliver Ellsworth, and William Paterson, all three of whom the president of the convention which formed our constitution selected from among its framers to be its earliest judicial interpreters. And with them are to be counted a cloud of witnesses, among whom are the master-builders of the constitution. Roger Sherman, George Washington, Charles Cotesworth Pinckney, James Madison, and Alexander Hamilton.
The language of the court is of such import to all American industry and intercourse from the most humble to the highest, and is moreover so subversive of a republic composed of states in union, and threatens such injury to the honor and hope of republicanism throughout the world, that I have thought it right to bestow upon it many of the few hours that may remain to me for labor. The decision of the question depends upon facts which are beyond the reach of change, and which for their establishment require only the strict application of the rules of evidence to historical investigations.
When questions of science arise, I shall cite only men that command the confidence of the civilized world; and I shall call the immortal framers of our constitution themselves as my witnesses to prove that it was their deliberate, unalterable purpose to withhold from the federal government the power to emit the promise of money as a legal tender for debt in money; and that they did beyond dispute withhold the power by very large and most determined majorities.
To set the subject in the clearest light, it will be proper to trace the history of American bills of credit until they were abolished by Massachusetts and Connecticut; to revive the memory of the great struggle for their suppression by the separate colonies or states to the end of 1786; and to ascertain what decision on paper money was made by the constitutional convention, and accepted, one by one, by every state. It will then be the time to examine the new interpretation of the constitution by the present court; and ask after the defenses of the people against the revolution with which they are threatened.
Published: October 16, 2008 9:26 AM
Miklos Hollender
BTW it's a very good article, but it exhibits that problem that makes me more and more disappointed in economics in general: economics takes a look at only a limited subset of human action (voluntary exchange) - and if we would look at the totality of human action, things would look different.
When banks don't accept each other's Letter of Credit, business and life grinds to a halt. Foods doesn't get to the stores, fuel to the gas startions, nothing, because they are all financed with short-term credits.
Now, from a theoretical point of view it's only the painful rearrangement of the market, but as I said there is more to human action than economics.
What would happen is entirely outside economics: if shops are empty for a weak, people get really angry. Riots, chaos, perhaps some burning down of Wall Street, widespread violence and at the end of the day you get some totalitarian dictator because after all that violence people want a "firm hand".
I'd rather choose a long recession...
Published: October 16, 2008 9:26 AM
Stuart MacLean
"Following the teachings of Friedman and Keynes".....
Milton Friedman 'taught' that the Federal Reserve should be aboloished. (I just heard him say it, again, in a 1994 interview with Brian Lamb in discussing F.A. Hayek's book "The Road to Serfdom"). Frank, don't 'teach' that Friedman and Keynes were of the same mind regarding the Federal Reserve banking system.
He 'taught' that if you're going to insist on having a central bank understand what affect your policies are having.
There is a difference.
Best regards,
Published: October 16, 2008 9:33 AM
Delgado
Thank you, Sir, for all these explanations, once more...
Good credit(fully backed-up) and bad credit (backed-up by fractional reserves), bad monetary policies ordonned by the Fed and Treasury, these are the real problems we face now. Doing nothing, and permitting the interest rate to reflect reality, that's the best policy. Bubble activities (feed with malinvestment) must disappear for the recovery of wealth-generating activities. It's the only way to support a sooner economic recovery.
Published: October 16, 2008 9:43 AM
george
It's ridiculous to expect the Fed to do nothing. The Fed is a creation of congress and will go where congress want's it to (or else congress will change the rules governing the Fed).
The Fed provides cover for congress. If congress created money directly then they would get the blame, with the Fed ("we control inflation and print money") no one has to worry because the Fed will keep inflation under control.
Published: October 16, 2008 9:44 AM
Maturin
Thanks, Frank, for another lucid explanation.
Here is my way of thinking about bad and good credit, that us non-economists might grasp:
Are you overextended and maxed out on your credit card? Interest rates now up to 20%+ and eating you up. Easiest solution: take out more credit cards at "introductory interest rate" to pay them off! Then you have credit again and can go on spending! Don't worry about paying these off. There are plenty more credit card issuing banks eager for your business, so you can do it over and over again.
That is what Bernanke is doing with the govt's credit card, the Fed.
But when do we end up actually paying off the accumulated debt of our fifty different credit card stuffed in our wallet? And who ends up paying for it?
Our future "savings" retirement plans, etc. and our children pay for it in the massive inflation that will erode all our "wealth," even if we do manage to stay afloat constantly refinancing on new credit cards, rather than going bankrupt.
Why save and plan for the future when whatever we save today will be worthless then, compared to now? This is Bernanke's plan: keep adding credit cards to our wallet.
Published: October 16, 2008 10:14 AM
Michael Ray
The one thing the federal government can do to help is to reduce taxes and regulations. Of course, until the mass of the people demand just that, it won't happen.
Published: October 16, 2008 10:32 AM
Jasmine
The fed's decision to purchase commercial paper has a very interesting aspect which has not been widely picked up by the media. Yesterday CNBC announced that PIMCO has been "chosen" as the company that will act as the agency to do this on behalf of the govt. There has been no discussion I have heard why this particular company was chosen and not any other! Obviously there are connection in high places, and a lot of wheeling and dealing here! I have listened to Bill Grossman of PIMCO on several occasions on CNBC -he always spouts more govt. regulation and socialism. I have found what he speaks particulary repulsive and horrendous. He and his company are the ones to benefit big from this further socialization of capital markets -there is always a beneficiary to govt. intervention and PIMCO has made windfall profits from taking this country on the road to disaster. His company made 8 billion dollars in one day on a Monday about three week ago, if I recollect correctly. He has the thug type of self-interest!! Considering the fact that the position he is in, it is hard to think that he is ignorant of where the country's inflationary environment will take it, but he just does not care. Since we all have to live in this environment of continuing ever greater statism and socialism, we do not need to act as sacrificial lambs. Do a lot of research on PIMCO's actions, follow what PIMCO does closely, armed with that knowledge and one can make a lot of money, I am confident.
Published: October 16, 2008 11:20 AM
Nolie Mills
The governments around the world are playing a giant game of musical chairs. The governments' current price of keeping the music playing (so everyone doesn't start fighting for a seat) is to take away additional chairs from the participants while they stroll around the ring of chairs. The governments don't want the economic downward production spiral that will happen by loosing the lower level marginal value producers' production. They are trying to finesse the world economy in order to spread the pain hoping to keep more people stuck within their power based control. They gave up on free markets long ago.
Published: October 16, 2008 11:28 AM
Nolie Mills
The governments around the world are playing a giant game of musical chairs. The governments' current price of keeping the music playing (so everyone doesn't start fighting for a seat) is to take away additional chairs from the participants while they stroll around the ring of chairs. The governments don't want the economic downward production spiral that will happen by loosing the lower level marginal value producers' production. They are trying to finesse the world economy in order to spread the pain hoping to keep more people stuck within their power based control. They gave up on free markets long ago.
Published: October 16, 2008 11:29 AM
john
It's simpler than that. It's the government spending that is out of kilter. What difference does it make what we use as the medium of exchange if the government just keeps spending. It's like a hole in the dam and all the water is being leaked out. A dry spell is coming.
Published: October 16, 2008 12:08 PM
Joey M
GREAT ARTICLE. Short and to the point.
So here is my question:
Was the contraction in the money supply caused by direct (planned) Fed policy or was it a snowballing effect of the fed's easy money 1920-1928 and their slowing of their easy money policies in '29 that caused the crash, resulting in people/institutions WITHDRAWING money from the supply regardless of the the Feds intervention).
We are currently experiencing a withdrawal of lending from the market, even though the fed is flooding the market with currency. Could this be the same. It's not that the money is not out there, is it that people/banks don't want to lend it and therefore contracting the money supply?
According to Big Ben, the money supply should have been expanded during the Depression, and the Fed allowed it to contract from '29-'32. -- according to Rothbard, this was following massive expansion from 1920-1928.
Is history repeating itself? Is Ben's observation correct, but conclusions wrong? (observation = easy money / tight money caused the depression, and conclusion = more easy money would have ended or shortened the depression).
Anyone's thoughts on this would be appreciated.
Published: October 16, 2008 12:10 PM
EconAndre
Thank you for the timely article. I notice that Dr. Shostak has dozens of articles on mises.org. Can anyone recommend an authoritative and comprehensive article by Dr. Shostak on this subject of real savings, good and bad credit, and the subsistence fund? Thanks.
Published: October 16, 2008 12:49 PM
Bernard
"Anyone's thoughts on this would be appreciated."
An excerpt from Antal Feketes beautiful explanation of the Real Bills Doctrine.
http://www.professorfekete.com/articles%5CAEFDetractorsOfAdamSmithsRealBillsDoctrine.pdf
"The volume of trade depends, not on the stock of monetary gold, but on the clearing system which can be improved to meet the challenge. Instead of improving it, governments conspired to sabotage the clearing system by blocking international trade in real bills that had worked so efficiently before the war. The proper prescription should have been the restoration of the clearing mechanism through real bills. Please remember that you have seen it here first: the main cause of the Great Depression of the 1930's was government sabotage of the Real Bills Doctrine of Adam Smith. The world’s monetary and payments system is still limping from crisis to crisis, and will continue doing so until the RBD is fully rehabilitated."
Published: October 16, 2008 1:48 PM
JOSEPH kECKEISSEN
If, as Mises held, the true rate of interest is the very same thing as the amount of savings, the other side of the coin, how does the do/nothing policy create more savings. Do/nothing would cause the artificially low rate of interest to rise to the level that reflects the actual paucity of savings. but that would not provoke more savings. If, besides the do/nothing of not investing in the banks, the normal continual creation of fiat money were stopped, then diluted savings would be reduced and the fund of disposable savings would be augmented and the true rate of interest lowered.
Is this logic correct. Thanks for illuminating me.
Sincerely, Keckjoe
Published: October 16, 2008 1:51 PM
Jacob Steelman
This is one of the most important issues in the world financial situation as the real pool of savings is being destroyed by taxation and central bank inflation. If we are to get out this recession/depression the real pool of wealth must be allowed to increase - government needs to end its intervention, taxation and inflation by its central bank.
Published: October 16, 2008 3:18 PM
Inquisitor
Stuart, Friedman changed his mind on money IIRC. He was not always for monetary freedom.
Published: October 16, 2008 3:59 PM
fundamentalist
Joey M: “Was the contraction in the money supply caused by direct (planned) Fed policy or was it a snowballing effect of the fed's easy money 1920-1928 and their slowing of their easy money policies in '29 that caused the crash, resulting in people/institutions WITHDRAWING money from the supply regardless of the the Feds intervention.”
It actually happened in several phases. Credit expansion causes malinvestment, that is, greater investment in capital goods industries than savings justify, but it also causes an increase in demand for consumer goods. The malinvestment becomes evident when consumers win the tug-of-war because labor and circulating capital flee to immediate production of consumer goods. Costs rise for captial goods businesses until many go broke. When they go broke, they default on loans. Those defaults set in motion the collapse of the money supply because 1) fewer businesses are borrowing and 2) banks are trying to build cash against more defaults so they’re loaning less. In the Great D, the collapsing money supply caused banks to fail, which caused runs on more banks and more banks to fail in a downard spiral. People lost confidence in banks and paper money. They only wanted to hold gold, which caused an even greater decline in the money supply. Falling money supplies translate into lower prices and profits which makes repaying debt harder and causes more defaults. All of that would have happened even if the Fed had tried to pump money into the system because Fed pumping requires the cooperation of businesses and people.
Published: October 16, 2008 4:11 PM
Dick Fox
This is a good article but Mr. Shostak’s criticism of fractional-reserve banking depreciates the value of his article.
He states:
Trouble emerges however if, instead of lending fully backed-up money, a bank engages in fractional-reserve banking, the issuing of empty money, backed up by nothing.
Using the same logic even a non-fractional-reserve bank is trouble. Consider that the baker in his example deposits his $8 in a non-fractional-reserve bank, but then because of illness does not produce the 8 loaves of bread. Is he now guilty of a crime, or is the bank guilty for issuing unbacked currency?
Fractional-reserve banking is simply another manner of banking. If there is full disclosure between the bank and customers there is nothing wrong. The money supply will grow to a certain point of equilibrium and then stop just as it would with a bank dealing with only fully backed currency. Mr. Shostak admits this when he states:
It has to be realized that banks cannot relentlessly pursue unbacked lending without the existence of the central bank…
While the paper could have been better if it had remained true to its theme, it is important to understand that it is the Central Bank that makes the error in money creation. The concept in this paper is importand, so it is a good paper even with the slight slip in logic.
Published: October 16, 2008 4:31 PM
Eric
Dick: "Consider that the baker in his example deposits his $8 in a non-fractional-reserve bank, but then because of illness does not produce the 8 loaves of bread. Is he now guilty of a crime, or is the bank guilty for issuing unbacked currency?"
As Rothbard said, money is unique in that it has value based on the past. All other goods have a value that is based on the present moment (and possibly the future). Although infeasible today, the only way to know if the $8 in money represents real wealth or not is to trace it's history through every exchange back to when it was first created.
So, if the $8 represents real wealth backed by 8 loaves of bread, then these 8 loaves must be stored away safely somewhere for all the future time that the $8 is in existence. If the bread is destroyed, eaten, lost, etc. then the $8 receipt should also be destroyed. This is how it would be if we had 100 percent honest money.
You pose a situation where the 8 loaves have not yet been delivered, but $8 has been given to the baker in exchange for 8 loaves of bread. If this is by way of a credit transaction, then what's at stake is simply that the baker is in debt for 8 loaves of bread to whoever bought them with $8. But this is a totally separate transaction that has all its own particulars.
But if we ignore the credit component, then the baker would have to have delivered the 8 loaves before (or concurrent with) the exchange of bread for dollars. But this is not how you stated your example.
If the baker did agree to deliver the 8 loaves at some future date, and then did not, because of illness, then the baker is now in default. That it was not his "fault" is irrelevant here. One would have to look to the delivery contract to see what happens next.
Published: October 16, 2008 5:43 PM
Eric
Mike (said):
"Fractional-reserve banking is simply another manner of banking. If there is full disclosure between the bank and customers there is nothing wrong. The money supply will grow to a certain point of equilibrium and then stop just as it would with a bank dealing with only fully backed currency."
I would agree but for the legal force involved. Fractional reserve banks are not the problem, provided they cannot force me to use their money. After all, if everyone simply ignored these bankers, as was done in the early days of the practice (and there were alternative monies), they would have little effect.
It is the legal tender laws which force the rest of us to accept in trade these fractional reserve monies. And this is what makes it wrong. In addition, by not explaining openly how fractional reserve banking works, there's also a hint of fraud going on. It begins with the government school's (and forced attendance) not explaining the true nature of our banking system.
But even with full disclosure, if you are not permitted to opt out of the fraction reserve money system (fed notes) then you are being forcefully robbed. As always, follow the force Luke.
Published: October 16, 2008 5:55 PM
Eric
oopps, that was Dick that I was quoting, sorry!
Published: October 16, 2008 5:57 PM
Ross
Maybe soon the U.S. will suffer inflation like Zimbabwee because of the pumping. That would then give the Fed an excuse to raise interest rates to damp inflation. As a result savings increase!
It would be good to stop the stimulating, the rescue of the economy and banks. Let the bad fall by the way. Stop paying for warmongering.
Lower taxes yes!
Smaller government yes!
Maybe the Mellon Fed did have the right idea in 1929. Pull the money off the table and stop the party.
That needs to happen now, so the correction we need to have, can occur with as little hangover as possible.
Published: October 16, 2008 7:41 PM
James Crosswell
Yet another great grass roots blog from Shostak!
One thing I'm not too certain of however is that the explanation of how new money steers real savings from profitable to unprofitable activities is given in the context of an inflationary monetary policy. What we're witnessing at present isn't so much an inflationary policy as an anti-deflationary policy. By that I mean that the bulk of the inflation (expansion of credit) occurred during the past 8 years. Presently, because of the fractional reserve banking system, lots of money is going up in smoke as it's realized that many of the loans that were made (and are held on banks books as assets) will not be paid back.
If the Fed were to do nothing then we could expect deflation (and Shostak has described the mechanics of this in his House of Cards article elsewhere on this website).
If the Fed pumps in enough money to replace the money that is evaporating though, what happens is slightly different. What happens is that they prop up a bunch of people (typically banks) that are technically bankrupt and keep them in business. They do NOT expand the money supply in any way though (they're just replacing money that was on it's way out) and so we should not expect an increase in prices.
The relative effects are much the same I guess since people with cash, who otherwise would have seen their spending power go up during inflation, in fact see their spending power stagnate and, indeed, if the pool of real savings continues to deplete then their real spending power will start to drop again as prices start to rise again.
Furthermore, people in unproductive activities (namely the bankers) are kept in unproductive activities rather than being shoved in the right direction by Adam Smith's invisible hand... so we have a bunch of people being paid by the state and the central bank to dig holes and fill them in again.
Finally, since the fundamental problem is one of a mispricing of real savings, we can conclude that the Fed's continuing to subsidise the price of real savings will have much the same effect as fuel subsidies in Indonesia - continued and chronic shortages, until such a time as prices are allowed to rise to more realistic levels (i.e. until interest rates are allowed to rise). As such, we can't really expect to see the back of this recession until interest rates go up (way up).
I'm starting to wonder if that was the mistake the Japanese made and the reason they never came out of their recession.
Published: October 16, 2008 8:15 PM
theeconomicfractalist
There is a new science of saturation macroeconomics that incorporates the qualitative elements of the Austrian school into an exact predictive science with simple quantum mathematical laws and defining limits to asset valuation growth and decay. The overproduction, oversupply, and overvaluation of assets fostered by excessive bad debt ultimately have their countervailing determining and reciprocal excessive effects on collective jobs and summation wage contraction in the real economy - collective wages necessary to continue servicing the bad debt. Understanding the Austrian truisms and the quantitative new science of saturation macroeconomics may be of benefit to the decision able monetary policy makers of the future generations.
Published: October 16, 2008 10:03 PM
Stephan Kinsella
"George" wrote: "It's ridiculous to expect the Fed to do nothing. The Fed is a creation of congress and will go where congress want's it to (or else congress will change the rules governing the Fed)."
Nobody expects them to do nothing. What they should do, and what they are "expected to do," are two different things.
Dick Fox: You first quote Shostak as writing: "Trouble emerges however if, instead of lending fully backed-up money, a bank engages in fractional-reserve banking, the issuing of empty money, backed up by nothing."
You reply to this: "Using the same logic even a non-fractional-reserve bank is trouble. Consider that the baker in his example deposits his $8 in a non-fractional-reserve bank, but then because of illness does not produce the 8 loaves of bread. Is he now guilty of a crime, or is the bank guilty for issuing unbacked currency?"
The baker gets the $8 by selling 8 loaves of bread that he already produced. Then he lends the $8 to the bank, which finds a borrower. The baker gets interest, minus the bank's commission.
So in this case: if the baker makes 8 loaves of bread and sells them for $8, and lends $8 to the bank, then falls ill and dies, the borrower still owes $8 back to the bank; and the bank pays principal plus interest back to the baker's estate.
The central mistake of all advocates of fractional-reserve banking is to conflate money--even mere fiat money--with wealth.
Try again.
Published: October 17, 2008 12:02 AM
Mary Diane Dolan
The Shostak article is superb! I wish that he would do a follow-up and better explain "savings" in this context. People are rushing to TRY to save in this depressionary environment, but I am not sure that they are all actually saving. Many citizens and foreigners are converting their wealth of deteriorating US stocks INTO DOLLARS. Many are converting their dollars INTO US TREASURY DEBT, even at zero interest. Do such attempts to save merely further feed and encourage the useless, uneconomic and clown-like antics of the Fed and the politicians? Do these attempts make it possible for the Fed to create even more "bad credit"? --Or do these attempts to save actually increase the pool of saving? It seems they might be increasing the pool of saving, since the dollar is said to be "strong" as a result of such civilian and foreign attempts to save. I really wish I knew how Frank Shostak would reply.
Published: October 17, 2008 1:52 AM
newson
to m. hollender:
i think you've painted a realistic picture of how ugly non-intervention could have become, but i don't think you've made a convincing case for intervention. civil unrest may not have lead necessarily to totalitarian rule. that's an entirely unknowable political question. not addressing the systemic causes only makes the shift to martial law more certain in the future, when the rescue-plans'real costs have to be borne.
Published: October 17, 2008 2:14 AM
eric lansing
"Understanding the Austrian truisms and the quantitative new science of saturation macroeconomics may be of benefit to the decision able monetary policy makers of the future generations."
but can you make money off it by making predictions? If not, not useful.
Published: October 17, 2008 8:07 AM
fundamentalist
Miklos Hollender: “…economics takes a look at only a limited subset of human action (voluntary exchange) - and if we would look at the totality of human action, things would look different.”
Mr. Shostak didn’t look at the consequences of crisis because his point was to uncover the cause and demonstrate the ineffectiveness of the state bail out plan. It would take a much longer article to cover what you want. But if you read longer Austrian works you’ll find that Austrians do look at the larger picture. In fact, the main complaint of Austrian economists against mainstream econ is that mainstream economists don’t look at the larger picture and extended effects because they’re stuck in equilibrium analysis. Austrians often quote Bastiat who wrote that good economists look at the long run as well as the short run effect, and the effect on all groups, not just the group immediately effected.
Miklos Hollender: “When banks don't accept each other's Letter of Credit, business and life grinds to a halt. Foods doesn't get to the stores, fuel to the gas startions, nothing, because they are all financed with short-term credits.”
That’s what Ben Bernanke, Henry Paulson, George Bush and most of the media want you to believe. And it would be true if absolutely no bank on earth would accept any letter of credit of any kind from any person at all. But that never has happened and never will happen. The current disruption in lending has been billed as the worst financial crisis since the Great D. But I read last week that Caterpillar recently refinanced millions of dollars of its bonds for 6%. Last year they paid 5%. That’s not a crisis. In fact, the American Bankers Association reports that most of its members are pissed off about the bail out because they have competed head to head with these national banks for years and now that they have any edge over them the government takes that edge away. One of those regional banks, the Bank of Oklahoma, is advertising no closing cost mortages.
Bernanke and Paulson screamed like teenage girls in a haunted house. Their shrieks frightened the media and politicians. But when the smoke clears, the truth will probably be that interest rates went up, but there was no crisis. If some banks won’t lend to each other, it’s probably because the Feds have been hiding the data on which banks are about to fail, which forces good banks to play the old shell game guessing where the failing banks are.
But back to the Austrian view of what would happen if the state did nothing. We have centuries of experience and some data on what would happen because “crises” such as this one have been happening for at least 400 years and until the Great D states stayed out of it. As a result, the crises were deep, but short-lived. None of what you predicted has come to pass. Most businesses survive. Only the weakest fail, mostly those that are deep in debt. The money supply never contracts to nothing and credit never completely disappears. A free market has built-in mechanisms to restart business activity. History proves it. The main engines are the Ricardo Effect and savings. Crises only become disastrous, as the Great D became, when the state steps in and tries to rescue us. Such intervention destroys savings and the natural workings of the Ricardo Effect.
Published: October 17, 2008 8:19 AM
Stanley Pinchak
Mary Diane Dolan,
my initial thoughts on increases in the amount of savings diverted into treasuries is that this is overall a bad situation for the economy. These savings are unavailable for market use and have been shifted to the political domain. The state will put the money to use, distorting the economy and creating demand in sectors which are less desired by the population as a whole. The money will be used in schemes to prop up the profligate bankers as well as to be spent on wholly unproductive goods like munitions. The more money is diverted in the direction of the government, the longer it will take for the economy to recover (at least the portion that the mass of the people are most interested in). I too would like to see a more in-depth analysis of this aspect of the economic downturn.
Published: October 17, 2008 9:07 AM
GeoPoliticsPoker
Re: "Economic Growth"
Before I give my comment on 'economic growth', let me just qualify that:
In terms of Geo Financial Policy: I do not support or endorse: fiat currency, fractional banking, helium bookkeeping, pump & dumping of 'stock', black hole derivatives, private central banking, positive compound interest (usury).
Geo-Economic Policy, however is not just about Financial Policy.
'ECONOMIC GROWTH' IS AN OXYMORON, IN AN ECOLOGICAL, PARTICULARLY ENERGY RESOURCE FINITE 'ECONOMIC ENVIRONMENT'.
INDUSTRIAL ECONOMY IS BASED on the quality of available ENERGY AND THE PARTICULAR NET ENERGY RATIO OF THE AVAILABLE ENERGY.
The world has passed PEAK OIL, and it doesn't matter if there are still 20 trillions of barrels of oil, somewhere under the Atlantic or Artic; if the energy ratio of producing each barrel of oil, requires more energy than shall be produced.
ALL OF THESE FINANCIAL PUNDITS GOING ON ABOUT THIS FINANCIAL CRISIS, EITHER REFUSE TO ACKNOWLEDGE, OR ARE TOO IGNORANT, OR IN DENIAL, OF THE REALITY OF ENERGY AS THE FOUNDATION OF ANY AND ALL INDUSTRIAL ECONOMIES.
Anyway, that's my opinion; I don't mind others disagreeing; I just find the addiction desperation for the illusion that this is only some minor little financial fiat currency central banking problem, rather than a fundamental ECONOMICS BASED ON ENERGY RESOURCES SYSTEMIC ANALYSIS one, rather sad.... Sorta like watching addicts refuse to acknowledge their addiction..
For those who don't know much about energy and it's relationship to the economy, and want a comprehensive economics 101 crash course, that would probably cost you 7 years of academic speak BS, and about $400,000 from Yale Business School; you can get the same fundamentals, in about 8 hours from Chris Martenson's Crash Course at:
http://www.chrismartenson.com/crash-course
It's really good!!
Published: October 17, 2008 10:02 AM
Michael A. Clem
Economically speaking, it doesn't matter if "peak oil" is real or not. All economic resources are finite, and, in a free market, are priced accordingly, based upon supply and demand. Politics obviously distorts pricing and supply and demand, and thus interfere with the value of pricing information and resource allocation.
Energy is obviously fundamental to all physiological factors and life itself, and certain types of energy are related to certain standards of living, but none of that matters economically. Economics is a social science, not a physical science. Finance, on the other hand, is not necessarily economics, although a good understanding of economics certainly helps. The financial crisis is really a political crisis of intervention into the economy, thus preventing the market from working as effectively as it could be. I fail to see any significant connection between this crisis and energy in general, or oil in particular.
Published: October 17, 2008 10:35 AM
Mike
Good article but to me it leaves a little to be desired. The assumption is that "liquidate, liquidate, liquidate" is the answer without fundamental reform of the money and banking system, i.e., without adoption of the gold standard, 100 pct. reserve requirements, and the abolition of the central bank and all banking regulation and deposit insurance schemes. "Liquidate" is probably preferable to prolonging the agony and accelerating the destruction of capital by further inflation, but this is not saying much. The process of liquidation would be extremely prolonged owing to an overwhelming of the capacity of the bankruptcy courts. Our present economy is so distorted, and the "economics profession" has so benighted the populace, that a fascist coup d'etat would not be a surprising development from such a catastrophic seizing up of business activity. I see no alternative to an immediate disengagement of the government from money and banking as per Prof. Reisman's proposal.
Published: October 17, 2008 11:07 AM
fundamentalist
Mike: "The assumption is that "liquidate, liquidate, liquidate" is the answer without fundamental reform of the money and banking system, i.e., without adoption of the gold standard, 100 pct. reserve requirements, and the abolition of the central bank and all banking regulation and deposit insurance schemes."
Of course you're right in theory. But it will not happen in our lifetimes. Fractional banking has been around for over 600 years, and like Hayek, I don't think it's going away. So we should learn to make money from it. Learn the cycle so well that you can make money on the booms and get out before the busts. That is one of Warren Buffet's secrets. How do people think he could pay cash for the shares in companies he just bought? He saw the crash coming and sold some of his stock market portfolio. Huge fortunes have been made in the past by men astute enough to have the cash to buy assets at blue light specials.
If all the richest people were Austrians, we would have a lot more influence. Instead, most of the rich, including Buffet, are socialists. Their financial expertise give them an understanding of the economy very similar to that of Austrians, but they promote socialism, possibly out of guilt.
Published: October 17, 2008 1:18 PM
Dick Fox
Eric and Stephan,
Sorry, but both of you go beyond the example to justify your criticism of fractional-reserve banking.
Eric's second post is excellent and actually makes my point from a different perspective where he points out that fractional-reserve banking only becomes a problem when the government passes legal tender laws.
Eric also points out in his first post, Rothbard (and other Austrians btw) says that "money is unique in that it has value based on the past. All other goods have a value that is based on the present moment (and possibly the future). Although infeasible today, the only way to know if the $8 in money represents real wealth or not is to trace it's history through every exchange back to when it was first created."
But as noted it is infeasible to trace the $8 dollars back and I would add actually unnecessary. If the dollars are valued in terms of a commodity, such as gold, then the value will remain stable with or without fractional-reserve banking.
The argument against fractional-reserve banking makes a false assumption that the money created is exogenius and stays exogenius to the money supply. Just as any increase in the money supply, on a commodity (gold) standard, the money supply will be automatically adjusted to a correct value accounting for the fractional-reserve amount.
It is important to consider fractional-reserve banking in the light of Hazlitt's Economics in One Lesson, considered over the full economic life and considering all economic sectors. Stephan only considers a small window.
Published: October 17, 2008 2:20 PM
Mary Diane Dolan
Stanley Pinchak,
Thank you for addressing my question, for it is truly driving me nuts. Yes, I see you are right to say "savings diverted" when you refer to the masses of money going into Treasury debt. These amounts do not BECOME savings at the time they purchase Treasury debt. Even if they are savings at all afterwards. Another quandary: What if all people worldwide become like hypnotists' subjects in that none will react appropriately if and when they see they sustain heavy losses in Treasuries? What if they only keep reciting what their lifelong, trusted, family financial advisors ceaselessly tell them: "US Treasury debt will preserve your capital. US Treasury debt is the safest investment in the world. Treasury debt...etc." There is someone who should downgrade Treasury debt if and when appropriate. I wonder who it is and what their standards are. --Seems to me the downgrading of Treasury debt should comprise the next "action-packed episode" in this clowns-on-review sequence. --But maybe that cannot happen so long as pushing savings into the Treasury's face continues, making the dollar "strong." "Strong dollar" and low Treasury rates do not go together--do they? In my mind this will not compute.
Published: October 17, 2008 10:26 PM
newson
to m.d. dolan:
i think the end of the quarter-century bull market in treasuries is at end. note how rout in shares since mid-september hasn't been accompanied by the usual reflex rally on 10-year t-bonds.
Published: October 18, 2008 12:03 AM
Mary Diane Dolan
Michael A. Clem,
Great answer that you gave to the guy concerned with energy! I'd like to add: Economics is about the distribution of scarce resources--as any professor of economics used to tell his class the first day. If there is some form of life, some mineral, SOMETHING, that no one, anywhere, cares ANYTHING at all about, it is not a resource, and the economist is not concerned with it. (It could become a resource later). Ecologists seem eager to find something that no human being cares anything at all about and to point to it saying, "See! Here is something that no human being cares anything about! And they ought to! Humans cannot judge things on the basis, merely, of their value to human beings! Things have value in and of themselves, just by existing in nature". --And so saying, the environmentalist thus demonstrates that the thing has value to HIMSELF. And causes it to become a resource. The new resource takes on the property of being either more scarce or less scarce. It aquires the property of "scarcity". Someone is going to suggest to the environmentalist that he become the owner of, and/or pay for, and/or work to own, and/or persuade somone else to pay for, the new resource and/or any environment--such as a certain piece of land--that the environmentalist may think necessary. This is often upsetting to the environmentalist. The environmentalist has been trying to demonstrate that there are things that are of no value to ANY human being, INCLUDING HIMSELF, but which are, nevertheless, of value.
Some resources (oil, for example) are of value to very large numbers of people. Judging just how scarce they are--and are/are not becoming--and how this will affect other things--is apt to be extremely tricky and controversial. Most environmentalists would be simply astonished to see how much thought and study economists have ALREADY given to scarcities they postulate and are concerned about.
Published: October 18, 2008 12:06 AM
Exponential-Yewgenics
Michael A. Clem (October 17, 2008 10:35 AM)
Your response:...
"Economically speaking, it doesn't matter if "peak oil" is real or not. All economic resources are finite.. "
Disagree, some are finite, and some are renewable....
As for your opinion that it doesn't matter if 'peak oil' is real or not; that may be your opinion; BUT IT IS NOT SHARED BY TPTB; nor by most of the analysts at various intelligence agencies on the planet;
Furthermore, according to various individuals in TPTB... one of the ENERGY RENEWABLE RESOURCES, are no less than the potential gaseous or otherwise of ARBEID MAAK FREI...., because to them it doesn't matter if most of the 'feebleminded' potential 'energy slaves' understand the exponential function, and particularly it's economic and political consequences or not; THEY DO, AND THEY ARE NEITHER FEEBLEMINDED, NOR PARTICULARLY CONCERNED ABOUT BEING EXCESSIVELY POLITICALLY CORRECT AND 'CIVIL' ABOUT THEIR INTENTIONS...
But as Voltaire said, it is indeed extremely difficult to free fools from the chains they revere..
Take care..
Published: October 18, 2008 4:05 PM
Haragan
The problem is that markets are not flawless and they intermediaries. The shoemaker and the baker are able to take advantage of real saving through the existence of banks. What good is it to the baker to save if he doesn't know where the shoemaker is. At this point, pumping money is trying to keep the banking system alive. True, if these banks are not able to be survive, they should be replaced by more competent ones, but until that happens, the baker is forgoing production if he cannot find the shoemaker. Raising interest rates won't help if there is no mechanism or clearing house to determine what the interest rate should be. The baker is not producing more not because his activity is a 'bubble' but because there is no credit market. Painful and unfair, but the Fed is only saving this banks to save everyone else.
Published: October 19, 2008 9:03 PM
fundamentalist
Haragan: “At this point, pumping money is trying to keep the banking system alive. True, if these banks are not able to be survive, they should be replaced by more competent ones, but until that happens, the baker is forgoing production if he cannot find the shoemaker.”
The problem with the bail out is that it assumes all banks are failing when they definitely are not. A few of the largest banks failed. But most banks were doing fine. In fact, the American Banker’s Association reports that regional banks are pissed off about the bail out because the Federal government is helping their competitors. We’ll never know how bad the “crisis” was because all reasonable discussion got drowned out by the hysteria. Bernanke and Paulsen were shrieking like teenage girls at a haunted house so that no one else could be heard. It has been repeated many times on this web site, but I’ll say it again. The bail out rewards failure and punishes success. Successful banks were punished by having the state assist their competitors and they will be punished further with unnecessary regulation that will assist the failed competition even more.
Paulsen and Bernanke pointed to the LIBOR and reluctance of banks to lend to each other as the main evidence of a crisis, but that “crisis” was caused by the Feds not disclosing which banks were in trouble. The sound banks didn’t know which banks were unsound because the Fed kept that info secret. The high LIBOR reflected the lack of transparency, not any crisis in the financial system.
Published: October 20, 2008 9:03 AM
Mark Humphrey
To Joey M:
The contraction of the USmoney supply from 1929 to 1933 of about 27% happened despite aggressive Federal Reserve attempts to counter the push of market forces. The Fed rapidly reduced interest rates throughout 1930, but the money supply fell for two primary reasons:
1) The easy money inflation of the twenties in the US raised our prices relative to prices in Europe, with whom nearly all of our foreign trade was conducted. Lower prices in Europe contributed to the outflow of gold from the United States. The gold outflow reduced the monetary base, in spite of Fed efforts to counter this tendency by monetizing treasury debt. As the base declined, banks were forced to sell assets, reduce lending. This reduced the deposit money component of our fiat money.
2) The Federal Reserve cartel sought to protect the profits of member banks by prohibiting certain forms of competition, namely the practice of branch banking. In Canada, where branch banking was permitted, the Depression years produced all of two bank failures. In the USA, where branch banking was outlawed, thousands of banks failed. Every bank that failed deprived depositors of the money they had deposited with the bank. So every bank failure reduced the supply of deposit money. As banks began to fold, frightened depositors lined up to cash out their checking and savings accounts; the retreat into cash forced further reductions in deposit money.
Of course, as the money supply contracted, prices fell, especially producer prices. This led to further loan defaults, which decimated bank capital, thereby forcing further bnak liquidations of assets--loans and securities.
Published: October 20, 2008 11:31 AM
Dennis
As a follow-up to Mark Humphrey's comment, I would recommend the following article by Professor Joseph Salerno that appeared in "The Freeman" a few years ago:
http://www.fee.org/publications/the-freeman/article.asp?aid=4942
Published: October 20, 2008 2:04 PM
Kaikane
I am genuinely interested in your thesis, and wholeheartedly agree that much of today's crisis arose from an unsustainable amount of bad credit. However, I would point out that during the Depression of 1929-39, didn't the Federal Government do precisely what you suggest they do now? By keeping interest rates high, didn't they prolonged the crisis? Or are you arguing that a 10+ year Depression is necessary to "cleanse" the global financial system of credit excess?
If we lower interest rates, we keep the bubble artificially inflated. If we raise them, we pop it violently now and bring the whole system to a grinding halt. I'm confused and I'm sure I'm not the only one.
Published: October 22, 2008 5:25 PM
Gerry Flaychy
Frank Shostak has written:
"Trouble emerges however if, instead of lending fully backed-up money, a bank engages in fractional-reserve banking, the issuing of empty money, backed up by nothing."
If I make a deposit on demand of 8 $, coming from the selling of bread, to a bank, and that bank take 4 $ of that 8 $, and make a loan of 4 $ to somebody else, this last 4 $ is then a fully-backed-up money, as much as the other 4 $, even if this is a fractional-reserve banking, here of 50%.
So what Frank Shostak has written up here is false.
Gerry Flaychy
Published: October 22, 2008 7:03 PM
Bill
I think the entire mess is unprecedented. There are places out there that can help but things need to be doen the right way by customers, banks, wall st etc for the economy to recover.
Published: December 11, 2008 2:44 PM
Bill
I think the entire mess is unprecedented. There are places out there that can help but things need to be doen the right way by customers, banks, wall st etc for the economy to recover.
Published: December 11, 2008 2:44 PM