Sunday, December 14, 2008

Fractional Reserve Banking is an Inherently Unstable System

There, I said it. File me away with the unibombers, the conspiracy theorists, and the gold bugs.

But the fact of the matter is that the whole system is really a sort of Ponzi scheme where you pay the people who want their money back with what you get from the people who are coming in. This works great until more people are going than are coming, a la Madoff. It makes you wonder if something fundamental will change once we pass through the steepest part of the global demographic phase transition.

This thought is inspired by a reading some commentary from Robert Bruner who recently wrote a book about the panic of 1907. I haven't read the book yet, but the commentary is probably sufficient to judge the conclusions he reaches. The basic idea is pretty simple. Fractional reserve banking is inherently unstable. Banks have a mismatch in the duration of their liabilities (I can get my deposits back any day of the week) and their assets (especially when they have made loans against that tried and true, but particularly iliquid, asset class -- real estate). Normally not everyone wants their money back at the same time, so this is fine. In a panic, even a solvent bank can be unable to pay its depositors.

The solution to this problem, as far as Bruner is concerned, is also pretty straightforward. You need some entity that backstops the banks, and convinces depositors not to pull their money out of solvent banks. You accomplish this by someone having enough cash in reserve to give the first group of depositors all their money back, so those after them realize that it's unneccesary even to ask for it. Simple enough. It's a con game really. Or a prisoner's dilemma, if you prefer. The success of fractional reserve banking as a business model depends on confidence and trust.

So how do you instill or recover that trust when for some reason people begin to lose it? In 1907 J.P. Morgan restored trust. Personally. I find it both sad and amazing that this could have worked. Sad, because it shows you how dominant a position this man had. In his commentary Bruner poses the question of whether there was a money trust (analogous to the oil trust and the cotton trust, etc ...) at the turn of the century. Poses it as if this were a question. I think the fact that any single man could restore trust in an entire system more or less tells you empirically that he had monopoly power. On the other hand it's kinda amazing that one man commanded such respect and was so competent that he could save an entire system. Imagine anyone trying to do this today. Are you going to put your trust in Geore W. Bush? Bill Gates? The suits from Goldman Sachs?

Bruner is clearly in awe of Morgan, and who wouldn't be? On the other hand, he obviously thinks that this was the last time any person could singlehandedly save the financial system. Today the problem is too big even for Warren Buffett, and requires a central bank instead a central financier (though wouldn't you rather have "Buffett Bucks" than dollars at this point?). A central bank is a perfectly sensible solution to the problem. Who can best restore confidence? The government. Where do all monopolies ultimately migrate to? The government. How do we solve problems of collective action? It's the government, stupid.

It's also the kiss of fucking death.

You haven't actually solved the problem with this, youv'e just pushed it up a level. Because there's no guarantee that we will always have confidence in our govenment. If we think it is run by a bunch of lying kleptocrats and their buddies, legitimized by dozens of pseudo-scientific technocrats who have had their heads in the sand for as long as we can remember, if perhaps we think the government and the people in it might, just maybe, be looking out more for themselves than for us -- well ... let's just say it may not be a foolproof firewall between us and the armageddon of zero-sum-ness.

Is anbody seeing a pattern here? Is it any wonder that this crisis happened when it did? I don't even trust my own shadow anymore, much less Ben Bernanke, Dr. Evil and mini-me over at the TARP. For all I know these guys are going to bomb the credit default swaps market because they heard somebody say that's where the weapons of mass destruction are. We'll have paper everywhere like confetti after the war.

In addition to creating the mother of all free-rider problems, pushing the question up a level and letting the government be the final backstop for the financial system means that the final instability of is now no longer solely financial, but cultural and political. Would you like to see what this slippery slope looks like when you've slid, repeatedly to the bottom of it?

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