By Keith Weiner
I have written a
number of pieces on fractional reserve banking and duration mismatch. I
have argued that the former is perfectly fine, both morally and economically,
but the latter is not fine. I have dissected the arguments made against
fractional reserve banking, and pointed out that it is nothing more than a bank
lending out some of the money it takes in deposits.
I have debunked
the most common errors made by opponents of fractional reserve
Banks print money;
They lend more than they take in deposits;
They inflate the money supply;
Money is the same as credit;
Fractional reserves banking is the same thing as central banking;
It is the same thing as duration mismatch.
Duration mismatch
is when a bank (or anyone else) borrows short to lend long. Unlike
fractional reserve, durati& Crediton mismatch is bad. It is fraud, it
is unfair to depositors (much less shareholders) and it is certain to collapse
sooner or later. This is not a matter for statistics and probability,
i.e. risk. It is a matter of causality, which is certain as I explain
below.
This discussion is of paramount importance if we are to move to a monetary system that actually works. Few serious observers believe that the current worldwide regime of irredeemable paper money will endure much longer. Now is the time when various schools of thought are competing to define what should come next.
I have written
previously on why a 100% reserve system (so-called) does not work. Banks
are the market makers in loans, and loans are an exchange of wealth and income
(http://keithweiner.posterous.com/the-loan-an-exchange-of-wealth-for-income). Without banks playing
this vital role, the economy would collapse back to its level the previous time
that the government made it almost impossible to lend (and certainly to make a
market in lending). The medieval village had an economy based on subsistence
agriculture, with a few tradesmen such as the blacksmith.
But I have not
directly addressed the issue of why duration mismatch necessarily must fail,
leading to the collapse of the banks that engage in it. The purpose of
this paper is to present my case.
In our paper
monetary system, the dollar is in a “closed loop”. Dollars circulate
endlessly. Ownership of the money can change hands, but the money itself
cannot leave the banking system. Contrast with gold, where money is an
“open loop”. Not only can people sell a bond to get gold coins, they can
take those gold coins out of the monetary system entirely, and stuff them under
the mattress. This is a necessary and critical mechanism—it is how the floor
under the rate of interest is set.
This bears
directly on banks. In a paper system, they know that even if some
depositors withdraw the money, they do not withdraw it to remove it
altogether (except perhaps in dollar backwardation, at the end.
See: http://keithweiner.posterous.com/dollar-backwardation). They withdraw it to
spend it. When someone withdraws money in order to spend it, the seller
of the goods who receives the money will deposit it again. From the
bank’s perspective nothing has changed other than the name attached to the
deposit.
The assumption
that if some depositors withdraw their money, they will be replaced with others
who deposit money may seem to make sense. But this is only in the current
context of irredeemable paper money. It is most emphatically not true
under gold!
There are so many
ills in our present paper system, that a forensic exploration would require a
very long book (at least) to dissect it. It is easier and simpler to look
at how things work in a free market under gold and without a central bank.
Let’s say that Joe
has 17 ounces of gold that he will need in probably around a month. He
deposits the gold on demand at a bank, and the bank promptly buys a 30-year
mortgage bond with the money. They assume that there are other depositors
who will come in with new deposits when Joe withdraws his gold, such as
Mary. Mary has 12 ounces of gold that she will need for her daughter’s
wedding next week, but she deposits the gold today. And Bill has 5 ounces
of gold that he must set aside to pay his doctor for life-saving surgery.
He will need to withdraw it as soon as the doctor can schedule the operation.
In this instance,
the bank finds that their scheme seems to have worked. The wedding hall
and the doctor both deposit their new gold into the bank. “It’s not a
problem until it’s a problem,” they tell themselves. And they pocket the
difference between the rate they must pay demand depositors (near zero) and the
yield on a 30-year bond (for example, 5%).
So the bank
repeats this trick many times over. They come to think they can get away
with it forever. Until one day, it blows up. There is a net flow of
gold out of the bank; withdrawals exceed deposits. The bank goes to the
market to sell the mortgage bond. But there is no bid in the mortgage
market (recall that if you need to sell, you must take the bid). This is
not because of the borrower’s declining credit quality, but because the other
banks are in the same position. Blood is in the water. The other
potential bond buyers smell it, and they see no rush to buy while bond prices
are falling.
The banks,
desperate to stay liquid (not to mention solvent!) sell bonds to raise cash
(gold) to meet the obligations to their depositors. But the weakest banks
fail. Shareholders are wiped out. Holders of that bank’s bonds are
wiped out. With these cushions that protect depositors gone, depositors
now begin to take losses. A bank run feeds on itself. Even if other
banks have no exposure to the failing bank, there is panic in the markets
(impacting the value of the other banks’ portfolios) and depositors are
withdrawing gold now, and asking questions later.
And why shouldn’t
they? The rule with runs on the bank is that there is no penalty for
being very early, but one could suffer massive losses if one is a minute late
(this is contagionhttp://dailycapitalist.com/2012/05/30/keithgram-contagion-defined/).
What happened to
start the process of the bank run? In reality, the depositors all knew
for how long they could do without their money. But the bank presumed
that it could lend it for far longer, and get away with it. The bank did
not know, and did not want to know, how long the depositors were willing to
forego the use of their money before demanding it be returned. Reality
(and the depositors) took a while, but they got their revenge. Today, it
is fashionable to call this a “black swan event.” But if that term is to
have any meaning, it can’t mean the inevitable effect caused by acting under
delusions.
Without addressing
the moral and the legal aspects of this, in a monetary system the bank has a
job: to be the market maker in lending. Its job is not to presume to say
when the individual depositors would need their money, and lend it out
according to the bank’s judgment rather than the depositors’. Presumption
of this sort will always result in losses, if not immediately. The bank
is issuing counterfeit credit (http://keithweiner.posterous.com/inflation-an-expansion-of-counterfeit-credit). In this case, the
saver is not willing (or even knowing) to lend for the long duration that the
bank offers to the borrower.
Do depositors need
a reason to withdraw at any time gold they deposited “on demand”? From
the bank’s perspective, the answer is “no” and the problem is simple.
From the
perspective of the economist, what happened is more complex. People do
not withdraw their gold from the banking system for no reason. The
banking system offers compelling reasons to deposit gold, including safety,
ease of making payments, and typically, interest.
Perhaps depositors
fear that a bank has become dangerously illiquid, or they don’t like the low
interest rate, or they see opportunities offshore or in the bill market.
For whatever reason, depositors are exercising their right and what they
expressly indicated to the bank: “this money is to be withdrawn on demand at
any time.”
The problem is
that the capital structure, once erected, is not flexible. The money went
into durable consumer goods such as houses, or it went into partially building
higher-order factors of production. Imagine if a company today began to
build a giant plant to desalinate the Atlantic Ocean. It begins borrowing
every penny it can get its hands on, and it spends each cash infusion on part
of this enormous project. It would obviously run out of money long before
the plant was complete. Then, when it could no longer continue, the
partially-completed plant would either be disassembled and some of the
materials liquidated at auction, or it would sit there and begin to rot.
Either way, it would finally be revealed for the malinvestment that it was all
along.
By taking demand
deposits and buying long bonds, the banks distort the cost of money. They
send a false signal to entrepreneurs that higher-order projects are viable,
while in reality they are not. The capital is not really there to
complete the project, though it is temporarily there to begin it.
Capital is not
fungible; one cannot repurpose a partially completed desalination plant that
isn’t needed into a car manufacturing plant that is. The bond on the
plant cannot be repaid. The plant construction project was aborted prior
to the plant producing anything of value. The bond will be
defaulted. Real wealth was destroyed, and this is experienced by those
who malinvested their gold as total losses.
Note that this is
not a matter of probability. Non-viable ventures will default, as
unsupported buildings will collapse.
People do not
behave as particles of an “ideal” gas, as studied by undergraduate students in
physics. They act with purpose, and they try to protect themselves from
losses by selling securities as soon as they understand the truth. Men
are unlike a container full of N2 molecules, wherein the motion of some to the
left forces others to the right. With men, as some try to sell out of a
failing bond, others try to sell out also. And they are driven by the
same essential cause. The project is non-viable; it is
malinvestment. They want to cut their losses.
Unfortunately,
someone must take the losses as real capital is consumed and destroyed. A
bust of credit contraction, business contraction, layoffs, and losses
inevitably follows the false boom. People who are employed in
wealth-destroying enterprises must be laid off and the enterprises shut down.
Busts inflict real
pain on people, and this is tragic as there is no need for busts. They
are not intrinsic to free markets. They are caused by government’s
attempts at central planning, and also by duration mismatch.
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