Thursday, December 30, 2010

End the Fed?

Despite being a long-time libertarian I normally think of a Ron Paul as a wacko, mainly because of his vocal resistance to the existence of the Federal Reserve. In all of my economics classes, the Federal Reserve was referred to in the highest regard, like some kind of holy Tabernacle, monitoring and guarding the nation's monetary lifeblood. My two year of experience inside the Fed was consistent with that notion in that the organization had high morale and a strong culture of honest inquiry and good-faith management. Today, however, I woke up realizing that Paul might actually be on to something.

My initial support of the Fed was nothing profound. The textbook argument is that the Fed was created to end banking panics, prompted by the Panic of 1907. After a few rough years, including the Great Depression, the Fed finally figured out how to do its thing and acted as a fantastic stabilizer right up to the present. The Fed is Fantastic!

But not so fast. Since when is the Fed the best solution for banking panics? Consider how banking panics used to start. A bank opens for business. A bunch of people put money in the bank. For illustration just suppose they all put their money in checking accounts, or "demand deposits" that they can come collect anytime. Then the bank starts using some of that money to make loans and charges interest, and gives some of that interest back to the people with checking accounts. Everyone is happy. Then there comes a time when a lot of people try to take their money out of the bank all at once. Since much of the money is out on loan, the bank can't give everyone their money back. People flip out. The bank goes out of business. People lose their money. Nobody is happy (except maybe for a few lucky people who had taken out a loan and now don't need to pay it back??).

A small group of weird extremist libertarian types argues that the best solution to banking panics is not the Fed but rather the outlawing of fractional reserve banking (fracking?). They call fractional reserve banking wrong, immoral, and fraudulent. This use of morality language threw me off at first, because it sounded sensationalist and made me suspicious that they were just railing instead of providing a good alternative. On closer examination, I think they could have a useful policy proposal.

Their alternative to the Fed is outlawing fractional reserve banking. What does that mean? In my little description of banking panics above, fractional reserve banking is the part where the bank makes loans using the money from customers' checking accounts. If all demand deposits are fully backed in the banks vaults, with nothing lent out, there is no possibility for a run on the bank. The system is perfectly stable. Starting from this perspective, the idea that the bank would lend out your demand deposits does start to sound a bit fraudulent. Maybe we accept fractional reserve banking because it has been around ever since the start of banking. Outlawing it is a rather novel concept for policymakers.

The obvious big problem is then how can I get a loan for a house (or whatever) if the bank can't lend me the money of its depositors? Well, you could still get a loan from a bank, but things would just work a little differently on the depositors' end of things. Since the bank would be earning no interest income on demand deposits, depositors would likely have to pay a tiny fee for the service of the bank storing their money on the record books or in the vault. The pool of money from which loans are made would come from depositors who buy CDs or bonds or similar instruments that involve actually giving up their money until the borrowers pay it back. In this new system, the bank, instead of being thought as a source of loans, becomes more like a middle-man for loans, helping to match up borrowers with lenders and taking a commission on the interest and/or perhaps selling some insurance on the credit risks.

Benefits of replacing the Fed with this pared-down banking system include
  • extreme stability in the banking sector that is ...
  • ... achieved with only as much governance as is required to prosecute "fraudulent" lending, which I'm guess would cost a lot less than our multi-billion dollar Federal Reserve banking operation,
  • the end of inflation.
Costs of replacing the Fed include
I'd love to hear from a real expert on this topic. Is Ron Paul not wacko after all?


Anonymous Anonymous said...

Is credit card use above one's ability to repay at any given moment also fraudulent, or just another means of obtaining a loan?

3:13 PM  
Blogger My Freakwentness said...

If a person lies to increase their credit limit, that's fraud. Otherwise, no, there is no fraud here.

I think the question raises a very important related point, which is that eliminating fraud is not enough to guarantee a stable economy. If lenders become over-confident about borrowers ability to repay, and then proceed to increase credit limits (like the easy housing credit just 3-4 years ago), "bad debt" can accumulate, and people could lose investments in the resulting chaos. But at least in "fraud-free" banking, the demand deposits would not be threatened, even without government there to insure those deposits.

3:45 PM  
Anonymous Brian said...

I find it supremely ironic that extremist libertarians would argue that fractional reserve banking should be *prohibited* by any government.

If my bank and I want to make a deal where I earn interest on a deposit in exchange for the bank's use of the money elsewhere, why should the government intervene in that process at all?

I can think of some good reasons, but then I'm not an extreme libertarian.

8:47 PM  
Blogger My Freakwentness said...

I'm not sure that it's inconsistent -- libertarians are not anarchists -- but I'm not here to defend libertarian ideology.

But the point you raise might be enough to render my whole spiel irrelevant anyway, I'm not sure. The thing is, I don't care about whether we call it fraud or not. I just want to know the effects of a policy on stabilizing the banking system. Back in the day, were customers adequately informed about the risks behind keeping money in "demand deposit" accounts? If so, I guess I drop all my claims. If not, requiring banks to properly inform customers of the terms of the deal should have lead to a consumer demand for "safe demand deposit" accounts which would have been restricted from fractional reserve lending. The stabilizing effect of the new policy would be only as large as the amount of money the risk-averse people chose to put in these non-interest-bearing accounts, and hence could be zero in the even that people prefer risk.

5:16 AM  

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