Tweet
http://www.mises.org/story/2926
It cannot be made any easier to understand. Here served on a Silver platter.
Enjoy,
-Sapiens
Our Financial House of Cards
Daily Article | Posted on 3/25/2008 by By George Reisman
A credit crisis has been spreading through the economic system. It began with the collapse of the housing bubble, which was the result of years of Federal Reserve–sponsored credit expansion. This credit expansion poured hundreds of billions of dollars into the purchase of homes largely by subprime borrowers who never had a realistic capability of repaying their mortgage debts in the first place. And, not surprisingly, large numbers of them in fact stopped making the payments required by their mortgages.
At first apparently confined to the market for subprime mortgages, the credit crisis has spread to other portions of the mortgage market, to the usually staid municipal bond market, and within the last week or so has led to a run against a major investment bank (Bear Stearns). Along the way, triple-A rated securities have overnight turned into junk bonds, multibillion-dollar hedge funds have collapsed, and major commercial banks have lost tens of billions of dollars of capital. All this, despite massive infusions of funds into the market by the Federal Reserve System and other central banks and a reduction in the federal funds rate from 5.25 percent in September of 2007 to 2.25 percent currently.
In the process, the triple-A rated securities that turned out to be junk served to confirm the old truth that lead cannot be turned into gold: the alleged triple-A securities were backed by collections of mortgages that in the last analysis consisted largely or even entirely of subprimes. An important new truth also appears to have emerged: namely, that PhDs in finance, the likely authors of the schemes for creating such securities, can turn out to be far more costly than anyone had ever dreamed possible.
Currently, untold billions more of banks' capital now hinge on the survival of bond insurers striving to insure more than two trillion dollars of outstanding bonds on the basis of capital of their own of roughly ten billion dollars. Collapse of the bond insurers would mean that credit-rating firms, such as Moody's and Standard and Poor's, would reduce the ratings of all the bond issues that would consequently be deprived of insurance coverage. This in turn would serve to reduce the prices of those bonds, because lower credit ratings would make them ineligible for purchase by numerous investors, such as many pension funds. To the extent that the bonds were owned by banks, the value of the banks' assets would be correspondingly reduced and with it the magnitude of the banks' capital.
The decline in the assets and capital of banks that has already taken place has served to reduce the ability of banks to lend money to borrowers to whom they would otherwise normally lend. To the extent, for example, that subprime mortgage borrowers have stopped paying interest and principal on their loans, the banks do not have those funds available to make loans to other borrowers.
The effects of such credit contraction can already be seen in business bankruptcies precipitated by an inability of firms to obtain refinancing of debts coming due. It can also be seen in the growing difficulty even of sound firms to obtain financing required for expansion.
The Role of Leverage
Our present circumstances follow decades, indeed, generations of almost continuous inflation and credit expansion, in which almost everyone has become accustomed to assume that asset values will always rise or at least will quickly resume their rise after any pause or decline. This assumption not only played an important role in the eagerness with which people lent and borrowed in the mortgage market, but also in bringing about the very high degree of financial leverage that has come to characterize practically all areas of our financial system. (Leverage is the use of borrowed funds to increase the returns that can be earned with a given sized capital. It equivalently increases the losses that can be incurred on that capital.)
Unduly high leverage explains the failure of major lenders in the prime portion of the real estate market. As the result of losses sustained in subprime mortgages, banks and other lenders could no longer provide funds as readily for the purchase of prime mortgages. The resulting few percent drop in the value of prime mortgages has served to wipe out the entire capital of prime mortgage lenders whose capital was so highly leveraged that it constituted an even smaller percentage of the value of their assets than the few percent drop in the price of those assets. For example, if a mortgage lender initially had assets worth $103 and debts of his own of $100 incurred in order to finance the purchase of those assets, a mere 4 percent decline in the value of his assets would wipe out his entire capital and then some. Multiply these numbers by many billions, and the example corresponds exactly to the real-world cases of Thornburg Mortgage and Carlyle Capital reported on the front page of The New York Times of March 8, and to that of Bear Stearns reported on the front page of The New York Times just one week later.
The liquidation of the assets of such lenders, which consisted mainly of prime mortgages, has meant a further fall in the price of prime mortgages, to the point where the credit even of the government-sponsored mortgage lenders Fannie Mae and Freddie Mac has come into question. These two lenders have outstanding mortgage-backed obligations of more than $4 trillion, which sum until recently was assumed also to be an obligation of the US government. Now it has become uncertain whether the actual obligation of the US government extends beyond the less than $5 billion in lines of credit these lenders have with the US Treasury.
The Federal Reserve's rescue of Bear Stearns can be understood in part in the light of its desire to avoid further declines in the assets and capital of Fannie Mae and Freddie Mac, which would have resulted if Bear had had to sell off its holdings of mortgages. The likelihood that the failure of Bear would have triggered the failure of other major Wall Street firms and thereby have resulted in even more massive sell-offs of mortgages, along with other assets, was a related important consideration.
Remarkably, at the very same time that the Federal Reserve has been striving to cope with the consequences of excessive leverage and possibly thereby help to prevent the collapse of Fannie Mae and Freddie Mac, the government regulator of these institutions — the Office of Federal Housing Enterprise Oversight — is not content with the fact that they are already skating on dangerously thin ice. Thus, The New York Times of March 20 reports that the regulator has just decided to reduce their capital requirements, for the purpose of enabling them to take on still more leverage. The effect of this will be that an even more modest decline in home prices and mortgage values will be sufficient to drive Fannie Mae and Freddie Mac into bankruptcy than is now the case.
As these examples illustrate, the failure of debtors can serve to wipe out the capital of highly leveraged creditors, who then become unable to pay their debts, perhaps causing the failure of their creditors, and so on. In other words, one failure can set off a domino effect of a chain of failures. What serves to end the process is when someone in the chain finally accumulates enough salvageable assets from those earlier in the chain to be able to satisfy his creditors.
Leverage and Bank Capital
Operating alongside the process of chains of failures is another, even more important aspect of the leverage present in today's financial system. This is the fact that reductions in the capital of banks can result in multiple contractions of credit. As a rough average, banks are normally required to possess capital equal to five percent of their outstanding loans and investments. (Investments are purchases of securities.) The implication of this is that reductions in banks' capital below the five percent level have the potential to result in contractions of credit twenty times as large, in efforts to reestablish the five percent ratio.
For example, a bank with an initial capital of $5 billion could support $100 billion in outstanding loans and investments, based on the requirement that its capital be at least 5 percent of the credit it has granted. But if its capital falls to $4 billion, it must reduce its outstanding loans and investments to $80 billion to be in compliance with that requirement. In other words, a $1 billion reduction in bank capital can cause a $20 billion reduction in outstanding bank credit.
Such announcements as that recently made by Citibank, that it would reduce its holdings of home loans by 20 percent, are entirely consistent with this phenomenon, as are the recent failures of banks and brokers to make bids in markets for so-called auction-rate notes. (These are credit instruments whose interest rates are set periodically on the basis of auctions and that until recently were billed as the equivalent of cash. Bidding for them would have placed banks at risk of acquiring additional assets and indebtedness when they urgently needed to reduce their assets and indebtedness.)
Credit Contraction and Deflation
Of the greatest importance is the further fact that credit contraction by banks has the effect of reducing the outstanding volume of checking deposits in the economic system and to that extent the quantity of money in the economic system. This result follows from the fact that when debtors repay their loans, they do so by means of writing checks, the proceeds of which are subtracted not only from their accounts but also from the balance sheets of the banks on which the checks are drawn. If those banks do not then make equivalent new loans, accompanied by the creation of equivalent fresh checking deposits for new borrowers, the amount of the checking deposits used to repay the loans simply disappears. (The same result occurs when banks sell portions of their securities holdings to members of the public. The buyers of the securities pay for them by means of writing checks, and the proceeds of those checks then disappear not only from the checking accounts of the purchasers but also from the balance sheets of the banks on which the checks are drawn.)
Such contraction of credit and money operates to reduce the amount of spending in the economic system. The money that is no longer present in the economic system — because the credit that would have provided it has disappeared — is money that can no longer be spent. Money no longer spent is business sales revenues no longer earned. A drop in business sales revenues, in turn, causes a drop in spending by the firms that would have earned those sales revenues.
This further drop in spending reduces both the sales revenues of other firms, namely, those that would have supplied the firms in question, and wage payments to workers, as employees are laid off in the face of declining sales. And, of course, as wage payments fall, so too does the spending of wage earners for consumers' goods. The decline in spending, sales revenues, and wage payments is repeated again and again throughout the economic system, as many times in a year as the vanished sum of money would have been spent and respent in that year.
Of no less importance is the fact that a decline in the quantity of money and volume of spending can itself cause further declines in the assets and capital of banks. This is because as the sales revenues of business firms decline, so too do their profits and their ability to repay debts, including debts to banks. The resulting further declines in the value of bank assets further reduce the capitals of banks, causing more credit contraction, further reductions in the quantity of money and volume of spending, and still more reductions in the asset values and capitals of banks, on and on in a self-reinforcing vicious circle.
Bank Failures and Bank Runs
Historically, processes such as those just described have not taken place smoothly and gradually, in a manner akin to the air slowly leaking from some kind of giant inflated balloon. To the contrary, they have been characterized by sudden massive ruptures in the fabric of the system, namely, by bank failures, often precipitated by bank runs.
Sooner or later, the erosion of its capital makes a bank actually fail. What is meant in saying that bank failures were often precipitated by bank runs is merely that at some point depositors woke up to the fact that a bank's assets were no longer sufficient to guarantee the repayment of its deposits, and so raced to withdraw their funds while it was still possible to do so.
Bank failures, and even bank runs, are by no means a phenomenon confined to history. Intermittent bank failures continued to occur through the entire 20th century. And the present chairman of the Federal Reserve System has said that some bank failures are to be expected in our present crisis. Only late last summer there was not only a failure but also an actual run on a major British bank, Northern Rock. If our own credit crisis continues and deepens further, it should not be surprising to start seeing bank runs here in the United States as well. Indeed, what happened to Bear Stearns — which is an investment bank — on March 13 and made it seek the help of the Federal Reserve System was precisely a run, as large numbers of its clients sought to withdraw their funds all at once. It is very possible that what has just happened at Bear Stearns will also happen at one or more major commercial banks, whose customers hold checking or savings accounts. (In this connection, it should be kept in mind that federal deposit insurance is limited to a maximum of $100,000 per account. The run would be on the part of those whose accounts are larger than $100,000.)
When a bank fails, unless it is immediately taken over by another, still-solvent bank, its outstanding checking deposits lose the character of money and assume that of a security in default. That is, instead of being able to be spent, as the virtual equivalent of currency, they are reduced to the status of a claim to an uncertain sum of money to be paid at an unspecified time in the future, i.e., after the assets of the bank have been liquidated and the proceeds distributed to the various parties judged to have legitimate claims to them. Thus, what had been spendable as the equivalent of currency suddenly becomes no more spendable than any other security in default.
This change in the status of a bank's checking deposits constitutes a fully equivalent reduction in the quantity of money in the economic system. Thus, for example, if a bank were to fail with outstanding checking deposits of $100 billion, say, and not be taken over immediately by another, still-solvent bank, the quantity of money in the economic system would also immediately fall by $100 billion.
As a result of this fact, bank failures have the potential greatly to accelerate and deepen the descent into deflation and economic depression. For they represent much larger, more sudden reductions in the quantity of money and volume of spending in the economic system. And, just like lesser reductions, their effect, unless somehow checked or counteracted, is to launch a vicious circle of contraction and deflation. The period 1929–1933 provides the leading historical example.
In 1929, the quantity of money in the United States was approximately $26 billion and the gross national product (GNP/GDP) of the country, which provides an approximate measure of consumer spending, was $103 billion. By 1933, following wave after wave of bank failures, the quantity of money had fallen to approximately $19 billion and the GNP to less than $56 billion. The failure of wage rates and prices to fall to anywhere near the same extent resulted in mass unemployment.
The Potential for Deflation Today
In order to understand the potential for deflation today, in 1929, or at any other time, it is necessary to understand the concepts "standard money" and "fiduciary media." Standard money is money that is not a claim to anything beyond itself. It is money the receipt of which constitutes final payment. Under a gold standard, standard money is gold coin or bullion. Paper currency under a gold standard is not standard money. It is merely a claim to standard money, i.e., gold.
Since 1933, paper currency in the United States has been irredeemable. It has ceased to be a claim to anything beyond itself. Its receipt constitutes final payment. Thus, since 1933, the standard money of the United States has been irredeemable paper currency.
Most of the money supply of the United States, today as in 1929, is not standard money of any kind, but rather fiduciary media. Fiduciary media are transferable claims to standard money, payable on demand by their issuers, accepted in commerce as the equivalent of standard money, but for which no standard money actually exists.
What precisely fits the description of fiduciary media are checking deposits insofar as they exceed the reserves of standard money held by the banks that issue them. Checking deposits are, first of all, transferable claims to standard money, payable on demand by the banks that issue them, and accepted in commerce as the equivalent of standard money. To the extent that they exceed the currency reserves owned by the banks that issue them, they are fiduciary media.
At the present time, there are approximately $2.5 trillion of checking deposits in one form or another. These checking deposits are those reported as part of the M1 money supply ($625 billion), plus those reported as so-called sweep accounts by the Federal Reserve Bank of St. Louis ($765 billion),[1] and those reported as retail money fund accounts ($1078 billion).[2]
In addition to these checking deposits, our present money supply consists of approximately $800 billion in currency outside the banking system. Our total money supply is thus currently $3.3 trillion. Of these $3.3 trillion, the quantity of standard money is approximately $840 billion: the currency outside the banks plus $40 billion of currency reserves of the banking system.[3]
There are no reserve requirements on either sweep accounts or retail money fund accounts. Supposedly there is a basic 10 percent reserve requirement against the checking deposits counted under M1. Nevertheless, the actual reserves held against these checking deposits are not $62 or $63 billion, but merely on the order of $40 billion, which implies an overall effective reserve requirement of less than 7 percent against these checking deposits. When compared to the total checking deposits of the economic system, the roughly $40 billion of reserves constitute a reserve on the order of less than 2 percent. This is the measure of the leverage of today's banking system with respect to reserves.
In an ongoing process of a vicious circle of bank failures, a falling quantity of money and volume of spending, and thus falling business sales revenues, mounting business losses and business failures, resulting in still more bank failures, the volume of checking deposits might ultimately be reduced all the way down to the system's $40 billion of standard money reserves. This last is the actual currency either in the possession of the banks or belonging to them while held by the Federal Reserve System. This currency is the only asset of the banks whose value cannot be reduced by the failure of debtors.
The potential deflation of checking deposits, if nothing were done to stop it, is the difference between their present amount of $2.5 trillion and the $40 billion of reserves that stand behind them. The potential deflation of the money supply as a whole, if nothing were done to stop it, is the difference between $3.3 trillion and $840 billion, i.e., approximately 75 percent.
Why Massive Deflation Must Be Prevented
Massive deflation is always something that should be avoided if it is humanly possible to do so. The surest and best way to avoid it is to avoid the prolonged credit expansions that set the stage for it.
The only way that the economic system can adjust to deflation once it has occurred is by means of corresponding reductions in wage rates and prices. These serve to increase the buying power of the reduced quantity of money and the reduced volume of spending that it supports. If they were sufficient, they would enable the reduced quantity of money and volume of spending to buy all that the previously larger quantity of money and volume of spending had bought.
Yet there are powerful obstacles in the way of wage rates and prices falling. Not the least of these is the prevailing belief that rather than it being the reduction in the quantity of money and volume of spending that is deflation, it is the fall in wages rates and prices that is deflation. This incredible confusion leads to misguided attempts to combat deflation by means of preventing the only thing that would make possible a recovery from deflation, namely, a fall in wage rates and prices.
This confusion is joined by the even more influential errors of the Marxian exploitation theory, which claims that employers would arbitrarily set wage rates at the level of minimum subsistence if not prevented from doing so by government intervention. The result of this stew of ignorance is the existence of laws such as pro-union and minimum-wage legislation, which make it extraordinarily difficult or plain impossible for wage rates to fall. These laws are tantamount to simply making it illegal for the process of recovery to proceed.
To these laws must be added the virtual paralysis of our present-day judicial system. Not only do convicted murderers often sit on death row for years or even decades before their sentences are carried out or finally set aside, but ordinary law suits now normally take years to wind their way through our court system. A leading consequence of a massive deflation would be millions upon millions of business and personal bankruptcies, which our court system is simply not equipped to handle. The functioning of an economic system depends on clear knowledge of who owns what and who has the legal right to do what with what property. It cannot wait years for judges to make clear and final decisions about such matters, which is the likely period of time it would take them if the present typical performance of our judicial system is any guide.
Given these legal obstacles, the effect of massive deflation would be long-term mass unemployment and economic paralysis. Literally tens of millions would be unemployed, with no way to find new employment. Such conditions, in combination with the massive economic illiteracy that prevails in our culture, would likely result in the adoption of many new and additional acts of destructive government interference. It would not by any means be out of the question that the likes of a native-born Hugo Chavez could be elected president of the United States.
True and False Remedies
It should be obvious from much of what has been said in this article that what is driving our impending deflation is the lack of capital on the part of the banks, resulting from the losses they have thus far sustained on their assets. This is what has been impelling them to contract credit, and which, if unchecked will serve to reduce their assets and capital further and further, until much or all of the banking system and the checking deposit money it has created collapses under its own weight for a sheer lack of monetary reserves.
In the light of this knowledge, such solutions as the recently enacted "stimulus package" designed to promote consumer spending should be dismissed as laughably naive. The economic system is not going to be rescued by consumers, let alone by consumers so incapable of producing that they require government handouts in order to consume. No one benefits by giving people the money with which to buy his products. Yet this is the position such programs force taxpayers to assume.
Likewise, when one keeps in mind that the problem is a lack of capital, such alleged solutions as the Federal Reserve's current policy of reducing interest rates must appear as clearly counterproductive. Reductions in interest rates in the United States relative to those in Europe and elsewhere serve to keep badly needed capital out of our country by making investment there more profitable than investment here. In keeping down the overall supply of capital in the United States, they contribute to the lack of credit and to making it more difficult for banks to obtain the additional capital they need. The Federal Reserve has carried this policy a large step further, with its most recent reduction in the federal funds rate from 3 percent to 2.25 percent.
Similarly, the rescue measure proposed for homeowners faced with foreclosure, namely, forcibly reducing interest rates on sub prime mortgages in violation of the contractual terms of the mortgages and against the will of the mortgage holders, would serve further to reduce the earnings, assets, and capital of the banks. Decisions of judges to place obstacles in the way of the foreclosure process, such as insisting on the presentation of the original mortgage documents, even though it is undisputed that the borrower is in default, also serve to weaken the financial position of banks. It can do so not only directly but also indirectly, by contributing to the bankruptcy of non-bank mortgage lenders with debts to banks.
The sympathy expressed for the families threatened with foreclosure is very largely misplaced. It is forgotten how many of them purchased their homes without making any down payment of any kind, and often without being obliged to make any payments of principal on their mortgages. Many of the homes now being foreclosed were purchased by such buyers not for the purpose of having a place to live, but for the purpose of profiting from a speculative investment.
Of course, there are also some homeowners who did make substantial down payments in purchasing their homes, even during the housing bubble. But there are many more who purchased their homes before the bubble began but who in recent years foolishly chose to consume their equity, by incurring additional debt to finance consumption in excess of their incomes. At the time, these people were lauded as pillars of the economy's strength, on the basis of the same ridiculous beliefs that underlie the proposals to rescue the economy now by still more consumption on the part of people who can't afford it.
The effect of the years of Federal Reserve–sponsored credit expansion and the resulting spending binge on housing that people could not afford was to make housing unaffordable by millions of other people. It was to raise median house prices in many places to the point where only the top 15 or 20 percent of income earners in the area could afford the median-priced home. To make housing affordable once again by the mass of people who normally could afford to buy a home, housing prices need to fall to whatever extent their rise in recent years has exceeded the rise in median family incomes. The foreclosure process is an essential step in bringing that about. It should not be prevented in any way from taking place.
How to Increase the Capital and Reserves of the Banking System
Since the problem behind our impending deflation is the lack of capital on the part of the banks, and beyond that the lack of monetary reserves to maintain the supply of checkbook money when banks fail, it should be obvious that what is needed to avoid the threat of deflation is an increase in the capital and reserves of the banks.
When the problem is stated this way, a thought that is likely to occur to many people is that the banks should simply go out and raise additional capital. They should sell stocks and bonds, for example. And, in fact, that has actually happened in some cases, for example, that of Citibank, which raised $14.5 billion in new capital from foreign investors this last February.
One problem with such a procedure is how much of the bank's ownership has to be given to the new investors to make their investment worthwhile for them. And, as indicated, raising the necessary capital is made more difficult by Fed's policy of low interest rates, which keeps down the supply of capital by discouraging foreign investment in the United States. Another, deeper problem for many banks is that in the minds of potential investors the bank's actual capital may be negative, requiring investors to put up not only new and additional capital but also capital required to overcome the bank's negative capital. (Negative capital can easily result when on the left-hand side of a bank's balance sheet there are tens or hundreds of billions of dollars of assets whose value can decline, while on the right-hand side there are tens or hundreds of billions of dollars of deposits whose value is fixed. As we saw earlier, when capital is only a very few percent of assets to begin with, even a modest decline in the value of assets can turn it negative.)
The existence of negative capital entails requiring first an investment sufficient to reach the point of zero capital — and only then the investment of the capital that will enable the bank to maintain and increase its operations. Moreover, the extent of the capital deficiency may not even actually be knowable. Such considerations make the raising of additional capital by conventional means extremely difficult or altogether impossible. It's a case simply of having to invest too much in order to receive too little.
In these circumstances the only party willing to provide the needed capital funds is the government, i.e., the Federal Reserve System, which has the power simply to print them if necessary.
At present, the Federal Reserve is already supplying the banking system (and the major investment banks as well) with capital. But it is doing so only to the extent of overcoming negative capital, and perhaps doing that less than fully. This is the essential meaning of the Fed's acceptance of billions of dollars of assets of dubious value in exchange for its own assets of relatively secure value, i.e., US government bonds and Treasury bills. (The Fed now even accepts assets for which there is no market because finding a market would require a radical reduction in the price of the assets compared to what was originally paid for them, and correspondingly wipe out capital on the books of the banks.)
The Fed has committed almost half of its own principal assets to this project: $400 billion out of its most recently reported total holdings of government securities of $828 billion. It will not be able to commit much more of those securities. Indeed, however ironic it may be, the Federal Reserve — the "lender of last resort," the alleged bailer-outer of the banking system and of the whole economy — is or may fairly soon be itself technically bankrupt as the result of this operation. (This would be clear if the assets it receives had to be valued at their actual market value. The result would be that the assets of the Fed would be less than the face value of its outstanding US currency and other liabilities.)
Unless the Fed's actions up to now prove sufficient to end the financial crisis, its next step will be the printing of money to prop up the banking system. Indeed, even if the crisis were to end as of now, there would still be the problem that the Fed's infusion of capital has thus far been only on a temporary basis. The banks are supposed to take back their low-grade and non-performing assets within a month or so and return the Fed's securities. Clearly, a solution to the problem of a lack of bank capital needs to be long-term, not something that must be renewed month by month.
Moreover, a proper solution to our present crisis should do more than merely overcome the difficulties of the moment. It should, in addition, provide a guarantee against the recurrence of such crises in the future. Above all, a proper solution to this or any other economic or political crisis should also meet the criterion of serving to advance the cause of economic freedom and should be designed with that objective in mind.
There is a means of accomplishing all three of these objectives.
That means is the use of gold as a major asset of the banking system.
Despite the certainty that a proposal of this kind will be almost completely ignored and has virtually no chance of being enacted in the foreseeable future, it still must be made. This is because the most fundamental and important consideration is not what people are willing to accept or reject at the moment but what would in fact accomplish the objectives that need to be accomplished. Using gold as a major asset of the banking system, in the way set forth below, would in fact safeguard the banking system from possible deflationary collapse, prevent the recurrence of any such threat, and do so in a way that substantially advanced the cause of economic freedom. Making the proposal is necessary in order to uphold the philosophy of economic freedom, by providing a demonstration that that philosophy offers the solution to the growing monetary problems we face and is not their cause.
Gold as the Source of New Bank Capital and of Reserves
The Federal Reserve System holds approximately 260 million ounces of gold. The market price of gold recently reached $1,000 per ounce. This means that the Fed's gold can easily be thought of as an asset with a market value of roughly $260 billion.
As an initial approach to understanding the solution to our problem, let us assume that the Federal Reserve declared its gold holding as being held in trust for the benefit of the American banking system, and proceeded to allow every bank to enter on the asset side of its balance sheet a portion of this gold corresponding to its share of the total of the $2.5 trillion of checking accounts presently in the economic system. The banks would not physically possess the gold but only book entries corresponding to it.
The gold entered on banks' balance sheets could also count as equivalent new and additional bank reserves. Thus the measure would simultaneously add $260 billion of new and additional bank reserves in the form of gold as well as $260 billion of new and additional bank capital. The reserves and the capital would both be essentially permanent.
In order to prevent the monetization of the gold reserves, the Fed could mandate a permanent required gold reserve against all checking deposits — those counted in M1, those counted as "sweeps," and those counted as retail money funds — in the ratio of $260 billion to $2.5 trillion, i.e., a little over 10 percent.
A major shortcoming of this very simple solution is that the addition of $260 billion in gold to bank assets would probably be insufficient. It almost certainly would be if the Fed decided, as it should, to take back its government securities from the investment banks and give them back their securities of far less value. That would probably bankrupt most or all of the investment banks. Furthermore, because the commercial banks are their main creditors, the assets of the investment banks would move into the possession of the commercial banks and do so, of course, at a far lower value than the loans that had been made to the investment banks. Thus, the present capital of the commercial banks and much more would be wiped out.
Accordingly, the book value placed on the Fed's gold holding needs to be substantially higher than $1,000 per ounce, if it is to result in the creation of sufficient bank capital and reserves. The question is, how much higher?
The most logical answer to this question was supplied as far back as the 1950s by the late Murray Rothbard, who argued for the establishment of a 100-percent-reserve gold standard by means of pricing the Fed's gold stock at whatever price was necessary to make it equal the outstanding supply of money.
Taking the outstanding supply of money today as being $3.3 trillion, Rothbard's proposal implies a gold price of approximately $12,700 per ounce. At such a price, the Fed's gold stock would be sufficient to provide a 100 percent reserve against all US checking deposits and all US currency.
The provision of a 100 percent reserve would be an immediate guarantee against any reduction in the supply of checkbook money. This would obviously be the case if the banks simply paid out gold in response to customers' demands for the redemption of their checking deposits. At $12,700 per ounce, the banks and the Fed would have enough gold to redeem every single dollar of checking deposits and currency in the economic system. (That's the meaning of a 100 percent reserve.)
Of course, in the circumstances envisioned here, the banks would not pay out physical gold. But they would have the ability to pay out paper currency to the full extent of outstanding checking deposits, and that currency would have an undiminished gold backing at the price of gold of $12,700 per ounce. Thus whatever the recession that might develop in the months ahead, it would be contained, insofar as the money supply of the country would not be reduced. That would guarantee a major reduction in the possible severity of what might otherwise develop.
This 100-percent-reserve gold standard as thus far described would obviously be a long way from the full-bodied 100-percent-reserve gold standard that Rothbard envisioned, and which I myself have elaborated upon and advocated. It would be a standard that for some time was largely just nominal, in that the actual gold of the monetary system would still be in the possession of the Federal Reserve System. Nor would there yet be any obligation of the Fed to buy or sell gold at the price of $12,700 per ounce or at any other price. The purpose of the system I have described would simply be the twofold one of providing reserves sufficient to prevent any possible reduction in the supply of checkbook money and also of providing capital to banks sufficient to substantially more than offset the losses otherwise resulting from a decline in the value of banks' assets.[4]
Indeed, given that what would be present is an addition to the assets of the banking system in an amount equal to the full magnitude of outstanding fiduciary media, i.e., of $2.5 trillion of checking deposits minus $40 billion of presently existing standard money reserves, the overwhelming likelihood is that the banks would be handed far too much capital. Even with losses of $1 trillion on their existing assets, they would still stand to gain practically $1.5 trillion in new and additional capital. Such a bonanza would not be justifiable. The solution would be to pass most of it on to the banks' depositors in the form of bank stock or bonds paid as a dividend on their accounts.
It is not possible in the space of one article to explore, beyond the very limited extent to which I've done so,[5] the problems and the solutions entailed in moving on to the full-bodied 100-percent-reserve gold standard that is the ultimate objective of my proposal. Under such a gold standard, paper currency and checking deposits will, of course, be fully convertible into gold, physical gold coin will enjoy wide circulation, and the supply of gold in the country will be free to increase or decrease simply in response to market forces.
All I have tried to show here is how the twin problems of a lack of bank capital and of bank reserves, which are the core of the threat of deflation, could be solved by means of establishing the framework of a 100-percent-reserve gold monetary system.
$22
$95 $80
Needless to say, such a system would not only end the threat of deflation, but, equally important, it could end the threat of inflation as well. For if it were actually followed, the increase in the quantity of money would be limited to the increase in the supply of gold, which is extremely modest compared with increases in the supply of irredeemable paper money. This is because gold is rare in nature and costly to extract. Irredeemable paper money in contrast is virtually costless to produce and is potentially as abundant as the supply of currency-sized sheets of paper, indeed, as abundant as the size of the largest number that can be printed on all such sheets of paper.
Above all, the solution I have proposed would constitute a major step toward the establishment of a full-bodied precious metal monetary system and thus toward ultimately eliminating the government's physical control over the money supply and all of the violations of individual freedom that that control represents and makes possible.
And what is more, it could be accomplished at a cost to the Federal Reserve not of hundreds of billions of dollars — the sums the Fed is risking in exchanging its government securities for bank assets of vastly lower value — not for the $30 billion it has risked to bail out just Bear Stearns, but for a little more than $11 billion! Just $11 billion is the value at which the Fed carries its gold stock on its balance sheet, at a price of gold of approximately $42 per ounce.
Thus, to say it all in one sentence, the threat of massive deflation can be eliminated, the threat of inflation ended, and the actual and potential domain of economic freedom greatly expanded, for $11 billion — an $11 billion that would not even be an out-of-pocket expense to anyone but merely a balance-sheet charge on the books of the Federal Reserve System when it deducted its gold holding from its balance sheet and added it to the balance sheets of the banks.
--------------------------------------------------------------------------------
George Reisman, Ph.D. is the author of Capitalism: A Treatise on Economics and is Pepperdine University Professor Emeritus of Economics. His web site is www.capitalism.net, and his blog is www.georgereisman.com/blog. Send him mail. Comment on the Mises blog.
Copyright © 2008 by George Reisman. All rights reserved.
Notes
I am indebted to Professor William Barnett, II, of Loyola University, New Orleans. His recent internet postings on the mises@yahoogroups list made me aware of the fact that the capital requirements of banks under the Basel II Capital Accord, rather than official reserve requirements imposed by the Federal Reserve System, is all that has served to constrain the increase in the quantity of money in the United States in recent years. His comments also served to provide important insight into understanding the role of banks' capital requirements in explaining essential aspects of their recent behavior as well as their likely behavior in the weeks and months ahead.
[1] Sweep accounts are checking deposits that banks transfer into savings deposit accounts overnight, on weekends, and on holidays, in order to reduce their required reserves and thus be able to use any given amount of reserves to support a larger volume of checking deposits.
[2] Inasmuch as the accounts subsumed under this last head generally allow the writing only of a limited number of checks per month, and sometimes impose limits on the minimum dollar amount of the checks that may be written, they probably should not be counted as part of the money supply to their full extent. To precisely what extent they should be counted is an open question. Nevertheless, it may be that counting them to their full extent represents a lesser error than attempting to adjust them downward. This is because doing so makes allowance for the extent to which roughly $2.1 trillion of institutional money funds may also actually serve as money.
[3] The $800 billion of currency outside the banks is counted as part of the M1 money supply along with the checking deposit component of $625 billion previously referred to. Thus, at present, M1 is approximately $1.4 trillion.
[4] It should be realized that in the absence of any commitment of the Fed to buy gold at $12,700 per ounce, the market price of gold would almost certainly be radically lower. To the extent that additional gold could be purchased at lower prices, the possibility would exist of increasing gold reserves relative to outstanding checking deposits and currency and thus of ultimately having a 100-percent reserve at a price of gold less than $12,700 per ounce. Furthermore, it should be kept in mind that the Fed would need to proceed with great caution in purchasing additional gold. The danger to be avoided is that of initially drawing a disproportionate share of the world's gold to the United States, when it alone was in process of remonetizing gold. If the US economy became accustomed to such a large gold supply, and then, later on, if and when the rest of the world remonetized gold and drew much of that gold back out, the US would be in the position of experiencing first a virtual inflation in terms of gold and then a virtual deflation in terms of gold, the very kind of sequence of phenomena that a properly established 100-percent-reserve gold standard would permanently prevent.
[5] See above, the preceding note.
Daily Article | Posted on 3/25/2008 by By George Reisman
A credit crisis has been spreading through the economic system. It began with the collapse of the housing bubble, which was the result of years of Federal Reserve–sponsored credit expansion. This credit expansion poured hundreds of billions of dollars into the purchase of homes largely by subprime borrowers who never had a realistic capability of repaying their mortgage debts in the first place. And, not surprisingly, large numbers of them in fact stopped making the payments required by their mortgages.
At first apparently confined to the market for subprime mortgages, the credit crisis has spread to other portions of the mortgage market, to the usually staid municipal bond market, and within the last week or so has led to a run against a major investment bank (Bear Stearns). Along the way, triple-A rated securities have overnight turned into junk bonds, multibillion-dollar hedge funds have collapsed, and major commercial banks have lost tens of billions of dollars of capital. All this, despite massive infusions of funds into the market by the Federal Reserve System and other central banks and a reduction in the federal funds rate from 5.25 percent in September of 2007 to 2.25 percent currently.
In the process, the triple-A rated securities that turned out to be junk served to confirm the old truth that lead cannot be turned into gold: the alleged triple-A securities were backed by collections of mortgages that in the last analysis consisted largely or even entirely of subprimes. An important new truth also appears to have emerged: namely, that PhDs in finance, the likely authors of the schemes for creating such securities, can turn out to be far more costly than anyone had ever dreamed possible.
Currently, untold billions more of banks' capital now hinge on the survival of bond insurers striving to insure more than two trillion dollars of outstanding bonds on the basis of capital of their own of roughly ten billion dollars. Collapse of the bond insurers would mean that credit-rating firms, such as Moody's and Standard and Poor's, would reduce the ratings of all the bond issues that would consequently be deprived of insurance coverage. This in turn would serve to reduce the prices of those bonds, because lower credit ratings would make them ineligible for purchase by numerous investors, such as many pension funds. To the extent that the bonds were owned by banks, the value of the banks' assets would be correspondingly reduced and with it the magnitude of the banks' capital.
The decline in the assets and capital of banks that has already taken place has served to reduce the ability of banks to lend money to borrowers to whom they would otherwise normally lend. To the extent, for example, that subprime mortgage borrowers have stopped paying interest and principal on their loans, the banks do not have those funds available to make loans to other borrowers.
The effects of such credit contraction can already be seen in business bankruptcies precipitated by an inability of firms to obtain refinancing of debts coming due. It can also be seen in the growing difficulty even of sound firms to obtain financing required for expansion.
The Role of Leverage
Our present circumstances follow decades, indeed, generations of almost continuous inflation and credit expansion, in which almost everyone has become accustomed to assume that asset values will always rise or at least will quickly resume their rise after any pause or decline. This assumption not only played an important role in the eagerness with which people lent and borrowed in the mortgage market, but also in bringing about the very high degree of financial leverage that has come to characterize practically all areas of our financial system. (Leverage is the use of borrowed funds to increase the returns that can be earned with a given sized capital. It equivalently increases the losses that can be incurred on that capital.)
Unduly high leverage explains the failure of major lenders in the prime portion of the real estate market. As the result of losses sustained in subprime mortgages, banks and other lenders could no longer provide funds as readily for the purchase of prime mortgages. The resulting few percent drop in the value of prime mortgages has served to wipe out the entire capital of prime mortgage lenders whose capital was so highly leveraged that it constituted an even smaller percentage of the value of their assets than the few percent drop in the price of those assets. For example, if a mortgage lender initially had assets worth $103 and debts of his own of $100 incurred in order to finance the purchase of those assets, a mere 4 percent decline in the value of his assets would wipe out his entire capital and then some. Multiply these numbers by many billions, and the example corresponds exactly to the real-world cases of Thornburg Mortgage and Carlyle Capital reported on the front page of The New York Times of March 8, and to that of Bear Stearns reported on the front page of The New York Times just one week later.
The liquidation of the assets of such lenders, which consisted mainly of prime mortgages, has meant a further fall in the price of prime mortgages, to the point where the credit even of the government-sponsored mortgage lenders Fannie Mae and Freddie Mac has come into question. These two lenders have outstanding mortgage-backed obligations of more than $4 trillion, which sum until recently was assumed also to be an obligation of the US government. Now it has become uncertain whether the actual obligation of the US government extends beyond the less than $5 billion in lines of credit these lenders have with the US Treasury.
The Federal Reserve's rescue of Bear Stearns can be understood in part in the light of its desire to avoid further declines in the assets and capital of Fannie Mae and Freddie Mac, which would have resulted if Bear had had to sell off its holdings of mortgages. The likelihood that the failure of Bear would have triggered the failure of other major Wall Street firms and thereby have resulted in even more massive sell-offs of mortgages, along with other assets, was a related important consideration.
Remarkably, at the very same time that the Federal Reserve has been striving to cope with the consequences of excessive leverage and possibly thereby help to prevent the collapse of Fannie Mae and Freddie Mac, the government regulator of these institutions — the Office of Federal Housing Enterprise Oversight — is not content with the fact that they are already skating on dangerously thin ice. Thus, The New York Times of March 20 reports that the regulator has just decided to reduce their capital requirements, for the purpose of enabling them to take on still more leverage. The effect of this will be that an even more modest decline in home prices and mortgage values will be sufficient to drive Fannie Mae and Freddie Mac into bankruptcy than is now the case.
As these examples illustrate, the failure of debtors can serve to wipe out the capital of highly leveraged creditors, who then become unable to pay their debts, perhaps causing the failure of their creditors, and so on. In other words, one failure can set off a domino effect of a chain of failures. What serves to end the process is when someone in the chain finally accumulates enough salvageable assets from those earlier in the chain to be able to satisfy his creditors.
Leverage and Bank Capital
Operating alongside the process of chains of failures is another, even more important aspect of the leverage present in today's financial system. This is the fact that reductions in the capital of banks can result in multiple contractions of credit. As a rough average, banks are normally required to possess capital equal to five percent of their outstanding loans and investments. (Investments are purchases of securities.) The implication of this is that reductions in banks' capital below the five percent level have the potential to result in contractions of credit twenty times as large, in efforts to reestablish the five percent ratio.
For example, a bank with an initial capital of $5 billion could support $100 billion in outstanding loans and investments, based on the requirement that its capital be at least 5 percent of the credit it has granted. But if its capital falls to $4 billion, it must reduce its outstanding loans and investments to $80 billion to be in compliance with that requirement. In other words, a $1 billion reduction in bank capital can cause a $20 billion reduction in outstanding bank credit.
Such announcements as that recently made by Citibank, that it would reduce its holdings of home loans by 20 percent, are entirely consistent with this phenomenon, as are the recent failures of banks and brokers to make bids in markets for so-called auction-rate notes. (These are credit instruments whose interest rates are set periodically on the basis of auctions and that until recently were billed as the equivalent of cash. Bidding for them would have placed banks at risk of acquiring additional assets and indebtedness when they urgently needed to reduce their assets and indebtedness.)
Credit Contraction and Deflation
Of the greatest importance is the further fact that credit contraction by banks has the effect of reducing the outstanding volume of checking deposits in the economic system and to that extent the quantity of money in the economic system. This result follows from the fact that when debtors repay their loans, they do so by means of writing checks, the proceeds of which are subtracted not only from their accounts but also from the balance sheets of the banks on which the checks are drawn. If those banks do not then make equivalent new loans, accompanied by the creation of equivalent fresh checking deposits for new borrowers, the amount of the checking deposits used to repay the loans simply disappears. (The same result occurs when banks sell portions of their securities holdings to members of the public. The buyers of the securities pay for them by means of writing checks, and the proceeds of those checks then disappear not only from the checking accounts of the purchasers but also from the balance sheets of the banks on which the checks are drawn.)
Such contraction of credit and money operates to reduce the amount of spending in the economic system. The money that is no longer present in the economic system — because the credit that would have provided it has disappeared — is money that can no longer be spent. Money no longer spent is business sales revenues no longer earned. A drop in business sales revenues, in turn, causes a drop in spending by the firms that would have earned those sales revenues.
This further drop in spending reduces both the sales revenues of other firms, namely, those that would have supplied the firms in question, and wage payments to workers, as employees are laid off in the face of declining sales. And, of course, as wage payments fall, so too does the spending of wage earners for consumers' goods. The decline in spending, sales revenues, and wage payments is repeated again and again throughout the economic system, as many times in a year as the vanished sum of money would have been spent and respent in that year.
Of no less importance is the fact that a decline in the quantity of money and volume of spending can itself cause further declines in the assets and capital of banks. This is because as the sales revenues of business firms decline, so too do their profits and their ability to repay debts, including debts to banks. The resulting further declines in the value of bank assets further reduce the capitals of banks, causing more credit contraction, further reductions in the quantity of money and volume of spending, and still more reductions in the asset values and capitals of banks, on and on in a self-reinforcing vicious circle.
Bank Failures and Bank Runs
Historically, processes such as those just described have not taken place smoothly and gradually, in a manner akin to the air slowly leaking from some kind of giant inflated balloon. To the contrary, they have been characterized by sudden massive ruptures in the fabric of the system, namely, by bank failures, often precipitated by bank runs.
Sooner or later, the erosion of its capital makes a bank actually fail. What is meant in saying that bank failures were often precipitated by bank runs is merely that at some point depositors woke up to the fact that a bank's assets were no longer sufficient to guarantee the repayment of its deposits, and so raced to withdraw their funds while it was still possible to do so.
Bank failures, and even bank runs, are by no means a phenomenon confined to history. Intermittent bank failures continued to occur through the entire 20th century. And the present chairman of the Federal Reserve System has said that some bank failures are to be expected in our present crisis. Only late last summer there was not only a failure but also an actual run on a major British bank, Northern Rock. If our own credit crisis continues and deepens further, it should not be surprising to start seeing bank runs here in the United States as well. Indeed, what happened to Bear Stearns — which is an investment bank — on March 13 and made it seek the help of the Federal Reserve System was precisely a run, as large numbers of its clients sought to withdraw their funds all at once. It is very possible that what has just happened at Bear Stearns will also happen at one or more major commercial banks, whose customers hold checking or savings accounts. (In this connection, it should be kept in mind that federal deposit insurance is limited to a maximum of $100,000 per account. The run would be on the part of those whose accounts are larger than $100,000.)
When a bank fails, unless it is immediately taken over by another, still-solvent bank, its outstanding checking deposits lose the character of money and assume that of a security in default. That is, instead of being able to be spent, as the virtual equivalent of currency, they are reduced to the status of a claim to an uncertain sum of money to be paid at an unspecified time in the future, i.e., after the assets of the bank have been liquidated and the proceeds distributed to the various parties judged to have legitimate claims to them. Thus, what had been spendable as the equivalent of currency suddenly becomes no more spendable than any other security in default.
This change in the status of a bank's checking deposits constitutes a fully equivalent reduction in the quantity of money in the economic system. Thus, for example, if a bank were to fail with outstanding checking deposits of $100 billion, say, and not be taken over immediately by another, still-solvent bank, the quantity of money in the economic system would also immediately fall by $100 billion.
As a result of this fact, bank failures have the potential greatly to accelerate and deepen the descent into deflation and economic depression. For they represent much larger, more sudden reductions in the quantity of money and volume of spending in the economic system. And, just like lesser reductions, their effect, unless somehow checked or counteracted, is to launch a vicious circle of contraction and deflation. The period 1929–1933 provides the leading historical example.
In 1929, the quantity of money in the United States was approximately $26 billion and the gross national product (GNP/GDP) of the country, which provides an approximate measure of consumer spending, was $103 billion. By 1933, following wave after wave of bank failures, the quantity of money had fallen to approximately $19 billion and the GNP to less than $56 billion. The failure of wage rates and prices to fall to anywhere near the same extent resulted in mass unemployment.
The Potential for Deflation Today
In order to understand the potential for deflation today, in 1929, or at any other time, it is necessary to understand the concepts "standard money" and "fiduciary media." Standard money is money that is not a claim to anything beyond itself. It is money the receipt of which constitutes final payment. Under a gold standard, standard money is gold coin or bullion. Paper currency under a gold standard is not standard money. It is merely a claim to standard money, i.e., gold.
Since 1933, paper currency in the United States has been irredeemable. It has ceased to be a claim to anything beyond itself. Its receipt constitutes final payment. Thus, since 1933, the standard money of the United States has been irredeemable paper currency.
Most of the money supply of the United States, today as in 1929, is not standard money of any kind, but rather fiduciary media. Fiduciary media are transferable claims to standard money, payable on demand by their issuers, accepted in commerce as the equivalent of standard money, but for which no standard money actually exists.
What precisely fits the description of fiduciary media are checking deposits insofar as they exceed the reserves of standard money held by the banks that issue them. Checking deposits are, first of all, transferable claims to standard money, payable on demand by the banks that issue them, and accepted in commerce as the equivalent of standard money. To the extent that they exceed the currency reserves owned by the banks that issue them, they are fiduciary media.
At the present time, there are approximately $2.5 trillion of checking deposits in one form or another. These checking deposits are those reported as part of the M1 money supply ($625 billion), plus those reported as so-called sweep accounts by the Federal Reserve Bank of St. Louis ($765 billion),[1] and those reported as retail money fund accounts ($1078 billion).[2]
In addition to these checking deposits, our present money supply consists of approximately $800 billion in currency outside the banking system. Our total money supply is thus currently $3.3 trillion. Of these $3.3 trillion, the quantity of standard money is approximately $840 billion: the currency outside the banks plus $40 billion of currency reserves of the banking system.[3]
There are no reserve requirements on either sweep accounts or retail money fund accounts. Supposedly there is a basic 10 percent reserve requirement against the checking deposits counted under M1. Nevertheless, the actual reserves held against these checking deposits are not $62 or $63 billion, but merely on the order of $40 billion, which implies an overall effective reserve requirement of less than 7 percent against these checking deposits. When compared to the total checking deposits of the economic system, the roughly $40 billion of reserves constitute a reserve on the order of less than 2 percent. This is the measure of the leverage of today's banking system with respect to reserves.
In an ongoing process of a vicious circle of bank failures, a falling quantity of money and volume of spending, and thus falling business sales revenues, mounting business losses and business failures, resulting in still more bank failures, the volume of checking deposits might ultimately be reduced all the way down to the system's $40 billion of standard money reserves. This last is the actual currency either in the possession of the banks or belonging to them while held by the Federal Reserve System. This currency is the only asset of the banks whose value cannot be reduced by the failure of debtors.
The potential deflation of checking deposits, if nothing were done to stop it, is the difference between their present amount of $2.5 trillion and the $40 billion of reserves that stand behind them. The potential deflation of the money supply as a whole, if nothing were done to stop it, is the difference between $3.3 trillion and $840 billion, i.e., approximately 75 percent.
Why Massive Deflation Must Be Prevented
Massive deflation is always something that should be avoided if it is humanly possible to do so. The surest and best way to avoid it is to avoid the prolonged credit expansions that set the stage for it.
The only way that the economic system can adjust to deflation once it has occurred is by means of corresponding reductions in wage rates and prices. These serve to increase the buying power of the reduced quantity of money and the reduced volume of spending that it supports. If they were sufficient, they would enable the reduced quantity of money and volume of spending to buy all that the previously larger quantity of money and volume of spending had bought.
Yet there are powerful obstacles in the way of wage rates and prices falling. Not the least of these is the prevailing belief that rather than it being the reduction in the quantity of money and volume of spending that is deflation, it is the fall in wages rates and prices that is deflation. This incredible confusion leads to misguided attempts to combat deflation by means of preventing the only thing that would make possible a recovery from deflation, namely, a fall in wage rates and prices.
This confusion is joined by the even more influential errors of the Marxian exploitation theory, which claims that employers would arbitrarily set wage rates at the level of minimum subsistence if not prevented from doing so by government intervention. The result of this stew of ignorance is the existence of laws such as pro-union and minimum-wage legislation, which make it extraordinarily difficult or plain impossible for wage rates to fall. These laws are tantamount to simply making it illegal for the process of recovery to proceed.
To these laws must be added the virtual paralysis of our present-day judicial system. Not only do convicted murderers often sit on death row for years or even decades before their sentences are carried out or finally set aside, but ordinary law suits now normally take years to wind their way through our court system. A leading consequence of a massive deflation would be millions upon millions of business and personal bankruptcies, which our court system is simply not equipped to handle. The functioning of an economic system depends on clear knowledge of who owns what and who has the legal right to do what with what property. It cannot wait years for judges to make clear and final decisions about such matters, which is the likely period of time it would take them if the present typical performance of our judicial system is any guide.
Given these legal obstacles, the effect of massive deflation would be long-term mass unemployment and economic paralysis. Literally tens of millions would be unemployed, with no way to find new employment. Such conditions, in combination with the massive economic illiteracy that prevails in our culture, would likely result in the adoption of many new and additional acts of destructive government interference. It would not by any means be out of the question that the likes of a native-born Hugo Chavez could be elected president of the United States.
True and False Remedies
It should be obvious from much of what has been said in this article that what is driving our impending deflation is the lack of capital on the part of the banks, resulting from the losses they have thus far sustained on their assets. This is what has been impelling them to contract credit, and which, if unchecked will serve to reduce their assets and capital further and further, until much or all of the banking system and the checking deposit money it has created collapses under its own weight for a sheer lack of monetary reserves.
In the light of this knowledge, such solutions as the recently enacted "stimulus package" designed to promote consumer spending should be dismissed as laughably naive. The economic system is not going to be rescued by consumers, let alone by consumers so incapable of producing that they require government handouts in order to consume. No one benefits by giving people the money with which to buy his products. Yet this is the position such programs force taxpayers to assume.
Likewise, when one keeps in mind that the problem is a lack of capital, such alleged solutions as the Federal Reserve's current policy of reducing interest rates must appear as clearly counterproductive. Reductions in interest rates in the United States relative to those in Europe and elsewhere serve to keep badly needed capital out of our country by making investment there more profitable than investment here. In keeping down the overall supply of capital in the United States, they contribute to the lack of credit and to making it more difficult for banks to obtain the additional capital they need. The Federal Reserve has carried this policy a large step further, with its most recent reduction in the federal funds rate from 3 percent to 2.25 percent.
Similarly, the rescue measure proposed for homeowners faced with foreclosure, namely, forcibly reducing interest rates on sub prime mortgages in violation of the contractual terms of the mortgages and against the will of the mortgage holders, would serve further to reduce the earnings, assets, and capital of the banks. Decisions of judges to place obstacles in the way of the foreclosure process, such as insisting on the presentation of the original mortgage documents, even though it is undisputed that the borrower is in default, also serve to weaken the financial position of banks. It can do so not only directly but also indirectly, by contributing to the bankruptcy of non-bank mortgage lenders with debts to banks.
The sympathy expressed for the families threatened with foreclosure is very largely misplaced. It is forgotten how many of them purchased their homes without making any down payment of any kind, and often without being obliged to make any payments of principal on their mortgages. Many of the homes now being foreclosed were purchased by such buyers not for the purpose of having a place to live, but for the purpose of profiting from a speculative investment.
Of course, there are also some homeowners who did make substantial down payments in purchasing their homes, even during the housing bubble. But there are many more who purchased their homes before the bubble began but who in recent years foolishly chose to consume their equity, by incurring additional debt to finance consumption in excess of their incomes. At the time, these people were lauded as pillars of the economy's strength, on the basis of the same ridiculous beliefs that underlie the proposals to rescue the economy now by still more consumption on the part of people who can't afford it.
The effect of the years of Federal Reserve–sponsored credit expansion and the resulting spending binge on housing that people could not afford was to make housing unaffordable by millions of other people. It was to raise median house prices in many places to the point where only the top 15 or 20 percent of income earners in the area could afford the median-priced home. To make housing affordable once again by the mass of people who normally could afford to buy a home, housing prices need to fall to whatever extent their rise in recent years has exceeded the rise in median family incomes. The foreclosure process is an essential step in bringing that about. It should not be prevented in any way from taking place.
How to Increase the Capital and Reserves of the Banking System
Since the problem behind our impending deflation is the lack of capital on the part of the banks, and beyond that the lack of monetary reserves to maintain the supply of checkbook money when banks fail, it should be obvious that what is needed to avoid the threat of deflation is an increase in the capital and reserves of the banks.
When the problem is stated this way, a thought that is likely to occur to many people is that the banks should simply go out and raise additional capital. They should sell stocks and bonds, for example. And, in fact, that has actually happened in some cases, for example, that of Citibank, which raised $14.5 billion in new capital from foreign investors this last February.
One problem with such a procedure is how much of the bank's ownership has to be given to the new investors to make their investment worthwhile for them. And, as indicated, raising the necessary capital is made more difficult by Fed's policy of low interest rates, which keeps down the supply of capital by discouraging foreign investment in the United States. Another, deeper problem for many banks is that in the minds of potential investors the bank's actual capital may be negative, requiring investors to put up not only new and additional capital but also capital required to overcome the bank's negative capital. (Negative capital can easily result when on the left-hand side of a bank's balance sheet there are tens or hundreds of billions of dollars of assets whose value can decline, while on the right-hand side there are tens or hundreds of billions of dollars of deposits whose value is fixed. As we saw earlier, when capital is only a very few percent of assets to begin with, even a modest decline in the value of assets can turn it negative.)
The existence of negative capital entails requiring first an investment sufficient to reach the point of zero capital — and only then the investment of the capital that will enable the bank to maintain and increase its operations. Moreover, the extent of the capital deficiency may not even actually be knowable. Such considerations make the raising of additional capital by conventional means extremely difficult or altogether impossible. It's a case simply of having to invest too much in order to receive too little.
In these circumstances the only party willing to provide the needed capital funds is the government, i.e., the Federal Reserve System, which has the power simply to print them if necessary.
At present, the Federal Reserve is already supplying the banking system (and the major investment banks as well) with capital. But it is doing so only to the extent of overcoming negative capital, and perhaps doing that less than fully. This is the essential meaning of the Fed's acceptance of billions of dollars of assets of dubious value in exchange for its own assets of relatively secure value, i.e., US government bonds and Treasury bills. (The Fed now even accepts assets for which there is no market because finding a market would require a radical reduction in the price of the assets compared to what was originally paid for them, and correspondingly wipe out capital on the books of the banks.)
The Fed has committed almost half of its own principal assets to this project: $400 billion out of its most recently reported total holdings of government securities of $828 billion. It will not be able to commit much more of those securities. Indeed, however ironic it may be, the Federal Reserve — the "lender of last resort," the alleged bailer-outer of the banking system and of the whole economy — is or may fairly soon be itself technically bankrupt as the result of this operation. (This would be clear if the assets it receives had to be valued at their actual market value. The result would be that the assets of the Fed would be less than the face value of its outstanding US currency and other liabilities.)
Unless the Fed's actions up to now prove sufficient to end the financial crisis, its next step will be the printing of money to prop up the banking system. Indeed, even if the crisis were to end as of now, there would still be the problem that the Fed's infusion of capital has thus far been only on a temporary basis. The banks are supposed to take back their low-grade and non-performing assets within a month or so and return the Fed's securities. Clearly, a solution to the problem of a lack of bank capital needs to be long-term, not something that must be renewed month by month.
Moreover, a proper solution to our present crisis should do more than merely overcome the difficulties of the moment. It should, in addition, provide a guarantee against the recurrence of such crises in the future. Above all, a proper solution to this or any other economic or political crisis should also meet the criterion of serving to advance the cause of economic freedom and should be designed with that objective in mind.
There is a means of accomplishing all three of these objectives.
That means is the use of gold as a major asset of the banking system.
Despite the certainty that a proposal of this kind will be almost completely ignored and has virtually no chance of being enacted in the foreseeable future, it still must be made. This is because the most fundamental and important consideration is not what people are willing to accept or reject at the moment but what would in fact accomplish the objectives that need to be accomplished. Using gold as a major asset of the banking system, in the way set forth below, would in fact safeguard the banking system from possible deflationary collapse, prevent the recurrence of any such threat, and do so in a way that substantially advanced the cause of economic freedom. Making the proposal is necessary in order to uphold the philosophy of economic freedom, by providing a demonstration that that philosophy offers the solution to the growing monetary problems we face and is not their cause.
Gold as the Source of New Bank Capital and of Reserves
The Federal Reserve System holds approximately 260 million ounces of gold. The market price of gold recently reached $1,000 per ounce. This means that the Fed's gold can easily be thought of as an asset with a market value of roughly $260 billion.
As an initial approach to understanding the solution to our problem, let us assume that the Federal Reserve declared its gold holding as being held in trust for the benefit of the American banking system, and proceeded to allow every bank to enter on the asset side of its balance sheet a portion of this gold corresponding to its share of the total of the $2.5 trillion of checking accounts presently in the economic system. The banks would not physically possess the gold but only book entries corresponding to it.
The gold entered on banks' balance sheets could also count as equivalent new and additional bank reserves. Thus the measure would simultaneously add $260 billion of new and additional bank reserves in the form of gold as well as $260 billion of new and additional bank capital. The reserves and the capital would both be essentially permanent.
In order to prevent the monetization of the gold reserves, the Fed could mandate a permanent required gold reserve against all checking deposits — those counted in M1, those counted as "sweeps," and those counted as retail money funds — in the ratio of $260 billion to $2.5 trillion, i.e., a little over 10 percent.
A major shortcoming of this very simple solution is that the addition of $260 billion in gold to bank assets would probably be insufficient. It almost certainly would be if the Fed decided, as it should, to take back its government securities from the investment banks and give them back their securities of far less value. That would probably bankrupt most or all of the investment banks. Furthermore, because the commercial banks are their main creditors, the assets of the investment banks would move into the possession of the commercial banks and do so, of course, at a far lower value than the loans that had been made to the investment banks. Thus, the present capital of the commercial banks and much more would be wiped out.
Accordingly, the book value placed on the Fed's gold holding needs to be substantially higher than $1,000 per ounce, if it is to result in the creation of sufficient bank capital and reserves. The question is, how much higher?
The most logical answer to this question was supplied as far back as the 1950s by the late Murray Rothbard, who argued for the establishment of a 100-percent-reserve gold standard by means of pricing the Fed's gold stock at whatever price was necessary to make it equal the outstanding supply of money.
Taking the outstanding supply of money today as being $3.3 trillion, Rothbard's proposal implies a gold price of approximately $12,700 per ounce. At such a price, the Fed's gold stock would be sufficient to provide a 100 percent reserve against all US checking deposits and all US currency.
The provision of a 100 percent reserve would be an immediate guarantee against any reduction in the supply of checkbook money. This would obviously be the case if the banks simply paid out gold in response to customers' demands for the redemption of their checking deposits. At $12,700 per ounce, the banks and the Fed would have enough gold to redeem every single dollar of checking deposits and currency in the economic system. (That's the meaning of a 100 percent reserve.)
Of course, in the circumstances envisioned here, the banks would not pay out physical gold. But they would have the ability to pay out paper currency to the full extent of outstanding checking deposits, and that currency would have an undiminished gold backing at the price of gold of $12,700 per ounce. Thus whatever the recession that might develop in the months ahead, it would be contained, insofar as the money supply of the country would not be reduced. That would guarantee a major reduction in the possible severity of what might otherwise develop.
This 100-percent-reserve gold standard as thus far described would obviously be a long way from the full-bodied 100-percent-reserve gold standard that Rothbard envisioned, and which I myself have elaborated upon and advocated. It would be a standard that for some time was largely just nominal, in that the actual gold of the monetary system would still be in the possession of the Federal Reserve System. Nor would there yet be any obligation of the Fed to buy or sell gold at the price of $12,700 per ounce or at any other price. The purpose of the system I have described would simply be the twofold one of providing reserves sufficient to prevent any possible reduction in the supply of checkbook money and also of providing capital to banks sufficient to substantially more than offset the losses otherwise resulting from a decline in the value of banks' assets.[4]
Indeed, given that what would be present is an addition to the assets of the banking system in an amount equal to the full magnitude of outstanding fiduciary media, i.e., of $2.5 trillion of checking deposits minus $40 billion of presently existing standard money reserves, the overwhelming likelihood is that the banks would be handed far too much capital. Even with losses of $1 trillion on their existing assets, they would still stand to gain practically $1.5 trillion in new and additional capital. Such a bonanza would not be justifiable. The solution would be to pass most of it on to the banks' depositors in the form of bank stock or bonds paid as a dividend on their accounts.
It is not possible in the space of one article to explore, beyond the very limited extent to which I've done so,[5] the problems and the solutions entailed in moving on to the full-bodied 100-percent-reserve gold standard that is the ultimate objective of my proposal. Under such a gold standard, paper currency and checking deposits will, of course, be fully convertible into gold, physical gold coin will enjoy wide circulation, and the supply of gold in the country will be free to increase or decrease simply in response to market forces.
All I have tried to show here is how the twin problems of a lack of bank capital and of bank reserves, which are the core of the threat of deflation, could be solved by means of establishing the framework of a 100-percent-reserve gold monetary system.
$22
$95 $80
Needless to say, such a system would not only end the threat of deflation, but, equally important, it could end the threat of inflation as well. For if it were actually followed, the increase in the quantity of money would be limited to the increase in the supply of gold, which is extremely modest compared with increases in the supply of irredeemable paper money. This is because gold is rare in nature and costly to extract. Irredeemable paper money in contrast is virtually costless to produce and is potentially as abundant as the supply of currency-sized sheets of paper, indeed, as abundant as the size of the largest number that can be printed on all such sheets of paper.
Above all, the solution I have proposed would constitute a major step toward the establishment of a full-bodied precious metal monetary system and thus toward ultimately eliminating the government's physical control over the money supply and all of the violations of individual freedom that that control represents and makes possible.
And what is more, it could be accomplished at a cost to the Federal Reserve not of hundreds of billions of dollars — the sums the Fed is risking in exchanging its government securities for bank assets of vastly lower value — not for the $30 billion it has risked to bail out just Bear Stearns, but for a little more than $11 billion! Just $11 billion is the value at which the Fed carries its gold stock on its balance sheet, at a price of gold of approximately $42 per ounce.
Thus, to say it all in one sentence, the threat of massive deflation can be eliminated, the threat of inflation ended, and the actual and potential domain of economic freedom greatly expanded, for $11 billion — an $11 billion that would not even be an out-of-pocket expense to anyone but merely a balance-sheet charge on the books of the Federal Reserve System when it deducted its gold holding from its balance sheet and added it to the balance sheets of the banks.
--------------------------------------------------------------------------------
George Reisman, Ph.D. is the author of Capitalism: A Treatise on Economics and is Pepperdine University Professor Emeritus of Economics. His web site is www.capitalism.net, and his blog is www.georgereisman.com/blog. Send him mail. Comment on the Mises blog.
Copyright © 2008 by George Reisman. All rights reserved.
Notes
I am indebted to Professor William Barnett, II, of Loyola University, New Orleans. His recent internet postings on the mises@yahoogroups list made me aware of the fact that the capital requirements of banks under the Basel II Capital Accord, rather than official reserve requirements imposed by the Federal Reserve System, is all that has served to constrain the increase in the quantity of money in the United States in recent years. His comments also served to provide important insight into understanding the role of banks' capital requirements in explaining essential aspects of their recent behavior as well as their likely behavior in the weeks and months ahead.
[1] Sweep accounts are checking deposits that banks transfer into savings deposit accounts overnight, on weekends, and on holidays, in order to reduce their required reserves and thus be able to use any given amount of reserves to support a larger volume of checking deposits.
[2] Inasmuch as the accounts subsumed under this last head generally allow the writing only of a limited number of checks per month, and sometimes impose limits on the minimum dollar amount of the checks that may be written, they probably should not be counted as part of the money supply to their full extent. To precisely what extent they should be counted is an open question. Nevertheless, it may be that counting them to their full extent represents a lesser error than attempting to adjust them downward. This is because doing so makes allowance for the extent to which roughly $2.1 trillion of institutional money funds may also actually serve as money.
[3] The $800 billion of currency outside the banks is counted as part of the M1 money supply along with the checking deposit component of $625 billion previously referred to. Thus, at present, M1 is approximately $1.4 trillion.
[4] It should be realized that in the absence of any commitment of the Fed to buy gold at $12,700 per ounce, the market price of gold would almost certainly be radically lower. To the extent that additional gold could be purchased at lower prices, the possibility would exist of increasing gold reserves relative to outstanding checking deposits and currency and thus of ultimately having a 100-percent reserve at a price of gold less than $12,700 per ounce. Furthermore, it should be kept in mind that the Fed would need to proceed with great caution in purchasing additional gold. The danger to be avoided is that of initially drawing a disproportionate share of the world's gold to the United States, when it alone was in process of remonetizing gold. If the US economy became accustomed to such a large gold supply, and then, later on, if and when the rest of the world remonetized gold and drew much of that gold back out, the US would be in the position of experiencing first a virtual inflation in terms of gold and then a virtual deflation in terms of gold, the very kind of sequence of phenomena that a properly established 100-percent-reserve gold standard would permanently prevent.
[5] See above, the preceding note.
Enjoy,
-Sapiens
Comment