Well Well, Look What The Cat Dragged In

The Cat Dragged In


I’ll be damned….

Banking is therefore not a normal market activity, because it provides two linked public goods: money and the payments network. On one side of banks’ balance sheets lie risky assets; on the other lie liabilities the public thinks safe. This is why central banks act as lenders of last resort and governments provide deposit insurance and equity injections. It is also why banking is heavily regulated. Yet credit cycles are still hugely destabilising.

A maximum response would be to give the state a monopoly on money creation. One of the most important such proposals was in the Chicago Plan, advanced in the 1930s by, among others, a great economist, Irving Fisher. Its core was the requirement for 100 per cent reserves against deposits.

The Chicago Plan is interesting in a number of ways, but a few years ago I authored a piece (which I had also featured inLeverage) called “One Dollar of Capital.

“100% Reserve” banking, as The Chicago Plan and others have advocated, sounds good at first blush but in fact it mayfunctionally be not 100% but a 200% reserve requirement, which not only goes too far mechanically (that is, well beyond what is necessary for stability) but in addition would be likely to return our financial and market systems to something akin to the 1500s overnight.

You wouldn’t like that world one bit!

Specifically, there are perfectly-legitimate short-term reasons to lend against easily-valued collateral (at a discount to reflect the risk that the collateral’s disposition will not raise the total amount borrowed); the most-obvious that is utterly necessary in a global economy is found in global trade where letters of credit allow the shipment of goods across international boundaries without ridiculous amounts of financial friction in the transaction.

Envision a 100% reserve world as The Chicago Plan; such a letter of credit would require that a depositor be willing to “back” that letter of credit.  The instrument itself is a market response to wildly-divergent legal structures between nations and the inherent difficulty in enforcement of a commercial contract when jurisdictional boundaries are crossed.  It is bad enough when you have a commercial dispute with a vendor or customer in the US and have to sue in a different state; a Chinese vendor who has to sue you here in the US for payment (or vice-versa) presents nearly-insurmountable obstacles for smaller concerns.

There are those who argue that imposing a strict “mark-to-market” standard would lead to cheating and impossible-to-value situations (which gets us right back to “mark to fantasy” as we have now.)  They miss the essential point; not only do we have these things called computers that were constructs of science fiction in the 1930s and information flows that make the immediate valuation (with a reasonable discount reserve percentage to guard against market movements) of most physical goods not only possible but eminently reasonable but in addition a statutory structure that involves voluntary disclosure of all assets held in detail on a daily basis as the quid-pro-quo for the extension of credit against tangible value and immediate forced liquidation of any firm that finds itself in a negative equity situation means that (1) independent and immediate verification of solvency by anyone who cares to do so becomes trivial and (2) the penalty for violations is immediate and severe enough (dissolution of the business!) while not presenting any systemic risk that enforcement does not present the obstacles that are currently present.

Every now and again over the last couple of years something along these lines has popped up in the media, with most of the mentions centered around The Chicago Plan.  The problem with implementing such a standard, beyond the political power of the big banks that would lose their ability to siphon off ridiculous amounts of a nation’s wealth through intentional creation of credit for which there is no backing, blowing bubbles and keeping the proceeds during the “boom” while being protected from their own hubris when the inevitable “bust” comes (since they caused it!) is that there is a perfectly-legitimate argument against 100% reserves to be found in the mechanisms of global commerce because the ordinary demands of global commerce turn a “100% reserve” requirement into a de-facto 200% reserve, crippling the clearance of ordinary commercial transactions in the global economic environment.

At its core the problem comes down to the definition of “M” in the classical economic equation “MV = PQ.”  “M” is contemplated as money but in fact it is moneyness; that is, money + credit.  Those who argue otherwise yet have a credit card in their wallet are either intellectually deficient or intentionally misleading the public.  Neither is acceptable and likewise it is not acceptable to design a system that actively removes moneyness from the system as tangible economic activity grows.

One Dollar of Capital as described both in my linked missive and in Leverage removes that barrier and thus prevents the faux “Hobson’s Choice” arguments from being persuasive while at the same time solving the problem of credit boom and bust cycles.  It further puts an end to the chimera of “2% inflation” as a profitable goal for private banking interests and the ratcheting mechanism for prices that they, in concert with governments, have leveraged over the last 100 years to steal from the common citizen.

Breaking the perverse and interlocking incentives that make this “ratcheting” mechanism desirable for both private banking entities and governments is essential.  We have seen over the last 100 years of The Fed’s existence that their willful and intentional violation of their statutory mandate to maintain stable (unchanging!) prices has not only been ignored it has beenapplauded by those on Capitol Hill; the reason for this is simply that their so-called “inflation target” encourages and permits deficit spending as a matter of public policy and that is one of the primary means by which Congress buys votes and deceives the common man.

In short, it’s time.

The Market Ticker

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