Saturday, September 27, 2008

The Bailout Debate: Disgraceful Failure of American Democracy

The following questions should be addressed before there is further talk of a bailout for banks and insurance companies.

1. What was the role of the Federal Reserve Bank's monetary expansion in facilitating overly aggressive lending that lead to financial loss?
2. Given that Fed policy may have caused multi-trillion dollar losses, can we continue to sustain this institution, whose sole putative purpose is to professionally manage the money supply?
3. What is the role of fractional reserve banking in causing the losses, and given the large losses, are we certain that the institution of fractional reserve banking to which we have become accustomed is economically justifiable?
4. Are we certain that federal regulation of the money supply and banking is preferable to state regulation?
5. Would re-institution of a gold standard inhibit future losses of this kind?
6. Why is Congress not discussing a gold standard, and why does the media avoid this question?

These questions have not been asked. They have not been asked by the liberal media, by the O'Reilly Spin Zone, by talk radio's right-wing Progressives like Rush Limbaugh and Sean Hannity, or by our political leaders. This failure to debate an aggressive, socialistic bailout is disgraceful. Americans have become like sheep, following the presidential shepherd leading them over a progressive cliff into the socialist pit.

Successive generations of progressives have weakened American democracy. In the 19th century, relatively limited government and a greater role for the states limited the cognitive demands on American voters. Americans did not need to pretend to be experts on banking, military, tax and industrial safety policy. Although there were issues, they were narrower in scope. Progressivism claimed that democracy was capable of managing such diverse issues through the expertise of college-trained experts. Thus, progressivism was associated with accentuated imperialism in the Spanish-American War, the income tax, workers' compensation, the Sixteenth Amendment and the Revenue Act of 1913 establishing the federal income tax, and establishment of the Federal Reserve Bank in 1913.

The issue of banking has become salient this month and it may pay to recall that, until the National Bank Acts of 1863 and 1864 and the federal tax on currency issued by state banks passed in 1865, the states were free to regulate banking, and they did so in diverse ways. Some western states did not allow fractional reserve banking at all and others limited the establishment of banks. Note that fractional reserve banking is not the only kind of banking available. Savings and Loans have traditionally lent based on their mortgage holdings rather than on a one sixth fractional reserve.

There is a thin line between fractional reserve banking and outright fraud. Bankers lend money that the bankers do not hold. They rely on the probability that enough deposits will be made the next day to cover the loans that they make. Writing a check to someone when you don't have the money is usually considered fraud, and frequent bank runs and inflation due to bank-issued currency led to economic cycles in the nineteenth century. States were subject to public opinion, and to the extent that they violated this trust there were political upheavals, as with the Loco Focos in New York in the 1830s, who took over the Democratic Party in response to banking "monopolies" or charters.

Laissez-faire principles do not require acquiescence to fraud, and at the height of laissez-faire in America there was considerable distrust of banks even though the nation depended upon them for economic growth. Because of this distrust, Andrew Jackson stopped depositing federal monies in the central bank in 1833 and the central bank lost its federal charter in 1836.

Until 1913 there was no central bank, although the Banking Act of 1864 established national charters and state and federal banks co-existed thereafter. During the Civil War, the United States issued "greenbacks" that led to a significant inflation in the post-Civil War era. Pundits of that time, such as EL Godkin, founder of the Nation magazine, frequently noted the connection between inflation and subsidization of speculation by Wall Street buccaneers such as Jay Gould.

Although there were frequent complaints of "depressions" in the late nineteenth century it is difficult to grasp their severity or the meaning of the term. Immigration considerably accelerated in the post-Civil War era as big business began to dominate the American landscape. Why did immigration accelerate at the very time that leftists argue that depression dominated the American economy and big business oppressed workers?

The fact is that real wages increased steadily during the late nineteenth century despite the "great deflation". Prices were going down and workers were mistreated but real wages were increasing and the ones who were really in trouble were the business owners, whose profit margins were squeezed by intense competition. Thus, the term "depression" may more accurately reflect a "profit depression" than unemployment.

In the 1890s, due to global monetary conditions (a shortage of precious metals) there was a slight inflation, but the public found this troubling. The inflation that Walter Weyl mentions in his New Democracy was in the range of 1% per year. Woodrow Wilson had no intention of abolishing the gold standard, and the Fed was initially viewed as a way to more professionally manage monetary policy and foreign exchange. It was related to the Progressives' interest in globalization as a way to extend the then-closed frontier. Subsequently, the FDR administration abolished the gold standard.

The question needs to be asked whether fractional reserve banking is a good idea. The Fed was established in part to rationalize the banking system and oversee foreign transactions. However, the banking system owns the Federal Reserve Bank and there is often political pressure for the Fed to permit excessive lending from politicians. Excessive lending leads to fast economic growth, but as I have previously blogged many times, the quality of the growth deteriorates as credit expands because of a diminishing marginal returns principle.

The purpose of the Fed is to more professionally manage the money supply than existed in the nineteenth century. But the economy has been choppier since the Fed was established. The Great Depression and the terrible inflation and stagflation of the 1970s were worse in many ways than any 19th century depression.

The current troubles of American lending institutions, including some banks as well as investment and insurance companies, is evidence that the costs of these institutions exceed their benefits. Normal market institutions charge what the market will bear and their existence is justified if they make a profit. If their costs are too high they close. The fact that the accumulated profits of investment banks and insurance companies are insufficient to cover losses means that the institutions have failed to provide a social service and should be closed. There would be little loss to the public.

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