Friday, January 23, 2009

The Banking System Has Caused Economic Slowdown

The consensus argument (which is often wrong) is that the banking system has caused the current economic malaise. In general, recessions and depressions are monetary. The Great Depression was a monetary phenomenon. This time, the Fed has ballooned money supply yet the slowdown continues. Of course, it is likely that there is a lag, and in a month, two or three there will be a turnaround. The stock market, however, continues to fall. This may have to do with continued media publicity. If the lag or media publicity arguments do not turn out to hold, the culprit is the banking system itself, which is what I keep hearing.

Not that money supply is independent of the banking system. Much of the money supply is created by the banks. But if the money supply is the reason for depressions and recessions, there is an argument to maintain the current banking system--the Fed can counter panics and so fractional reserve banking's chief problem (the threat of runs) can be countered. But not if the banking system itself is faulty. Then the argument for the current fractional reserve system is attenuated. Then, fractional reserve banking is in part responsible for misallocation and slowdowns, and money supply (itself a product of fractional reserve banking) is only partly to blame. In that case, a clear thinking public (sans the New York Times, pro-bank "liberals" and the like) ought to ask why the the banking is perpetuated given its dismal performance.

Fractional reserve banking is a form of fraud and need not be legal. Bankers lend out more money than they have on reserve. For every one dollar deposit, banks lend out up to six additional dollars. These dollars are covered by incoming new deposits. The system is not far from a Ponzi scheme. New investment covers old loans. It works if borrowers come and go with regularity. The problem until the days of the New Deal was that they frequently did not. There would be "runs", banks would falter and depressions would result.

Without fractional reserve banking there would be more savings and less economic activity. The economic activity that occurred would be more rational than it is with fractional reserve banking. Over time, better projects would be built and there would be more innovation because investors would be more focused on rational investments. This would stabilize economic outcomes over time, as more good ideas were implemented as were fewer bad ones. There would be less reckless depredation of the environment as unnecessary housing and manufacturing would be cut back. Higher unemployment levels over the intermediate and perhaps long term could be subsidized through relief, just as it is now. Interest rates would be higher and more people would save. There would be less or no inflation (and perhaps deflation) so people planning for retirement would not need to rely on the stock market. Savings would generate adequate returns for retirement. Better investment would be made, so that statistical economic growth might be slower but substantive economic growth would be much faster. The difference to which I'm alluding, satistical versus substantive economic growth, is that statistical growth includes garbage investment like sub-prime housing and public schools that do not produce value. Substantive economic growth would include private schools that do produce value and housing that people really want.

Banks need not be permitted to lend more money than they have. The argument for doing so is economic growth. But the argument against it is the rape of America's retirees; and the stifling of innovation caused by the misallocation of credit and irrational turns in the economy due to banking panics--on the part of bankers themselves.

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