Winterspeak, meanwhile, responds to my post on duration-matched banking:
1. It would involve a massive, massive credit contraction. Hello, Great Depression.2. Actually matching pool credit to particular loans would be a much more expensive business than the current banking system.
3. The expansion of credit has historically enabled a lot of things we like, such as homeownership and entrepreneurship.
4. How many people want to pay the bank to hold onto their money?
5. A smaller credit system will not ultimately prevent inflation/deflation. Without interest bearing accounts, savings become a wasting asset.
6. To the extent that it does prevent inflation, this is not necessarily a good thing--a little inflation greases the labor market, mitigating the effects of demand shocks.
1. It sure would. That said, the US$ has lost over 90% of its value in just three generations, and if that's a feature of the system, how great is that system?2. Matching pool credit would be more expensive than maturity mismatched accounting as you would switch to, essentially, a multiple year cash accounting system. Other costs would be lower though -- no more FDIC. Other costs would be much lower, remember the US taxpayer is on the hook for almost $1T (yes, T) shoring up bad housing loans and the shadow banking system via recent Treasury and FNMA intervention.
3. Entrepreneurship would go on unimpeded. Remember, VC funding (a key driver of entrepreneurship) *is* maturity matched. Speculation would be less well supported though, and that is a feature, not a bug.
4. Suppose money did not lose value such that it became near worthless in three generations? Suppose you were hiring someone to protect gold? If we lived in a world of mild deflation (zero currency dilution + technological improvement) then paying a modest fee to have our cash stashed someplace safe would be fine.
5. You are correct that a smaller credit system will not, in and of itself, impact inflation/deflation. Monetary dilution (or concentration) is what drives inflation/deflation. Credit is part of this, and a bank's ability to extend credit (print money) via brittle maturity mismatched instruments is certainly dilutive. But there is also the government's dilutive ability to run the presses, and that element is quite independent of whether maturity mismatching is allowed or not.
6. The standard line is that some inflation makes it easier to cut wages, which has beneficial impacts on the labor market. I used to believe this also, and I still think it has some truth. I also think that, in an environment of mild deflation, over time people would make their peace with nominal wage cuts in the face of demand shocks.
There is no such thing as a perfect system. The question is whether the current credit system is better than a system without fractional reserve banking. Observationally, societies without banks didn't have great capital systems, but of course, that generally involves societies at a low level of economic development, or Muslim countries.
On the specific points:
1. We both agree that while fractional reserve banking is the current vehicle of inflation, since the invention of the Federal Reserve that is more a matter of convenience than a necessity. If the government wanted to inflate the currency under a full-reserve system, it could simply run the printing presses. So I don't see that this objection holds. Moreover, I don't see why this is such a terrible thing. The Great Inflation of the 1970s was terrible, but the central bank is unlikely to let that happen again. A long, slow erosion of the dollar didn't do anyone much harm--financial assets are priced to cover the erosion, and non-financial assets generally rise along with the broader price index.
2. The bad housing loans are duration matched--they were all securitized. As long as trading firms need working capital, there will never be perfect duration matching in the financial system as a whole. In addition, the US taxpayer is not going to pay anything like $1 trillion; that would require every single borrower to default. The cost to the taxpayer is the default risk plus the opportunity cost of the funds; this is probably pretty small.
3. Lots of businesses get their start on credit cards, mortgages, and bank loans. Moreover, the VC pool of funds is "extra" money. Fractional reserve banking lets us tap the short money pool for longer term projects. Without it, there would be less funding for new businesses.
4. Psychologically, hiring someone to protect your gold is different from loaning it to them at a low interest rate. Many people would store their money in their homes, which would, among other things, up the returns to robbery.
5. We agree.
6. Look at the trouble even industries in deep trouble have securing nominal reductions in benefits, much less wages. Even collective bargaining agents accept plant closures rather than broader nominal wage cuts. Nominal wage cuts would also produce heavy political pressure for government interventions.
Mostly, it's simply not clear to me what the giant problem is that duration matching is supposed to solve. Over time, the banking system has produced a lot of growth and a great deal of convenience. The cost to the taxpayer has been pretty small--even the S&L Bailout had a relatively minor effect on real growth. If it ain't broke, don't destroy it.
From Megan:
Really? This assumes that everyone catches the benefit of new money at the same time, which is clearly not the case. Those at the spigot mouth get the benefit, while everyone else downstream gets increasingly smaller benefits while suffering the corresponding losses in ever greater amounts.
That said, the US$ has lost over 90% of its value in just three generations, and if that's a feature of the system, how great is that system?
The US$ has, but most people don't keep their wealth in the form of cash buried in the back yard.
Most people keep their wealth in some combination of stocks, bonds, real estate and commodities. And all 4 of those asset classes account for inflation. Bond yields account for it, stocks pay both dividends and adjust as the value of underlying assets rise, real estate and commoditie rise with inflation.
Obviously at 10% or 100% per year inflation is bad - just like anything is bad in excess - but 2-4% a year is actually beneficial.
"Most people keep their wealth in some combination of stocks, bonds, real estate and commodities."--jmo
That is hardly the case. "Most people" don't even have + Financial Net Worths beyond U$D 10K. The majority of the people, extant, suffer greatly from the insidious effects of Inflation, even our Founding Fathers knew it. It is the bedrock reason why they insisted, in the Constitution, that our Money be of Gold & Silver, to protect the less savvy among us from the ravages of Inflations caused by the Fractional-Reserve bankers..
jmo, in which world is it, that you're currently enjoying the beneficence of 2-4% Inflation?
Hi Megan:
All of your points are well taken, particularly your last one, which is that the US system is not all that bad, so why propose such a radical change?
My only answer is that "it could be so much better". Since a non-factional reserve banking system has not been implemented in the modern world, I cannot point to any examples, but perhaps that may change in the future.
Ending maturity mismatch *would* solve the bank run/credit problem that the collapse in the housing market triggered. It is true that mortgages were maturity matched through securitization, but the institutions holding that paper ran on the fractional reserve system. When their asset value fell, they needed to hoard cash to build reserves, and this created the credit crises that has the US government putting $1T of taxpayer money at risk (final bill hopefully smaller), has the US$ losing 30% of its value, and has triggered massive commodity speculation as people look for somewhere, anywhere, safe to put their money.
There is only one way to prevent bank runs, and that's to not allow them to mismatch security. As you yourself point out, it's not like other regulatory approaches are going to solve the problem:
http://meganmcardle.theatlantic.com/archives/2008/06/two_four_six_eight_how_we_gonn.php
Maybe the problem has no solution. Maybe the best we can do is this boom/bust cycle, with 30% devaluation every generation.
But if China ever decides to stop buying dollars we will revisit this issue.
-winterspeak
Let me see... 2 - 4% inflation. Graduated from college in 1998 and rented a new apartment with a roomate for $1050 a month and bought a new VW Passat for $21,500.
Lets look up the rent at that apartment complex - internet search shows rents now at 1100. Cost of a 2008 VW Passat similarly equiped 24,500.
Sounds like 2-4% inflation to me...
But if China ever decides to stop buying dollars we will revisit this issue.
So you're saying plan on hearing more about this after the Olympics?
jmo,
cherry-picking like that could earn you a job at the BLS :)
http://www.bls.gov/cpi/cpifact8.htm
We both agree that while fractional reserve banking is the current vehicle of inflation, since the invention of the Federal Reserve that is more a matter of convenience than a necessity. If the government wanted to inflate the currency under a full-reserve system, it could simply run the printing presses.
I always thought that those who advocated duration-matched banking also advocated a gold standard.
Remember, destroying the duration-matched banking and substituting fractional reserve was how inflation was created prior to the end of the U.S. domestic gold standard in the 30s and the end of the international gold standard of the 70s. What happened was that the obligations under the fractional reserved system began to come due and there was not enough gold to pay for them all.
1) If the Fed actually started printing money, we'd be arguing against it as vehemently as we argue against maturity mismatching.
2) The housing loans certainly were duration mismatched. From Barron's:
"SIVs play a game of fixed-income arbitrage on a grand scale. They earn a spread by investing in a group of highly rated assets, primarily debt issued by financial companies and residential mortgage securities, while financing those assets with a mix of debt and equity. A maturity mismatch between their longer-dated assets and short-term financing creates the major risk. That mismatch is behind the current SIV mess. SIV debt holders are concerned about the credit quality of SIV assets, particularly subprime mortgage issues, and want to get paid off when their debt matures. But the SIVs face limited liquidity for their assets."
Also, the cost is not just to taxpayers. The cost is to everyone who holds dollars. When the Fed guarantees loans, the effect is the same as if the Fed printed dollars (and this effect occurs regardless of whether the lender actually uses the guarantee).
3) Paul Graham, one of Sillicon Valley's most prolific angel investors, who has funded nearly a hundred companies, writes: "Do not finance your startup with credit cards. Financing a startup with debt is usually a stupid move, and credit card debt stupidest of all. Credit card debt is a bad idea, period." Debt should only be used by a new business to purchase assets. However, due to inflation, assets are way overpriced compared to what they would be priced in a non-inflationary world. America has way too much debt because interest rates have been close to or even lower than the rate of inflation. I'm incredulous that you would say credit card debt is a feature of maturity mismatching.
4) People would keep most of their money in CD's, bonds, and stocks. In these days of direct deposit, debit cards, and automatic transfers from checking accounts into CD's, I don't think we have to worry about people stuffing bills under the mattress.
6) Massive monetary deflation only happens after a massive unsustainable credit expansion (due to demand mismatching). End demand duration mismatching, and you would not have so-called "demand shocks".
Mostly, it's simply not clear to me what the giant problem is that duration matching is supposed to solve
The monetary dilution since the 1970's has been far more corrosive than you believe. First you must recognize the difference between general price level changes and monetary dilution. The "general price level" has increased at a lower rate than the money supply, due to wonderful technological productivy increases. Silicon Valley's success hides the Fed's mistakes.
A reasonable estimate for the rate of monetary dilution is somewhere between the rate of nominal GDP growth ( 5% ) and M3 growth ( 15% ). This is a very high level of dilution, and its effects have been corrosive.
- With low interest rates and high monetary growth, it is rational to borrow as much as possible and buy as much house as possible. This has generated a tremendous amount of malinvestment in exurban real estate and McMansions. In the cities that have fixed supplies of housing, prices and the cost of living have gone through the roof ( and are staying there).
- People also try to put money in stocks to protect from inflation. Unfortunately, the supply of stocks is not fixed, and so again, malinvestment occurs. Hello, Pets.com! Stocks no longer even bother paying dividends, because most people are hold S&P 500 stocks as collectibles that protect against inflation, not as vehicles of investment that produce value.
- The only assets that do have a fixed supply are commodities like oil. Thus we have pension funds have invested massively in commodity future indexes to protect their investments against inflation. Oil prices are now higher than in the 1970's. The United States will transfer at trillion dollars over the next year to OPEC.
- Fed loan guarantees make playing with leverage far more profitable than a free market would allow. This profitablity has seduced many bright minds into going to Wall St, rather than doing something useful like creating a new product.
- Monetary dilution, malinvestment in housing and stocks, and the flight of money into commodities, are probably the biggest reasons why real wages have been been stagnant since the early 1970's.
- Bonds do not protect against inflation. The interest rates are artificially low, because the ordinary investor is competing against big banks who have acccess to Fed backed, maturity mismatched loans. As any financial advisor will tell you, the 30-year bond simply is not a wise place to put money.
So let's sum this up: stagnant real wages for the past 30 years, massive asset bubbles, trillions of dollars being transferred to the Middle East because oil is a safer currency than greenbacks, and extortionary bailouts to the most profitable industry in the country. Other than that, I can't see any giant problems.
Unwinding duration mismatching is probably impossible in the current political climate. The same factors that created the problem are more powerful than ever before. Bankers like it because as the middlemen, they make huge profits. Government economist like it, because managing duration mismatching induced instability provides lots of jobs for economists. And progressives like the idea of the government taming the market. But the current climate might change quickly if China or Saudi Arabia stop buying dollars. And if it does, we should have the right solutions waiting in the wing.
Libra: First you must recognize the difference between general price level changes and monetary dilution. The "general price level" has increased at a lower rate than the money supply, due to wonderful technological productivy increases. Silicon Valley's success hides the Fed's mistakes.
Amen to that -- the confusion out there between monetary dilution and price level changes out there is tremendous. The blanket term "inflation" is truly useless.
-winterspeak
On point 1.
I criticize Global warmenists because their studies always start at a trough and end at a peak. If you are going to look at the dollar, how about comparing it to other currencies from say 1932 instead of 1945 when all of their national equity has been destroyed.
Yes the dollar held 90% of world economic value in 1945, so what, that is meaningless to compare to 2008. If that had continued to hold true to today we would be living in a terrible world.
Since then we have chosen to transfer whole industries to other countries and the related wealth (and problems). Currently we are in the process of transferring all plastic and petrochemical industries to other countries which is certainly a significant percent of our national wealth that is stored in the value of the dollar. In the 90's we were creating wealth faster than we were transferring old industries overseas and the dollar increased in value. Now we are transferring business overseas faster than we create new ones and the dollar is falling. It seems to me that is much more important than how much we buy and sell with other countries, although that is certainly important. Yes in 1945 we held most of the worlds wealth, but I don't think you can make a case that we are less wealthy now than we were then.
John:
I was actually going back to 1908, not 1945. And my point had nothing to do with the productive the US economy is (which actually has little to do with currency strength. After all, gold is a currency, and it isn't tied to anything at all!)
My point is that the US has printed large amounts of money. The inflationary effect this dilution has had has been masked by 1) technological improvements that lower price, and 2) China buying dollars to "vendor finance" domestic exports, both of which are significant. So even with two *dramatic* deflationary forces at work, a bottle of coke that used to cost 10 cents now costs a dollar.
Remember -- inflation is a monetary phenomenon. Any country can keep it in check by not printing money (or increasing credit supply, which is the same thing).
To believe that this monetary dilution is bad, you need to believe that the US could be doing much better than it is now, since, despite all its problems, the US economy has done well across any 30 year period you choose to pick. This is a stretch, I admit.
-winterspeak
That said, the US$ has lost over 90% of its value in just three generations, and if that's a feature of the system, how great is that system?
This reminds me of my first algebra class. "So let's say x=3y..." "Wait. What is 'x'?" "We don't know. It's a variable." "Okay, but YOU know what it is, right?" "No. Nobody knows what it is. It's a variable." "What do you mean it's a variable! It has to be something." "Well, it's 3y." "What's y?" "It's another variable." "Just tell me what they are!!!"
Why on earth does it matter that the dollar has lost 90% of its value? Who cares how many dollars it takes to buy a hamburger, if you have a system that allows everyone to get more hamburgers? I have a feeling that 30 years later, the kids in my algebra class who insisted that X had to be something are all voting for Ron Paul.
winterspeak-
As brooksfoe points out, arguing that Coke now costs a dollar went it used to cost 10 cents is does not elucidate the real problem with monetary dilution.
Theoretically, if there really was a "helicopter" like distribution of inflation, and everybody received dollars in equivalent to the dollars they already owned, then dilution would have no ill effects. If the price of coke, income, and savings all increased at the same rate, there is no problem.
The trouble of course, is that there is no helicopter. Dilution happens via a tremendously distorting mechanism - subsidized loans. The creation of new money is not neutral. Since interest rates are subsidized and dollars become more worthless, it is rational to borrow too much and place their money in commodity ETFs rather than in bonds and stocks. The real problem is the malinvestment, systemic instability, and the overpricing of hard assets ( property, oil, commodities) as people replace their dollars with ETFs.
LIBRE: I'm afraid I have no idea what brooksfoe is pointing out.
Your point that is that if dilution were even (everyone received 10 2008-dollars in exchange for 1 1908-dollar) it would not matter is correct.
However, the dilution has not been unevenly distributed in any way, the dilution always penalizes savers at the expense of those carrying debt. Note: banks operate at 90%+ leverage as a matter of course.
Subsidized loans are one way that money is diluted. Maturity mismatch is another (unless you are arguing that maturity mismatch *is* a subsidy to long duration loans, which I think is a reasonable position to take). Plain ol' printing money and giving it to financial institutions is a third. There are others too.
I'm not sure you and I are disagreeing. I am confused about why you think I believe that the damage done by monetary dilution manifests itself as anything other than crappy investment decisions, boom/bust cycles, and lower overall wealth creation.
-winterspeak
winterspeak-
I was just making a minor quibble about your first point: "That said, the US$ has lost over 90% of its value in just three generations, and if that's a feature of the system, how great is that system?" The above statement means nothing by itself. If the value drop had come from a completely neutral, redenomination, then the 90% drop in value has no ill effects. When making the anti-dilution case, its not enough to point out that more dollars now exist (everyone knows that), you have to show they were created in a way that produced redistribution and malinvestment ( most people do not realize this, and I didn't see it mentioned in your original post).
We agree completely, I was just trying improve the phrasing of your argument, not sure if I helped at all :-)
I, personally, would like to see 'Brooksfoe' cogently argue the point that counters what Libra and Winterspeak are describing...
Good Luck with that 'Brooksfoe', all the smoke&mirrors, you care to employ, will not mask the Reality your Ideology seeks to Destroy.
financial assets are priced to cover the erosion, and non-financial assets generally rise along with the broader price index.
How can you possibly justify this claim with interest rates as they currently are? After taxes, low-risk bonds typically have *negative* real returns.
Who's loaning on those terms, and can I smack him?
The point, winterspeak, is that you fetishize money. You speak as though the purpose of an economy ought to be the strengthening of the purchasing power of each unit of currency, rather than the strengthening of the purchasing power of the people who make up the economy.
I think you are right that to believe that a radical change in monetary policy which would set the US on a course dramatically different from those pursued by every other wealthy country in the world would have given the US economy even more growth than the world-beating growth it experienced over the past 70 years...is "a stretch".
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BROOKSFOE: Thank you for clarifying your point -- I understand your question now.
Actually, I agree with you that an economy ought to be strengthening the purchasing power of the people who make up the economy.
The way to do this is to improve the productive capacity of the people who make up the economy through all flavors of technological innovation: process, organizational, engineering, scientific, etc. etc. This has certainly been the story of the US economy's world-beating growth from about 1890-1990, China's from 1980+, India's from 1980+ etc.
I do not see how reducing the value of the savings the aforementioned, technologically enhanced population helps in any way. I do see how it hurts. Moreover, I also see how the bad incentives created by monetary dilution reduces the ability to make good investment allocation decisions in technology, and I think you and I both agree that good investment allocation decisions in technology are critical to improving the purchasing power of the people.
To me, those who "fetishize" money are those who insist that, if an economy grows X%, the money supply also needs to grow X% (or X%+y, if the "economy" needs a little "stimulus" to perform "better" as it seems to have done for the past 90 years and counting).
My position is very simple: money is a store of value, and it should not be diluted.
Resource allocation decisions should be made on whether a project idea is a good one or not, not in some desperate attempt to preserve the value of earned wealth, trying to guess what currency will devalue, what political promise will be made (or broken), or what commodity asset class will begin levitating next.
Good resource allocation decisions have been central to the "strengthening of the purchasing power of the people who make up the economy". As we have seen in the ludicrous up/down cycles in the economy, monetary dilution is frankly contrary to achieving this.
-winterspeak