Maturity mismatch is taking something of a beating in the comments, including from smart people like former co-blogger Winterspeak. They urge the end of fractional reserve banking and its replacement with maturity matched investments--someone who wants to borrow for two years has to find someone who wants to lend for the same period of time. That's much less unstable, they say, than a fractional reserve system.
That's true, it is. It has the appeal of perfect simplicity. But I am not a huge fan of perfect simplicity. A wheelbarrow is simpler than a car. It is less likely to break, and less expensive to fix when it does break. But I would still rather have a car to do my shopping.
So what are the reasons to favor fractional reserve banking? Threefold:
1) Stopping it would require a huge regulator to keep people from doing what they naturally want to do, which is lend short and borrow long. As long as a big fractional reserve banking system exists, it will require periodic government interventions. You cannot credibly commit to not intervening when a failure to do so risks a double-digit GDP contraction.
So keeping people from doing this will require constant watching. You will have to aggressively invade company books to ensure that all of their borrowing is duration-matched. Remember, money market funds were very close to maturity matched--they borrowed in weeks and months, and lent in same.
2) Fractional reserve banking vastly increases the supply of savings available for investment. I don't know about you, but I can't afford to lock up a chunk of my savings for six months to two years. The money in my savings and money market accounts is there for a reason--I don't know when I'll need it. I have longer term savings in stock funds, but that's superfluous money.
Hedge funds and private equity can demand long lockups because they are using surplus money that their investors don't expect to need--really need--any time soon. The less affluent have to have a reasonably large cushion they can get their hands on in case of emergency, such as car repairs or a really good deal on a jet ski. Without fractional reserve banking, that would be dead money, sitting in a vault somewhere. Indeed, they'd probably end up paying someone to guard it for them.
Maturity-matched lending also has enormous transaction costs. Most companies don't want to borrow in $2,000 increments. The search costs of finding someone who wants to loan the amount you want at the time period you want, or a pool of same, is huge. There's a reason that private equity has big minimum buy-ins, and tends not to disburse amounts in the size of an auto loan. Trying to maturity match loans would essentially kill the market for both borrowing and lending in small amounts.
Fractional reserve banking puts that money to work. It gives us periodic crises. But by putting all that extra money to work in productive investments, it also gives us the wherewithal to pay for the periodic crises.
3) The financial market can still have big crises. AIG went down on credit default swaps--aka insurance (or, if you prefer, gambling)--not short paper. Huge defaults on duration-matched securities can take down institutions in a domino-like fashion (remember Latin America? Russia?) Borrowing and lending money are risky endeavors. They are unfortunately necessary in a society where the people with the good ideas aren't always the people with the money.
Maybe I should add
4) It's a political nonstarter. Maybe in some mad moment you could prohibit fractional reserve banking. Right up to the point where people find out that instead of getting interest on their checking account they have to pay the bank to guard their money, and can't prepay their mortgage. I doubt even my credit hawk commenters would like to find that, like companies, they might be stuck with paying 10% for all thirty years of their loan if they happened to borrow in a bad year.
Copyright © 2009 by The Atlantic Monthly Group. All rights reserved.
But I would still rather have a car to do my shopping.
I thought you were all about the "walkable community." That would make a wheelbarrow perfect.
On the substance, I've often said that banks are simply market makers between people who want to lend and people who want to borrow. Nothing more sinister than that.
Let's take this point by point.
(1) Excessive regulation. Right now we have a significantly worse situation. The financial industry is regulated quite heavily but ultimately, makes profits for its employees (the shareholders get kinda screwed, but oh well). Since any failures lead to a cascading failure (when massive amounts of assets get liquidated, the price of those assets drops since financial institutions all tend to hold the same types of stuff) no bank or investment bank can be allowed to fail. As a result you have a guarantee of a bunch of people who get really really rich and can't lose (you can wipe out the shareholders, but the annual bonus pool is always much larger than the annual profits). This is supposed to be better?
The actual regulation should be fairly simple compared to the scale we're talking about: what are your 20 year obligations? What are your 20 year assets? Are they the same? Repeat for all terms (how granular this is can be tuned to how difficult this process is to start). Banks already have to mark the entire book to market daily; this simply breaks it out by terms. Harder to meet? Yes, obviously. Different in nature than anything done today? Not really.
(2) Savings would dry up. Well, since the United States doesn't save as a nation I don't see how it can get worse. To be less flip about it, what the real issue is that we're trying to get something for nothing: cheap long term credit without cheap long term savings. In a maturity matching system, long term borrowers would have to offer higher rates to offset the inconvenience and risk in locking up money for the long term. This cost still exists in the current system but it's being paid by the wrong people: everyone who holds dollars (though dilution when things go wrong and through the risk of dilution when things aren't going wrong) instead of being paid by long term borrowers. I thought that setting up rules that cause market participants allocate costs properly was the role of government in a market economy (in the libertarian framework you and I share)?
(3) This doesn't prevent all financial crises. Companies will still fail in a maturity matching system. Some can take on too much risk and get bitten by unexpectedly high default rates. Others can make derivative bets that are both wrong and too large for them to settle. Right now, however, the financial system is in equilibrium like a pencil balanced on it's point. If creditors see any chance that other creditors think that there is a risk of default they withdraw their funds (unless you're just going to propose that it's all guaranteed by the printing press, in which case you've officially made it policy that you can't have a private financial sector). A matched system is actually stable. There's no incentive to run the bank if the bank actually holds the assets to cover any possible demands.
(4) Can't be done politically because of (a) fixed term borrowing and (b) lower or negative short term rates.
Re (a) there's no reason that under a maturity matched financial system you couldn't negotiate a pre-payment clause in a long term loan. This after all, is an asset to the bank. If it pays off early, the bank can roll the money back into an investment with the needed remaining term. Under a maturity mismatched financial system, a long term loan is an even worse deal: pre-payment risk if rates go down since the borrower will refinance, that's the same in both systems but the fractional reserve system also risks a run when creditors get nervous and they have the right to withdraw their funds at will.
Re (b) negative short term rates. People would adapt (and the market could provide solutions). Most expenses are known in advance. You don't need to hold funds in a demand deposit account for your rent / mortgage / car payment. You only need the funds in place when the payment is due.
Would this be painless / easy? No, clearly not. Is the current system bad enough to warrant the pain of switching? Well, if you think this is as bad as it can get then probably not. If you think (as I do) that the system will lurch from crisis to crisis each getting worse and worse then maybe it is worth the pain to make a change now.
I'm a supporter of fractional reserve banking, but I don't think it's quite as unworkable as all that. One possible workaround for maturity mismatching in a full reserve banking economy is to treat maturity-mismatched investments as equity.
Suppose I have $2000 I want to lend short. Instead of putting it in a bank or a money market account, I buy shares in a mutual fund which invests in low-risk, low-volatility investments (short term treasuries, AAA corporate paper, etc). While the fund's assets look a lot like a money market fund in a fractional reserve system, it does not attempt to guarantee that it won't break the buck -- if I want to cash out, I find someone to buy my shares. And if I can only get 97 cents on the dollar, that's the risk I signed up for when I bought into the fund.
With respect to number 1), couldn't we repeal the legal tender laws, and see where the market would lead us without all the regulation and intervention?
Money is not investment, Megan. You don't "put money to work" when you invest- you allow the surplus goods and services you produced, but did not consume, to be used by others in productive consumption. The steaks you did not eat are used to feed those engaged in the production of capital equipment, for example- or the metal that did not go into the car you did not buy is used to fabricate the robot that is used in future auto production.
You must overcome the money illusion to see the real factors that you are actually discussing. Money is the measuring stick only, not the things themselves. With this in mind, what is dead, unproductive money, exactly?
A wheelbarrow is simpler than a car. It is less likely to break, and less expensive to fix when it does break. But I would still rather have a car to do my shopping. - MM
Hard to maneuver them through the aisles, though.
Megan, just how far-out and cranky a view is this maturity-matching idea, when we're talking about commercial banking? My sense is this is about an 8 on a 10-point crank scale. It's one thing to talk about maturity matching for countries, but for commercial banks it seems like it would be incredibly onerous and might actually make it occasionally difficult to take your money out of the bank.
Megan-
If there was no FDIC, what reserve ratio would you require of a bank, for you to put your money in it? Let's assume the bank paid .3% interest a year. 0%? 10%? 40%? 100%? Assuming no FDIC, would you rather pay $30 a year for a 100% reserve account, or earn .3% in a 10% reserve account?
I love this stuff, and I love Ms. McArdle because she has all these readers who weigh in with comments like "I support fractional reserve banking"--not to mention many who don't--as if it were a live issue. It's like going to a theological convention from some bizarre religion, except these people are harmless.
You cannot credibly commit to not intervening when a failure to do so risks a double-digit GDP contraction.
If government did not actively encourage and create maturity mismatching, I do not think it would last long in the free market. The government has been actively building the pyramid of leveraged credit since the National Banking Acts of the 1860's. By putting a 10% tax on all banks not part of the national banking system, it forced all banks with high reserve ratios out of the market.
I still don't understand why you think maturity mismatching is a natural product of the free market, when it's pretty clear that all institutions that have practiced consistently need government intervention to survive.
You are right that at this point the pyramid is too big to fail. But if the government made the bailout to end all bailouts, and then made a firm commitment never to bailout again, I don't think we'd see maturity mismatching banks become too big to fail. These funds would fail very early, because it is such an unstable practice.
Maturity-matched lending also has enormous transaction costs. Most companies don't want to borrow in $2,000 increments. The search costs of finding someone who wants to loan the amount you want at the time period you want, or a pool of same, is huge.
Huh? Why would the transaction cost be any greater than buying and selling stocks?
There's a reason that private equity has big minimum buy-ins, and tends not to disburse amounts in the size of an auto loan.
It's called angel investing and they invested $26 billion last year. All of it was perfectly maturity matched. The transaction costs for angel investing are very high, but that's mainly due to SEC regulations preventing more efficient angel investment markets from being created.
I don't know about you, but I can't afford to lock up a chunk of my savings for six months to two years.
Tens of millions of Americans are saving for retirement, college education, and other future events.
Fractional reserve banking puts that money to work.
Money doesn't work. People work. Your statement is nonsensical. Are you suggesting that without maturity mismatching people would just sit idle? Would they not invest as much in capital goods? Of course that doesn't make any sense, since we know from four decades of experience that inflation created by fractional reserve results in way too much short term consumption.
Also, I should point out that historically, the Dutch were able to finance decades long sailing adventures using 100% maturity matched loans.. Silicon Valley also operates almost entirely on maturity matched funds.
A little while ago, when I was trying to figure out for myself if the Austrians were right about fractional reserve, I created a mini-model of the economy. What I found is that the cheaper interest rates created by fractional reserve are almost entirely counteracted by the fact that you have to borrow more money to account for inflation. The only net effect of fractional reserve is that it ends up being a transfer of wealth from people saving money to people who are over investing in things that a free market wouldn't ordinary provide.
The financial market can still have big crises.
I partly agree with this. I tend to think that maturity mismatching is a special case the general problem. The general problem is pursuing strategies that have a high probability of being somewhat profitable and a very low probability of completely blowing up. But given enough time, it always blows up. But by that time, the money managers have pocketed a lot of dough.
You are also right that no regulation can prevent this - there are way too many variations. The only solution is a no bailout every policy, so that the investors learn never to invest in anything you don't understand.
It's a political nonstarter.
Of course. The Anglo-American banking system has been messed up for 300 years and counting. There must be deep political reasons behind it. But it's still worthwhile to think about how you would fix the financial crisis if you had complete power. Then you can you can triangulate from your current situation to try and get as close to a good solution as you can. Of course, you may find that no good solution is not politically possible. In that case, you have to start seriously thinking about if the problem is big enough to warrant Constitutional reform.
All true, but isn't it even worse than you say? How would these people feel about a steel company that funded its partially illiquid assets with commercial paper (which has to be rolled over on a short-term basis)? Or how about trade credit, which is trillions of dollars a year?
Put more simply: which bank would you choose to deposit money with:
... and you are arguing for it? With friends like these...(a) a bank with no oversight and no deposit insurance, which pays 1% on demand deposits
(b) a bank that has an outside auditor, as well as an outside insurer, both of whom agree that the bank is actuarially sound, but which only pays 0.5% on 6 month CDs?
Well let me make the case against fraction reserve: as long as a big fractional reserve banking system exists, it will require periodic government interventions.
0) You can't afford... really? What interest rate do you get on your savings account for 2 months? Well, I just looked at Bank of America's website, and do you know what they are paying for savings deposits? 0.20%! Yes, 0.2%! So that $10000 you have in your savings account, is getting you exactly three dollars and thirty-three cents for that 2 month period, while you wait for the car repairs.Are you seriously claiming that you cannot afford the $3.33 in lost interest on your $10000? Seriously? Can't you just, say, skip lunch twice a year?
1) Six months? Really? I really doubt that. Not to mention that you give the lie to yourself, by claiming you've got money in stocks. You can sell stocks any time you want, you know. Well, 8 hours a day or so, at least.
2) So buy a bond. If you need the money in 4.3 months, sell it.
3) With maturity mismatch blocked, the next most convenient thing would be an actuarially sound system of lending based on bond-like CDs (that is, instruments that may be sold). Given that, there's no reason why you could not have a market for such paper that, given mass involvement, would be remarkably stable.
Posh. I have a computer that, trust me, can do millions of comparison a second! You could too... for the right price.Your point would have taken slightly more time to demolish 30 years ago. Well, 40, really. OK, 50. But not today.
The greatest fallacy of Keynesians. Money does not work. People, that is capitalists, do use money to do things. Falsifying the interest rate does not do good for the entrepreneur, who you are falsely signaling future demand to. So to the exact extent that fractional reserve "works" in the sense that it artificially lowers interest rates, it is failing. It is destroying wealth. Fortunately, in most typical times, fractional reserve does not really destroy all that much wealth, though, for the reasons I've outlined above: a maturity matched system would really not have significantly less investment than a maturity-mismatched one. The idea that fractional reserve, as such, is "creating money" is mostly wrong. (It's the centralized bank within fractional reserve that does that. But this is a different problem.) No, not at all. By destroying wealth, it actually makes us poorer, less able to pay for its crises.Look, if the government falsified the price of bananas, do you expect that it would increase wealth? No? Why not? Does micro tell us anything about that? Then why do you expect that when the government falsifies the price of capital that good should result? Isn't capital a bit more important than bananas?
Yes, and an asteroid might hit the Earth. Let's fight the things we can do something about. And let's not fight things we cannot do anything about. I think we agree on that! May be! That is, if reasonably intelligent people would support the idea. But then, if even the glibertarian Megan McArdle thinks fractional reserve is a good idea, why should anybody seriously consider changing anything?Megan, here's the thing about being a public intellectual: they'll pay you better if you run with the herd. Your job, ultimately, is to support and rationalize the status quo. But as an intellectual, as a person, as a soul, you should not.
If you open yourself up and think about how the market might accommodate to the banning of maturity mismatch, perhaps you might be pleasantly surprised. However, it will certainly mean you're never getting that plum job in the Obama administration. But you know what? You're not, anyway. You're already off the res! So, why not freethink?
Unimaginative you are. Look, to the extent that lending and borrowing is matching up real people and their needs -- real savers, and real borrowers -- it will continue to happen. The conditions may be slightly different, yes. Saving will probably pay slightly better, meaning, slightly higher interest rates. But it will happen, if and only if the two parties can actually agree on terms. That they are agreeing now under ... let us say, "misleading"? ... terms is nothing you should be proud of.There's plenty of non-fraudulent ways to get people to agree to terms. You are acting as if maturity transformation is the only way to do that. It isn't. Reconsider that. People are smarter than you give them credit for, even when money is not on the line. And when it means money, watch out. They'll solve your silly coordination problem in about 10 seconds. That's the market in action.
I think Maniakes has a good point. This system is the result of large amount of government involvement. Perhaps banks would be a lot smaller and just function as (fee charging) short-term money servicers (see Western Union). For medium to long term money storage people would invest in different funds. And then if we didn't have things like FDIC, then investors would really care to see how their $50k is being invested.
Megan,
Let me ask a question. If I have saved $100 dollars and deposit it in a 1 year CD, and the bank uses that deposit as the base to lend out $1000, have they increased savings by a factor of ten?
Bring back the real bills doctrine.
It was good enough for Adam Smith.
I don't know about you, but I can't afford to lock up a chunk of my savings for six months to two years.
I take it you don't have a 401k or IRA then?
A client of mine owns a business that actually borrows long and lends short. He's able to charge high short-term rates because he's lending to businesses that don't have access to traditional bank lenders. Not a bad business, actually.
In any case, if you are aware of the duration mismatch, you can hedge against the yield curve moving against you, using, for example, a cms swap. The issue with S&L was duration mismatch they were unaware of. It is always a problem if senior management is unaware of some risk factor affecting their business.
If I have saved $100 dollars and deposit it in a 1 year CD, and the bank uses that deposit as the base to lend out $1000
Yancey, is this actually possible? The bank can't just print the money. It has to actually take in real dollars to lend them out. If it only takes in your 100 bucks, it doesn't have 900 to lend.
What we're talking about here is what happens if the bank takes in 100 dollars each from 11 people and loans 1000 of it to other people, while only holding 100 dollars. As long as the CDs' maturity dates and the loan repayments are timed right, it will always have enough money in the bank to pay out those CDs as they mature. Unless the borrowers default. Which is why you have 1. credit ratings and loan officers, and 2. FDIC.
I'm really heartened by the comments here. Before the current crisis, when the birds were singing and the economy was pumping strong on imaginary money, it was only a small group of loons and cranks pointing out what money represents, and why it's not just a bad idea but actually immoral to pretend there is more money (or slips of paper representing money) out there than actually exists. And now here we are, staring down a long slide, and of course it's too late to change - fractional reserve is here to stay, it's a globally supported fraudulent system - but there are plenty of folk who at least realize the Emperor is naked (in a real story based on that fable, the boy pointing it out would get dispatched by the guards).
Notice if you will how Megan's arguments do not address the fundamentals, but argue from consequentialist grounds - if we have honest money, we won't have nearly as much (unstable and unsustainable) growth. Instead of people being able to borrow so much money on (highly inflated) home prices, they may have to actually save in order to make purchases. It's somewhat like saying "if government doesn't deliver mail, people will never get birthday cards" - the conditions of the market dictate the products and services that arise from that market. What a world would look like without fractional reserve certainly would be different than today. Perhaps we'd see more decentralized loan institutions, like Prosper.com - unlike the bankers and government, people can't loan out money they don't actually have.
Yancey, is this actually possible? The bank can't just print the money. It has to actually take in real dollars to lend them out. If it only takes in your 100 bucks, it doesn't have 900 to lend.
What we're talking about here is what happens if the bank takes in 100 dollars each from 11 people and loans 1000 of it to other people, while only holding 100 dollars.
Yancey is correct.
Suppose that we have a city with only a single bank, where everyone deposits cash they don't intend to use. The bank keeps a reserve of 20% on all deposits and loans out the remaining 80% to make a profit. You (A) make a deposit of $100 to the bank. They hold $20 in reserve and loan out the other $80. The person who took out the loan buys $80 worth of goods from B. B deposits the cash in the bank. The bank keeps $16 in reserve for that deposit and loans out the remaining $64. The process repeats, eventually reaching a state where $100 is actually held by the bank as reserves for multiple deposits and they've loaned out $400.
Brooksfoe,
There are two types of money in a fractional reserve system- the base money supply (federal reserve notes in the US) one would initially deposit ($100) in a demand account and the commercial bank money created as the bank lends out $90. Whoever receives that $90 then deposits that, and that bank then loans out $81 keeping $9 as reserves, and so forth. The upper bound limit is $900 of commercial bank money and the initial $100 deposit of base money. This is the essence of giving multiple claims to the same base money (or, more fundamentally, to the same goods and services). The process works in reverse when loans are repaid (or defaulted on, as we are seeing today)- commercial bank money vanishes, leaving, at the end, only the base money.
I asked the question because I am trying to get at the basis for Megan's claim that "fraction reserve banking vastly increases the amount of savings available for investment". I suspect that this credit expansion is the basis for that belief.
aka insurance (or, if you prefer, gambling)
Nitpicking your otherwise delightful post, but insurance is not gambling. Gambling is taking a (basically) riskless situation and creating risk for loss and gain. With insurance, risk for loss is preexisting and there is (in theory) no opportunity for gain.
Sorry to nitpick but I have a small passion for theory of insurance, because I am an actuary.
Pleasantries,
bcg
Why did this get sidetracked to fractional reserve banking? We've had what, 12 commercial banks fail all year? And that was from bad mortgage lending. This crisis doesn't seem to have been caused by fractional reserve banking or have anything to do with it.
MEGAN: The internet ate my original response, so here's a shorter one.
I agree that making this switch is a political non-starter. Having Great Britain abdicate it's empire in 1910 was also a political non-starter, but low and behold, a mere generation later, it was done. Events have a way of enforcing reality onto politicians, and the move away from the dollar as the world's reserve currency will not be passed by a Senate resolution.
Also, remember that fractional reserve (FR) banking is only possible in a world where the government stands ready to step in and make depositors whole when there is a bank run. Retail banking would not exist in its current form without FDIC. Investment banking has shown that it cannot exist without the government stepping in to back up every institution (see Recent Events). In a world WITHOUT FDIC, a maturity matched bank (MM) would compete perfectly well with a FR bank (subject to runs). You'd need to audit both, of course, but I don't see this as an INCREASE in government regulation.
Finally, I am not doing away with BANKS -- they would still exist, and the world still needs financial services! I think that you aren't envisioning all of the banking functions that an MM bank could do -- and these include pooling deposits to make larger loans, carving up deposits to make smaller loans, evaluating default risk, matching lenders and borrowers, and guarding the true cash money in the vault. There is no reason a company couldn't take out a $100K 5 year loan, and an individual could not take out a 2 year $10K loan. The only requirement is that the term of those loan(s) are matched by the term(s) of the deposits. True cash deposits are just that -- cash. So if you don't have surplus money you can do without for 3 months, keep it in cash, not a 3 month CD.
This would not require "invading companies". The accounting requirements would essentially be cash accounting rules, over many years. So instead of your balance sheet saying "long term desposits, short tern deposits" it would say "2009 deposits, 2010 deposits, 2011 desposits" etc. A line item for each year. It isn't that different from GAAP -- it really is just multi year cash accounting.
But I don't want to diminuate the extent of the change. The biggest impact would happen in long term loans, where the current quantity of money supplied comes from maturity transformation. Once you turn that off, you see exactly how much money really wants to hang around for 30 years, and what price you need to offer to coax that money out of the woodwork. It's more than the current 4%, I'm sure. I don't think it's a bad thing to have an honest supply and demand dynamic determining 30 year money, especially if, as a bonus, you get a banking system that doesn't keep blowing up.
I'm not sure you wanted to mention AIG, Russia, Asia, and Latin America. AIG's blowups were for Credit Default Swaps, and our discussion here is on how maturity transformed credit is inherently unstable. CDS would not exist in a MM world -- you would not need it.
Also, Russia, Asia, and Latin America are all text book examples of countries unable to rollover short term debt to match long term obligations -- which is *exactly* what a FR banking system exposes you to, and is *exactly* what a MM system would eliminate.
-winterspeak
PS. I would add, that standard Macro theory at U Chicago, or any other school, is completely unhelpful in understanding any of this. So my sympathies lie with you. To my knowledge the Academy has not produced any papers between 2000-2007 talking about how the American financial system is systematically vulnerable to bank runs, and will need to be bailed out by the US government, and that perhaps this is a bad thing. This tells you a little bit about the priorities of the Academy, and how well they align with the priorities of the real world.
Brooksfoe:
The bank does too create the money entirely out of thin air, that's the point of there being a bank.
If you go into a bank to get a loan for 'working capital' for one's business, all the bank does is create an accounting entry that says 'Brooksfoe owes $10k' and also another accounting entry that says 'Brooksfoe has $10k in his new checking account'. These obviously balance. The loan is in accordance with 'sound banking practices' if Brooksfoe really is using it for 'working capital', money is an essential input to running say a store, just like shelf space and inventory, which also means that though the balance in Brooksfoe's account will vary from day to day, it's expected value is the amount of the loan to Brooksfoe. This is a way of more efficiently deploying 'reserves' or actual money (now a ledger entry at the Fed, since we are under a fiat money system, but not necessarily), given that assuming a large number of accounts, a 1 to 1 ratio is a sign of tremendous inefficiency in using one's reserves of 'hard' money.
Per the whole where does the good from fractional reserve banking come in, basically it is because the stock of high powered money or specie is what determines what the price level is, but what would now be called M1 is what determines what the interest rate is. One can look at it the extra money lowering the interest rate by expanding the money supply without inflation, or that the price of money drops since itr is being more efficiently used and gets cheaper. Since all interest rates riff off the overnight lending rate, this means capital investing gets cheaper, and asset prices rise.
The classic treatment on this by a traditional smart guy is 'On the National Bank' by Alexander Hamilton.
Yancey says "The process works in reverse when loans are repaid (or defaulted on, as we are seeing today)- commercial bank money vanishes, leaving, at the end, only the base money."
But, as someone pointed out already above, this hasn't, by and large, been a crisis of the commercial banks. In fact, commercial banks have been saving (or rapaciously taking advantage of adverse times to buy cheaply, depending on your perspective) some of the i-banks that have been swept up in all this.
I'm not sure that ending the fundamentals of the commerial banking system is the correct response to a largely unrelated crisis. Though I can certainly see the appeal in taking advantage of emergency measures to suggest your pet-peeve be corrected as well. That's just good politics.
winterspeak - I'm relatively certain that "diminuate" is not a word, at least not an English word. I don't have my OED handy, so maybe it's just a very rarely used word but Google seems to think it's an Italian word.
Money is the measuring stick only, not the things themselves.
Yeah, that was my point a few days back. I think people who work with money forget it.
blighter,
If the crisis hasn't spread to the banks, then what is this bailout plan for? I am not as cynical as a lot of people (never thought I would ever write that line :~) that think this bailout plan is all a head fake and plunder by Wall Street- I give Paulson and Bernanke credit for at least believing it is necessary and vital.
Steve Johnson - re: "Savings would dry up. Well, since the United States doesn't save as a nation I don't see how it can get worse."
Having no net savings (which you can argue is the case), is not the same as having no gross savings.
bcg - re: "Gambling is taking a (basically) riskless situation and creating risk for loss and gain. With insurance, risk for loss is preexisting and there is (in theory) no opportunity for gain."
The insurance company, before it writes any insurance policies, has basically a risk less situation, but no chance of gain (or even breaking even since it has costs). Then it writes policies, it takes risks in order to make gains. The risks being the risk of having to pay out on the policies. The gains being the premiums from the policies. Its different than most gambling, in that it gets "winnings" before the gamble is complete (as premiums are paid over time, and not just at the end of the period covered), and than its effectively risking a lot of its money for a small but rather likely net payout, rather than risking relatively little money for a relatively large potential payout.
But broadly speaking its still gambling.
Or from the perspective of the person buying the insurance. The insurance contract itself, considered in isolation, is a bet on an unlikely event, with a high potential payout, similar to bets with large potential wins in Vegas. Your considering the insurance buyers overall position, and that's reasonable, but in isolation, the purchase of the insurance is very much a case of gambling.
Tim Fowler - I think you're misunderstanding what my fellow actuary was saying.
From the perspective of the individual policy holder, presumably he was going to be engaging in some risky activity (aka owning a home, driving a car, being alive). This is the pre-existing opportunity for loss. Since the insurance he gets is, in theory at least, just going to make him whole (minus a small amount for profit and to mitigate moral hazard) there is no potential for gain.
You seem to believe he is "gambling" that he will undergo the negative event and have his insurance "pay-off". But the odds of the negative event are (again, in theory) not related to his having insurance. His "bet" then is really just a move to make sure that he isn't adversely affected by the bad event. From his perspective it eliminates the pre-existing risk.
This is the opposite of gambling wherein you create the possibility of an adverse event where there was no possibility before you entered the game.
From the perspective of the insurance company, yes, I suppose you're right that they could have stayed home and not had any potential for loss.
But if you think of the insurance comany as just an agreement among all the policy holders to pool risk (which is, in effect, what it is), then all of the risk was there anyway. (For the reasons I gave above: irrespective of their participation in the insurance pool they were still going to have a home, drive a car, be alive, etc.)
Very simply, by pooling the risk the mean expected loss increases directly with the number of participants but the variance only increases with the root of the number of participants. Thus the more risks in the pool, the greater the expected (and potential maximum) loss but the variance becomes much less, thus the amount of the risk is much more predictable. If this were not the case, pooling risk might still make sense but not nearly as much.
So, in a nutshell, insurance, unlike gambling, is an effort to mitigate pre-existing risk. If you decide not to "bet" on insurance, you are not changing the odds of getting in an accident or having your house burn down or dying. You are reducing the impact of those adverse events on yourself or your family.
From the perspective of the insurance company, by pooling many risks together they are, once again, not affecting the probability of the many potential adverse events (which would happen regardless of the presence of insurance) but they are taking advantage of the dramatically more predictability of aggregate losses.
This is, of course, in theory and ignores the potential for moral hazard but is basically true.
blighter - There is a potential to gain, on the insurance contract considered in isolation. Its reasonable to consider the whole situation, but its hardly invalid to break it down to its constituent parts and analyze each of them seperately.
Assuming its not legally required (or that he can get away with it), the car or home owner, already has the car and home. Buying the insurance is the change. Since it doesn't have to be a package deal it does make sense to analyze the change as a separate action. As a separate action buying insurance clearly is gambling.
To use an example outside of insurance. If I own stock, and I buy a put, I can look at the whole position, and see that I've reduced my risk (for the period of time of the put), at the cost of the price of the put. But I can also look at the purchase of the put separately. It is, at least in a wide sense of the term, gambling, just as buying insurance, considered in isolation, is gambling.
You seem to believe he is "gambling" that he will undergo the negative event and have his insurance "pay-off". But the odds of the negative event are (again, in theory) not related to his having insurance.
The fact that the odds of the negative event are not related to his having insurance, is pretty much irrelevant. There isn't any logical connection between your premise and your conclusion.
The odds that a roulette wheel will land on red are (again, in theory, assuming its not a crooked casino) unrelated to whether I bet or not. But if I bet than I'm gambling.
So, in a nutshell, insurance, unlike gambling, is an effort to mitigate pre-existing risk.
When you consider the position as a whole its lower risk. But the purchase of the insurance itself is a gamble. The fact that the motivation is to reduce pre-existing risk is irrelevant to this point. The put purchase also temporarily reduces the risk of stock ownership, but that transaction itself is a gamble.
Taking an action that is in isolation a gamble, can reduce pre-existing risk, the two ideas are not mutually exclusive.
Tim -
Ah. Yes, now I see what you're saying. You're treating insurance like a derivative. The thing about insurance, generally, is that you can't insure stuff that you don't own, unlike derivatives which you can clearly play with just like a casino, though they are more properly used to hedge other risks you might be exposed to.
But you are correct, analyzed completely alone, insurance behaves much like derivative which is in effect a bet. But insurance tends to be sold only for risks you are already exposed to.
It would be difficult, for example, for me to take out insurance on your life, your car and your house. Certainly it would be difficult for me to take out policies on those that cover multiple times their actual value (multiple policies on each, if you will). But I can easily (well, assuming I can afford it, perhaps not a reasonable assumption) take out derivatives against any stock or other financial positions you might have and many, many times over.
But yes, I see what you are saying. Ignoring the fact that you must usually already be exposed to the risk that you are insuring, insurance behaves like a derivative, which is to say like gambling.
What I see on this comment board is a lot of confusion regarding the difference between fractional reserve banking and fiat currency.
Human beings have been engaging in "maturity mismatching" since some lamed geezer began chipping stone tools for the fitter members of the tribe in exchange for a share of mammoth. It takes a very long time and a lot of practice to become truly proficient at flintknapping. A mammoth hunt may have taken several days but certainly not so long as learning how to make stone tools consistently and well. So the mammoth hunters were engaged in a short-term investment (time spent hunting) that entailed some risk (they could be trampled and die) some of the proceeds of which (mammoth meat) was used to invest in a longer-term project (feeding the flintknapper while he makes stone tools) with its own level of risk (he could be eaten by a sabertooth, the loss of his help hunting could result in the whole tribe starving and leaving behind a number of unfinished stone tools, he could fail to figure out how to make the tools efficiently and well...) with a potentially greater long-term payoff (better tools with which to bring back a lot more mammoth meat). Yes, it's possible the flintknapper took his turn hunting as well (though one might argue this was an unacceptable risk) but the two roles, hunter and flintknapper, are separate and distinct and that is all we really care about.
That's "maturity mismatching" in a nutshell. Even non-human primates engage in this sort of activity, just not with flintknapping. If you think this is a terrible, bad idea that is doomed to fail, I invite you to go play with your unevolved, single-celled, pond-scum brethren where you belong.
Fiat currency, on the other hand. With fiat currency, the entity which makes the fiat (let's call this a "government") can arbitrarily change the supply of currency. We need to understand "currency" as a symbol - a medium of exchange and naturally outgrowth of the barter system. As one commenter rightly pointed out, Megan, you cannot "make money work for you" - people work, not money. Money is just a unit of barter that is hopefully easy to carry around in your pocket and doesn't spoil.
Within a fiat currency regime, the government (or those with a strong interest and the means of putting pressure on the government) looks at the maturity mismatching phenomenon and decides that it's simply terrible that the tribe has to invest so much effort in obtaining mammoth meat to feed one flintknapper when, really, there is a pretty big risk to the tribe that the old geezer will get sick next winter and die, taking all of his half-learned knowledge and practice with him to the happy hunting grounds beyond. It would in fact be a wonderful thing if everyone in the tribe could be a flintknapper. Success would then be assured, and everyone could have nice stone tools. The government in its power and wisdom then causes freshly-cooked mammoth meat to magically appear right outside the tribe's camp, every day. (Mammoth meat is neither particularly portable nor particularly immune to spoilage, but it works for our purposes.) No longer do the hunters need to risk their lives to hunt mammoths! Everyone sits around the cave and learns to make stone tools. There is so much mammoth meat that the tribe grows in size, more and more join it and new babies are born since there is plenty of food for all. It takes more and more mammoth meat to feed everyone so they can continue to make wonderful stone tools, but that is all right because "the government" continues to provide mammoth manna. The "ivory age" of growth and prosperity is talked of reverently by all.
Then one day there is no mammoth meat. "Where is our meat?" ask the tribespeople.
"There is no more meat," says the government, "the mammoths are all dead and there is no more to be had. Sorry. Actually, we fed a lot of mammoth meat to the sabertooths to keep them off your backs. We could bring the sabertooths over and you can ask them if you can climb into their stomachs and see if there is any meat left in there. In hindsight maybe we should have encouraged you to use something of relatively fixed quantity, like this shiny stuff called gold, as a medium of exchange, instead of mammoth meat that we magically created out of nothing. Oops."
So all the people starve and die, leaving their nice stone tools about unused, and the dodos live happily ever after.
Fractional reserve banking GOOD. Fiat currency BAD.
End of lesson.