The Fed, the FDIC, and Other Problems

0:00Our next speaker is Dr. Joseph Salerno. Joe is professor of economics at Pace University and head of the graduate program in economics right here in New York City. He's the academic vice president of the Mises Institute, the editor of the quarterly journal of Austrian Economics, a close friend and student and eventual colleague of Murray Rothbard's. and Joe is going to talk to us today about the Fed, the FDIC and other problems. Joe. Thank you very much. Thank you for the introduction, Lew, and welcome to the afternoon sessions. All the topics that I've been assigned have been touched on more or less broadly by this morning's speakers.

0:51David Stockman did a wonderful job of talking about Bernanke's Day of Infamy and Walter introduced the problem of fractional reserve banking while Doug talked about the FDIC and its special programs and Peter talked about the intermechanics or rather machinations of the Federal Reserve system. What I want to do though is to focus a little bit more closely And what I believe is the core of the problem, that is the core of the financial crisis, the meltdown, and the reason why the Fed had to respond as it has done yesterday. And really what I'm talking about is fractional reserve banking.

1:38Now Walter dealt with the ethics of it, but I want to take a little closer look at the and mechanics of it, and of how it can exist in today's world, okay, and to give away a little bit of the answer, it's really enabled by the Federal Reserve system, a monopoly central bank that can issue money at will and bail any banker, any company out. The fact that we have something called a too-big-to-fail doctrine for banks and financial institutions, But we all know if something is too big to fail, it's too big, and the market will cut it down to size, but that's not allowed to happen because of the existence of the Fed. And finally, of course, the existence of deposit insurance.

2:26So let me just talk a little bit about fractional reserve banking, why it exists, we'll see there's a problem with public confidence, and then briefly go over a solution. Let me just start with fractional reserve banking, really a bank is simply a business firm that issues claims to a fixed sum of money in return for a deposit of cash. These claims are payable on demand and without cost to the depositor. In today's world, these claims may take the form of checkable deposits or checking accounts or even savings deposits, which are payable on demand or at ATM machines. In the United States, the cash for which the deposit claim is redeemable are Federal Reserve notes.

3:12Those are the dollar bills that we are all familiar with. That is the cash of the system. Previously, prior to 1933 and especially prior to 1914, the ultimate cash of the system were gold coins. Fractional reserve banking occurs when the bank lends or invests some of its depositors' funds and retains only a fraction of the deposits in cash. This cash is the bank's reserves, hence the name fractional reserve banking. All commercial banks and thrifts in the U.S. and in the world today engage in fractional reserve banking. Now, Walter gave an illustration of this, I'll give another illustration. Assume that a bank with deposits of $1 million makes $900,000 worth of loans and investments. If we ignore for simplicity the capital paid in by the bank's owners, the deposits constitute The bank's liabilities because the bank is contractually obligated to redeem them on-demand.

4:09The assets of the bank are its reserves, loans and investments. Bank reserves consist of the dollar bills in its vaults and its ATM machines, and the bank's deposits at the Federal Reserve System, which can be cashed in on-demand for dollar bills, which are printed by the Federal Bureau of Engraving and Printing at the order of the Fed. The bank's loans and securities are non-cash assets, which are titles to sums of cash payable only in the near or distant future. These assets include business loans, credit card loans, mortgage loans and securities issued by the U.S. Treasury and foreign governments. The key to understanding the nature of fractional reserve banking and the problem it creates is to recognize that the bank deposit, the checking deposit, is not money itself.

4:57It is rather a money substitute, a claim to standard money, a claim to dollar bills, that is universally regarded as perfectly secure. Bank deposits are transferred by check or debit card will be routinely paid and received in exchange as substitutes for money, only as long as the public does not have the slightest doubt that the bank which creates these deposits is able and willing to redeem them without delay or expense. Under these circumstances, bank deposits are eagerly accepted and held by businesses, households and they're regarded as indistinguishable from the dollar bills that they are claims to. And they are included properly as part of the money supply. Now, the balance sheet of a fractional reserve bank represents an immediate problem.

5:47On the one hand, all of the bank's deposit liabilities mature on a daily basis because it is a promise to cash on demand. On the other hand, only a small fraction of its assets is available at any moment to meet these liabilities. For example, during normal times, U.S. banks effectively hold much less than 10% of deposits in cash reserves. The rest of the bank's liabilities will only mature after a number of months, years, or in the case of mortgage loans, decades. In the jargon of economics, fractional reserve banking always involves term structure risk, which arises from mismatching the maturity structure of the liabilities with assets. Now in layman's terms, all that means is that banks borrow short and lend long.

6:36They promise to pay off in the short term, but they lend the money out for much longer periods of time. And of course, the problem is revealed when demands for withdrawal of deposits exceeds a bank's existing cash reserves. The bank is then compelled to hastily sell off some of its longer-term assets, many of which are not readily saleable. It will thus incur big losses because it must dump these assets at bargain-basement prices. This will cause a panic among the rest of the depositors, who will scramble to withdraw the deposits before they become worthless. A classic bank run will then occur, and at this point the value of the bank's remaining assets will no longer be sufficient to pay off the deposit liabilities, and the bank Bank will fail. Now, let me talk about why this doesn't happen on a regular basis.

7:25A fractional reserve bank, therefore, can only remain solvent for as long as public confidence exists that its deposits really are secure claims to cash. If for any reason the faintest suspicion arises among its clients that a bank's deposits are no longer payable on demand, the bank's reputation as an issuer of money substitutes The banks brand of money substitutes is then instantly extinguished and people rush to withdraw their deposits in cash, cash that no fractional reserve bank can provide on demand in sufficient quantities, thus the threat of instant insolvency is always looming over fractional reserve banks, that is all banks in the world today.

8:14The particular bank's deposits may still exist as part of people's wealth, but they will no longer be treated as money substitutes. You will be able to use them to purchase goods and services and assets. Thus, in order to issue money substitutes, a bank must develop what Ludwig von Mises called a special kind of goodwill that goes beyond business goodwill. On a free market, this kind of goodwill is very difficult and costly to acquire and maintain, But it is this reputational asset that induces a bank's clients to abstain from immediately cashing in the deposit at every moment and driving the bank into instant insolvency. So at every moment there has to be a decision to hold these banks' claims to cash.

9:00Once any suspicion arises that the bank's not going to pay off, at that moment you have the bank run. But unlike the common form of goodwill, essential to all successful business ventures, the goodwill that is necessary for fractional reserve banks' deposits to circulate as money substitutes is highly peculiar. Now either all customers trust the bank and hold its deposits, or no one does. Once some people lose confidence and begin to cash in their deposits, the bank's days are numbered, the bank's moments are numbered. Now Ludwig von Mises described the loss of confidence in a bank's solvency and the related phenomenon of brand extinction, meaning that their deposits are no longer considered legitimate claims to money.

9:49And here's what he said, the confidence which a bank and the money substitutes it has issued enjoy is indivisible, it is either present with all its clients or it vanishes entirely. If some of the clients lose confidence, the rest of them lose it too. One must not forget that every bank issuing fiduciary media, that is, unbacked checking account deposits, is in a rather precarious position. Its most valuable asset is its reputation. It must go bankrupt as soon as doubts arise concerning its perfect trustworthiness and solvency. And Murray Rothbard echoed this. Murray Rothbard wrote, but in what sense is a bank sound? In one whisper of doom, one faltering of public confidence should quickly bring the bank down.

10:38In what other industry does a mere rumor or hint of doubt bring down a mighty and seemingly solid firm? What is it about banking that public confidence should play such a decisive and overwhelmingly important role? The answer lies in the nature of our banking system, in the fact that both commercial banks and thrift banks have been systematically engaging in fractional reserve banking. is they have far less cash on hand than there are demand claims to cash outstanding. I want to give you a few examples. Rothbard's point about the extreme fragility of public confidence in issuers of fractionally backed money substitutes is illustrated by the stunning collapse of Washington Mutual, or Waymu as it was called, in September 2008, the largest bank failure in the United States history.

11:28EMU had been in existence for 119 years and was the sixth largest bank in the United States with assets of $307 billion. It had branches throughout the country and billed itself as the Walmart of banking. Everyone remember that? It was one of the top performers on Wall Street until shortly before its failure. So Wall Street did not see the failure coming. Its depositors clearly had confidence in its solidity, especially given that its deposits were ensured by the Federal Government, reinforced by the existence of the Fed's too-big-to-fail policy. And yet, almost overnight, the special goodwill that gave its deposits the quality of money substitutes vanished as panic-stricken depositors rushed to withdraw their funds.

12:13The unlikely event that triggered the sudden loss of confidence and subsequent brand extinction was a failure of Lehman Brothers, a very venerable investment house, it wasn't initially a problem with Washington Mutual at all, it was a contagion. A week after Lehman failed, Mighty Waymo was no more, it was gone, it was completely gone. The highly publicized Lehman Brothers failure had shaken public confidence in the solvency not only of Waymo but of the entire banking system, had the Fed and Treasury not acted aggressively to bail out the largest banks in the fall of 2008, there is no doubt that the entire system would have collapsed in short order.

13:03Indeed, on a single day in December, the combined emergency lending by the Fed and the U.S. Treasury had risen to a peak of $1.2 trillion. The recipients of these billions included some of the most trusted and reputable brand names in banking, Citibank, Bank of America, Morgan Stanley, as well as European banks Banks like the Royal Bank of Scotland and UBS AG, despite their long existence, despite their reputation for solidity, the slightest doubt that they were no longer able to pay off their deposit claims would have brought them down within a week after the Washington mutual failure. Now let's contrast this example with the Tylenol murders that occurred in Chicago in in 1982, which you may still remember.

13:54In this incident, seven people died from ingesting capsules of the analgesic, super-strength Tylenol that were laced with potassium cyanide. However, not only was the parent company, Johnson & Johnson, able to maintain its own business goodwill by its successful and prompt response to the tragedy, it was also able to recover the goodwill of the Tylenol brand name itself, so the brand name didn't vanish in the thin air. It is true that many customers stopped purchasing the Tylenol brand for a while, and that its share of the painkiller market swiftly plunged from 37% to 8%, didn't disappear, got very small. Nevertheless, its market share rebounded back to 30% in less than a year. A few years later, Tylenol was again the most popular painkiller. Furthermore, the Johnson & Johnson stock, which had been trading at an all-time peak shortly before the incident plunged, but then rose back to its peak three months later.

14:47This doesn't happen in the banking industry. Once the bank's reputation is impugned, it is gone. It is as good as gone, okay? It can take a few days, it can take maybe a month, but the bank is no longer a functioning issuer of reputable deposits, checking deposit claims. This can only occur in banking. Moreover, the reputational setbacks suffered by the Tylenol brand did not spread to the other brands marketed by Johnson & Johnson or obviously to any other over-the-counter painkillers. And of course, there was never any question that the incident would bring down the entire over-the-counter pharmaceuticals industry. The events of 2008 would have brought down the entire banking system, not just here in the U.S., but throughout So the ever present threat of insolvency is really a minor problem with fractional reserve banks, because its effects are restricted to the banks, stockholders, creditors and depositors who voluntarily assume these peculiar risks involved in this business.

15:56The major problems I'm just going to mention, and then I want to give you a solution, are of course the fact that fractional reserve banking is inherently inflationary. As soon as the bank lends any deposits out, that increases the money supply, because the person who puts $10,000 in a checking account still has full access to that $10,000. But if you now lend $9,000 out to someone else to expand their dry cleaning establishment, that person now has $9,000. So now there's, instead of $10,000, there's $19,000. And that goes on and on, and it multiplies to a maximum of 10 times the original deposit. So it's inherently inflationary and when the money's lent out it falsifies interest rates, it pushes them below the market rate, the equilibrium rate, and that causes entrepreneurs and homeowners to make errors in their financial decisions and that brings about, eventually, the recession or depression or lingering stagnation as we now have.

17:00Okay, what is the solution to this? The solution is going to sound paradoxical. Inflation and the boom-bust cycles generated by fractional reserve banking are enormously intensified by the Federal Reserve and U.S. government interference with the banking industry. Indeed, this interference is justified by economists and policymakers precisely because of the instability of the fractional reserve system. The most dangerous forms of such interference are the power of the Federal Reserve to create bank reserves out of thin air, really just with a keystroke, okay, they create these reserves in cyberspace, okay, they just credit the bank's account.

17:45So instantaneously new money is created and that is what will happen every month to the tune of 40 billion new dollars of bank reserves. It's actually done between 11 and 11 o'clock to 12 o'clock in the morning every day. It's called Fed time where they go into the market and there's an auction and they purchase these mortgage-backed securities and treasuries and so on. So in purchasing them, they create money because the Fed obviously does not tax. Its only power to purchase comes from the ability to create money. So that's one of the problems. The other is its use of these phony reserves to bail out failing banks in its role as a lender of last resort and federal insurance of bank deposits, which Doug talked about this morning. In the presence of such policies, the deposits of all banks are perceived and trusted by the public as one homogeneous brand of money substitutes guaranteed by the federal government and backed up by the Fed's power to print up bank reserves

18:52In other words, people don't distinguish between sound banks and unsound banks. When you have deposit insurance and you have a Fed willing and able to bail out failing banks, everyone looks on a checking account at any bank as pretty much the same thing. Under the current monetary regime, there is thus absolutely no check on the natural propensity of fractional reserve banks to mismatch their assets and liabilities. and Liabilities, to borrow short and lend long, which then leads to an expansion of the money supply and an artificial depression of interest rates and all the problems that result. With our fundamental changes in the U.S. monetary system, the growth of bubbles in various sectors of the economy and the subsequent financial crises will continue.

19:41The solution is to treat banking as any other business and permit it to operate on a free market, a market completely free of government guarantees, of bank deposits and of the possibility of Fed Bailouts. In order to achieve the latter, Federal Deposit Insurance must be phased out and the Fed would have to be permanently and credibly deprived of its legal power to create bank reserves out of thin air. The best way to do this is to establish a genuine gold standard in which gold coins would circulate as cash and serve as bank reserves. At the same time, the Fed must be stripped of its authority to issue notes and conduct open and Market Operations. Also, banks would once again be legally enabled to issue their own brands of notes as they were in the 19th and early 20th century. Once this mighty rollback of government intervention and banking is accomplished, each fractional reserve bank would be rigidly constrained by public confidence when issuing money substitutes. One false

20:38step, one questionable loan, one imprudent emission of unbacked notes and deposits would would cause instant extinction of its brand substitute, of its money substitutes, a bank run and insolvency. So banks would now compete to be solid. There's no bailout, there's no guarantee, okay? Each bank is on its own bottom, each bank is undertaking its own risk. In fact, on the banking market, as I have described it, I foresee the ever-present threat of insolvency, forcing banks to refrain from further lending of their deposits to payable on Demand. This means that if a bank wished to make loans of shorter or longer maturity, they would do so by issuing credit instruments whose maturities matched the loans. Let me give you some examples.

21:23For short-term business lending, they would issue certificates of deposits with maturities of three or six months. So if you're lending to a business for six months, you borrow from someone who cannot reacquire their money for another six months. The finance car loans, they might issue three-year or four-year short bonds. Mortgage lending would be financed by five or ten-year bonds. Without government institutions like Fannie Mae and Freddie Mac, which is backed by the Fed's money-creating power, implicitly guaranteeing mortgages, mortgage loans would probably be transformed into shorter five or ten balloon loans, as they were until the 1930s. The bank may retain an option to roll over the mortgage loan when it comes due pending a re-evaluation of the borrower's current financial situation and recent credit history.

22:18In short, on a free market, fractional reserve banking with all its inherent problems would slowly wither away. This was also the position of Murray Rothbard who concluded, quote, contrary to propaganda and myth, free banking would lead to hard money and allow very little credit expansion of fractional reserve banking.