Can The Monetary System Regulate Itself?

0:00Thank you Art, but you took away the surprise. The surprise is that the answer to the question, can the monetary system regulate itself? Or if we want to consider the banking system as part of the monetary system, can the monetary and banking system regulate itself? The answer is yes. I better put my glasses on so I remember why. Now, I will grant that most economists will probably say no, but the idea today, but the idea that a monetary system can regulate itself is actually one of the oldest ideas in economics. Some of you have been students in Professor Cardin's History of Economics thought class, or what is it, classical and Marxian economics.

0:51Before the birth of economics as a discipline, there were a bunch of writers, nowadays known as mercantilists. And on monetary policy, the mercantilists' advice to the king was, the king should outlaw the export of gold and silver. Because if he didn't do that, the country might lose all its money. It might drain out to the rest of the world. It was the great philosopher David Hume who argued, who showed that that kind of fear was really just nonsense. And the way he showed it most convincingly was with the following thought experiment. He said suppose we live in a world where the money everywhere in the world is silver coins, just for the sake of simplicity.

1:37Now imagine the people in England, sort of subset of this world, wake up in the morning So each individual's holdings of money are half of what they were, half of what they were accustomed to, half of what they felt comfortable holding. Isn't it obvious, Hume asked, that people will react to that by trying to build their money balances back up? They don't have enough really to make the transactions they want to make. So how do you build your money balances back up? You try to sell more, and you try to spend less. So, how do you bill your money balances back up? You try to sell more and you try to spend less. So, in England, there will be less spending. There will be an attempt to sell more goods. But with less demand for local goods and with more supply of local goods, prices in England have to fall.

2:27As prices in England fall, foreigners, people on the continent of Europe, are going to notice that English prices are now low. So, they're going to start buying more English goods, meanwhile, people in England are buying less of imports because they're trying to build their money balances back up, so exports will rise from England. To pay for this excess of English goods over the goods they're now selling to England, the foreigners are going to have to pay for their increased purchases with coin. Silver is going to begin to flow back into England, to replace the silver that mysteriously disappeared. And silver will continue to flow in until people are satisfied that they've built their money balances back up, and until English prices return back to world prices, or European prices, and at that point the inflow stops.

3:18So the supply of money in the nation following the initial disturbance returns to equilibrium. It's a self-correcting process, and when there's too little money, the market will self-correct by attracting as much additional money as people want to hold. Similar sequence works in the other direction, if we imagine instead that people wake up and find they have double the money they had the night before. Now they've got an excess money balance. They'll start spending more. That's going to drive local prices up. Imports are going to now become cheaper than local goods. English people will start buying more imports. That'll make coins flow out to the rest of the world in order to pay for the imports. So when this excess has been vented, when people are back down to holding the amount of money they want to hold, the outflow stops.

4:08So the outflow of money is both a symptom of an excess supply and it corrects the excess supply. So contrary to the mercantilists, the silly king doesn't have to worry that the money is all going to drain away, the quantity will regulate itself, the king doesn't have to hamper trade with restrictions that, actually they're kind of pointless, it's impossible to bottle up money, but restrictions that aimed at bottling up money inside the kingdom, so that's the earliest example, in fact it's one of the earliest examples in economics of a theory of a self-regulating order and it's a theory of a self-regulating monetary order. The famous Adam Smith applied the same kind of lesson to the system he saw around him, which was a mixed currency, he called it. That is, it wasn't just coins, it was also redeemable bank notes.

4:58So the paper notes that people use, that today we have Federal Reserve notes, but in Scotland in those days, they had notes issued by private banks. Actually, in Scotland today, they still have notes issued by private banks, if you've been there. It's interesting to see. In those days, in Adam Smith's day, the notes were redeemable for silver coin. So if you wanted to, you could go to the bank that issued it and demand coin in exchange for it. And Smith applied kind of Hume's reasoning to this mixed currency and said, if the banks issue more currency than people want, the way he put it was, more than they can usefully absorb and employ, the same kind of mechanism will drain silver from the vaults of the banks.

5:45If the banks in the aggregate issue too much, prices will rise. In order to pay for imports, people can't export Scottish bank notes. People in London won't take those. They want silver coin. So they'll have to go to the banks that issued the notes, get silver coin and export that. But that means the banks see their reserves of silver coin, the reserves they're counting on to be able to redeem the notes when the public comes and asks for redemption. They'll see their reserves leaving, and that'll force them to reverse the over-issue. So banks are not able in any sustainable way to put more money into circulation than the public wants to hold. So like the pure coin system, this kind of mixed system is self-regulating with regard to the quantity of money, provided that it's anchored by redeemability into metallic coins.

6:38Even within the country, any single bank is going to be restrained from over issuing relative to other banks because its notes will get in the hands of those other banks. The banks in Scotland all accepted one another's notes just like banks today accept one another's checks and then they return them to the bank that they're drawn on and demand redemption and so reserves drain from one bank to another very quickly, that restrains over-issue by any particular bank. All right, well that's some ancient theory as a background. So you may be wondering, doesn't our current financial crisis show that the answer to the question, can the system regulate itself?

7:25Doesn't it show that the answer is no? Well, it doesn't. It shows that our current system doesn't regulate itself. It doesn't show that in principle a monetary and banking system can't regulate itself because our current crisis is not a crisis that arose in an unregulated financial system or a free banking system. It arose in a pervasively regulated system, a perversely regulated system, a legally restricted, a hampered system. I got loads of synonyms. We don't have laissez-faire in money. We don't have laissez-faire in banking. We don't have laissez-faire in finance. We have not a silver standard, not a gold standard. We have a fiat money standard. A bank note under a silver standard is an IOU issued by a bank. A Federal Reserve note today is an IOU nothing.

8:17You take a $10 bill to the Federal Reserve bank and say, I'd like to redeem this, you'll get two fives. We have a government central bank, the Federal Reserve system, whereas in an unregulated system, in a kind of natural system, there isn't any central bank, but rather the issue of currency is handled by decentralized competing commercial banks. That's sometimes called a free banking system. And of course we have heavy legal restrictions both on banks and on other financial firms. There's been some loose talk in the current crisis about it being the responsibility, the fault of deregulation. But if you look for details in that charge, you can't find them because, well, there hasn't been deregulation.

9:08The last thing that was partial deregulation was the Financial Services Modernization Act of 1999, signed by President Clinton. I had a dinner with one of your economics professors last night who reminded me to give the proper name of the act. What that act did was to allow regulated bank holding companies to become regulated financial holding companies. So instead of just owning banks, they can now also own insurance companies and they can own investment banks and other financial subsidiaries. That's clearly been a help in the current crisis because it's allowed troubled institutions to be acquired by these financial holding companies where previously they couldn't have been acquired by them.

10:07So Merrill Lynch could not have been sold to Bank of America if not for this act. Anyway, to be clear, I'm arguing that a free market monetary and banking system can regulate itself, not that our current system is self-regulating. If we want a more self-regulating system, we need to move in the direction of a more free market system in order to get a better regulated system. So, the term regulated is kind of ambiguous. It suggests that regulation, as usually understood, which is a system of government guidance and restriction and supervision, gives us greater regularity, but actually that's the opposite of the truth. So we need to unpack it.

10:52We have legal restrictions, we don't have regularity. We have a crisis-prone system. And if we want a less crisis-prone system, we need market regulation rather than the kind of regulation we've got today. There are basically going to be two elements to my argument. There's a positive element. There's a positive case for believing that unregulated or free banking is going to work. It's going to restrain itself, and the case there is very much like the case for free trade. It's a case that indicates that the benefits are going to exceed the costs, profit opportunities are going to be exploited. I got additional evidence of that today. I went swimming in the pool here.

11:40I didn't believe that it was going to be warm enough, but apparently it's self-regulating too. Why don't more economists believe that monetary system can be self-regulating? There is honest opposition, there are honest doubts about the theory, or lack of familiarity with the theory, which is no longer so commonly taught. But there's also sort of historical myths that have become prevalent.

12:29And of course there are entrenched interests. There are people who benefit from being part of the current regulated system. The negative part of my argument is going to be trying to show that there isn't any good theoretical case to establish that government needs to or should provide money or regulate banks. The leading market failure arguments don't really hold water. In order not to be misinterpreted, let me repeat something I learned from one of my economics professors. Whenever he was asked, so, professor, you have faith in the free market, he would say, no, I don't have faith in the free market, I have evidence.

13:20I have evidence that free market institutions work. So that's the kind of case I'm going to try to present. So I've talked a little about Hume's theory and Adam Smith's theory. You can go back to the very origins of money. Carl Menger's theory, Carl Menger was an Austrian economist the late 19th century. If you want to understand why money emerges in the first place out of a barter economy, Menger explained how each individual in a barter system has the problem, If you're trying to swap what you come to market with, say you're an asparagus farmer, and you want to go home with plaid shirts, you have a problem. You've got to find somebody selling plaid shirts who wants to be paid in asparagus.

14:09And if he doesn't want asparagus, now you have a problem. So what can you do? Well, you can go home and wear your asparagus, I suppose. Or, if you're a little bit entrepreneurial, say to yourself, Or say to the guy selling the plaid shirts, well, if you don't want asparagus, what do you want? He says, I'm looking for cabbage. Oh, well in that case, if I can trade my asparagus for cabbage, I could trade the cabbage for the shirts. And if you can do that, then cabbage becomes your medium of exchange. It becomes the vehicle which carries your exchange process forward. So once people discover that, they become on the lookout for trades they can make that even if they don't get them what they really want to consume, get them a step closer whether it gets you a step closer depends on whether other people accept it so you need to be on the lookout for what other people want to consume or will

15:03use as a medium of exchange and that sets the stage for the whole thing to converge because if i see that a lot of other people using salt as a medium of exchange then i'll use it because now i can trade with them so the group of people who accept it grows and the economy converges on a commonly accepted medium of exchange. So no king had to invent money, no chamber of commerce had to get together and hold a convention and decide what it was to adopt as money. We know historically it was gold and silver that emerged out of this process. One of the things that held them back initially was The gold and silver are actually not very uniform when they come out of the mine, so it took the invention of coinage as a way to certify weight and fineness so people could trust the pieces of metal that were being offered to them, as long as they could trust the seal that was stamped on it.

16:03And if you think about it that way, if you think about the function of the mint being to certify the weight and fineness of the metal, well, we rely today on all kinds of private certification agencies for weight and fineness of precious metals. You buy a gold bar nowadays. It's typically stamped by the Engelhard Minerals Company. Similarly, there was a private market that provided the service of certifying the weight and fineness of metals. In the US, during the California gold rush, there were something like, well there were gold and silver rushes throughout the west, there were something like 20 private companies that minted their own coins. Go online, you can find pictures of them. They're quite pretty. They're quite valuable these days, so if you find one in your grandmother's attic, don't send it to that company that offers to buy your gold without telling you at what price they're going to buy it.

17:01And these private mints had an excellent reputation for, in fact, we have examples of their work that have been tested very carefully, they were more precisely minted than the coins being minted by the U.S. government, they did not have a problem of fraud, you might think, well, a private mint would pretend that this is a one ounce gold coin, but only be half an ounce of gold and the other half would be. Some copper or tin or something they snuck in there. But if you're running one of these mints, your whole business is certification. If people suspect or if the word gets out that one of your coins was bogus, there goes your entire business.

17:46Nobody's going to bring you money if other people won't accept it because your brand name is no longer trusted. So these mints actually had an excellent reputation for certifying the weight and fineness of the gold. the gold. They didn't invent their own units. They minted them to the common official standard. There was one exception. There was a mint associated with the Mormon church, which minted its coins 10% underweight so that members of the church could have a built-in tithe. But nobody except Mormons would accept those coins except at a 10% discount. So that system and regulated itself, too. Why have governments typically gotten into the business of minting coins?

18:35Well, it's like asking why governments do anything. There are two possibilities. One is that there's some kind of market failure that they're remedying. The other is there's revenue in it. In the case of coinage, as far as all the evidence indicates, it wasn't to improve the quality of coins. Privately minted coins were quite good. On the other hand, The history of government coinage of gold and silver is a long history of debasements, mixing in more and more copper and tin and cheaper metals into the coins. Typically reusing the old coin dyes so that it wasn't obvious that the coin's value had been diluted. Passing off the debased coins as just as good as the old coins.

19:21And when the public began to catch on, the government could pass a law that said, no, no, you have to accept the new coins as though they're just as valuable as the old coins. In medieval France, it was actually a crime to weigh coins or to test them for purity. In the French Revolution, the penalty for asking whether somebody intended to pay with government money with pure money was the guillotine. So they made it mandatory to take their money at face value. So you can make a big profit if you can do that. Now, of course, remember we're talking about ancient despotic governments here. We're not talking about elected governments, which of course would never expand the quantity of money to raise revenue at the public's expense.

20:11Well, nowadays, for the revenue raising point of view, we're in the perfect position, we've eliminated the gold and silver entirely, so the government doesn't have to call in the coins and remint them, it just needs to print more paper in order to expand the money supply. For those of you who've taken money in banking, I mean open market operations. and so it's very easy to generate revenue now in the US we collect taxes in so many ways that we don't rely heavily on printing money to pay the government's bills although as the government debt gets bigger and bigger the temptation to inflate it away gets higher and higher so keep that in mind in countries that have less ability to collect income Inflation Taxes, say, because so much of the economy is informal.

21:08Reliance on this inflation tax is heavier, so inflation rates are typically higher in countries at lower levels of economic development. Now most money and banking textbooks will tell you that fiat money is more efficient. It's better for the public than commodity money. And why would they say that? Because it saves resources. It's cheaper to print a $10 bill than it is to mint a $10 coin. But I think they're overestimating the resource costs of a commodity standard, and I think they're engaging in wishful thinking about the management of a paper standard because they typically fail to take into account that with inflation, The inflation that's typical with a paper money standard, it's actually more costly for the public to hold money because it's melting away in their pockets.

22:08The purchasing power is melting away, that's a tax on holding money that you didn't experience under the gold standard. Some economists have unfortunately fed this misperception that a commodity standard is is really expensive by insisting that a free market in money means that all money would be pure silver and gold coins or warehouse receipts for gold and silver coins. But I don't think it means that. I think it means that privately issued money is restricted by contracts, but a possible contract and a contract that historically seemed to be attractive to people was a fractional reserve contract, meaning instead of the bank acting as a pure warehouse, the customer gives it permission to lend some of the money out.

22:58Now why would they be so foolish? Because that way they don't have to pay storage fees, and instead the bank pays them for using their money. They're on notice that they're taking a risk, right? But if the risk is small enough, then it's worth it to get the higher return. So, banks have an incentive and customers have an incentive to allow the banks to economize on gold, as long as they live up to their promise to provide coins to redeem the notes whenever demanded. Banks provided much less costly methods of payment than lugging around bags of coins.

23:44So before banks got into payment, when payment was purely in gold and silver coins, if Alice wants to pay Bob $1,000 and suppose she's keeping her coins with a local vault keeper, She has to go to the vault, take out the thousand in coins, put it in her wheelbarrow, wheel it over to Bob's house. Bob says, thank you very much. He counts the coins, maybe weighs them, puts them back in his wheelbarrow, wheels them back across town, puts them back in the vault. Bob and Alice don't have to be too clever to say, hey, wait a minute, instead of doing all this lugging of coins around, why don't we meet at the vault? at the Vault. Then Alice can take the coins out, hand them over to Bob, and Bob can put them right back in. Hey, wait a minute. We don't even have to take the coins out. And this is the breakthrough that gets bankers into the payment business. You don't have to take the coins out because at the end of the day the coins are going to be back in

24:44the vault. And all that's changed at the end of the day is the banker owes Alice a thousand $1,000 less than he used to, and the banker owes Bob $1,000 more than he used to. So Alice and Bob just have to meet in the banker's office and tell him, hey, move $1,000 on your books from Alice's account to Bob's account. That accomplishes the same thing as taking the coins out and putting them back in. So that's a deposit transfer. And the subsequent history of banking is the development of new methods for deposit transfer. These new methods change the way in which the banker is notified that Alice and Bob want to make this transfer, but it doesn't really change the back end of the transaction. It doesn't change what happens on the bank's balance sheet.

25:32Alice could write Bob a check. Initially, Alice went to the bank in person. Instead, Alice could write a check, give it to Bob, and Bob could take it to the bank. or Alice could go to the bank and tell the banker transfer the money to Bob's account and Bob will know he's been paid when it shows up. That's what electronic funds transfer does. So when you pay at the pump and the gas is going into your car, glug, glug, glug, the money's coming out of your bank account, glug, glug, glug, going into the gas company's bank account, glug, glug, glug. Not really. They wait till the end of the transaction and just do it once. But wire transfer, electronic funds transfer, works that way. It's just a different way to signal the banker to make the payment.

26:19So that's the nature of technical advances in banking. Now there was a second kind of important bank liabilities besides deposits and deposit transfer, which I've already mentioned, which is bank issued currency, bank notes. There are still three places in the world where you can find privately issued bank notes, Scotland, Northern Ireland and Hong Kong. In the U.S., I guess the closest thing we have is travelers checks, right? A hundred dollar American Express travelers check is like a banknote in that it's a monetary claim issued by a private firm, right? Which is valuable because you can go to American Express and redeem it for a hundred dollars in what you might call more basic money.

27:06now the more basic money nowadays isn't gold or silver of course it's Federal Reserve notes one of the worries people have about a system of privately issued notes if you have say a dozen or two dozen different banks issuing their own currencies is how do we know they'll be accepted at one for one with each other well we have a problem of floating exchange, a dozen, two dozen floating exchange rates within the same economy. Wouldn't that be a hassle? Yeah, it would be a hassle, and that's why you shouldn't expect it to happen. It's in a bank's interest to make sure its notes are accepted everywhere at their face value because the bank does more business that way.

27:52So how can they assure that? Well, where banks are not restricted from setting up branch offices, they'll set up branches to redeem their notes all over the economy. and if they don't do that there's another thing they can do which is they can make agreements with other banks would you please accept our notes at face value and what's the other banks incentive to do that they'll return the favor we'll accept your notes at face value and that'll be better for both of our customers this is the way ATM networks spread more recently right ATM networks are private agreements among banks to allow each Other access to their computers so they can see that the customer who's withdrawing money at an ATM, which is not his home bank's ATM, actually has the funds in his account.

28:43They don't have to cooperate that way, but they do because it allows each bank to do more business. The first ATM network was the New York Cash Exchange, NYCE, nice. It was a bunch of banks in New York City who wanted to compete with Citibank. Citibank already had a thousand ATMs. Dime Savings Bank had three ATMs. It was hard for them to attract customers with the slogan, put your money here and you can withdraw it at three points. So they joined together with other banks, they got a network going, and these networks then spread, because the benefits from joining a network aren't exhausted in one city, they became regional, they became national. Cirrus, Avail, Plus, Star, and now they're worldwide. Worldwide, right? Now, travelers checks is a very dwindling business, because you can just take your ATM card, you can get local cash in London, in Paris, in Mumbai, anywhere around the world.

29:42And the fees are not any worse than Thomas Cook charges to change travelers checks. Okay, so that's the positive case. What about rebutting the negative case? There are two arguments offered against a free market monetary system. What are the standard arguments against allowing free markets and the production of any good or service? That it's somehow a public good, or involves significant externalities, that's one argument. The other argument is that there's some kind of natural monopoly that calls for government control.

30:27It's pretty clear that the public good argument is not going to get very far when it comes to money. You know, money is a commonly accepted form of exchange. It's a private good. The money in your pocket is not showering benefits on anybody else. So a standard example of a private good, a good that your consumption is yours alone, doesn't provide benefits to anybody else. My favorite example is a chocolate donut. If you eat a chocolate donut, there's one less chocolate donut for other people to eat. Mmm, donuts. It's not providing benefits to other people. A public good would be something like a broadcast television signal.

31:12Now, you may have never experienced broadcast television, but ask your grandparents about it. It's a system where waves are broadcast out in the air, just over everybody's property, and you tune them in. And if you tune in Channel 9, you're not reducing the amount of Channel 9 available to other people. You're watching, it doesn't diminish anybody else's enjoyment of that good. And I like to use that example because it's a privately produced public good. But the long history of the evolution of money out of barter, the emergence of private mints, the provision of money by private banks, shows that markets don't fail to produce money. There's no market failure here. So that argument's not going to work.

31:57Probably the leading argument today against unregulated banking, and banks are important in the payment system, has to do with external effects of bank runs. So part A, an unregulated banking system is inherently prone to bank runs. And if you want to generalize it, these bank runs become contagious, they spread from bank to bank, so it's inherently prone to panics, financial panics. That's part A. Part B, these runs and panics are bad. They have harmful spillover effects. Part C, if it's going to be a justification for government intervention, there's something, some policy we can adopt, Bankrupt, which reduces runs and panics and has a cost less than the benefit of reducing runs and panics.

32:58So you know what a bank run is. A bank run is when many people line up to try to pull their money out at the same time. By panic, I mean the same thing happens at many banks. And this is the standard argument cited to support having a central bank to act as a The Lender of Last Resort, having deposit insurance, having restrictions on bank capital ratios, so banks aren't too failure-prone, having restrictions on bank entry, can't let just anybody start a bank because that could lead to bad banks and that could lead to a domino effect. In the Great Depression, this was used as an argument for restricting deposit interest rates. Banks can't be allowed to pay interest on their deposits because then they'll compete to pay the most and that means they'll have to adopt risky investment strategies and that'll lead to the domino effect, bank failures and domino effects.

33:50Restrictions on bank reserve ratios, same thing. Restrictions on the assets banks are allowed to invest in. Restrictions on the activities banks are allowed to invest in. That was the theory behind the Glass-Steagall Act, which the Graham-Leach-Bliley Act, I already mentioned, partially repealed. Now, the second claim, the claim that bank runs are harmful, that I'm going to mostly accept. I think that one's pretty solid. They're harmful to bank shareholders, they're harmful to bank borrowers, but mostly they're harmful to depositors. And if it's a panic, it's even worse, it has macroeconomic effects. But I will qualify it a little and say that runs are not always bad.

34:37Why not? Because a run on an insolvent bank, a bank that's squandering depositors' money, is a good thing. You need to close that bank and you need to close it now before it squanders any more money. It's taking $1,000 in savings and turning it into $900 of assets. That needs to be stopped. A bank run stops it. In other businesses, if a business, an ordinary industrial If it can't pay its debts, then the debtors who are not getting paid get together and force the business into insolvency. That's called a bankruptcy. Who are the debtors of a bank? The depositors. A bank run is like a debtor meeting to force the insolvent firm into bankruptcy.

35:27It's a little more chaotic. And there's an unfortunate aspect to it that you don't see in ordinary bankruptcy, which is it's kind of first-come first-serve, which means that people have to run to the bank, that's why it's called a run, and there is a danger that they may be running on a bank that isn't insolvent, and that's when it's a tragedy when a bank run closes a bank. But that's the only case. And if the bank's insolvent, then the run is good to close the bank now rather than later. The reason that insolvent institutions ought to be closed is pretty simple. They need to get out of the way, stop squandering our time and resources, get out of the way and make room for better run banks.

36:12A financial system where failed banks never get closed up is like American Idol where the worst singers never go home. Do you really want to watch American Idol where Tatiana never goes home? Here's another benefit of bank runs you may not have thought of, the threat of runs keeps These banks on their toes. It compels the depositors to monitor what the bank is up to, and if the bank is engaged in silly, dangerous, crazy investment strategies, people are going to leave the bank.

37:03That forces the bank not to do that kind of stuff. Now it used to be that banks were constrained by that. And then we got deposit insurance. Now up until recently deposit insurance only covered part of the bank's depositors. Only up to $100,000. And there were a lot of accounts over $100,000. In fact, the last figure I saw was before the changes in deposit insurance, 28 percent of the deposits in the American banking system were uninsured. They were over the $100,000 limit. They were corporate payrolls, they were the savings accounts of churches, and so those people had an incentive to monitor the banks.

37:50So the system wasn't completely without a penalty for running a risky investment strategy. Today, the limit's been raised to 250,000. The percentage of legally uninsured is much smaller, and the percentage who are de facto to Uninsured has been reduced to zero in the largest banks because they're implicitly guaranteed on the grounds that they're too big to fail. And too big to fail means I, the regulator, don't want this to happen on my watch. If it causes too little incentive for safe banking, that problem will show up later when somebody else is the regulator, but today there's not going to be bank runs.

38:38But if no depositors are monitoring, then the bank is not facing a penalty for risky behavior. And when I say risky, I mean excessively risky behavior. Banks have to take some risks. They ought to take some risks. But I mean crazy risky behavior. Banks are freer to engage in that sort of thing than depositors. So if depositors aren't monitoring the bank, who's left? Well the shareholders, if the shareholders aren't paying attention, regulators. If the regulators aren't paying attention, then God help us. We know what happens actually. We saw it in the savings and loan fiasco in the 1980s. Nobody runs. Regulators fail to close insolvent banks. And a problem of insolvency that could have been solved with $10 billion if it had been done promptly but as soon as the banks became insolvent grew to a hundred and fifty billion dollars because the regulators uh... if we wait the banks will become healthy again and while they didn't and i'm a five fear that were currently in a replay of something like that where

39:50regulators are deliberately forgoing to close insolvent banks City Bank, Bank of America. The best indicator of whether a bank is actually insolvent is not the capital it reports to the regulators. There's plenty of evidence that when eight percent is the required capital ratio, a bank can maintain eight percent capital on its books, even while it's becoming insolvent. The indicator of this becoming insolvent is the market value of the bank's shares because people who are buying and selling its shares want to know what the bank is actually worth not what it's reporting to the regulators and so in the japanese banking crisis of the nineteen nineties in case after case the market value of the bank's capital remained at eight percent sorry that the regulatory ratio that was reported the book value of the bank's capital reported the regulators stated eight percent sorry for you time's going this way the market value went to two percent and at that point the bank was had to be closed by regulators because

41:01it was already actually insolvent well if you're an ordinary depositor how could you know whether the banks in engaging in a crazy investment strategy you don't have to be an expert in reading bank balance sheets you just have to read the reports of people who are you just have to read money magazine all you have to do is the same thing people do nowadays when they invest in mutual funds read a report about what what its strategy is and how well it's doing okay uh... if a bank is i mean there is a way to make a bank really fragile to make it really run prone but of course banks have an incentive not to do that there's a kind of popular model of the bank run one of the economists is that arts alma mater, Wash U Diamond and Dibvig, Diamond is at Chicago, Dibvig is at Wash U and they have this theory, this model of a very fragile bank and it's internally consistent

42:16the problem is it doesn't describe any bank in the real world If a bank was really that fragile, how did banking survive centuries and centuries until deposit insurance came along? It sort of doesn't make evolutionary sense. So how did banks avoid being so fragile? The most important thing they did was to hold enough capital. That's what made them secure against asset losses, pushing them over the brink into negative equity, negative net worth, liabilities greater than their assets. So the capital is a cushion that absorbs the losses to the bank before deposit insurance you can go back and see photographs of this banks used to paint in their window typically in gold leaf this bank has five million dollars capital when federal deposit insurance came along the bank hired somebody with a scraper to scrape that out of the window and replace it with a sticker FDIC So FDIC guarantees are a substitute for bank capital in reassuring depositors and the result is predictable.

43:28Capital is costly for the bank to hold. Stickers practically free. Before deposit insurance banks typically had twenty percent capital. Nowadays well they're supposed to have eight percent capital. We're lucky if they really do. But before capital requirements began being imposed banks had run their capital down to like four percent depositors didn't care anymore depositors would put their money in a thinly capitalized bank because they were protected uh... by Uncle Sam now the amount of your capital whether that's adequate depends on how risky your assets are banks held safer asset portfolios there were no mortgage-backed securities in bank portfolios there were no sub No prime mortgages in bank portfolios. In fact, there were almost no mortgages in ordinary commercial bank portfolios.

44:24Mortgages were mostly held by specialized savings banks. Savings banks that did not offer checking accounts, so they weren't subject to the problem of rapid withdrawal of money. Banks that needed to be liquid did not tie up their portfolios in long-term assets. Banks were run more conservatively when they weren't protected against the consequences of behaving non-conservatively. Now in the model where banks are inherently fragile, they're fragile because people run on the bank just out of fear that other people will run. And in the Diamond Divig model, in fact, that's the only thing that causes bank failures is and so the solution to that is deposit insurance and here's the really cool part deposit insurance is free it never costs anything because once people are assured that they won't lose money should other people run and empty out the bank before they get there if everybody's assured that they'll get their money back nobody ever wants to run and since a run is the only thing that closes a bank banks never fail and therefore the only way to close a bank is to get your money back

45:39The insurance agency never has to make a payout, isn't that great? Like I said, this doesn't really describe the real world, because real world bank failures are not due to runs, they're due to bad loan decisions, 99 times out of 100. And when a run is the thing that precipitates the closure, the bank was already insolvent, usually, not always, there can be mistaken runs, and that's where it is unfortunate. But because that's not why banks fail, but rather bad loan decisions, deposit insurance is costly. Taxpayers are on the hook for bank failures due to bad banking.

46:25Today we've got not just partial FDIC coverage, we've got, at least in large banks, blanket federal guarantees. We've got a risk encouragement effect, what economists call moral hazard, we've got moral hazard on steroids. So my view is that we would be better off without an FDIC. Now I'm not saying we could abolish it tomorrow, not the way banks are today. There would have to be a longer process to sort of get banks back toward sounder practices. But, we would be better off without an FDIC. What about the Federal Reserve? Do we need a Federal Reserve system?

47:13Well, the Federal Reserve system does some useful things. So does the Post Office do some useful things. Nonetheless, I would like to see it legal for private firms to deliver first class mail. And then we'll see if the Post Office can survive. The Fed does some useful things. It issues currency, it clears checks, it processes electronic transfers, it provides a mechanism for banks to pay each other. All those useful things are things that private institutions used to do before the Fed nationalized them. Private bank clearing houses, founded as kind of clubs among banks to clear checks and to settle up among each other efficiently.

48:02Those were all private institutions. It would be more efficient to re-privatize those surfaces. The other things the bank does, the non-useful things the Fed does, enforcing harmful legal restrictions on banks, conducting monetary policy, those would be better off without. So we can abolish the Fed. Most of our history we didn't have a Federal Reserve system. Other countries have done well without central banks. Central banks are fairly a latecomer in the history of banking. So without the Fed what would replace monetary policy?

48:47Well, commercial banks would be issuing all types of money, paper currency as well as checking accounts. The basic money, the Federal Reserve liabilities that sort of underpin the entire system would have to be replaced with something, and the most natural candidate is a gold or silver standard. A gold or silver standard, as Hume explained, will regulate the quantity of money. It will do so without the need for Ben Bernanke's wisdom. Now there's a second leading argument for having a central bank, besides trying to stabilize the banking system against runs and panics, and that is macroeconomic policy.

49:32Smooth out interest rates, smooth out the business cycle. and the Business Cycle. Chairman Bernanke is trying very hard to do that. But the evidence is pretty clear that stabilization policy doesn't actually stabilize. It hasn't worked in practice. It's not that it could never work. There are conditions under which it can help. But more often than not, it works badly. it actually makes cycles bigger, it doesn't carry its own weight and the reason is not that the Fed is particularly incompetent other central banks haven't succeeded either the problem is that to stabilize the economy the Fed would have to know more than it's humanly possible to know and so in practice the Fed has made inflation higher it's distorted interest rates, it's fueled unsustainable booms it's made recessions deeper than they would otherwise be And our current crisis, our current recession, the result of Alan Greenspan's loose money policies from roughly 2001 to 2006 is just the latest example of that.

50:42So we have a crisis due to poor central banking policy, due to mistaken regulatory policy. That should raise, I think, certainly not lower, the likelihood we attach to the idea that the way forward is toward a freer banking system, greater self-regulation in the monetary system. Thanks very much and I'll take questions.