Monday, October 06, 2008

Is Banking Immoral?

Connor Boyack asserts in this post that our banking system is inherently immoral. At issue is the fractional-reserve system.

Most adults understand that the money they deposit in a bank is invested or loaned to others. It is not held in a massive vault like Scrooge McDuck’s money bin. That would be like you trying to privately loan money to someone but still retain the cash in your hand. The bank retains only a fraction (thus, the term fractional) of the actual deposits on hand (in reserve) to meet regular business needs. The bank acts as a clearance house that links up willing investors and those seeking investment capital.

The bank pays us interest for the amount we keep on deposit. The bank charges a higher rate of interest to those that take out loans. After subtracting operating costs, the difference between the interest paid by debtors and the interest paid out to depositors is profit to the bank.

Connor claims that this system is immoral, because most depositors expect to be able to access all of their funds at any time they wish. The system only works because the depositors generally do not all want all of their funds at the same time.

If depositors ever demand more funds than the bank holds in reserve, the bank cannot meet the demand. This is called a run on the bank. The bank would have to call in its loans and sell its investments to satisfy depositors’ demands for their funds.

As far as I can tell, there is no implication in this argument that the bank does not have sufficient assets to cover its liabilities. Rather, Connor seems to assert that fraud exists because deposit funds are expected to be far more liquid than the instruments into which those funds are invested.

Let’s put it this way. If you were to privately loan $5,000 to someone with the agreement that this amount would be repaid in monthly installments over a period of two years at a set interest rate, you would not expect to be able to call in the entire debt should you suddenly decide that you wanted to use that money to buy a car instead. You would patiently wait for each monthly payment to arrive. You would also bear the entire cost, should the debtor default on the loan.

However, if you take that same $5,000 and put it in a regular bank account, the bank might take that money and loan it out under a similar agreement to the one in the private loan example. For your trouble, the bank pays you a portion of the interest from the loan.

But you also expect to be able to walk into the bank tomorrow and pull out the entire $5,000, should you wish to do so. In addition, you expect that your funds will be available even if the debtor defaults on the loan. Thus, your deposited funds are highly liquid, while the corresponding debt is far less liquid.

To Connor this is fraud. I can only assume that he would want the bank to tell you at the time of deposit that you can only withdraw, say, $210 per month and that your funds are toast if the debtor fails to repay the loan.

I disagree that this system is inherently immoral or that fraud exists. Rather, the differences between depositor and debtor expectations of liquidity are calculated as risk. We receive information about the nature of the risk via the interest rates associated with the instruments involved. In fact, this is really the only way depositors and debtors have of understanding the risk of using the clearing house’s services.

Each of us engages in risk calculations on a daily basis. You put your life in jeopardy simply by walking out the door to go to work. Will the total cost (including value derived) of taking mass transit exceed the total cost of driving myself? Would it be better to be a few minutes late, or should I try to get there on an eighth of a tank of gas?

Sometimes we subcontract risk, such as with auto insurance. Even ordering something off the Internet to be delivered to your home is a type of risk subcontract. You transfer the risk of driving to the store to the professional UPS driver, for example. If the item arrives damaged, you expect the seller and/or shipper to bear the cost of replacing the item.

In these examples and many other daily risk transfer decisions, the costs of our actions are constantly in front of our faces helping us make informed decisions, even if we don’t understand how the whole system works.

I do not see that the use of a bank as a clearing house is much different than other types of risk transfers in which we regularly engage. The costs of the risks involved in depositing funds in a bank are readily apparent. If you choose a very low-interest deposit instrument, your funds are safer than if you choose a riskier investment. The bank bears the cost of failed loans usually with small impact to you.

Financial Immorality
The problem we run into is when the pricing mechanisms tied to banking transactions are messed up. The prices (interest rates) constitute the information we need to make informed decisions and to weigh alternatives. When anyone meddles with interest rates, we get inaccurate information. This causes investors and depositors to make faulty decisions, resulting in bad behavior.

When a business manipulates financial information, it is called fraud and it should be prosecuted. When the government meddles with interest rates it is called shoring up the economy, or some other politically correct term that is trumpeted by the media and swallowed up by citizens.

In the former case, a firm is trying to unfairly harm others to their benefit. In the latter case, the political class is inserting itself into the market under the guise of altruistically improving the common good (see Aschwin de Wolf article) — paving the road with noble intentions. But in either case, deception is being employed to manipulate the messages participants in the market rely on to make informed decisions. This is immoral.

As economist Judy Shelton noted in this WSJ article, it is not the overall system that is broken, but rather our medium of exchange — “the measure, the standard, the store of value -- which defines the very substance of the economic contract between buyer and seller.” She writes, “It is the money that is broken.”

In other words, our Federal Reserve System is at the heart of our current crisis. Shelton writes:
“Think of it: Nothing is more vital to capitalism than capital, the financial seed corn dedicated to next year's crop. Yet we, believers in free markets, allow the price of capital, i.e., the interest rate on loanable funds, to be fixed by a central committee in accordance with government objectives. We might as well resurrect Gosplan, the old Soviet State Planning Committee, and ask them to draw up the next five-year plan.”
Whenever I mention the problems with the Fed and suggest that there are viable and better alternatives, people’s eyes tend to gloss over and the ticker tape running in the background starts spitting out, “Warning! Warning! Crazy lunatic!” They have accepted the propaganda about how much the Fed is needed to create economic stability (gee, that sure worked out well) and how awful things were in the days before the Fed.

Even for those that disagree with me about the (im)morality of the private banking system, I suggest that they take a closer look at the inherent immorality of our public banking system. I hope people start thinking to themselves, “There has got to be a better and freer way.”


y-intercept said...

This argument has been around for a long time. It is called lending long on short money.

The ancients used to called lending at interest "usery."

When you think of things on a macro level, interest bearing loans are extremely risky.

The whole mortgage mess is the result of overloading properties with fixed loans. That created a brittle economy.

BTW, the moral arguments against mortgages are part of the reason taht I have been blogging about shared risk financing of late.

The moral point being that a community where people are sharing the risks and rewards of home ownership is better off than one where the banks use home buyers for fixed rate loans (rent seeking) and one where home buyers are trying to outwit the market in buying homes larger than they need or can afford.

Cameron said...

This was a great discussion of private banking. Thanks Reach.

I'd be interested in your thoughts concerning the pros and cons of dismantling the Federal Reserve. I promise my eyes won't glaze over. :-)

Scott Hinrichs said...

Cameron, that is a topic worthy of an entire post or even a series of posts. Let me say that there seems to be ample evidence that FA Hayek's contentions about centralized banking have some validity.

Hayek noted that money predated governments and has successfully operated in the absence of governmental interference. Government manipulation of money has caused a great deal of mischief. Hayek contended that any problems with private money have been far less than the problems with government-controlled money.

A different perspective on this matter is offered by financial historian and author John Steele Gordon in this WSJ op-ed. Gordon says that a strong central bank with a solid regulatory structure is essential to financial and monetary stability. He lays out a case for his theory, citing the problems during the decades when the US lacked a central bank.

Celebrated former central banker Paul Volcker argues here for government taking a strong role in fixing our current problems. But he also says, "The extraordinary interventions by the government (and taxpayer) should be ended as soon as reasonably feasible."

That sounds pretty good, but it seems that too often, once government gets its fingers into something, there are many that never see and "reasonably feasible" point at which those "interventions" can be ended.

Libertarian-minded people would counter Gordon and Volcker, suggesting that their view of government involvement in money is skewed. They would say that the real reasons government are involved in money is because it brings them incredible levels of power and control over the lives of people. They would say that private money has failed mainly due to government intervention and meddling.

I think Gordon makes some very good points in favor of a strong central bank. But I also think that Hayek has some valid arguments.

Might I suggest a compromise. Craft sturdy regulations and then allow any financial institution to offer competing currencies. The central bank's currency would compete as well. These competing currencies would force the money makers to compete to provide value for the users of their currencies. This would force our central bank to be far more disciplined than it is today.

Almost everything you can read about competing currencies seems to come from people connected to Ron Paul. I don't think that necessarily says anything inherently good or bad about the idea.

For those that oppose competing currencies, I would like to ask what they are afraid of. I dunno, maybe broad-based inflation like we've had in the past 18 months? Or maybe a global financial crisis? Make some fair rules. Let anyone that is willing to abide by those rules issue their own currency based on something of value. The Fed can compete as well. Let's see how it goes.