Breaking the Banks

Simon Johnson at the New York Times takes Ron Paul seriously:

Mr. Paul  has a clearly articulated view on the American banking system, laid out forcefully in his 2009 book, “End the Fed.” This book and its bottom-line recommendation that the United States should return to the gold standard – and abolish the Federal Reserve System – tend to be dismissed out of hand by many. That’s a mistake, because Mr. Paul makes many sensible and well-informed points.

But there is a curious disconnect between his diagnosis and his proposed cure, and this disconnect tells us a great deal about why this version of populism from the right is unlikely to make much progress in its current form.

There is much that is thoughtful in Mr. Paul’s book, including statements like this (on Page 18):

“Just so that we are clear: the modern system of money and banking is not a free-market system. It is a system that is half socialized – propped up by the government – and one that could never be sustained as it is in a clean market environment.”

Mr. Paul is also broadly correct that the Federal Reserve has become, in part, a key mechanism through which large banks are rescued from their own folly, so that their management gets the upside when things go well and the realization of any downside risks is shoved onto other people.

But Mr. Paul’s book also acknowledges the imbalance of power within the financial system that prevailed at the end of the 19th century. Wall Street financiers, like J.P. Morgan, were among the most powerful Americans of their day. In the crisis of 1907, it was Morgan who essentially decided which financial institutions would be saved and who must go to the wolves.

Would abolishing the Fed really create a paradise for entrepreneurial banking start-ups, enabling them to challenge and overthrow the megabanks?

Or would it just concentrate even more power in the hands of the largest financial players?

Important questions, no doubt — but also something of a contradiction.

Absolute power — who gets bailed out, who gets access to a lender of last resort, who gets access to money at next-to-zero rates, who gets stimulus funds — is today concentrated in the hands of the largest financial players— the US government, and the Federal Reserve system.

And the US government is susceptible (understatement is an art!) to the activities of lobbyists.

Here’s the NYT on that issue:

The financial industry has spent more than $100 million so far this year [2011] to court regulators and lawmakers, who are finalizing new regulations for lending, trading and debit card fees. During the second quarter, Wall Street spent $50.3 million on lobbying, a small dip from the prior period, according to an analysis by the Center for Responsive Politics.

 Big banks are among the most prolific spenders. JPMorgan Chase‘s team of in-house lobbyists spent $3.3 million, a slight uptick over last year. The biggest war chest among organizations focused primarily on Dodd-Frank belongs to the American Bankers Association, which so far spent $4.6 million on lobbying. The organization wrestled the top spending spot from the Financial Services Roundtable, a fellow trade group that represents 100 of the nation’s largest financial firms.

And the Federal Reserve itself is much worse still. Its stock is owned by private banking interests:

The 12 regional Federal Reserve Banks  issue shares of stock to member banks. The stock may not be sold, traded, or pledged as security for a loan; dividends are, by law, 6 percent per year.

The banking industry effectively writes much of its own regulation, because it is enmeshed into the governmental-bureaucratic superstructure:

Frankly, I don’t think that power could get any more concentrated.

So surely only the naive would be surprised that the banking industry — through their benefactors at the Fed — bailed themselves out of the last crisis to the tune of $29 trillion.

And that is not just unfair; it’s unhealthy.

As I wrote in November:

Bailing out failed and failing financial institutions creates a zombie economy. Why?

In nature, ideas and schemes that work are rewarded — and ideas and schemes that don’t work are punished. Our ancestors who correctly judged the climate, soil and rainfall and planted crops that flourished were rewarded with a bumper harvest. Those who planted the wrong crops did not get a bailout — they got a lean harvest, and were forced to either learn from their mistakes, or perish.

These bailouts have tried to turn nature on its head — bailed out bankers have not been forced by failure to learn from their mistakes, because governments and regulators protected them from failure.

So it should be no surprise that financial institutions have continued making exactly the same mistakes that created the crisis in 2008.

So while it is all very well debate the various schemes to end the problem of too-big-to-fail, it is important to remember that the problem will ultimately solve itself — a system that rewards failures and creates zombies is fundamentally unsustainable.

Ron Paul does not need to end the Fed. By bailing out a system shot with fragility, leverage junkies and counter-party risk — by attempting to sustain a system that is fundamentally unsustainable — the Fed is quietly abolishing itself, or at very least strongly endangering the status quo.

18 thoughts on “Breaking the Banks

  1. Your quote from your November blog contains a mischaracterization in my opinion.Chances are that one farmer was lucky and the other was not … chances are that the lucky farmer thinks he is a better farmer than the unlucky farmer.

    This concept needs to be woven into the conversation about the future of capitalism. We need to be transparent about luck.

    • He was no farmer, but Samuel Goldwyn observed:
      “The harder I work, the luckier I get.”

      Chances are that one farmer took more time to understand the soil, the climate, etc. Maybe this isn’t hard work specifically but is longer work and knowledge gained through experience (as Aziz suggests). Maybe the successful farmer was “lucky” enough that he chose a set of parents who knew about the soil and climate and were able to pass along their experience.

      While luck often plays a role in some economies, I think the characterization by Aziz is appropriate.

    • Oftentimes what humans characterise as “luck” really isn’t, particularly in empirical and heuristic fields like farming.

      Predicting the future is not just about correct predictions. It’s about getting into a position where you are less vulnerable to incorrect predictions — you don’t know what the average temperature will be in December, but you do know that maintaining two granaries — in case one burns or is devoured by rodents — is robust.

  2. “the Fed is quietly abolishing itself”

    Maybe yes, maybe not. Some people think it is a sinister plan to destroy the current economic system and to replace it with another, more powerful and more centralized, with IMF Special Drawing Rights as reserve currency and a big role for the Bank of International Settlements playing the part of the Fed but on a global scale. Who knows, sometimes it just looks like a huge mess and no one really knows how not to self destruct, other times we might think some hidden players are ‘conspiring’.

    • First I think it should be noted that if there was such a conspiracy, surely it would have transpired in 2008, when a huge default cascade caused a global liquidity panic? If the powers that be wanted the IMF or BoIS to be a global central bank (the Fed fills that role very “nicely”, actually) surely they would have allowed the banking crisis to continue and worsen, setting the stage for a global institution to step in and save the day? The truth, I think, is that 2008 proves that the powers that be think the status quo is very cushy. A 6% annual guaranteed dividend is one reason why…

      Second, I don’t think conspiracy theorists understand quite how bad central planning really is. Most modern-day conspiracy theorists unknowingly believe that central planning (i.e. economic and political conspiracy) can work. But reality makes fools of central planners. Why?

      Zombification hurts the real economy: How many good ideas and good businesses have been denied credit or investment since 2008? How many nonsense businesses and ideas have been approved for credit as a result of stimulus packages, etc? How many useless and incompetent people kept their jobs and were promoted?

      The lack of capitalism hurts everyone, because in a centrally planned environment decisions are arbitrary, and based on the prejudices of the central planner. For good decisions to succeed and bad ones to fail you need the market mechanism. An economy without the market mechanism is fundamentally weak. Ultimately this is why government and economic management by conspiracy does not really work.

      Central planners throughout history have often believed that through “careful” planning and management they have created a new order to things. Their best laid plans are houses of cards in the wind…

      • I concur. To say the Illuminati could organise anything gives them too much credit.

        I feel that the world is broken because everybody is out to feather their own nest, and they make mistakes along the way.

        • Conspiracy theorists should read Nassim Taleb’s work, particularly the Black Swan. History and world events are not orchestrated. Many groups and cadres have attempted throughout history to orchestrate events, and they have all bungled terribly, and at great cost to society at large. The same fate will befall this generation of central planners. Centralised and “controlled” systems are never robust to volatilities.

  3. Bravo, once again, your ultimate conclusion is priceless.
    I appoint you “mentor who oftentimes gets it right”…
    ….so let it be written, so let it be done

    caution: my appointments are pretty whimsical

  4. I am catching a van in two hours from now to drive from Cleveland to New Hampshire to campaign for Ron Paul. I am not a college kid, and niether are most of the 33 folks making the 12 hour drive in the dead of night. I am 52 and have never been politically active. I do not believe in any sort of Utopia on earth and have not the time to research every detail of the good doctors 5 page plan. However, I am convinced the Federal Reserve Bank is at the core of this rotten apple. Without the FED, politicians would be forced to increase taxes to pay for the Welfare/Warefare state they have created. Instead, the stealth tax imposed by inflation continues to hurt the middle and lower income earners. We hurtle along with 40+ trillion in unfunded liablilites and the politicians talk of eliminating double lattes and cutting out a few magazine subscriptions. Ron Paul sums it up well, “Spending is a tax.”

  5. You make an interesting point about entrepreneurial banks, because I have been trying to gain support for a new Australian bank, with a fresh IT system, and the best staff from our top banks. I was involved in the setup of a bank in Australia, and if you have enough capital (Public offer subscription) you can get a banking license.

    If this bank made bad investment decisions, then we would have a bank run, and a collapse. I read the history of the National Australia Bank, around 1850’s it was set up by wealthy merchants, and the lessons are invaluable. Rumors and competitor politics were rife.

    Any new bank could easily be set upon by nasty competitors. Does a Government guarantee help competition by insuring against nasty rumors? Or does it breed complacency?

    Australia has a “4 pillars policy” (4 major banks can’t merge) Does this mean the lack of scale, and duplication creates waste, or provides healthy competition?

    Ron Paul will not win the nomination, because he is seen as a radical element. He is also seen as too old. After watching the Republican nomination process, basically frenzied idealistic registered voters have a say in who goes against Obama.

    Hopefully religious zealots don’t vote in a war monger.

  6. I was away from computers for a month. Today I’m back! (Really who cares?)

    I have to catch-up on a month of news, but I thought this post pretty much nails the door shut. The FED isn’t even a good idea on paper, let alone put into practice in real life.

    I mean for heaven’s sake, you had 100’s of ECON. PHDs at the FED and none of them saw the housing bubble? Not one? You mean to tell me that the supposedly smartest people in the room missed what is turning out to be the biggest bubble in the history of man?

    The advice in poker is as follows, ‘When you sit down at the table to play poker, you have 30 minutes to find out who is the mark. If in 30 minutes time you have still not singled out the mark at the table, then YOU are the mark!”

    In the game of life, who is the FED?

    PS Thank God the FED isn’t invovled in farming

    • @ Fo Sho :”Thank God the Fed is not involved with farming”.

      I second that. Look what happened when centralist planning Russian Bolsheviks, took the peasant system of individual plots and locally stored seed, and organised mass plantings to raise capital on the international market (Was not designed to feed the masses) Famine, 6 million Ukrainians killed. Was it deliberate or just idiotic planning?

    • Welcome back!

      Thank God the FED isn’t involved in farming

      The Fed was involved in farming (indirectly, anyway) in the 1920s and 30s, because farmers were involved in a huge debt bubble, and we saw how that ended.

      In the game of life, who is the FED?

      Nassim Taleb has a phrase: autisticacademics. Maths whizzes with no philosophical or epistemological sense.

  7. Reade the following article:

    I assume the policy makers have to use optimism to get us out of this deflationary death spiral.

    Note the following excerpt:

    “Fed officials will receive much more detailed reports before their policy meeting. But these reports are kept secret for years after the meeting.”

    Kept secret for years! Why? Because the facts don’t justify policy responses?

    I look forward to reading this information whe it is released. I am bookmarking to follow up!

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