Abstraction & Reality

Brad DeLong alleges that critics of fractional reserve banking and fiat money suffer from (at best) a mental disorder (or, at worst, anti-semitism).

From Brad DeLong:

I think that the deep point of view underlying von Mises’s — and von Hayek, and Marx, and Ron Paul — complaint against fiat money in general and monetary management of the business cycle in particular is this: that value comes from human sweat and toil, not from being clever. Thus it is fine for money to have value if it is 100% backed by gold dug from the earth by sweat and machines and muscles (even if there is no state of the possible future world in which people actually want to exchange their pieces of paper for the gold that supposedly backs it). But it is not fine for money to have value simply because it is useful for buying things. There is, von Mises — and Marx, and von Hayek, and Ron Paul — think, something profoundly wrong on an economic and on a moral level with procedures that create value that is not backed by, in Marx’s case, human labor, and in von Mises’s and von Hayek’s case human entrepreneurial ingenuity. And in its scarier moments some of the trains of thought emanating from this deep point of view slide over to: “good German engineers (and workers); bad Jewish financiers” (and “good Russian Stakhanovites, bad Jewish Trotskyite intellectuals”).

Now I cannot speak for any of those named, but I am a critic of aspects of fractional reserve banking, and monetary management of the business cycle.

As I wrote last month:

Fractional reserve banking… means that the money supply is not in fact determined by the central bank (or by gold miners, politicians or economists, etc) but mostly by lenders. The problem is the fragility of any such a system to liquidity crises. If 10% of investors decide to withdraw funds at the same time, banks will quickly be illiquid. If 20% of investors do, bank failures will usually pile up. The system’s stability is contingent on society’s ability to not panic.

It is my belief that this fragility has been totally overlooked. Many have fallen into the lulling notion that the only thing we have to fear is fear itself — and that that fear can be conquered by rationality. This is to ignore man’s animal nature: the unforeseen, the unexpected, and the wild (all of which occur very, very frequently in nature and markets) make humans fearful, and panicky — not by choice, but by impulse. This is the culmination of millions of years of evolution — primeval reality is unconquerable, immutable and obvious. More than half a century after Roosevelt and Keynes markets still crash, fortunes are lost, and millions of grown men and women still tremble in irrational, primitive fear.

The textbook answer to this is that a lender of last resort should fix this problem by ensuring that enough new money is disbursed into the system for it to remain liquid, and confidence regained. The recent reality, though, has been that rather than fixing the problems, policy  — both in Japan in the 1990s, and now in the West — has resulted in zombification. Governments chose to keep bad banks going. Almost all the new money the government created has gone to shore up the balance sheets of irresponsible bankers. Now those banks sit on piles of idle cash while other businesses starve or cannot get started for want of credit.

As I noted earlier:

Vast sums spent on rescue packages to keep the zombie system alive might have been available to the market to increase the intellectual capabilities of the youth, or to support basic research and development, or to build better physical infrastructure, or to create new and innovative companies and products.

Zombification kills competition, too: when companies fail, it leaves a gap in the market that has to be filled, either by an expanding competitor, or by a new business. With failures now being kept on life-support, gaps in the market are fewer.

In other words, fractional reserve banking seems to lead to fragile systems that are hard to fix when they go awry. Now, I will readily admit that perhaps I am railing against a system that I can’t change or ban. Banning fractional reserve banking, or shadow banking or the various forms exogenous money creation will probably just drive it underground. Certainly, a pure gold standard has never prevented it. Perhaps full-reserve banking or the Chicago Plan may be some kind of panacea, but these ideas remain untested.

So — for me at least — the problem is not where money comes from, or whether it is backed by gold, or backed by labour, or entrepreneurship, or the Flying Spaghetti Monster. It is the managerialists’ mundane and matter-of-fact ignorance of the depth, the richness, the randomness, and the texture of reality – not captured by models that focus solely on money. The problem for me is that I see a fragile system and I want to fix it. But I am not sure I have the tools…

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