The problem with institutions that borrow short and lend long is that they are inherently volatile. They subject the economy to wild rides, while spreading a systemic risk of failure.
In normal operation, even if the amount of actual currency issued by a central bank is held constant, these short borrowers - long lenders cause a varying supply of money. When you deposit $100 at the bank, you think and act as though you still have $100, but in fact, your bank has gone right out and loaned $90 or more to someone else. The other guy is supposed to pay this back after a while, some day, somehow, but in the mean time, he deposits those $90 into his own bank account, so the bank takes that and lends another $81 to someone else again. This is normally repeated endlessly, and the net effect is an increase in the amount of money in the economy by a factor of 10! This produces a wild ride when the economy is alternately flooded with money when banks feel good and lend freely, then starved again when they feel vulnerable and lend less.
For example: if banks lend out the maximum amount permitted, say 90%, the amount of money in the system reaches 10x the amount of issued currency: a series of 1 plus 0.9 plus 0.9^2 plus 0.9^3 and so on, equals 1/(1-0.9), which equals 10. On the other hand, if the banks tone down their lending just a little bit - to, say, 80% - then the amount of money in the economy decreases by half: 1 plus 0.8 plus 0.8^2 plus 0.8^3 into infinity, equals 1/(1-0.8), which equals 5. (Now weren't those high school infinite series useful?)
The worse problem yet is that all these institutions are subject to 'runs on the bank'. You know that at any given time your bank has only 10% or so of everyone's money available. You know that, if this percentage ever truly reaches zero, you will be unable to use the money in your account; the bank's vault will be empty then. So if you hear the word that many others are going to start to withdraw money, your best option is to run to the bank and beat them to it. You tell your friends, and now everybody is running as fast as they can to the bank. A bank can collapse on a rumour, even if it's business was entirely solid - if 'solid' is, of course, a word that can even be used for a bank.
The bankers saw that this is no good, so they banded together at some time around 1910, joined heads with government, and the Federal Reserve was born. The Federal Reserve is basically a facility that allows unlimited amounts of money to be invented out of thin air if circumstances require. If there's a bank run, no problem. As the bank's cash reaches zero, it goes to the Federal Reserve, borrows an awful lot of money, invented right then and there, and gives it to everyone who wants to withdraw. The bank doesn't fail, and soon enough, people bring their money back. The invented money is returned to the Federal Reserved with some interest, where it's destroyed, and everything is back to normal. Assuming the bank run was only due to a rumour.
Ah yes. But this creates a moral hazard. With money that can be created out of thin air, banks must now be regulated. If they are not, any schmuck can create a "bank" which "lends" to friends with no expectation of repayment. People hear word, everyone withdraws, the Federal Reserve provides the money, and someone just got rich at the expense of everyone else.
So deposit-taking banks are regulated. But broker-dealers, hedge funds, money markets and non-bank mortgage lenders, so far, were not. Which means they don't have access to the Federal Reserve, which means that they are subject to bank runs. And as Nouriel explains, many of these just occured. 51 hedge funds collapsed since 2006, compared to 14 in all years before.
Arguably, people who invest in businesses that lend long and borrow short, and which do not get Federal Reserve protection, and who thus expose themselves to bank runs that can be triggered by rumours alone - well, such people are stupid-ass investors, who in addition can afford to lose. You can't invest in vehicles like these unless you have at least $1 million. So, most people who lost money there, will not be homeless soon.
However, the systemic risk that these entities create - and more importantly, the economic wild ride that results from normal bank operation - leaves me considering that we might be better off without these entities at all.
What would a world look look like where borrowing short and lending long is banned?
First and foremost, banning such transactions would require all loans to be covered by credit explicitly provided for the duration of the loan. In other words: a 30-year mortgage would require someone to provide the money and not expect it back for 30 years. "Hogwash," some people will say. "This will not work! Whoever will loan you money for a 30-year duration?"
Ah... but there are loads of money praying to be invested for the long run. All our pension savings are such funds.
And by the way: in case most people cannot get a 30-year mortgage, what happens to the price of housing?
It goes down! It goes down until it reaches a point where the market clears. Did you notice - it's hard to notice unless you look at historic charts, but: have you noticed that real house prices in the U.S. doubled over about the same time as women entered the work force, now working side by side with men? It used to take one person's work to buy a place for the family to live. It now takes the income of two people, because twice the number of workers are now competing for the same number of houses.
So, the economy adapts. Pension funds are an obvious large source of credit perfect for long term lending commitments. Without banks - or any other institutions to lend long and borrow short - the volatility of the economy drops to near zero. Any remaining boom and bust cycles would become much less pronounced. The economy would hum along at a steady pace. Growth would still occur; businesses would still borrow to invest. Big businesses could sell bonds. Meanwhile, the void produced by banning banks would be filled by investors who know exactly where they put money. New and sturdier bridges between investors and borrowers would arise. Web sites would match interested lenders with loan seekers fitting all desired profiles.
Best of all, the role of the central bank would be reduced to trivial. No more bailing out financial institutions; there would be no organizations to lend long and borrow short. No more setting fractional reserves; there would be no fractional reserve lending. No more target interest rates; these would be determined entirely by the economy, which would comfortably hum along.
Instead, the entire role of the central bank would be replaced by a single task: maintain a fixed amount of issued currency. No more inflation; the amount of money relative to the number of products and services in the economy would never increase. No chance of catastrophic deflation either; all money would be out there, it couldn't simply disappear - as 50% of the money would today, if banks merely reduce lending from 90% to 80%.
The only thing that would happen to prices, over time, is that they would slowly fall. As technological progress makes it possible for services and products to be provided more efficiently, more things would gradually be available, while the same volume of currency remains. Prices could be expected to fall a few percent per year in the long run, while wages and salaries remain constant.
Having explained that, I hereby declare that I am running for world president. ;) If I was one, I would:
- Phase out lending long and borrowing short, thereby removing boom and bust cycles, with an economy that goes on growing.
- Introduce a world currency with an issuing authority dedicated solely to maintaining a predictable amount of issued currency, thereby ensuring robust prices and a stable growing economy, subject to no more volatility.
Tragedy and roller coaster rides are not an inherent design component of a well-functioning economy. We would all benefit to remove the components of the economic system that cause major and, in the large scheme of things, unnecessary volatility and risk.
UPDATE: In the above post, I proposed a fixed money supply. It is possible, though I don't find it certain, that growth would benefit more with a predictable money supply - one that would be steadily increasing. I discuss this in my next post.