A question for Ron Paul (on Freakonomics)

Freakonomics has published the first part of Ron Paul's answers to their readers' questions. The guy strikes me as probably the most reasonable, clear-headed politician I've encountered. He seems almost like a Warren Buffett of politics, except that in politics, dishonesty is what's rewarded, so Ron Paul isn't doing very well. (He's doing well with about 10% of people who actually have a clue, but that will never include most voters. I wonder how many supporters he has in Detroit.)

That having been said, though, I sincerely hope (but do not really expect) that - at least in the second part - he might get around to answering my question. Essentially, what I'm wondering about is this:
Q: Do you believe that it is possible to make positive incremental changes to our monetary policy, entitlements, taxes, etc. within the system, or is it just a matter of waiting for failure and then coming in with a solution?

A: Yes, I do believe we can make successful changes. And I want to start making those changes now so that we can avoid a devastating collapse. But we need to start quickly before it’s too late. If we can cut spending and balance budgets, beginning with our overseas expenditures, we can do a lot to fix this mess. We also need monetary reform. I would begin with the incremental step of repealing legal-tender laws and legalizing the use of gold and silver to act as a currency alongside the dollar. That would help stabilize the dollar and strengthen our monetary system. [denis: my emphasis]
I just don't see things happening this way. If gold and silver are allowed to act as currency alongside the dollar, the effect will be a collapse of the dollar. This is unless issuing policy for the dollar is rewritten to credibly ensure that the supply of dollars will increase no faster than the supply of gold and silver. This, in turn, would basically prevent the state from being able to protect bank depositors in the event of a financial crisis; and this, in turn, would bury banks. Which then prompts the question that I ask:
The way I understand it, one of Dr. Paul’s fundamental proposals is to deregulate currency, allowing people to use gold as they choose to, or whatever else they like. This renders an inflatable fiat currency non-viable, and provides the state with no way to support banks in rumor-based runs or in liquidity crises. This in turn leads to the Iceland effect, where banks go down not because they are insolvent, but because there is a run on them or because the market temporarily dries up.

The monetary policy that Dr. Paul is proposing would therefore make it foolish to put money in a bank, as any interest gained is likely to be outweighed by risk of the bank’s failure.

My question to Dr. Paul is as follows: is your opinion that banks are not fundamentally important to prosperity and growth? If they are not, then what is your opinion of the economists who say that banks are a crucial link between borrowers and savers?

On the other hand, if banks are important for GDP growth, then what system do you envision would replace banking, after your monetary policy has rendered bank deposits foolish, and banks prone to fail?

— denis bider

Comments

Anonymous said…
That's a good question. I don't know the answer but you might be able to find it here somewhere:

http://www.lewrockwell.com/

and/or

mises.org

There is more data here than one can consume. Cheers.
Daniel said…
So the current state of affairs allows central banks to print enough money to cover all the deposits in case of bank runs?
Doesn't that results in high inflation?
denis bider said…
Daniel: yes indeed.

Inflation is complex. If the system was in a steady state and the amount of money was the only thing that changed, then yes, one should see prices start to go up.

But it's not just the supply of base currency that matters. When banks function normally, their acts of borrowing and lending increase the effective monetary supply by about ten-fold. Banks retain on-hand only a small percentage of their deposits; the rest is lent out. As long as everyone doesn't withdraw their deposits at the same time, this increases the amount of money by a factor of 1/(reserve percentage).

Suppose that reserve percentage is 8% in normal times. This means that the effective monetary supply is 1/0.08 = 12.5 times the amount of actual currency. Suppose then that banks become worried and start increasing their reserves to 10%. This means that, for a while, less loans are being made than the banks are taking in deposits. Once the reserve fraction reaches 10%, the effective supply of money in the economy has decreased from 12.5 times the amount of actual currency, to 10 times the amount of actual currency, for a decrease of 25%.

When banks do that, we should therefore be seeing a 25% deflation. But if, in the mean time, the government prints 25% more currency, and spends it in some way, then the prices remain the same, and meanwhile the government was able to spend a lot of money. Yay!

Similarly, if banks are in dire straits, they won't be lending as much, which will decrease the effective supply of money. If the central bank then creates some money out of thin air, to lend it to the banks, this is probably less than the supply that disappeared because the banks have tightened lending.

The government (and the Fed) are basically hacking with the system all the time, and half the time they don't know what they're doing.

The issue is that banks are desperately fragile, and cannot function in the long run without access to unlimited funds if need be. The Icelandic banks collapsed, even though their balance sheets might have been entirely healthy, because they had nowhere to turn to borrow unlimited money.

Anonymous: I'll check that out. Thanks for the links.
denis bider said…
Meh... the stuff on LewRockwell.com is useless - the quality of the articles seems about the same as a brainless leftist pamflet. In one of his most recent articles, Lew comes off as an anarcho-capitalist, opposing even limited government. If anarchy is what he likes so much, he ought to move to Somalia.

Given that anarchy doesn't work in Somalia, it looks like his ideology, in order to work, would require a special breed of human. But communism would work, too, if a different breed of human was available to the state.

The articles on Mises.org seem more informative and less pamflet-like in nature, but I cannot find anything that would address the role of the banking system specifically. In this article, for example, Mark Thornton has lots to say about the monetary system, but almost nothing about banks. The fiat currency exists due to banks! How can you talk about fiat currency vs. market currency, and not talk about banks?

All that Mr. Thornton has to say on the topic is this:

"Deposit insurance is a natural moral hazard and therefore bank deposits are not an insurable risk. Banks and depositors can overcome this problem simply by being certified as holding 100% reserves against all their demand deposits."

Ah, yes, it's that simple! Let's just remove deposit insurance and access to any lender of last resort. This just happens to render all banks and bank-like institutions prone to rumor-based collapse and fatally vulnerable to money market hiccups. Then we can treat ourselves to a series of banking panics, just like in the 19th century.

The problem I see with anarchists is that they are trying to undo systematic solutions to problems, even when systematic solutions are factors of magnitude more efficient than everyone tackling the same problems privately. They're willing to trade about a 10x impairment in everyone's living standards for the dubious benefit of ultimate freedom - the freedom of being shot by your neighborly warlord just like in Somalia, presumably.

I don't think that makes a lot of sense to me. Liberty is good, government waste is bad, but well-being is paramount. Freedom is very important, but it is important because it affects well-being.
Daniel said…
Thanks for clarifying that. Was aquainted with the fractional-reserve banking, but I haven't accounted for the credit supply fallout.
boris_kolar said…
An interesting thought: isn't currency itself prone to rumor based collapse? Since currency itself has no intrinsic value, its value depends not only on supply, but also level of trust in government.

Another danger for currencies is information technology. One defining strength of currencies is convenience: it is accepted everywhere for just about anything. Let's assume currency is inflating. If one could, with the help of information technology, instantly exchange gold (or even something more complex) and currency, the currency would be only useful for a very short time during transaction. Computers could quickly calculate exchange rate between gold and currency and present the buyer prices in gold units. In other words: inflating currency would become irrelevant. A prerequisite is, of course, that exchange is untaxed.
denis bider said…
Boris: Isn't currency itself prone to rumor based collapse?

Not if you pass a law mandating everyone to use it.

But if there is no such law, or if it is unenforceable, then in theory, yes.

But with a currency, the barriers to a run are much higher. To run away from a bank, you withdraw your money if you can, and then put it in another bank, or hide it somewhere. There is no question that holding currency is safer than a bank account in the same currency, unless someone robs you.

You can't withdraw from a currency in the same way. You have to exchange it for something that you perceive will have more durable value. In that case, do you really trust your judgement? What if the rumor is wrong, and the exchange rates go the opposite way?

Running from a currency is much less clear-cut than running from a bank. Therefore it tends to happen primarily when people generally agree that the currency sucks, and when they generally agree on an alternative.


Boris: In other words: inflating currency would become irrelevant. A prerequisite is, of course, that exchange is untaxed.

That sounds like basically what went on in Yugoslavia. Everyone held Deutsche Marks, which we exchanged as necessary to/from Dinars.
denis bider said…
Also, if everyone did things the way you described - had a transaction account denominated in gold and paid with plastic such that the value is automatically converted to/from dollars on the spot - then this would again make inflating dollars non-viable. Suppose you get a loan of freshly printed dollars from the government. If everyone wants to hold gold, who are you going to sell your dollars to?

You might as well be holding a bunch of leaves.

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