Without banks: A proposal for a prosperous and stable economy

After reading Nouriel Roubini's The Shadow Banking System is Unravelling, I wonder if there's any real place, in an economy that wants to be robust, for institutions that lend long and borrow short. The most obvious such institutions are deposit-taking banks, but as Roubini explains, many other organizations work like that, including broker-dealers, hedge funds, private equity groups, structured investment vehicles and conduits, money market funds and non-bank mortgage lenders.

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.
With these changes to the economy, we can then only fear a natural event.

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.


Ah. As world president you are speaking about re-instating the gold standard. Why not tulips?

For me, when I die, I wish to have tulips on my organ.
denis bider said…
There are important differences between my proposals and the gold standard.

First, adopting the gold standard says nothing about fractional lending. The core of my article is about the desirability of institutions that borrowing short and lend long. This is unrelated to the gold standard.

Second: I do think that the gold standard might be preferable to what we have, in the sense that it would provide a more predictable money supply. However, I don't see the gold standard being as good as I propose. With a gold standard, monetary supply is more predictable, but not fully predictable. Find a large enough gold mine, and money inflates. Invent a process that creates gold atoms from water, e.g. with fusion, and it's over.

I am advocating a fiat currency, but one with a predictable money supply - either fixed, or steadily increasing.

Most of all, I am advocating the phasing out of institutions that lend long and borrow short. Which is related to currency, but is independent of whichever monetary supply is chosen.

I will discuss the possibility of a fixed monetary supply vs. one that is steadily increasing in my next post.
Wei Dai said…
Vernor Vinge had predicted that if there is some hard limit on technological advancement which stops the Singularity from occurring, catastrophic boom and bust cycles would be unavoidable, because civilizations will constantly shave off stability and safe margins in order to increase efficiency. Once people have gotten used to the higher standard of living, it's impossible for them to voluntarily give it up. And the financial sector is only one area where this can occur.

Having said that, it might still be good to explore alternatives. Maybe next time (if there is one) we can somehow avoid going down this road in the first place. So, a question for you: under your system, would you allow loans to be traded? Say I give a 10-year loan to a company so it can build a factory and earn it back over 10 years, and then I get sick and need to use the money to get treatment. Can I sell the loan to a friend? Or use it as collateral to borrow money from a friend? If the answer is yes to either of those, we're back in the same situation. I will act as if I still have that money because I think I can "withdraw" it at any time.

If the answers are no to the above, would the factory be allowed to offer 1-year loans even if it doesn't expect to earn the money back until 10 years later? (It expects to offer another 1-year loan one year later to get the money to repay this one.) If yes, then that is what it will do, because the supply of people who can give 1-year loans is much bigger than the supply of people who can give 10-year loans, therefore the interest rate on 1-year loans will be much lower. Then we're back to the same situation again.

If the answer is no to all of the above, how will you police these laws? It just seems too easy to have the effect of a "short borrower/long lender" without looking too much like one from the outside.

Another idea I have in this same vein of "let's trade off efficiency for more stability" is what if we disallow credit and only allow equity? Meaning bonds and loans are not allowed, but stocks are. You can invest your money in a bank, but only as a common shareholder. And banks in turn can only make equity investments in companies and individuals. (An equity investment in an individual would be to give him money now for a given percent of all of his future incomes.)

This idea probably has just as many problems as yours, but it's always harder to find flaws in one's own ideas than in other people's...
denis bider said…
Finally! Someone makes the obvious hard argument. :-)

Yes, there's lots of ways to structure a borrow-short/lend-long arrangement, and it doesn't need to be called a "bank".

For the reasons you described, it's probably impossible to completely eliminate this sort of transaction from the economy.

However, I think that what needs to happen is that these transactions play a much smaller role in the economy than they do now. This role should be small enough that it doesn't noticeably inflate the effective supply of money.

Also, people need to clearly understand the risk they are dealing with.

When you are depositing your money with a bank where depositors are not insured - which, in a libertarian state with a non-inflatable currency, or a free choice of currency, they could not be - then you are effectively committing your money to the bank for a few decades, but with a high likelihood of being able to withdraw it prematurely.

If people's money was not insured, and they understood it was not insured, and they understood the risk of such a bank failing based on rumor alone, then perhaps we could avoid the tar pit of trying to ban a type of economic transaction in the first place.

It might however be a good idea to ban deception in economic transactions, to make sellers portray what they're selling objectively, or else be responsible to the buyer.

Finally, you hypothesize that bank-like institutions do indeed increase the efficiency of the economy, as you claim.

But I do not see evidence for this. All I see is the U.S. economy growing at a snail-like pace of 1% or so per year.

The U.S. has been the investment destination of worldwide savings for several decades, and I would expect it to be showing much sturdier growth if the erstwhile financial system was in fact as big a boon as it's been hailed. What I see, instead, is a casino-like system where only a small proportion of investments help towards economic growth, while the rest are gambled in various zero-sum games.

It might even be that those investments that actually contribute toward economic growth are predominantly equity-based investments.

I'm not sure I like your equity-only proposal with respect to individuals. People give loans to other individuals out of charity, often with no interest, as a favor to the person who needs the loan. When such favors are returned, they build cohesion. I doubt that it's possible to prevent people giving each other loans - or that it is a good idea.

But how about this modification of your idea. Instead of prohibiting credit outright, just prohibit interest. This enables charity-based loans, it plays to people's sense of righteousness, and the only way to make a profit by loaning is through equity. Perhaps that might work.
Wei Dai said…
But I do not see evidence for this. All I see is the U.S. economy growing at a snail-like pace of 1% or so per year.

The marginal value of credit is low now because there is so much of it already, so the extra credit the U.S. got in the last decades hasn't helped much, but if you compare the situation with an economy with a much lower level of credit, I think yes, it does improve efficiency. I'm pretty sure if we got rid of all long lenders/short borrowers, our standard of living would be reduced.

The reason credit does improve efficiency is that equity reduces individual incentives. If 50% of my future income is owned by somebody else, I'm not going to work as hard as if I just owed him a fixed amount of money.

But my objection to your idea isn't that it will decrease efficiency, but rather it seems impossible to draw a bright line around "long lenders/short borrowers" so it will be very difficult to prevent the situation from creeping back to something similar to today's. Everyone will have incentives to gradually relax the definition of "long lenders/short borrowers" or find loopholes in it, and nobody will have incentives to push in the other direction until there is a crisis. You can see something similar in the current crisis, where there are laws against banks being over-leveraged, but people work around those laws by not calling themselves banks.

Hence my proposal of disallowing all credit, because there is a bright line between credit and equity. Your modification of just disallowing interest seems even better. The nice thing is that there will be people who have incentives to enforce the law. Say I get an interest-bearing loan on the black market, I can then go to the police, report the transaction, and not have to pay back the interest.
denis bider said…
Wei: "The marginal value of credit is low now because there is so much of it already, so the extra credit the U.S. got in the last decades hasn't helped much, but if you compare the situation with an economy with a much lower level of credit, I think yes, it does improve efficiency."

I am still inclined to think that banking is not the efficiency generator that we think it is. It seems to me that banking engenders a certain "fire and forget" approach to investment. It allows people to think they're getting a "return" on an "investment" - whereas, all they did, in fact, was give their money to a fund or to a bank. This fails to harness the supervisory potential of investors, who would have otherwise given more thought to how their money is being spent; meanwhile, decision-making power is being delegated to a much smaller number of agents, who are motivated primarily by short-term incentives, and don't have much of their own skin in the game.

I see a lot of problems here that, in my view, are bound to lead to widespread malinvestment. How can this system be efficient, when it results in throwing money away?

Wei: "I'm pretty sure if we got rid of all long lenders/short borrowers, our standard of living would be reduced. The reason credit does improve efficiency is that equity reduces individual incentives. If 50% of my future income is owned by somebody else, I'm not going to work as hard as if I just owed him a fixed amount of money."

That's a good point. But this effect could very well be offset by the waste generated by the cycles of lending.

Imagine all the money that investors worldwide have thrown into U.S. bubbles over the past few decades, for reasons that could in large part have to do with systematic problems I described above. There are other reasons that have to do with the U.S. being a superficially more attractive investment destination. However, improving other countries is the only way to tackle that.

Yet, how are those other countries going to improve, if capital tends to flee from those countries, and into the U.S.?

Isn't global poverty being prolonged because of this?

Wouldn't there be more real investment, into places that need it, if people couldn't simply abdicate responsibility and put their money into banks? Who invest it into bubbles, and so then cannot return it, so the depositors are paid off with new money from the Federal Reserve? So in effect, the people who deposit their money with banks, are not so much investing, as being paid interest with newly minted money - at everyone's inflationary expense?
denis bider said…
Instead of banks, I think proper (and more efficient!) investment vehicles are actually companies like Berkshire Hathaway.

At the core of that business are a few people who have demonstrated good long-term judgement. They have their own skin in the game - a large percentage of Berkshire is owned by people who run it. They take capital through equity investments, and they invest it into equity as well. No borrowing or lending.

That, I think, is an example of a sturdy investment vehicle. You face risks that are predictable; the people who run the business have their own skin in the game; you are informed of what they're doing; your money is not being managed in an opaque manner by agents whose incentives are short-term.

Your investment is liquid: you can trade your shares, but you know that they're still shares. You are under no illusion that they cannot lose value, and you can envision in what circumstances that could be.

The perceived risk seems greater than putting money in a bank. But actual risk is lower, because there's no opacity or mis-incentives.

For these reasons, this seems to me a sturdier investment approach, with greater overall economic benefits, than fractional reserve lending.

And it seems like it would function without a hitch, even in a world without interest-based lending.

Wei: "Say I get an interest-bearing loan on the black market, I can then go to the police, report the transaction, and not have to pay back the interest."

Or better yet - you don't have to pay back the loan.

If it's just a matter of interest, people still might not report - perhaps if they depend on loans, or if there's a threat from the lender involved.

But what to do for people who need loans in emergencies? With no interest, no one except charities might lend. This could be insufficient.

One idea I had recently is that this could be solved with a monetary system that allows people to have negative money, up to a point. I'll explain in my next post.
Wei Dai said…
I've realized that while there is a bright line between credit and equity, there may not be one between credit and other things, so the laws we're proposing may still be difficult to enforce. Historically, at least two major religions had decided that interest is bad. Christianity had prohibited charging interest in the past, and Islam still does today. And people found ways to work around those restrictions. See Lombard banking and Islamic banking.

It's interesting that despite the religious restrictions against credit, the development of large scale credit seems to have preceded large scale equity by several centuries in the West. I wish I knew this history better... it might offer some insights into the current problems.
denis bider said…
You're right - Islamic banks do manage to engage in fractional reserve banking without charging interest, or at least calling it such. Instead they will, say, enter into an agreement to buy a house, sell it to a borrower at a higher-than-market price, and allow him to pay for it in installments.

What I am really trying to get at is a rule that will prevent economies being built like houses of cards. Essentially, I'm trying to figure out something that will cause an economy to be built on solid foundations. Barring external shock such as war or a natural catastrophe, there should be no major upsets emanating from the system itself.

There must be some way for us to avoid continuously shooting ourselves in the foot like this. But unless a clear and simple principle can be identified, then the only alternative is proactive government regulation - which is about as effective as no regulation at all.

We need a clear and simple principle that doesn't require the government to constantly be on the hunt for the latest way people are avoiding a ban on banks or a ban on interest. :-/

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