A Radical Solution for America's Insolvent Financial System

The core problem of the U.S. banking system (and maybe the world's banking system) is not liquidity but insolvency. The liabilities of the United States' banking system exceed the value of its assets. The issue is not only the toxic assets (toxic mortgage backed securities, toxic commercial real estate loans, sub-prime mortgages, alt-A loans, adjustable loans likely to go bust, increase in prime mortgage default rates, etc) but also off-balance sheet liabilities (such as expected huge-unaccounted-for future derivatives losses).

This means that bailouts are just beginning and will require bigger and bigger sums of taxpayer money as time goes on. The government will resort to borrowing more and more and eventually to printing money when treasury debt auctions start failing. The end result of this path is a currency collapse and probably total chaos as expected by gold bugs.

One other way to deal with this issue is to stop the bailouts and let the dominoes fall. Defaults and cross-defaults will cause many, many depository institutions (even very large ones) to collapse leading to extreme decrease in money supply as bank deposits are destroyed. Deposits of failed banks cannot be used to pay bills, make purchases and/or service debts.

Which will probably lead to even more defaults as unemployment increases and debtor's are unable to service their debts. This process will probably cause extreme deflation as businesses lower prices in a bid to survive. This will also lead to wage cuts, increased unemployment and a deflation spiral and much chaos. But probably less chaos than a currency collapse.

Is there a better way?

Here is my idea:

1) We essentially need an orderly bankruptcy and liquidation of the United States' financial system.

2) I suggest we create a government owned bank and transfer all deposits of the private commercial banking system to the new government owned bank. This "transfer" is really just new money creation. This new money will be digital cash (electronic version of physical paper cash). Very much like reserves at the FED.

3) Note that the plan will not create net new money since we will be destroying all deposits of the commercial banking system in the process.

4) All assets of the commercial banking system will be transferred to the government and auctioned off in an orderly manner over the next 10 years. The proceeds from the sale would go to the United States treasury and not the commercial banks. The assumption here is that commercial banks deserve nothing since the entire industry would have been most likely destroyed any way. Even good banks would have been destroyed due to bank runs and defaults if the government had allowed the dominoes to fall. Of course bank shareholders, bank bond holders and counter parties of bank derivatives would not receive anything.

5) After the transfer FDIC protection will be removed for any private bank which wishes to remain in business or any new private depository institution or bank. From that point on the government should make it absolutely clear that there will be no more bailouts and no more conversions. This will discourage (but not completely eliminate) fractional reserve deposit banking and private money creation that results from pyramiding of government created money. This will also limit debasement of the currency that results from fractional reserve deposit banking. In fact, we can have "free banking" from that point on and not even have reserve requirements or capital requirements. All depositors who use private banks will be fully at-risk. The industry will have to set the interest rate high enough to attract depositors.

6) The new government bank will act as an electronic "piggy bank" only. All deposits will be 100% reserve and it will not make any loans. Loan making will be left to the private banking system (with no deposit insurance or a possibility of a future bailout). The new government owned bank exists only as a "safe" money storage and a payment clearing system so the public does not have to carry around physical paper cash to make purchases and pay bills.

7) Of course this plan is not without pain or cost. Cost of funds for banks and borrowers will probably rise as bank deposits are a source of very low cost money for the banks. Nothing is free. We are just exchanging higher cost of funds for removal of systemic failure risk. Economically we are recognizing that when money is loaned there is always credit risk.

8) We are just separating the payment and clearing transaction system which is absolutely necessary for day-to-day commerce (no credit risk) from the loan banking and investment system (has credit risk).

100% Reserve Account Proposal - Update

Yves Smith of Naked Capitalism has pointed out that Irwing Fisher had proposed something similar in his book, 100% Money (Published in 1935).

Here is how my proposal is different:

Irving Fisher in his book 100% Money (1935) proposed that all banks be required to hold 100% reserves for money deposits payable on demand. In other words the government should outlaw fractional reserve banking. Fisher believed that booms and busts are a result of credit created by fractional reserve banking.

I propose that the government require commercial banks to provide 100% reserve account as one of the options. I do NOT propose that the government should outlaw fractional reserve banking.

Summary:

a) The 100% reserve accounts would just be another option that a public would have. I am in no way saying that banks should be forced to offer 100% reserve deposit accounts only just that they must provide it as one of the choices.

b) I also propose that many institutions absolutely necessary to maintain law and order must not take any credit risk with their liquid capital (utility companies, municipalities, states, hospitals, etc). The idea here is that civil law and order should not be disrupted even if several very large financial institutions fail at the same time.

c) I would also remove the protection of FDIC insurance for moral hazard reasons. But I would still have an FDIC like institution to facilitate a quick and smooth transfer of 100% reserve accounts to another bank from the failing bank. The idea here is to keep the payment system running smoothly so day-to-day commerce can continue to function even if a very large deposit taking institution fails.

d) The main objective is to preserve Adam Smith’s invisible hand in disciplining and destroying poorly managed very large financial institutions. I am not proposing that we write a more stringent Glass-Steagall Act or keep anyone from creating complex financials products (securitization, derivatives, etc.) or keep any bank from investing non-100% reserve bank deposits in risky and/or complex financial products. In fact, I would want most banking regulations repealed, as they are unable to protect us from systemic meltdown. Doing this will greatly lower regulatory compliance costs for banks.

e) I strongly believe that if we don’t let very large financial institutions die then they will eventually economically destroy us by mis-allocating huge amounts of capital. There should be no such bank that is too big to fail. But we also don’t want to descend into total chaos after a meltdown and not be able to maintain a basic payment system to conduct day-to-day commerce.

f) In short, our basic electronic ledger based payment system should function even if several very large deposit taking financial institutions fail at the same time without resorting to physical paper cash to conduct day-to-day transactions. Deposits in 100% reserve accounts will provide a basis to build new viable financial institutions if a meltdown occurs.

g) My proposal is a variation on what is sometimes called “Free Banking” with the 100% reserve deposit account as a required option for the public.

Welcome Market Oracle and Seeking Alpha Readers

Welcome to Aquinum's Razor.

If you are visiting this site as a result of the article published in Market Oracle and Seeking Alpha, thank you for stopping by!

You should know that the article on those websites is a slightly edited version of the first two blog entries here. In the near future on this blog I will be discussing other economic topics and ideas, including: my thoughts on free markets; how banks create money; why money can't be saved; money supply and fractional reserve banking. Check back in a week or so for the next entry.

Meantime, feel free to peruse what's here, leave your thoughts and comments, and let me know if you have any questions. And have a great Fourth of July weekend!

Not the End of the World, Part II

This is a continuation of my previous blog entry: Not the End of the World.

In part II I would like to elaborate why I think we could avoid future banking crises, such as the one we are now going through, by adopting slight and strategic "tweaks" to our free market principles (as we currently implement them).

Previously I implied that leaving the resolution of the current banking crisis to the market is like allowing nuclear bombs to explode all over the country (and maybe all over the industrialized world) in order to punish bad management in the banking industry. I suggested that defaults and cross-defaults and bank runs would lead to a nuclear fission-like chain reaction, causing massive bankruptcies and a huge, sudden and violent contraction in the money supply, and probably deep, double-digit unemployment (the unemployment rate during the great depression was 25% -- except now it would probably occur at the speed of the internet).  This would be the classic Adam Smith way of punishing bad behavior by the banking industry. In the modern economy, this would involve a tremendous amount of collateral damage.

As background to my proposed alternatives, I would first like to remind readers how banking currently works, and how the public uses the services of a bank. I would also like to talk about the big difference that exists between paper money and bank deposit money.

Great Confusion

The (usually) transparent process of inter-bank lending works so well that most of the time we don't even think about it. This process has largely weaned the public away from physical paper money. Note that most money (about 90%) now exists only as entries on bank ledgers, backed by loans (debt). Possessing physical dollars is like having equity in the economic output of the United States of America, and has no credit risk associated to it. Physical paper money is not anyone's liability.

Bank deposit money, on the other hand, does have credit risk associated to it. That risk consists of the liability of the bank in which the deposit resides. Strangely enough, most of the time the credit risk of bank deposit money is lower than the theft and physical-loss risk of paper money. That is why we use bank deposit money more than physical money. Through this (normally) transparent process of inter-bank lending, the banking system acts like a huge clearinghouse (essentially a giant ledger) which clears payments between its customers without the physical transfer of cash, and keeps track of who has how much money. Most money in the world economy is not physical (paper cash or gold) but logical (ledger entries).

To summarize: physical paper money is equity. Bank deposit money is backed by debt (actually that's not 100% true--reserves at the federal reserve system are also equity, essentially an electronic version of physical paper cash).

That difference -- that paper money = equity in the nation's economy, and that a bank deposit = debt (a bank obligation) causes great confusion.

We have become very comfortable with bank deposit money, without thinking much about the credit risk we are taking. Bank failures, when they happen, create confusion and chaos because the vast majority of businesses and individuals use banks for convenience (they can write checks rather than handling physical paper cash) and they don't really think much about the credit risk that is normally associated with keeping their money (their most liquid capital) in a bank.

Is There a Better Way?

Now back to the banking crisis. Two solutions suggest themselves: a long term solution and a short term solution. For the purposes of this essay, we'll start with the long term solution.

Consider the banking industry's contribution to society. The banking industry provides three major services to the public:

1. It provides a "safe" place to hold the public's most liquid assets (cash).

2. It acts like a giant clearinghouse (settling checks without physical paper cash transfer).

3. It is a source of loan money (they evaluate the credit worthiness of borrowers). Think of "credit worthiness evaluation" as a service to society. If bankers do a poor job at evaluating credit worthiness they end will up mis-allocating economic resources.

What I am asserting that it is possible to have a banking system where a customer would get benefits 1 and 2 described above without taking a credit risk, if banks gave people a choice between a regular account and a special "100% reserve account." These special accounts, which are not available to the public today, would have no credit risk. The money in such accounts would not be lendable. There would still be fraud risk, of course. A bank desperate for cash might be tempted to "dip" into the reserves allocated to their 100% reserve accounts. Of course we would make such "dipping" illegal. These accounts would be the electronic equivalent of storing physical paper bills in a safe deposit box at the bank.

Such accounts would have no credit risk (like physical paper cash) but would have the benefit of being used in electronic transactions and be accessible by personal checks. Of course, a reserve account would not earn interest but would most likely have monthly maintenance fees associated to it (similar to a safe deposit box; it would also be very much like the reserve accounts that banks have with the FED). Such accounts, if widely used, would lessen the impact of bank failures on the economy in terms of a contraction of the money supply, chaos and confusion--but would not completely eliminate them. More on this later.

Avoiding Future Meltdowns

Lending involves business risks (credit risks). If a customer were to choose a non-reserve account then he would be subject to losing his money. This would force the public to do some homework before handing money over to a bank (in essence, customers would need to consider banks' credit ratings). Of course in this type of setup, a non-reserve account would probably have to pay a higher interest rate than the fractional reserve accounts do today. In fact if the public had a choice of 100% reserve accounts, there would be no need to impose legal reserve requirements on non-reserve accounts. There would be a clear separation between accounts that have a credit risk and accounts that don't. The accounts with credit risk would need to set their interest rates high enough to attract depositors.

If our banking system were setup this way, we would avoid huge systemic risks in the future, since a major part of the money supply would likely be sitting in non-lendable accounts. Many enterprises probably should not take any credit risk with their liquid capital (utility companies, municipalities, states, hospitals, etc.). In any insolvency or bankruptcy the reserve accounts would receive priority, and unless the bank was fraudulently “using” these reserves the deposit owners of such accounts would never lose their money. If an electronic deposit account with no credit risk were available, then any individual or business choosing not to use such an account would be subject to losing their at-risk deposit. If such an alternative were available, then the depositor who chose the lendable money account would be warned that he or she could lose money if the bank became insolvent.

I will go a step further and state that the availability of such accounts (non-lendable, 100% reserve accounts) should be mandated by Congress through force of law. Each business and individual should be able to choose whether they want to take a credit risk or not.

Coming Soon...

In my next blog entry, I will propose general principles that I believe our government should follow, in any situation, when deciding whether or not to interfere in the normal workings of the free market in order to avert or minimize damage to society (and such interference should always be the exception, not the norm).

Stay tuned.

Not the End of the World

I have been thinking a great deal about money, banking, credit and gold since the near collapse of the world’s financial system during the week of September 15, 2008.

I have scoured the Internet for articles on this subject.  Economics books don’t help much.  I am not satisfied with their explanations.  However, I believe I have nailed the main issue that needs to be understood.  The following are some thoughts and observations.

Paper Money and Loaves of Bread

Gold bugs (by which I mean, people who push gold as a medium of common exchange or money) are only partially right.  They say world civilization will revert to gold and silver as money when paper money and bank deposits become worthless due to rampant hyperinflation, after a worldwide Weimar Republic type scenario.  This assumes that there will be a complete mistrust of governments and the banking industry.

Even if this unlikely scenario (world wide hyper-inflation) occurs, I believe paper money and bank deposit money will not be abandoned.  The benefits of paper money and modern banking are just too great.  Gold and silver based money requires physical possession, storage, safekeeping services, and transport for exchange in economic transactions (i.e., for making purchases or payment of bills).  Note that there have been hundreds of currencies that have failed due to hyper-inflationary money creation (via both the printing of money and bank-deposit money creation), but this has not meant that people have stopped seeing the value of a paper money system and bank-deposit based economy. 

People know from the collective experience of the last few hundred years (remember, the pound sterling is 317 years old), that when managed properly, this type of economic organization is superior to carrying around gold and silver.  If a worldwide Weimar event does come to pass it will not be the end of paper money and bank deposit money.  We will just have a fresh start with a new currency, much like what Germany did after the Weimar hyperinflation. (Sorry gold bugs and survivalists, we won’t all be shooting at each other, and gold will go up but only in terms of hyper-inflated money, not much in terms of loaves of bread).

Money Creation

At this point, the world civilization has sufficient understanding that too much money creation can lead to hyperinflation and make a currency worthless.  Note that in modern economies, most money creation is done by the banking system through the process of fractional reserve banking. 

Fractional reserve banking is just another way of saying that cash initially created by the government is lent and re-lent many times over (i.e., lent, deposited, re-lent, deposited again, and so on).  So the initial cash created is multiplied by the banking system.  The economy “acts” like there is more cash than what was originally created by the government, because bank deposits can be used to pay for purchases or to pay bills just like paper cash.  The amount of money thus “created” is only limited by the banking industry’s willingness and ability to find credit-worthy borrowers.  

Note that it is NOT the government creating the money most of the time; it is the banking system doing it.   United States Government-issued paper cash is only 3% of the world’s dollar supply, and its electronic equivalent, the central bank dollar reserves at the FED (sometimes also called “base money” or “high-powered money”) are probably not much more, in percentage terms. 

Collateral Damage

So what is the problem?  The problem is that the world is finding out that Adam Smith needs to be updated.  Economists know that Capitalism works well because the punishment of the marketplace is allowed to destroy bad actors (a la Lehman Brothers).  Henry Paulsen and Ben Bernanke tell us that Lehman Bankruptcy started a chain reaction where there was so much mistrust between counter-parties of the major financial institutions that inter-bank lending and other lending “seized up” (almost stopped).  If that had been allowed to continue we probably would have had extreme deflation very fast (at the speed of the internet). 

Deflation will occur if bank deposits are destroyed. Remember--each commercial bank, savings and loan, credit union or even money market mutual fund that fails would have reduced the total bank deposits in the banking system.  Failure of a depository institution means that its deposits cannot be used to make purchases, or pay bills, by depositors of those institutions (i.e., businesses and individuals).  Defaults lead to cross-defaults (party B defaults because its counter-party A has defaulted).  Cross-defaults on a massive scale, where a money center bank like Citibank is involved, would have led to massive bankruptcies and widespread bank runs. 

Therefore, in order to punish bad actors we would have to inflict tremendous amount of collateral damage on innocent bystanders.  The Great Depression of the 1930s comes to mind.  Adam Smith’s invisible hand works, but sometimes the collateral damage is enormously large. 

Is There a Better Way?

World War II was a pivotal event in human history.  It did so much collateral damage that near the end of the war, world powers were convinced that all-out total “hot” war was no longer an option, given the current technology.  Therefore, world powers started fighting more “cold” than “hot” wars (Roman and Persian Empires probably fought more “hot” than “cold”).  The USA and USSR fought mostly “cold,” with some small “hot” proxy wars. 

The rules of all-out war broke down in the face of massive weaponry.  The superpowers adjusted to the new reality.

Newton's laws break down near the speed of light.  Einstein updated them.

Where am I going with all this?  Today's world economy, where most of the world's money supply (i.e., stuff used to pay bills and make purchases) is in the form of bank deposits residing in mega-institutions, can suddenly and violently contract if the invisible hand is allowed to dole out punishment in the traditional way to bad actors (in this case, poorly managed large financial institutions).  So the trillion-dollar question is... how should Adam Smith be updated? 

I will discuss this next time.