The business of banking has long been rather exceptional with regards to the way that it treats profits and losses. In any industry, when a company makes profits these are either retained by the company as capital or distributed to shareholders – and so it is in banking. However, in most industries when a company makes losses these must be born by the shareholders – not so in banking. Banks enjoy various government guarantees including the ability to borrow from the central bank and to use tax payer’s money to insure bank deposits. When banks lose money, only  a fraction of the money that they lose actually belongs to bank shareholders.

So we have the problem that, whilst the profits resulting from profitable lending serve to enrich bank shareholders and bank employees, the losses resulting from unprofitable lending serve to impoverish those who are forced to guarantee bank loans, which generally means tax payers. This fact has led some economists (such as Jeffrey Sachs) to suggest that the banks should be nationalized. Since tax payers always end up shouldering the losses when times are bad, say these economists, perhaps it would make more sense if those same tax payers at least stood to make some profits when times were good.

Banking is not entirely unique in this respect – this condition exists wherever there are government guarantees. Henry Hazlitt quite plainly pointed out the risks of extending government guarantees to mortgage lenders in his great classic Economics in One Lesson over 30 years ago:

The case against government-guaranteed loans and mortgages to private businesses and persons is almost as strong as, though less obvious than, the case against direct government loans and mortgages. The advocates of government-guaranteed mortgages also forget that what is being lent is ultimately real capital, which is limited in supply, and that they are helping identified B at the expense of some unidentified A. Government-guaranteed home mortgages, especially when a negligible down payment or no down payment whatever is required, inevitably mean more bad loans than otherwise. They force the general taxpayer to subsidize the bad risks and to defray the losses. They encourage people to “buy” houses that they cannot really afford. They tend eventually to bring about an oversupply of houses as compared with other things. They temporarily overstimulate building, raise the cost of building for everybody (including the buyers of the homes with the guaranteed mortgages), and may mislead the building industry into an eventually costly overexpansion. In brief in the long run they do not increase overall national production but encourage malinvestment.

Hence government guarantees have meant that in addition to paying for the losses of banks, taxpayers today must also pay for the losses of mortgage lenders such as Freddie Mac and Fannie Mae, and once again this fact has led certain economists and policy makers to suggest nationalization.

However this is a very dangerous road to walk down. We could hardly expect government to start making good loans where private banks that were risking (at least in part) shareholder funds were unable to do so. The concepts of profit and loss mean very little to governments, whose primary source  of funds is the barrel of a gun, and if governments are not motivated by profit (which it is clear they are not) we would do well to remember that they are not there simply for our amusement. Principally they are there to achieve political goals and when loans in the economy are extended by government they will be extended not on the basis of economic profitability but instead on the basis of political gain. Where the votes of troubled home owners could tip the balance of power, loans will be made to home owners on the basis of their ability to vote for politicians rather than on their ability to repay the loans and the economic good sense of extending such loans. Companies will receive loans not because they are in a position to pay these back but because they have friends in government, contributed to one or other politician’s campaign or because they are considered “strategic” to some political pressure group (such as the UAW).

Under a system of nationalization, economic activity would be directed not by profit and loss and not by human needs and the satisfaction of those needs (i.e. supply and demand) but by central government and bureaucracy. The pricing system as a means for rationally allocating scarce resources would be replaced by the kind of democracy and political pressure groups that have brought about shortages and rationing of water in Australia, petrol in Indonesia and bread in Egypt… however where the later are examples of governments bungling the delivery of individual commodities the nationalization of banking and the institution of government lending would see the soviet style collapse of the rational distribution and use of savings more generally across all categories, from paper to silicon chips and from road workers to neurosurgeons.

Sadly, many of these undesirable side-effects of nationalization have already been brought about, even without having officially nationalized banks, mortgage lenders and insurance companies, since their true cause is not whether government is the legal owner of such institutions but the government guarantees that have been provided  to them. These government guarantees are almost as explicit now as they would be if these institutions were nationalized and so should their nationalization come to pass then probably very little would change down in the trenches. However this is all the more reason to to think that nationalizing these already highly political institutions would in no way cure any of our current problems – it would change very little and merely ensure that our current problems stayed with us for years to come.

Two wrongs do not make a right and nationalizing banks cannot be considered an adequate solution to the problem of moral hazard presented above, whereby shareholders and bank employees take profits but tax payers shoulder losses. Rather than trying to take the profits of these institutions as some form of compensation for the government guarantees that have brought them so much pain, tax payers should instead attempt to alleviate themselves of the requirement to shoulder the losses of these institutions in the first place. This is the root of the problem and if government guarantees (backed with tax payer’s money) were withdrawn then the problem would go away. If government guarantees are instead made explicit by way of nationalizing the affected instittutions then our current problems will merely worsen and become permanent.

Regulation for show

The most commonly suggested alternative to nationalization is that government regulation should be reviewed and improved to “ensure this doesn’t happen again”. This is a half-arsed solution and those suggesting it are usually sorely short on details as to how their new super-regulations might work, where the plethora of regulations that came before them have failed so miserably. Previous attempts at regulation over the past 80 years haven’t even been able to prevent the basic Ponzi scheme. We can perhaps give the pro-regulation cheerleaders a helping hand by pointing out that the regulations that would be required would need to ensure that the folks making loans were a little more careful with the money they were lending… indeed ultimately we want to make sure these folks are as careful lending that money as they would be lending their own money (since that would be the only way to truly counter the moral hazard resulting from the fact that they’re not lending their own money).

Here, of course, we have a problem. How can we possibly ensure that someone is as careful lending out other people’s money as when they lend out their own money? One possibility would be to make sure that they are lending at least a portion of their own funds but, here again, if they are lending $X of their own money and $Y of someone else’s money, and taking a percentage of the gains on the whole of the money that is invested during the good years but only being limited to losses concerning a portion of the money during the bad years then the equation remains fundamentally skewed in favor of excess risk taking and no moral hazard has been averted. The risk appetite of fund managers should be testament to this – fund managers are happy to lose 100% of the few million that they invest in a bad year, providing the preceding years saw them take 20% of the profits on the billions of dollars that they were investing on behalf of their clients. In short, no requirement for bank shareholders to invest a percentage of their own money, short of a requirement that they invest 100% of their own money, can avoid moral hazard.

A 100% reserve requirement would definitely be an improvement on the current situation. Deposit insurance would no longer be necessary, since deposits would not go missing (except where it was criminal, which would result in bankers going to jail). Bankers certainly wouldn’t be happy about it initially… with 100% reserves it would be impossible for them to leverage depositors money by lending out multiples of the cash that they had on hand and no doubt both the volume of the loans that banks extended and the size of the banking sector overall would shrink considerably. However, although the total receipts of banks would fall and the size of the banking sector would shrink, under a system of 100% reserves banks would be much more solid institutions. They would not need  government handouts since they could only ever lose as much money as either shareholders or investors had contributed (like all other companies) and so those wearing the losses for failing banks would only be those who had chosen to risk their funds. Thus the banks would be able to pay their management whatever salaries they pleased without needing government approval and, more importantly, the public could rest assured that those banks that still existed were, on the balance of things, profitable and thus contributing to the broader economy rather than weakening it.

However a 100% reserve requirement still would not address the problems that result from the existence of a central bank and legal tender laws. This would leave control over  the supply of money and therefore interest rates in the hands of government, who cannot possibly know what what an appropriate price for savings is, at any one time, and even if they were capable of knowing what an appropriate price for savings was they certainly could not be trusted to try to bring such a price about and nor would there be any need for their involvement if that was all that they wanted to achieve. A market price for savings would emerge from a free market  for money without any government involvement at all. The only reason to involve government and the central bank is in order to alter prices and shift them away from their market rate for political reasons rather than economic ones… a problem which has plagued us for centuries, ever since the existence of legal tender laws and lenders of last resort and which has led to ever more frequent and ever more serious booms and busts, as has been pointed out by Mises, Hayek and numerous Austrian scholars since.

As such, far from the addition of new government regulation, a proper and lasting solution would be the removal of all and any government guarantees which are responsible for moral hazard. Trouble in the market for savings and loans has been inevitable ever since government gave implicit baking to loans made on the basis of fractional reserves and put in place legal tender laws, a lender of last resort and deposit insurance. The only genuine way to resolve the problem of moral hazard that has developed as a result of these government guarantees would be the complete removal of such guarantees. 

Pretend solutions

In mainstream media, the suggestion of private banking (i.e. the removal of all government guarantees for banks and the dissolution of the central bank) is generally either treated as laughable or met with complete incomprehension. Most individuals are unable to conceive of a world in which money might not be controlled and made by government (as can be evidenced by the reaction of interviewers during Jim Rogers’ March 2008 interview on CNBC when Rogers suggests dissolving the Fed – Maria considered Rogers’ suggestion to be no less fantastic than trolls and wizards and was obviously incapable of wrapping her head around the idea that the central bank might not really be required or the possibility that Rogers’ suggestion was actually a very good one).

In political circles private banking fares no better. The words “change” and “reform” are heard quite frequently in elegant speeches made by politicians and financial authorities, however it is clear at the same time that they want neither. Those making such speeches show no inclination to remove the government guarantees which are the root cause of the problems. At the same time, they are clearly quite reluctant to formally nationalize the banks. What they want then is not change but stasis. They want to be able to keep the current system but somehow cover up its problems and pretend this whole messy affair never happened.

As such, instead of real solutions we’ll probably see the formation of things like Bad Banks, which are no solution at all. These basically involve wiping out the shareholders, making tax payers pay for the rest of the losses and then selling anything of worth to someone else, simply to get it out of government hands. It’s not nationalization (which is good) but the creation of a Bad Bank in no way addresses any of the structural issues that brought about the current crisis – it is simply a way to make shareholders and tax payers wear the losses in an orderly fashion.

Additionally we’ll see new regulations being proposed to make certain that this doesn’t happen again. But the new rules will be just as ineffective as the old rules and the rules before them, because no regulation is capable of negating the moral hazard that results from the government guarantees which allow bankers to invest more money than they actually have and to lose other people’s money, rather than their own. Additional regulation is mere posturing by politicians who want to be seen to be “doing” something but it cannot address the underlying issues which neither politicians nor mainstream commentators make any mention of.

Economic realities

None of the current measures being suggested are real solutions to our current problems. However it must be admitted that these problems are hardly make believe and that they are vast indeed. If CNBC are to be believed then when all is said and done the losses from the current financial crisis could weigh in at as much as $7.36 trillion dollars (more than double the inflation adjusted cost of World War II). That sounds like a fantastically big and irrelevant figure, but these losses are not mere numbers in accounting ledgers. The whole purpose of accounting is to estimate real profits and losses and, in the case of the losses that we’re currently incurring, what has been lost is savings… not money but what money represents – the savings of real goods and services (such as wood, bread and health care). If those savings had not been wasted by financial institutions as a result of misguided government guarantees then they might have been available to be used for other things. For example, the estimated cost of Hurricane Katrina was $81.2 billion. Insurance company AIG lost more than that last year alone and has, to date, been the recipient of very nearly double that in government bailouts!  When AIG announces such losses they are announcing the loss not just of dollars but of real savings sufficient to rebuild entire States in the wake of national disasters. Were government money not used to bailout these loss making entities, it might instead be used for such disaster relief… of even better left in the hands of private companies and relief agencies. Regardless, the point is that these are real losses paid for with real savings.

Over the past few decades these real losses have been largely masked by borrowing in Western countries. Whenever our economies were short of money because they incurred massive losses (which they had no savings to guard against) or simply because they wanted to consume or invest more, they were able to borrow from the East. Where money (and thus real savings) was borrowed from the East in order to fund extra investment and to increase future production – production that could be used to repay such loans – the borrowing did not present any insurmountable problems. However, borrowing on the part of government to bail out loss making institutions is not investing in future production – it’s investing in past mistakes. Nor do housing or personal consumption in any way serve to improve the productive output of the economy – two activities that have recently accounted for nearly 80% of the U.S. GDP, according to Stephen Roach in the February 2009 edition of Foreign Policy magazine. This recent borrowing on the part of Western nations is not sustainable and the longer it persists the more remote the possibility of ever repaying our debts becomes.

Every few years we have another financial crisis or another natural disaster that we don’t have the money to pay for and every few years we postpone addressing the underlying issues. Politicians smooth talk and pretend to make things better whilst sweeping the problems under the rug with deficit spending that drives our economies further and further into debt. Sales taxes, energy taxes and all manner of other sneaky little taxes get introduced to try to plug a few of the cracks in the dam – but the walls are starting to rumble as the pressure mounts on the other side. Sometimes we have even been offered “tax cuts” in one form or another but these are always financed through yet more deficit spending and so are more accurately described as “tax tabs” – invoices for taxes to be paid at some future (unspecified) date when the East tires of buying bonds that pay no yield, denominated in currencies that do not hold their value. Government debt and future commitments climb steadily whilst personal savings rates hardly fare any better. After all, why save when interest rates are almost zero?

But if the East ever falters… if the Chinese and Japanese economies ever stumble and they’re not in a position to buy Western bonds, what would happen if we had another financial crisis then?

Rather than begging from the East, the economies of the West need to learn to stand on their own two feet again and that is not going to happen while our politicians and financial authorities are doing everything that they can to avoid real change. What is required is that the economies of the West return to profitability and that means that

1. the borrowing that we are doing has to become profitable again and
2. we must reduce both our trade deficits and our current account deficits

The first step to making borrowing profitable again is to get it out of the hands of government – not just in name but in spirit – borrowing needs to go back to the private markets. Once government guarantees are removed so that private banking can be stable and once the central bank is removed so that interest rates can rise to natural levels that would require funds be borrowed only for those activities that are truly profitable, our economies would stop lending so much money to consumers and start lending more to investors who are able to make profits. And if we wish to avoid selling the farm to buy the milk (i.e. selling  assets like companies, mining rights etc. to the East) then the new industries that will be built by these investors must not service domestic demand but must export goods and services back to the East in order to pay down debt.

Reducing the twin deficits would require massive shifts of western currencies in the downward direction with respect to Eastern currencies… implying higher prices (since we are net importers) without larger pay checks. 

Largely what is required is belt tightening and a lower standard of living for the West, but her citizens don’t want to hear it and her politicians don’t want to tell it to them. So the charade continues with governments borrowing to delay the realization of economic reality. They patch up symptoms rather than treating causes and they pile wrong upon wrong in the vain hope that the sum total will eventually be a right. Further control is given to government to cure problems resulting from previous government control and, slowly but surely, the free market pricing system is smothered and replaced by soviet style allocation that further frustrates the ability of our economies to turn a profit. Indeed the ability of our economies to even function is now starting to be called into question.

In 1920 Ludwig von Mises famously postulated, in his essay Economic Calculation in the Socialist Commonwealth, that government intervention begets even further government intervention leading eventually to economic collapse and/or total central control. Today, I’m not sure which I fear most. I’d like to be optimistic, but in order for this story to have a happy ending both politicians and the general public would need to be far more willing to accept economic realities than they currently appear to be. My only hope is that perhaps economic reality will force Western nations to do the right thing. Perhaps with China planning a little deficit spending of its own and Japan in serious trouble, we’ll finally get the push we need in the right direction from that old mother of invention – necessity.