Re: ECON: The Fed's Y2K Recession of 2001

From: Technotranscendence (
Date: Sat Apr 07 2001 - 13:04:16 MDT

On Thursday, April 05, 2001 11:12 PM wrote:
> That would have more to do with the bank's rates relative to other banks.
> In any case, banks can and do change the number of loans they give out,
> independently of interest rate. Slowdowns get triggered when banks
> simply refuse to loan much, regardless of interest rate. Banks can
> reserves easily under "incorrect" interest rates.

Inflation = increase in money supply above demand. Do you agree? In free
banking, a bank clearing with other banks is one of the ways it would notice
its inflating. (Actually, just outflow of reserves would be enough. These
might be caused by clearings from other banks or by depositors redeeming
their notes for reserves. The latter might even happen en masse as in a
classic run.)

> All true; but none of this is related to the herd mentality problem.
> (snip various discussion of how the above limits could make banking less
> efficient, which I basically agree with)

By making them less efficient, it would contribute to an unstable system.
Shocks and changes that would be easily absorbed under free banking would be
harder to adjust to under the highly regulated regime in the US prior to
1913 when the Federal Reserve System started.

Limiting banks's actions and structure would contribute to them being more
alike than different. Also, some specific limits I mention, especially
those on branch banking, would make it harder for more experienced and
larger banks to expand. This would definitely contribute to a "herd
mentality." Inexperienced people often follow the herd, as we notice now
during and after the dot-com boom. (The more experienced investors did not
get onbound as much as the neophytes. Their selection criteria seemed to be
much more sophisticated than "Buy any tech now!" or "But IPOs no matter
what!") I thought that obvious.

For more on this, see "Is Free Banking More Prone to Bank Failures than
Regulated Banking?" by Kam Hon Chu at (The bibliography is also
useful there, though, if you've ignored my other web citings, especially
Kevin Dowd's site, I don't see why this one will be given attention.:)

Actually, Chu, paraphrasing George Benston, goes over, more succinctly than
I, the problems of bank regulation, i.e., of non-free banking:

"First, regulations constrain banks' diversification by limiting banks'
portfolio choices or by restricting branching, thus reducing the flexibility
of banks to accommodate unanticipated shocks. Second, as implicit taxes,
regulations reduce banks' profitability. Third, regulations often create a
moral hazard problem by encouraging risk taking. Fourth, while it may be the
intention of the regulatory authorities to promote banking stability by
interventions through monitoring, supervising, and preventing fraud and
grossly incompetent management, it is usually the case that supervision is
inadequate." (At above link.)

> Data does vary by country, which is why I put in the "relatively
> independent" caveat.

It's still debateable whether apolitical is what the FRS is. I see, to a
great extent, an institution in the throes of regulatory capture by the
stockholders and other major debtors. (Regulatory capture is where the
regulator gets winds up pandering to one group or set of groups, such as the
FDA being heavily influenced by the drug industry.) The Mexican bailout of
the early 1990s -- just after NAFTA was enacted -- and the more recent
bailout of LTCM are examples of this capture. Sort of the principle of
"what's good for [well connected and often rich] debtors is good for the
whole economy" being applied. (My implication here is that these debtors in
a free market would have went belly up or their creditors would suffered,
making all less wary of taking stupid risks. Instead, the Fed and other
government institutions helped to reinforce taking such risks because some
sort of relief is always available, especially to the bigger risk takers.
In other words, if you win you win and if you lose you win.)

> In the US case, growth volatility has been much
> less after the Fed came in than before.

But if you believe this is so, how much of that volatility was caused by
banking regulations? If you're going to stick with the US case, you have to
find a way to separate between the effects of regulation and what would have
happened under a free banking system. This is why I used the example of
Scotland prior to the Bank of England takeover in 1844.

See also Kevin Dowd's _Money and Market: Essays on Free Banking_, especially
chapter 7 -- "Are free markets the cause of financial instability?" -- which
available on the cheap from Laissez Faire Books, (The list price for the book is $100,
LFB sells it for $27.95. They must have a rich uncle or something.:) A lot
of instability is caused not by markets per se but by government attempts to
regulate them to a hopefully better outcome. (Or, admittedly, there are
times when regulators are just out to help their buddies, but even if this
wasn't the case regulation generally leads to worse outcomes.)

> With the Fed, we had the deflation
> of the 30' and the inflation of the 70's, which I agree would not have
> gone
> on nearly so long under market systems. The Bundesbank has never had
> that kind of major goof in 50 years. No "myriad inflations" here, or
> in Japan, Germany, or Switzerland.

In the US, what about the 1920s prior to the Great Depression? What about
1999? What about 1980, where the money base alone increase over 300%? (See
"Does the Fed Fight Inflation?" by Frank Shostak at
ion%3F )

In fact, the whole last century was inflationary. See "Central Banks, Gold,
and the Decline of the Dollar" by Robert Batemarco at on this. Batemarco claims "The
quantity of U.S. money has increased year in and year out every year since
1933." (This is, of course, only a rough measure of inflation. After all,
the demand for money might also have increased every year. Even so, it's
notable that the jump in increase happened through Fed action and has not
abated. The rate of increase might vary, but not the direction. Meaning,
we go from inflation to hyperinflation to inflation -- not inflation to

Also, what about Germany during the early 1920s? What about Germany during
the late 1920s and early 1930s? (I need not even, I hope, need to mention
France, Italy, Latin America, or Africa.) I am not yet familiar enough with
the Swiss and current German examples. The Japanese one is one of inflation
from what I've read, though only of mild to moderate inflation, which is
still bad. (The current deflation there actually seems to be an example of
just cutting back the usual rate of inflation, rather than a true deflation.
Deflation = decrease in money supply below demand for money. In other
words, the direction of monetary increase has changed. This is sort of like
how the US government didn't stop growing during the 1990s; it just didn't
grow as fast as it had been.:)

> Free banking, then, would increase short-term volatility compared to our
> current system while protecting from long-term mismanagement.

I doubt this. In fact, I think free banking would prevent most long run
mismanagement -- "most" because no system is perfect -- because it gives
proper short run signals (reserve outflows and inflows), allows for quick,
local reactions to changes in the demand for money and time preferences
(each bank setting its portfolio, reserve, interest rate, etc.), and
provides proper incentives to make those changes (profit and loss). These
signals just do not exist under FRS or any central bank. Also, the
incentive is not there for central bankers. In fact, the incentive is to
inflate, which is why we have long periods of inflation punctuated mostly by
ones of hyperinflation. (The value, e.g., of the dollar declined over most
of the 20th century in real terms.)

> Which
> is more important is not immediately clear. Further, the Fed
> *once* and hyper-inflated *once* and now seems acutely aware of both
> risks. The chance of a repeat occurance should be less than the once-in-
> 40 years we got in this century.

See above. Free banks almost constitutionally can't hyperinflate or
hyperdeflate. It would spell doom for any one of them that did. Free
banks, also, can hardly inflate or deflate. Either would be unprofitable
and they have the correct signals not to make those mistakes -- or make them
for too long. (Granted, new or incompetent banks might do this, but the
correction would be swift. Also, depositors would be wary of putting their
funds in banks they didn't think would be stable and profitable. This is an
important point. Government backed deposit insurance right now really has
stifled the learning process. Today, most depositors do not even think
about the stability or management of the bank they put their funds in --
except for larger depositors.)

> (to be fair, you could make a case that short-term volatility has
> benefits. But you do have to demonstrate that first.)

See above. See especially the Dowd article. I think one has to prove that
central banks can actually being stable and promote growth -- real growth,
not inflationary booms -- in both the long and short runs. Power and
control of other people, IMO, should never be condoned without a thorough
examination. Central banking is merely one instance of such control.


Daniel Ust

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