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Preventing the Free Market from Doing Its Job

Economically speaking, the so-called credit market crisis is, first and foremost, a reallocation of property rights.

Overstretched borrowers default on their obligations. Lenders, who have made unwise credit decisions, run up losses if they fail to collect interest and principal payments on credit extended. Luckily, all this leaves the physical supply of economic goods untouched.

The reallocation of property rights is typically accompanied by changes in market valuations. Financial asset prices such as stocks, bonds, and derivatives may decline, reflecting changes in people's preferences. While this is certainly unfavorable from the viewpoint of financial asset holders, it is welcomed by those seeking to invest their money, as they are now in a position to purchase assets at lower prices.

As the unhampered market finds a new equilibrium via price changes, it exposes malinvestment. Some of the investments made and some of the jobs created prove to be unprofitable. It is the process of altering prices for capital and labor that brings the economy's production structure back in line with people's preferences. In that sense, a so-called crisis, or bust, is actually a correction of bad decisions made in the past; the term crisis would appear to be inappropriate.

In fact, the term crisis should be attributed to the boom period. It is here where scarce resources, mostly due to artificially reduced interest rates through monetary policy, are being channeled to unprofitable businesses. While the period of building up malinvestment is typically hailed as a period of economic expansion, it is actually a period of squandering.

As Ludwig von Mises put it,

The boom is called good business, prosperity, and upswing. Its unavoidable aftermath, the readjustment of conditions to the real data of the market, is called crisis, slump, bad business, depression. People rebel against the insight that the disturbing element is to be seen in the malinvestment and the overconsumption of the boom period and that such an artificially induced boom is doomed. They are looking for the philosophers' stone to make it last.[1]

Many people think that state interventionism can (and has to) fight against financial market turmoil and any consequences it may have for output and employment growth. While this is certainly a fatal belief, one thing seems certain: the latest developments suggest that without a far-reaching coercive redistribution of income through state action, the government-controlled paper-money standards would go belly up immediately.

The Intricacies of Fractional-Reserve Banking

To see this, we must be aware of the fact that today's government-controlled money-supply systems rest on fractional-reserve banking. Banks create money when they extend loans to, or buy assets from, nonbanks. If, for instance, a bank grants a loan in the amount of, say, US$10,000, it creates money in the same amount. If a borrower repays his loan, the money stock declines. That said, the money stock is basically the result of bank-credit supply and bank-credit demand.

What is more, banks are required to hold just a fraction of their obligations in cash (minimum reserves). If confidence in the financial solidity of a bank should erode and customers want to withdraw their deposits, a bank could not meet its promise to pay in full. The ensuing bank run could spread to other banks, to the point where the banking sector as a whole becomes insolvent.

However, government-sponsored central banks have the power to prevent any such bank default. If it is politically expedient, a central bank can, at any point in time, provide banks with whatever money is needed (lender of last resort), so that the risk of bank runs has been reduced greatly.

But there remains another weak point of the government sponsored money system. The governments' financial watchdogs encourage banks to keep a small ratio of regulatory equity capital to risky assets, around 8%. As a result, relatively small losses have the potential to wipe out banks' capital base. In such a case, not only would bank shareholders suffer losses, but so would depositors and holders of bank liabilities.

It is this fact that can have far-ranging consequences for the economy's credit and money supply. To see what bank losses mean under fractional-reserve banking backed by little equity capital, let us take a look at a simple example. Below we show a (stylized) consolidated balance sheet of the banking sector (Figure 1). It records banks' assets on the left-hand side and banks' liabilities on the right-hand side.

As can be seen, banks hold a fraction of fractional reserves: base money (minimum reserves) amount to a small portion of clients' demand deposits and time deposits. What is more, the banking sector's (regulatory) equity capital in relation to risky assets (loans, bonds, and other assets) is assumed to be 10.1%.

Bank Recapitalization Reduces the Money Stock

Now let us assume that — as a result of a collapsed lending- and credit-speculation boom — 10.1% of banks' risky assets (an equivalent of US$1,170bn) have to be written off. In our example, the resulting loss would wipe out the banking sector's entire equity capital (Figure 2). Banks would be on the verge of bankruptcy.

To remain in business, banks would need new equity capital. If nonbank investors buy new stocks, the banking sector's balance sheet would change in an important way: bank liabilities (in the form of demand and time deposits and long-term liabilities) decline in the same amount as banks' equity capital rises.

If we assume that bank clients exchange demand and time deposits for new bank stocks, the increase in banks' equity capital of, say, US$1,051bn (which would restore an equity-capital-to-risky-assets ratio of 10.1%) would reduce the stock of deposits held with banks by 15.3% (Figure 3).

A sharp drop in the stock of bank deposits would be deflationary, potentially leading to a marked decline in goods and asset prices, even triggering a severe fall in output and employment, thereby aggravating bank-loan losses. In view of such a scenario, panic may spread like wildfire. Public opinion can be expected to call for government policies that would fend off any such development.

Policies for Socializing Bank Losses

The central bank could intervene by buying banks' distressed assets (at par or even at elevated prices), or extending loans to banks, with newly issued central bank money. This would reduce bank losses and release equity capital for additional lending and money creation.

However, such a policy would be unmistakably inflationary, running the risk of destroying confidence in paper money. Market interest rates could rise, causing borrower defaults on a wider scale, thereby pushing the economy into recession, increasing banks' loan write downs and thereby equity capital losses considerably.

In fact, a strategy of outright inflation might not be rational from the viewpoint of government politicians, central bankers, and influential vested interest groups; all of them would have much to lose, and at least those in command of the printing press and taxation can be expected to opt for strategies that would, from their viewpoint, appear to cause as little damage as possible.

The central bank could — actually before any major write-downs are recorded — take over banks' risky assets in exchange for government bond holdings. In our example, the central bank transfers its government bond holdings to banks in the amount of US$744bn (Figure 4).

In our example, the transaction has prevented a severe decline in banks' equity capital. Clearly, if its security holdings are (much) lower than banks' write offs, the central bank cannot prevent banks' equity capital from eroding markedly. However, there is another way of subsidizing banks via mobilizing taxpayers' money.

To see how this can work, we need to take a look at the year 1948, when the Deutschmark was introduced in West Germany. Due to differences in converting asset and liabilities from Reichsmarks into Deutschmarks, German banks found themselves with revaluation gaps on the asset side of their balance sheets.

The German public sector came to help and provided banks with so-called Ausgleichsforderungen (or compensation claims). These were effectively state bonds that had a long maturity, a low interest rate, and were repaid over time. These taxpayer-funded assets helped shore up the banking sector's equity capital.

In a similar fashion, governments, or their central banks, could in the current situation provide banks with claims on the government (or claims on the central bank). Banks would record these assets on the left-hand side of their balance sheets, and they would help increase banks' equity capital.

Let us assume that the central bank provides banks with US$1,051bn (the amount that would restore banks' equity-capital ratio of 10.1%) of claims on the central bank (Figure 4). The banking sector would be restored to health as far as its capital base is concerned, while the stock of money remains unchanged.

As in our example, the central bank's equity capital would be wiped out with additional liabilities in the amount of US$1,051bn; the government could provide its central bank with additional government bonds (with a long maturity and a low interest rate), so that the central bank's equity base would remain unchanged.

What about the option of the government setting up special funds, which would take over banks' distressed loan and security portfolios? Here, banks would receive (interest bearing) claims against the government-sponsored special funds, while the latter would be refinanced by issuing government-guaranteed bonds.

However, such a transaction would reduce the economy's money stock: the government's special fund would pay for banks' assets with commercial-bank money (which was acquired through the issue of bonds). As a result, the banking sector's balance-sheet volume would shrink, and so would the money stock.

Finally, one could let bank depositors and holders of bank liabilities take part in banks' losses. In this case, banks' depositors and creditors would see their claims converted into bank equity capital; it would actually be a bank-debt-for-equity-swap on a grand scale. But would there be a political willingness to declare the national banking sector bankrupt?

Returning Money to the Free Market

Whatever the technicalities for propping up the government-sponsored paper-money systems may be, the decade-long debt binge will most likely end in inflation. This is because the "crisis" is widely perceived as a calamity — rather than the necessary economic correction of malinvestment brought about by central banks' manipulation of market interest rates through credit and money expansion. On top of that, people fear deflation much more than inflation. Lower interest rates and more credit and money are seen as a remedy of the disease brought about by central banks' artificial lowering of the interest rate through credit expansion.

We currently find ourselves in a situation Ludwig von Mises warned against:

The boom produces impoverishment. But still more disastrous are its moral ravages. It makes people despondent and dispirited. The more optimistic they were under the illusory prosperity of the boom, the greater is their despair and their feeling of frustration. The individual is always ready to ascribe his good luck to his own efficiency and to take it as a well-deserved reward for his talent, application, and probity. But reverses of fortune he always charges to other people, and most of all to the absurdity of social and political institutions. He does not blame the authorities for having fostered the boom. He reviles them for the inevitable collapse. In the opinion of the public, more inflation and more credit expansion are the only remedy against the evils which inflation and credit expansion have brought about.[2]

There is no escape from the costs of correcting the damage inflicted by government paper-money standards. However, when looking for monetary-reform proposals, Mises's work must be given highest public attention: he proposed ending the government money-supply monopoly — which he identified as the root of the problem — and returning money to the free market. Only in this way can the costs of the final monetary and economic collapse be prevented from becoming disastrously high. Mises wrote, "The alternative is only whether the crisis should come sooner as the result of a voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved."[3]