Salerno on The Fed, the FDIC and Other Problems

Here is an excellent introduction to the source of the financial meltdown that ushered in our current economic woes. Salerno builds on the monetary theory of Ludwig von Mises and Murray Rothbard. He rightly notes the dangerous brew of Federal Reserve central banking, fractional reserve banking, and federal deposit insurance.




Salerno delivered his lecture at the most recent Mises Circle held in Manhattan. The theme of the event was "Central Banking, Deposit Insurance, and Economic Decline."

A Complication of Fractional Reserve Banking

One of the complications of fractional reserve banking is that a bank's demand deposit customer's can be held hostage, so to speak, to a bank's investment follies. Recent portfolio movements at the Bank of America illustrate this quite nicely.

According to Bloomberg News, the Bank of America has moved its Merrill Lynch derivatives unit to "a subsidiary flush with insured deposits." Officials at the Federal Reserve liked this move, because it gave some relief to the bank holding company. Moving bad assets off a balance sheet will do that. Officials at FDIC, however, understandably do not like the move, because such a move greatly weakens the balance sheet of the subsidiary, making it more likely to fail with the FDIC on the hook for the losses. The Bloomberg story reminds us that even three years after the financial crisis, things are not yet cleaned up.

Three years after taxpayers rescued some of the biggest U.S. lenders, regulators are grappling with how to protect FDIC- insured bank accounts from risks generated by investment-banking operations. Bank of America, which got a $45 billion bailout during the financial crisis, had $1.04 trillion in deposits as of midyear, ranking it second among U.S. firms.

The frustrating thing is that banking does not have to be like this. It is possible to have deposits that are entirely secure. The way to do it is to practice 100 per cent reserve banking. Instead of allowing banks to lend out their clients demand deposits and create additional demand deposits out of thin air, banks could be required to maintain enough reserves to cover 100 per cent of their outstanding demand deposits all of the time. In such a banking environment, there would be no risk of clients losing their deposits due to foolish investments. Banks could still make entrepreneurial error and still exhibit losses, but there would be no link between their investment practices and their deposit banking.

As Guido Hulsmann notes in his article, "Free Banking and the Free Bankers," under 100 percent reserve banking,

[T]here could be crises of confidence, but there can be no crises of the payments system. This is because the monetary aggregate that is relevant for payments--the money supply in the larger sense, that is, money plus fiduciary issues--could not differ from the supply of money. Its quantity could only vary to the extent that the quantity of money varies.

The money supply plus fiduciary money (in our present system demand deposits not fully redeemable by bank reserves) would equal the money supply, because there would not be any fiduciary money. In which case there could be financial panics, but they would not inhibit a bank's ability to redeem its clients' checking deposits, because they would always have enough reserves on hand to redeem every penny. In such a happy environment, there would be no need for FDIC. 

Troubled Banks Hit an All-Time High

This is another indication we still have malinvestment in the economy. Business Insider's Chart of the Day notices that, according to the FDIC, the number of troubled banks insured by the FDIC reached an all-time record in June.

Notwithstanding significant increases in quarterly earnings compared to a year ago, the number of "problem banks" continues to grow.  Despite Bernanke's massive liquidity injection, for much of the banking industry things have continued to get worse.

Another Sign the Recessionary Restructuring Is Not Complete

One of the great achievements of Austrian economists Ludwig von Mises and his student F. A. Hayek, was the development of what became known as Austrian business cycle theory. It shows that boom/bust business cycles are not inherent, necessary features of capitalism, but are instead the necessary consequences of monetary inflation via artificial credit expansion.

Such inflation makes interest rates artificially low and enticing, leading entrepreneurs to malinvest capital in production projects that appear profitable, but in fact are not. Such projects, because they are unprofitable, cannot continue indefinitely and eventually must be liquidated. The economy dips into recession. Some of the capital sunk in these unprofitable projects will be non-convertible to other uses, so it is consumed in unwise investment. As painful as it sounds, the only way for the economy to get back on track, so to speak, is to allow for unsound investments to be liquidated and a restructuring of the available capital stock, so that factors of production will be directed into the hands of those entrepreneurs who will use them productively in sound investments. As long as there is still capital frozen in unprofitable ventures, recessions are prolonged and prosperity is forestalled.

Over the weekend, we received news that indicates the necessary liquidation process is still continuing. The Associated Press reports that bank regulators closed five more banks, bringing the total for the year so far up to 108 compared to only 69 bank failures this time last year. Clearly any recovery is definitely not in full swing.