Real Banking Reform? End the Federal Reserve

By Richard M. Ebeling
Northwood University
Friday, January 22, 2010

http://defenseofcapitalism.blogspot.com/2010/01/real-banking-reform-end-federal-reserve.html

President Obama announced on January 21 that he will push for legislation that would significantly limit the size of banks to make sure that they are not “too big to fail,” as well limiting their ability to invest in what the president referred to as investments that are “too risky.”

Two important questions immediately come to mind: First, when is a bank “too big” to be too big to fail? And, second, when is an investment “too risky” and who is to make that judgment call?

The fact is, the answers to both questions will end up being decided by politicians who sign off on the regulatory legislation and by bureaucrats who will have the discretionary power to implement the new guidelines.

Legalized Plunders and Political Power

The next major question that needs to be asked is: How do they know? These are the same politicians whose time horizon goes no further than the next election day, and who pander to the special interest groups that provide them with the campaign contributions and the votes that keep them in office.

And these are the same bureaucrats whose bread and butter are based on constantly finding more “social problems” and “market failures” to justify getting bigger budgets each year, along with more authority to control other people’s lives as the vehicle to get promotions and higher pay and perks within the bureaucratic structure.

They are not quite the god-like oracles and disinterested ethical eunuchs they claim to be in their public rhetoric about their desire to only further some elusive and indefinable “common interest” and “general welfare.” They are, in fact, what the ninteenth century French economist, Frederic Bastiat, called the “legalized plunders” of society.

They are also the same people who have a professional knack for shifting responsibility for their own policy mistakes on to others. The current economic and financial crisis was “made in Washington D. C.,” by politicians and bureaucrats who orchestrated a disastrous monetary policy and a frenzy-like housing boom, the consequences of which have now fallen on the shoulders of millions of ordinary Americans, as well as many others around the world.

But listening to those politicians and bureaucrats it is all the fault of the greedy bankers and businessmen, whose irresponsible behavior now has to be reined in by wise and judicious government regulation. It reminds one of that scene in the old movie, Casablanca, in which the prefect of police announces that he is ordering Rick’s Café to be closed because he is shocked to discover there is gambling going on in the backroom, and just then the croupier walks up to the prefect and says, “Your winnings, sir.”

Free Markets and the Banking Industry

In reality, those politicians and bureaucrats have neither the knowledge nor ability to rationally regulate either banking or business in general, even if they were the disinterested public servants they so loudly claim to be. Theirs is the arrogance of the social engineer who believes himself wise enough to mastermind the complex economic affairs of an entire nation.

The advantage of a decentralized and competitive market economy is that it can leave each of us free to manage and guide our own business affairs, with our limited and specialized knowledge about our own particular circumstances. It is the role of market prices and the profit and loss mechanism to guide us into producing and providing those products and services that consumers want to buy, while providing the required feedback to tell us if we are doing so successfully or not. The market gives us the necessary pat on the head (profits) or slap on the behind (losses), to see that the supplies we offer are more or less matching up with things that are demanded.

This applies no less to the banking industry than any other line of business in the economy. The problem with the banking industry is that it is not a free, competitive market. It is already highly regulated – in spite of the rhetoric coming out of Washington and much of the news media – and it operates within a system of monetary central planning.

Banks are supposed to act as intermediaries lending the savings of income earners to others who wish to borrow that savings for investment activities and other future-oriented desired uses. The market rates of interest are supposed to balance the supply of savings with the demands to borrow, and see to it that the investments undertaken do not over reach the savings available to sustain and maintain them. A construction project begun may not be completed, for example, if the blueprint design that is guiding the work requires more resources and building material than are available to finish the job.

How “big” any bank should be is the same question that can be asked about any other business in the free market: It should be the size that represents its profitability and market share as a reflection of its success in better serving its customers than its rivals in the market place.

What kind of and how much risk should a bank take on in investing its capital and its depositors’ saving? That type and degree of risk that sound business practices suggest in a financial environment not manipulated or distorted by “activist” monetary policy. If a bank makes a sufficient number of mistakes in making these decisions, then it will fail the market test and should be allowed to go under, regardless of its size. This will create more caution by other banks in making their own investment decisions when they really believe that there is no taxpayers’ safety net to bail them out.

Central Banking the Cause of Economic Crises

America’s central bank – the Federal Reserve – is the monopoly controller of the supply of money and credit. It has the ability to create the illusion that there is more savings in the economy to start and work on investment projects than is really the case by pumping money into the banking system “out of thin air.” As a result, interest rates can be artificially pushed down for a period of time that generates a mismatch between investments undertaken and the real savings pool available to support them. Investment and housing bubbles can be created that eventually must burst.

This situation easily fosters a feeding frenzy in which banks and other financial institutions undertake risks in support of investment ventures that would never appear attractively profitable at higher market-based interest rates, and if the amount of money available to lend out was limited to the real savings that has been set aside out of people’s incomes.

There often is unreasonable systemic risk-taking in the banking sector, but it is not due to anything inherent in the banking business or the profit-motivated behavior of bank managers or lending officers. It has to do with the Federal Reserve’s mismanagement of the financial environment in which bank managers and lending officers are given “money to burn” through monetary expansion, and induced to inappropriately evaluate what is reasonable risk and who is a creditworthy borrower due to false interest rate signals resulting from misguided monetary policy.

A Free Market Agenda for Banking Reform

The only real banking reform that would reduce the possibility and likelihood of the type of financial and economic disaster through which we have been passing is to radically reform the monetary system. This means abolishing the Federal Reserve System and end monetary central planning by doing away with central banking.

In other words, the goal of real reform should be the establishment of private, competitive free banking in the United States.

The following would be the steps to bring this about:

1.The repeal of the Federal Reserve Act of 1913 and all complementary and related legislation giving the federal government authority and control over the monetary and banking system.

2. Repeal of legal-tender laws, which give government the power to specify the medium through which all debts and other financial obligations, public and private, may be settled.

3. Repeal of all restrictions and regulations on free entry into the banking business, including interstate banking.

4. Repeal of all restrictions on the right of private banks to issue their own bank notes and to open accounts denominated in foreign currencies or gold and silver.

5. Repeal of all federal and state rules, laws, and regulations concerning bank reserve requirements, interest rates, and capital requirements.

6. Abolish the Federal Deposit Insurance Corporation. Any deposit-insurance arrangements and agreements between banks and their customers, or among associations of banks, would be private, voluntary, and market-based.

This six-point plan for banking reform would set America on a path to far greater monetary, banking, and financial stability than anything central banking has or can provide. It would be the establishment of a real free enterprise system in the banking industry, and put an end to the danger and damage of a Federal Reserve-created business cycle for the remainder of the twenty-first century.

For further reading:
"The Gold Standard: The Case for Another Look", Sean Fieler and Jeffrey Bell, The Wall Street Journal, May 7, 2010