Not more regulation, but fundamental reform: An Austrian perspective on banks and the financial crisis

Austrian 50 Schilling

by Matthias Kelm

Matthias Kelm received his Ph.D. in Economics from Cambridge University, with a dissertation on institutional determinants of economic evolution in the tradition of Hayek and Schumpeter.
He is one the speakers at the Free Market Raod Show 2013. For seven weeks the Free Market Road Show is touring through 24 European countries and 26 European cities.

Although most politicians and some economists like to lay the blame for the recent financial crisis on free markets or capitalism in general, most of them know that the financial sector is at the heart of the problem. The conclusion that most politicians and mainstream economists draw from the crisis is therefore the need for more regulation of the financial industry. Austrian economists have a different view, arguing that the banking system does not need more regulation, but fundamental reform because the current system of fractional-reserve banking is inherently problematic.

The problematic nature of deposits under the current system is highlighted by a letter from the Central Bank of Cyprus to the CEO of Laiki Bank dated 11 February 2013, a few weeks before the decision about the Cyprus bailout on 25 March. In this letter, the Central Bank stresses “that any action aimed at reducing, depriving or restricting the property rights of depositors, contradicts the provisions of the Constitution of the Republic of Cyprus and of Article 1 of the First Protocol of the European Convention of Human Rights… Hence, any suggestion to the contrary is not legally unfounded, but it cannot merit serious consideration.” Six weeks later, large depositors lost a lot of the money they had entrusted to the largest Cypriot commercial banks, and Laiki Bank was actually closed down. If the Central Bank is right and deposits really are the depositors’ property, who stole them? Or, to use the more precise legal term, who embezzled them? The Troika? Mrs Merkel?  The previous (communist) government? The current (conservative) government? But the Troika (and Mrs Merkel) actually agreed to lend 10 billion Euros to Cyprus. This would be the first thieves who actually gave money to their victims. And the Cypriot government actually agreed to borrow this money in order to support whatever could be saved of its national banking system.

The truth is that the depositors’ property rights are a fiction that is consciously maintained by central banks and commercial banks. Despite a bank’s promise to the contrary, deposits are not money stored in a bank that customers can get back whenever they demand it, but they are just a bank’s liability. Banks do not safeguard deposits as their customers’ property, but they treat them as their own property by lending them to other customers. Looking at the most recent published balance sheet of Laiki Bank, dated 30.9.2012, we see that the bank had customer deposits of 18 billion Euros, but only 1 billion Euros in official money (cash and reserves with Central Banks). So the reserve ratio of cash to deposits was about 5.5% (1/18). This is not at all unusual in the current system of fractional-reserve banking. The only sign that Laiki bank was already in deep trouble was not the reserve ratio, which was quite normal, but the extremely large debt of 10 billion Euros to the Central Bank and other banks. Without this life support received by the Central Bank, Laiki Bank would have collapsed much earlier. But the general point is valid for all banks under the current system, even the healthiest ones. For the customers, most deposits serve as money substitutes expected to be available on demand, whenever they need them. But for the banks, deposits are liabilities that serve to finance loans to customers and other assets, e.g. securities such as government bonds. Fractional-reserve banks are therefore, inherently insolvent. If all customers would demand their deposits back the same day, no bank could keep its promise, and it would be immediately destroyed by a bank run, unless it would be supplied with sufficient amounts of new money created by the Central Bank.

So why do all banks operate on fractional reserves, despite the dangers for their solvency inherent in this system? First of all, it is very profitable for the banks. Deposits, based on the customers’ illusion that all the money is available on demand, are much cheaper for the bank than explicit loans, such as bonds issued by the bank, because interest rates for deposits are much lower as a rule. This means higher profits for the bank’s shareholders, and higher salaries and boni for the bankers themselves. But even better, the system allows the banks to create money themselves. Fractional-reserve banking is, quite literally, a license to print money, with the peculiarity that the printing is done electronically in the bank’s books and account statements. With this possibility to create money, banks can give more loans to their customers and earn more interest on these loans. This means, again, even higher profits for the bank’s shareholders, and higher salaries and boni for the bankers themselves. The system is obviously very profitable for banks and bankers, but why do the state and its agencies, the Central Bank and the Financial Service Authority, tolerate it? They tolerate it because it generates easier credit for governments, businesses and consumers. And the state, as one of the greatest debtors, is one of the main beneficiaries of the almost unlimited credit expansion made possible by the system of fractional-reserve banking.

How do fractional-reserve banks create money? Let us look at the balance sheet of a typical bank, with deposits of 20 billion Euros, the same amount of loans to customers, and 1 billion of cash and Central Bank reserves. The reserve ratio is 5% (1/20). Now suppose that customers, reassured by politicians that banks are safe, return one more billion of cash to their bank accounts. This means that deposits increase from 20 to 21 billion Euros, and the bank’s cash reserves increase from 1 to 2 billion Euros. But now the reserve ratio has increased to 9,5% (2/21), and the bank can give another 19 billion Euros as additional loans to their customers before the reserve ratio falls again to the old level of 5% that the bank and the supervising state authorities apparently consider satisfactory. How does the bank lend out another 19 billion Euros? Simply by creating deposits of the same amount. So loans to customers increase from 20 to 39 billion Euros, deposits further increase from 21 to 40 billion Euros, and the reserve ratio is 5% (2/40) as before. In case the customers do not return 1 billion of cash to the bank, the same process of credit expansion and money creation can also be started by the Central Bank, which can provide easily an additional billion of reserves either by buying assets, e.g. government bonds, from the bank, or lending one billion directly to the bank. The result is the same: With 1 extra billion of cash reserves received from the Central Bank, the commercial bank can create up to 20 billion Euros more of credit and deposits. Since these deposits are believed to be available whenever the customers demand them, the deposits serve as money for all practical purposes. In this way, just one billion Euros created by the Central Bank have increased the total money supply in the economy by 20 billion Euros.

As a result of fractional-reserve banking, many customers, including the government, get more loans, the bank’s shareholders get higher profits, and the bankers get higher salaries and boni. Everybody seems to be happy, so what is the problem? First the increased money supply sooner or later generates inflation. This does not always show in the consumer price index measured by government statisticians. The additional money is always received by specific people, e.g. additional state employees hired before elections, and these people always spend this money on specific goods, services, or assets. A lot of the money generated by Central and Commercial Banks during the last years increased prices of assets, such as real estate, gold, shares, bonds, and even works of art, whereas the prices of basic consumer goods measured by government statisticians did not increase significantly.

There is a second serious problem with a credit expansion generated by fractional reserve-banking. Despite the additional money that makes many people feel richer, the real resources available for producing real products for investment and consumption have not increased to the same extent. Under normal conditions, free markets provide signals, in the form of interest rates and other prices that help entrepreneurs focus on investments that will produce in the future goods which will fulfill the most urgent needs of consumers. But with the easy credit and the artificially low interest rates created by Central Banks and commercial banks together, entrepreneurs will start even investment projects that would not be viable under normal conditions, and that will actually turn out non-viable once the credit expansion slows down and reality in the form of limited resources sets in. As a consequence, the artificial boom generated by credit expansion necessarily turns into a bust. The companies that were seduced into erroneous investment projects (called malinvestments by Austrian economists) start making losses, lowering employment, and some of them have to close down. The ensuing recession, and the resulting unemployment, is a necessary consequence of the previous unsustainable growth triggered by artificial credit expansion. This is the basic idea of the Austrian Business Cycle Theory developed by Ludwig von Mises and elaborated by Friedrich von Hayek, the two most famous Austrian economists of the 20th century. And this remains the most plausible explanation of the current global financial crisis.

Finally, fractional-reserve banking creates irresistible political pressures to bail out banks at the expense of taxpayers. As we have seen, fractional-reserve banks are inherently insolvent, but as long as depositors believe, contrary to reality, that the banks are solvent and their deposits are safe, the system appears to be stable. As the bank must always appear to be solvent to avoid a disastrous bank run that will close it down immediately, it must always receive additional money from the Central Bank whenever its reserves are running low, and if this is not possible any more, it must be bailed out by the taxpayers so that depositors are not hurt. In this sense, deposits serve as “hostages” held by the banks to ensure that it is politically impossible to let them fail. This implicit state guarantee encourages them to take even higher risks, generating temporarily even higher profits, salaries, and boni for banks and bankers, but increasing also the likelihood of future losses and bailouts. It was the violation of this assumed state guarantee that created such horror in the recent Cyprus bailout. But the fact remains that these deposits were not stolen by anybody, but they had disappeared long before in non-performing loans to businesses and in bad investments such as Greek government bonds, with the full knowledge and acquiescence of the state and the Central Bank which are supposed to supervise the commercial banks.

The new regulatory framework currently discussed by politicians and mainstream economists does not really address the fundamental problem of fractional-reserve banking. There are some measures that point at least in the right direction (stricter liquidity standards, higher capital requirements, a new restructuring act to ensure that bank owners and creditors cover losses first), but as long as deposits supposed to be available on demand are not fully covered by money that is really available whenever demanded, the fundamental problem will at best be mitigated by certainly not solved. And all the other measures currently planned just increase regulation of almost any activity in financial markets, and create lots of new jobs for tax-funded bureaucrats, but do not address the fundamental problem at all. According to the German Federal Ministry of Finance, the following measures are planned to regulate financial markets: Reform of national financial supervision, strengthening of cross-border financial supervision, more comprehensive European supervision with the ECB, sustainable remuneration systems with less variable elements, ban on naked short-selling, regulation of computer-aided high-frequency trading, regulation of derivatives-trading, regulation of hedge funds and alternative investment funds, regulation of rating agencies, regulation of shadow banks, regulation of fee-based investment consulting, and last, but not least, a financial transaction tax that increases government revenues.

Even before the current financial crisis, the financial sector was one of the most heavily regulated industries, controlled in all countries by large supervisory authorities and subject to detailed prescriptions regarding capital requirements and many other aspects of their operations. Some of the banks playing a leading role in the drama were even state-controlled, both in the US and in Europe. And the American real estate bubble from which the crisis originated was actively supported by the US government and central bank, through general credit expansion orchestrated by the Fed, expansion of the mortgage market through government-sponsored mortgage banks, encouragement of subprime lending by government incentives for home-ownership by low-income groups, and dubious ratings by state-licensed rating agencies. So the response of mainstream politicians and economists to a crisis that an already heavily regulated and state-supported industry created by excessive credit expansion is basically: more regulation and more credit expansion, the latter through the emergency measures adopted by the Fed, the ECB, and other Central Banks. In other words, the sobering reply of the political, financial, and academic establishment to the crisis is: more of the same.

Austrian economists propose a radically different solution based on sound money. Without a fundamental reform of the current monetary system, we will not permanently overcome the current crisis, and we will not avoid future ones, similar or worse. Sound money means first of all money that cannot be manipulated by governments. For this reason, Austrian economists advocate a return to a monetary unit based on a real commodity. Throughout human history and in many different cultures all over the world, gold and silver were the commodities most frequently chosen in free market processes as the dominant means of exchange.

The classical gold standard worked well until the beginning of the 20th century, before it was gradually undermined and finally destroyed by governments eager to cover their ever-growing expenses and to artificially boost their economies with virtually unlimited supplies of paper money. Sound money also means money that cannot be arbitrarily created by commercial banks. For this reason, Austrian economists advocate a 100% reserve requirement on all deposits that are promised to be available on demand. This would mean the abolishment of fractional-reserve banking. Each bank customer should have a choice between a really safe deposit, fully backed by real money but not earning any interest, and an explicit loan to the bank for a specific period of time during which the money would not be available, earning interest but also bearing risk as any other investment. The bank could use such money borrowed from customers for a specific period of time to provide loans to other customers for the same or a shorter period of time, thereby avoiding completely the risk of insolvency inherent in the current fractional reserve banking system. Of course banks could still lose money on loans to their customers and other investments, but these losses would be covered first by their owners and then only by those customers who explicitly agreed to bear this risk in order to earn an interest return. Most importantly, these losses would not be covered by customers who explicitly renounced interest returns in order to be sure that their deposits are really safe and always available on demand. Loan banking and deposit banking would be strictly separated as they were historically, and with regard to deposits banks would revert to their original function of honest money-warehouses.

If the Austrian proposals for sound money were implemented, the current problems of almost permanent inflation and recurring booms and recessions would disappear, or at least greatly reduced in severity. There would be no need any more for taxpayers to bail out banks. There would also be no need any more for any special regulation of the banking industry. Banks could finally be like any other business, free to make entrepreneurial decisions to take any risk they want, but subject to the discipline and rules of free markets.

Support for sound money seems to be increasing in many countries. Ron Paul, the 12-term congressman and 2012 US presidential candidate, is the best-known politician who has been advocating the Austrian proposals for a long time, but recently other MPs in the US and in several European countries (e.g. Switzerland, UK) have introduced initiatives towards the same direction. And even some economists at the IMF, a bastion of mainstream economics, have recently expressed their support for the Chicago Plan, an old proposal by Irving Fisher (1936) to separate the monetary and credit functions of the banking system by requiring a 100% reserve backing for deposits.

But history shows that it may take a long time for the correct view to prevail, and sometimes a necessary reform can only be implemented after the collapse of the previous system. Ludwig von Mises, the greatest Austrian economist of the 20th century, explained already in 1920 why socialism as an economic system could not work. Paul Samuelson, possibly the greatest neoclassical economist of the 20th century, stated still in 1989 his belief that “a socialist command economy can function and even thrive”, and he changed his mind only once these command economies had actually collapsed. If the Austrian economists are right again without being listened to, monetary socialism, characterized by state-controlled paper money that is created by state-controlled central banks and multiplied by state-supported fractional-reserve commercial banks, will collapse as well, sooner or later. We should support the political fight for the necessary reforms to avoid this outcome, but at the same time take measures to protect our wealth in the not unlikely case that the collapse of paper money cannot be avoided.

The 2013 Free Market Road Show

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OLYMPUS DIGITAL CAMERAMatthias Kelm:

After professional training as an investment advisor at Deutsche Bank Berlin and undergraduate studies at St. Gallen (Switzerland), Matthias Kelm received his Ph.D. in economics from Cambridge University, with a dissertation on institutional determinants of economic evolution in the tradition of Hayek and Schumpeter. Following academic work as a Research Fellow at the ESRC Centre for Business Research, he started a career as a management consultant with McKinsey & Company, serving mainly financial institutions in Germany and Greece.

He left McKinsey as an Associate Principal to assume the position of Managing Director and CFO at ASK S.A., a Greek network of independent financial consultants founded by a German private investor, where he was also responsible for financial planning and investment advice to private clients. He presented his current work on Austrian financial economics at the 2013 Austrian Economics Research Conference at the Ludwig von Mises Institute (Auburn, AL). As an independent Austrian economist and investment advisor, he recently started a close co-operation with Tareno (Luxembourg) S.A., an independent asset management company with headquarters in Switzerland.

2013-05-16T12:52:11+00:00

One Comment

  1. jas 30.01.2014 at 07:28

    well written reform of australian prospective..

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