The House That Regulation Built

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Ground zero of the economic depression is the banking system — worldwide. The system is collapsed, exploded, demolished, gone, ruined, kaput. The global banking system was a house of cards, and it has fallen. Governments and central banks everywhere do not yet realize this. They are attempting to rebuild the house from the pieces and scraps scattered far and wide. Better to salvage the pieces that still work and use them in an entirely new system than attempt to rebuild this one on the same cracked foundation and along the same flawed lines that produced this wreck.

It was a flimsy and jerry-rigged house that regulation built — it was built on the government regulation of money and banking. This was the house built by central banks, forced currencies, inconvertible currencies, manipulated currencies, monopoly money, deposit insurance, the IMF, paper reserves, and inept regulation; all linked into government control of economies, welfare states, and managed trade. And now incredibly costly repairs are being attempted.

This was the house that neared collapse before but was always saved despite itself by the ability of businesses to bring back economies from their banking-produced wrecks. This time matters are different. Attempts are being made to energize the system into a new orbit. We are seeing a quantum leap as governments, central banks, and major businesses all become intertwined at orbital levels that erase the distinction between private and public. The new orbit is even less stable than the old one. It promises a system in which the line between central banks and governments is blurred. It is a system in which these two institutions directly influence and control bank managements and lending. If they lacked the capabilities to regulate the system they created, they surely lack the capabilities to manage it. The result will be inefficient fascism presiding over a system that bends to the political forces and whims of its masters. If current trends persist, this is the system Americans will be living and suffering under. It may take such severe knocks on the head before the pendulum swings back to the free market, as it will when people experience the deprivations of fascism. Large social groups are slow learners with short memories.

Government after government, and this includes the federal government of the U.S., has shown itself incapable of controlling bank lending while simultaneously mandating a single national currency and insuring bank deposits. Banks are always one or more steps ahead of regulators, or else obtain concessions that allow them to take on inordinate risks. Central banks and governments are always all too ready to encourage banks to make marginal and risky loans. Banks are always all too ready to count on central banks to alleviate their risk-taking and errors. They are all too ready to seek profit in ways that take on more risk. They are all too ready to borrow far too much, receive short-term deposits and make long-term loans, and borrow in domestic currencies while lending in foreign currencies. Banks are all too prone to lend on collateral that is inflated in price due to central-bank created speculative bubbles. Banks are all too ready to take inordinate risks using insured deposits. The government-regulated banks are all too ready to destabilize themselves and the entire economic system.

Regulators are all too slow to identify and control banking behavior. This does not mean that they should control banks, or that they should bring in new controls and regulations to rebuild the house. The very opposite is the case. The failed government banking system rests on a basic false assumption. The idea prevails that government regulators should control money and banking because the market cannot. That idea is entirely false.

The notion of a free market in money and banking needs to be sharply distinguished from the government-regulated system that is now prevalent throughout the globe.

In a market system, individual banks that provide loans and create deposits and that issue their own bank notes, cannot long survive without prudent policies. The market discipline operates continuously and mercilessly. Individual banks in a free market system cannot issue bank notes that have value unless at the same time they have assets that back those notes. The market will not accept pieces of paper that lack anything behind them. The promise to redeem notes in something of undisputed value (like silver and gold) provides customers with the assurance that the bank actually has these assets.

In the existing government and central banking system, this discipline is absent. Banks that are in a central bank system do not issue their own notes, so that there is no pricing of their currencies. The notes of the central bank are forced on everyone at nominal par value. A central bank and its associated member banks can multiply notes indefinitely. In a market system, if a bank over-issues, or makes bad loans, or makes loans that endanger its ability to meet deposit withdrawals, its notes depreciate in the market place. This induces people to present the notes for redemption. If the bank is not to experience a bank run, it must heed the market price of its notes. It cannot allow them to depreciate in price. It has to prevent over-issue, carefully make and monitor loans, and watch deposit withdrawals.

The solution to the central banking system is free markets in money and banking. There is no quicker or more effective regulation than that of the market, which means the people who are using bank notes as currency and the banks that are competing to issue this currency.

The current U.S. Constitution gives Congress the power to regulate the gold content of the dollar. This means that Congress has power to control what is called the unit of account. In a true competitive system, there would be competing units of account. However, a system in which the dollar is fixed at a certain weight in gold is workable. It means that all prices that are in terms of dollars are actually in terms of a fixed weight of gold. Insofar as gold has a value that remains relatively stable, prices will remain relatively stable.

In a free money and banking system, there need not be a single medium of exchange. If individual banks issue their own notes, there can arise several media of exchange. If individual companies and persons can issue their own notes, there can arise even more possible media of exchange. Furthermore, there need not be a single medium of redemption. Notes can be redeemed in a great many things that have value. These are matters to be decided in free markets.

The path the U.S. is on is toward an ever-more centralized and government-controlled financial system in which capital is allocated by the government. This system leads inevitably to suppressed inflation. It leads to government attempts to control capital movements. It is a deadly step backwards to the fascism of the 1930s and the Nazi methods of economic control. Just as partial collapse encourages more authority being exercised at the center, complete collapse of the banking system and/or economy is likely to engender even more of such police state methods as long as people maintain their faith in government as savior and doer of all good. Militarism becomes more likely in such situations too.

The only way to avoid these dire outcomes is to move toward a free market in money and banking. Unfortunately, the Bush-Obama policies are doing the opposite, and in response to the financial problems of banks they’ve been at it for two years now.

A large amount needs to be done by legislators to dismantle regulations that are preventing a new money and banking system from arising. The immediate need is to encourage a rival and entirely deregulated system that lies outside federal and state control. Given the chance, such a system would arise speedily. There is plenty of existing case law to govern its activities without having the massive overlay of federal and state regulations and laws that are now in place.

Federal and state authorities should immediately encourage new banks to be chartered by any group or company that wants to establish them. They should be allowed to issue their own bank notes and credit in order to form a new alternative banking system. New banks can mobilize the immense amounts of money now locked up in money market accounts and Treasury bills. New banks can take over consumer loans, auto loans, and mortgage loans from older banks. Credit need not be interrupted.

Monetary freedom will produce an immediate alleviation of unemployment. When any company or any group can easily form a bank and create credits as well as possible currencies, then new prices for goods and factors can come into existence. Then it will be feasible and profitable to seek new ways to employ the currently unemployed people and resources. The profit possibilities are very great when large numbers of people and resources go unemployed. Unemployment would never happen on a widespread and continuing basis in a free market economy that has monetary freedom. The economy would rapidly adjust to what shocks there were that did occur. The existing hardships and misery are directly attributable to the lack of monetary freedom that we now have.

Existing banks that are failing should be allowed to fail. The FED and Treasury should stop expanding their programs immediately. They should immediately begin to contract them. They can dispose of their loans to new banks and investors who may be willing to take them. The FED should terminate the TALF program that it is just now starting up. The TARP program should be repealed. Basically, the actions of the last two years need to be reversed as soon as possible. All bailouts should cease. They encourage failing institutions to keep on operating, and they impose massive losses on taxpayers.

Troubled and failing banks can be restructured using the FDIC, so that credit interruptions are mitigated and insured depositors left whole. The federal authorities should immediately encourage the FDIC to facilitate the merger of existing branches and good assets of failed banks into sound banks that are willing to take them over. This will maintain intact the ability of insured depositors to access their accounts.

The regulatory authorities should encourage the restructuring of unsound banks in other ways, such as by spin-off, sale of divisions, sale of subsidiaries, sale of product lines, and sale of assets. The bad loans should be auctioned off in the market as soon as possible for whatever they will bring. There are many pools of investment money that will bid for these packages of loans.

The U.S. has established bankruptcy laws and procedures. In some cases, banks may choose bankruptcy and maintain their operations while under court supervision. This too will maintain the integrity of insured deposits. Banks, insurers, and other firms that are near bankruptcy will choose that path when they realize that the bailouts are over.

Credit through the capital markets offers another alternative to credit from new banks, merged banks, and restructured banks. Businesses can obtain credit and capital from investors directly without the intermediation of banks. To facilitate robust capital markets, the Congress needs to revisit and repeal a number of acts passed during the New Deal and after and since amended. In particular, the Securities and Exchange Act should be repealed.

These channels will work far better if business prospects stabilize. The federal government should immediately freeze its new intrusions into the economy. The Obama administration’s announcements on tax policies, health policies, energy policies, and bailout policies are shocking the economy on a daily basis and de-stabilizing capital flows.

Naturally, these suggestions barely scratch the surface of what needs to be done to create a free market economy with a free market money and banking system that will not be subject to the kind of devastation we are now seeing. Clearly, there is no national vision at present to accomplish measures like these. Nevertheless, at some point in the future and in some ways that cannot now be envisaged, this political economy will go through changes that will reduce national and state control and increase the presence of free markets. This will happen because the injustice, waste, and damage caused by government control and regulation will no longer be tolerated as a social consensus. The profit opportunities from a free market system will become so large and attractive that society will move in that direction. We will pass from one era to another. The house that regulation built will become a relic. It may even be seen as the barbarous relic that it is.

Michael S. Rozeff [send him mail] is a retired Professor of Finance living in East Amherst, New York.

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