What Our Officials Most Fear
by Michael S. Rozeff
by Michael S. Rozeff
What do our officials most fear? They fear the public's loss of confidence. Events are driving their improvised attempts to stem a general loss of confidence in the dollar, in them, the financial and monetary system, and the government as a whole.
It is not clear that they recognize that this is their greatest fear. But even if they do recognize that this is their greatest fear, they have no clear roadmap for dealing with it.
Barack Obama's speeches have kindled some hope. If and when he takes office, he can maintain that hope and a degree of confidence for a spell, by strong government action, for, despite its perverse effects, strong measures are what give many voters confidence in the system. They feel good if something is being done, even if it means they'll pay double or triple in the end.
A recent news headline reads "Obama gives Bernanke vote of confidence." Obama is not even President yet, and he is already trying to bolster confidence in the system.
On May 13, 2008, Chairman Ben S. Bernanke spoke of many things, as he often does, of economic growth, of housing losses, of liquidity, of financial strains, and so on. And in doing so, he obscured his main fear. He fears our fears. He fears fear itself. He fears our loss of confidence in the currency and the monetary system and in the entire system itself. If he doesn't, he should or soon will. Such a loss of confidence is inevitable.
Bernanke does not fully and openly express these broadscale fears. It would not be politic to do so. He might fan the flames of fear. When he is alone with himself in quiet moments, do these large fears cross his mind? Maybe, but it is just possible that he is not fully aware that these are his main fears. His self-knowledge may be deficient.
In his speech, he expressed only part of this fear-cluster; but he expressed more than enough to support my statement that our officials fear a loss of confidence. I quote:
"Walter Bagehot's Lombard Street, published in 1873, remains one of the classic treatments of the role of the central bank in the management of financial crises. Bagehot noted that the basis of a successful credit system is confidence. In one passage, he writes, ‘Credit means that a certain confidence is given, and a certain trust reposed. Is that trust justified? and is that confidence wise? These are the cardinal questions' (p. 11). He pointed out that confidence is particularly important in banking and in other situations in which the lender's own liabilities are viewed as very liquid by its creditors. In such situations, as Bagehot put it, ‘…where the 'liabilities,' or promises to pay, are so large, and the time at which to pay them, if exacted, is so short,' borrowers must demonstrate ‘an instant capacity to meet engagements' (p. 11)."
And Bernanke went on to note that "the loss of confidence, even if not originally justified by fundamentals, will tend to be self-confirming. If the loss of confidence becomes more general, a broader crisis may ensue." In this passage, he puts his finger on the larger fear, which is a general loss of confidence.
The Fed Chairman understands that confidence in the financial system and in banks in particular is the foundation of the system. Without it, lending evaporates and the economic system grinds to a halt until people arrange new channels of borrowing and lending. Bernanke, being a central banker, sees the solution to this as providing liquidity in a host of new and creative ways. It is the "how" of providing liquidity that interests Bernanke. The techniques of providing liquidity while not introducing moral hazard and not inflating the money supply are what fascinate him.
Our other major financial official is Henry Paulson, who is Secretary of the Treasury. I need only provide the titles of two of his speeches to make my point. On July 22, 2008, he gave a speech with the title: "Reinforcing Market Stability and Confidence." He stated unequivocally that these were his "highest priority." He means it. On June 5, 2002, while still Chairman and CEO of Goldman Sachs Group, Inc., he made a speech titled "Restoring Investor Confidence: An Agenda for Change."
Paulson in his speech tackles the topic of confidence in a very broad way. He touches upon banks, failing banks, the IndyMac failure, the FDIC, the financial markets, and non-bank financial institutions. Paulson is always attempting to reassure the people that the system is sound, so that they will have confidence in it. On January 22, 2008, for example, he said, "I continue to have confidence in the underlying strength of the global economy."
Paulson, like Bernanke, thinks in terms of confidence in the system. And so does a former Secretary of the Treasury, Lawrence Summers. He supported the bailout of Fannie Mae and Freddie Mac because, for one thing, "Failure to pass even this minimal measure would undermine confidence." Summers weights the confidence factor very, very highly because his list of reservations about the bailout bill is very long.
Is the focus that these officials have on confidence misplaced? Not at all. They are all right on target. Where we can fault them, if we must, is that they do not express clearly and cogently enough the precise nature of their fear that the American public will lose confidence. They raise the issue clearly enough, but it is always to pour the syrup of comforting reassurances into the public's ears so that any troubles will be smothered in sweet talk.
If we want to understand what the most basic issue of confidence is really about, we need to look elsewhere. One good place is Human Action by Ludwig von Mises. Chapter 17 deals with Indirect Exchange, that is, exchange using money and other media.
In a pre-FDIC (Federal Deposit Insurance Corporation) system, a bank traditionally stands ready to redeem its notes in money (like gold or silver). The bank's assets, however, are mostly illiquid securities like mortgages and loans. The bank needs to manage its position such that if called upon to redeem a large volume of notes in money, it can. But in this system, the banks issue money-substitutes or what Mises calls fiduciary media. These are notes in excess of its available money. Like Bagehot, Mises notes that confidence in the bank is essential to the bank's survival:
"People deal with money-substitutes as if they were money because they are fully confident that it will be possible to exchange them at any time without delay and without cost against money. We may call those who share in this confidence and are therefore ready to deal with money-substitutes as if they were money, the clients of the issuing banker, bank, or authority."
In the post-FDIC system that we have, banks do not redeem notes in gold and silver. They don't redeem them at all! There is confidence in this arrangement, not because the FDIC exists with its meager insurance fund, but only because depositors regard the banking system's assets — its loans and mortgages — as sound. Liquidity is not an issue because the central bank can print certificates on demand. If bank assets in general come under suspicion, confidence will evaporate, nonetheless.
Mises points out that the bank can undermine confidence (in the pre-FDIC system) in several ways. One way is to increase its fiduciary media too greatly, at which point the public may engage in a run on the bank and demand redemption. The public will become suspicious when the bank over-issues notes because it is in the bank's interest to take on any loan whatever that pays a rate of interest greater than the cost of issuing money-substitutes. Hence, the bank will be tempted to make bad loans as it extends credit. Sound familiar?
Nowadays, depositors who are insured don't seem to worry about this, which means that a vital depositor control over bank lending is absent. The gap is supposedly filled in by bank regulators and examiners, but the subprime fiasco is evidence that such measures have failed to control bad loans.
However, there is another check on the system. As investors see that the assets of the banking system are unsound, they mark down the stock and bond prices of the banks. The banks find their capital costs rising and they are forced to cut back on loans. Some banks go bankrupt and the stock and bondholders lose, as well as large depositors who are uninsured. A justifiable loss in confidence of the system results in its contraction, and that negatively affects the entire economy.
The second way in which banks can undermine confidence is this:
"It must not increase the amount of fiduciary media at such a rate and with such speed that the clients get the conviction that the rise in prices will continue endlessly at an accelerated pace. For if the public believes that this is the case, they will reduce their cash holdings, flee into ‘real' values, and bring about the crack-up boom. It is impossible to imagine the approach of this catastrophe without assuming that its first manifestation consists in the evanescence of confidence."
This path faces us even in the post-FDIC system because if people lose confidence in the money when they observe a rapid rise in prices of goods, then they still have the option of converting cash and fixed-income assets into real assets. Done in great volume, this conversion causes a rash of speculation, asset and commodity price bubbles, and an eventual crash.
Our officials are worried about a loss in confidence, and they are trying to stem it by shoring up institutions like Fannie Mae. The loss in confidence is coming from one basic source, which is the banking system's over issue of fiduciary media. This has had the effects of a large volume of bad loans and asset price bubbles. It may lead into the further effect of a flight into real-valued assets.
The damage to bank assets is system-wide. If the lion's share of the banks and other lenders have made bad loans or made loans that have gone bad, then the amounts become unmanageably large for taxpayers and their government to handle. There is, in fact, no action that government can devise that will not make the situation worse. Bailouts are bad. Nationalization is bad. Inflation is bad.
A loss in confidence in the system is justified because the system is faulty to begin with.
There is nothing for it but to end legal tender laws and go to fully free markets in banking and money. There is no need to legislate that gold, silver, or anything else serve as money. People acting in free markets can decide that on their own. The answer is free banking.
If there is one thing that our officials fear more than a loss of confidence in the existing banking system, it is free banking.
Von Mises knew of this. I close with several quotations of his on free banking:
"It is extremely difficult for our contemporaries to conceive of the conditions of free banking because they take government interference with banking for granted and as necessary."
"Today even the most bigoted étatists cannot deny that all the alleged evils of free banking count little when compared with the disastrous effects of the tremendous inflations which the privileged and government-controlled banks have brought about."
"The establishment of free banking was never seriously considered precisely because it would have been too efficient in restricting credit expansion."
"Free banking is the only method available for the prevention of the dangers inherent in credit expansion."
"Only free banking would have rendered the market economy secure against crises and depressions."
July 29, 2008
Michael S. Rozeff [send him mail] is a retired Professor of Finance living in East Amherst, New York.
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