WEBVTT NOTE Can The Monetary System Regulate Itself? 1 00:00:00.000 --> 00:00:05.000 Thank you Art, but you took away the surprise. 2 00:00:05.000 --> 00:00:11.000 The surprise is that the answer to the question, can the monetary system regulate itself? 3 00:00:11.000 --> 00:00:15.000 Or if we want to consider the banking system as part of the monetary system, 4 00:00:15.000 --> 00:00:19.000 can the monetary and banking system regulate itself? 5 00:00:19.000 --> 00:00:24.000 The answer is yes. I better put my glasses on so I remember why. 6 00:00:24.000 --> 00:00:41.000 Now, I will grant that most economists will probably say no, but the idea today, but the idea that a monetary system can regulate itself is actually one of the oldest ideas in economics. 7 00:00:41.000 --> 00:00:51.000 Some of you have been students in Professor Cardin's History of Economics thought class, or what is it, classical and Marxian economics. 8 00:00:51.000 --> 00:01:00.000 Before the birth of economics as a discipline, there were a bunch of writers, nowadays known as mercantilists. 9 00:01:00.000 --> 00:01:10.000 And on monetary policy, the mercantilists' advice to the king was, the king should outlaw the export of gold and silver. 10 00:01:10.000 --> 00:01:16.000 Because if he didn't do that, the country might lose all its money. It might drain out to the rest of the world. 11 00:01:16.000 --> 00:01:24.000 It was the great philosopher David Hume who argued, who showed that that kind of fear was really just nonsense. 12 00:01:24.000 --> 00:01:29.000 And the way he showed it most convincingly was with the following thought experiment. 13 00:01:29.000 --> 00:01:37.000 He said suppose we live in a world where the money everywhere in the world is silver coins, just for the sake of simplicity. 14 00:01:37.000 --> 00:01:42.000 Now imagine the people in England, sort of subset of this world, wake up in the morning 15 00:01:42.000 --> 00:01:49.000 So each individual's holdings of money are half of what they were, half of what they were accustomed to, half of what they felt comfortable holding. 16 00:01:49.000 --> 00:01:56.000 Isn't it obvious, Hume asked, that people will react to that by trying to build their money balances back up? 17 00:01:56.000 --> 00:02:00.000 They don't have enough really to make the transactions they want to make. 18 00:02:00.000 --> 00:02:06.000 So how do you build your money balances back up? You try to sell more, and you try to spend less. 19 00:02:06.000 --> 00:02:12.000 So, how do you bill your money balances back up? You try to sell more and you try to spend less. 20 00:02:12.000 --> 00:02:18.000 So, in England, there will be less spending. There will be an attempt to sell more goods. 21 00:02:18.000 --> 00:02:27.000 But with less demand for local goods and with more supply of local goods, prices in England have to fall. 22 00:02:27.000 --> 00:02:34.000 As prices in England fall, foreigners, people on the continent of Europe, are going to notice that English prices are now low. 23 00:02:34.000 --> 00:02:46.000 So, they're going to start buying more English goods, meanwhile, people in England are buying less of imports because they're trying to build their money balances back up, so exports will rise from England. 24 00:02:46.000 --> 00:02:56.000 To pay for this excess of English goods over the goods they're now selling to England, the foreigners are going to have to pay for their increased purchases with coin. 25 00:02:56.000 --> 00:03:03.000 Silver is going to begin to flow back into England, to replace the silver that mysteriously disappeared. 26 00:03:03.000 --> 00:03:10.000 And silver will continue to flow in until people are satisfied that they've built their money balances back up, 27 00:03:10.000 --> 00:03:18.000 and until English prices return back to world prices, or European prices, and at that point the inflow stops. 28 00:03:18.000 --> 00:03:25.000 So the supply of money in the nation following the initial disturbance returns to equilibrium. 29 00:03:25.000 --> 00:03:35.000 It's a self-correcting process, and when there's too little money, the market will self-correct by attracting as much additional money as people want to hold. 30 00:03:35.000 --> 00:03:43.000 Similar sequence works in the other direction, if we imagine instead that people wake up and find they have double the money they had the night before. 31 00:03:43.000 --> 00:03:50.000 Now they've got an excess money balance. They'll start spending more. That's going to drive local prices up. 32 00:03:50.000 --> 00:03:53.360 Imports are going to now become cheaper than local goods. 33 00:03:53.360 --> 00:03:55.880 English people will start buying more imports. 34 00:03:55.880 --> 00:03:58.480 That'll make coins flow out to the rest of the world 35 00:03:58.480 --> 00:04:00.600 in order to pay for the imports. 36 00:04:00.600 --> 00:04:03.200 So when this excess has been vented, 37 00:04:03.200 --> 00:04:05.160 when people are back down to holding the amount of money 38 00:04:05.160 --> 00:04:08.000 they want to hold, the outflow stops. 39 00:04:08.000 --> 00:04:11.400 So the outflow of money is both a symptom of an excess supply 40 00:04:11.400 --> 00:04:13.600 and it corrects the excess supply. 41 00:04:14.800 --> 00:04:17.120 So contrary to the mercantilists, 42 00:04:17.120 --> 00:04:19.080 the silly king doesn't have to worry 43 00:04:19.080 --> 00:04:49.080 that the money is all going to drain away, the quantity will regulate itself, the king doesn't have to hamper trade with restrictions that, actually they're kind of pointless, it's impossible to bottle up money, but restrictions that aimed at bottling up money inside the kingdom, so that's the earliest example, in fact it's one of the earliest examples in economics of a theory of a self-regulating order and it's a theory of a self-regulating monetary order. The famous Adam Smith applied the same kind of lesson 44 00:04:49.080 --> 00:04:58.080 to the system he saw around him, which was a mixed currency, he called it. That is, it wasn't just coins, it was also redeemable bank notes. 45 00:04:58.080 --> 00:05:09.080 So the paper notes that people use, that today we have Federal Reserve notes, but in Scotland in those days, they had notes issued by private banks. 46 00:05:09.080 --> 00:05:17.080 Actually, in Scotland today, they still have notes issued by private banks, if you've been there. It's interesting to see. 47 00:05:17.080 --> 00:05:22.080 In those days, in Adam Smith's day, the notes were redeemable for silver coin. 48 00:05:22.080 --> 00:05:27.080 So if you wanted to, you could go to the bank that issued it and demand coin in exchange for it. 49 00:05:27.080 --> 00:05:32.080 And Smith applied kind of Hume's reasoning to this mixed currency and said, 50 00:05:32.080 --> 00:05:36.080 if the banks issue more currency than people want, 51 00:05:36.080 --> 00:05:40.080 the way he put it was, more than they can usefully absorb and employ, 52 00:05:40.080 --> 00:05:45.080 the same kind of mechanism will drain silver from the vaults of the banks. 53 00:05:45.080 --> 00:05:54.080 If the banks in the aggregate issue too much, prices will rise. In order to pay for imports, people can't export Scottish bank notes. 54 00:05:54.080 --> 00:06:02.080 People in London won't take those. They want silver coin. So they'll have to go to the banks that issued the notes, get silver coin and export that. 55 00:06:02.080 --> 00:06:11.080 But that means the banks see their reserves of silver coin, the reserves they're counting on to be able to redeem the notes when the public comes and asks for redemption. 56 00:06:11.080 --> 00:06:17.080 They'll see their reserves leaving, and that'll force them to reverse the over-issue. 57 00:06:17.080 --> 00:06:24.080 So banks are not able in any sustainable way to put more money into circulation than the public wants to hold. 58 00:06:24.080 --> 00:06:31.080 So like the pure coin system, this kind of mixed system is self-regulating with regard to the quantity of money, 59 00:06:31.080 --> 00:06:38.080 provided that it's anchored by redeemability into metallic coins. 60 00:06:38.080 --> 00:06:51.080 Even within the country, any single bank is going to be restrained from over issuing relative to other banks 61 00:06:51.080 --> 00:06:54.080 because its notes will get in the hands of those other banks. 62 00:06:54.080 --> 00:07:01.080 The banks in Scotland all accepted one another's notes just like banks today accept one another's checks 63 00:07:01.080 --> 00:07:06.080 and then they return them to the bank that they're drawn on and demand redemption 64 00:07:06.080 --> 00:07:14.080 and so reserves drain from one bank to another very quickly, that restrains over-issue by any particular bank. 65 00:07:14.080 --> 00:07:18.080 All right, well that's some ancient theory as a background. 66 00:07:18.080 --> 00:07:25.080 So you may be wondering, doesn't our current financial crisis show that the answer to the question, can the system regulate itself? 67 00:07:25.080 --> 00:07:28.080 Doesn't it show that the answer is no? 68 00:07:28.080 --> 00:07:33.080 Well, it doesn't. It shows that our current system doesn't regulate itself. 69 00:07:33.080 --> 00:07:46.080 It doesn't show that in principle a monetary and banking system can't regulate itself because our current crisis is not a crisis that arose in an unregulated financial system or a free banking system. 70 00:07:46.080 --> 00:07:55.080 It arose in a pervasively regulated system, a perversely regulated system, a legally restricted, a hampered system. 71 00:07:55.080 --> 00:07:58.080 I got loads of synonyms. 72 00:07:58.080 --> 00:08:04.080 We don't have laissez-faire in money. We don't have laissez-faire in banking. We don't have laissez-faire in finance. 73 00:08:04.080 --> 00:08:09.080 We have not a silver standard, not a gold standard. We have a fiat money standard. 74 00:08:09.080 --> 00:08:17.080 A bank note under a silver standard is an IOU issued by a bank. A Federal Reserve note today is an IOU nothing. 75 00:08:17.080 --> 00:08:25.080 You take a $10 bill to the Federal Reserve bank and say, I'd like to redeem this, you'll get two fives. 76 00:08:25.080 --> 00:08:45.080 We have a government central bank, the Federal Reserve system, whereas in an unregulated system, in a kind of natural system, there isn't any central bank, but rather the issue of currency is handled by decentralized competing commercial banks. That's sometimes called a free banking system. 77 00:08:45.080 --> 00:08:50.080 And of course we have heavy legal restrictions both on banks and on other financial firms. 78 00:08:50.080 --> 00:09:00.080 There's been some loose talk in the current crisis about it being the responsibility, the fault of deregulation. 79 00:09:00.080 --> 00:09:08.080 But if you look for details in that charge, you can't find them because, well, there hasn't been deregulation. 80 00:09:08.080 --> 00:09:19.080 The last thing that was partial deregulation was the Financial Services Modernization Act of 1999, signed by President Clinton. 81 00:09:19.080 --> 00:09:30.080 I had a dinner with one of your economics professors last night who reminded me to give the proper name of the act. 82 00:09:30.080 --> 00:09:43.080 What that act did was to allow regulated bank holding companies to become regulated financial holding companies. 83 00:09:43.080 --> 00:09:52.080 So instead of just owning banks, they can now also own insurance companies and they can own investment banks and other financial subsidiaries. 84 00:09:52.080 --> 00:10:07.080 That's clearly been a help in the current crisis because it's allowed troubled institutions to be acquired by these financial holding companies where previously they couldn't have been acquired by them. 85 00:10:07.080 --> 00:10:12.080 So Merrill Lynch could not have been sold to Bank of America if not for this act. 86 00:10:12.080 --> 00:10:21.080 Anyway, to be clear, I'm arguing that a free market monetary and banking system can regulate itself, not that our current system is self-regulating. 87 00:10:21.080 --> 00:10:31.080 If we want a more self-regulating system, we need to move in the direction of a more free market system in order to get a better regulated system. 88 00:10:31.080 --> 00:10:36.080 So, the term regulated is kind of ambiguous. 89 00:10:36.080 --> 00:10:45.080 It suggests that regulation, as usually understood, which is a system of government guidance and restriction and supervision, 90 00:10:45.080 --> 00:10:50.080 gives us greater regularity, but actually that's the opposite of the truth. 91 00:10:50.080 --> 00:10:52.080 So we need to unpack it. 92 00:10:52.080 --> 00:10:55.080 We have legal restrictions, we don't have regularity. 93 00:10:55.080 --> 00:10:57.080 We have a crisis-prone system. 94 00:10:57.080 --> 00:11:07.080 And if we want a less crisis-prone system, we need market regulation rather than the kind of regulation we've got today. 95 00:11:07.080 --> 00:11:12.080 There are basically going to be two elements to my argument. There's a positive element. 96 00:11:12.080 --> 00:11:19.080 There's a positive case for believing that unregulated or free banking is going to work. 97 00:11:19.080 --> 00:11:26.080 It's going to restrain itself, and the case there is very much like the case for free trade. 98 00:11:26.080 --> 00:11:34.080 It's a case that indicates that the benefits are going to exceed the costs, profit opportunities are going to be exploited. 99 00:11:34.080 --> 00:11:40.080 I got additional evidence of that today. I went swimming in the pool here. 100 00:11:40.080 --> 00:11:46.080 I didn't believe that it was going to be warm enough, but apparently it's self-regulating too. 101 00:11:46.080 --> 00:12:11.080 Why don't more economists believe that monetary system can be self-regulating? 102 00:12:11.080 --> 00:12:21.080 There is honest opposition, there are honest doubts about the theory, or lack of familiarity with the theory, which is no longer so commonly taught. 103 00:12:21.080 --> 00:12:29.080 But there's also sort of historical myths that have become prevalent. 104 00:12:29.080 --> 00:12:38.080 And of course there are entrenched interests. There are people who benefit from being part of the current regulated system. 105 00:12:38.080 --> 00:12:55.080 The negative part of my argument is going to be trying to show that there isn't any good theoretical case to establish that government needs to or should provide money or regulate banks. 106 00:12:55.080 --> 00:12:59.080 The leading market failure arguments don't really hold water. 107 00:12:59.080 --> 00:13:12.580 In order not to be misinterpreted, let me repeat something I learned from one of my economics professors. 108 00:13:12.580 --> 00:13:20.580 Whenever he was asked, so, professor, you have faith in the free market, he would say, no, I don't have faith in the free market, I have evidence. 109 00:13:20.580 --> 00:13:26.580 I have evidence that free market institutions work. So that's the kind of case I'm going to try to present. 110 00:13:26.580 --> 00:13:36.580 So I've talked a little about Hume's theory and Adam Smith's theory. You can go back to the very origins of money. 111 00:13:36.580 --> 00:13:43.580 Carl Menger's theory, Carl Menger was an Austrian economist the late 19th century. 112 00:13:43.580 --> 00:13:49.580 If you want to understand why money emerges in the first place out of a barter economy, 113 00:13:49.580 --> 00:13:55.580 Menger explained how each individual in a barter system has the problem, 114 00:13:55.580 --> 00:14:00.140 If you're trying to swap what you come to market with, say you're an asparagus farmer, 115 00:14:00.140 --> 00:14:02.580 and you want to go home with plaid shirts, 116 00:14:02.580 --> 00:14:04.260 you have a problem. 117 00:14:04.260 --> 00:14:06.460 You've got to find somebody selling plaid shirts 118 00:14:06.460 --> 00:14:09.620 who wants to be paid in asparagus. 119 00:14:09.620 --> 00:14:11.380 And if he doesn't want asparagus, 120 00:14:11.380 --> 00:14:13.540 now you have a problem. 121 00:14:13.540 --> 00:14:16.540 So what can you do? Well, you can go home 122 00:14:16.540 --> 00:14:19.340 and wear your asparagus, I suppose. 123 00:14:19.340 --> 00:14:20.700 Or, if you're a little bit 124 00:14:20.700 --> 00:14:23.940 entrepreneurial, say to yourself, 125 00:14:23.940 --> 00:14:28.640 Or say to the guy selling the plaid shirts, well, if you don't want asparagus, what do you want? 126 00:14:28.640 --> 00:14:30.080 He says, I'm looking for cabbage. 127 00:14:30.080 --> 00:14:31.560 Oh, well in that case, 128 00:14:31.560 --> 00:14:33.660 if I can trade my asparagus for cabbage, 129 00:14:33.660 --> 00:14:35.600 I could trade the cabbage for the shirts. 130 00:14:35.600 --> 00:14:38.240 And if you can do that, then cabbage 131 00:14:38.240 --> 00:14:40.940 becomes your medium of exchange. It becomes 132 00:14:40.940 --> 00:14:44.200 the vehicle which carries your exchange process forward. 133 00:14:44.200 --> 00:14:46.180 So once people discover that, 134 00:14:46.180 --> 00:14:50.360 they become on the lookout for trades they can make that even if they don't get 135 00:14:50.360 --> 00:14:52.000 them what they really want to consume, 136 00:14:52.000 --> 00:14:55.380 get them a step closer 137 00:14:55.380 --> 00:14:59.400 whether it gets you a step closer depends on whether other people accept it 138 00:14:59.400 --> 00:15:03.080 so you need to be on the lookout for what other people want to consume or will 139 00:15:03.080 --> 00:15:05.440 use as a medium of exchange 140 00:15:05.440 --> 00:15:08.620 and that sets the stage for the whole thing to converge 141 00:15:08.620 --> 00:15:12.580 because if i see that a lot of other people using salt 142 00:15:12.580 --> 00:15:16.320 as a medium of exchange then i'll use it because now i can trade with them 143 00:15:16.320 --> 00:15:18.700 so the group of people who accept it grows 144 00:15:18.700 --> 00:15:23.940 and the economy converges on a commonly accepted medium of exchange. 145 00:15:23.940 --> 00:15:26.900 So no king had to invent money, 146 00:15:26.900 --> 00:15:31.620 no chamber of commerce had to get together and hold a convention 147 00:15:31.620 --> 00:15:37.180 and decide what it was to adopt as money. 148 00:15:37.180 --> 00:15:41.940 We know historically it was gold and silver that emerged out of this process. 149 00:15:41.940 --> 00:15:45.540 One of the things that held them back initially was 150 00:15:45.540 --> 00:16:03.540 The gold and silver are actually not very uniform when they come out of the mine, so it took the invention of coinage as a way to certify weight and fineness so people could trust the pieces of metal that were being offered to them, as long as they could trust the seal that was stamped on it. 151 00:16:03.540 --> 00:16:10.540 And if you think about it that way, if you think about the function of the mint being to certify the weight and fineness of the metal, 152 00:16:10.540 --> 00:16:18.540 well, we rely today on all kinds of private certification agencies for weight and fineness of precious metals. 153 00:16:18.540 --> 00:16:24.540 You buy a gold bar nowadays. It's typically stamped by the Engelhard Minerals Company. 154 00:16:24.540 --> 00:16:32.540 Similarly, there was a private market that provided the service of certifying the weight and fineness of metals. 155 00:16:32.540 --> 00:16:45.540 In the US, during the California gold rush, there were something like, well there were gold and silver rushes throughout the west, there were something like 20 private companies that minted their own coins. 156 00:16:45.540 --> 00:17:01.540 Go online, you can find pictures of them. They're quite pretty. They're quite valuable these days, so if you find one in your grandmother's attic, don't send it to that company that offers to buy your gold without telling you at what price they're going to buy it. 157 00:17:01.540 --> 00:17:31.540 And these private mints had an excellent reputation for, in fact, we have examples of their work that have been tested very carefully, they were more precisely minted than the coins being minted by the U.S. government, they did not have a problem of fraud, you might think, well, a private mint would pretend that this is a one ounce gold coin, but only be half an ounce of gold and the other half would be. 158 00:17:31.540 --> 00:17:35.540 Some copper or tin or something they snuck in there. 159 00:17:35.540 --> 00:17:40.540 But if you're running one of these mints, your whole business is certification. 160 00:17:40.540 --> 00:17:46.540 If people suspect or if the word gets out that one of your coins was bogus, there goes your entire business. 161 00:17:46.540 --> 00:17:53.540 Nobody's going to bring you money if other people won't accept it because your brand name is no longer trusted. 162 00:17:53.540 --> 00:18:00.540 So these mints actually had an excellent reputation for certifying the weight and fineness of the gold. 163 00:18:00.540 --> 00:18:07.540 the gold. They didn't invent their own units. They minted them to the common official standard. 164 00:18:07.580 --> 00:18:12.420 There was one exception. There was a mint associated with the Mormon church, which minted 165 00:18:12.420 --> 00:18:19.420 its coins 10% underweight so that members of the church could have a built-in tithe. 166 00:18:22.020 --> 00:18:27.020 But nobody except Mormons would accept those coins except at a 10% discount. So that system 167 00:18:27.020 --> 00:18:29.220 and regulated itself, too. 168 00:18:29.220 --> 00:18:35.180 Why have governments typically gotten into the business of minting coins? 169 00:18:35.180 --> 00:18:38.420 Well, it's like asking why governments do anything. There are two possibilities. 170 00:18:38.420 --> 00:18:41.660 One is that there's some kind of market failure that they're remedying. 171 00:18:41.660 --> 00:18:43.740 The other is 172 00:18:43.740 --> 00:18:47.020 there's revenue in it. 173 00:18:47.020 --> 00:18:49.100 In the case of coinage, 174 00:18:49.100 --> 00:18:53.180 as far as all the evidence indicates, it wasn't to improve the quality of coins. 175 00:18:53.180 --> 00:18:54.980 Privately minted coins were quite good. 176 00:18:54.980 --> 00:18:56.140 On the other hand, 177 00:18:56.140 --> 00:19:08.140 The history of government coinage of gold and silver is a long history of debasements, mixing in more and more copper and tin and cheaper metals into the coins. 178 00:19:08.140 --> 00:19:16.140 Typically reusing the old coin dyes so that it wasn't obvious that the coin's value had been diluted. 179 00:19:16.140 --> 00:19:21.140 Passing off the debased coins as just as good as the old coins. 180 00:19:21.140 --> 00:19:25.140 And when the public began to catch on, the government could pass a law that said, 181 00:19:25.140 --> 00:19:31.140 no, no, you have to accept the new coins as though they're just as valuable as the old coins. 182 00:19:31.140 --> 00:19:39.140 In medieval France, it was actually a crime to weigh coins or to test them for purity. 183 00:19:39.140 --> 00:19:47.140 In the French Revolution, the penalty for asking whether somebody intended to pay with government money 184 00:19:47.140 --> 00:19:51.540 with pure money was the guillotine. 185 00:19:51.540 --> 00:19:55.580 So they made it mandatory to take their money at face value. 186 00:19:55.580 --> 00:20:00.100 So you can make a big profit if you can do that. 187 00:20:00.100 --> 00:20:03.420 Now, of course, remember we're talking about ancient despotic 188 00:20:03.420 --> 00:20:04.500 governments here. 189 00:20:04.500 --> 00:20:06.740 We're not talking about elected governments, which of course 190 00:20:06.740 --> 00:20:10.260 would never expand the quantity of money to raise revenue at 191 00:20:10.260 --> 00:20:11.500 the public's expense. 192 00:20:11.500 --> 00:20:29.500 Well, nowadays, for the revenue raising point of view, we're in the perfect position, we've eliminated the gold and silver entirely, so the government doesn't have to call in the coins and remint them, it just needs to print more paper in order to expand the money supply. 193 00:20:29.500 --> 00:20:33.500 For those of you who've taken money in banking, I mean open market operations. 194 00:20:33.500 --> 00:21:03.500 and so it's very easy to generate revenue now in the US we collect taxes in so many ways that we don't rely heavily on printing money to pay the government's bills although as the government debt gets bigger and bigger the temptation to inflate it away gets higher and higher so keep that in mind in countries that have less ability to collect income 195 00:21:03.500 --> 00:21:08.180 Inflation Taxes, say, because so much of the economy is informal. 196 00:21:08.180 --> 00:21:13.420 Reliance on this inflation tax is heavier, so inflation rates are typically higher in 197 00:21:13.420 --> 00:21:20.300 countries at lower levels of economic development. 198 00:21:20.300 --> 00:21:27.700 Now most money and banking textbooks will tell you that fiat money is more efficient. 199 00:21:27.700 --> 00:21:30.940 It's better for the public than commodity money. 200 00:21:30.940 --> 00:21:38.900 And why would they say that? Because it saves resources. It's cheaper to print a $10 bill 201 00:21:38.900 --> 00:21:45.700 than it is to mint a $10 coin. But I think they're overestimating the resource costs 202 00:21:45.700 --> 00:21:50.660 of a commodity standard, and I think they're engaging in wishful thinking about the management 203 00:21:50.660 --> 00:21:57.660 of a paper standard because they typically fail to take into account that with inflation, 204 00:21:57.660 --> 00:22:03.460 The inflation that's typical with a paper money standard, it's actually more costly for the 205 00:22:03.460 --> 00:22:08.100 public to hold money because it's melting away in their pockets. 206 00:22:08.100 --> 00:22:12.740 The purchasing power is melting away, that's a tax on holding money that you didn't experience 207 00:22:12.740 --> 00:22:15.860 under the gold standard. 208 00:22:15.860 --> 00:22:21.420 Some economists have unfortunately fed this misperception that a commodity standard is 209 00:22:21.420 --> 00:22:35.420 is really expensive by insisting that a free market in money means that all money would be pure silver and gold coins or warehouse receipts for gold and silver coins. 210 00:22:35.420 --> 00:22:49.420 But I don't think it means that. I think it means that privately issued money is restricted by contracts, but a possible contract and a contract that historically seemed to be attractive to people 211 00:22:49.420 --> 00:22:58.420 was a fractional reserve contract, meaning instead of the bank acting as a pure warehouse, the customer gives it permission to lend some of the money out. 212 00:22:58.420 --> 00:23:06.420 Now why would they be so foolish? Because that way they don't have to pay storage fees, and instead the bank pays them for using their money. 213 00:23:06.420 --> 00:23:15.420 They're on notice that they're taking a risk, right? But if the risk is small enough, then it's worth it to get the higher return. 214 00:23:15.420 --> 00:23:32.420 So, banks have an incentive and customers have an incentive to allow the banks to economize on gold, as long as they live up to their promise to provide coins to redeem the notes whenever demanded. 215 00:23:32.420 --> 00:23:44.420 Banks provided much less costly methods of payment than lugging around bags of coins. 216 00:23:44.420 --> 00:23:50.420 So before banks got into payment, when payment was purely in gold and silver coins, 217 00:23:50.420 --> 00:23:58.420 if Alice wants to pay Bob $1,000 and suppose she's keeping her coins with a local vault keeper, 218 00:23:58.420 --> 00:24:15.420 She has to go to the vault, take out the thousand in coins, put it in her wheelbarrow, wheel it over to Bob's house. Bob says, thank you very much. He counts the coins, maybe weighs them, puts them back in his wheelbarrow, wheels them back across town, puts them back in the vault. 219 00:24:15.420 --> 00:24:24.420 Bob and Alice don't have to be too clever to say, hey, wait a minute, instead of doing all this lugging of coins around, why don't we meet at the vault? 220 00:24:24.420 --> 00:24:29.780 at the Vault. Then Alice can take the coins out, hand them over to Bob, and Bob can put 221 00:24:29.780 --> 00:24:37.340 them right back in. Hey, wait a minute. We don't even have to take the coins out. And 222 00:24:37.340 --> 00:24:41.900 this is the breakthrough that gets bankers into the payment business. You don't have 223 00:24:41.900 --> 00:24:44.980 to take the coins out because at the end of the day the coins are going to be back in 224 00:24:44.980 --> 00:24:50.360 the vault. And all that's changed at the end of the day is the banker owes Alice a thousand 225 00:24:50.360 --> 00:24:56.120 $1,000 less than he used to, and the banker owes Bob $1,000 more than he used to. 226 00:24:56.120 --> 00:25:00.700 So Alice and Bob just have to meet in the banker's office and tell him, hey, move $1,000 227 00:25:00.700 --> 00:25:05.240 on your books from Alice's account to Bob's account. 228 00:25:05.240 --> 00:25:10.160 That accomplishes the same thing as taking the coins out and putting them back in. 229 00:25:10.160 --> 00:25:12.120 So that's a deposit transfer. 230 00:25:12.120 --> 00:25:17.640 And the subsequent history of banking is the development of new methods for deposit transfer. 231 00:25:17.640 --> 00:25:24.640 These new methods change the way in which the banker is notified that Alice and Bob want to make this transfer, 232 00:25:24.640 --> 00:25:28.640 but it doesn't really change the back end of the transaction. 233 00:25:28.640 --> 00:25:32.640 It doesn't change what happens on the bank's balance sheet. 234 00:25:32.640 --> 00:25:36.640 Alice could write Bob a check. 235 00:25:36.640 --> 00:25:39.640 Initially, Alice went to the bank in person. 236 00:25:39.640 --> 00:25:44.640 Instead, Alice could write a check, give it to Bob, and Bob could take it to the bank. 237 00:25:44.640 --> 00:25:49.240 or Alice could go to the bank and tell the banker transfer the money to Bob's account 238 00:25:49.240 --> 00:25:51.740 and Bob will know he's been paid when it shows up. 239 00:25:51.740 --> 00:25:54.740 That's what electronic funds transfer does. 240 00:25:54.740 --> 00:25:59.340 So when you pay at the pump and the gas is going into your car, glug, glug, glug, 241 00:25:59.340 --> 00:26:02.140 the money's coming out of your bank account, glug, glug, glug, 242 00:26:02.140 --> 00:26:06.140 going into the gas company's bank account, glug, glug, glug. 243 00:26:06.140 --> 00:26:07.040 Not really. 244 00:26:07.040 --> 00:26:11.340 They wait till the end of the transaction and just do it once. 245 00:26:11.340 --> 00:26:15.340 But wire transfer, electronic funds transfer, works that way. 246 00:26:15.340 --> 00:26:19.340 It's just a different way to signal the banker to make the payment. 247 00:26:19.340 --> 00:26:23.340 So that's the nature of technical advances in banking. 248 00:26:23.340 --> 00:26:27.340 Now there was a second kind of important bank liabilities besides 249 00:26:27.340 --> 00:26:31.340 deposits and deposit transfer, which I've already mentioned, 250 00:26:31.340 --> 00:26:35.340 which is bank issued currency, bank notes. There are still 251 00:26:35.340 --> 00:26:39.340 three places in the world where you can find privately issued bank notes, Scotland, 252 00:26:39.340 --> 00:26:47.900 Northern Ireland and Hong Kong. In the U.S., I guess the closest thing we have is travelers checks, right? 253 00:26:47.900 --> 00:26:57.800 A hundred dollar American Express travelers check is like a banknote in that it's a monetary claim issued by a private firm, right? 254 00:26:57.800 --> 00:27:06.340 Which is valuable because you can go to American Express and redeem it for a hundred dollars in what you might call more basic money. 255 00:27:06.340 --> 00:27:13.940 now the more basic money nowadays isn't gold or silver of course it's Federal Reserve notes 256 00:27:13.940 --> 00:27:18.300 one of the worries people have about a system of privately issued notes if you have 257 00:27:18.300 --> 00:27:24.360 say a dozen or two dozen different banks issuing their own currencies is 258 00:27:24.360 --> 00:27:29.160 how do we know they'll be accepted at one for one with each other 259 00:27:29.160 --> 00:27:34.080 well we have a problem of floating exchange, a dozen, two dozen floating exchange rates 260 00:27:34.080 --> 00:27:36.320 within the same economy. 261 00:27:36.320 --> 00:27:38.480 Wouldn't that be a hassle? 262 00:27:38.480 --> 00:27:40.240 Yeah, it would be a hassle, 263 00:27:40.240 --> 00:27:43.760 and that's why you shouldn't expect it to happen. 264 00:27:43.760 --> 00:27:47.560 It's in a bank's interest to make sure its notes are accepted everywhere at 265 00:27:47.560 --> 00:27:49.200 their face value because 266 00:27:49.200 --> 00:27:52.240 the bank does more business that way. 267 00:27:52.240 --> 00:27:54.160 So how can they assure that? 268 00:27:54.160 --> 00:27:57.920 Well, where banks are not restricted from setting up branch offices, they'll set 269 00:27:57.920 --> 00:28:00.000 up branches to redeem their notes 270 00:28:00.000 --> 00:28:01.960 all over the economy. 271 00:28:01.960 --> 00:28:05.200 and if they don't do that there's another thing they can do which is they can make 272 00:28:05.200 --> 00:28:07.820 agreements with other banks 273 00:28:07.820 --> 00:28:11.280 would you please accept our notes at face value 274 00:28:11.280 --> 00:28:13.720 and what's the other banks incentive to do that 275 00:28:13.720 --> 00:28:14.960 they'll return the favor 276 00:28:14.960 --> 00:28:17.760 we'll accept your notes at face value 277 00:28:17.760 --> 00:28:20.460 and that'll be better for both of our customers 278 00:28:20.460 --> 00:28:24.200 this is the way ATM networks spread more recently 279 00:28:24.200 --> 00:28:27.280 right ATM networks 280 00:28:27.280 --> 00:28:30.000 are private agreements among banks to 281 00:28:30.000 --> 00:28:30.920 allow each 282 00:28:30.920 --> 00:28:35.600 Other access to their computers so they can see that the customer who's withdrawing money 283 00:28:35.600 --> 00:28:39.560 at an ATM, which is not his home bank's ATM, 284 00:28:39.560 --> 00:28:43.120 actually has the funds in his account. 285 00:28:43.120 --> 00:28:46.480 They don't have to cooperate that way, but they do because it allows each bank to do 286 00:28:46.480 --> 00:28:47.600 more business. 287 00:28:47.600 --> 00:28:53.540 The first ATM network was the New York Cash Exchange, NYCE, nice. 288 00:28:53.540 --> 00:28:57.200 It was a bunch of banks in New York City who wanted to compete with Citibank. 289 00:28:57.200 --> 00:28:59.700 Citibank already had a thousand ATMs. 290 00:28:59.700 --> 00:29:05.780 Dime Savings Bank had three ATMs. It was hard for them to attract customers with the slogan, 291 00:29:05.780 --> 00:29:09.500 put your money here and you can withdraw it at three points. 292 00:29:09.500 --> 00:29:14.000 So they joined together with other banks, they got a network going, and these networks 293 00:29:14.000 --> 00:29:19.580 then spread, because the benefits from joining a network aren't exhausted in one city, they 294 00:29:19.580 --> 00:29:26.580 became regional, they became national. Cirrus, Avail, Plus, Star, and now they're worldwide. 295 00:29:26.580 --> 00:29:42.580 Worldwide, right? Now, travelers checks is a very dwindling business, because you can just take your ATM card, you can get local cash in London, in Paris, in Mumbai, anywhere around the world. 296 00:29:42.580 --> 00:29:49.580 And the fees are not any worse than Thomas Cook charges to change travelers checks. 297 00:29:49.580 --> 00:29:57.580 Okay, so that's the positive case. What about rebutting the negative case? 298 00:29:57.580 --> 00:30:07.580 There are two arguments offered against a free market monetary system. 299 00:30:07.580 --> 00:30:15.580 What are the standard arguments against allowing free markets and the production of any good or service? 300 00:30:15.580 --> 00:30:21.580 That it's somehow a public good, or involves significant externalities, that's one argument. 301 00:30:21.580 --> 00:30:27.580 The other argument is that there's some kind of natural monopoly that calls for government control. 302 00:30:27.580 --> 00:30:33.580 It's pretty clear that the public good argument is not going to get very far when it comes to money. 303 00:30:33.580 --> 00:30:38.580 You know, money is a commonly accepted form of exchange. It's a private good. 304 00:30:38.580 --> 00:30:43.580 The money in your pocket is not showering benefits on anybody else. 305 00:30:43.580 --> 00:30:53.580 So a standard example of a private good, a good that your consumption is yours alone, doesn't provide benefits to anybody else. 306 00:30:53.580 --> 00:31:00.580 My favorite example is a chocolate donut. If you eat a chocolate donut, there's one less chocolate donut for other people to eat. 307 00:31:00.580 --> 00:31:06.580 Mmm, donuts. It's not providing benefits to other people. 308 00:31:06.580 --> 00:31:12.580 A public good would be something like a broadcast television signal. 309 00:31:12.580 --> 00:31:17.580 Now, you may have never experienced broadcast television, but ask your grandparents about it. 310 00:31:17.580 --> 00:31:26.580 It's a system where waves are broadcast out in the air, just over everybody's property, and you tune them in. 311 00:31:26.580 --> 00:31:32.580 And if you tune in Channel 9, you're not reducing the amount of Channel 9 available to other people. 312 00:31:32.580 --> 00:31:36.580 You're watching, it doesn't diminish anybody else's enjoyment of that good. 313 00:31:36.580 --> 00:31:40.580 And I like to use that example because it's a privately produced public good. 314 00:31:40.580 --> 00:31:48.580 But the long history of the evolution of money out of barter, the emergence of private mints, 315 00:31:48.580 --> 00:31:53.580 the provision of money by private banks, shows that markets don't fail to produce money. 316 00:31:53.580 --> 00:31:57.580 There's no market failure here. So that argument's not going to work. 317 00:31:57.580 --> 00:32:03.580 Probably the leading argument today against unregulated banking, 318 00:32:03.580 --> 00:32:07.580 and banks are important in the payment system, 319 00:32:07.580 --> 00:32:12.580 has to do with external effects of bank runs. 320 00:32:12.580 --> 00:32:22.580 So part A, an unregulated banking system is inherently prone to bank runs. 321 00:32:22.580 --> 00:32:33.580 And if you want to generalize it, these bank runs become contagious, they spread from bank to bank, so it's inherently prone to panics, financial panics. 322 00:32:33.580 --> 00:32:41.580 That's part A. Part B, these runs and panics are bad. They have harmful spillover effects. 323 00:32:41.580 --> 00:32:49.580 Part C, if it's going to be a justification for government intervention, there's something, some policy we can adopt, 324 00:32:49.580 --> 00:32:56.140 Bankrupt, which reduces runs and panics and has a cost less than the benefit of reducing 325 00:32:56.140 --> 00:32:58.140 runs and panics. 326 00:32:58.140 --> 00:32:59.140 So you know what a bank run is. 327 00:32:59.140 --> 00:33:06.140 A bank run is when many people line up to try to pull their money out at the same time. 328 00:33:06.140 --> 00:33:08.940 By panic, I mean the same thing happens at many banks. 329 00:33:08.940 --> 00:33:13.420 And this is the standard argument cited to support having a central bank to act as a 330 00:33:13.420 --> 00:33:20.760 The Lender of Last Resort, having deposit insurance, having restrictions on bank capital ratios, 331 00:33:20.760 --> 00:33:25.980 so banks aren't too failure-prone, having restrictions on bank entry, can't let just 332 00:33:25.980 --> 00:33:30.020 anybody start a bank because that could lead to bad banks and that could lead to a domino 333 00:33:30.020 --> 00:33:32.480 effect. 334 00:33:32.480 --> 00:33:36.020 In the Great Depression, this was used as an argument for restricting deposit interest 335 00:33:36.020 --> 00:33:37.340 rates. 336 00:33:37.340 --> 00:33:41.140 Banks can't be allowed to pay interest on their deposits because then they'll compete 337 00:33:41.140 --> 00:33:50.260 to pay the most and that means they'll have to adopt risky investment strategies and that'll lead to the domino effect, bank failures and domino effects. 338 00:33:50.260 --> 00:33:53.440 Restrictions on bank reserve ratios, same thing. 339 00:33:53.440 --> 00:33:58.080 Restrictions on the assets banks are allowed to invest in. 340 00:33:58.080 --> 00:34:08.140 Restrictions on the activities banks are allowed to invest in. That was the theory behind the Glass-Steagall Act, which the Graham-Leach-Bliley Act, I already mentioned, partially repealed. 341 00:34:08.140 --> 00:34:18.540 Now, the second claim, the claim that bank runs are harmful, that I'm going to mostly accept. 342 00:34:18.540 --> 00:34:20.200 I think that one's pretty solid. 343 00:34:20.200 --> 00:34:24.580 They're harmful to bank shareholders, they're harmful to bank borrowers, but mostly they're 344 00:34:24.580 --> 00:34:27.420 harmful to depositors. 345 00:34:27.420 --> 00:34:31.420 And if it's a panic, it's even worse, it has macroeconomic effects. 346 00:34:31.420 --> 00:34:37.860 But I will qualify it a little and say that runs are not always bad. 347 00:34:37.860 --> 00:34:45.300 Why not? Because a run on an insolvent bank, a bank that's squandering depositors' money, 348 00:34:45.300 --> 00:34:50.500 is a good thing. You need to close that bank and you need to close it now before it squanders 349 00:34:50.500 --> 00:34:57.380 any more money. It's taking $1,000 in savings and turning it into $900 of assets. That needs 350 00:34:57.380 --> 00:35:06.980 to be stopped. A bank run stops it. In other businesses, if a business, an ordinary industrial 351 00:35:06.980 --> 00:35:13.980 If it can't pay its debts, then the debtors who are not getting paid get together and force the business into insolvency. 352 00:35:13.980 --> 00:35:16.980 That's called a bankruptcy. 353 00:35:16.980 --> 00:35:20.980 Who are the debtors of a bank? The depositors. 354 00:35:20.980 --> 00:35:27.980 A bank run is like a debtor meeting to force the insolvent firm into bankruptcy. 355 00:35:27.980 --> 00:35:30.980 It's a little more chaotic. 356 00:35:30.980 --> 00:36:00.980 And there's an unfortunate aspect to it that you don't see in ordinary bankruptcy, which is it's kind of first-come first-serve, which means that people have to run to the bank, that's why it's called a run, and there is a danger that they may be running on a bank that isn't insolvent, and that's when it's a tragedy when a bank run closes a bank. But that's the only case. And if the bank's insolvent, then the run is good to close the bank now rather than later. 357 00:36:00.980 --> 00:36:12.980 The reason that insolvent institutions ought to be closed is pretty simple. They need to get out of the way, stop squandering our time and resources, get out of the way and make room for better run banks. 358 00:36:12.980 --> 00:36:22.980 A financial system where failed banks never get closed up is like American Idol where the worst singers never go home. 359 00:36:22.980 --> 00:36:39.980 Do you really want to watch American Idol where Tatiana never goes home? 360 00:36:39.980 --> 00:36:46.820 Here's another benefit of bank runs you may not have thought of, the threat of runs keeps 361 00:36:46.820 --> 00:36:49.780 These banks on their toes. 362 00:36:49.780 --> 00:36:56.380 It compels the depositors to monitor what the bank is up to, and if the bank is engaged 363 00:36:56.380 --> 00:37:03.740 in silly, dangerous, crazy investment strategies, people are going to leave the bank. 364 00:37:03.740 --> 00:37:10.420 That forces the bank not to do that kind of stuff. 365 00:37:10.420 --> 00:37:15.820 Now it used to be that banks were constrained by that. 366 00:37:15.820 --> 00:37:18.220 And then we got deposit insurance. 367 00:37:18.220 --> 00:37:23.620 Now up until recently deposit insurance only covered part of the bank's depositors. 368 00:37:23.620 --> 00:37:25.820 Only up to $100,000. 369 00:37:25.820 --> 00:37:28.540 And there were a lot of accounts over $100,000. 370 00:37:28.540 --> 00:37:35.540 In fact, the last figure I saw was before the changes in deposit insurance, 28 percent 371 00:37:35.540 --> 00:37:38.420 of the deposits in the American banking system were uninsured. 372 00:37:38.420 --> 00:37:40.640 They were over the $100,000 limit. 373 00:37:40.640 --> 00:37:47.680 They were corporate payrolls, they were the savings accounts of churches, and so those 374 00:37:47.680 --> 00:37:50.980 people had an incentive to monitor the banks. 375 00:37:50.980 --> 00:37:56.760 So the system wasn't completely without a penalty for running a risky investment strategy. 376 00:37:56.760 --> 00:38:03.560 Today, the limit's been raised to 250,000. 377 00:38:03.560 --> 00:38:09.100 The percentage of legally uninsured is much smaller, and the percentage who are de facto 378 00:38:09.100 --> 00:38:16.940 to Uninsured has been reduced to zero in the largest banks because they're implicitly guaranteed 379 00:38:16.940 --> 00:38:19.840 on the grounds that they're too big to fail. 380 00:38:19.840 --> 00:38:27.080 And too big to fail means I, the regulator, don't want this to happen on my watch. 381 00:38:27.080 --> 00:38:32.780 If it causes too little incentive for safe banking, that problem will show up later when 382 00:38:32.780 --> 00:38:38.920 somebody else is the regulator, but today there's not going to be bank runs. 383 00:38:38.920 --> 00:38:47.520 But if no depositors are monitoring, then the bank is not facing a penalty for risky behavior. 384 00:38:47.520 --> 00:38:51.600 And when I say risky, I mean excessively risky behavior. 385 00:38:51.600 --> 00:38:53.560 Banks have to take some risks. 386 00:38:53.560 --> 00:38:55.920 They ought to take some risks. 387 00:38:55.920 --> 00:39:00.760 But I mean crazy risky behavior. 388 00:39:00.760 --> 00:39:04.280 Banks are freer to engage in that sort of thing than depositors. 389 00:39:04.280 --> 00:39:07.280 So if depositors aren't monitoring the bank, who's left? 390 00:39:07.280 --> 00:39:13.480 Well the shareholders, if the shareholders aren't paying attention, regulators. If the 391 00:39:13.480 --> 00:39:19.880 regulators aren't paying attention, then God help us. We know what happens actually. We 392 00:39:19.880 --> 00:39:26.440 saw it in the savings and loan fiasco in the 1980s. Nobody runs. Regulators fail to close 393 00:39:26.440 --> 00:39:32.120 insolvent banks. And a problem of insolvency that could have been solved with $10 billion 394 00:39:32.120 --> 00:39:33.800 if it had been done promptly 395 00:39:33.800 --> 00:39:36.640 but as soon as the banks became insolvent 396 00:39:36.640 --> 00:39:40.360 grew to a hundred and fifty billion dollars because the regulators 397 00:39:40.360 --> 00:39:43.300 uh... if we wait the banks will become healthy again 398 00:39:43.300 --> 00:39:46.600 and while they didn't 399 00:39:46.600 --> 00:39:50.240 and i'm a five fear that were currently in a replay of something like that where 400 00:39:50.240 --> 00:39:51.640 regulators are 401 00:39:51.640 --> 00:39:52.840 deliberately 402 00:39:52.840 --> 00:39:56.800 forgoing to close insolvent banks 403 00:39:56.800 --> 00:40:03.800 City Bank, Bank of America. 404 00:40:04.480 --> 00:40:09.200 The best indicator of whether a bank is actually insolvent is not the capital it 405 00:40:09.200 --> 00:40:11.220 reports to the regulators. 406 00:40:11.220 --> 00:40:12.800 There's plenty of evidence that 407 00:40:12.800 --> 00:40:15.880 when eight percent is the required capital ratio, 408 00:40:15.880 --> 00:40:19.400 a bank can maintain eight percent capital on its books, 409 00:40:19.400 --> 00:40:21.800 even while 410 00:40:21.800 --> 00:40:23.240 it's becoming insolvent. 411 00:40:23.240 --> 00:40:25.540 The indicator of this becoming insolvent 412 00:40:25.540 --> 00:40:28.160 is the market value of the bank's shares 413 00:40:28.160 --> 00:40:30.420 because people who are buying and selling its shares 414 00:40:30.420 --> 00:40:32.560 want to know what the bank is actually worth 415 00:40:32.560 --> 00:40:35.480 not what it's reporting to the regulators 416 00:40:35.480 --> 00:40:36.840 and so 417 00:40:36.840 --> 00:40:40.960 in the japanese banking crisis of the nineteen nineties in case after case 418 00:40:40.960 --> 00:40:43.620 the market value of the bank's capital remained at eight percent 419 00:40:43.620 --> 00:40:45.520 sorry that the regulatory 420 00:40:45.520 --> 00:40:47.400 ratio that was reported 421 00:40:47.400 --> 00:40:50.040 the book value of the bank's capital reported the regulators 422 00:40:50.040 --> 00:40:53.880 stated eight percent sorry for you time's going this way 423 00:40:53.880 --> 00:40:55.320 the market value 424 00:40:55.320 --> 00:40:57.540 went to two percent 425 00:40:57.540 --> 00:40:59.120 and at that point the bank was 426 00:40:59.120 --> 00:41:01.620 had to be closed by regulators because 427 00:41:01.620 --> 00:41:02.860 it was already 428 00:41:02.860 --> 00:41:07.720 actually insolvent 429 00:41:07.720 --> 00:41:09.980 well if you're an ordinary depositor 430 00:41:09.980 --> 00:41:14.900 how could you know whether the banks in engaging in a crazy investment strategy 431 00:41:14.900 --> 00:41:17.980 you don't have to be an expert in reading bank balance sheets 432 00:41:17.980 --> 00:41:20.900 you just have to read the reports of people who are you just have to read 433 00:41:20.900 --> 00:41:22.460 money magazine 434 00:41:22.460 --> 00:41:26.940 all you have to do is the same thing people do nowadays when they invest in mutual funds 435 00:41:26.940 --> 00:41:28.420 read a report about 436 00:41:28.420 --> 00:41:34.440 what what its strategy is and how well it's doing 437 00:41:34.440 --> 00:41:41.440 okay uh... 438 00:41:43.900 --> 00:41:45.360 if a bank is 439 00:41:45.360 --> 00:41:47.760 i mean there is a way to make a bank 440 00:41:47.760 --> 00:41:51.720 really fragile to make it really run prone 441 00:41:51.720 --> 00:41:54.780 but of course banks have an incentive not to do that 442 00:41:54.780 --> 00:41:59.360 there's a kind of popular model of the bank run 443 00:41:59.360 --> 00:42:01.500 one of the economists is that 444 00:42:01.500 --> 00:42:04.340 arts alma mater, Wash U 445 00:42:04.340 --> 00:42:09.040 Diamond and Dibvig, Diamond is at Chicago, Dibvig is at Wash U 446 00:42:09.040 --> 00:42:12.960 and they have this theory, this model of a very fragile bank 447 00:42:12.960 --> 00:42:14.320 and it's 448 00:42:14.320 --> 00:42:16.700 internally consistent 449 00:42:16.700 --> 00:42:21.040 the problem is it doesn't describe any bank in the real world 450 00:42:21.040 --> 00:42:27.640 If a bank was really that fragile, how did banking survive centuries and centuries until deposit insurance came along? 451 00:42:27.640 --> 00:42:30.520 It sort of doesn't make evolutionary sense. 452 00:42:30.520 --> 00:42:33.160 So how did banks avoid being so fragile? 453 00:42:33.160 --> 00:42:37.000 The most important thing they did was to hold enough capital. 454 00:42:37.000 --> 00:42:39.960 That's what made them secure against 455 00:42:39.960 --> 00:42:41.480 asset losses, 456 00:42:41.480 --> 00:42:44.220 pushing them over the brink into negative equity, 457 00:42:44.220 --> 00:42:45.820 negative net worth, 458 00:42:45.820 --> 00:42:47.840 liabilities greater than their assets. 459 00:42:47.840 --> 00:42:49.620 So the capital is a cushion 460 00:42:49.620 --> 00:42:53.700 that absorbs the losses to the bank 461 00:42:53.700 --> 00:42:55.520 before deposit insurance 462 00:42:55.520 --> 00:42:59.500 you can go back and see photographs of this banks used to paint in their window 463 00:42:59.500 --> 00:43:01.460 typically in gold leaf 464 00:43:01.460 --> 00:43:07.100 this bank has five million dollars capital 465 00:43:07.100 --> 00:43:09.540 when federal deposit insurance came along 466 00:43:09.540 --> 00:43:13.380 the bank hired somebody with a scraper to scrape that out of the window 467 00:43:13.380 --> 00:43:15.780 and replace it with a sticker 468 00:43:15.780 --> 00:43:18.740 FDIC 469 00:43:18.740 --> 00:43:22.820 So FDIC guarantees are a substitute for bank capital 470 00:43:22.820 --> 00:43:25.400 in reassuring depositors 471 00:43:25.400 --> 00:43:28.440 and the result is predictable. 472 00:43:28.440 --> 00:43:31.780 Capital is costly for the bank to hold. 473 00:43:31.780 --> 00:43:35.900 Stickers practically free. 474 00:43:35.900 --> 00:43:39.540 Before deposit insurance banks typically had twenty percent capital. 475 00:43:39.540 --> 00:43:41.740 Nowadays 476 00:43:41.740 --> 00:43:44.640 well they're supposed to have eight percent capital. 477 00:43:44.640 --> 00:43:46.740 We're lucky if they really do. 478 00:43:46.740 --> 00:43:47.400 But 479 00:43:47.400 --> 00:43:48.680 before capital 480 00:43:48.680 --> 00:43:51.180 requirements began being imposed 481 00:43:51.180 --> 00:43:55.880 banks had run their capital down to like four percent 482 00:43:55.880 --> 00:43:58.800 depositors didn't care anymore depositors would put their money in a 483 00:43:58.800 --> 00:44:00.440 thinly capitalized bank 484 00:44:00.440 --> 00:44:02.480 because they were protected 485 00:44:02.480 --> 00:44:06.400 uh... by Uncle Sam 486 00:44:06.400 --> 00:44:09.760 now the amount of your capital whether that's adequate depends on how risky 487 00:44:09.760 --> 00:44:11.380 your assets are banks 488 00:44:11.380 --> 00:44:14.500 held safer asset portfolios 489 00:44:14.500 --> 00:44:17.900 there were no mortgage-backed securities in bank portfolios there were no sub 490 00:44:17.900 --> 00:44:24.900 No prime mortgages in bank portfolios. In fact, there were almost no mortgages in ordinary commercial bank portfolios. 491 00:44:24.900 --> 00:44:28.900 Mortgages were mostly held by specialized savings banks. 492 00:44:28.900 --> 00:44:34.900 Savings banks that did not offer checking accounts, so they weren't subject to the problem of rapid withdrawal of money. 493 00:44:34.900 --> 00:44:41.900 Banks that needed to be liquid did not tie up their portfolios in long-term assets. 494 00:44:41.900 --> 00:44:47.300 Banks were run more conservatively when they weren't protected against the consequences 495 00:44:47.300 --> 00:44:54.100 of behaving non-conservatively. 496 00:44:54.100 --> 00:45:01.660 Now in the model where banks are inherently fragile, they're fragile because people run 497 00:45:01.660 --> 00:45:05.020 on the bank just out of fear that other people will run. 498 00:45:05.020 --> 00:45:09.580 And in the Diamond Divig model, in fact, that's the only thing that causes bank failures is 499 00:45:09.580 --> 00:45:39.580 and so the solution to that is deposit insurance and here's the really cool part deposit insurance is free it never costs anything because once people are assured that they won't lose money should other people run and empty out the bank before they get there if everybody's assured that they'll get their money back nobody ever wants to run and since a run is the only thing that closes a bank banks never fail and therefore the only way to close a bank is to get your money back 500 00:45:39.580 --> 00:45:44.740 The insurance agency never has to make a payout, isn't that great? 501 00:45:44.740 --> 00:45:49.420 Like I said, this doesn't really describe the real world, because real world bank failures 502 00:45:49.420 --> 00:45:55.420 are not due to runs, they're due to bad loan decisions, 99 times out of 100. 503 00:45:55.420 --> 00:45:59.700 And when a run is the thing that precipitates the closure, the bank was already insolvent, 504 00:45:59.700 --> 00:46:06.700 usually, not always, there can be mistaken runs, and that's where it is unfortunate. 505 00:46:06.700 --> 00:46:17.700 But because that's not why banks fail, but rather bad loan decisions, deposit insurance is costly. 506 00:46:17.700 --> 00:46:25.700 Taxpayers are on the hook for bank failures due to bad banking. 507 00:46:25.700 --> 00:46:34.700 Today we've got not just partial FDIC coverage, we've got, at least in large banks, blanket federal guarantees. 508 00:46:34.700 --> 00:46:43.700 We've got a risk encouragement effect, what economists call moral hazard, we've got moral hazard on steroids. 509 00:46:43.700 --> 00:46:49.700 So my view is that we would be better off without an FDIC. 510 00:46:49.700 --> 00:46:53.700 Now I'm not saying we could abolish it tomorrow, not the way banks are today. 511 00:46:53.700 --> 00:47:03.700 There would have to be a longer process to sort of get banks back toward sounder practices. 512 00:47:03.700 --> 00:47:09.700 But, we would be better off without an FDIC. 513 00:47:09.700 --> 00:47:13.700 What about the Federal Reserve? Do we need a Federal Reserve system? 514 00:47:13.700 --> 00:47:17.700 Well, the Federal Reserve system does some useful things. 515 00:47:17.700 --> 00:47:22.700 So does the Post Office do some useful things. 516 00:47:22.700 --> 00:47:27.700 Nonetheless, I would like to see it legal for private firms to deliver first class mail. 517 00:47:27.700 --> 00:47:30.700 And then we'll see if the Post Office can survive. 518 00:47:30.700 --> 00:47:44.700 The Fed does some useful things. It issues currency, it clears checks, it processes electronic transfers, it provides a mechanism for banks to pay each other. 519 00:47:44.700 --> 00:47:51.700 All those useful things are things that private institutions used to do before the Fed nationalized them. 520 00:47:51.700 --> 00:48:02.700 Private bank clearing houses, founded as kind of clubs among banks to clear checks and to settle up among each other efficiently. 521 00:48:02.700 --> 00:48:08.700 Those were all private institutions. It would be more efficient to re-privatize those surfaces. 522 00:48:08.700 --> 00:48:18.700 The other things the bank does, the non-useful things the Fed does, enforcing harmful legal restrictions on banks, 523 00:48:18.700 --> 00:48:23.700 conducting monetary policy, those would be better off without. 524 00:48:23.700 --> 00:48:26.700 So we can abolish the Fed. 525 00:48:26.700 --> 00:48:30.700 Most of our history we didn't have a Federal Reserve system. 526 00:48:30.700 --> 00:48:36.700 Other countries have done well without central banks. 527 00:48:36.700 --> 00:48:41.700 Central banks are fairly a latecomer in the history of banking. 528 00:48:41.700 --> 00:48:47.700 So without the Fed what would replace monetary policy? 529 00:48:47.700 --> 00:48:54.700 Well, commercial banks would be issuing all types of money, paper currency as well as checking accounts. 530 00:48:54.700 --> 00:49:04.700 The basic money, the Federal Reserve liabilities that sort of underpin the entire system would have to be replaced with something, 531 00:49:04.700 --> 00:49:08.700 and the most natural candidate is a gold or silver standard. 532 00:49:08.700 --> 00:49:14.700 A gold or silver standard, as Hume explained, will regulate the quantity of money. 533 00:49:14.700 --> 00:49:18.700 It will do so without the need for Ben Bernanke's wisdom. 534 00:49:18.700 --> 00:49:24.700 Now there's a second leading argument for having a central bank, 535 00:49:24.700 --> 00:49:30.700 besides trying to stabilize the banking system against runs and panics, 536 00:49:30.700 --> 00:49:32.700 and that is macroeconomic policy. 537 00:49:32.700 --> 00:49:37.700 Smooth out interest rates, smooth out the business cycle. 538 00:49:37.700 --> 00:49:43.700 and the Business Cycle. Chairman Bernanke is trying very hard to do that. 539 00:49:43.700 --> 00:49:49.700 But the evidence is pretty clear that stabilization policy doesn't actually stabilize. 540 00:49:49.700 --> 00:49:54.700 It hasn't worked in practice. It's not that it could never work. 541 00:49:54.700 --> 00:50:02.700 There are conditions under which it can help. But more often than not, it works badly. 542 00:50:02.700 --> 00:50:06.680 it actually makes cycles bigger, it doesn't carry its own weight 543 00:50:06.680 --> 00:50:10.780 and the reason is not that the Fed is particularly incompetent 544 00:50:10.780 --> 00:50:13.580 other central banks haven't succeeded either 545 00:50:13.580 --> 00:50:16.940 the problem is that to stabilize the economy the Fed would have to know more 546 00:50:16.940 --> 00:50:19.900 than it's humanly possible to know 547 00:50:19.900 --> 00:50:23.340 and so in practice the Fed has made inflation higher 548 00:50:23.340 --> 00:50:27.740 it's distorted interest rates, it's fueled unsustainable booms 549 00:50:27.740 --> 00:50:30.840 it's made recessions deeper than they would otherwise be 550 00:50:30.840 --> 00:50:36.800 And our current crisis, our current recession, the result of Alan Greenspan's loose money 551 00:50:36.800 --> 00:50:42.900 policies from roughly 2001 to 2006 is just the latest example of that. 552 00:50:42.900 --> 00:50:50.880 So we have a crisis due to poor central banking policy, due to mistaken regulatory policy. 553 00:50:50.880 --> 00:50:57.240 That should raise, I think, certainly not lower, the likelihood we attach to the idea 554 00:50:57.240 --> 00:51:02.760 that the way forward is toward a freer banking system, greater self-regulation in the monetary 555 00:51:02.760 --> 00:51:03.760 system. 556 00:51:03.760 --> 00:51:06.040 Thanks very much and I'll take questions.