Sic Semper Tyrannis

In the latest "Credit Bubble Bulletin," from Doug Noland, a peerless job is done (as always) diagnosing the state, trend, mechanics, and consequences of the global credit bubble. But this time, Noland delves more into the prescriptive: how to fix the mess; how to do things differently?

Noland's call, like that of so many others observing the credit bubble (or any of its myriad asset-market bubbles, or any other large-scale financial shenanigans), is for more regulation. Not surprising. Noland trots out a number of quotes from the first half of the 20th century warning of bubbles and calling for greater central control of the money supply and the issuance of credit -- why didn't we listen to these sages? And of course, he doesn't forget to roast Milton Friedman a bit for unspecified reasons (that one's obligatory for those that advocate more regulation in general).

Follow up:

I can even add to Noland's citations of Simons and Sproul a personal favorite of my own, Frederick Soddy, a Nobel laureate physicist who wrote as early as 1926 on the dangers of fractional reserve banking run amok. Soddy proved more rigorously than any thinker I have seen since that this system was unstable and ruinous. And like Noland's sages, Soddy called for strong central regulation to solve the problem: "taking back" money creation from the bankers and returning it to the government.

The obvious problem with this line of reasoning is that we did, in fact, implement "total" centralized control of the money supply early on in the last century, and tightened that control considerably at the beginning of the Great Depression.

It didn't work. It isn't laissez faire, de-regulation, or anarchy that isn't working now: it is regulation itself that is failing us. The prescription of Soddy, Simons, Sproul, and doubtless many others, is simply unrealistic. Corruptible and fallible human beings cannot lastingly implement it.

Yes, as both Noland and I have pointed out, the implementation of this sort of regulation has technically slipped considerably. The Fed has dialed back the traditional reserve requirements to no meaningful level at all; the government has made a joke of bond-based financing, and most key government economic statistics are suspect -- with concomitant and ruinous influence on finance in general. You might also point out that financial innovation has, and will always inevitably leave the regulators behind the curve -- which certainly isn't their fault.

And I'd agree with these these points, descriptively speaking. But agreement here doesn't imply that the solution is simply more of the same (centralization and regulation). That's not a real solution -- that's a stopgap. Perhaps the stopgap will "work" in the short term (though probably not in the comprehensive sense, with unintended consequences factored in), but it won't work for very long. Politics and power guarantee a dysfunctional system can be kept in place far longer than is healthy. For example, look at how long we've been going without truly fixing social security or medicare -- simply because the worst of the consequences haven't arrived yet! This last point is key: a politically-based system will remain dysfunctional as long as horribly bad consequences have not yet manifest.

And even if we could extend the reach of regulators into the Byzantine world of modern high finance, would that really help us? How long would the regulators remain independent and free of corruption? What about chilling effects on legitimate financial activities? How long would they be able to ignore political influences and stick to economic fundamentals? What would happen when they made fundamental mistakes?

How long would we have to wait to oust them when they have become more of a hazard than a benefit?

How long until we realize it?

The answer isn't more regulation and more powerful regulators. We are, apparently, condemned to repeat the mistakes of the past if we attempt to solve our problems in the same manner. The true answer, is, then, no regulation -- combined with no socialized support in the financial arena.

This system would not be "radical" or "new". It would simply be a return to the (non-)system in place in the United States from its founding until 1913, the date of the creation of the Federal Reserve (which is still the current regulatory regime).

That period is coincident with two key trends: (1) the rise of the United States from a global backwater to an industrial and economic power, and (2) gradual deflation -- an increase in the overall value of money.

Not too shabby.

There were no economy-wide financial bubbles like we have today. There were no Great Depressions. There was no long-term inflation -- which means workers made more every year, all other things equal, and could accumulate savings without risky investment. Yes, there were mild business-cycle recessions, and periodic (but short-lived) runs on banks and market "panics". But these ills, supposedly cured by the Fed system, were in fact trivial compared to what that regulatory system has produced.

The old system wasn't centrally-regulated: it was regulated naturally, by fundamentals. Contrary to popular assumption, the presence of a gold/silver standard was not responsible for the benefits of the pre-Fed era. Even though the dollar was backed by precious metals, banks could still freely implement fractional reserves, a practice that dates back to the Florentine banks of Rennaissance times (which were also gold-centric). (Fractional reserves mean you only hold a fraction of real cash or commodity relative to the total amount of deposits.)

That's why bank runs happened periodically before the Fed: when banks were discovered to be insolvent, depositors would rush to withdraw their money (or gold/silver) as quickly as possible.

While this might sound awful, it's actually good, in the same way natural selection is "good" in the Darwinian model: it weeds out the weak members of the population. What is left is a healthier ecosystem. Of course, since human beings are capable of planning and anticipating, such a force (in the banking context) also serves as a built-in incentive for banks to lend prudently and keep reserves relatively high. There is no actual need for a bank to be shut down in a panic for it to be influenced beneficially.

This natural incentive is totally lacking from the current system. Not only does the Fed allow nearly negligible fractional reserves (or conversely, unlimited multiplication of money), but the FDIC "insurance" system gives false assurance to depositors that there is no need to worry. But these facilities are artificial props: like wildfire prevention, they are capable only of putting out small fires, leaving the overall landscape more vulnerable to completely-destructive inferos. We need those periodic minor fires to clean out the "underbrush". In the current system, we don't have this.

Want examples?

In the 80s economic malaise, we had a large number of bank failures -- even more than in the Great Depression -- which required the FDIC to come in and rescue depositors, at great stress to itself, and ultimately, the taxpayer. Did anyone learn their lesson? Nope.

In the early 90s, we had the S&L failures, which actually collapsed the SLIC (the S&L counterpart to the FDIC), which was then merged into the FDIC. The bailout of S&Ls cost around $300 billion in contemporary dollars.

In 1998, a hedge fund called Long Term Capital Management collapsed, having taken on leverage in the ballpark of 100:1, and making a losing bet with a minority of its portfolio which totally wiped out the principal value. Trillions were at stake, so the Fed had to orchestrate a bailout with LTCM's creditors, for fear of a cascading financial system failure otherwise (much like a all-encompassing wildfire).

That should be enough. The point is that imprudent behaviors have risen to a very high level of financial management, becoming systemic under the current regulatory regime. This problem doesn't seem to be going away; it is getting worse.

This is why I call for a return to the naturally-regulated, fundamentals-based financial system model. Central management of money and credit is simply not viable for a significant length of time. The old system worked well, and prevented all of the worst ills we are currently experiencing.

The current system isn't so much "regulated" or "de-regulated" as purporting-to-be regulated, while falling far short of promises, claims, and abilities. The end result is that the system is anti-regulated, with malfeasance and imprudence rising to supernatural levels due to the complacence of all participants and the wink-and-nod of the central masters of the system. This would not be possible in a system where all participants had to be personally vigilant.

The only reason to keep the current system is, of course, to preserve the power of those central controllers. And that's no good reason at all.

In fact, traditional supporters of regulation might try this little exercise: replace the word "regulation" with what it really is -- the assignment of power to a tiny, elite class of human beings, along with trust that this class will do more good than harm throughout time and in all present and future conditions.

That sounds pretty scary to me. And thus so does "centrally-regulating the banking system."

So abolish the Fed; re-institute a free market in banking, and let nature regulate effectively as no Leviathan "mastermind" can.

And if you still don't agree with me regarding the folly of a centrally-regulated banking system, perhaps the next Great Depression will convince you.