With respect to the acceptable limits of credit in a sound banking system, some rather long winded thoughts on a hypothetical fair gold-backed, banking system.
I consider that for any money to be sound it must necessarily be linked to productive activity, that it in fact equates to deferred spending, an IOU on the market system or as Ayn Rand brilliantly put it, frozen effort. If such were the case, every dollar held and not yet spent could legitimately be used by another for investment purposes. Yet the true owners of those funds would, for a myriad of reasons, baulk at gambling with their nest eggs.
With the current system as i understand it, bank deposits are technically repayable on demand. Bankers in turn, knowing seldom will all depositors want all their money back at the same time, gamble and lend out as much as they dare. But what if we were to inject honesty into the system?
As individual we all have varying time horizons for our unspent dollars. someone with a weeks worth of reserve wouldn't likely have need for a bank, whereas the the guy with 25 years of reserve spending most definitely would appreciate having a safe place to put that 4000 oz. of gold.
The above thinking was derived from an argument about Ayn Rand and marginal lending and my reading of Hernado DeSoto's book, "The Mystery of Capitol." I'm guessing you are familiar with his book, but he brings up the point of how difficult it is, in the developing world, to leverage real assets into collateral for bank loans. He writes about regulatory impediments and inability to attract micro loan as the factors that continue to impoverish the third world.
As an aside, he has a very informative look at the way legal issues were dealt with in the American gold rush, essentially discussing how common law works.
Back to the hard, gold as currency era. You make the point that when a loan is repaid the paper certificate is erased, but I wonder if that is the case . If for example, the bank did have a leger that separated available and on loan gold holding with limits placed on minimum reserve holding I could see that happening if loan certificates were name dedicated and not transferable. If the bank gold was held in a common pool I wonder if those paid loans would just wind up being added to the banks balance sheet as diluted the value of money.
That's my short take on early money but the point I want to make is that I see that it's logically valid to lend out all assets not needed for immediate use. If there were no artificial spending methods outside of productive exchanges there still would be a truly phenomenal quantity of investment capitol. The idea that the money would be 'owned' by people that worked for it would be a great incentive to look for high quality loans, as opposed to government boondoggle loans a market system would reject.
The marvel of our modern money system would take a volume to describe but while etransfers and micro credit card transactions are highly valued by me, I hold little confidence in the trustworthiness of giving up on physical money, the Canadian government seizure of Trucker Protester's bank accounts without warning or warrant being my wakeup call as to the fragility of security when an all powerful government agency pits itself against a private citizen.
And a final point, it is well know and has often been implement in times of war, adding counterfeit paper to a country's money supply is destabilizing to that country. I still wonder how we ever got to the place where no one seems to recognize that doing so to your own country is tantamount to committing suicide.
'Look at history where the fiat reserve system produced money that stayed relatively sound for
nearly 50 years. Sound means it is accepted everywhere in commerce and retains its purchasing
power over time.'
Do you really want to phrase this statement this way? Do you really mean what it says?
A hard money guy might really wince seeing the devaluation of the USD since 1971 till today and hear you say that the current system has allowed the USD to 'retain its purchasing power over time'. Allowed the USD to 'decline gracefully (mostly)' might be more like it.
Or, are you OK with historical post 1971 devaluation? (serious question). It would be ok if you were --- some economists argue that a low, say annual 2% devaluation allows businesses to 'claw back' 'excessive wage grants' over time (because wages are 'sticky' and no one likes to receive an absolute lowering of wages even if such a lowering is necessary and market priced --- 2% devaluation allows for gradual 'wage correction to market' to occur over time). It's ok if that is what you are saying / supporting, but if you are not implying support for this position, well then be careful what you are writing here.
Overall, this phrasing sounds too 'generous' to the system we have today (if you are a hard money advocate) and not 'clear enough' as to 'why 2% debasement is good' if you are Neo-Keyesian.
Anyway, not trying to bore you with comments but if you were looking for someone's feedback on the current 'draft' of your opus, there it is. With much respect, Go Army Beat Air Force
Another comment I had about the 'paragraph in question' regards your statement:
'Banks are constrained by the need to maintain
a prudent level of cash reserves. Loss of deposits means loss of reserves, which restricts the
banks ability to expand its loan book further'
My sincere question is 'why?'.
Clearly, banks need enough 'reserves' on hand to meet a'reasonable' amount and flow of deposit withdrawals. But this is a very low bar.
The next question therefore is what is the constraint between reserves and lending?
I know that at various times there have been statutory requirements between lending and reserves -- but I have two pieces of 'knowledge' that get in my way here. The first is that US bank lending has apparently been constrained more by capital regulations (e.g. Basel I-III) than by reserves. There is a FED chart somewhere that shows that the thirty year period of time prior to 2007 had a roughly zero percent increase in bank reserves (despite a massive increase in M2 and M3 during this time). The second piece of information is that, in 2020, the Federal Reserve and regulators eliminated the reserve constraint on lending all-together (as part of the COVID changes -- as far as I understand, this elimination of the reserve constraint to lending is still in place and is permanent).
So, in that context, bank reserves are not an 'immediate' brake on lending (since lending occurs happily without them). Instead, it appears that reserves are a 'nuclear' limit of lending (that only seems to come into affect catastrophically after a crisis has already occurred and a bank run is in process). Your point on not having the Federal Reserve rescue the troubled bank(s) would be a 'harsh' corrective to this behavior (in theory), but the problem for me, once again, is on the 'stair step' and absolute nature of the feedback loop.
If the conditions triggering this 'bank crisis' where isolated to one (or a very small number of banks), well, then I think you are can get away with allowing claims to exceed reserves and bailing-in the depositors of the failed bank. In this scenario, everybody sees the bank's dead carcass and recently impoverished depositors as a warning sign of 'beware and don't do as they did'.
But what if the conditions triggering this banking crisis are 'general' and affecting all or nearly all banks? What if it was 'unforeseen' and 'unforeseeable' (a true Black Swan event). If the only signal that you've 'gone too far' is sudden metaphorical 'Nuclear Winter' -- you probably need some better and earlier signaling tools than 'FAFO'.
I really do struggle trying to understand how reserves actually constrain lending (outside of a very simple, stylized bank example). If you have more on this topic, I'd really like to learn more.
A corollary my first point would be another problem caused by wholesale money. If wholesale money starts to take over the role of depositor money in the bank's balance sheet, it may be lead to all kinds of perverse behavior on behalf of the bank (and the system as a whole).
A depositor, faced with risky behavior at a bank, has few options other than 'pulling their deposits' (and hence reserves) from the bank. A wholesale bank to bank loan on the other hand can be (and usually is) securitized by some other bank asset (a liquid security). Furthermore, wholesale bank money tends to be very short term (e.g. overnight). Therefore, the wholesale bank can increase the securitization requirement and or the interest rate on the bank to bank loan to compensate themselves for the first banks increased riskiness. Once again, this may have the affect of reducing the 'signal' the 'risky' bank needs to 'discipline' behavior (if the consequence for infidelity in marriage is divorce, that may discipline wayward behavior, but if the consequence for infidelity is just 'some nice jewelry' -- then you may get a lot more bad behavior in the second system than in the first).
Of course, at some point, the bank's wholesale money providers may balk at providing more short term funds to the risky bank -- but at that point, the situation is probably so serious that it is 'too late' to gradually 'change bank behavior' or 'adequately warn' the remaining depositors. And while these remaining depositors are not entirely 'innocent' -- they may be worthy of intervention and protection (a bail out by the system of some kind) because the nature and terms of the bank-to-bank wholesale funding relationship is bespoke and hidden from their purview (until it is too late).
So, instead of a 'smooth curve' of deposit flight disciplining the 'risky' bank, you might get a 'nuclear option': things appear to be 'good' right up until the nuclear bomb is dropped (or about to be dropped). This is a very fragile, anti-stable situation.
Another take-away from this 'wholesale money' issue might be that 'maybe we shouldn't have wholesale money' (as a topic of discussion and debate). Wholesale money theoretically distributes capital to those in a better position to utilize it (from bank A to bank B) and it allows the recipient bank to lever up its loan portfolio (but is that a good thing)?
A couple of comments: In one part of today's talk, you state:
'Finally the behavior of depositors can limit credit creation in the banks. Depositors will move
out of banks where they perceive excessive risk. Banks are constrained by the need to maintain
a prudent level of cash reserves. Loss of deposits means loss of reserves, which restricts the
banks ability to expand its loan book further. To attract new deposits (and thus cash reserves)
the bank will likely have to offer higher interest rates to depositors'
I think that there are a couple of issues with that paragraph but let me start off with its 'phrasing' -- or more specifically, 'what you didn't say'. In particular, you might want to be a bit more explicit and reference the bank's leverage ratio and balance sheet as to why there is the 'perception of excessive risk'. And while depositors may perceive 'excessive risk' in the nature of the bank's loans themselves (e.g. too much speculative lending versus productive lending as you describe), most likely, the perception of 'excess' will come from the balance sheet and leverage ratio of total liabilities to equity. A bank with a 5:1 leverage ratio is more resilient than one with a 9:1 ratio .... or Bear Sterns (and its 33:1 leverage ratio). Bringing up the capital ratio of the bank more clearly identifies the main 'signal' depositors would likely use to perceive this risk.
But there is another reason for bringing up 'the nature of the bank's balance sheet' as well -- whole sale bank money (or other bank lending to the another bank). If the bank's only source of liabilities is deposits, then everything you say in this chapter is both 'correct' and 'clear and easy to understand' -- but it is not a good description of an actual bank (even small local ones) since about the late 1970's. Wholesale money is a 'thing' and it changes the process you describe for 'disciplining' bad bank behavior (or at least I think it does -- help me here if I am wrong).
Without wholesale money, individual depositors would, presumably one at a time, start to 'peel away' from the bank as soon as the risky bank's most risk adverse depositor gets concerned about the bank's lending (practices or leverage ratio). This peeling away would occur first with the most 'risk averse' depositor and than progress to the next most risk adverse, etc. At some point, this loss of depositors gets significant and the trend itself becomes a 'signal' for other depositors, further accelerating deposit loss. At some point along the way, the bank 'gets the signal' and 'corrects' is risky behavior (or it fails, which is a catastrophe for its remaining depositors and a 'warning' sign for other banks and depositors in the industry).
With wholesale money, the total level of the banks liabilities (and assets) may be unaffected or minimally affected by small to moderate deposit loss from this 'informed' and 'risk adverse' depositors group. Unless the bank is near its reserve constraints (and it is unlikely that it is reserve constrained since the 1950's on), this small to moderate loss of deposits doesn't affect its lending since the inflow of wholesale money enables the bank to continue on doing what it was doing. So, the bank's behavior is largely unaffected.
The more important piece however is what happens to remaining depositors in the bank. These remaining depositors won't see the balance sheet of the bank decrease due to deposit flight (if they look closely at the balance sheet, they will see the nature of the bank's liabilities changing, but that is a much less obvious and powerful signal). Therefore -- wouldn't the signaling mechanism of deposit flight to other depositors become delayed or interrupted? Could this delay / interruption become so pronounced that the 'self-correcting' process you hope to see not take place?
I have a couple of extra comments but let me break them up to make it easier for you to address them (if you wish to address them).
With respect to the acceptable limits of credit in a sound banking system, some rather long winded thoughts on a hypothetical fair gold-backed, banking system.
I consider that for any money to be sound it must necessarily be linked to productive activity, that it in fact equates to deferred spending, an IOU on the market system or as Ayn Rand brilliantly put it, frozen effort. If such were the case, every dollar held and not yet spent could legitimately be used by another for investment purposes. Yet the true owners of those funds would, for a myriad of reasons, baulk at gambling with their nest eggs.
With the current system as i understand it, bank deposits are technically repayable on demand. Bankers in turn, knowing seldom will all depositors want all their money back at the same time, gamble and lend out as much as they dare. But what if we were to inject honesty into the system?
As individual we all have varying time horizons for our unspent dollars. someone with a weeks worth of reserve wouldn't likely have need for a bank, whereas the the guy with 25 years of reserve spending most definitely would appreciate having a safe place to put that 4000 oz. of gold.
The above thinking was derived from an argument about Ayn Rand and marginal lending and my reading of Hernado DeSoto's book, "The Mystery of Capitol." I'm guessing you are familiar with his book, but he brings up the point of how difficult it is, in the developing world, to leverage real assets into collateral for bank loans. He writes about regulatory impediments and inability to attract micro loan as the factors that continue to impoverish the third world.
As an aside, he has a very informative look at the way legal issues were dealt with in the American gold rush, essentially discussing how common law works.
Back to the hard, gold as currency era. You make the point that when a loan is repaid the paper certificate is erased, but I wonder if that is the case . If for example, the bank did have a leger that separated available and on loan gold holding with limits placed on minimum reserve holding I could see that happening if loan certificates were name dedicated and not transferable. If the bank gold was held in a common pool I wonder if those paid loans would just wind up being added to the banks balance sheet as diluted the value of money.
That's my short take on early money but the point I want to make is that I see that it's logically valid to lend out all assets not needed for immediate use. If there were no artificial spending methods outside of productive exchanges there still would be a truly phenomenal quantity of investment capitol. The idea that the money would be 'owned' by people that worked for it would be a great incentive to look for high quality loans, as opposed to government boondoggle loans a market system would reject.
The marvel of our modern money system would take a volume to describe but while etransfers and micro credit card transactions are highly valued by me, I hold little confidence in the trustworthiness of giving up on physical money, the Canadian government seizure of Trucker Protester's bank accounts without warning or warrant being my wakeup call as to the fragility of security when an all powerful government agency pits itself against a private citizen.
And a final point, it is well know and has often been implement in times of war, adding counterfeit paper to a country's money supply is destabilizing to that country. I still wonder how we ever got to the place where no one seems to recognize that doing so to your own country is tantamount to committing suicide.
My final comment pertains to your line:
'Look at history where the fiat reserve system produced money that stayed relatively sound for
nearly 50 years. Sound means it is accepted everywhere in commerce and retains its purchasing
power over time.'
Do you really want to phrase this statement this way? Do you really mean what it says?
A hard money guy might really wince seeing the devaluation of the USD since 1971 till today and hear you say that the current system has allowed the USD to 'retain its purchasing power over time'. Allowed the USD to 'decline gracefully (mostly)' might be more like it.
Or, are you OK with historical post 1971 devaluation? (serious question). It would be ok if you were --- some economists argue that a low, say annual 2% devaluation allows businesses to 'claw back' 'excessive wage grants' over time (because wages are 'sticky' and no one likes to receive an absolute lowering of wages even if such a lowering is necessary and market priced --- 2% devaluation allows for gradual 'wage correction to market' to occur over time). It's ok if that is what you are saying / supporting, but if you are not implying support for this position, well then be careful what you are writing here.
Overall, this phrasing sounds too 'generous' to the system we have today (if you are a hard money advocate) and not 'clear enough' as to 'why 2% debasement is good' if you are Neo-Keyesian.
Anyway, not trying to bore you with comments but if you were looking for someone's feedback on the current 'draft' of your opus, there it is. With much respect, Go Army Beat Air Force
Another comment I had about the 'paragraph in question' regards your statement:
'Banks are constrained by the need to maintain
a prudent level of cash reserves. Loss of deposits means loss of reserves, which restricts the
banks ability to expand its loan book further'
My sincere question is 'why?'.
Clearly, banks need enough 'reserves' on hand to meet a'reasonable' amount and flow of deposit withdrawals. But this is a very low bar.
The next question therefore is what is the constraint between reserves and lending?
I know that at various times there have been statutory requirements between lending and reserves -- but I have two pieces of 'knowledge' that get in my way here. The first is that US bank lending has apparently been constrained more by capital regulations (e.g. Basel I-III) than by reserves. There is a FED chart somewhere that shows that the thirty year period of time prior to 2007 had a roughly zero percent increase in bank reserves (despite a massive increase in M2 and M3 during this time). The second piece of information is that, in 2020, the Federal Reserve and regulators eliminated the reserve constraint on lending all-together (as part of the COVID changes -- as far as I understand, this elimination of the reserve constraint to lending is still in place and is permanent).
So, in that context, bank reserves are not an 'immediate' brake on lending (since lending occurs happily without them). Instead, it appears that reserves are a 'nuclear' limit of lending (that only seems to come into affect catastrophically after a crisis has already occurred and a bank run is in process). Your point on not having the Federal Reserve rescue the troubled bank(s) would be a 'harsh' corrective to this behavior (in theory), but the problem for me, once again, is on the 'stair step' and absolute nature of the feedback loop.
If the conditions triggering this 'bank crisis' where isolated to one (or a very small number of banks), well, then I think you are can get away with allowing claims to exceed reserves and bailing-in the depositors of the failed bank. In this scenario, everybody sees the bank's dead carcass and recently impoverished depositors as a warning sign of 'beware and don't do as they did'.
But what if the conditions triggering this banking crisis are 'general' and affecting all or nearly all banks? What if it was 'unforeseen' and 'unforeseeable' (a true Black Swan event). If the only signal that you've 'gone too far' is sudden metaphorical 'Nuclear Winter' -- you probably need some better and earlier signaling tools than 'FAFO'.
I really do struggle trying to understand how reserves actually constrain lending (outside of a very simple, stylized bank example). If you have more on this topic, I'd really like to learn more.
A corollary my first point would be another problem caused by wholesale money. If wholesale money starts to take over the role of depositor money in the bank's balance sheet, it may be lead to all kinds of perverse behavior on behalf of the bank (and the system as a whole).
A depositor, faced with risky behavior at a bank, has few options other than 'pulling their deposits' (and hence reserves) from the bank. A wholesale bank to bank loan on the other hand can be (and usually is) securitized by some other bank asset (a liquid security). Furthermore, wholesale bank money tends to be very short term (e.g. overnight). Therefore, the wholesale bank can increase the securitization requirement and or the interest rate on the bank to bank loan to compensate themselves for the first banks increased riskiness. Once again, this may have the affect of reducing the 'signal' the 'risky' bank needs to 'discipline' behavior (if the consequence for infidelity in marriage is divorce, that may discipline wayward behavior, but if the consequence for infidelity is just 'some nice jewelry' -- then you may get a lot more bad behavior in the second system than in the first).
Of course, at some point, the bank's wholesale money providers may balk at providing more short term funds to the risky bank -- but at that point, the situation is probably so serious that it is 'too late' to gradually 'change bank behavior' or 'adequately warn' the remaining depositors. And while these remaining depositors are not entirely 'innocent' -- they may be worthy of intervention and protection (a bail out by the system of some kind) because the nature and terms of the bank-to-bank wholesale funding relationship is bespoke and hidden from their purview (until it is too late).
So, instead of a 'smooth curve' of deposit flight disciplining the 'risky' bank, you might get a 'nuclear option': things appear to be 'good' right up until the nuclear bomb is dropped (or about to be dropped). This is a very fragile, anti-stable situation.
Another take-away from this 'wholesale money' issue might be that 'maybe we shouldn't have wholesale money' (as a topic of discussion and debate). Wholesale money theoretically distributes capital to those in a better position to utilize it (from bank A to bank B) and it allows the recipient bank to lever up its loan portfolio (but is that a good thing)?
Merry Christmas Jim.
A couple of comments: In one part of today's talk, you state:
'Finally the behavior of depositors can limit credit creation in the banks. Depositors will move
out of banks where they perceive excessive risk. Banks are constrained by the need to maintain
a prudent level of cash reserves. Loss of deposits means loss of reserves, which restricts the
banks ability to expand its loan book further. To attract new deposits (and thus cash reserves)
the bank will likely have to offer higher interest rates to depositors'
I think that there are a couple of issues with that paragraph but let me start off with its 'phrasing' -- or more specifically, 'what you didn't say'. In particular, you might want to be a bit more explicit and reference the bank's leverage ratio and balance sheet as to why there is the 'perception of excessive risk'. And while depositors may perceive 'excessive risk' in the nature of the bank's loans themselves (e.g. too much speculative lending versus productive lending as you describe), most likely, the perception of 'excess' will come from the balance sheet and leverage ratio of total liabilities to equity. A bank with a 5:1 leverage ratio is more resilient than one with a 9:1 ratio .... or Bear Sterns (and its 33:1 leverage ratio). Bringing up the capital ratio of the bank more clearly identifies the main 'signal' depositors would likely use to perceive this risk.
But there is another reason for bringing up 'the nature of the bank's balance sheet' as well -- whole sale bank money (or other bank lending to the another bank). If the bank's only source of liabilities is deposits, then everything you say in this chapter is both 'correct' and 'clear and easy to understand' -- but it is not a good description of an actual bank (even small local ones) since about the late 1970's. Wholesale money is a 'thing' and it changes the process you describe for 'disciplining' bad bank behavior (or at least I think it does -- help me here if I am wrong).
Without wholesale money, individual depositors would, presumably one at a time, start to 'peel away' from the bank as soon as the risky bank's most risk adverse depositor gets concerned about the bank's lending (practices or leverage ratio). This peeling away would occur first with the most 'risk averse' depositor and than progress to the next most risk adverse, etc. At some point, this loss of depositors gets significant and the trend itself becomes a 'signal' for other depositors, further accelerating deposit loss. At some point along the way, the bank 'gets the signal' and 'corrects' is risky behavior (or it fails, which is a catastrophe for its remaining depositors and a 'warning' sign for other banks and depositors in the industry).
With wholesale money, the total level of the banks liabilities (and assets) may be unaffected or minimally affected by small to moderate deposit loss from this 'informed' and 'risk adverse' depositors group. Unless the bank is near its reserve constraints (and it is unlikely that it is reserve constrained since the 1950's on), this small to moderate loss of deposits doesn't affect its lending since the inflow of wholesale money enables the bank to continue on doing what it was doing. So, the bank's behavior is largely unaffected.
The more important piece however is what happens to remaining depositors in the bank. These remaining depositors won't see the balance sheet of the bank decrease due to deposit flight (if they look closely at the balance sheet, they will see the nature of the bank's liabilities changing, but that is a much less obvious and powerful signal). Therefore -- wouldn't the signaling mechanism of deposit flight to other depositors become delayed or interrupted? Could this delay / interruption become so pronounced that the 'self-correcting' process you hope to see not take place?
I have a couple of extra comments but let me break them up to make it easier for you to address them (if you wish to address them).