Detlev Schlichter

One with a populist view might ask:

Is it really true that we have too-much state involvement in finance? Do we really have some form of monetary central planning? Does this view not completely underestimate the power of the big private banks?

When one looks at the gigantic positions these private banks have on their balance sheets (and the even bigger positions they have ‘off balance sheet’), and when one looks at the outsized bonuses the bankers pay themselves, and when one furthermore considers that most money-creation is done by the private banks, then it appears as if ‘central planning’ or ‘the power of the bureaucracy’ appear inaccurate descriptions of the present system.

After all, J.P. Morgan just admitted to losing $2 billion and counting on complicated derivative positions. How can that be the fault of central bankers or imaginary monetary ‘central planners’? Isn’t this the opposite of central planning? Is this not capitalism running amok?

Maybe we need more regulation and more control by the state authorities. Is the main threat to our economic well-being really a too-powerful central bank? Isn’t it really a private banking system that is run for the benefit of the bankers rather than the ‘real’ economy and that may collapse as a result of uncontrolled speculation? Our system doesn’t look like grey and boring Soviet-style central planning at all but more like flamboyant capitalism spinning out of control.

And by going back to a gold standard would we not restrict the power of the central bank to save us from the mistakes of the bankers? Bringing back gold and restricting the maneuvering space of central bankers will make things worse.

The way I described the populist view here contains observations and conclusions. I believe the conclusions to be largely incorrect. They may appear intuitively sensible but they do not stand up to closer scrutiny. However, there is no denying that many of the observations that form the basis of this popular view are evidently correct.

There is no logical conflict, however, between these observations and the critique of fiat money as a form of monetary central planning. In fact, all the symptoms that the populist view concerns itself with and that form the basis of the widespread public anger – the apparent detachment of global finance from the real economy, the outsized and uncontrollable derivatives market, the bonus culture and the instant claims of the private banks on unlimited bank reserves and unlimited bailouts – all have their origin in the decision to abandon the gold standard and replace it with unlimited fiat money under state control.

Once this connection has become clear, more of the system’s critics should see that the cure is not more power to the bureaucracy and more regulation and controls but simply a return to hard money and thus a return of a system that is controlled, not by bureaucrats and bankers, but by the consumers of financial services.

The power of the consumer

In capitalism, in a truly free market, the consumer decides what is being produced, how resources are allocated, and who makes profits and who doesn’t. By buying from some and not buying from others the consumer ultimately directs production, economic activity and the use of scarce resources.

Under capitalism the consumer decides how capital is deployed. Our problem is that today we have no capitalism in finance, and the reason for this is quite simply the abandonment of a gold standard and the establishment in its place of a system of unlimited fiat money and of central banking.

What is money?

Gold and silver have been used as money in the form of coins for 2,500 years. ‘Modern’ finance started with the rise of banking, roughly 300 years ago. Banks have never really confined themselves to just taking deposits and making loans but, pretty much from the start, have been in the business of creating money, a business that they invented.

Of course, money proper was still gold or silver, and those could not be created by banks, but banks issued what I will call money derivatives. Think banknotes or bank deposits. As these were not gold or silver they were not money proper but they were usually claims on gold or silver, and they began to circulate in the economy and were used by the public as if they were money proper.

And of course, if all money derivatives in circulation had been fully backed by gold or silver in the banks’ vaults (i.e. by gold and silver that is not presently in circulation) then the supply of what the public uses as money would not have expanded and the banks would not have become money producers.

But as we all know, banks quickly managed to issue money derivatives that were not backed by gold or silver, or at least not fully backed by gold or silver. To the extent that the public accepted uncovered money derivatives as money, the banks had indeed a license to print money, and this allowed the banks to extend more loans and make more profits.

But the operative words in the previous sentence are “to the extent that the public accepted”. The consumer of finance, in particular the depositor, decided to what extent bankers could become money producers. If depositors became uncomfortable with the practices of their banker, they no longer accepted his money derivatives but instead removed their deposits and placed it with somebody else, or simply held physical gold and silver again. The consumer had the power to pull the plug on the bankers.

In defense of bank runs

What was money and what was not money had, with the arrival of deposit banking and fractional-reserve banking, become a somewhat fluid concept. And it has remained such ever since. It has become subject to change.

There is, in the words of Keynesian Paul Krugman, a continuum. But under a gold standard, what was accepted as money was ultimately decided by the public. The license to print money could be revoked by the depositors at any time. That put the banker in a perilous position. Being a money creator was lucrative but it placed the banker at the mercy of a fickle public. There was always the risk of a panic and a bank run.

Now, who would be in favor of bank runs and panics? Are they not a sign of a potentially irrational and panic-prone public that fails to make wise decisions in its own best interest? — That is today the generally accepted view, I guess. But the prospect of bank runs is also without question a drastic form of consumer power, of capitalism’s essential checks and balances.

The risk of a bank run, of the public’s sudden loss of faith in the prudence, reliability and solvency of a banker, is a powerful check on the banker’s risk-taking and overall business strategy. Not surprisingly, prior to the arrival of lender-of-last resort central banks and unlimited fiat money, banking seemed to have attracted a very different type of individual than it does today. Bankers were conservative and extremely concerned with a public appearance of restraint, prudence and the utmost reliability. Because they had to be. No macho-talk about “global business opportunities'” of market share and high “return on equity”.

Power shifts from the depositor to the bureaucrat

Enter the central banks. This is what Milton Friedman and Anna Schwartz had to say in their seminal book A Monetary History of the United States about the founding of the Federal Reserve:

“The Federal Reserve System was created by men whose outlook on the goals of central banking was shaped by their experience of money panics during the national banking era. The basic monetary problem seemed to them to be banking crises produced by or resulting in an attempted shift by the public from deposits to currency (currency meant specie at the time, DS.)”

This “attempted shift by the public” was none other than the sovereign consumer deciding that there were now too many money derivatives around and that he now preferred to hold money proper again, i.e. gold. It was apparently deemed okay for the consumer to shift from currency (gold) to deposits, thereby widening the definition of what was accepted as money and thus allowing the banks to create more of it.

But, so the founders of the Federal Reserve System decreed, it was not acceptable that the consumer would ever narrow the definition of money again and reduce the banks’ ability to place more money derivatives. The state thus entered the scene in order to protect the banks from changing preferences of the public, at least those changes in preferences that were bound to limit money creation and credit expansion.

You may say it was good of the Fed to reduce the risk of bank runs and make banking safe. That is the standard interpretation today. (By the way, the Fed has neither made the economy more stable nor banking safer, as George Selgin demonstrates nicely in this excellent presentation.) However, the good economist does not just look at the immediate and most obvious consequences of policy but also at the long run consequences.

There is no escaping the fact that the establishment of a central bank as a backstop for the banks’ production of money derivatives was the starting point of a process of disenfranchisement of the depositor as ultimate controller and arbiter of what is money, of how much there should be of it, and of what makes good and prudent banks. The power of the depositor — the consumer of banking — was weakened, and the power of the central banker, the bureaucrat, as ultimate judge of what is money and what is good banking was strengthened. The bond between banker and depositor was starting to be replaced with the bond between banker and central banker.

It is clear that the interests of banker and bureaucrat were closely aligned and both pointed toward ever more money production. The banker wanted to conduct the lucrative business of creating and placing money derivatives with the public without the risk of sudden changes in consumer preferences. The state officials wanted to encourage monetary expansion as this was deemed to be good for business and because the state itself was of course an important borrower. It is hardly surprising that with the advent of central banking and later unlimited fiat money, state borrowing began to expand.

The score at this point: Bankers/bureaucrats 1 – Consumers 0

There is no such thing as a free lunch. While that is a famous and very fitting quote of Milton Friedman’s (1912-2006), it is Ludwig von Mises (1881-1972) who the bankers and central bankers of the 1920s and 1930s should have listened to. The money-induced credit boom of the 1920s ended in the crash of 1929, and although the public had accepted more money derivatives during the boom as these now came with a government backstop from the young Federal Reserve (and this had made the extended boom possible in the first place), when the bust started the consumer definitely wanted to hold money proper again, and that was still gold.

Bank runs still ensued and now were much worse than they ever had been in the pre-Fed era, simply because the Fed had by now encouraged the issuance of vastly more money derivatives. Although the country was officially on a gold standard and the banks had promised their depositors repayment in gold as part of their strategy to place their money derivatives with the public, the state decreed that the banks would collectively default on this promise and that they could still continue as going concerns.

The state also decreed that money derivatives were now the new money proper and in order to leave the public no choice whatsoever – and no say in what was money or not -the state confiscated all previous money proper (that is gold) via executive order of the president in 1933. (In the United States of America private ownership of gold remained severely restricted until 1974.)

History is always written by its victors, and the victorious money statists, central bankers and Keynesian economists claim – to this day – that this was all for the better. It ended monetary contraction (true) and ended the Great Depression (not quite true but it probably provided a break). But – oh those long run consequences!

The money consumer had been disenfranchised. What bankers could do and not do, how much money there was in the economy and what interest rates were – none of this was any longer a give and take between profit-seeking bankers and their banking consumers, and thus identical in its dynamics to the relationship between any entrepreneur and his customer, but it was now the outcome of policy. In 1953 the Chamber of Commerce of the United States published a pamphlet entitled The Mystery of Money that roundly stated: “Money is what the government says it is.”

The bankers, by and large, embraced this change. It was better to be in bed with the state than the fickle public. The state had unlimited resources (almost) and could make laws. And most important, the state was interested in constant monetary expansion – a magnificently lucrative proposition for the bankers as money derivative producers.

The score: Bankers/bureaucrats 2 – Consumers 0…


Detlev Schlichter

Detlev Schlichter

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