Myth: The problem is "toxic" assets (e.g. mortgage-backed securities) which have created systemic risk
When a hospital can't collect payment, the hospital sells this debt to a collection agency. This doesn't create booms and busts. The risk is asystemic unless the government bails out every debtor and/or creditor.
Myth: Present problems were caused by bad lending (i.e. sub-prime loans)
Promiscuous lending is a symptom -- not a cause -- of economic conditions. Take bad lending to its own logical conclusion: Creditors give away money as an act of charity, getting nothing in return. Does charity cause booms and busts? No. Promiscuous lending is a symptom of loose monetary policy at the Fed, which tricks the loan market into consummating unjustifiable loans.
It's primarily through FOMC operations that interest rates are determined (until the Fed loses control, which will eventually happen). By expanding the money supply, this increases the supply of loanable funds, but without an expansion of genuine savings. In doing so, the loan market appears to be more solvent than it truly is, tricking the loan market into consummating unjustifiable loans. This artificially suppresses nominal interest rates below their natural level (i.e. where they should be pursuant to the true supply of savings). By expanding the money supply, this allows debtors/borrowers to pay creditors/lenders with devalued dollars, thus lowering the real rate of interest.
The essence of a credit transaction is an exchange of a present good for a future good. If there are no present goods (i.e. savings, which aren't created on a printing press), then credit has to be curtailed. The problem in that case would not be a credit crunch, but a savings crunch. Investment can only come out of savings because producers must consume in order to sustain the process of production. In order for the baker to make more bread, the baker himself must eat. Thus somebody must forego present consumption in order to fund credit expansion.
The rate of interest is the discount rate of future goods against present goods. An example would be what an investor pays for a printing press. Suppose the printing press will generate $500,000 in net income throughout a ten-year life. The entrepreneur will certainly not bid up the price of the capital equipment to $500,000. The entrepreneur is willing to invest, say, $200,000 for the printing press and the vendor is willing to part ways with the printing press in exchange for an immediate $200,000. The entrepreneur and capital equipment vendor mutually settle upon $200,000 -- a sum far less than the $500,000 -- in exchange for the printing press.
How much present income (i.e. present goods) is an entrepreneur willing to invest in order to garner $500,000 in future net income (i.e. future goods) over a ten-year period? Reflected in the transaction is the rate of interest as determined by time preferences. Interest rates represent an agio on present goods since present goods are more valuable than are future goods. A person would rather eat an apple today than eat an apple ten years from now. Interest rates must be set pursuant to the true supply of savings and are determined by time preferences. If everybody wants to consume without saving, then interest rates must rise to reflect time preferences.
There is no right way to extend credit at negative real rates, which is a negative rate of return in real terms. It's a calculus for the loan market to go bust. Any person, firm, or institution (e.g. government) that's dependent upon inflationary credit expansion is, by definition, insolvent (i.e. a non-income generator). Failure has to be an option for bad business decisions. That's the check on excessive risk taking.
Capital naturally gravitates to lower priced, higher-yield economies. Artificially low interest rates engenders capital outflow. Capital goes racing overseas. The problem isn't a dollar shortage, but a dollar leakage. The dollars are out there; they're just piled up in foreign reserves. The way to repatriate these dollars is for the Fed to tighten, interest rates rise, prices collapse to reflect wages, which will then beget capital inflow thus lowering the natural rate of interest. If I give you $10 in exchange for a book and you turn around and give me that $10 in exchange for a DVD, the real means of purchase for the book was the DVD and the real means of purchase for the DVD was the book. Increasing the quantity of dollars creates no benefit for the economy.
If the Fed tightens, while it's true interest rates could gyrate upwards in the short term , the market wouldn't take very long to append a deflation agio onto rates by lowering rates, since the real rate of return would come from an increase in the purchasing power of the dollar.
Myth: The FDIC is good for depositors
The FDIC offers deposit insurance for bank customers, which is really a backdoor way to bailout insolvent banks. Could you imagine being able to run a ponzi scheme (e.g. fractional-reserve banking), knowing that when your insolvency is exposed the government will pay off your customers (i.e. a de facto bailout of you)? This creates yet another layer of moral hazard on top of the central bank injecting "liquidity" into the loan market. Thus the FDIC's true purpose is designed to keep the unsustainable intact.
Needing to insure bank deposits should raise questions in and of itself. Unlike natural disasters, economic risk can't be pooled. It's one thing to guarantee one's solvency should they get wiped out due to, say, a flood. It's quite another thing to guarantee solvency, per se. It's impossible to insure against economic miscalculation and loss. If I were to go into business and you offered to insure me against business failure, by underwriting and assuming the risk, you become the true entrepreneur.
The FDIC (insolvent) is backed by the Treasury (insolvent) which is backed by the Federal Reserve (insolvent). The Federal Reserve is backed by a printing press, which is backed by the savings of Americans. Not only is the concept of insuring economic risk altogether chimerical, but there's a reason why only a government-backed entity would offer insurance to banks. Inflationary (as opposed to non-inflationary) credit expansion makes banks inherently insolvent. Demand deposits are payable on demand, while banks are lent long. Thus the time structure of assets and liabilities does not match.
At the end of the day, the FDIC/Treasury/Federal Reserve (all three of which are insolvent) can guarantee depositors pull money out of their bank, but there's no guarantee of the currency's value. By guaranteeing solvency, this inherently places the currency's value at risk. Deposits are guaranteed in nominal terms, but not in real terms.
(Note: You can view every article as one long page if you sign up as an Advocate Member, or higher).
1
