Sheila Bair was chairman of the FDIC
from June 2006 to July 2011. Her
memoirs, Bull by the Horn: Fighting to Save Main Street from
Wall Street and Wall Street from Itself,
is a fascinating and sometimes frustrating glimpse into the mind of a career
bureaucrat. She recounts myriad meetings
and battles with fellow regulators, of which there are way too many, American
bankers and foreign central bankers.
Needless to say, Ms. Bair portrays herself as the blameless, honest
bureaucrat who foresaw the coming crisis and fought, as the title implies, to
save both Main Street and Wall Street.
People write memoirs mostly out of
hubris. Do we really care what Ms. Bair
thought as she entered rooms full of powerful people? Ms. Bair certainly thinks we do. The tenor of the book has a touchy-feely tone
to it that may interest some, but I found it to be distracting and rather
annoying. But this is a minor quibble
compared to my main complaint about the book, which is that it tells me
something frightening about people who have way too much power over us. And that something is that they have no
insight into the nature of the system in which they operate and, therefore,
they cannot accomplish their mission of making banking safe and affordable for
all. Let me elaborate.
The Hubris of the Bank Regulator
Ms. Bair does indeed understand certain
fundamentals about our banking system, but she understands nothing about the monetary system upon whose foundation it
rests. She gives the lay reader a very
nice explanation of fractional reserve banking.
She explains that a bank deposit is really a loan to the banker and that
the banker does not keep anywhere near sufficient reserves to honor demands for
repayment from all but a small fraction of his depositors. That is the purported purpose of the Federal
Reserve Bank; i.e., to lend to the banker when his depositors withdraw their
funds in such amounts that the banker's liquid funds are depleted. The banker has borrowed short and lent
long. This Ms. Bair fully understands
and she supports the Fed's role as lender of last resort.
She also understands that the agency
that she led, the Federal Deposit
Insurance Corporation, causes
moral hazard. (To my delight she
actually used and explained the term!) Ms.
Bair explains that, because bankers know that the FDIC will pay off their
depositors in the event of excessive losses, bankers engage in more risky
lending. Riskier lending gives the
bankers bigger profits, IF the loans are repaid. If not, bankers can tap the FDIC. This arrangement, whereby the banker gets all
the profit from successful ventures but does not suffer all the loss if
unsuccessful, creates classic moral hazard, whereby the risky venture is
encouraged rather than discouraged. But
Ms. Bair feels that, although moral hazard is a problem, it is manageable. She believes that regulators like herself can
ensure that bankers do not engage in risky lending. And this, my friends, is the heart of her
hubris--that she is capable of preventing the very moral hazard that her agency
helps make possible.
A lay person reading Ms. Bair's book
would get the following impression of our banking system. Left to their own devices--that is, when lightly
regulated--bankers will pillage the economy for their own benefit. Their depositors will not care, because the
FDIC guarantees almost all deposits. To
prevent reckless lending, bankers must adhere to very strict rules of what
kinds of products they can offer, the extent to which these products are
booked, the prices they charge for their products, the disclosures that must accompany
their offerings, etc. In other words,
bankers are portrayed as modern Genghis Khans that must be reined in by the
likes of Sheila Bair not only to protect the public but to protect the bankers
from themselves. The entire book is
based upon this chain of logic. But
nowhere does Ms. Bair explain how bankers are legally able to pillage an
economy and why they do not go to jail for doing so. As I will explain in more detail below, it is
the failure of the state's legal system to protect private property combined
with monetary intervention by the state chartered central bank that is at the
heart of the problem. Again, Ms. Bair
sees the symptom but does not understand the nature of the banking business in
our modern fiat money monetary system.
The Incremental Steps that Feed the Moral Hazard
Monster
Although Ms. Bair states that she recognizes
that deposit insurance carries with it a moral hazard component, she does not
mention the number one reason that turned what she considers to be manageable
moral hazard into a moral hazard monster--monetary expansion engineered by the
Federal Reserve. But monetary expansion
by the Fed is just the final link in the incremental chain of government
failures and interventions that have led to greater and greater misallocation
of resources through moral hazard. It all
started with fractional reserve banking.
The oldest banking crises are linked to
the banker's issuance of uncovered money certificates. Here the banker violates his contract to
redeem ALL demand deposits for the monetary metal, gold or silver. Instead, he lends out a greater and greater
percentage of his demand deposits, retaining a smaller and smaller fraction of
the monetary metal to honor daily withdrawal demands. The subsequent economic booms and busts can
be ascribed directly to the state's failure to prosecute fractional reserve
banking as a crime, with the banker's personal assets at risk as compensation
to his creditors for contract violation in addition to personal imprisonment
for the crime of committing fraud. However,
the booms and busts experienced through the centuries were relatively mild and
self-correcting by modern terms. The
banker who engaged in excessive fractional reserve lending was brought to heel
by his fellow bankers through the mechanism of the clearinghouse, in which the banker
had to honor checks drawn upon his bank for which he had insufficient liquid
funds, and ultimately by his customers who "ran to the bank" and
demanded specie redemption.
In an attempt to square the circle and
retain the lucrative practice of fractional reserve banking without suffering
bankruptcy through demands for specie redemption, the central bank was born as
lender of last resort. Initially that
function of the central banker was to be rare and short lived. The great English intellectual Walter Bagehot
advised the Bank of England to, "Lend freely at a high rate on good
collateral." The borrowing bank
would survive, but it would learn its lesson.
Furthermore, in the era during which precious metals were the ultimate
medium of exchange, the central bank itself had to take care that it did not
run out of specie. Therefore, it did
lend cautiously, at high rates, and on good collateral. The crown helped out by granting the central
bank the sole authority of note issuance, thereby increasing demand for its
notes. If the crisis persisted, the
crown would allow the central bank to suspend specie redemption until it became
more liquid.
The next step along the road to greater
and greater malinvestment via moral hazard was the practice of the central bank
to engage in interest rate manipulation via open market operations to lower the
market rate of interest. It buys assets
to pump more reserves into the banking system.
This added more thrust to the moral hazard induced boom, which led to
even greater busts. Finally, as the
banks suffered devastating runs upon specie, the state first suspended specie
redemption and then ultimately instituted deposit insurance. This is the point at which Ms. Bair picks up
her narrative. True to her bureaucratic
background and a good example of Public Choice theory, Ms. Bair insists that
deposit insurance is absolutely necessary to prevent bank runs. Because the common man is not capable of
judging the safety and soundness of his bank, at the first whiff of a problem,
he will withdraw his funds and bring the bank to its knees. Deposit insurance allays this concern for the
depositor. But Ms. Bair fails to
understand that deposit insurance is just one more intervention designed to
cure a problem caused by previous interventions. This phenomenon was well understood by Ludwig
von Mises.
The Moral Hazard Monster Is Unleashed
So, we have arrived at the great day in
which the depositor need not take care that his bank is solvent, government
turns a blind eye to the fraud of fractional reserve banking, and the central
bank can pump unlimited amounts of fiat money reserves into the banking system
upon which can be pyramided greater and greater credit booms. Needless to say, all this is lost on Ms.
Bair. She touches only upon the symptoms
of the real problem. The behavior that
she describes with disgust--the bailouts of Wall Street and the neglect of Main
Street, the robo-signing scandals, etc.--are the inevitable result of an ever
increasing attempt to perpetuate a boom that was never supported by the
underlying savings of the economy. Moral
hazard became a monster--there was money to be made and no power on earth was
going to stop the boom once initiated.
The economy was said to be in a new paradigm, a new era of permanent
prosperity in which everyone could own the home of their dreams. In this Never Never Land mindset it was not unusual
to grant a loan to someone who did not have the income to support the purchase
of his McMansion, because the home could ALWAYS be sold for more than the
purchase price. The bank would be made
whole and the borrower most likely would walk away with money in his pocket.
Ms. Bair does recognize that her
institution--the FDIC--is exposed to losses beyond its resources should the
boom turn to bust. Her answer is to make
the banks pay for their own future losses via higher capital requirements, a
battle that she fought her entire tenure at the FDIC. Ms. Bair's campaign for higher capital
standards will slow down the boom, for no matter what the level of excess
reserves (currently a whopping $1.5 trillion!), the banks cannot increase loans
outstanding if they are under-capitalized.
(Loans
are funded by money created out of thin air; i.e., when the bank books a loan,
it credits the borrower's checking account.
This inflates the bank's balance sheet and, concomitantly, reduces its
capital ratio.)
But, the inflationist pressures in favor
of more lending will not be held back very long. The Fed itself can simply lend long term to
the banks and allow them to count these loans as capital. The Fed has not been deterred by the legality
of its actions so far--lending massive amounts to European banks, for
example--so don't think it might not happen.
Conclusion: the Moral Hazard Monster Devours Capital
Nevertheless, the laws of economics always
prevail. The progressive political
systems of the world and their number one tool for expanding state power and
realizing heaven on earth, the central banks, have created a moral hazard
monster, not a slightly misbehaving pet.
The monster started as comparatively mild and self-correcting boom/bust
cycles caused by fractional reserve banking.
He grew from a child to a juvenile delinquent by feeding on central bank
lender of last resort money, first at penalty rates then at below market rates. Now he is an angry, steroid packed adult Godzilla
gorging himself on unlimited fiat money reserves created by oh so willing
central bankers. There is nothing that
can stop him...not higher capital requirements for banks and especially not Ms.
Bair's favorite cure--tougher regulation.
The Fed's Quantitative Easing Forever policy will lead to a worse
recession than the one that began in 2007.
Malinvestment is being piled on top of previous malinvestment. If fiat money credit expansion caused the
2007 Great Recession, then the Fed's program of Quantitative Easing Forever
cannot be the cure. On the contrary, it
is breeding even greater malinvestment.
The world needs real reform: an end to fractional reserve banking
(prosecuted as a financial crime), the liquidation of both central banks and deposit
insurance, and the end to legal tender laws.
The moral hazard monster must be destroyed or all society is at risk.
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