Breeding pessimism: Part II

Moral hazard as the natural spawn of fractional-reserve banking

By Geoffrey Lawrence
  • Wednesday, November 18, 2009

"The bank mania... is raising up a moneyed aristocracy in our country which has already set the government at defiance, and although forced at length to yield a little on this first essay of their strength, their principles are unyielded and unyielding. These have taken deep root in the hearts of that class from which our legislators are drawn, and the sop to Cerberus from fable has become history. Their principles lay hold of the good, their pelf of the bad, and thus those whom the Constitution had placed as guards to its portals, are sophisticated or suborned from their duties."

— Thomas Jefferson

Federal policy responses to the current recession have increasingly channeled the nation's productive resources into a handful of government-protected yet inefficient firms while protecting those firms from accountability for their own actions.

Members of Congress and their corporate sponsors have acted to privatize all the gains and socialize the losses of protected firms on Wall Street and elsewhere. As a result, important decisions concerning the wealth and power of the nation are being monopolized by fewer and fewer individuals, including politically connected corporate fat cats and their accomplices in government.

Strict adherence to laissez-faire principles would stifle this growth of state corporatism and empower private individuals to control their own destiny. However, any emergence of true laissez-faire economic policies is remote, given the structure of the American banking system. For reasons discussed below, moral hazard is endemic to fractional-reserve banking under a democratic government and a fiat money system.

The business cycle that naturally results from alternating periods of government-sanctioned credit expansion and contraction produces periods of boom and bust. Fractional-reserve banking allows financial institutions to create currency out of thin air by expanding credit far beyond the amount of real wealth that actually exists.

Initially, this credit expansion can lead to accelerated economic growth. Over time, however, a significant portion of the new loans will necessarily be invested in unsound ventures — ventures lacking enough genuine demand to be truly viable. This happens because the artificially low price of money as reported by interest rates gives investors and entrepreneurs false signals as to the real prices of everything involved in making a business successful over time.

When this inefficient allocation of economic resources has distorted the structure of production sufficiently that firms begin failing to repay their loans, lenders recognize it and turn cautious, and credit begins to recede. This recession is the healing process required by the earlier, covertly destructive credit expansion behind the inflationary boom. But as the recession proceeds toward purging the malinvestment from the economy's structure of production, the cascade of defaults — especially after years and years of bad Federal Reserve policy — can be quite daunting.

It is this aspect of the deflationary recession that leads to government bailouts and the rise of state corporatism. Elected officials who feel pressure to "do something" to stop the deflationary spiral will organize a series of bailouts for firms that have purchased political favor through campaign donations or other means. This prescription has called forth a massive expansion of Federal Reserve-issued currency notes — "quantitative easing" designed explicitly to re-exert inflationary pressure on economic activity.

The danger with this response is that it only exacerbates the underlying cause of the recession: the inefficient allocation of economic resources due to artificial credit expansion. While the response may stem a recession in the very short term, it only sets the stage for a deeper and broader recession in the future. It addresses the symptoms while feeding the cancer itself. Indeed, the severity of the current recession is due in large part to the Fed's policy responses to the 2001 recession. The similar policy responses that the current recession has called forth can only give rise to extreme pessimism for the future.

Indeed, none of the fundamental problems have been solved by federal policy responses over the past year. Policymakers have simply encouraged capital consumption in order to place a glossy veneer over the underlying problems in order to buy support. Federal programs such as "Cash-for-Clunkers" and the homebuyer's tax credit have artificially accelerated consumer demand in order to create the statistical illusion that the recession has ended. Yet, these programs, in combination with artificially low interest rates set by the Federal Reserve, are only designed to persuade individuals to forego saving — accumulating capital — in favor of spending in the present. This is eating the seed corn.

So long as the American banking system is characterized by fractional-reserve transactions in a merely fiat currency, politicians will always be predisposed to government bailouts to stop the supposed threat of a deflationary spiral — even though deflation is the necessary corrective for previous inflation.

The trajectory of current economic policies points toward a prolonged slump in production. That means even more defaults and bankruptcies — meaning more bailouts and greater moral hazard — ultimately leading to hyperinflation and the wholesale destruction of American wealth.

The solution lies in ending federal bailouts and reestablishing a hard currency. There would be short-term pain, but also the solid prospect of resurgence on the horizon. The alternative is an accelerating deterioration in our way of life.

If a bit of short-term pain is necessary for long-term survival, why not start it now?

Geoffrey Lawrence is a fiscal policy analyst at the Nevada Policy Research Institute.

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