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Austrians and Banking Regulations

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Jargon Posted: Tue, Apr 2 2013 5:41 AM


Austrians and Banking Regulations
Steve Keen presents an interesting case in this interview and I believe that it's correctness would have far-reaching implications. The argument is approximately this: in a situation where there is a central bank which offers a discount rate, money creation is private. Banks do not have to hold reserves in order to lend. They can offer a loan to whoever wants one, and then right afterwards call up the central bank for a loan to cover the liquidity costs which arose by giving that first loan. Under a system of free banking, where note issue is private and pluralized, banks would have to lend off of their reserves. If they over-expanded, their notes would be called upon in clearing houses and traded at discounts, both of which would penalize monetary expansion and force the bank back down to a regular level of currency production - one which was in concordance with demand for money. Even in a system of monopolized currency production - like in post-Civil War Era, where the amount of notes banks could offer hinged on the amount of Gold or Greenbacks they held - the money supply could not be increased by private banks. The decision to increase the money supply would come from the treasury, when they decided to either mint coins or sell greenbacks. Our system of fiat central banking today, however, is different. The discount window system opens up a way of money creation which is totally dependent on the actions of private bankers, not central bankers. It has long been the operational function of the Federal Reserve bank to cover the liquidity costs of the big banks. When there is a discount window, banks will not have to rely on reserves. They can give a loan to a loan-purchaser first, and then call upon the Central Bank for a loan to cover the previous loan as reserves. Of course Open Market Operations are an example of the central bank unilaterally expanding the money supply, and the rate of money supply expansion will be heavily effected by whatever rate the Central Bank is offering at the time. But since the operational function of the Fed has been to cover the banks's liquidity costs since the discount window has been in use, the causes of the pegging of that interest rate will come from the pressure of private bankers, not merely arbitrary decisions of the central bankers trying to stabilize the price level or something. Following this, it seems that private banks are capable of unilaterally expanding the money supply (and at acceleration, should the Central Bankers comply, as they often do) and initiating a Misesian-Hayekian boom-bust cycle.
Following this, then, if we are doomed to have a central bank with a discount window, would not an imposition of a narrower scope of banking be a positive thing for macroeconomic stability? An imposition of a narrower scope of banking meaning: limitations on asset rehypothecation, limits on credit instruments, swaps, things of that nature, or a higher reserve ratio? Do you see flaws in Keen's thinking here?
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Rehypothecation strikes me as something that should be illegal. What right have they to use someone elses collateral to abck up their own loans?

As for Keen's thinking, he makes it sound like Bernanke did not declare his intention of using unlimited QE to keep inflation at 2% minimum, and whatever else he feels like doing. That's all from the Fed, not from private bankers.

To the extent that what he says is right, and I've heard it before, that the Fed will follow the lead of the banks, giving them newly printed money if their reserves fall below requirements, if you want "macroeconomic stability", how about not doing that? It is a source of inflation right there, both from the printing of new digital cash to cover the banks' reserve requirements, and the fractional reserve banking it covers for, meaning the loans of money they do not actually have. No matter what limitations you impose on the money after it's created, you can be sure of one thing, that it will be spent, or more accurately, used to act as a reserve for 10 times the amount in loans, which will be spent. That's the whole point of it. And newly created money or money lent that doesn't exist, aka credit expansion, is inflationary, so long at it is spent anywhere and anyhow, even if not on swaps or what have you.

Now it may well be that he wants to ban are risky ventures, nothing more than gambling with other peoples money [which is the money usually gambled].

These gambles are made because of moral hazard, meaning the banks know they will be bailed out if they lose. If you want to make sure they do not take irresponsible risks, one way is to make good and sure you do not bail them out, placing at least some of the risk on them, a la Lehman Bros, or you can impose limitations on what they do with their money, as Keen suggests.

So let's restate the question as follows:  If a govt doesn't care at all about inflation, and also intends, by imposing the loss on the general public, to bail out banks who risk the depositors' money irresponsibly, and the banks know this full well, and said govt doesn't care about the fact that all limitations imposed by a govt on banks are used by the bankers to get rid of competition, usually because they decide what the limitations are to be, might it be a good idea to impose those limitations anyway, given that the govt has no intention of getting to the root of the problem, and so the limitations will not solve, but just reduce a little bit, the potentials for abuse by the banks? 

Sadly, the answer might be yes. 

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