The high rates of the 1920-1921 depression had certainly been painful, but they had cleaned the rot out of the structure of production very thoroughly. There is a perfectly good theoretical explanation for why the record-high rates in the early 1920s were the right policy, while the record-low rates in the early 1930s were the wrong policy. FULL ARTICLE
Source link: http://archive.mises.org/9384/banks-should-raise-prices-in-a-recession/
Banks Should Raise Prices in a Recession
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Nice. A++.
Another illustration from intermediate microeconomics is capital budgeting. A firm has five potential projects, at descending rates or IRR, to choose from. It also has, say, 3 sources of capital, at ascending rates of cost of capital. Which projects should the firm accept? The firm should pick the highest IRR project and fund it with the lowest cost capital, and so on until IRR less cost of capital turns negative. So, by increasing the interest cost of debt, banks would weed out the marginal and weaker projects. But but artificially lowering the cost of capital (interest rate), the Fed is stimulating the development of the weakest and most marginal projects of them all. When rates recover to normal levels, these same projects will be the first to become unsustainable. So government intervention is setting up a lot of projects for eventual failure.
The Fed today (or since 1931) is: (a) a $800 billion gorilla such as could never exist in a competitive environment; and (b) not a “selfish” actor in the manner of a true market participant. Instead, it is a politically motivated actor attempting to advance or protect the interests of a small group of powerful investors with good political connections.
Upshot – the REST of us (without political connections) are screwed. Government protects the governing class, always. At the expense of the governed. We’re going to be paying for this one for a LONG time.
Very good article.
The price of the bank’s services is its interest margin, i.e. the margin between its borrowing rate and its lending rate. This rate or price also incorporates a price for the risk of the bank’s loans, and it is this risk premium that increases. During a panic investors seek safety, and lending money to a strong bank is a safer investment than lending it to an industrial borrower. Thus the bank’s borrowing rate, and the risk free interest rate, may not in fact rise but fall, while the margin the bank makes (ex ante) increases (ex post it may fall due to an increase in bad loans).
Under frb and a gold standard, when demand for holding metallic reserves is high, the opportunity cost of holding them well be also, i.e. the risk free interest rate will be higher to allocate the stock of metallic reserves to those who are seeking safety at the expense of making any explicit interest return at all. Reserve ratios should fall during this situation, other things being equal (see White’s bank profit optimisation model).
So, putting these two elements together, we might expect both the risk free interest rate, and the bank’s borrowing cost to increase, and its lending price to increase even more. The result is to make investment of capital into new buildings etc. less viable, and to cause a period of deflation.
Robert Murphy, sir, I have been following your articles for a while and have great respect for you. But in this article you have made a fundamental error. It is true that today the Federal Reserve Bank prints money. We all know that. You can say that this bank is the ‘seller’ of money. I am using the term ‘seller’ loosely here of course. I agree.
However, the role of banks in the Austrian sense is to safe guard other people’s money and invest other people’s money. They are not in the business of selling money. They are in the business of selling a service with money.
If vine is being sold the seller is the vine dealer, if gold is money, the seller is the gold Smith. If the vine dealer dilutes his vintage and sells it for less. Will people buy it? The answer is some would it depends on their subjective value.
If a gold smith sells adulterated coins will the other merchants buy it if he sells it cheap and makes no secret about the nature of its (im)purity. The answer is of course but it will not circulate for the same value as as a pure gold coin of the same weight. Yet that is not fractional banking.
Now you spoke about spreading the reserves thinner. Here is how it can be achieved without theft.
Suppose 1 dollar is 1oz gold and I make a deposit to the bank as saving. Another depositor deposits 1oz silver worth 50 cents.
Say there are two entrepreneurs who want to borrow it. The bank is offering $1.50 and they want only 75 cents each. The bank has a problem in spreading the reserves now.
They do not have two 75 cent coins to lend. They have a 50 cent and a 100 cent coin. To spread the credit they need to clip 25 cents worth of metal from the 100 cent coin. Now they have two 75 cents to loan out. Or they can break both the coins in half and give each entrepreneur two half pieces. So why would they do that? They can get more interest by lending 75 cents to two borrowers than 1.50 to one. So the unit price of credit is higher now.
My point – the co-relation between stretching the reserves thinner and fractional reserve banking is false.
What I am saying, though, is that if we decide banks ought to be able to engage in fractional-reserve lending — so that the total supply of credit can be expanded if the banks want to stretch their reserves thinner — then we still agree that the unit price of that expanded credit issue ought to be higher. – Robert Murphy
A very good article Dr Murphy.
However, it is a good rule of thumb never to praise Herbert Hoover in an article.
Your line of praise near the end of this article could be taken out of context and used to discredit the other things you are saying. And could be used as part of the long term effort by the left to make people think “free market people = Herbert Hoover supporters = Great Depression”.
===”However, the role of banks in the Austrian sense is to safe guard other people’s money and invest other people’s money. They are not in the business of selling money. They are in the business of selling a service with money.”===
I didn’t say that, or at least, I didn’t mean to. I tried to be very specific that the banks *rent* cash reserves, and sell liquidity. They do.
Renting cash, that is loaning money out. But what exactly are you referring to when you say sell liquidity? Would it not be more appropriate to say banks facilitate liquidity? Even so is it not just a consequence of their primary function which is keeping money safe and loaning it out? Are not speculators the people who are primarily the seller of liquidity? Assuming ideal conditions of course, not the way things are running today.
Abhilash Nambiar,
Liquidity is the ability to access cash by selling assets or borrowing funds (or issuing shares). Banks provide liquidity to their customers both through borrowing money (bank liabilities payable on demand are able to be used as or converted to cash) and through lending money (providing credit, typically on the security of the borrower’s assets).
Robert Murphy is referring to central banks providing liquidity by providing credit to other financial institutions, on the security of their financial assets.
I am a great admirer of Professor Murphy’s work, but I disagree with this article. Perhaps I didn’t properly understand his argument.
“when a panic hits and most people realize that they haven’t been saving enough — that they wish they were holding more liquid funds right this moment than their earlier plans had provided them — what should the sellers of liquid funds do? The answer is obvious: they should raise their prices.”
Professor Murphy seems to be suggesting that there will be an increase in the demand for loanable funds when the panic hits, leading to an increase in the interest rate.
I think Professor Murphy is neglecting the supply side of the loanable funds market. On the free market, interest rates are high when people aren’t “saving enough” because savings constitutes the supply of loanable funds. Thus, interest rates will be high when savings are in short supply.
In contrast to Professor Murphy, I believe that “most people” will start saving when they “realize that they haven’t been saving enough”. This should lead to a fall in the interest rate.
David Hillary,
I understand that banks do provide liquidity through the process of borrowing and lending. Which is basically what renting cash refers to. So when you ‘rent’ cash are you ‘selling’ liquidity? Yes, I see it now. But seems to me that renting cash and selling liquidity are not two different functions. They are different ways of looking at the same function.
I have reexamined the article and I realize that my initial criticism was incorrect. I simply misunderstood Professor Murphy’s argument (I think). Either way, I still believe professor Murphy is incorrect.
Professor Murphy isn’t suggesting that there is a change in the supply or demand for loanable funds (as I originally believed). He is arguing that there is a change in the composition of the supply/demand for loanable funds, towards more cash. I believe Professor Murphy is saying this will cause the interest rate to rise.
However, this new demand for cash does not drive up interest rates. The increased demand for cash will lead to an increase in the purchasing power of money.
See Rothbard: “the scramble for greater cash balances begins. People will spend less and save more to add to their cash holdings. In the aggregate, M, or the total supply of cash balances, is fixed and cannot increase. But the fall in prices resulting from the decreased spending will alleviate the shortage” (Mystery of Banking, pg. 39).
Professor Murphy’s argument (as I have presented it) sounds like Keynes’s Liquidity Preference Theory of Interest. But … he couldn’t possibly being siding with Keynes.
I’d like to hear Stefan Karlsson / Dick Fox’s take on the issue?
Did the other Feds do the same thing ?
What about all the banks who were not under the juridiction of the Feds ?
Econ Man, I think we can agree that this particular article is a bit muddled up.
I don’t see a rush right now from people to get money from the banks when those people are spending less and saving more than before by putting more money in the banks and by paying their debts.
For the banks, they are afraid to make loans. They better like to keep the money then loan it. They are even in excess of reserve cash in their account at the central bank ! They are not at all “taking advantage of the unprecedented demand”, as for the trucking company in the example. Even if they wanted to raise their prices of money, they are pushed by the central bank to keep it down. And too, the banks make money by the difference between the price they pay for the money and the price they rent it, not with the price of the money they rent it in itself, wich means that they don’t have to necessarily raise their lending rates to make more money.
In a word, the situation of the commercial banks right now is not at all the same as the situation of the trucking company of the example. This example is misleading, at least in my point of view.
All I get from this article is: “If central banks raise & lower interest rates in accordance with the ABCT, then central banks are legitimate.”
I’m sorry to keep posting criticisms of Professor Murphy’s recent article. He is a great economist and thinker. But this article doesn’t sit right with me, and I agree with Abhilash Nambiar that “this particular article is a bit muddled up”.
I think the following Hazlitt quote is relevant.
“If Keynes’s theory were right, then short-term interest rates would be highest precisely at the bottom of a depression, because they would have to be especially high then to overcome the individual’s reluctance to part with cash—to “reward” him for “parting with liquidity.” But it is precisely in a depression, when everything is dragging bottom, that short-term interest rates are lowest. And if Keynes’s liquidity-preference were right, short-term interest rates would be lowest in a recovery and at the peak of a boom, because confidence would be highest then, everybody would be wishing to invest in “things” rather than in money, and liquidity or cash preference would be so low that only a very small “reward” would be necessary to overcome it. But it is precisely in a recovery and at the peak of a boom that short-term interest rates are highest” (The Failure of the New Economics, pg. 192).
If Professor Murphy’s argument is correct, why shouldn’t the liquidity frenzy continue and intensify as the panic turns to depression? Why is the liquidity frenzy only confined to the panic? Why wouldn’t banks continuing raising their prices until the bottom of the depression?
I simply can’t make any sense of this article.
Econ Man, it seems to me that in economics one can get muddled up pretty easily if one seriously considers fractional reserve banking. It is fundamentally as wrong as a square circle or dry water. The difficulty is in figuring out at what point in the said person’s chain of reasoning did he make a mistake. Especially if all of it has not been put into writing.
There is this video by Larry White in the misesmedia YouTube channel.
http://www.youtube.com/watch?v=lspRNed3VhQ
He was defending fractional reserve in the name of freedom of contract. It sounded wrong to me but I couldn’t put a finger on it beyond the point that people would not prefer it. Hans Herman Hoppe figured it out (he is good at clearing muddles, even took care of Karl Marx beautifully). He pointed out that freedom of contract implies that you are the owner of the asset you are contracting, or acting on behalf of that owner with his consent. In the case of fractional reserve banking, neither is true.
Yes Abhilash, precisely!
fractional banking is breach of contract.
Also, the depositor is told his funds are very low risk when in fact the bank is using the same funds in a higher risk situation and pocketing the difference in interest due to risk. The FDIC, rather than protecting the depositors investment, is facilitating this interest fraud. Without this FDIC insurance [which in reality doesn't fully exist anywhere] the depositor would demand the full interest relative to his risk or take his funds elsewhere.
A panic is often just the three parties trying to sort out the chasm between the “low” risk and the actual loss of value due to high risk.
100% reserves is nothing but a performed contract.
Before saying that fractional banking is a breach of contract, we have to know what the contract says.
If the contract says that the banker have to give us back the amount we deposit on demand when we demand it, and the banker give us this amount of money when we make the demand for it, then there is no breach of contract. If he doesn’t, then it is a breach of contract and we can sue him.
If the contract says that the banker must keep our money and must not lend it to anybody and not use it in any other way, and that he have to give it us back when we ask him to give it us back, and he does not conform to any one whatsoever of those clauses, then it is a breach of contract.
So what the contract with your banker does say ?
Gerry: the last one I read [8 pages] stated neither. We are not given the choice.
We should be given the choice to “store” our funds or to invest them, in which case the banker would be forced to compete with all other forms of investment and would probably be limited to a “fee” rather than obtaining the interest that by the normal course of market principles and forces, belongs to the risk taker.
The government enables this fradulent advantage with Fdic insurance coverage, otherwise it would be as risky as the investment actually is. This is obviously market intervention and also not really insurance as you know the funds are not there to actually back our deposits.
So, to sum up, we have our money put at higher risk than disclosed, being used by bankers without investment of their own, to earn profit by confiscating interest that is rightfully the depositors, enabled by the government’s insurance which not only doesn’t actually exist but if put into place is none other than the taxpayer’s [depositors] money. And if there ever was a “demand” or panic as it is called, we would recieve the numerical monetary value but devaluation would put the real value at who knows where.
Yes, I think there are obviously some issues with the banking system!
To gene:
1- My question was for everybody and not especially for you exclusively. That’s why I din’t put your name at all in my intervention.
2- Are you sure that your 8 pages contract is for a checking account (deposit on demand) and not for a term deposit ? Because I was on the impression that there was no contract for a checking account. At least, I don’t remember to have sign such a contract when I open my checking account, but it was a long time ago.
3- To store our funds, banks have safety-boxes, but we have to pay a fee. We can also store it at home in a safe. So, for this purpose, we have a choice.
4- A bank who borrow money from me and then lend it to somebody else, is like a friend who borrow money from me and then lend it to somebody else. The only obligation they have, in relation to me, is to give me back the same amount when the time has come. If my friend burn the money instead of using it to lend or to buy something, it is not my business. He can do what he wants with it, but he must give me back the same amount at the term. For the banks, they have laws and rules to follow in using that money, but, in relation to me, they must give me back the amount that I lent to them when the term has come … plus my interests!
I am going to read the above comments, but write before I forget what I wanted to post. It appears professor Murphy has a lot on the ball here, but also misses the point about financial bubbles. There would have been no booming 30′s, maybe a return to normalcy, but no boom. The 1920′s were as much a credit bubble as the 1965 to 2008 period was. Dollars don’t have babies and though people know this, they are taught in a way that it is impossible, regardless of other education to think around compound interest with no mathematical formula equation. The Great Depression was a Great depression because the Federal Reserve presented Wall Street with a system that allowed them to carry on a drunken orgy for a few years longer than before with debt piled up from the War. The end result was the bankruptcy of the debtor and the creditor with the general public holding the bag. The current bubble went on so long because LBJ got rid of silver then the US broke Bretton Woods and got rid of gold, then they screwed around with what bank capital there was then let the crap shooters back into the vaults to play with other peoples money in all kinds of derivative and financing games. The 1960′s used to work as Von Mises boom and bust cycle, then they figured out how to do away with the busts while sustaining the orgy. Normalcy isn’t anything like we have seen in years and the yearning is going to be to get back to the unlimited stream of borrowed money to keep the game going, for the debtor and creditor again. Strange as it may seem, debt and savings are the same thing in this game.
At least in a fractional reserve sense, banks don’t lend money, but act as surety in extending credit. Robert Murphy is most likely correct in that what causes times like these is too much credit floating around to start and the way to fix the system isn’t to give the drunk more scotch to drink, but at the same time keep the bar open for those that really could use some. No one ever went broke paying an extra couple of percent interest over the short run for liquidity, but plenty went broke over bad business decisions. The older business of banking had more to do with paying trade accounts and floating inventory on a seasonal basis than ambitious long term investments, which were generally financed out of savings in general. To say that the risk of financing inventories isn’t higher in a downturn would be extremely naive. The Fed today should operate in that fashion, especially when the system is saying we need a slowdown to make up for the misallocation of resources. The current system attempts to fix a housing problem of surplus by creating some kind of magical finance to do away with the excess by creating more excess by making it cheaper to create more excess. I am not sure the mistake wasn’t made over and over again in the late 1990′s into 2003 and now to no avail. No one is going to pay you interest to borrow their money and the Fed and government walk on shaky ground to purely print money. A dead horse will never run another race and it appears 64% is the rough top of legitimate home ownership, not supported by financial insanity. The market sets the rates in the end and all artificial means will be defeated. Which is probably why gold has done well in what clearly is an asset deflationary period.
Hi Gerry, yes it was checking, “deposit account agreement and disclosure”. i have read a few and none mention the actual actions the banks take with the fund.
the point i was trying to make is that the only advantage the banks have is the FDIC insurance which is taxpayer funds.
this enables them to extract interest from what is our money and our investment, otherwise we would just go some where else for more return.
If you lent your friend your money and whoever he lent it to lost it, and there was no insurance, what then? banks do not have the funds to repay, only the government does.
Why doesn’t the government insure all investments?, there is no difference in the logic. the investments are the same, some riskier than others but as you can see from current events, banks take risky investments.
storage would probably as you mentioned, come with a fee. but it would be our decision not the banks, what we do with our money. it is deceptive and a socialization of risk for the benefit of the banking corporations.
Gerry and Gene,
I think you both have a fundamental misunderstanding of difference between loan and bailment contracts. This could be solved by reading “Money, Bank Credit, and Economic Cycles”:
“each of the parties to the monetary bank-deposit contract thinks it is entering into a “different†contract. In other words, depositors hand over money as if making a deposit, and bankers receive it as if it were a loan. Yet, what kind of contract has two essentially distinct legal causes? Or to put it another way: How is it possible that both parties to the same contract simultaneously intend to retain the availability of the same sum?” (pg. 136)
The contract does not exist because the purpose is impossible. Therefore, the contract is null.
re: econ guy
In what context from which the Hazlitt quote was taken? Why is it that short term interest rates are lowest in a recovery and at the peak of a boom? Or is Hazlitt merely pointing to empirical studies?
To Econ Guy.
1- Contract between parties are ruled by the law. We could say that in every contract, every law is implicitly included. Example: if the law say that tenants cannot have cats in their apartments, it is not necessary for the landlord to put a clause in the lease saying that cats are not accepted. It is automatically and implicitly included.
2- If there is a different interpretation of a contract between the parties, this could be solved by going in court to have a legal decision, and the court is oblige to follow the law in making its decision. In addition to the law, there is too the question of jurisprudence.
If the law and the jurisprudence say that banks can do what they want with the money in a deposit account on demand, or that they can treat this money as if it was a loan, then they may do it or not to do it, as they please. It is not even necessary that they put it in a contract.
3- So, the question now is: what the law and the jurisprudence say about what the bank can do and can not do with the money in a deposit account on demand ?
Econ Guy: the quote makes perfect sense. both parties can’t retain availability of the same funds. it is deception on the banking side, backed by the FDIC.
it is traditional in law to settle on the side of the party with the “least knowledge”. The banker, who deals in money every minute, must inform the depositor of the nature of the transaction.
i believe we should be aware and demand “truth in depositing” but it makes sense that the general public can not be “expert” in financial affairs.
All I am saying is that because it is indeed a loan, it should be treated as such and compensated at a market rate, which is impossible with federal insurance. the risk should be as such, and depositors should be able to decide where there money should be and what they want to do with it. as it is now they are channeled into banks, which are nothing but intermediaries or brokers for investment. as brokers they should be subject to the same competition other brokers are.
when the decision is between true storage [rather than loaning to a bank, who invests] and investment, depositors can then use market factors and there own personal choices to determine where there money should be.
treasury securities have the same insurance as FDIC [taxpayers], if the depositor wants a safe, timed investment with some return, there it is.
reserves are a farce, how can you reserve a portion of someone else’s funds, that you promised the entirety on hand at all times? it is an abuse of private property.
if we are working toward a truly free economy, the basic institutions must follow the same rules we all have to follow, and as it stands, they don’t.
Excellent point gerry!
Money creation seems to be above the law. When the Fed increases the money supply, they confiscate value from your wallet. they can impoverish those retired workers who spent fifty years in the work force. there are no laws against this.
Banks are doing the exact same thing. the same money cannot exist twice. it is the right of the owner of funds to decide the direction of the funds, not some powerful outside force. this is free market thinking. what we have is corporate socialism. creation of money for the benefit of the creators.
money creation belittles those who truly create wealth.
Someone has to say this…
Leading up to the depression, the US tax rate was lowered. The depression happened when taxes were at the lowest (highest bracket was 24%)
The recession in 1992 broke after Clinton raised taxes.
It’s possible that profits are taken when taxes are low, and profits are reinvested when taxes are high.
There’s a tax slant you never hear! makes sense. points to consistent taxing, rather than always changing due to lobbying, etc. I am in favor of the land fee myself, really the only “fair” tax.
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