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Strategies & Market Trends : The Epic American Credit and Bond Bubble Laboratory -- Ignore unavailable to you. Want to Upgrade?

To: gpowell who wrote (54047)	2/17/2006 7:18:33 AM
From: basho	Read Replies (2) \| Respond to of 110194

Fractional reserve systems are not inherently unstable. Given rising marginal cost of keeping currency in circulation, legally unrestricted currency issuers will not issue without limit, nor earn unlimited profits. The real economic issue here is not the stability of the banking system, but whether fractional reserve banking leads to economic instability through distorting interest rates away from their natural rate. From my perceptive, that instability is the very reason why fractional reserve banking would persist in a free market, as it allows for a more efficient market for risk. BTW, I don't think Austrians are united on their FRB views. Entirely agree that Austrians are divided on fractional reserve banking. That’s why I added the adjective “strict”. I wouldn’t say fractional reserve systems are inherently unstable if by that one means inherently prone to serious systemic breakdown. I do think, however, that the greater the duration mismatch between assets and liabilities, and of course the more extended the leverage, the greater the danger of periodic liquidity crises. Still, absent moral hazard there are as you say fairly strict limitations on how far banks can go in building their books and problems will generally be bank specific rather than systemic. As for distorting the interest rate structure, I’m inclined to think that fractional reserve banking will tend to do so if only because under such a system animal spirits and their associated volatility are more likely to be fully unleashed. Not sure I understand your last sentence. (Savings deposits?) I don’t think Mises is correct on this one. Bank runs were an endemic feature of US Banking and that has its seeds entirely in banking regulations. It’s a long time since I read that piece (I saved the reference years ago) and I may be misrepresenting Mises. Equally, I don’t pretend to any expertise on US banking law either then or now. Nevertheless, as touched on above, it seems axiomatic to me that if banks based most of their longer term lending on time deposits and depositors were made aware they would be held to those terms, bank runs would be greatly reduced or eliminated. I wasn’t clear on what I meant by reserves. I extract currency held in the public hands from the monetary base to arrive at a reserve figure. This in essence treats “reserves” as if they were a commodity reserve (being made up of both vault cash and deposits at the Federal Reserve) and currency in the public hands as if they were a claim on those reserves. By doing this we can see that much of the increase in the monetary base is due to an increase in the demand for currency, which I take as being consistent with changing expectations for low rates of inflation and increased use of the dollar in foreign markets. That much of the demand is from abroad also serves to increase the elasticity of demand, which, in turn, serves to discipline the Fed. Thanks. I think I now understand what you’re saying but confess to being a bit unsure about this approach. In no particular order, I’ll just list some concerns/questions: 1) Isn’t a large part of the reason why reserves have remained relatively stable in the last few decades because reserve requirements have been reduced, regularly adjusted and at times effectively abolished? Seems to me that to use the term “reserves” when we are talking about $42.5 billion stacked up against M1/M2/M3 of $1,380 billion, $6,740 billion and $10,250 billion respectively is to be in danger of rendering it meaningless. It has, as best I can judge, gradually become more a figleaf than a serious constraint on credit expansion. 2) No question that almost all of the growth in Fed liabilities has been in currency.in circulation. Nor, I’m sure, that much of it is offshore. Still, the issuance of these FRNs has monetised some $550 billion of government debt since 1986 so it is not without effect in a broader monetary sense. 3) Not sure I see why the Fed is disciplined because much of the currency demand is from abroad. In some ways, it seems to me this parallel circulation outside the US would tend to dampen any inflationary effect of the issuance. Much as has, in my view, the indirect monetisation carried out by Japan, China et al in recent years. If you like, from the Fed's point of view these factors have allowed the most serious expansionary activity to occur at least partly “off balance sheet”. All in the best traditions of contemporary finance. Anyway, apologies for going on at such length. It’s easy to become altogether too caught up in (as Frank Shostak puts it) the mystery of the money supply. Bit of a Russian doll game in many ways.