A little fear is a good thing

TED, whose beautifully written posts are always stimulating, challenges me on my last post:

I worry that those who argue for a wholesale return to unlimited liability for the owners of financial intermediaries simply have not thought out the problem of scale inherent in the current global economy.

and I’m first to admit that a wholesale return to unlimited liability in banking by congressional fiat is — shall we say — unrealistic.  But I also think some of TED’s concerns about insufficiency of capital and excessive interest rates in a system with unlimited liability are overblown.

The system of unlimited liability banking grew up in an environment with usury laws, so interest rates (on short-term debt) did not exceed 5% per annum.  Market rates often fell as low as 2%.  It’s far from clear that low interest rates for borrowers are inconsistent with unlimited liability on the part of lenders who choose to use their ability to borrow to leverage their returns (i.e. to act as partial reserve banks).

Furthermore, from a theoretic point of view, a banking system doesn’t need capital, it needs trust (aka credit).  If the institutional framework is carefully structured (that is, debts are enforceable, outright fraud is disincentivized/rare, etc.) there is no shortage of capital — capital is created out of thin air by a plethora of unsecured, but trustworthy, promises.  Effectively, capital is cheap, because the institutional structure of finance reduces the risk of losses to a minimum.

One of the most worrisome aspects of our current financial evolution is the shift to ever-increasing use of collateral, which to me is testimony to the fact that the institutional structures supporting a financial system with cheap capital are disappearing before our eyes.  Collateral adds expenses that are unnecessary when the unsecured financial system works well.  One of the first policies I would propose is a (phased-in) prohibition on the posting of collateral by our largest financial institutions.

I’d be more optimistic about the future of our financial system if certain aspects of banking were understood.

(i)  Total collapse of the financial system is possible.  I’m talking about the kind of event that will cast a shadow over the Great Depression.  I am reminded of the fact that China had a fiat money system that lasted for about 200 years before it imploded, creating a vast demand for silver that fueled the silk and spice trade of the middle ages, and arguably set off the development of European finance.

(ii)   “Safe assets” like deposits and bills of exchange were created by a merchant class subject to common law (i.e. law for the commoners) at a time when the idea of a government guarantee of a financial asset was somewhat ridiculous.  (Kings have a habit of taking property — with or without your leave — and failing to return it.)  That is, when assets were “safe,” they were safe because of a complex web of social characteristics including law, social norms, property rights, etc.  Such safety cannot be recreated by a myth of governmental infallibility — all that will be demonstrated by seeking refuge in government guarantees is the weakness of the governance structures.  To recreate an environment with relatively “safe” assets will require reworking of the institutional structure of the financial system, so that it can provide these assets on its own with little reliance on government.

(iii)  It would be helpful if the members of our financial elite could take a long enough break from their rent extraction activities to take a look at the path we’re on — and whether they’re sure the world they’re leaving to their children is the one they want to leave behind.  And, maybe, throw their weight behind some wholesale reform themselves.  (Pace, TED, I don’t mean you, because you do worry and you are speaking up.  You give me hope.)

With a little fear of total financial collapse, maybe we can manage to change the the system enough to keep it running for another few decades.