Failing to Understand the Moral Hazard Monster

Sheila Bair was chairman of the FDIC from June 2006 to July 2011.  Her memoirs, Bull by the Horn: Fighting to Save Main Street from Wall Street and Wall Street from Itself, is a fascinating and sometimes frustrating glimpse into the mind of a career bureaucrat.  She recounts myriad meetings and battles with fellow regulators, of which there are way too many, American bankers and foreign central bankers.  Needless to say, Ms. Bair portrays herself as the blameless, honest bureaucrat who foresaw the coming crisis and fought, as the title implies, to save both Main Street and Wall Street.

People write memoirs mostly out of hubris.  Do we really care what Ms. Bair thought as she entered rooms full of powerful people?  Ms. Bair certainly thinks we do.  The tenor of the book has a touchy-feely tone to it that may interest some, but I found it to be distracting and rather annoying.  But this is a minor quibble compared to my main complaint about the book, which is that it tells me something frightening about people who have way too much power over us.  And that something is that they have no insight into the nature of the system in which they operate and, therefore, they cannot accomplish their mission of making banking safe and affordable for all.  Let me elaborate.

The Hubris of the Bank Regulator

Ms. Bair does indeed understand certain fundamentals about our banking system, but she understands nothing about the monetary system upon whose foundation it rests.  She gives the lay reader a very nice explanation of fractional reserve banking.  She explains that a bank deposit is really a loan to the banker and that the banker does not keep anywhere near sufficient reserves to honor demands for repayment from all but a small fraction of his depositors.  That is the purported purpose of the Federal Reserve Bank; i.e., to lend to the banker when his depositors withdraw their funds in such amounts that the banker’s liquid funds are depleted.  The banker has borrowed short and lent long.  This Ms. Bair fully understands and she supports the Fed’s role as lender of last resort.

She also understands that the agency that she led, the  Federal Deposit Insurance Corporation, causes moral hazard.  (To my delight she actually used and explained the term!)  Ms. Bair explains that, because bankers know that the FDIC will pay off their depositors in the event of excessive losses, bankers engage in more risky lending.  Riskier lending gives the bankers bigger profits, IF the loans are repaid.  If not, bankers can tap the FDIC.  This arrangement, whereby the banker gets all the profit from successful ventures but does not suffer all the loss if unsuccessful, creates classic moral hazard, whereby the risky venture is encouraged rather than discouraged.  But Ms. Bair feels that, although moral hazard is a problem, it is manageable.  She believes that regulators like herself can ensure that bankers do not engage in risky lending.  And this, my friends, is the heart of her hubris–that she is capable of preventing the very moral hazard that her agency helps make possible.

A lay person reading Ms. Bair’s book would get the following impression of our banking system.  Left to their own devices–that is, when lightly regulated–bankers will pillage the economy for their own benefit.  Their depositors will not care, because the FDIC guarantees almost all deposits.  To prevent reckless lending, bankers must adhere to very strict rules of what kinds of products they can offer, the extent to which these products are booked, the prices they charge for their products, the disclosures that must accompany their offerings, etc.  In other words, bankers are portrayed as modern Genghis Khans that must be reined in by the likes of Sheila Bair not only to protect the public but to protect the bankers from themselves.  The entire book is based upon this chain of logic.  But nowhere does Ms. Bair explain how bankers are legally able to pillage an economy and why they do not go to jail for doing so.  As I will explain in more detail below, it is the failure of the state’s legal system to protect private property combined with monetary intervention by the state chartered central bank that is at the heart of the problem.  Again, Ms. Bair sees the symptom but does not understand the nature of the banking business in our modern fiat money monetary system.

The Incremental Steps that Feed the Moral Hazard Monster

Although Ms. Bair states that she recognizes that deposit insurance carries with it a moral hazard component, she does not mention the number one reason that turned what she considers to be manageable moral hazard into a moral hazard monster–monetary expansion engineered by the Federal Reserve.  But monetary expansion by the Fed is just the final link in the incremental chain of government failures and interventions that have led to greater and greater misallocation of resources through moral hazard.  It all started with fractional reserve banking.

The oldest banking crises are linked to the banker’s issuance of uncovered money certificates.  Here the banker violates his contract to redeem ALL demand deposits for the monetary metal, gold or silver.  Instead, he lends out a greater and greater percentage of his demand deposits, retaining a smaller and smaller fraction of the monetary metal to honor daily withdrawal demands.  The subsequent economic booms and busts can be ascribed directly to the state’s failure to prosecute fractional reserve banking as a crime, with the banker’s personal assets at risk as compensation to his creditors for contract violation in addition to personal imprisonment for the crime of committing fraud.  However, the booms and busts experienced through the centuries were relatively mild and self-correcting by modern terms.  The banker who engaged in excessive fractional reserve lending was brought to heel by his fellow bankers through the mechanism of the clearinghouse, in which the banker had to honor checks drawn upon his bank for which he had insufficient liquid funds, and ultimately by his customers who “ran to the bank” and demanded specie redemption.

In an attempt to square the circle and retain the lucrative practice of fractional reserve banking without suffering bankruptcy through demands for specie redemption, the central bank was born as lender of last resort.  Initially that function of the central banker was to be rare and short lived.  The great English intellectual Walter Bagehot advised the Bank of England to, “Lend freely at a high rate on good collateral.”  The borrowing bank would survive, but it would learn its lesson.  Furthermore, in the era during which precious metals were the ultimate medium of exchange, the central bank itself had to take care that it did not run out of specie.  Therefore, it did lend cautiously, at high rates, and on good collateral.  The crown helped out by granting the central bank the sole authority of note issuance, thereby increasing demand for its notes.  If the crisis persisted, the crown would allow the central bank to suspend specie redemption until it became more liquid.

The next step along the road to greater and greater malinvestment via moral hazard was the practice of the central bank to engage in interest rate manipulation via open market operations to lower the market rate of interest.  It buys assets to pump more reserves into the banking system.  This added more thrust to the moral hazard induced boom, which led to even greater busts.  Finally, as the banks suffered devastating runs upon specie, the state first suspended specie redemption and then ultimately instituted deposit insurance.  This is the point at which Ms. Bair picks up her narrative.  True to her bureaucratic background and a good example of Public Choice theory, Ms. Bair insists that deposit insurance is absolutely necessary to prevent bank runs.  Because the common man is not capable of judging the safety and soundness of his bank, at the first whiff of a problem, he will withdraw his funds and bring the bank to its knees.  Deposit insurance allays this concern for the depositor.  But Ms. Bair fails to understand that deposit insurance is just one more intervention designed to cure a problem caused by previous interventions.  This phenomenon was well understood by Ludwig von Mises.

The Moral Hazard Monster Is Unleashed

So, we have arrived at the great day in which the depositor need not take care that his bank is solvent, government turns a blind eye to the fraud of fractional reserve banking, and the central bank can pump unlimited amounts of fiat money reserves into the banking system upon which can be pyramided greater and greater credit booms.  Needless to say, all this is lost on Ms. Bair.  She touches only upon the symptoms of the real problem.  The behavior that she describes with disgust–the bailouts of Wall Street and the neglect of Main Street, the robo-signing scandals, etc.–are the inevitable result of an ever increasing attempt to perpetuate a boom that was never supported by the underlying savings of the economy.  Moral hazard became a monster–there was money to be made and no power on earth was going to stop the boom once initiated.  The economy was said to be in a new paradigm, a new era of permanent prosperity in which everyone could own the home of their dreams.  In this Never Never Land mindset it was not unusual to grant a loan to someone who did not have the income to support the purchase of his McMansion, because the home could ALWAYS be sold for more than the purchase price.  The bank would be made whole and the borrower most likely would walk away with money in his pocket.

Ms. Bair does recognize that her institution–the FDIC–is exposed to losses beyond its resources should the boom turn to bust.  Her answer is to make the banks pay for their own future losses via higher capital requirements, a battle that she fought her entire tenure at the FDIC.  Ms. Bair’s campaign for higher capital standards will slow down the boom, for no matter what the level of excess reserves (currently a whopping $1.5 trillion!), the banks cannot increase loans outstanding if they are under-capitalized.

(Loans are funded by money created out of thin air; i.e., when the bank books a loan, it credits the borrower’s checking account.  This inflates the bank’s balance sheet and, concomitantly, reduces its capital ratio.)

But, the inflationist pressures in favor of more lending will not be held back very long.  The Fed itself can simply lend long term to the banks and allow them to count these loans as capital.  The Fed has not been deterred by the legality of its actions so far–lending massive amounts to European banks, for example–so don’t think it might not happen.

Conclusion: the Moral Hazard Monster Devours Capital

Nevertheless, the laws of economics always prevail.  The progressive political systems of the world and their number one tool for expanding state power and realizing heaven on earth, the central banks, have created a moral hazard monster, not a slightly misbehaving pet.  The monster started as comparatively mild and self-correcting boom/bust cycles caused by fractional reserve banking.  He grew from a child to a juvenile delinquent by feeding on central bank lender of last resort money, first at penalty rates then at below market rates.  Now he is an angry, steroid packed adult Godzilla gorging himself on unlimited fiat money reserves created by oh so willing central bankers.  There is nothing that can stop him…not higher capital requirements for banks and especially not Ms. Bair’s favorite cure–tougher regulation.  The Fed’s Quantitative Easing Forever policy will lead to a worse recession than the one that began in 2007.  Malinvestment is being piled on top of previous malinvestment.  If fiat money credit expansion caused the 2007 Great Recession, then the Fed’s program of Quantitative Easing Forever cannot be the cure.  On the contrary, it is breeding even greater malinvestment.  The world needs real reform: an end to fractional reserve banking (prosecuted as a financial crime), the liquidation of both central banks and deposit insurance, and the end to legal tender laws.  The moral hazard monster must be destroyed or all society is at risk.

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