The Free Market 16, no. 11 (November 1998)
As the world financial system entered a state of collapse, commentators said that Russia had traded the shortages of socialism for the bank runs and financial panics of capitalism. In fact, modern finance and banking are built on unstable, socialistic foundations.
Central Banking. Earlier in this century, Western nations established a cartel-like arrangement among their largest banks and the government. From the bankers’ point of view, these mutual protection rackets were a way of collectivizing their risk of runs and making imprudent credit expansion permanently possible. Governments liked having their favorite non-tax revenue regularized (coin clipping having become a political problem).
Bad economists were there to claim that the financial system required constant injections of “liquidity,” and that central banks would abolish financial panics. In fact, they eliminated crucial competitive forces that would otherwise force banks to lend prudently. When trouble comes, they rely on the money-creation powers of the central bank as the lender of last resort. In contrast, a market-driven banking system would be wholly private and responsible solely to its depositors’ demand for sound lending policies.
Fractional-Reserve Banking. A competitive banking system would constantly face the threat of runs and would therefore be forced to stay heavily capitalized to meet its obligations. Depositors would retain title to their deposits, which could only be lent out on a contractual basis. Checking accounts (demand deposits) would therefore be backed by 100 percent reserves.
Today, fractional-reserve banking is the norm all over the world. But it still takes people by surprise when they discover this. In Russia, dollar-denominated accounts were held fractionally so people could not withdraw their money when they wanted it. They rightly called this robbery. What they didn’t know is that it is the established practice in all countries.
Deposit Insurance. This was a New Deal invention, a Band-Aid to patch up a system fatally flawed by the existence of central banking and fractional reserves. So rather than bring more stability, deposit insurance permits banks to act even less responsibly. The banks are rewarded for performing loans, but are allowed to slough off their losses on non-performing loans to society at large.
Banking is an entrepreneurial business which, like other speculative activities, is inherently uninsurable, as Mises explained. That’s why there can only be government “insurance,” which is socialism disguised by the language of commerce.
The IMF. Created after World War II to become a new global central bank, the IMF of Keynes’s dream didn’t work out. But instead of closing shop, the IMF has become a cash cow for undercapitalized banking systems and profligate governments. For example, just prior to Russia’s banking crisis, the IMF promoted a lending package worth $23 billion. It was not only a waste; it encouraged destructive behavior. When the U.S. bailed out Mexico three years ago, supporters said greater monitoring would prevent the problem from spreading. Instead, it made more bailouts an inevitability.
Floating Exchange Rates. In a sound money system, there is a tendency toward the creation of a single money in all countries. Before 1973, the single money was a gold-backed dollar. Before World War I, all civilized countries based their currencies directly on gold. But since the advent of pure paper money, currencies have traded against each other in a system of floating exchange rates that has only created new instabilities and new inefficiencies.
The world dollar standard helps mitigate such problems, but this system also contains a crucial flaw. If the dollar fails, it will take down the world economy with it. The solution isn’t to fix exchange rates or to hope for new competitors to the dollar like the Euro. It is to base currencies on a fixed gold standard that deters all manner of political manipulation.
