Tuesday, May 30, 2017

Moldbug On Fractional Reserve Banking

Great Moldbug post on "maturity transformation," aka the fractional reserve banking scam:

Our financial system is not a new operating system. It is a very old operating system. Worse, there is only one of them: the whole world runs the Anglo-American banking system, more or less as described by Walter Bagehot in Lombard Street (1873). Lombard Street is our Windows. There is no Mac. There is no Linux. Our experts in finance are not experts in finance. They are experts in Lombard Street finance. Asking them to imagine an alternative is like asking a Windows programmer to imagine OS X - except that Windows isn't 314 years old. [...]

The end goal is to phase out this lending-counterfeiter business, and construct a new financial system - the motorcycle - in which lending is really, truly private, and financial intermediaries match their maturities. If Bobby needs money for three weeks, he asks you for a three-week loan. He does not ask you for a one-week loan and then get a surreptitious, covert, informal three-week loan from the Fed's "technology, called a printing press."

In any such financial system, we would see the true yield curve, the graph of interest rates at every maturity, uncontaminated by maturity mismatching. My suspicion is that at least at first, long-term rates would be quite high. Which means lower house prices. In the spirit of portfolio neutrality, USG might want to print some more money and kick it back to homeowners, such as, of course, myself...
It probably would not be possible to get 30 year loans to buy real estate in a free market system where you had to borrow the money from an actual investor. It would be more like 5-10 year money. And if you take a look at what housing finance was like 100 years ago, I think that is pretty much how it was.

The current system results in subsidization of residential real estate. It leads to an allocation of capital to houses that is much larger than you would see under a free market system. This system also creates a lot of financial intermediation "jobs". The herding behavior of these bankers seems really non-free-market.

It's interesting that the comment thread on that post in September 2008 was much more intelligent than any other blog I can think of. I think it's really hard for most people to grapple with the existence of a flawed (crooked) system that benefits the elite and will therefore be kept around, with modifications and tinkering, to the extent possible.


CP said...

Also good point:

"Essentially, Wall Street (a) thought it was a free market, and (b) assumed that MT in a free market just works. Both of these assumptions were wrong. The financial system was both free and protected, but the part that was free was not protected, and the part that was protected was not free. And the border between the two was completely informal, and was set in an ad-hoc, after-the-fact way by panicked bureaucrats in Washington."

CP said...

The ideal investor over the past decade is someone who did not believe in the "Lombard Street" system but is able to analyze and predict what it will do.

The believers are always shocked when it has its predictable failures.

Almost all of the disbelievers think its going to get its final comeuppance when it has one of the failures, but the elite are able to resuscitate it.

I think a lot of the disbelievers think the elite running it are just stupid, so when it fails naturally smarter people will step forward and get to replace it.

Also, I think a lot of disbelievers would almost rather not make money on the resuscitation because they find the system so distasteful.

T-Bone said...

Moldbug's followup, which is also excellent, TL;DR:

"Banking schemes characterized by systemic maturity transformation backed by govt could save a step by just having the gov't originate all loans, yet no modern economic theory [this was written before MMT got popular] advocates the govt be the only bank"

Aka: "Banking is too hard if you do it the right way. Therefore, do it the wrong way or some way other than the right way."


CP said...

From MM:

The end result of Bagehotian banking is that, without any government protection, it is incredibly unstable and will melt down at a drop of the hat. With full government protection, it is stable, and it drives down long-term interest rates - just as if the government itself had been making the loans itself. The lender of last resort might as well be a lender of first resort. (There are no modern schools of economics which believe, as far as I know, that governments should print money and lend it.) And with wishy-washy, informal, wink-and-a-nod protection - which is what we had until the other day - these toxic qualities are combined.

And this is how we continually stumble forward with a broken, Victorian-era banking system, suffering the slings and arrows of bad financial engineering. The whole thing needs to be rebooted, if not reinstalled, and we simply don't have a political system - or an intellectual system - which is capable of this.


Anonymous said...

I think the term "elite" needs to be defined a little more rigorously. In assorted contexts it has meant the top bankers, all bankers, the wealthy, much of the middle class, homeowners, Californians and New Yorkers, and whomever the author (not just speaking of CP) dislikes. If a group can encompass a majority of the population, is it an elite?

That a system has beneficiaries is not a flaw; I think the offense is taken more that the system promises benefits to all but only offers it to some. Or is it something else?

Absolutely right on flawed/corrupt/creaky/bizarre current system, but the general notion that "this cannot go on"--while also true--threatens to become a "stopped clock" statement (this idea is contained within CP's post and elucidation). The idea of a free market as a panacea is alluring, but quite apart from the "reboot" issues, the price-discovery competition is not necessarily self-sustaining; since a great many participants in any market--unfree (where it's easier; think regulatory capture) and free (think Al Capone, though of course the critique of that is obvious)--have as their primary goal share market power and curtailment of freedom.

Put another way: humans, individually and en masse, are always involved, so there are always problems.