The Berger Memoranda

Some people might think that my writings in this space lean too much toward criticism and negativity. In conversations about the same topics I have had people say, “How can you say so much negative without offering a positive solution?”

Frequently, the most direct resolution to a systemic problem comes from removing obstacles to the natural operation of the system. This point applies in multiples to economic systems. Free markets do not arise out of positive design. They arise from the natural forces of humans acting and interacting in the process of trying to satisfy their needs. In other words, freedom exists as an absolute. Anything that interferes with that freedom amounts to oppression.

Occasionally, however, it helps to provide a little positive guidance as to which obstacles the interventionists should remove from the system to allow it to operate freely. So, I will try to provide one positive suggestion regarding removing a negative in the system.

In order to allow a free market monetary system to emerge the government needs to remove its guarantees of money accounts. Those guarantees provide a false sense of safety on the part of depositors and investors, which ultimately leads to imprudent borrowing and lending. But, removing those guarantees will require a few of steps, which the Feds have entirely overlooked.

First, the government has created a money system that has no backing by any other economic production or consumption good. Thus, to suddenly remove the guarantees that exist would cause the present system to become very unstable. The way out, therefore, is through.

Second, many of the suggestions related to salvaging the financial system focus on protecting losses from unsound investments. The government has, however, focused on the wrong side of the balance sheet. They created an unsound money system. Their exit from that system must start with protecting the value of money they created.

Third, instead of worrying about “toxic” assets the government should provide an unconditional, but temporary, guarantee for all bank deposits. (They way through.) That provides temporary stability for an unstable system. Then, if the losses from unsound assets eat up a bank’s capital, another bank can acquire the remaining assets and deposits without fear of loss or run.

Fourth, the government should liquidate the Federal Reserve Bank. In addition, it should close out some or all of the gold reserves of the Treasury. They should transfer all of these assets to banks in proportion to their share of guaranteed deposits. The end result should create a system that provides 100% reserves for demand deposits and adequate reserves for time deposits.

Finally, once the individual banks have established their individual reserve levels, the government should withdraw its deposit guarantee (and close the FDIC).

This process would need a lot more detail, but it would leave in place a free banking system.

In summary, my positive solution consists of eliminating the fractional reserve banking system supported by government.

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I hear a lot of this kind of question. People see that the Fed (and the Federal Government) has taken a number of actions, and they plan to take a lot more. Remember we have the President who believes that government must do something. But have these actions done any good? Will they do any good in the future?

I can answer these questions in two ways: 1) based on empirical evidence or 2) based on economic theory. I will comment on the methods rather than the results.

First, a great likelihood exists that things at some point will get better. But does that prove that the intervnetionist actions worked? No. If the consumption of ice cream rises at the same time that the crime rate rises, that does not mean eating ice cream causes crime. If a hundred men build a bridge that we see, does not mean that the money used to finance that bridge might not have built a factory employing a thousand men-all of which remain unseen. Researchers cannot gather sufficient empirical evidence to eliminate the possibility of counterfactual relationships between two events that occur closely in time and space or between the seen results and the unseen results.

Second, economic theory tells us that, regardless of any counterfactual evidence to the contrary, what the government has done has harmed the economy, and what it will do will harm the economy. Monetary expansion, government spending, and government regulations always harm the economy because they distort the natural resource allocation processes of the market. The economy will eventually recover in spite of, not because of, government intervention.

Only one question remains. When will the next crash occur caused by current interventions?

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It seems that, to a large degree, Chairman Bernanke’s insane conduct of Fed policy finds its motivation in his fear of “deflation.” Again, he has confused a healthy decline in prices with an unhealthy decrease in the quantity of money.

Before I continue I must re-reiterate that inflation and deflation refer respectively to increases and decreases in the quantity of money. Chairman Bernanke uses the words in the popularly misconstrued reference to increases and decreases in the general price level.

Let me use a very simple example to demonstrate the misplaced fear of a decrease in the general price level, which Bernanke calls deflation.

Pretend you have all your money, consisting of $1,000, in your check account. When you go to the grocery store you find that you can buy your groceries, for which you normally pay $400, for only $200. Now that decline in prices does not seem so bad. You buy more for less.

You now have $200 more than you had expected. You must find some thing to do with it.

If you spend it on some gadget you have desired, you add to the demand for those gadgets and their price will tend to stay the same or rise. If you save/invest the money, you add to the investment pool, which drives the demand and prices of investment assets up.

You can see that the prices of products in the market move interdependently. Thus, with your fixed supply of money the reduction of one price or group of prices allows you to spend that money on other things. The likelihood that all prices in your market (a decrease in the general price level) will decline at the same time is very, very small.

Now what happens if (through monetary policy) today you now have $800 in the same account that had $1,000 yesterday? That’s real deflation.

You also find that prices have remained the same as before (no discount on those groceries.)

You will now spend less on everything on your shopping list. The gadget and the extra investment will drop off the list for sure. Because of the reduction in your supply of money you will contribute to a decline in demand for a broad range of products.

If you scale this example up to the size of an economy, you can see that the probability of changes in the general level of prices becomes very small. When the price of one product declines, the price of another product(s) will tend to rise. If the supply of money throughout the economy declines, demand for products throughout the economy will also decline. Not a good thing.

Chairman Bernanke should cheer price declines not caused by changes in money supply. They signal increases in supply relative to the supply of money. He should avoid actions by the Fed that would trigger deflation (a decline in the quantity of money.) Deflation causes general price declines that signal that supplies have increased more than they actually have.

Chairman Bernanke, give up your fear of general price declines. Avoid triggering contractions in the quantity of money. And stop the stupid expansion.

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Michael Barone gets credit for coining the term “Gangster Government,” which CNBC used and helped to spread. In this case they have applied this term to the specific actions of the current administration to intimidate creditors of Chrysler (and maybe General Motors). I find the image helpful, however, to illustrate a point I made with a couple of friends this weekend about the evils of government.

Consider the general behavior of government in juxtaposition to the behavior of gangsters. What types of behavior can you find in common with these two groups? Make your own list, but I will share with you some on my list.

Government and gangsters share the disregard for the sanctity of personal property. Gangsters have no compunction about breaking into the homes and offices of people and taking whatever property they choose. Governments lack that same compunction, but on a much grander scale. Through their taxes governments confiscate the property of a much larger number of people over larger geographic territories than any shakedown scheme of any crime organization. The protection racket of the mob pales in comparison to that of any government.

Government and gangsters both have their own versions of eminent domain. Both operate under the rule of “if we want it, we take it.” Government appropriation, unlike gangster thievery, provides not recourse. I find it ironic that government might actually help you retake your property from gangsters.

In addition to violating personal property at will, government and gangsters both violate individual liberties. Arguably the gap between gangsters and government widens in terms of violations of personal freedom. Gangsters tend to limit their impingement on liberty to few behaviors in small geographic territories. Stay out of those territories and remain free of gangster influence.

The violation of personal freedom by government reigns over many behaviors and wide territories. Government restricts the clothes you wear, the food you eat, the homes you live in, the drugs you take, the cars you drive, the buildings you work in… To keep this list from continuing perpetually I direct your attention to the Federal Register for a list of the violations of your freedom. (I would suggest that you read the Register, but how would you keep up? It runs over 22,000 pages already for 2009.)

See chart of Pages in Federal Register.

Pages in the Federal Register

From this evidence of Gangster Government I would like to move to one final question.

When you hear names like Stalin, Hitler, Mussolini, Pol Pot, or Ghingus Khan, do you think of government or gangsters? Maybe both.

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Stability sounds like a good thing to have. With stability we can have more confidence about what happen in our lives. Or so we believe.

Consider just a couple of things that we may not want to remain stable. Your heart beat will finally remain stable when you “flat-line.” Your breathing will become stable when it stops.

Okay, so you concede that you might want just a little instability in some important things. So what level of stability (or instability) do you want in financial institutions and markets? And how do you want to regulate that financial stability (or instability)?

This morning (May 7, 2009) FRB Chairman Ben S. Bernanke, at the Federal Reserve Bank of Chicago Conference on Bank Structure and Competition, in Chicago, Illinois made these comments (via satellite) regarding stability in financial institutions and markets:

I have been discussing supervisory policy aimed at ensuring the stability of individual financial institutions. However, the Federal Reserve also has the broader objective of enhancing the stability of the financial system as a whole. Supervision of individual institutions and fostering broader stability are, once again, complementary activities, with information and expertise gained in one arena often proving highly useful in the other. Drawing on the lessons of the crisis, we have gone beyond efforts to improve our supervision of individual institutions to try to bolster the capacity of the financial system overall to withstand shocks.

He definitely believes that financial institutions and markets require some external force to regular their relative stability. But do we really want that intervention?

Financial markets operate, within the system of economic markets, in ways similar to the heart, within the system of the human body. They self-regulate. External intervention only compounds normal variances within the system and turn healthy functioning into problematic or pathological dysfunction.

I have to disclose that I have selfish reasons for making this argument. As a person with a relatively lower resting heart rate (for my age) of 45 bpm, I don’t want someone prodding me with an electric probe to raise that rate to a more common 60 bpm.

From a less selfish perspective I don’t want some external force (i.e. the Fed) prodding the market every time some designated genius in Washington thinks it has become “unstable.”

I don’t stand alone in that belief. Coincidently the Mises Institute posted an article today by Isaac M. Morehouse titled “Creating Disequilibrium, and Benefiting Society” http://mises.org/story/3442, in which he more eloquently made my point.

Also, Fredrich Hayek pointed out the danger of stabilizers in 1932. The Mises Institute has memorialized Hayek’s comments with a shirt you can buy on their web site.

On the front it reads:

Stablization is Chaos

On the back it reads:

Overthrow Stabilizers

Chairman Bernanke should invest in a good shirt and leave the markets alone.

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This Thursday the Treasury Department will announce the results of the vaunted bank stress tests. These tests will allegedly tell us which of the major banks (only specific banks) have sufficient capital to withstand further or protracted economic adversity. That makes sense, doesn’t it?

It makes sense until you actually think about it for a second. All national banks insured by the FDIC receive regular examinations by the Comptroller of the Currency and the FDIC. In addition, publicly traded banks, such as these few, have bank analysts and investors looking at them regularly. What, then, can the Treasury Department add to this scrutiny?

In a word, nothing.

By conducting these stress tests Treasury has devised a clever (although a bit embarrassing) way to justify their future actions with regard to the TARP funds forcibly injected into these banks. If they want to nationalize (or more accurately, further nationalize) any of these banks, they can just say, “We have to. They failed the stress test.”

But why does the government want to keep taxpayer money in the banks when the banks would rather pay it back? Government wants the banks to get back to making imprudent loans, just like before the crisis.

Banks have reached the limit of the amount of money that they can prudently lend because of their capital requirements. Current levels of excess reserves create no impediment to lending. Thus, since the availability of money presents no problem, the government has only one way to get banks to make more bad loans. Treasury must give them so much cheap capital that banks find themselves subjected to market pressures to make those loans in order to improve profits.

If you find yourself scratching your head and saying, “It makes no sense for Treasury to encourage more bad loans,” I would agree, and disagree. I agree it makes no economic sense. It will lead us back into the catastrophe from which we wish to exit. It does, however, make political sense.

People vote for politicians that give them money they do not deserve (whether through handouts or unjustified loans). If they succeed in paying off the loans, it proves they voted for the right people. If they fail to pay off their loans, the unscrupulous banks will again take the blame.

For the banks the stress test means: If you fail, you lose; and if you pass, you lose. And so do we.

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In the process of trying to save General Motors (and Chrysler, and B of A, and etc.) the government has further contributed to the extinction of the idea that built General Motors in the first place. Various congressmen and government officials have advocated actions that further weaken the idea of saving and capital formation. Whatever happens to General Motors saving that idea should take precedence.

Economic progress physically depends on the processes of curtailing consumption, which creates savings, and investment in capital, which actually produces the goods of a thriving economy. Only thing precedes actual saving and investment in time and importance: the idea that defines the importance of saving and investment.

Simply preventing the demise of a business or industry will not prevent economic decline, particularly when we pay for that rescue by confiscating the savings of others. Taking resources from more productive uses and applying them to less productive uses will only lead to the slow, steady decline of economic activity in this country. Instead of attacking the idea of saving in the name of salvaging sick companies, we need to save and support the very idea of saving. The idea of saving and investing led to the creation of General Motors in the first place.

If you want to worry about an economic decline, worry about the decline of the very ideas that first built our strong economy.

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