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A Simple Math Question for Bankers
Dec 28, 2013 09:00 am by David Howden posted in Banking, Economics, Education, Law, Regulation, Fractional Reserve Banking Like A Simple Math Question for Bankers on Facebook share on Twitter Google Plus One Button

Think back to your high-school math class, and reminisce about this question:

“Train A departs from Union Station at noon travelling eastward to Halifax at a speed of 80km/hr. Train B departs three hours later from the same station travelling in the same direction at a speed of 100 km/hr. When and where will they collide?”

We strained our minds, and most came up with the conclusion that 15 hours and 1,200 kms from where train A set off, the carefree conductors would face a rude awakening.

Most of us were just glad to be done with the question, and probably didn’t think of it much further. But consider what was going on at one minute past midnight in this imagined world.

There were two conductors each told that they could depart Union Station at a certain time and speed towards their destination. Each had done exactly what they were told, with the predictably disastrous results. There was probably a track-side argument, with each side blaming the other. Possibly the conflict spilled back to Union Station, with blame being attributed to whoever was in control of the train schedules that fateful day.

One way to look at this is that there was a conflict. Each conductor was told to do something, and when they did the disaster struck. Laying blame at the end is difficult, as neither side did anything wrong. As outsiders to this problem we can see that if blame does lie somewhere, it is with the Union Station scheduler.

Now take yourself out of your math class and consider reality. We have a similar train wreck brewing in our economy.

Depositors go to their banks and put aside some money. They are made a promise: the ability to withdraw their deposit at a moment’s notice (i.e., on demand), and be paid the proceeds at the same value as when they made the deposit (i.e., par value). In layman’s terms, you get back what you deposited, and you get it whenever you want.

Bankers receive these deposits, and the law gives them a different set of privileges. Bankers too may make use of this deposit, and they use it to fund investment and lending operations. For example, in the modern fractional-reserve banking system your banker uses a portion (or fraction) of your original deposit to lend to a potential homeowner as a mortgage.

The conflict depositors and bankers are subject to should be apparent. They each have a claim to the deposit, but there is only one deposit available to satisfy each claim.

This usually isn’t too big a problem, at least not for depositors, as not all of them ask to redeem their funds at the same time. Thus, even though there is an oversubscription of rights to the original deposit at all times, this oversubscription goes unnoticed until many depositors redeem their money at the same time.

When this mass redemption occurs the conflict is exposed. Depositors expect to get their money back as per the original terms of the deal – on demand and at par value. Bankers expect to be able to continue using the money to fund their lending operations, and thus the money is not in their possession to return to the original depositors.

This is the case of the common bank run. A bank run is really just a simple outcome that results from when too many people have claim to not enough goods. The ire and angst that is generated during a run, whereby depositors are genuinely upset that the bank is not able to return their deposits, signifies that there is a conflict between the two parties.

When a bank run occurs, the primal question is “who to blame?”

With our original math question still fresh in our minds, let’s answer the question. Two parties are given conflicting orders (or rights). Each did as they were told, and the predictably bad result occurred. It is pretty hard to blame either of these parties for the outcome. Depositors and bankers are just abiding by the law. They don’t make the law, and although both sides may have knowledge that the law is inconsistent and creates conflict, they have to play with the cards that they’re dealt.

If we want to assign blame to someone, why not look at the institution that sets the rules of the game. The initial conflict of the oversubscription of claims to the original deposits is created by legislation by Parliament, and enforced by the Bank of Canada. Just like the scheduler at Union Station is responsible when two trains collide which he instructed to embark, law makers should be held responsible for the ire, angst and lost money when banks go bankrupt or bank runs result.

If Parliament and the Bank of Canada wanted to be proactive about this conflict, they would act now. Changing banking laws to outlaw fractional reserves would not only erase this conflict, but would harmonise those laws controlling banking relations with the laws that enforce other contractual relations in the economy. Doing so might just avoid a train wreck in the future.

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Yes, It Really Is a Wonderful Life
Dec 27, 2013 06:13 pm by James E. Miller posted in Banking, Capitalism, Economics, banking, Christmas, Fractional Reserve Banking, George Bailey, It's a Wonderful LIfe, Mr. Potter Like Yes, It Really Is a Wonderful Life on Facebook share on Twitter Google Plus One Button

bank run1In the spirit of the holiday season, I recently watched the classic film It’s a Wonderful Life. Starring the drawl-voiced James Stewart, the movie depicts numerous hardships faced by small town loan man George Bailey. The film is well-renowned for presenting joy and hope around otherwise dismal circumstances. For its critical acclaim, it received five Oscar nominations and regularly places at the top of “best of all time” lists. Poor box office sales upon release were made up for in decades and decades of praise.

It’s a Wonderful Life is a great film because unlike the quasi-amoral pop motion pictures of today, it contains various lessons on the topics of family, community, duty, doing right by others, and humility. But around Christmas time, many economic commentators take to penning missives on another issue they see contained in the movie: fractional reserve banking. It is certainly true the practice of banking with fractional reserves is a great tragedy that befalls our current banking system. But this masterpiece of cinema is often wrongly described as presenting the financial dangers of borrowing short and lending long.

The common narrative goes like this: in Bailey’s early adult years, as he is preparing to go off on a honeymoon with his new bride, panic sets in. There is a run on the Building and Loan Association which has been in his family for years. Depositors desperately attempt to reclaim what little wealth remains in their accounts. Many economic-minded viewers regard this as a sign the bank operates as a fractional reserve institution – meaning short term deposits are used for long term loans – as there is not enough cash on hand to satisfy customers.

As Bailey tries to calm the ensuing crowd, he has to explain why exactly the money is not readily available. “You’re thinking of this place all wrong, as if I had the money back in the safe,” he tells onlookers. “The money is not here….your money is in Joe’s house…and the Kennedy house…,” Bailey exclaims while imploring the crowd to give him time. Finally, he appeals to the logic behind his business practice: “you’re lending them the money to build and then they are going to pay it back in two years best they can…” Many take this as an admission of fractional reserve banking. But it turns out the beloved townsfolk did agree to a certain time constraint on making withdraws. As Bailey reminds the crowd, they accepted a 60 day waiting period for retrieving their cash. When one gentleman expresses anger over having to wait nearly two months for his money, Bailey politely explains “that’s what you agreed to when you bought your shares.”

The problem is, the people want their money now and don’t seem to give a damn over the contract they agreed to. This isn’t fractional reserve banking. It’s fear driven presumably by deteriorating economic conditions. The film’s antagonist, Mr. Potter, plots to buy up the shares at a heavy discount in order to take over Bailey’s properties. To subvert this conspiracy, Bailey and his wife use their honeymoon savings to appease their customers for the time being. It’s an act of personal sacrifice to save his family’s legacy, and one Bailey is remembered for in the future.

Had It’s a Wonderful Life presented a clear-cut case of fractional reserve banking, it would have given viewers a great demonstration on why pyramiding credit is the equivalent to playing Russian roulette. As Harvard economist Gregory Mankiw explains in his bestselling textbook Essentials of Economics:

Although you have probably never witnessed a bank run in real life, you may have seen one depicted in movies such as Mary Poppins and It’s a Wonderful Life. A bank run occurs when depositors suspect that a bank may go bankrupt and, therefore, “run” to the bank to withdraw their deposits.

Bank runs are a problem for banks under fractional-reserve banking. Because a bank holds only a fraction of its deposits on reserve, it cannot satisfy withdraw requests from all depositors. Even if the bank is in fact solvent (meaning that its assets exceed its liabilities) it will not have enough cash on hand to allow all depositors immediate access to all of their money.

Bank runs are not nearly as prominent as they once were thanks to the advent of federal deposit insurance. While it’s not given a precise date, the panic in It’s a Wonderful Life presumably occurs at the height of the Great Depression. In the period following the stock market crash on Black Tuesday until President Roosevelt was inaugurated in 1933 and declared a national bank holiday, thousands of banks failed across the country. A good portion of the money supply was veritably wiped out as whole parts of balance sheets had to be written off. The gushing of bank failures finally receded to a dripping point when Roosevelt took the reins of the banking system via outright socialism. The Federal Reserve pledged infinite amounts of credit creation to shore up the banking system. Essentially, FDR took the Emanuel-esque advice of never letting a good crisis go to waste. His actions succeeded in calming the country down. It was too late for the fictional George Bailey however.

After the Federal Deposit Insurance Corporation was established in 1933 by Congressional diktat the public was finally able to disregard any suspicion of losing their life savings in a panic. From then on, Uncle Sam would simply rob their neighbors to make up for any banking shortfalls. The kind of bank run witnessed in It’s a Wonderful Life is now seen as an anachronism. As economist Gary North explains,

“A bank run today is not the old-fashioned kind that we see every Christmas season when we watch “It’s a Wonderful Life.” That was a pre-FDIC bank run. A bank run took place in the Great Depression when depositors, who had been promised payment in currency on demand, exercised their contractual rights.”

George Bailey’s predicament seems to be the product of both historic conditions and fear caused by the prevalence of fractional reserve banking. While he runs a relatively sound business model, his efforts are undercut by the overwhelming fraud that was occurring in the banking sector. Fractional reserve banking is based on a conflating between two types of contracts: mutuum and deposit. Whereas a mutuum contract, which dates back to antiquity, involves the lending of fungible goods to be paid back after a specific period, a deposit contracts involves lending goods available on demand. Bailey’s Building and Loan Association seems to operate with mutuum contracts – which the community of Bedford Falls totally reneged on. Most other banks function by using demand deposits to finance longer term loans. The result is a mismatch of funds.

Fractional reserve banking is, above all, illogical. And since law should be based on the rational and logical understanding of humanity and matter, it doesn’t make sense to hold certain transactions as fraudulent and others as not. If farmer Joe commits a crime by misrepresenting a bailment of straw in his silo, then banker Bill does the same when misrepresenting deposits to his customers. As U.S. Supreme Court Justice Antonin Scalia wrote in his famed Lawrence v. Texas dissenting opinion, “the people, unlike judges, need not carry things to their logical conclusion.”

It’s wrong to misinterpret It’s a Wonderful Life as an example of fractional reserve banking. George Bailey’s family business seems to engage in banking proper. Even so, he still hits a snag thanks to the economic conditions of the time. Of all the lessons contained in It’s a Wonderful Life, the economic fact-of-life that there is a cost and risk for everything is not given enough consideration. The economic free lunch is like Santa Claus – it doesn’t exist. The movie concludes on a memorable line as the youngest Bailey happily proclaims “every time a bell rings an angel gets his wings.” The same can be said of a fractional reserve banking system, in that every time a deposit is made, someone gets duped.

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The Cowboys: Learning Life on the Job
Dec 27, 2013 11:23 am by Doug French posted in Capitalism, Economics, Education, Lifestyle Like The Cowboys: Learning Life on the Job on Facebook share on Twitter Google Plus One Button

There’s plenty of fretting about children. They’re obese, mentally weak, lack ambition, feel entitled, and must have instant gratification. This is all the result of walling off children from adults with child labor laws and an increasing minimum wage. Now with ObamaCare, children can remain on their parent’s health care plan until age 26, further expanding the definition of childhood.

Kids want to grow up and become adults as soon as possible. There shouldn’t be an age requirement. But adults keep them them cooped up in school for more than a decade to hang around other kids, learning to move at the sound of intermittent bells like Pavlov’s dogs. If any knowledge is transmitted it is purely by happenstance.

Then at the end of the schooling sentence the not-so-young person is deemed fit for employment, despite having never functioned in the real world.  My umpteenth viewing of “The Cowboys” brought this all to mind on Christmas Day.

The movie was based on a novel of the same title written by William Dale Jennings, who was more famous as a gay activist and founding member of the Mattachine Society, a group formed to protect and improve the rights of homosexuals.

John Wayne plays Will Andersen an aging rancher who needs to drive his cattle from Montana to Belle Fourche, South Dakota before winter sets in.

Gold fever has attracted all the possible trail hands and Andersen is forced to recruit school boys. “A fool comes to town with a fistful of gold dust, and every jackass from 50 miles around lights out after him,” Andersen grouses.

Hiring kids wouldn’t be an option today. The current oil and natural gas gold rush is also beckoning all available workers with eyes on making six-figure salaries with no college degree. This has forced even McDonalds to pay signing bonuses and WalMart to pay $17.50 an hour for cashiers, double what they pay in other locations.

A business person requiring labor to move his or her product to be sold would be out of luck if the only workers available were under 16. The government would rather the product go to waste than young people being “exploited.”

Many of Andersen’s crew are barely big enough to get on a horse and of course safety helmets were nowhere to be found.  Rivalries develop quickly and are sorted out with flying fists and rolling in the dust. In the end the two older Alpha males (Slim and Cimarron) earn each other’s respect. All the boys learn to work together and have each other’s back.

The trail hands are promised 50 silver dollars each when the drive is done and cattle are sold. They are thrilled at the prospect of earning their own money. Andersen paid what he thought was fair. No government was needed to intervene on the boy’s behalf.

Cowboys don’t punch a clock working a cattle drive. Andersen gets the boys up at 3 am, shouting in the dark that they “are burning daylight.” Someone always has to stand watch through the night to watch the herd. It’s grueling work for a healthy reward at the end. But the cattle must be delivered.

When one of the boy’s stuttering kept him from alerting Andersen to the drowning Slim, the trail boss berates the boy in what today would be considered politically incorrect fashion. These days, merely trying is viewed as paramount. Trophies in little league are distributed for just showing up.

Andersen tells him he almost drowned his friend and that if he wanted to stop stuttering he would just stop. Wilson, the stuttering boy, says he tried, to which Andersen says, “trying don’t get it done.” The boy proceeds to call Andersen a “god-damned, mean son-of-a-bitch.” The rancher makes him repeat it until the furious Wilson forgets his anxiety and the words began to flow.

Young people who don’t work early on never learn to work alongside adults and others who are different from them. When Andersen’s expected trail cook sends Jebediah Nightlinger (Roscoe Lee Browne) in his place, Andersen and the boys, none of whom had ever seen a black man, are confronted with working alongside and trusting someone seemingly very different from them.

Nightlinger is one of the best characters of any Wayne movie. The eloquent Browne brings Shakespearean chops to the chuckwagon, providing as much gravitas to the movie as the Duke. When Cimarron and one of the other boys stumbles upon a wagon full of working girls, the exchange between madam Kate Collingwood (Colleen Dewhurst) and Nightlinger is priceless.

Collingwood asks the cook if he would be interested in their services, to which Nightlinger replies in rich baritone, “Well, I have the inclination, the maturity, and the wherewithal… but unfortunately, I don’t have the time.”

As the boys become accomplished trail hands, earning the respect of Andersen and Nightlinger, they begin to identify with the two adults and the two men are reminded of their childhoods. It isn’t long before the boys discover Nightlinger’s liquor bottle and the boys get rip-roaring drunk while the cook and trail boss watch from the bushes.  In the morning the boys pay the piper, choking down Nightlinger’s hangover medicine. Another lesson learned.

The movie illustrates the learning curve all new employees go through. In this case the boys learn the basics, riding and roping, but also nuances like not running the cattle too fast and hard. “Running the tallow off of them costs me money,” Andersen tells one of his young charges. There is nothing more satisfying than becoming accomplished at a task, and director Mark Rydell has the boys looking more and more confident as the movie progresses.

Mr. Andersen had the opportunity to hire older hand Asa (Long Hair) Watts (Bruce Dern) and his gang. However, the uncious Watts is tested by the wily cattleman as to where he’d worked and Andersen catches him in a lie. As bad as the rancher needed experienced hands, he wouldn’t work with liars.

Watts and his gang follow the herd and ultimately Dern’s character not only shoots Andersen in the back, but kills the actor’s career. Now 77, Dern–who Jack Nicholson called the best actor of his generation–is up for a Golden Globe for his role in “Nebraska” and will likely be nominated for an Oscar. However, this acclaim didn’t seem possible forty years ago after “The Cowboys” was released.

Writing for the Calgary Herald, Jamie Portman explains, “Dern wasn’t mincing words: Accepting the role of the slimy, slack-jawed Long Hair in The Cowboys was the worst career choice he ever made, because he ended up messing around with the John Wayne mythology and the Duke’s image of invincibility.”

Dern says on the day the offending scene was shot, Wayne, totally in the bag via Wild Turkey, sidled up to him, and said. “Oh, they’re gonna hate you for this.”

Andersen’s demise is turned into triumph by the boys, who, with the help of Nightlinger, steal back the herd and ride tall as they funnel the livestock through the streets of Belle Fourche with the townspeople whispering, “they’re only kids.”

They may have looked like kids and a few weeks before they had been. However, by the time they herded those cows into the buyer’s stable, they, while still in their teens, were men.  That’s what on-the-job training will do, when minimum wage and child labor laws don’t stand in the way.

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Collapse of the Irish Housing Boom
Dec 27, 2013 10:23 am by Patrick Barron posted in Economics Like Collapse of the Irish Housing Boom on Facebook share on Twitter Google Plus One Button

Re: Irish Try to Eradicate Ghosts of a Housing Crash

Lord Keynes famously said that paying people to dig holes and fill them back up was necessary for recovery.  His disciple Paul Krugman wants Martians to attack earth so that we can spur the economy via war spending.

Read the above NY Times report, if you have a strong enough stomach.  Keynes would have applauded the Irish housing boom, and von Mises would have explained that such malinvestment leads to bankruptcy and poverty.  I would add that it leads to despair, as the wealth, hopes, and dreams of hard working people are shattered.

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