Monday, March 8, 2010

Financial crisis of 2008

The problem with the banking system is not corrupt people (people are always corrupt).  The problem is that the system is not robust to corruption.  The current system has feedbacks that magnify rather than reduce problems. One big bank failure should strength all other banks, instead it weakens them.

Part of the problem is that the green back is too strong.  It is too highly desired.  It is treated by most people as safer than real assets despite being just paper. In a contractionary banking crisis people want greenbacks and Federal Government bonds over real assets. If this was not so people would rush to spend their cash and Government bonds on real assets like Restate and loans would be strengthened. 

We need fundamental change.  the old saying,  "anything that can happen will happen holds".  If greed can break the system it will.  
We need a fail safe mechanism.

I have seen 3 proposed solutions: 

Possible solution 1. The post Keynesians say that Government should stop selling bonds at all and use seniorage  (the creation of money) in recessions and depressions to increase aggregate demand and taxes in inflationary periods to reduce aggregate demand.  As far as I can see this should work.  The down side is that it separates taxing from spending giving more power to the state.  Also would require the raising of lowering of taxes and spending in response to economic conditions.  Politicians have real problems reducing spending and raising taxes. 

Possible solution 2. Some free banking advocates advocate currency made by banks backed only by bank assets.  The banks would never have to pay out in Gold, so there would be no danger of bank runs.  If the demand for currency was to rise they would just print more.  If bank assets value falls so does their currency but only relative to other bank's currencies.  we generally are not aware of it by currency is not that different from checks and bonds.  

Possible solution 3. 100 percent reserve banking.  Noble economist James Buchanan has come out for this option.  This was once only proposed by fringe economists.  Presumably savings accounts would no longer exists but would be replaced by bond funds that fluctuate with the bond market and the strength of the bank's portfolio. The money market accounts would become short term government bond funds.  A better term for fractional reserve banking is "maturity-transformation" , it makes things clearer. like 02/maturity-transformation-cat-bag-out.html

We can never be sure if either system would work to prevent bouts of high unemployment but we do know that what we have now produces bouts of high unemployment. 

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