Tuesday, November 11, 2008

"Money, Banking and the Federal Reserve"

I just finished viewing a youtube video produced by the Mises Institute that gives an interesting explanation of how money and banking works. Every freshman in Econ 101 needs to watch this video to learn why berries or wampum could be the currency of choice, rather than reserve notes, and what fractional reserve banking is all about. It also covers a good bit of banking history, although as I will discuss in a bit, it is highly selective in its coverage of the subject.

Then the video engages in a long rejection of central banking, and calls for a return to the gold standard. There are several related themes that the Mises Institute cites:

  1. The Federal Reserve Board of Governors (FRB) is not accountable to anyone. No one audits their operations; they can buy and sell assets as they please. You cannot obtain a transcript of their deliberations; they only publish a brief summary.
  2. Inflation is baked in to the current banking system--300% in the 25 years after Nixon ended Bretton Woods! But you don't want a low inflation environment; you want the currency you own to gain value over time. Only a deflationary environment can provide the confidence that investors and entrepreneurs need to do their part for economic growth.
  3. Central banking is the cause of all economic booms and busts. It leads to booms and busts because the presence of a "lender of last resort" removes the need for banks to lend prudently during the good years.
  4. History shows that a return to the gold standard will stabilize the economy; for example, sound money was the impetus for a pleasant 18-year expansion from 1879 to 1896. On the other hand, the video implicates central banking as the ultimate cause of the Great Depression.
The video's analysis ignores so much history, so much about how banking operates, and so many serious pragmatic issues, that I scarcely know where to begin my critique. For now, since my time is limited, I'll just list some semi-random thoughts:

  1. The members of the Federal Reserve Board are appointed by the President and confirmed by the Senate. Opinions vary as to whether this provides enough accountability for the Board, but the appointment/confirmation process certainly mitigates the problem. In addition, the video is dramatically wrong about the availability of transcripts for the FRB's meetings; they have been available since 1994. The video was produced in 1996, so there is no excuse for this misleading argument.
  2. Central banking's promotion of monetary inflation is not the only cause of the boom/bust cycle. Any time investors believe that outsized profits can be gained from some new resource, technology or business practice, they stampede into the capital market and produce a rush of new lending. This is a boom cycle, and it doesn't need the assistance of central banking. The Holland tulip craze, the 19th century railroad boom, and the 21st century housing boom were driven primarily by investors' appetites for enormous and easy returns. The video praises the reliability of a market-regulated currency, but in point of fact the rush into the housing market by Wall Street lenders and Main Street borrowers that we saw during W's early years is but the latest example of how the market can drive a currency boom. An earlier example, provided by the video itself, is how the long expansion after the Civil War was followed by a decade's worth of instability that culminated in the Crash of 1907. That crash in turn led to the birth to the Federal Reserve during a 1910 meeting of Wall Street titans on Jekyll Island. Of course, the fact that 18 years of boom followed by a decade of instability and bust occurred when the Fed did not yet exist is an extremely strong refutation of the video's argument, but the producers rise to the challenge of completely overlooking this inconvenient fact.
  3. While few are happy during the bust after a boom, Daniel Gross argues that the boom/bust cycle is critical for a healthy economy. Booms often give us infrastructure (like telegraphs, railroads, and fiber-optic cable) that can boost production for decades. Of course, not all booms are of equal value (think tulip bulbs and vacant housing), but you've got to expect some chaff with the wheat. At the risk of redundancy, I again point out that booms are what happen when investors get excited about emerging opportunities; history has proven that you can't have marvelous new opportunities without a boom/bust cycle.
  4. Do not believe the video when it states that you want your money to gain value over time. The years 1929 - 1940 saw the greatest increase in the value of money in American history; this period is also referred to as the Great Depression. The link between increasing money value and severe economic depression is quite obvious. If the value of goods I can buy with money will increase over time, I have no incentive at all to invest it; I can get a risk-free increase in value just by stuffing my money in a mattress. So from the viewpoint of society, when the value of money is increasing, investment naturally falls sharply. Furthermore, this fall in value can be a vicious circle: as the value of money increases, investment drops; as investment drops, economic activity drops; as economic activity drops, the value of money in hand goes up; as the value of money in hand goes up, investment drops more, etc. This, in a nutshell, is how the Great Depression happened.
  5. The video attacks fractional reserve banking from pillar to post, but it is impossible for a conversion to the gold standard to eliminate fractional reserve banking. Here's why: the world's outstanding gold reserves are but a tiny fraction of the world's economic output. As long as the reserve assets on hand are but a fraction of the lending in the economy, there will be fractional reserve banking. It is mathematically impossible to have any form of banking other than fractional reserve banking when aggregate reserves are lower than aggregate deposits. "Well, we'll just revalue gold so that banking reserves and demand deposits are in equilibrium," Ron Paul might reply. While that is possible, I'm not sure I want to give a windfall profit of $15 trillion to a handful of mining companies.
  6. The video proclaimed (in 1996) that the federal budget had been in deficit every year since Nixon ended Bretton Woods. Of course, just like it seems you have to wash your car to enjoy a rainfall, no sooner was this video released than our country enjoyed a string of impressive budget surpluses from 1996 to 2001. Of course, the Republican Congress and President put an end to that with a huge tax cut and out-of-control military spending in the years 2001 and following, but that's a different story.
  7. The video proposes that investors will lend their gold to banks for (negotiated) fixed periods of time at a fixed interest rate, and the banks will in turn will lend to creditworthy borrowers. Congratulations, Mises Institute, you have just invented the Certificate of Deposit (CD).
  8. The video proposes that banks will charge fees to depositors for holding their savings and demand deposits, instead of earning profits by lending a portion of the deposit money. In other words, the Mises Institute proposes to kill fractional reserve banking. Of course, this would decrease the availability of capital dramatically, which would starve our economy of the resources needed to pursue new investment opportunities. In other words, the Mises Institute's proposal would provoke a downturn so colossal that we would rename the 1930s as the "Mild Disappointment."
  9. It is true that deposit insurance and the Fed's discount window serve as a "lender of last resort," which can encourage private lenders to take some imprudent risks. However, the alternative is not some nirvana where all investors and lenders are perfectly rational. Rather it's a system where you and I will be afraid to put our savings in a bank for fear that some crazy loan officer will lend it to his visionary cousin Marvin's real estate company, and we'll lose the capital we painfully gathered for decades as we raised our families. And if you and I are afraid of putting our money in savings accounts, it will be the 1930s all over again.

EDIT: I have corrected the inadvertant misspelling of the name of Mises Institute. Thanks, Thom!

Monday, November 3, 2008

Analyzing the Republican Pro-Life Case

As readers of the comments on my previous blog are aware, it is impossible to support a Democrat for pro-life reasons without stirring up controversy. A lot of controversy. In addition to the published comments, I have received many emails and even letters from passionate Christians and family members who implore me to consider further arguments.

I do appreciate the sentiment and thoughts. I have very carefully considered these arguments, and at one point seriously contemplated the possibility of voting for Bob Barr. (Sorry, Senator McCain--I could never vote for anyone who labels a Palestinian peace activist as a "neo-Nazi.") The arguments are as follows:

  1. Abortion restrictions such as parental consent/notification laws actually do reduce abortions, according to a 2006 analysis by Prof. Michael New.
  2. Obama plans to sign the Freedom of Choice Act (if it is passed), which would eliminate any restriction of any type on abortion. Doctors, nurses, and hospitals could no longer refuse to provide abortion. Partial-birth abortions could no longer be restricted. State parental notification and informed consent laws would be nullified.

As I examined the data as carefully as possible, though, I think my original public policy analysis was sound. A vote for Obama is vote to improve the economic and societal situation of expectant mothers, and thus is a vote to reduce abortion. Let's see why:

1. New's analysis is faulty because it fails to control for the correct variables. Prof. New only controlled for income growth and racial demographics in his analysis of the effects of abortion restriction policies. The Catholics in Alliance for the Common Good (CACG) analysis, however, controls for 16 economic and welfare policy factors, in addition to the abortion restriction policies. Once these additional factors are considered, the effect of abortion restriction policies becomes immaterial. As Wright and Bailey report in the CACG paper:

Using the nationwide data, we also analyzed the effect of state-level laws that are designed to prevent abortions. In the Appendix, we show that laws concerning parental and informed consent had no significant effect on the number of abortions in the United States. We tested for the effect of both passing and enforcing parental and informed consent laws, and find that the net effect on the abortion rate of both passing and enforcing these laws was very close to zero. While we did find that partial-birth abortion laws are associated with decreases in the abortion rate, this result was not statistically different from zero and was not consistent across different specifications. These results stand in contrast to earlier research, but that research did not control for important socioeconomic factors such as government assistance and employment rates by gender.
Thus the primary policy factors to reduce abortions are economic assistance programs that can help expectant mothers, although the elimination of Medicaid funding for abortions also helps.

2. The Freedom of Choice Act appears to be little more than lip service to the pro-choice movement. I urge my readers to go read the actual Act, rather than rely on what I or anyone else says. You will see that it basically enacts as a matter of federal legislation the policies already propounded by Roe v. Wade and Doe v. Bolton.

  • It does not prevent medical professionals from exercising their conscience--a right which does not rely on state abortion restriction legislation.

  • It does not prevent states from restricting partial-birth abortions; in fact, the effect of the Act does not extend beyond the 22d week of pregnancy, since it states
    A government may not...deny or interfere with a woman's right to choose...to terminate a pregnancy after viability where termination is necessary to protect the life or health of the woman
    This balancing of the unborn child's right to life with the woman's life or health is no different from today's law.
  • And I do not believe that the law will affect state's choices not to fund abortions with Medicaid dollars. The Act is spectacularly vague on the question of Medicaid funding, and even if it could be interpreted to override state funding choices, it would never survive a state challenge based on the 10th Amendment ("the powers not delegated to the United States by the Constitution, nor prohibited by it to the States, are reserved to the States respectively, or to the people.")