From: Travis Subject: Confidence Is Leaving the Fiat Money System Date: Friday, October 10, 2008,
Confidence Is Leaving the Fiat Money System *Daily Article* by Thorsten Polleit<http://mises.org/articles.aspx?AuthorId=793>| Posted on 10/10/2008 Were it not for ever-greater increases in central-bank money and the market expectation that governments are about to make taxpayers shoulder commercial banks' huge losses, the fiat money systems would presumably collapse right away. International interbank short-term lending rates say it all: the latest drastic increases in yield spreads between money-market rates and official central-bank rates are indicative of the growing reluctance among banks to extend loans to each other, for fear that borrowers could default on their payment obligations (see graph below). Under today's fiat-money regime, banks, under governments' auspices, increase the money stock "out of thin air" whenever they extend loans. The money supply is *built on credit*, which, in turn, hinges on peoples' confidence in banks and banks' confidence in their borrowers' ability and willingness to service their debt. As confidence leaves the system, banks refrain from extending loans and demand repayment of outstanding loans, and the money stock contracts. Economies that have for decades been fuelled by ever-higher doses of credit and money fall into depression — that is, declining production, employment, and prices. Where the Losses Come From To better understand the drop in confidence in the paper-money system, one should take a look at the issue of banks' *accounting losses* and *payment losses*. Assume, for instance, a bank buys a corporate bond for, say, US$100 and records it in its balance sheet. If the bond price declines to, say, US$50 (due to rising market yields), the bank would have to make a write-down. The resulting US$50 loss would, via the profit-and-loss account, reduce the bank's recorded equity capital. As long as the issuer of the bond continues to service his debt, however, the bank would recover its investment over the time. The accounting loss would not diminish the banks' capacity to pay its obligations vis-à-vis its own depositors and creditors. If, however, the market price of the bond declines because its issuer no longer pays, the banks' incoming cash flows would be lower than hitherto expected, resulting in a *payment loss* — and this could, if payment losses are large, make the bank default on its obligations. The Issue of a Loss of Confidence An accounting loss can easily develop into a payment loss. This is because bad news about banks' financial health (profit warning) can trigger a loss of confidence. Such a market reaction is rational, given the system of fractional-reserve banking. Under fractional-reserve banking, banks keep just a fraction of their immediate payment obligations (basically sight deposits) in the form of cash. As a consequence, they cannot meet all their payment obligations should customers whish to withdraw their sight deposits all at once. However, banks enjoy a privilege granted by the government. Central banks, the holders of the money supply monopoly, can provide banks with whatever amount of cash is needed. With central banks acting as lender of last resort, the chances for a bank run, initiated by private savers, have been greatly reduced. What spells trouble, however, is an institutional bank run: banks lose confidence in each other. Most banks rely heavily on interbank refinancing. And if interbank lending dries up, banks find it increasingly difficult, if not impossible, to obtain refinancing (at an acceptable level of interest rates). Maturity Transformation and Credit Derivatives An institutional bank run is particularly painful for banks involved in maturity transformation. Most banks borrow funds with short- and medium-term maturities and invest them longer-term. As short- and medium-term interest rates are typically lower than longer-term yields, maturity transformation is a profitable. However, in such a business, banks are exposed to rollover risk. If short- and medium-term interest rates rise relative to (fixed) longer-term yields, maturity transformation leads to losses — and in the extreme case, banks can go bankrupt if they fail to obtain refinancing funds for liabilities falling due. Growing investor concern about rollover risks has the potential to make a bank default on its payment obligations: interest rates for bank refinancing go up, so that loans falling due would have to be refinanced at (considerably) higher interest rates. The latest price action clearly suggests that banks active in maturity transformation could be up for quite some trouble (see graphs below). In an environment of rapidly declining confidence in the banking system, investor concerns about derivative instruments, credit derivatives in particular, may well accelerate the very forces that disintegrate the fiat-money regime. To be sure, there is nothing wrong with credit derivatives as such. Credit derivatives are instruments that help to value, trade, and reallocate existing risks among market participants, thereby making the financial system more efficient. However, the outstanding expansion of credit derivatives, heaped upon a gigantic paper-credit pyramid, has been stimulated to a great extent by central banks' chronic low interest rates, having made investors search for yield pick-up and ignore credit and market risks. There is little experience with how the financial positions of market participants would be affected in the case of major players going bankrupt. The extraordinary size and complexity of the credit-derivative market could pose a substantial *unwinding challenge* in the event of the exit of several major counterparties. Closing out and replacing positions could lead to drastic changes in underlying financial-asset prices. As investors cannot be sure that all market participants could weather the consequences of a default in the underlying credits or the effects of a prolonged disruption to market liquidity, confidence in the solidity of the monetary order may drop even faster in times of market stress. Postponing the Ultimate Disaster The issues outlined above are *symptoms* of the crumbling monetary (dis)order. Their underlying *causes* are to be found in the government-sponsored expansion of bank credit and money. It is a system that stretches the monetary demand beyond the economies' economic resources. By artificially lowering the interest rate through credit expansion, central banks induce inflation-induced boom-and-bust-cycles, which lead to unsustainable debt levels. In all western countries overall debt levels as a percent of GDP have gone up strongly in recent decades. Whenever financial markets set out to end the disastrous process through, for instance, a decline in economic activity, governments and their central banks will do whatever it takes to keep the fiat-money system going: lowering interest rates by increasing credit expansion and increasing the money supply. In the current situation, however, banks' capacity to keep expanding the credit and money supply has been greatly diminished: accounting losses and — due to waning confidence in the system — presumably also payment losses erode banks' equity capital further in the time to come. With their far-reaching coercive power, however, governments may, at least temporarily, be in a position to prevent an imminent implosion of the credit and money system. Governments can decide to redistribute peoples' incomes on the grandest scale: shoring up banks' eroding equity capital or guaranteeing financial institutions' assets or liabilities, or nationalizing the banking/finance industry. At a more technical level, central banks can be made to refinance banks directly, thereby replacing the interbank markets altogether. In such a regime, central banks would presumably not only fix the short-term (overnight) interest rate but medium- to longer-term interest rates as well. Alternatively, central banks can prop up banks' capital base by taking over their loss-making assets — a procedure already adopted by the US Federal Reserve and by other central banks, as they have also started accepting securities of questionable value in their open-market operations. When central banks form an *international cartel* — with the purpose of preserving the fiat-money system — domestic banks wouldn't default, even if their payment obligations are denominated in foreign currency (which the national central bank cannot produce): central banks would simply lend money to each other. Abandoning the Path Towards Inflation By increasing the base money supply in the interbank market, guaranteeing financial institutions' liabilities or nationalizing the banking industry, governments suppress free-market forces, which could move the system back towards equilibrium. There should be little doubt that, after decades of government sponsored credit and money-supply expansion, such a correction would be economically painful, accompanied by further bank failures and output and employment losses. However, it is hard to see how fighting the symptoms of the unfolding monetary fiasco could solve its underlying cause. Starting the printing presses wouldn't solve the debt crisis either. Hyperinflation would cause economic and political damage to the greatest possible extent. To qualify as a remedy to present ills, government action needs to be constrained to a far-reaching reform of the monetary systems, which, if implemented properly, would neither cause deflation nor inflation.[1]<http://mises.org/story/3146/preview#_ftn1>Markets need to be liberalized to the greatest extent to allow prices to adjust back to equilibrium. <http://www.mises.org/store/What-Has-Government-Done-to-Our-Money-MP3CD-P329C0.aspx> A return to *sound money* is needed. This would, as outlined by many Austrian economists, require putting an end to government's monopoly over monetary affairs. The power for determining the quantity and quality of money must be returned to free-market forces. Money in the hands of the government and its central bank would sooner or later become the ruin of the free societal order. As Ludwig von Mises noted, The wavelike movement affecting the economic system, the recurrence of periods of boom which are followed by periods of depression, is the unavoidable outcome of the attempts, repeated again and again, to lower the gross market rate of interest by means of credit expansion. There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as the result of a voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved.[2]<http://mises.org/story/3146/preview#_ftn2> [VIEW THIS ARTICLE ONLINE] <http://mises.org/story/3146> ________________________ Thorsten Polleit is Honorary Professor at the Frankfurt School of Finance & Management. Comment on the blog <http://blog.mises.org/>. Notes [1] <http://mises.org/story/3146/preview#_ftnref> In this context see, for instance George Reisman, "Our Financial House of Cards,"<http://www.mises.org/story/2926>25 March 2008. [2] <http://mises.org/story/3146/preview#_ftnref> Ludwig von Mises, *Human Action*<http://www.mises.org/store/Human-Action-The-Scholars-Edition-P119.aspx>, Chapter XX, section 8 <http://mises.org/humanaction/chap20sec8.asp>. *Join the Mises Institute* <https://www.mises.org/donate.asp>* **Mises.org Store* <http://www.mises.org/store> *Home* <http://www.mises.org/>* | **About* <http://www.mises.org/about.asp>*| **Email List* <http://www.mises.org/elist.asp>* | **Search*<http://www.google.com/u/Mises> * | **Contact Us* <http://www.mises.org/contact.asp>* | **Periodicals*<http://www.mises.org/journals.asp> * | **Articles* <http://www.mises.org/articles.asp>* | **Games & Fun<http://www.mises.org/fun.asp> * *FAQ <http://www.mises.org/fun.asp> | **EBooks*<http://www.mises.org/StudyGuideDisplay.asp?SubjID=117> * | **Resources* <http://www.mises.org/scholar.asp>* | **Catalog*<http://www.mises.org/catalog.asp> * | **Contributions* <https://www.mises.org/donate.asp>* | **Freedom *<http://www.mises.org/calendar.asp> You are subscribed as [EMAIL PROTECTED] EasyUnsubscribe<http://mises.biglist.com/do/unsub/article/87556804/s265y83c20/1429>(by email <[EMAIL PROTECTED]>) | Settings<http://mises.biglist.com/do/acct/article/87556804/s265y83c20/1429>| Report Abuse <http://mises.biglist.com/do/abuse/article/87556804/s265y83c20/1429> -- *~@):~{> --~--~---------~--~----~------------~-------~--~----~ Thanks for being part of "PoliticalForum" at Google Groups. 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