Powell’s Real Choice: His Reputation Or Esteem

Image by Gerd Altmann sourced from pixabay

Banking’s History Reveals An Impossible Decision

Market participants ascribed a lot of importance to the December meeting of the Federal Open Market Committee (FOMC). Many expected (and even pleaded) the committee to take a dovish stance. When the Federal Reserve (Fed) disappointed, markets continued to liquidate. Did the FOMC commit a policy error? Well, they faced a catch-22. In my view, Chairman Jerome Powell’s choice was not between making the correct or incorrect policy decision; it was between maintaining some semblance of intellectual independence and being forever enslaved to the markets. Said differently, his choice was to either save his reputation or his self-esteem.

No single monetary policy decision should be that important in a dynamic economy. Conditions are ever-changing and markets still set the overwhelming majority of interest rates; the Fed controls just one—the Federal Funds Rate. In fact, it’s worth asking: Who needs the Fed?

If true, why did markets react so negatively? Did they overreact? I think they’re sniffing out an unavoidable risk created by the combination of central banking and fiat currency issuance: leverage—not just on balance sheets, but throughout the entire financial system.

To be sure, Powell is not to blame for this development; it’s been building for decades. Truth be told, central bankers face an impossible task. Their fundamental function—to effectively balance the supply of money to demand—is no job for a committee. It requires omniscience. Thus, the task is best left for the decentralized decision making process of markets. The result of successive and unavoidable missteps is higher leverage throughout the financial system.

Anyone following my What I’m Reading pages will see that I’m a bit of a history buff when it comes to banking. No, I’m not very popular at parties. But this historical perspective is quite useful for analyzing the esoteric workings of our modern monetary and financial system. The history of banks is the history of the financial system. Tracking their evolution illustrates why this increase in leverage was unavoidable once control over the money supply was centralized and currencies went fiat.

Here in Part 1, I run through the progression of banking and money issuance up to the era of central banking. In a forthcoming Part 2 I will show how the combination of fiat currency and central banking led to increases in leverage.

So how did we get here?

The Origins Of Fractional Reserve Banking

We currently have a fractional reserve banking system. Banks originate loans using their customers’ deposits. Thus, there is less cash “in the vaults” than what banks owe to depositors (hence the “fractional reserve” moniker). This creates the potential for devastating bank runs to occur, a common critique of the system. While a risk, fractional reserve banking was nonetheless a revolutionary leap forward for human progress and is the foundation for modern economies.

For most of existence money took the form of some asset. Over time, precious metals—and eventually gold—won the evolutionary race. Since money is merely past production transformed into a tradeable form, growing economies require a growing money supply; more importantly, dynamic economies require a dynamic money supply. Unfortunately, the production of gold is not very dynamic (though it is steady and responsive to market conditions). At any given time there’s only so much of it in circulation. Luckily, markets created a fix.

At first, “banks” were warehouses. They simply stored customers’ gold for a fee. Depositors were issued deposit receipts that represented claims to their gold held in storage. Considered as good as the metal itself, these deposit receipts eventually supplemented the usage of gold in commerce (especially for large transactions). It was far easier to carry a pocketbook of paper than crates of coins. Paper money was born.

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Gary Anderson 2 months ago Contributor's comment

Interesting! Of course, Mises would say deflation is no big deal. But where credit is applied or taken away, deflation can be a very big deal.

Seth Levine 2 months ago Author's comment

Absolutely. There's nothing wrong with leverage. It just magnifies the pain when you get things wrong (and profits when done right).