Sound Money and Financial Crisis
One of the main virtues of sound money is stability. We sound-money types like to point out that financial systems built on core sound money principles—namely, free competition at all stages of money production and credit markets—are not nearly as prone to monetary crises and money-induced recessions. Sounds too good to be true, I know. But the basic economics of it is rather simple. Indeed, the reason you don’t see devastating financial crises in a sound money economy is the same reason that you never see an ice cream crisis or a car repair crisis or a video rental crisis. Competitive forces keep these markets in check, balancing supply and demand over time and space. Likewise with money and banking—competitive forces, if allowed to function, will keep bank credit in check, balancing supply with demand, and more crucially, risk with return.
What a Financial Crisis Is
The crux of a financial crisis is simply “too much debt.” More lending means riskier lending. When banks get into a lending frenzy—such as home mortgage finance from the late 1990s-mid 2000s—they wind up scraping the bottom of the barrel to find loan applicants. The very terminology of a credit boom is indicative of the change in credit quality: Subprime, NINJA, no-doc, liar loans, etc. Thus a credit boom sows the seeds of its own destruction: marginal creditworthiness of borrowers declines drastically as the lending is ramped up, setting the stage for a wave of defaults that reduces exposed banks’ net worth. Crisis really sets in when a bank’s depositors and other creditors get a whiff of the bad debt buildup, and demand the bank make good on its liabilities to them. In a classic bank run scenario, insolvent banks are suddenly revealed as such; you know it’s a genuine panic when those who stand to lose money (both bankers and their depositors/creditors) begin the loud and public wailing and gnashing of teeth: “something must be done to save us from this crisis of capitalism!” But why did so much bad debt get built up in the system? Any theory of financial crisis must explain this essential fact. It simply won’t do to begin the explanation at the point of panic—“capitalist greed, irrationality, and animal spirits at work!” some critics might proclaim. But to simply say “bankers are greedy” or “banks were deregulated” won’t cut it. In competitive markets, guess who eats the losses that result from bad debt? That’s right—banks, and the people who fund them. In the “tough love” world of a true market economy, bank insolvency means losses for the stockholders, depositors, and bondholders of that bank. Oh yeah, and unemployment for its managers. The crisis is not the beginning of the problem, but rather the end of a reckless accumulation of bad debt. So why the excessive lending? Did bankers suddenly get stupid, or is something else at play?
Whence the Bad Debt?
There’s a vast pool of lousy potential borrowers out there. In normal times, the banking industry does not want to touch them with a 10 foot pole.[1] Indeed, in a competitive economy, bankers are careful with their funds. Sure, higher risks mean higher returns on average, but they also mean a steeply increased possibility of default. Default is death in a competitive economy—bankers need to avoid insolvency and illiquidity lest they lose their own shirts! Therefore, for bankers to begin extending loans en masse to really bad debt risks (e.g. subprime mortgages), there has to be some inducement from outside of the banking system itself. Some entity basically says to the industry, “go ahead and lend to those higher-risk folks. If something goes wrong (and what could possibly go wrong?!), we’ll take care of you—we’ll cover your own obligations to your depositors and creditors and ensure you stay in business.” Of course there’s a name for this arrangement: the taxpayer-funded bailout. The promise is not quite this explicit, and the vehicles that do the actual bailing are many and complex. But the basic economics is this simple: if your rich uncle (let’s call him Sam) promises to cover your investment losses, but lets you keep your investment gains, are you going to change the way you invest? And we have a name for this, too: moral hazard. For a good economic detective, moral hazard is always a prime suspect in a financial crisis. Here’s a partial line up of the moral-hazard-inducing entities that we dragged in from the streets. Do you recognize any of the suspects, Ma’am?
- Federal Loan Guarantees (FHA, VA, SBA, etc.)
- Subsidized/Nationalized Secondary Debt Buyers (Fannie and Freddie)
- Subsidized Deposit “Insurance” (FDIC)
- FED/ Treasury/ FDIC policy of “Too Big to Fail”®Since 1984
- TARP
- FED
Now regular readers might be asking: what happened to the adverse clearings mechanism—that glory of competitive market-based bank “regulation” that was supposed to keep banks on their toes? Was it somehow broken, or non-operational in the build-up to the crisis? No. It was muted by, you guessed it: government intervention. What it boils down to is this: every time the market threatens a bank, or bank-like institution with failure, the FDIC stands in to rescue that bank’s depositors. For really large banks, the FED also stands in to rescue that firm’s creditors, lest a crisis ensue. When the government’s own pet mega-bank behemoths, Fannie and Freddie, discovered they’d eaten way too much of the subprime poison, Congress itself launched the largest stomach-pumping operation in world history. But here’s the problem: When the FED rescues anyone, everyone else (logically) expects to get rescued. The market mechanism is muted—the FED simply won’t let competition do its job of exposing and de-funding the losers. Oh clearing mechanism, where is thy sting? Competition, where is thy victory? Well, you can’t silence the market forever. Market forces have a knack for eventually scraping and clawing their way back to equilibrium. Government can’t eliminate the pain of failure. It can only medicate it for a while. Ultimately, the medication wears off, and the pain returns with a vengeance, in the form of a renewed and larger crisis. So remember this when the next crisis rolls around, which it surely will: financial crises, and the recessions they bring, are not spontaneous products of the greedy bankers. They are products of the institutionalized bailout—a direct, and predictable, consequence of subsidizing failure.
Some financiers have always catered to the subprime market, such as payday lenders, pawnshops, and loan sharks. Their high default rates are expected and “priced into” the loans. The absence of deposit finance, implied or expressed bailouts, and the relatively small size of the overall industry means they don’t really contribute to financial crises. I’ll go way out on a limb and say the next financial crisis will be a government debt crisis—a consequence of Federal overspending, of course, but also involving the government’s swallowing of bad housing and other debts in the bailout process.
Tyler Watts is an assistant professor of economics at Ball State University.
