by Richard Martin
This post continues the discussion I started yesterday. You can read that here: How We Ended Up with a Fiat Money System.
All I’m advocating is full transparency of risk and reward and maturity matching. If someone wants to take a risk beyond that, they should be fully informed. Sort of like mutual fund ads that say past performance is not a guarantee of future performance.
Demand deposits such as checking accounts shouldn’t be lent out. Businesses can acquire startup capital from equity investments and/or loans. Anyone partaking in equity ownership gets the ups and the downs. Loans that are generated from actual savings of depositors that are maturity-matched to time deposits would have some risk of default, but that would be priced in to the fees and interest rates. There could also be default insurance provided by other financial institutions, such as Lloyd’s.
In a free banking system, which is what I’m presenting here, there is nothing stopping a lender from advancing funds that are not fully backed by reserves or allocated from savings, either their own (i.e., from their own capital) or from depositors, as long as they realize the level of risk they are assuming and that they are fully responsible for any losses. Same goes for the borrower. With less credit-induced spending and investment, there would be less buy-now-pay-later. It would be like our parents: save up for an appliance and then purchase it. The big difference also is that fractional-reserve banking would be much more limited and not underlie the entire financial-monetary-banking system, as it does now.
The question of how economic growth occurs is a whole different matter. Any credit based money system is liable to booms and busts. The question is how much credit-based money there is. As long as there are central banks backed up by government fiat, there will always be a lender of last resort to offer bailouts. That causes inflation of the money supply, which in turn has many other effects in the economy, on real people.
One of these is that there are too many marginal buyers of, say, houses. These are people who wouldn’t normally rate a mortgage but get one because of artificially low interest rates and government-sponsored mortgage insurance, which in turn are politically motivated to gain votes and pretend there is no problem. With the house held as collateral, this can be a break on housing booms and busts. But we have to admit what happens: the equity in the house is effectively monetized and tokenized which adds to circulating money supply, thus contributing to inflation. Even if that continues, which it probably would (see my comments above about transparent risks), then we can surely do better than the current system by tightening conditions and letting the free market decide, rather than Congress or Parliament.
Another effect of credit-induced inflation and lower than natural interest rates is that investment projects are started that really shouldn’t. Production processes are also lengthened. In both cases, you end up with too much malinvestment which then leads to a boom and must be washed out by a credit bust. That is disruptive to the economy if it was encouraged and enabled for too long for political reasons. But, just as it is better to prune trees and underbrush regularly to avoid a major conflagration, it is better to allow businesses and projects to fail and for their investors or creditors to lose their funds than to end up with a massive boom and bust cycle that inevitably ends in disaster, depression, poverty, and conflict.