Monday, October 6, 2008

Why The Free Market Works: Part 1 of Many

One widely unappreciated aspect of true free market capitalism is the limited liability of failures. When a business fails and goes bankrupt, it is not only the owners' liability that is limited, but also society's. We don't have a bankruptcy system to keep individual's from ruining themselves; we have it to keep them from inflicting too much damage on the rest of the economy. If we give someone an infinite credit line, then in theory, that one person can take everything down.

I keep saying this, but I'm more certain every day that it's true: These guys are creating the very problems they claim to be solving.

Reserve ratio thoughts:

A bank's reserve ratio is the percentage of total demand deposits that the bank is capable of paying out now. Basically, reserves are cash in the vault plus some electronic entries at the Federal Reserve which, in theory, could be immediately delivered as cash. The rest of deposits are lent to customers and cannot be accessed by the bank. The Federal Reserve sets the minimum reserve ratio allowed.

The discount rate is the rate at which member banks can borrow from the Federal Reserve.

The federal funds rate is the rate at which banks borrow (overnight) from each other. This rate floats, but the Federal Reserve intervenes in the market, by buying or selling U.S. Treasury securities, to keep it close to a target. When reporters speak of the Fed lowering or raising rates, it is this that they refer to.

A bank executive in the current financial crisis is likely to do one of two things:

1) If the bank is in bad shape, he is going to be risky in a way that doesn't appear too reckless, lobby for federal help, and try to keep the party rolling a few more quarters to squeeze out a few more paychecks. Maybe get lucky in the process and pull the bank out of failure. There is little cost to reckless lending for a bank on the brink of failure.

2) If the bank is in good shape, he tries to ride out the storm, tighten up lending standards (but lend freely to people with secure jobs, really good credit history, etc.), try to increase the deposit base, look for really cheap acquisitions a year or two down the road.

It seems to me that keeping a low discount rate / Fed Funds rate encourages both of these, but reducing the reserve ratio only encourages the first, as the second type is likely to keep increased reserves as a matter of internal policy. This, I believe, is why the actual fed funds rate has been below 2% (the current target) for the past two weeks.

Maybe if we do see Bernanke reduce the reserve ratio, it will signal the end, that he has given up and decided to throw the Hail Mary.


CowBear said...

When was the last time the US had a free market system? There is no free market system and hasn't been one for generations. Only a shell game where the rich get richer. A couple things to read that gives some perspective are:

'The Creature from Jekyll Island' that talks about the creation of the Fed and how this monster has grown to keep the funnel of money going to the top 5%.

'The Corporation' the gives a history on how corporations since the late 1800's have been given special priviledge to basically wreak havoc with any economic system. Corporations can go bankrupt without any really consequence. I think most do default just so they can get out from under obligations such as pensions and retirements (see the airline and automotive industries).

Another book to read is 'The Shock Doctrine' which goes in depth with how the economic thoughts from Milton Friedman and the Chicago school were used in as a policy to upend democraticlly elected and populist governments in South and Central America.

When you pull down the mask and look under the surface of good ole US style capitalism and foreign policy it gets pretty ugly. Basically the full scale explotation of the masses that enables the American pathology, ohh I mean dream, to continue.

Cowbear recommends putting that in your pipe and smoking it.

fishy said...

A few points on the bankruptcy system.. The bankruptcy system actually serves different purposes for different types of users. First, for individuals, the bankruptcy process serves as a fresh start from overwhelming debt. Otherwise such individuals might become wards of the state. So in this sense, you're correct, bankruptcy is a way to protect society from supporting overburdened individual debtors. For corporations, however, the role of bankruptcy is a little more complex. Most view it as the most efficient means for financially distressed (as opposed to economically distressed) corporations to restructure their debt. In this regard, you could say that bankruptcy is meant to help the corporation, but it also helps society in that we want financially distressed corporations to continue as going concerns.