Ludwig von Mises

Does It Make Sense to Resurrect the Glass-Steagall Act?

Two opposing viewpoints on the Glass-Steagall Act. I would love some reader feedback on this. I have always supported Ludwig von Mises Institute’s insight on these matters, that will not change. But I wanted to share the viewpoint of La Rouche PAC on this matter, in the video directly below followed by a post from Ludwig von Mises Institute. La Rouche is ready to remove Obama from the Oval Office and also strongly hold the position of resurrecting the Glass-Steagall Act.

Lyndon LaRouche Webcast July 22, 2008


The Opposing Viewpoint

Mises Daily: Tuesday, February 16, 2010 by Frank Shostak
At the end of January, President Barack Obama announced that he is planning to introduce new regulations for the banking industry, to prevent excessive speculation. According to the president, no bank or financial institution that contains a bank will own, invest in, or sponsor a hedge fund or private equity fund, or have proprietary trading operations unrelated to serving customers for its own profit.

The driving force behind this plan is the former Federal Reserve Board chairman Paul Volcker who, it seems, wants to resurrect the Glass-Steagall Act of 1933. Instead of the separation of commercial and investment banking, we will now have a separation of banking business from proprietary trading, hedge funds, and private equity. In his testimony to the Senate on February 2, 2010, Volcker said,

The specific points at issue are ownership or sponsorship of hedge funds and private equity funds, and proprietary trading — that is, placing bank capital at risk in the search of speculative profit rather than in response to customer needs.

Some provisions of the Glass-Steagall Act, such as Regulation Q, which allowed the Federal Reserve to regulate interest rates on savings accounts, were repealed in 1980. The provisions that prohibited a bank-holding company from owning other financial companies were repealed on November 12, 1999. The repeal enabled commercial banks to underwrite and trade instruments like mortgage-backed securities, and establish structured investment vehicles (SIVs) that bought those securities.

Most experts are of the view that the repeal of the Glass-Steagall Act contributed to the global financial crisis of 2008–2009. They believe the repeal of the act was instrumental in the creation of the subprime-loans bubble, which they see as the driving force behind the financial crisis.

The year before the repeal, subprime loans were around 10% of all mortgage lending. By 2005 they were approaching 21%.

From this way of thinking, it would appear that a reform along the lines as suggested by Volcker could stabilize financial markets and prevent boom–bust cycles.

The opponents of the Volcker plan, such as the Federal Reserve Board governor, Kevin Warsh, are of the view that the plan may only stifle the economy. In his comments published in a Financial Times opinion piece (February 2, 2010), he said,

We must resurrect market discipline as a complement to prudential supervision. Otherwise, the spectre of government support threatens to confuse price signals and create a class of institutions that operate under different rules.… The US economy runs grave risks if we slouch toward a quasi–public utility model.

According to opponents, the best way to fix the problem is to allow the market forces to do the job.

Do Less Banking Controls Always Mean a More Free Market?

The proponents for less control in the banking industry hold that fewer restrictions imply a better use of scarce resources, which will lead to the generation of more real wealth.

It is true that a free-banking environment is an agent of wealth promotion through the efficient use of scarce real resources, whilst controlled banking stifles the process of real-wealth formation. However, the opponents of the Volcker plan overlooked that the present banking system has nothing to do with free banking or a free market.

What we have at present is a banking system within the framework of the central bank, which promotes monetary inflation and the destruction of the process of real-wealth generation through fractional-reserve banking.

In the present system, the more unrestricted the banks are, the more money they can generate “out of thin air,” and the more damage they can inflict upon the wealth-generation process.

This must be contrasted with genuine free banking, i.e., the absence of the central bank, where the potential for the creation of money out of thin air is minimal.

Fractional-Reserve Banking Creates Money out of Thin Air

Through fractional-reserve banking, banks can create money out of thin air. We suggest, however, that in a genuine free-banking environment the likelihood of banks practicing fractional-reserve banking would be minimal. Here is why.

Take, for instance, Farmer Joe, who sells his saved 1kg of seeds for $100. He then deposits this $100 with Bank A. Note that the $100 is fully backed up by the saved 1kg of seeds. Also, observe that Joe is exercising his demand for money by holding it in the demand deposits of the bank. (Joe could also have exercised his demand for money by holding the money at home in a jar, or by keeping it under the mattress).

Whenever a bank takes a portion of Joe’s deposited money and lends it out, it sets in motion serious trouble. Let us say that Bank A lends $50 to Bob by taking $50 out of Joe’s deposit. Remember that Joe still exercises his demand for $100. No additional saving backs up this $50. Once Bob uses the money, he in fact engages in an exchange of nothing for something. This amounts to nonproductive consumption of real wealth. What we have here is $150 that is backed by $100. (Remember that $100 is fully backed up by 1kg of seeds — real savings).

Now, Joe demands money, not to hold it as such but to use it as the medium of exchange. So let us say that Joe decides to use his $100 to buy goods from Sam, who banks with Bank B. On the following day, Bank B will present the check on $100 to Bank A. In short, $100 is shifted from A to B. No more money is now left at Bank A.

Let us say that Bob, who borrowed $50 from Bank A, also buys goods from Sam, who keeps his money with Bank B. This will pose a problem to Bank A since it doesn’t have the $50 to pay Bank B once the check on $50 written against A is presented by B. In short, Bank A is “caught,” so to speak.

As the number of banks rises and the number of clients per bank declines, the chances that clients will spend money on the goods of individuals that are banking with other banks will increase. This in turn increases the risk of the bank not being able to honor its checks if this bank practices fractional-reserve banking — i.e., lends fictitious claims or money out of thin air.

Conversely, as the number of competitive banks diminishes, that is, as the number of clients per bank rises, the likelihood of being “caught” practicing fractional-reserve banking diminishes. In the extreme case, if there is only one bank, it can practice fractional-reserve banking without any fear of being “caught,” since it will always clear its own checks. Thus Sam, who sold goods to Bob, would simply deposit the check with Bank A.

All that would happen in that case is that the ownership of the deposit would be transferred from Bob to Sam. If Joe decides to spend his $100 on goods from Tom, then again we would have a transfer of the ownership of the deposit.

We can thus conclude that in a free-banking environment with many competitive banks, if a particular bank tries to expand credit by practicing fractional-reserve banking, it runs the risk of being caught. So it is quite likely that in a free-market economy the threat of bankruptcy will bring to a minimum the practice of fractional-reserve banking.

The Existence of a Central Bank Encourages Fractional-Reserve Banking

This is, however, not so in the case of the existence of a central bank. By means of monetary policy, the central bank protects fractional-reserve banking and thus the creation of money out of thin air.

If Bank A is short of $50, it could borrow from the central bank. Where does the central bank get the money? It actually generates it out of thin air .

The modern banking system can be seen as one huge monopoly bank, guided and coordinated by the central bank. And as we have seen, one monopoly bank can practice fractional-reserve banking without running the risk of being caught.

Through ongoing monetary management, i.e., money pumping, the central bank makes sure that all the banks engage jointly in the expansion of credit out of thin air.

The joint expansion in turn guarantees that checks presented for redemption by banks to each other are netted out. By means of monetary injections, the central bank makes sure that the banking system is liquid enough that banks will not bankrupt each other.

The Myth of Financial Deregulation

Prior to the financial deregulation of the 1980s, we had controlled banking. Banks’ conduct was guided by the central bank. Within this type of environment, banks’ profit margins were nearly predetermined, because the Fed imposed interest-rate ceilings and controlled short-term interest rates. Hence, the life of the banks was quite easy, albeit boring.

The introduction of financial deregulations and the dismantling of the Glass-Steagall Act changed all that. The deregulated environment resulted in fierce competition between banks.

The previously fixed margins were severely curtailed. This in turn called for an increase in volumes of lending in order to maintain the level of profits.

This increase culminated in an explosion in the creation of credit out of thin air. Indeed, in the deregulated environment, banks’ ability to amplify the Fed’s pumping has enormously increased.

Note that the AMS-to-trend ratio hovered very close to 1.0 from 1959 to 1979.[1] Since the early 1980s, this ratio has been rising visibly, climbing to 1.77 by November 2008.

We suggest that it is this massive explosion of money that has severely damaged the pool of real savings and laid the foundation for the present economic crisis. Rather than promoting an efficient allocation of real savings, the current “deregulated” monetary system has been channeling money created out of thin air across the economy.

From this it follows that in the present banking system, what is required to reduce a further weakening of the real-wealth-generation process is to introduce tighter controls on banks.

As Murray Rothbard put it,

Many free-market advocates wonder: why is it that I am a champion of free markets, privatization, and deregulation everywhere else, but not in the banking system? The answer should now be clear: Banking is not a legitimate industry, providing legitimate service, so long as it continues to be a system of fractional-reserve banking: that is, the fraudulent making of contracts that it is impossible to honor.[2]

Pay attention that we don’t suggest suppressing the free market, but suppressing banks’ ability to generate credit out of thin air. The present banking system has nothing to do with a true free-market economy.

It must be reiterated here that more controls in the framework of central banking can only slow down the pace of the erosion of real-wealth formation. They cannot prevent the erosion. (Remember, the Fed continues to pump money to navigate the economy). More controls will simply suppress banks’ ability to amplify the Fed’s pumping. In this sense, controls are preferable to a so-called deregulated banking sector.

Would more controls, i.e., keeping the Glass-Steagall Act intact, have prevented the current economic crisis? We suggest that the crisis wouldn’t have been as severe, since controls would have prevented the massive monetary explosion since the early 1980s, which put the pool of real savings under severe pressure.

The financial deregulations have sped up the erosion of the real-wealth-generation process. Consequently, instead of having a severe crisis in 20 years’ time, we have it now.

Why the Volcker Plan Cannot Prevent Boom-Bust Cycles

Now, if controls were the answer for economic instability, then why, prior to financial deregulation in early 1980s, did the US economy experience vicious economic swings?

The chart below depicts sharp swings in the growth momentum of US industrial production during the period of the Glass-Steagall Act. For instance, after peaking at 11.6% in November 1972, the yearly rate of growth of industrial production plunged to −12.3% in May 1975.

In the present setup, the policy makers of the Fed are of the view that they can somehow navigate the economy toward the path of stable economic growth. Their navigation via money pumping leads to fluctuations in the money supply’s rate of growth. This in turn leads to the boom–bust cycles that the Fed supposedly is trying to smooth out or eliminate all together.

Conclusion

At the end of January, US president Barack Obama announced that he plans to introduce new banking-industry regulations in order to prevent excessive speculation. The driving force behind this plan is the former Fed chairman Paul Volcker, who seems to want to resurrect the Glass-Steagall Act. Instead of the separation of commercial and investment banking, we will now have a separation of banking business from proprietary trading, stock broking, and hedge funds.

The US president is of the view that this will help stabilize the financial system. Some critics of the proposed plan are of the view that it will only make things much worse by stifling the efficient allocation of scarce real resources. Our analysis holds that the key reason for financial instability is not the repeal of the Glass-Steagall Act as such but the existence of the central bank. It is the central bank that enables banks to practice fractional-reserve banking and thereby pollute the economy with money created out of thin air.

As long as we have a central bank, it makes sense to impose tighter controls on banks in order to minimize the damage the central bank’s policies inflict. A better alternative is, of course, to have genuine free banking without the central bank.

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Why The Police State is Doomed by Gary North

An email from Gary North
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I am perceived by many readers as a pessimist. I am
not a pessimist. I am an optimist beyond your wildest
imagination. I am an eschatological postmillennialist.
There are not many of us. I am also a believer in the free
market social order — not just in its superiority in
theory, but in its inevitable triumph in history. I
believe that Leonard E. Read’s book title is correct: “Then
Truth Will Out.”

I am not an optimist with respect to the pathway
between here and there. Big Brother lurks in the state-
maintained shrubbery of the pathway.

When a pride of lions is waiting patiently in the tall
grass for zebras, some zebras are going to get eaten. When
we think “bureaucrats,” we should think “lions.” We are
zebras.

There will be losses. But the lions are getting old.
They don’t run as fast these days. Zebras are multiplying.
Think “China.” Think “Russia.” Then think back to Mao and
Stalin. If those two concentration camps could collapse
without a shot being fired, don’t tell me about the
inevitability of tyranny.

Lincoln Steffens visited the Soviet Union in 1921 and
returned to say, “I have been over into the future, and it
works.” No, it didn’t. Neither do the mini-despotisms of
the various Keynesian utopias. Their employees will not
receive those pensions after all.

THE LITERARY DYSTOPIAS

Our thinking regarding the modern police states has
been shaped by literary masterpieces. The most famous ones
are “1984,” written by an anti-Communist socialist, and
“Animal Farm,” also written by him, and “Brave New World,”
written by the socialist’s French instructor at Eton:
Aldous Huxley.

There is a far better novel about the police state:
“That Hideous Strength: A Fairy Tale for Grown-ups.” It
was published in 1945. C. S. Lewis wrote it. I commend it
to you. I re-read it every few years — one of two novels
I re-read. (The other is “Good Omens.”) I first read it
in the spring of 1964, beginning about four months after
the deaths of Lewis, Huxley, and Kennedy on November 22,
1963. Lewis saw where we were headed in 1945. He also saw
how it would end: the scattering of the empire-builders.

The positive utopias of the good society in literature
were utopias of centrally planned states. No one has
written them in a century. The dystopias are also
centrally planned states. They reflect modern men’s
declining faith in the healing powers of science as
implemented by the state.

The power of science is seen as unstoppable. In the
hands of bureaucrats, the tool of science produces a social
order without liberty. The state’s controls may be
justified as rational and therapeutic, but the system is
tyrannical. This is the vision of the dystopias.

In “Brave New World,” the tool of control is a drug:
soma. It keeps the masses docile. In “1984,” it is two-
way television. There is no privacy. In “Animal Farm,” it
is widespread belief in the good of the whole, which
mandates individual sacrifice. The results are the same: an
elite maintains control over the masses. There is no way
out.

The authors were not free market economists. The free
market economist finds it difficult to believe that a
system of centralized economic planning could ever gain
access to resources sufficient to hold the masses together.
The failures of the Soviet Union and Communist China stand
as tombstones. They mark the inability of central planning
to achieve its goals or the goals of the planning elite.
Or, as the saying goes, money talks.

In 1978, Deng Xiaoping got capitalist religion. He
announced the freeing up of agriculture, which has always
been the weak link of socialism. In 1979, the Chinese
economy started to grow.

In 1980, Moscow hosted the Olympics. From all over
the world, Westerners came to see the show. The Soviet
leaders saw for the first time how rich the West was, and
how poor they were by comparison. They saw with their own
eyes — first with amazement, then with horror — what the
West had known for 60 years: they all dressed like Russian
bureaucrats. They never recovered psychologically. Within
a decade, the Soviet economy was broke. Hope had finally
departed from the elite. It had departed from the masses
decades earlier.

The elite publicly abandoned the system. Money talks.

It still talks.


SOCIALIST ECONOMIC CALCULATION

In 1920, Ludwig von Mises wrote a short essay,
“Economic Calculation in the Socialist Commonwealth.”

http://mises.org/econcalc.asp

He argued that socialist economic planning is
inherently blind. Without free market prices that are
based on private ownership, the government’s central
planners have no way of knowing where to allocate scarce
resources. This is especially true of capital goods. The
planners are forced to copy prices in the non-socialist
societies. This was his theory. It turned out to be
correct in practice.

The socialists rejected this argument for seven
decades. But, socialist experiment by experiment, Mises
was proven correct. Of course, he argued that economic
logic is the basis of economic proof, not historical data.
But he was never taken seriously on this point by his
critics or even most of his fans. The endless failures of
Communist central planning to make anyone rich, including
the Communist elite, finally got too much for the Communist
elites to tolerate.

This brings me to the central thesis of my article.
It is best expressed in three questions.

1. What is the value of suppressing a political
deviant?
2. What is the cost?
3. Is the benefit greater than the cost?

Assume that you are Big Brother. You can monitor
anyone. You can find out what he owns, what he earns,
where he lives, where he works, what credit cards he uses.
You have a database on him. Any information that your
database lacks can be bought from private database
companies.

If you can monitor anyone, you can target anyone. You
can bankrupt almost anyone. Just bring a lawsuit against
him. His legal bills will bust him. He knows this. He
will capitulate. Money talks.

Do you want to set a legal precedent? Target someone
with limited financial resources and no connections.

Scholars and journalists who are committed to a
defense of individual liberty have collected databases of
horror stories on coercive yet legal government invasions
of privacy. For every documented story, there are untold
numbers of similar stories that never reached the media.

As surely as the zebras know that there are lions out
there, so do citizens know that there are bureaucrats out
there. Some of these bureaucrats have access to databases.

We all are impressed how fast NCIS agent McGee can
find out almost anything on any suspect, just by sitting at
his computer and typing. We all know that the bad guys
will not get away.

The problem is, in the real world, the bad guys often
get away until they finally confess. Think “Bernard
Madoff.” Furthermore, the good guys sometimes get nailed
for something they never did.

The Madoff case is classic. All that government
regulation, so little awareness! The reports got filed on
time. The SEC was tipped off to chicanery. Yet nothing
was done. Why not?

Mises told us why not. The government does not know
how to price anything rationally. It cannot determine
which cases are worth pursuing and which are not. There
are no official guidelines that provide insight.

Here is the operational rule. Bureaucrats pursue
those cases that justify their continuing employment. This
goal includes the survival of their bureaucracies.

Civil Service laws protect most Federal employees.
Bureaucratic immunity from budget cuts protects the
bureaucracies. So, bureaucrats pick the easy targets in
the same way that lions pick zebras: the young, the old,
and the sick.

I once read an article about a jet fighter ace in the
Korean War. He revealed his secret of success. He would
rapidly survey a squadron of MIG-15s, looking for a plane
that looked a little wobbly. If he spotted one, he knew
the pilot was inexperienced. He went after that plane.

This strategy can make you an ace. It will not win
wars. The Korean War ended in a cease-fire. It is still
officially going on.

THE SPONTANEOUS SOCIAL ORDER

F. A. Hayek’s greatest intellectual contribution was
not “The Road to Serfdom” (1944). It was the article
published the next year: “The Use of Knowledge in Society.”

http://bit.ly/HayekKnowledge

He argued that the amount of decentralized and highly
specialized knowledge in society is enormous when compared
to the knowledge available to a government committee. This
should be obvious to anyone. What was not obvious to
Western intellectuals was his conclusion: government
planning is unable to match the efficiency of individual
planning in a free market society.

This is a variation on Mises’s argument. Hayek
emphasized the free market’s system of profit and loss. It
elicits information from individuals who would not
otherwise provide it or put it to socially positive uses.
A planning board cannot get their collective hands on this
information, he argued. Mises had emphasized that, even if
the committee could get its hands on it, the committee
would not know what to do with it. It could not put this
information to its highest use.

The question then arises: Can a committee put this
information to good use for the committee? Can its members
feather their own nests? Can it achieve results that are
sufficiently beneficial to the committee and those leaders
it serves, so as to make irrelevant the fact that the
committee cannot not solve the allocation problem for the
masses? In short, can the committee find a positive answer
to the universal question: “What’s in it for me?”

The results of all but two of the Communist economic
schemes in the twentieth century was “no.” The two
exceptions were North Korea and Cuba. So far, these two
systems remain Communist. But it is looking more and more
as though this will end sometime in the next decade.
Poverty in those two countries is overwhelming.

The only way for the rulers to keep this information
from the masses is control over information. North Korea
is better at this than Cuba is. It is also a poorer
nation. We are back to the Austrian economists’ analysis
of the shortage of reliable information.

To run a really successful tyranny, the leaders must
have increasing wealth as well as more reliable data. They
need wealth to hire the programmers, the data collectors,
and the police. Computer costs keep falling, but they fall
much faster in the private sector (microcomputers) than the
government sector (mainframes).

The government’s computer systems are not integrated.
Not even the Internal Revenue Service has a seamless
system. (The two greatest lies in computer marketing are
these: “seamless transfer of data” and “user-friendly.)

Yes, governments have access to ever-growing
quantities of data. But the public has far greater access
to low-cost information that it uses to increase the
overall complexity of society. The task of monitoring what
is going on becomes ever-more utopian. The government is
always falling behind, for the reasons Hayek described.
The greater the complexity of society, the less able the
State is to monitor it, assess it, and use the data to
control it.

SOCIETY VS. THE STATE

Society is not the State. Society is a complex social
order which is based on voluntary exchange. The State is
an institution that imposes coercion. The State’s budget
constitutes a large section of every modern society, but
the inefficiency of the State is legendary. The State
cannot get much accomplished. Why not? Because its
employees are rewarded for following the book. They are
not rewarded for innovation. Mises made this point clear
in his 1944 book, “Bureaucracy.” The State’s system of
funding is different from the free market’s system.

The free market rewards successful forecasting to meet
the demands of customers. It is future-oriented: meeting
future customers’ demand. Society advances through
innovation and capital formation. It advances because of a
system of profit and loss. Successful innovators get very
rich. Unsuccessful ones lose control over resources.

The successful bureaucrat advances up the chain of
command by not making a big mistake. The essence of
bureaucracy is risk-avoidance. It is slow. It is self-
consciously slow. It is defensive. It is always looking
up regulations. Its answer to every request is “no.” Why?
Because you can retreat from “no” to “yes” if you have to,
and no one gets upset. You cannot avoid trouble by moving
from “yes” to “no.”

One implication of all this should be obvious, but it
isn’t: the State is rapidly falling behind in its ability
to control the economy. That was Mises’s insight in 1920.
Libertarians and free market conservatives believe this in
general, but they do not believe it specifically. They
give the state more credit for its ability to extend its
power than they should.

Think of Geithner and Bernanke. They are frantically
trying to restore the rate of economic growth. Nothing is
working. The economy is clearly broken. The banking
system is in retrenchment mode. Bankers know their banks’
balance sheets are held together with phony numbers. They
refuse to lend.

On October 25, Mervyn King, the Governor of the Bank
of England, gave a speech in which he admitted the
following: “Of the many ways of organising banking, the
worst is the one we have today” (p. 16). Thanks, Merv, for
putting it so well! Now please forward a copy to Ben.

http://bit.ly/KingBanking

What is true of the government’s ability to control
the economy is equally true of its ability to control
political resistance. The Tea Party is creating a threat
to the Old Boy Network. It is the handwriting on the wall.
Voters are beginning to rebel. They are not playing by the
traditional rules.

The ability of the Establishment to maintain its power
is dependent on its being able to buy off the voters and
co-opt the newly elected representatives. The failure of
the economy reduces the Establishment’s ability to hold
onto power.

The police State is going bankrupt. It has issued
more promises to voters and more promises to pay investors
in Treasury debt than it can possibly fulfill. When it
goes belly-up, as the USSR did, and as Red China did, the
Keynesian system will be exposed as the little man behind
the curtain — with a badge, a gun, and a printing press.

A determined herd of zebras can outrun any pride of
lions. Eventually, lions will be too weak to run.

Zebras don’t need to kick lions to death. They merely
need to run fast.

CONCLUSION

The police State is doomed. It cannot possibly keep
up with the constant innovation of society. It cannot gain
access to enough resources to maintain control. It wastes
the resources it commandeers.

The free market is winning. The attempts of the
Federal Reserve and Congress to delay the readjustment of
capital pricing goes on, but these attempts are not
bringing the promised recovery.

The voters are growing restless. They have been
promised miracles by the politicians. These promises are
visibly disintegrating. We are seeing a loss of faith.

The key to government control is voluntary compliance.
Without self-government, the civil government cannot
exercise control. Self-government relies on widespread
trust far more than widespread fear.

Widespread trust is fading. Widespread fear will fade
with it.

The little men behind the various curtains are getting
exposed on YouTube. There is nothing they can do about
this.

Familiarity breeds contempt. It can’t happen fast
enough for me.

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