I have written a number of pieces on fractional reserve banking and duration mismatch.  I have argued that the former is perfectly fine, both morally and economically, but the latter is not fine.  I have dissected the arguments made against fractional reserve banking, and pointed out that it is nothing more than a bank lending out some of the money it takes in deposits.

I have debunked the most common errors made by opponents of fractional reserve:

1. Banks print money
2. They lend more than they take in deposits
3. They inflate the money supply
4. Money is the same as credit
5. Fractional reserves banking is the same thing as central banking
6. It is the same thing as duration mismatch

Duration mismatch is when a bank (or anyone else) borrows short to lend long.  Unlike fractional reserve, duration mismatch is bad.  It is fraud, it is unfair to depositors (much less shareholders) and it is certain to collapse sooner or later.  This is not a matter for statistics and probability, i.e. risk.  It is a matter of causality, which is certain as I explain below.

This discussion is of paramount importance if we are to move to a monetary system that actually works.  Few serious observers believe that the current worldwide regime of irredeemable paper money will endure much longer.  Now is the time when various schools of thought are competing to define what should come next.

I have written previously on why a 100% reserve system (so-called) does not work.  Banks are the market makers in loans, and loans are an exchange of wealth and income (http://keithweiner.posterous.com/the-loan-an-exchange-of-wealth-for-income).  Without banks playing this vital role, the economy would collapse back to its level the previous time that the government made it almost impossible to lend (and certainly to make a market in lending).  The medieval village had an economy based on subsistence agriculture, with a few tradesmen such as the blacksmith.

But I have not directly addressed the issue of why duration mismatch necessarily must fail, leading to the collapse of the banks that engage in it.  The purpose of this paper is to present my case.

In our paper monetary system, the dollar is in a “closed loop”.  Dollars circulate endlessly.  Ownership of the money can change hands, but the money itself cannot leave the banking system.  Contrast with gold, where money is an “open loop”.  Not only can people sell a bond to get gold coins, they can take those gold coins out of the monetary system entirely, and stuff them under the mattress. This is a necessary and critical mechanism—it is how the floor under the rate of interest is set.

This bears directly on banks.  In a paper system, they know that even if some depositors withdraw the money, they do not withdraw it to remove it altogether  (except perhaps in dollar backwardation, at the end.  See: http://keithweiner.posterous.com/dollar-backwardation).  They withdraw it to spend it.  When someone withdraws money in order to spend it, the seller of the goods who receives the money will deposit it again.  From the bank’s perspective nothing has changed other than the name attached to the deposit.

The assumption that if some depositors withdraw their money, they will be replaced with others who deposit money may seem to make sense.  But this is only in the current context of irredeemable paper money.  It is most emphatically not true under gold!

There are so many ills in our present paper system, that a forensic exploration would require a very long book (at least) to dissect it.  It is easier and simpler to look at how things work in a free market under gold and without a central bank.

Let’s say that Joe has 17 ounces of gold that he will need in probably around a month.  He deposits the gold on demand at a bank, and the bank promptly buys a 30-year mortgage bond with the money.  They assume that there are other depositors who will come in with new deposits when Joe withdraws his gold, such as Mary.  Mary has 12 ounces of gold that she will need for her daughter’s wedding next week, but she deposits the gold today.  And Bill has 5 ounces of gold that he must set aside to pay his doctor for life-saving surgery.  He will need to withdraw it as soon as the doctor can schedule the operation.

In this instance, the bank finds that their scheme seems to have worked.  The wedding hall and the doctor both deposit their new gold into the bank.  “It’s not a problem until it’s a problem,” they tell themselves.  And they pocket the difference between the rate they must pay demand depositors (near zero) and the yield on a 30-year bond (for example, 5%).

So the bank repeats this trick many times over.  They come to think they can get away with it forever.  Until one day, it blows up.  There is a net flow of gold out of the bank; withdrawals exceed deposits.  The bank goes to the market to sell the mortgage bond.  But there is no bid in the mortgage market (recall that if you need to sell, you must take the bid).  This is not because of the borrower’s declining credit quality, but because the other banks are in the same position.  Blood is in the water.  The other potential bond buyers smell it, and they see no rush to buy while bond prices are falling.

The banks, desperate to stay liquid (not to mention solvent!) sell bonds to raise cash (gold) to meet the obligations to their depositors.  But the weakest banks fail.  Shareholders are wiped out.  Holders of that bank’s bonds are wiped out.  With these cushions that protect depositors gone, depositors now begin to take losses.  A bank run feeds on itself.  Even if other banks have no exposure to the failing bank, there is panic in the markets (impacting the value of the other banks’ portfolios) and depositors are withdrawing gold now, and asking questions later.

And why shouldn’t they?  The rule with runs on the bank is that there is no penalty for being very early, but one could suffer massive losses if one is a minute late (this is contagion http://dailycapitalist.com/2012/05/30/keithgram-contagion-defined/).

What happened to start the process of the bank run?  In reality, the depositors all knew for how long they could do without their money.  But the bank presumed that it could lend it for far longer, and get away with it.  The bank did not know, and did not want to know, how long the depositors were willing to forego the use of their money before demanding it be returned.  Reality (and the depositors) took a while, but they got their revenge.  Today, it is fashionable to call this a “black swan event.”  But if that term is to have any meaning, it can’t mean the inevitable effect caused by acting under delusions.

Without addressing the moral and the legal aspects of this, in a monetary system the bank has a job: to be the market maker in lending.  Its job is not to presume to say when the individual depositors would need their money, and lend it out according to the bank’s judgment rather than the depositors’.  Presumption of this sort will always result in losses, if not immediately.  The bank is issuing counterfeit credit.  In this case, the saver is not willing (or even knowing) to lend for the long duration that the bank offers to the borrower.

Do depositors need a reason to withdraw at any time gold they deposited “on demand”?  From the bank’s perspective, the answer is “no” and the problem is simple.

From the perspective of the economist, what happened is more complex.  People do not withdraw their gold from the banking system for no reason.  The banking system offers compelling reasons to deposit gold, including safety, ease of making payments, and typically, interest.

Perhaps depositors fear that a bank has become dangerously illiquid, or they don’t like the low interest rate, or they see opportunities offshore or in the bill market.  For whatever reason, depositors are exercising their right and what they expressly indicated to the bank: “this money is to be withdrawn on demand at any time.”

The problem is that the capital structure, once erected, is not flexible.  The money went into durable consumer goods such as houses, or it went into partially building higher-order factors of production.  Imagine if a company today began to build a giant plant to desalinate the Atlantic Ocean.  It begins borrowing every penny it can get its hands on, and it spends each cash infusion on part of this enormous project.  It would obviously run out of money long before the plant was complete.  Then, when it could no longer continue, the partially-completed plant would either be disassembled and some of the materials liquidated at auction, or it would sit there and begin to rot.  Either way, it would finally be revealed for the malinvestment that it was all along.

By taking demand deposits and buying long bonds, the banks distort the cost of money.  They send a false signal to entrepreneurs that higher-order projects are viable, while in reality they are not.  The capital is not really there to complete the project, though it is temporarily there to begin it.

Capital is not fungible; one cannot repurpose a partially completed desalination plant that isn’t needed into a car manufacturing plant that is.  The bond on the plant cannot be repaid.  The plant construction project was aborted prior to the plant producing anything of value.  The bond will be defaulted.  Real wealth was destroyed, and this is experienced by those who malinvested their gold as total losses.

Note that this is not a matter of probability.  Non-viable ventures will default, as unsupported buildings will collapse.

People do not behave as particles of an “ideal” gas, as studied by undergraduate students in physics.  They act with purpose, and they try to protect themselves from losses by selling securities as soon as they understand the truth.  Men are unlike a container full of N2 molecules, wherein the motion of some to the left forces others to the right.  With men, as some try to sell out of a failing bond, others try to sell out also.  And they are driven by the same essential cause.  The project is non-viable; it is malinvestment.  They want to cut their losses.

Unfortunately, someone must take the losses as real capital is consumed and destroyed.  A bust of credit contraction, business contraction, layoffs, and losses inevitably follows the false boom.  People who are employed in wealth-destroying enterprises must be laid off and the enterprises shut down.

Busts inflict real pain on people, and this is tragic as there is no need for busts.  They are not intrinsic to free markets.  They are caused by government’s attempts at central planning, and also by duration mismatch.

The current financial crisis, may progress to a phase where people demand and hoard dollar bills but take electronic deposit credits only at a discount which increases until electronic deposit credits are repudiated entirely.  The Federal Reserve would be powerless to solve the problem, because while they can create unlimited electronic deposit credits they can’t create unlimited paper dollar bills, “money you can fold” as Professor Antal Fekete calls it.  There would be a glut of electronic deposits, but a shortage of dollar bills.

Before the financial crisis metastasized in 2008, Fekete wrote a paper that I think is underappreciated and under-discussed.  Can We Have Inflation and Deflation at the Same Time?  In his paper, he discussed the “tectonic rift” between paper Federal Reserve Notes (i.e. dollar bills) and electronic deposits.  By statute, the Federal Reserve cannot print dollar bills without collateral (e.g. Treasury bonds).  Also, they have limited printing press capacity that is insufficient to keep up with a catastrophic crisis.

He discussed the inverted pyramid of John Exter.  Gold is the triangle at the bottom, and then above is silver, dollar bills, and then the various kinds of electronic deposits, stocks, real estate, etc.  In a crisis, people want to move from top to bottom of the pyramid, but of course there isn’t enough of the stuff at the bottom.

In a scenario in which desperate, panicky people are trying to cope with the enormity of a collapse that they don’t and can’t understand, I think this split between “physical” dollars and “electronic” dollars is very plausible.

Just as there is nothing to be accomplished by selling an underlying security as it becomes worthless, only to buy a derivative of it, selling Treasury bonds and buying dollars is equally nonsensical.  The dollar is the Federal Reserve’s liability, backed by the Treasury bond as the asset.  If you believe the Treasury bond is worthless, then you ascribe no value to the dollar either.  This is why gold will go into permanent backwardation.  Holders of dollars will provide an unlimited bid for gold that will not be reciprocated by holders of gold.  The latter own the only safe asset, and the only monetary asset that is not ultimately backed by the Treasury bond or the dollar, and they will have no desire to give it up.

The concept of backwardation is simple.  It is when people accept a future promise to deliver only at a discount to physical stuff handed over right now.  This could be when there is a shortage, such as wheat before the harvest.  Or in the case of gold, backwardation signifies a collapse in trust.  But isn’t this the same phenomenon of a tectonic rift between paper dollars and electronic deposits?

In a certain sense, the “money you can fold” behaves like a physical commodity, a present good (I realize I am stretching the concept here more than a bit).  The electronic deposit credit is most definitely a future promise.  In my gold backwardation thesis, the action begins with the offer on the futures contract falling below the bid on spot gold.  The bid-ask spread on spot gold widens, as the offer is relentlessly advancing, pulling the bid behind it.  The bid-ask spread on the futures contract also widens, as the offer remains stubbornly high, but the bid withdraws and retreats as gold buyers don’t trust futures and buy physical gold instead.  Eventually, there are no more sellers of physical gold and that is that (except for the dollar-commodities-gold arbitrage, a backdoor way for dollar holders to get a little gold before the end of the game).

If this split occurs in the dollar, I think it will play out the same way.  At first, sellers of real goods may accept electronic credit money, but demand a higher price.  The spread on the electronic dollar widens, with the bid from real goods falling.  At the same time, virtually unlimited demand for the “real” paper you can fold causes the bid on the paper dollar to rise.

Who knows how long it could last?  People could go on accepting paper dollars out of long habit.  Obviously, this is an unstable situation that must necessarily collapse.  Unlike gold, the paper dollar has no value other than the broken promises that back it.

I dub this “dollar backwardation”.