The missing link of financial reform

20 04 2009

Throughout the entire financial crisis/meltdown the calls for reform are pretty spot on and uniform:  A more regulated less leveraged system to decrease volatility.  Fine.  Sign me up.  But something always bothered me about finance that never seems be addressed.  Its pretty clear that banks artificially raises the prices of key assets (like housing and tuition) through leverage.  In a pure market where loans are not allowed and you could only sell assets for whatever cash people had on hand, well guess how much that “million dollar” home down the street would really sell for?  The answer is likely for whatever the down payment would be – usually around 20% of the loan.  The problem is that in exchange for this artificial pricing there is no systemic payoff – only the banks realize a profit through the interest they charge.  Thats because the people who sell a million dollar home don’t share in the profit for the most part – they need to buy a new house to live in which, in turn, is also artificially inflated by the same system.  Think about the tuition rate over the last twenty tears.  Is it any coincidence that the cost of college has increased exponentially along with federally funded student loan programs?

What does all this lead to?  Well in times of crises all of this leverage makes the downturn exponentially worse and that much harder to get out of.   But how do we deal with this issue?  Is it just a necessary evil of a modern financial system?  Last week I read a very interesting NY Times piece by Eric Zencey entitled “Mr. Soddy’s Ecological Economy.”  In the aftermath of the Depression Frederick Soddy, a British nobel prize winning chemist who helped bring about the atomic age, decided to turn his attention to economics.  He was disgusted with the destructive powers of atomic energy and turned, rather brazenly, to trying to solve the inefficiencies of economics.  He was considered a kook – he used laws of thermodynamics and nature and applied them to economics.  He had 5 natural laws that he wanted to impose (see the article for a more in depth description).  He died pretty much discredited but guess what?  Four of the five are now considered mainstream regulatory necessities.  But it is the fifth, still marginalized, that I see as a possible answer of the leverage problem of finance:

Soddy’s fifth proposal, the only one that remains outside the bounds of conventional wisdom, was to stop banks from creating money (and debt) out of nothing. Banks do this by lending out most of their depositors’ money at interest — making loans that the borrower soon puts in a demand deposit (checking) account, where it will soon be lent out again to create more debt and demand deposits, and so on, almost ad infinitum.

One way to stop this cycle, suggests Herman Daly, an ecological economist, would be to gradually institute a 100-percent reserve requirement on demand deposits. This would begin to shrink what Professor Daly calls “the enormous pyramid of debt that is precariously balanced atop the real economy, threatening to crash.”

Banks would support themselves by charging fees for safekeeping, check clearing and all the other legitimate financial services they provide. They would still make loans and still be able to lend at interest “the real money of real depositors,” in Professor Daly’s phrase, people who forgo consumption today by taking money out of their checking accounts and putting it in time deposits — CDs, passbook savings, 401(k)’s. In return, these savers receive a slightly larger claim on the real wealth of the community in the future.

In such a system, every increase in spending by borrowers would have to be matched by an act of saving or abstinence on the part of a depositor. This would re-establish a one-to-one correspondence between the real wealth of the community and the claims on that real wealth.