JPMorgan Chase and Central Banking

Mises Daily: Friday, May 18, 2012 by Frank Shostak

On Friday, May 1, 2012, JPMorgan Chase said it suffered a $2 billion trading loss. Some
commentators have suggested that the huge loss emanates from so-called proprietary trading
or placing risky bets using the bank's money. The loss raised the credibility of the Volcker rule,
which restricts banks from trading their own money. Despite JPMorgan Chase's large loss, the
opponents of the Volcker rule are of the view that the rule, if it is introduced, will only
destabilize the financial markets and make things much worse. Hence they would like to allow
market forces to do their job.

Do Fewer Banking Controls Always Equate with a Free

Market?

The proponents for less control in the banking industry hold that fewer restrictions imply a
better use of scarce resources, which leads 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, while controlled banking stifles the process of real
wealth formation. However, it is overlooked by the opponents of the Volcker rule that the
present banking system has nothing to do with free banking and thus 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 "out of thin air" can be generated and hence greater damage inflicted on the
wealth-generation process. This must be contrasted with genuine free banking, i.e., the
absence of a central bank, where the potential for the creation of money out of thin air is
minimal.

Elsewhere we have shown 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 would 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 the central bank. By means of
monetary policy, which is also termed the reserve management of the banking system, the
central bank permits the existence of fractional-reserve banking and thus the creation of
money out of thin air.

The modern banking system can be seen as one huge monopoly bank that is guided and
coordinated by the central bank. Banks in this framework can be regarded as "branches" of the
central bank.

For all intents and purposes the banking system can be seen as being comprised of one bank.
(Note that a monopoly bank can practice fractional-reserve banking without running the risk of
being "caught.")

Through ongoing monetary management i.e., monetary 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" so banks will not bankrupt each other.

The Myth of Financial Deregulation

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

The introduction of financial deregulation 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.

In the present central-banking framework this increase culminated in an explosion in the

creation of credit out of thin air a massive explosion in the money supply. (In the
deregulated environment, banks' ability to amplify the Fed's pumping has enormously
increased.)

Rather than promoting an efficient allocation of real savings, the current so-called deregulated
monetary system has been promoting the channeling of money out of thin air across the
economy. From this it follows that, in the framework of the present monetary system, in order
to reduce a further weakening of the real wealth-generation processes, it is necessary to
introduce tighter controls on banks. Murray Rothbard wrote,

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. (Making Economic Sense, p. 279)

Bear in mind that we don't suggest here suppressing the free market but suppressing banks'
ability to generate credit out of thin air. Please note that the present banking system has
nothing to do with a true free-market economy.

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

Summary and Conclusions

According to some commentators, the huge $2 billion loss by JPMorgan Chase, caused by the
risky bets placed using the bank's money, raises the need to implement the Volcker rule
more controls on banks' activities. Critics of the Volcker rule 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 as long as we have a central bank, in order to minimize the damage its
policies inflict, it makes sense to impose tighter controls on banks. It is the central bank that
enables banks to practice fractional-reserve banking, thereby polluting the economy with
money out of thin air. A better alternative is of course to have genuine free banking without
the central bank.
Charting Fun with Krugman
Mises Daily: Wednesday, May 23, 2012 by Robert P. Murphy

In a few recent blog posts, Paul Krugman used bar graphs and tables to (allegedly) prove the
superiority of his views over those of the Austrians. Yet, as I'll show in this article, I can use
Krugman's own data to demonstrate the exact opposite.

Krugman on the Fed and Banking Panics

Perhaps spurred by his Bloomberg debate with Ron Paul, Krugman posted the following
regarding financial panics and the US central bank:

There's a very widespread belief on the right that banking crises only happen because either
the Fed or Barney Frank cause them; go back to a gold standard, and there would be no need
for financial regulation or anything like that.
This is, of course, nonsense; Walter Bagehot knew all about financial crises, which have been a
constant feature of modern economies since at least the early 19th century. Just to drive the
point home, I thought it might be worth posting Gary Gorton's chart (pdf) of "panics" before
the Fed went into operation:
Panics will happen; the question is how they are contained. (emphasis added)

Now although Krugman doesn't explicitly say "Ron Paul" or "Austrian economists," I think he has
to have them in mind here. After all, before the Austrians rose in popularity, hardly anybody
talked about the gold standard, let alone abolishing the central bank. It was the Austrians, and
most notably Ron Paul, who put those ideas back into the limelight so that Paul Krugman feels
the need to address the issue.

In that light, Krugman is simply making stuff up when he says such people think banking panics
never happened before the Fed. Murray Rothbard's doctoral dissertation was The Panic of 1819,
and Rothbard also wrote on the history of the Fed, so I'm pretty sure he wouldn't be shocked
by Krugman's table.

But besides the cheap debating ploy setting up his opponents as believing something
obviously ridiculous Krugman leaves open the door to his own demise in his final sentence,
after the chart, when he writes, "Panics will happen; the question is how they are contained."

Fortunately, Krugman himself provides the answer in a follow-up post on the very same day. In
this new post he writes,

A followup on this post. We had frequent banking panics before there was a Fed; how bad
were they?
Well, Christy Romer has an old paper on long-run volatility, in which she created a metric:
percentage-point months of industrial production lost until previous peak was regained:
So some of those pre-Fed panics were worse than the big slumps of 1974 and 1981, although
far short of Great Depression stuff.
By my estimate, the current number using industrial production data is 455; it will get a bit
bigger but not much if the recovery continues.
So we're doing worse than after, say, the Panic of 1907 but not that much worse.

How do you like that? By Krugman's own admission, the two worst panics occurred after the
Fed was formed. And if we take Romer's numbers from the table above, and plug in a decline
of 455 for the most recent recession (which Krugman himself says will be an understatement),
we get that the average "output loss" (measured in the units Romer defines in the chart) during
recessions from the pre-Fed era was 158.1, while in the post-Fed era it was 356.4.

Does everyone see the significance of this? Krugman himself said that panics will always
happen, and the question is how they are contained. Using Krugman's own source, we find that
the establishment of the Fed generated (a) the two worst panics in US history and (b) a string
of panics that were on average more than twice as bad as the average panic from the pre-Fed
era.

Steve Horwitz does a good job explaining why Krugman's understanding of US banking history is
flawed, because we didn't have laissez-faire banking in the late 1800s. But we don't even have
to rely on such explanations for the matter at hand. Remember, these data weren't pulled
from Krugman after a session of waterboarding. He volunteered them as if they were somehow
supposed to embarrass the critics of the Fed. What would the numbers have to look like, for
Krugman to have admitted, "Hmm, it seems like for once, empirical reality has turned against
my Keynesian nostrums"? Would the post-Fed panics have to be three times as bad?
One last thing before I leave this topic, because I just want to make sure everyone sees what a
rhetorical illusionist Krugman is. After he ballparks the current number (using Romer's metric
for output loss) at 455, he writes, "So we're doing worse than after, say, the Panic of 1907
but not that much worse."

That word "say" in his quotation makes it sound as if Krugman threw a dart at Romer's left
column, and picked the panic that happened to come up. But no, the Panic of 1907 is the
worst one of the pre-Fed era shown in Romer's list. With as much justification, Krugman could
have written the following summation instead: "So the second-worst recession of the Fed era
which we're experiencing right now even though the guy I said there's nobody I'd rather be Fed
chief has been at the helm the whole time is already worse than the absolute worst episode
from the pre-Fed era. But hey, as long as this recovery continues and I often warn that we
are on the verge of disaster if Republicans take over we're not doing that much worse. It's
not like right now we're anywhere close to being as awful as under the Great Depression,
which happened 20 years after the Fed was formed to prevent things like the Panic of 1907."

The Structural Signature

A bit earlier in the month, Krugman returned to his familiar theme of saying that the
employment data best match aggregate-demand explanations of the recession:

How do you assess stories about what's going on in the economy? You can go with your
prejudices, of course. But the way I usually try to do it is to ask whether the available facts
fit the "signature" the story seems to imply that is, do we see the general pattern that the
argument would suggest we'd see?
Now consider the argument that our problems are mainly structural. The way this story is
usually told is that we had too many workers in the wrong industries, that we have to expect a
depressed level of overall employment as workers are moved out of these "bloated" sectors.
OK, so what should be the signature of that story? Surely it is that job losses should be
concentrated in the bloated sectors, that employment should if anything be rising elsewhere
and wages should be rising in the unbloated sectors more rapidly than in the bloated ones.
So, let's take a quick look at BLS data on employment and wages. Here's what we get on a first
pass:
Kind of looks like job losses everywhere, doesn't it?
And on wages,

Who's bidding for workers?

You can try to refine this stuff by disaggregating, but on first pass the signature of a structural
problem just isn't there.

Before diving into the substantive issue, let me note that once again Krugman is engaging
in sleight of hand. Ask yourself: Why is he using the absolute change in job numbers in the first
chart, when he (quite correctly) used percentage changes in the second chart? The answer, I
suspect, is that percentage changes in the first chart look like this:
Now let's make one more tweak. Although it's true that Arnold Kling (and perhaps others) have
been pushing his "recalculation" story as if it continues to be the dominant theme throughout
the entire recession, the standard Austrian position was that the initial downturn was
necessary because of the structural imbalances of the boom years. Yet no Austrian to my
knowledge said that the various rounds of quantitative easing, TARP, or the Obama stimulus
package would have a disproportionate effect on construction.

If anything, those programs would have dampened the blow to housing and construction more
generally, and the Austrian point was that we weren't doing the economy any favors by
preventing the needed recovery. To put it in other words, the standard Austrian story was that
the various interventions (all of which Krugman favored, though with caveats as to their design
and implementation) would make Americans collectively poorer, and would hurt "the economy"
in general. There is no reason to think that, say, the Obama stimulus package would yield a
larger drop in construction versus services in Q4 2009.

To get a much better test, then, of whether the recession exhibited the "structural signature"
before Krugman's favored (and what he considered inadequate) measures kicked in, we can
look at employment in the three sectors Krugman chose for the test. The only difference
(besides the obvious one of using percentages rather than absolute job losses) is that I'll
change the time period from 2006 to 2008. The BLS link Krugman gave only has annual data, so
these are the best start and end dates to isolate the popping of the housing bubble and the
official onset of recession (in December 2007) but before most of the Keynesian "medicine" was
administered (starting in late 2008 but kicking in especially in early 2009). Here's what the
revised chart looks like:

That sure looks like a sector rebalance underway, to me.[1]

Conclusion

This is not the first time that Krugman has erroneously used data to cast aspersions on the
Austrian position. In my reply to the first (and last?) blog post where Krugman specifically
mentioned me, I wrote,

I can point to at least two episodes where the "sectoral-readjustment" story of the Austrians
clearly has more explanatory power than Krugman's "insufficient demand" story. Specifically, in
late 2008 Krugman argued that the housing bust had little to do with the recession, because
the latest BLS figures showed that unemployment at the state level bore little relationship to
the declines in home prices across the states.
However, I pointed out that looking at year-over-year changes in unemployment at the end of
2008 was hardly the right test. If we looked at changes from the moment the housing bubble
burst, then five of the six states with the biggest housing declines were also in the list of the
six states with the biggest increases in unemployment.
On another occasion Krugman once again thought he had dealt the readjustment story a
crushing blow when he pointed out that manufacturing had lost more jobs than construction. I
pointed out that this too wasn't a valid test, because manufacturing had more workers to begin
with. When we looked at percentage declines, then construction did indeed crash more heavily
than manufacturing. Furthermore and just as Austrian theory predicts the employment
decline in durable-goods manufacturing was worse than in nondurable-goods manufacturing,
while the decline in the retail sector was lighter than in the other three.

These are very important episodes. When Krugman thought the numbers were on his side, he
was happy to cast aspersions on the sectoral-readjustment story; he thought his own model
was perfectly able to explain the situation if the crash in housing really didn't have much to do
with the upheaval in the labor markets. And, as Krugman himself argued, had he been using
valid tests, then the outcomes would indeed have been challenging to the Austrian story.
Because Krugman was the one who set up these two challenges, it is significant that the
Austrian theory passed with flying colors.

In light of his recent blog posts on banking panics and structural signatures, I think we need to
amend my statement to read that Krugman has now set up four separate empirical tests, and
using his own data we see that the Austrian approach does far better than the Keynesian.