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The Morality of Money, 5: Moral Hazard and Malinvestment

By Thomas Van (bio - articles - email) | Nov 21, 2016

Fractional-reserve banking depends on the assumption that the bank’s clients will not all try to redeem their notes at once: that there will not be a “run” on the bank. But as Hulsmann and other Austrian economists have argued, even if one banker is cautious in the degree of his inflation, the competition of other fractional-reserve bankers will drive him to reduce his reserves further and further, with a greater and greater risk of a run, resulting in bankruptcy for that bank.

Because the bank in danger of bankruptcy will need to borrow from other banks, which themselves need their reserves in case of runs on their own banks, this could trigger a wider collapse of the fractional-reserve banking industry. This happened numerous times in the nineteenth century and, notably, with the collapse of the international Bretton Woods banking system in 1971. Such collapses are harmful not just to bankers but to everyone who has invested savings in the banks. As people start refusing to use banknotes, this reduction in the money supply forces down money prices (including wages), interrupts production and causes temporary unemployment.

The risk of total collapse provides a strong incentive for banks to work together to nip such crises in the bud, which in turn provides an incentive for less responsible bankers to take greater risks in the knowledge that the burden will fall on their colleagues—a phenomenon known as moral hazard.

Cartelization, regulation and centralization of banking have basically been attempts to deal with the above problems of fractional-reserve banking when it has been legitimized, emboldened and enabled by legal tender laws.

A crucial form of state sponsorship of fractional-reserve banking has been the privilege of suspended payments, whereby a bank is permitted to enforce its contracts with debtors while being exempted from its contracts with creditors. The central banks of France, Germany and Great Britain did this to finance World War I. (Needless to say, an inflationary policy is often the financial key enabling a government to wage unlimited war.) Suspension of payments turns false legal tender bank notes into paper money. This was done definitively for all the world’s central banks when, on August 15, 1971, the US Federal Reserve System permanently suspended and ceased redemption of its notes.

The omnipresent threat hanging over economies today is the business cycle, popularly known as boom and bust. Murray Rothbard keenly observed that it is almost never noted that the business cycle is a uniquely modern phenomenon, nor is it asked why before a few centuries ago, economies apparently did not suffer such vicissitudes. Austrian business cycle theory offers a coherent account of certain features of the boom and bust that other schools of thought have not adequately addressed. Here too, at any rate, inflation plays a large role. Because it distorts the price system and cost calculations, and because the acceptance of false credit artificially lowers interest rates, inflation tricks entrepreneurs into thinking there are more resources available for investment than there really are.

This, of course, can entail massive waste and entrepreneurial failure on a vast scale. Artificially low interest rates do not increase objective capacity for production. They increase the projects launched but not the projects completed, as in Luke 14:28-30:

Which of you wishing to construct a tower does not first sit down and calculate the cost to see if there is enough for its completion? Otherwise, after laying the foundation and finding himself unable to finish the work the onlookers should laugh at him and say, “This one began to build but did not have the resources to finish.”

As the economy adjusts back to normal, illusions are dispelled and the extent of waste and malinvestment is made clear. Naturally, those who were drunk on the boom do not want to suffer the hangover, and the government is tempted to keep inflating (necessarily at higher and higher rates) to delay the crash. But this will only increase the economy’s need to correct itself, making the return to reality all the more painful when it finally comes. (There is a reason why everyone remembers the Great Depression, while nobody remembers earlier American depressions that were more severe while they lasted, yet did not last nearly as long.)

Since printers of paper money, unlike gold or silver miners, have no real limit on the amount of money they can produce, they are in no danger of bankruptcy. They are only limited by the threat of hyperinflation: that is, the extremely rapid devaluation of currency, all known cases of which have occurred with paper money. Paper money has also allowed public debt to grow exponentially (by the factor of 20 in the US since 1971). The anticipation of being bailed out by a central bank encourages private entrepreneurs, in real estate for example, to speculate far more recklessly than they otherwise would—another example of moral hazard.

It is worth noting that in The Ethics of Money Production, written in 2006, at a time when everyone was blithely enjoying the housing boom, Hulsmann predicted that the bubble would burst. He was not the only Austrian economist to do so. He wrote:

Consider the current (2006) U.S. real-estate boom. Many Americans are utterly convinced that American real estate is the one sure bet in economic life. No matter what happens on the stock market or in other strata of the economy, real estate will rise. They believe themselves to have found a bonanza, and the historical figures confirm this. Of course this belief is an illusion, but the characteristic feature of a boom is precisely that people throw any critical considerations overboard. They do not realize that their money producer—the Fed—has possibly already entered the early stages of hyperinflation, and that the only reason why this has been largely invisible was that most of the new money has been exported outside of the U.S.... [p. 171]

Bringing it back to the larger point, Hulsmann continued:

In the past, governments have tried to counter this trend through regulations. Moral hazard first became visible in the banking industry, and today this industry is indeed very strongly regulated. The banks must keep certain minimum amounts of equity and reserves, they must observe a great number of rules in granting credit, their executives must have certain qualifications, and so on. Yet these stipulations trim the branches without attacking the root. They seek to curb certain known excesses that spring from moral hazard, but they do not eradicate moral hazard itself. As we have seen, moral hazard is implied in the very existence of paper money. Because a paper-money producer can bail out virtually anybody, the citizens become reckless in their speculations; they count on him to bail them out, especially when many other people do the same thing. To fight such behavior effectively, one must abolish paper money. Regulations merely drive the reckless behavior into new channels.

One might advocate the pragmatic stance of fighting moral hazard on an ad-hoc basis wherever it shows up. Thus one would regulate one industry after another, until the entire economy is caught up in a web of micro-regulations. This would of course provide some sort of order, but it would be the order of a cemetery. Nobody could make any (potentially reckless!) investment decisions anymore. Everything would have to follow rules set up by the legislature. In short, the only way to fight moral hazard without destroying its source, fiat inflation, is to subject the economy to a Soviet-style central plan. [p. 171-172]


Previous in series: Manipulation by the State
Next in series: Social Consequences of Inflation

The Ethics of Money Production may be purchased in hardback from its publisher, the Mises Institute, at a third of the Amazon price, or, like all of the Institute’s publications, downloaded for free as a PDF or ebook.

Thomas Van is an administrative assistant and writer at CatholicCulture.org. A jazz pianist with a music degree, he often takes the lead in our commentary on the arts. See full bio.

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