Deconstructing the credit pyramid of FRB

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Juan replied on Sat, Oct 18 2008 8:02 PM

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Since all banks are (likely) insolvent if not backed by the central bank, immediately requiring free banking could (would?) force the liquidation of many banks.

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jason4liberty replied on Sun, Oct 19 2008 11:14 AM

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I guess that my concern is more pragmatic than idealistic.  I personally believe that FRB constitutes fraud, and is therefore wrong and should be illegal.  I am concerned that due to its entrenched and widespread nature nearly all banks in the US would collapse immediately if the central crutch of the Fed was removed.  My fear is that the liqudation of all loans - or at least a whole bunch of them - might "kill the host" and fully dissipate the pool of real savings.  I was hoping to consider a stern and rapid but less abrupt transition back to private banking, so that fiscally conservative institutions could perhaps make it through, but that the less conservative would fail. 

Are there any banks in the world that could survive an immediate removal of the support of their central bank?  I want the Fed gone, I am just fearful of the consequence of immediate removal of that crutch.  I guess that the favored institutions under the Fed regime would be the first to fail, and that is just fine with me, but can it be done without bankrupting all banks and starting the whole system over again?

(Or would that be the best choice?)

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Felix replied on Fri, Oct 31 2008 7:17 AM

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I want to deviate a bit from the topic and write about Check Fraud. There are several ways check fraud is done. It usually means purchasing goods or services and paying with the check that was been stolen from the owner and counterfeited or manipulated. Usually thieves steal the check from the owner, counterfeit owner’s signature and try to use the check for fraudulent purposes. Generally criminals focus on merchants that trade with high-value goods, such as cars. In fact such merchants must be more cautious about accepting checks or banker’s drafts, since they can be stolen or counterfeited and merchants may lose a lot from fraudulent transaction. However as practice shows, such merchant are often deceived due to their negligence.

Criminals often pursue following tactics: they make purchase at the merchant’s store and make a payment through the check or banker’s draft that is of the higher amount than the goods purchased. Criminals assure merchant that the check or banker’s draft will be cleared and ask him/her to transfer excess funds either to their account or to the account of the third person. In fact such a conduct should be alarming for the merchant and should raise a concern that it can be a scam, however in many cases such fraudulent conduct turns to be successful.

In these cases it is extremely difficult to track fraudulent checks in the clearance system. Although banks try to do their best to tackle this kind of fraud, but owner of the check very often does not realize that one of the checks from his/her checkbook has been stolen and moreover money has been withdrawn from the account using the missing check. Sometimes it takes weeks or even month before the fraudulent cash is claimed back.

Since 2007 the banking system through the Check and Credit Clearing Company is amending the ways by which checks are processed. The new system involves the following: in case the fraudulent check is used, merchant retains funds if they are not claimed within six working days with the exception, when merchant voluntarily agrees to give them back, or the merchant is part of the fraud scheme.

Generally banks examine credit fraud events case to case, but in most cases if the customer is innocent and just a victim of check theft, he/she is refunded. However if the merchant accepts fraudulent check or check for inflated amount, the merchant is unlikely to get the goods back and he/she is obliged to refund the cash. However after 2007 merchants can be sure that they do not have liability to refund fraudulent cash, if it is not claimed within six working days, unless merchant is part of the fraud scheme.

Despite these changes, banking industry continues to recommend merchants to be cautious about accepting checks; however it seems that these recommendations and actual deeds deeply contradict to each other. On one hand, in the previous scheme merchants were heavily discriminated, since they were the ones who bore all the risk and check owners were the ones, who were not subject to financial loss, despite the possibility that checks could be stolen due to owner’s negligence. The new scheme offers quite a good solution for merchants: if the funds are not claimed in time, then check owner loses them. At the first sight founds fair!

But let us now analyze this situation more deeply. In fact new measures raise moral hazard problem: if merchant knows that after six days fraudulent cash will become his/hers, he/she will have less incentive to control and refrain from suspicious operations, since there is high possibility of retaining these funds. Now let us imagine situation, when a merchant and a thief can find it beneficial to cooperate and can even agree to divide proceeds from the fraud. Why not? Before stealing checks, thieves often gather some information about habits of a victim. If the thief is sure that the person he stole a check from with the high probability will not check his/her bank statement within six days, then the whole operation can turn out to be quite beneficial. This may give rise to the wave of fake transactions, where merchants will be involved.

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alansmithee replied on Sat, Nov 1 2008 6:47 PM

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I see where you are coming from with the pragmatic stance. This is the difficulty with the wallstreet(+/welfare) state; namely the government creates a legion of dependants to protect it's interests and so defend it from capitalist encroachment, for example the doing away with the Fed'. I've got to say Jeffrey's argument brings a smile to my face, being the idea that no real wealth is destroyed, but this does not alter people's perception of what is going on (e.g. libertarians are going to take their cheque away or whatever the particular case may be).

Once this issue is discussed in these terms it resembles very much Bismark's claims about what he was trying to create with public social programs, namely total dependance on the state apparatus.

An difficult question indeed, and one that proves that the theory truely is the easy part...would be interest ed in hearing other answers to this. I personally am of the opinion (i thyink) that revolutionary acts like this one are not going to be (the most) effective as they do not change peoples ideas, only their circumstance. Only when people realise that the Fed and the social policies it indirectly funds are not good for them will people allow this sort of thing to 'go down' so to speak. If the Fed is abolished in a revolutionary manner than people will just demand another (there or there abouts)..

This issue in many gives ways gives way (sry) to the larger question of conservative progression to liberty or a revolutionary leap to liberty. As I indicated I think im in the camp of mass ideas and perceptions must be changed first (thus rendering a revolution redundant), as opposed to violent (even if only metaphorical) overthrow of the system.

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Rubén replied on Sat, Nov 1 2008 9:15 PM

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jason4liberty:

I guess that my concern is more pragmatic than idealistic.  I personally believe that FRB constitutes fraud, and is therefore wrong and should be illegal.  I am concerned that due to its entrenched and widespread nature nearly all banks in the US would collapse immediately if the central crutch of the Fed was removed.  My fear is that the liqudation of all loans - or at least a whole bunch of them - might "kill the host" and fully dissipate the pool of real savings.  I was hoping to consider a stern and rapid but less abrupt transition back to private banking, so that fiscally conservative institutions could perhaps make it through, but that the less conservative would fail.

I truly support your idea. I think it is brilliant, and I think a lot of minds should start focusing on the specific technical details of proposing such a transitional schedule taking into account the multiple political, economic, social and cultural variables, instead of theoritizing in the middle of nowhere.

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szh replied on Sat, Nov 22 2008 10:31 AM

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In "Mystery of banking" M Rothbard suggested to allocate gold amongst banks against M1 ( I arrived to $5166 per ounce). But what happens if CD holders after maturity will want to reduce (M2-M1) in favour of M1 so that M1 increases. How then banks will back these new demand money? Will right solution be to allocate gold against M2 at $28,000 per ounce. Thoughts?