At the moment I am reading a book called “Gold – The once and future Money“. Published in 2007 it is written by Nathan Lewis. Given that Nathan is a long standing advocate of the gold standard and given that he eminates from the same economic school of thought as me (supply-side) he is preaching to the choir in many ways. Yet the book is still surprising to me. More than just another tomb about the superior nature of the gold standard and free market money the book is more an account of monetary history and the numereous times since antiquity that we have used floating currencies (soft currencies) and redemable currencies (hard currencies), central banks and other monetary tools of trade. Thus far I have encountered a lot of history about liquidity crisis and solvency crisis back to antiquity. For instance it has an interesting account of a Roman liquidity crisis the year Jesus Christ was executed as well as the mechanism by which it was resolved. It contains a wealth of other examples through history with an account of how the problems were ultimately resolved in each instance (sometimes neatly, sometimes quite poorly). I had naively believed that central banking had been invented in the last couple of centuries but examples can be found thousands of years ago. The book is in many ways a book about statesmanship as it applies to monetary affairs and well worth the read.
One of the points that the book brings home, and which is very relevant in the current global financial context is the difference between a bank solvency crisis and a bank liquidity crisis. The former can cause the latter but the two are quite distinct problems and the remedy is quite different. What the world is witnessing at the moment is primarily a solvency crisis in part of the banking sector and liquidity issues are a secondary effects driven by uncertainty. The remedy for a solvency crisis is bankruptcy. Nationalisation of the insolvent banks can be a workable proxy for normal bankruptcy processes however nationalisation cuts against my libertarian instincts (I worry that unlike bankruptcy proceedings government nationalisation will lead to governments holding onto the banks at the end of the process). Understanding the solution to a liquidity crisis entails a little more work and I don’t care to use up too much space on the details here.
However on the issue of liquidity crisis the book makes a good point via an anecdote from history that I thought worthy of sharing. For a long time US law has mandated that banks hold reserves of a prescribed amount. Currently the amount is 10% of demand deposits. Prudence would dictate that banks hold reserves as a form of insurance against a liquidity crisis even in the absence of any law but the law has a strange effect. The law creates a form of insurance that can’t be readily used. In the event of a liquidity crisis banks can’t reduce their reserve below the legislated level. At the precise time when solvent banks need to fascilitate a transfer of short term credit (from the insolvent to the solvent) the legal system effectively bars them from doing so. In attempting to guard against the bad times the law prevents the flexibility needed to deal with the bad times. One example given in the book is a liquidity crisis in the USA in 1907. The crisis was averted because J.P.Morgan used his personal influence amoungst bankers (some might call this cartel behaviour) to collectively break the law and reduce their reserves. Reserve ratio laws are like insisting that everybody has a basement full of food for the difficult times, and yet it insists that you never eat the food, even in bad times. It is in effect insurance that you can’t use.
In Australia we don’t have reserve requirements proscribed by law. Yet.