On 9th October, Anatole Kaletsky, Associate Editor of The Times, wrote “Banking crises have never been resolved purely by market forces. Once a financial panic starts, government intervention is always required.”
The simple fact is that genuinely free-market banking has a far better record than central banking and government in both the frequency and consequences of financial crises. Unfortunately Kaletsky’s beloved government intervention snuffed out free-market banking in the UK before 1850 and in England a century or so before that. (In the USA, fully free-market banking has never been permitted.)
Today, the banking industry is one of the clearest examples of corporatism or state capitalism, in which unholy alliances are formed between big government and big business. Yet as part of the general outcry of our fourth estate, another prominent Times columnist last week described the banking system as “laissez-faire”!
This corporatism, with government very much the senior partner, causes financial crises by creating the unsustainable boom of the boom and bust. The main culprit is the deliberate pursuit of artificially low interest rates (strongly associated with the election cycle).
The unique function of banking is the payment of interest on demand deposits. In order to do this, banks must “borrow short and lend long”. Interest cannot be created out of thin air and net new interest can come only from capital formation – which can hardly occur overnight! Banks depend on deposits being rolled over or replaced until the benefits of new capital formation come on stream.
The payment of interest requires “fractional reserves”. In genuine free-market banking the extent of the fraction is effectively determined by the consumers in a trade-off between absolute security (meaning no interest) and a return on short-term savings. The use of “outside money” (independent of the banking system) to pay inter-bank settlements ensures that “over-issue” is kept within bounds. Perfect – just as it was in Scotland in the 19th century – until the clunking fist of Sir Robert Peel’s Banking Acts brought it smartly into line.