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Decimal Digest
04 Feb 2013


Allocation of Resources in Capitalism, and Fractional Reserve Banking System

Last week, as the EURUSD continued to record new highs, even as the underlying news in Europe was of renewed stress on the fringes of the European banking industry. The Netherland in the North of Europe nationalized its fourth largest lender; while Italy in the South may soon need to do the same with the oldest bank in the world.

Thus, we see a continuation of the spate of spectacular bank failures and rescues in the western world, which started in the UK with Northern Rock and quickly spread to Iceland and Ireland, with even the mighty Buba being “reimbursed” its losses by ECB in 2008 – the same year when across the Atlantic, the TARP and other measures rescued a countless number of American banks. The saga continues without any respite even in 2013.

The only thing which has changed is the intensity of the reaction of financial markets to bank failures. Now, markets just yawn when yet another bank is rescued. The Financial Market Punditry may like to ascribe this yawn to the bank rescues being “already in the price”. However, one needs to be cognizant of a major insidious effect this rampant rescues of banks by government will have on the future of capitalism and on the future of free markets.

Capitalism’s claim to glory, rightly so, is ability to allocate societal resources in the most optimal manner without the need for a central soviet style system of planning and directing the economy. Banks, along with other financial institutions, are a central piece of this resource allocation process. For this resource allocation process to work, the system requires market based checks and balances – especially the idea of creative destruction originally proposed by German philosopher Friedrich Nietzsche, and popularized by Austrian American Economist Joseph Schumpeter. Creative destruction is a powerful force in the operation of a market based economy. The fear of being destroyed should, as theory goes, prompt, economic agents to act on market based price signals when things go wrong and take corrective actions. Without this fear being present in sufficient force, capitalism risks becoming a greedy monster focusing on value appropriation rather than value creation. Those of us who still remember the Soviet system will recall that the main fallacy of that system was a focus on value appropriation rather than value creation.

So, as the governments in the western world rescue more and more banks, the edge of the sword of creative destruction will progressively turn blunt, and there will be no more capitalism in the real sense.

Now, the question arises, why governments are being required to rescue banks with such regular frequency? The answer lies in the interaction of two design truths. The first design truth is that the allocation of resources is inherently a risky proposition, and mistakes are an unavoidable part of this process, given our current inability to forecast the future. The second design truth is that a fractional reserve banking system’s capital account faces a telescopic effect of any losses that arise in its credit portfolio. If banks turn out to be unviable, even when a small portion of its credit portfolio experience losses, its has further telescopic effect on societal confidence in its economic future, given the central role the banking system plays as a store of wealth of people.

It is essential that policymakers understand that losses in credit portfolio or in equity portfolios are a natural outcome of the way capitalism operates. The real culprit is the fulcrum of leverage used by the banking system to appropriate more of society’s value creation.

The earlier policymakers appreciate the folly of allowing banks to run large leverages, the earlier we all can go back to a purer, more efficient form of capitalism.

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