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Audit the Fed Moves Forward! – Article by Ron Paul

Audit the Fed Moves Forward! – Article by Ron Paul

The New Renaissance Hat
Ron Paul
July 31, 2012
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Last week the House of Representatives overwhelmingly passed my legislation calling for a full and effective audit of the Federal Reserve.  Well over 300 of my Congressional colleagues supported the bill, each casting a landmark vote that marks the culmination of decades of work.  We have taken a big step toward bringing transparency to the most destructive financial institution in the world.

But in many ways our work is only beginning.  Despite the Senate Majority Leader’s past support for similar legislation, no vote has been scheduled on my bill this year in the Senate.  And only 29 Senators have cosponsored Senator Rand Paul’s version of my bill in the other body.  If your Senator is not listed at the link above, please contact them and ask for their support.  We need to push Senate leadership to hold a vote this year.

Understand that last week’s historic vote never would have taken place without the efforts of millions of Americans like you, ordinary citizens concerned about liberty and the integrity of our currency.  Political elites respond to political pressure, pure and simple.  They follow rather than lead.  If all 100 Senators feel enough grassroots pressure, they will respond and force Senate leadership to hold what will be a very popular vote.

In fact, “Audit the Fed” is so popular that 75% of all Americans support it according to this Rasmussen poll.  We are making progress.

Of course Fed apologists– including Mr. Bernanke– frequently insist that the Fed already is audited.  But this is true only in the sense that it produces annual financial statements.  It provides the public with its balance sheet as a fait accompli: we see only the net results of its financial transactions from the previous fiscal year in broad categories, and only after the fact.

We’re also told that the Dodd-Frank bill passed in 2010 mandates an audit.  But it provides for only a limited audit of certain Fed credit facilities surrounding the crisis period of 2008.  It is backward looking, which frankly is of limited benefit.

The Fed also claims it wants to be “independent” from Congress so that politics don’t interfere with monetary policy.  This is absurd for two reasons.

First, the Fed already is inherently and unavoidably political.  It made a political decision when it chose not to rescue Lehman Brothers in 2008, just as it made a political decision to provide liquidity for AIG in the same time period. These are just two obvious examples.  Also Fed member banks and the Treasury Department are full of former– and future– Goldman Sachs officials.  Are we really to believe that the interests of Goldman Sachs have absolutely no effect on Fed decisions? Clearly it’s naïve to think the Fed somehow is above political or financial influence.

Second, it’s important to remember that Congress created the Fed by statute.  Congress therefore has the full, inherent authority to regulate the Fed in any way– up to and including abolishing it altogether.

My bill provides for an ongoing, thorough audit of what the Fed really does in secret, which is make decisions about the money supply, interest rates, and bailouts of favored banks, financial firms, and companies.  In other words, I want the Government Accountability Office to examine the Fed’s actual monetary policy operations and make them public.

It is precisely this information that must be made public because it so profoundly affects everyone who holds, saves, or uses US dollars.

Representative Ron Paul (R – TX), MD, is a Republican candidate for U. S. President. See his Congressional webpage and his official campaign website

This article has been released by Dr. Paul into the public domain and may be republished by anyone in any manner.

Let Unsound Money Wither Away – Article by Joseph T. Salerno

Let Unsound Money Wither Away – Article by Joseph T. Salerno

The New Renaissance Hat
Joseph T. Salerno
July 29, 2012
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[This is a revised version of written testimony submitted to the the Subcommittee on Domestic Monetary Policy and Technology of the Committee on Financial Services, US House of Representatives “Fractional Reserve Banking and Central Banking as Sources of Economic Instability: The Sound Money Alternative,” June 28, 2012.]
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Chairman Paul and members of the subcommittee, I am deeply honored to appear before you to testify on the topic of fractional-reserve banking. Thank you for your invitation and attention.

In the short time I have, I will give a brief description of fractional reserve-banking, identify the problems it presents in the current institutional setting, and suggest a potential solution.

A bank is simply a business firm that issues claims to a fixed sum of money in receipt for a deposit of cash. These claims are payable on demand and without cost to the depositor. In today’s world these claims may take the form of checkable deposits, so called because they can be transferred to a third party by writing out a check payable to the party named on the check. They may also take the form of so-called “savings” deposits with limited or no checking privileges and that require withdrawal in person at one of the bank’s branches or at an ATM. In the United States, the cash for which the claim is redeemable are Federal Reserve notes — the “dollar bills” that we are all familiar with.

Fractional-reserve banking occurs when the bank lends or invests some of its depositors’ funds and retains only a fraction of the deposits in cash. This cash is the bank’s reserves. Hence the name fractional-reserve banking. All commercial banks and thrift institutions in the United States today engage in fractional–reserve banking.

Let me illustrate how fractional-reserve banking works with a simple example. Assume that a bank with deposits of $1 million makes $900,000 of loans and investments. If we ignore for simplicity the capital paid in by its owners, this bank is holding a cash reserve of 10 percent against its deposit liabilities. The deposits constitute the bank’s liabilities because the bank is contractually obligated to redeem them on demand. The assets of the bank are its reserves, loans, and investments. Bank reserves consist of the dollar bills in its vaults and ATMs and the bank’s deposits at the Federal Reserve, which can be cashed on demand for dollar bills printed by the Bureau of Engraving and Printing at the order of the Fed. The bank’s loans and securities are noncash assets that are titles to sums of cash payable only in the near or distant future. These assets include short-term business loans, credit-card loans, mortgage loans, and the securities issued by the US Treasury and foreign financial authorities.

Now the key to understanding the nature of fractional-reserve banking and the problems it creates is to recognize that a bank deposit is not itself money. It is rather a “money substitute,” that is, a claim to standard money — dollar bills — universally regarded as perfectly secure.

Bank deposits transferred by check or debit card will be routinely paid and received in exchange in lieu of money only as long as the public does not have the slightest doubt that the bank that creates these deposits is able and willing to redeem them without delay or expense.

Under these circumstances, bank deposits are eagerly accepted and held by businesses and households and regarded as indistinguishable from cash itself. They are therefore properly included as part of the money supply, that is, the total supply of dollars in the economy.

The very nature of fractional-reserve banking, however, presents an immediate problem. On the one hand, all of a bank’s deposit liabilities mature on a daily basis, because it has promised to cash them in on demand. On the other, only a small fraction of its assets is available at any given moment to meet these liabilities. For example, during normal times, US banks effectively hold much less than 10 percent of deposits in cash reserves. The rest of a bank’s liabilities will only mature after a number of months, years, or, in the case of mortgage loans, even decades. In the jargon of economics, fractional-reserve banking always involves “term-structure risk,” which arises from the mismatching of the maturity profile of its liabilities with that of its assets.

In layman’s terms, banks “borrow short and lend long.” The problem is revealed when demands for withdrawal of deposits exceeds a bank’s existing cash reserves. The bank is then compelled to hastily sell off some of its longer-term assets, many of which are not readily saleable. It will thus incur big losses. This will cause a panic among the rest of its depositors who will scramble to withdraw their deposits before they become worthless. A classic bank run will ensue. At this point the value of the bank’s remaining assets will no longer be sufficient to pay off all its fixed-dollar deposit liabilities and the bank will fail.

A fractional-reserve bank, therefore, can only remain solvent for as long as public confidence exists that its deposits really are riskless claims on cash. If for any reason — real or imagined — the faintest suspicion arises among its clients that a bank’s deposits are no longer payable on demand, the bank’s reputation as an issuer of money substitutes vanishes overnight. The bank’s brand of money substitutes is then instantly extinguished and people rush to withdraw their deposits in cash — cash that no fractional-reserve bank can provide on demand in sufficient quantity. Thus the threat of brand extinction and insolvency is always looming over fractional-reserve banks.

In other words, a fractional-reserve bank must develop what Ludwig von Mises called a “special kind of good will” in order to create a clientele who treats their deposits as money substitutes. On a free market this kind of good will is very difficult and costly to acquire and maintain. This reputational asset is what induces a bank’s clients to forebear from immediately cashing in their deposit claims and driving the bank into instant insolvency. Of course to remain profitable the bank must also build up conventional business good will, which depends upon convenient geographical location, outstanding customer service, attractive facilities, the reputation of its management team and so on. But unlike the common form of good will essential to all successful business ventures, the good will that is necessary for a particular bank’s brand of deposits to circulate as money substitutes is indivisible. In almost all other industries, customer good will can be gained or lost in marginal units and does not typically vanish all at once, destroying its product brand and plunging the firm into immediate insolvency.

Ludwig von Mises described the loss of confidence in a bank’s solvency and the related phenomenon of brand extinction in the following terms:

The confidence which a bank and the money-substitutes it has issued enjoy is indivisible. It is either present with all its clients or it vanishes entirely. If some of the clients lose confidence the rest of them lose it too.… One must not forget that every bank issuing fiduciary media is in a rather precarious position. Its most valuable asset is its reputation. It must go bankrupt as soon as doubts arise concerning its perfect trustworthiness and solvency. [1]

The issuing of deposits not fully backed by cash is therefore always a precarious business on the free market. The slightest doubt about the bank’s solvency among even some of its clients will instantly destroy the character of its deposits as money substitutes. Furthermore, the loss of confidence that causes this phenomenon of “brand extinction” is the cause and not the result of a run on the bank and cannot be deterred by a high ratio of reserves to deposits. For under fractional-reserve banking, by definition, reserves are always insufficient to pay off all the demand liabilities that the bank has incurred. In fact the level of cash reserves is not directly relevant to the stability of a bank. It is simply one of several factors that a bank’s clients take into account in forming their subjective judgment concerning whether a bank’s brand of notes and deposits are or are not money substitutes. For example in the 19th century the ratio of gold reserves to notes and deposits of the Bank of England are reported to have been as low as 3 percent, yet it was generally regarded as one of the most stable financial institutions in the world.

The peculiar and overriding importance of public confidence in sustaining fractional-reserve banking was particularly emphasized by Murray N. Rothbard:

But in what sense is a bank “sound” when one whisper of doom, one faltering of public confidence, should quickly bring the bank down? In what other industry does a mere rumor or hint of doubt bring down a mighty and seemingly solid firm? What is it about banking that public confidence should play such a decisive and overwhelmingly important role? The answer lies in the nature of our banking system, in the fact that both commercial banks and thrift banks have been systematically engaging in fractional-reserve banking: that is, they have far less cash on hand than there are demand claims to cash outstanding.[2]

Rothbard’s point about the extreme fragility of public confidence in issuers of fractionally-backed money substitutes is well illustrated by the stunning collapse of Washington Mutual (WaMu) in September 2008, the largest bank failure in United States history. WaMu had been in existence for 119 years and was the sixth-largest bank in the United States with assets of $307 billion. It had branches throughout the country and billed itself as the Walmart of banking. It was one of the top performers on Wall Street until shortly before its failure. Its depositors clearly had enormous confidence in its solidity, especially given that its deposits were insured by the federal government reinforced by the existence of the Fed’s “too-big-to-fail” policy. And yet, almost overnight the special good will that gave its deposits the quality of money substitutes vanished as panic-stricken depositors rushed to withdraw their funds. The unlikely event that triggered the sudden loss of confidence and subsequent brand extinction was the failure of Lehman Brothers, a venerable investment house. A week after Lehman failed, mighty WaMu was no more.

The highly publicized Lehman Brothers failure had shaken public confidence in the solvency not only of WaMu but of the entire banking system. Had the Fed and Treasury not acted aggressively to bail out the largest banks in the fall of 2008, there is no doubt that the entire system would have collapsed in short order. Indeed on a single day in December, the combined emergency lending by the Fed and the US Treasury had risen to a peak of $1.2 trillion. The recipients of these billions included some of the most trusted and reputable brand names in banking: Citibank, Bank of America, Morgan Stanley, as well as European banks like the Royal Bank of Scotland and UBS AG. Without this unprecedented bailout, these discredited brand names would have been relegated to the dustbin of business history

The ever-present threat of insolvency is a relatively minor problem with fractional-reserve banks, however. Its effects are restricted to the bank’s stockholders, creditors, and depositors who voluntarily assume the peculiar risks involved in this business.

The major problems with fractional-reserve banking are its harmful effects on the overall economy caused by the related phenomena of inflation and business cycles.

First, fractional-reserve banking is inherently inflationary. When a bank lends out its clients’ deposits, it inevitably expands the money supply. For example, when people deposit an additional $100,000 of cash in the bank, depositors now have an additional $100,000 in their checking accounts while the bank accumulates an additional $100,000 of cash (dollar bills) in its vaults. The total money supply, which includes both dollar bills in circulation among the public and dollar balances in bank deposits, has not changed. The depositors have reduced the amount of cash in circulation by $100,000, which is now stored in the bank’s vaults, but they have increased the total deposit balance that they may draw on by check or debit card by the exact same amount. Suppose now the loan officers of the bank lend out $90,000 of this added cash to businesses and consumers and maintain the remaining $10,000 on reserve against the $100,000 of new deposits. These loans increase the money supply by $90,000 because, while the original depositors have the extra $100,000 still available on deposit, the borrowers now have an extra $90,000 of the cash they did not have before.

The expansion of the money supply does not stop here however, for when the borrowers spend the borrowed cash to buy goods or to pay wages, the recipients of these dollars redeposit some or all of these dollars in their own banks, which in turn lend out a proportion of these new deposits. Through this process, bank-deposit dollars are created and multiplied far beyond the amount of the initial cash deposits. (Given the institutional conditions in the United States today, each dollar of currency deposited in a bank can increase the US money supply by a maximum of $10.00.) As the additional deposit dollars are spent, prices in the economy progressively rise, and the inevitable result is inflation, with all its associated deleterious effects on the economy.

Fractional-reserve banking inflicts another great harm on the economy. In order to induce businesses and consumers to borrow the additional dollars created, banks must reduce interest rates below the market-equilibrium level determined by the amount of voluntary savings in the economy. Businesses are misled by the artificially low interest rates into borrowing to expand their facilities or undertake new long-term investment projects of various kinds. But the prospective profitability of these undertakings depends on expectations that bank credit will remain cheap more or less indefinitely. Consumers, too, are deceived by the lower interest rates and rush to purchase larger residences or vacation homes. They take out second mortgages on their homes to buy big-ticket luxury items. A false economic boom begins that is doomed to turn into a bust as soon as interest rates begin to rise again.

As the inflationary boom progresses and prices rise, the demand for credit becomes more intense at the same time that more cash is withdrawn from bank deposits to finance the purchase of everyday goods. The banks react to these developments by sharply raising interest rates and contracting loans and deposits, causing a decline in the money supply. Indeed the money supply may very well collapse, as it did in the early 1930s, because the public loses confidence in the banks and demands it deposits back in cash. In this case, a series of bank runs ensue that pushes many fractional-reserve banks into insolvency and instantly extinguishes their money substitutes, which had previously circulated as part of the money supply. Recession and deflation results and the binge of bad investments and overconsumption is starkly revealed in the abandoned construction projects, empty commercial buildings, and foreclosed homes that litter the economic landscape. At the end of the recession it turns out that almost all households and business firms are made poorer by fractional-reserve bank-credit expansion, even those who may have initially gained from the inflation.

Inflation and the boom-bust cycles generated by fractional-reserve banking are enormously intensified by Federal Reserve and US-government interference with the banking industry. Indeed, this interference is justified by economists and policymaker precisely because of the instability of the fractional-reserve system. The most dangerous forms of such interference are the power of the Federal Reserve to create bank reserves out of thin air via open market operations, its use of these phony reserves to bail out failing banks in its role as a lender of last resort, and federal insurance of bank deposits. In the presence of such polices, the deposits of all banks are perceived and trusted by the public as one homogeneous brand of money substitute fully guaranteed by the Federal government and backed up by the Fed’s power to print up bank reserves at will and bail out insolvent banks. Under the current monetary regime, there is thus absolutely no check on the natural propensity of fractional-reserve banks to mismatch the maturity profiles of their assets and liabilities, to expand credit and deposits, and to artificially depress interest rates. Without fundamental change in the US monetary system, the growth of bubbles in various sectors of the economy and subsequent financial crises will continue unabated.

The solution is to treat banking as any other business and permit it to operate on the free market — a market completely free of government guarantees of bank deposits and of the possibility of Fed bailouts. In order to achieve the latter, federal deposit insurance must be phased out and the Fed would have to be permanently and credibly deprived of its legal power to create bank reserves out of nothing. The best way to do this is to establish a genuine gold standard in which gold coins would circulate as cash and serve as bank reserves; at the same time the Fed must be stripped of its authority to issue notes and conduct open-market operations. Also, banks would once again be legally enabled to issue their own brands of notes, as they were in the 19th and early 20th century.

Once this mighty rollback of government intervention in banking is accomplished, each fractional-reserve bank would be rigidly constrained by public confidence when issuing money substitutes. One false step — one questionable loan, one imprudent emission of unbacked notes and deposits — would cause instant brand extinction of its money substitutes, a bank run, and insolvency.

In fact on the banking market as I have described it, I foresee the ever-present threat of insolvency compelling banks to refrain from further lending of their deposits payable on demand. This means that if a bank wished to make loans of shorter or longer maturity, they would do so by issuing credit instruments whose maturities matched the loans. Thus for short-term business lending they would issue certificates of deposits with maturities of three or six months. To finance car loans they might issue three-year or four-year short bonds. Mortgage lending would be financed by five- or ten-year bonds. Without government institutions like Fannie Mae and Freddie Mac — backed by the Fed’s money-creating power — implicitly guaranteeing mortgages, mortgage loans would probably be transformed into shorter five- or ten-year balloon loans, as they were until the 1930s. The bank may retain an option to roll over a mortgage loan when it comes due pending a reevaluation of the mortgagor’s current financial situation and recent credit history as well as the general economic environment. In short, on a free market, fractional-reserve banking with all its inherent problems would slowly wither away.

Notes

[1] Ludwig von Mises, Human Action: A Treatise on Economics. Scholar’s Ed. (Auburn, AL: Ludwig von Mises Institute, 1998), pp. 442, 444.

[2] Murray N. Rothbard, Making Economic Sense, 2nd ed. (Auburn, AL: Ludwig von Mises Institute, 2006), p. 326.

Joseph Salerno is academic vice president of the Mises Institute, professor of economics at Pace University, and editor of the Quarterly Journal of Austrian Economics. He has been interviewed in the Austrian Economics Newsletter and on Mises.org. Send him mail. See Joseph T. Salerno’s article archives.

This is a revised version of written testimony submitted to the the Subcommittee on Domestic Monetary Policy and Technology of the Committee on Financial Services, US House of Representatives “Fractional Reserve Banking and Central Banking as Sources of Economic Instability: The Sound Money Alternative,” June 28, 2012.

You can subscribe to future articles by Joseph T. Salerno via this RSS feed.

Copyright © 2012 by the Ludwig von Mises Institute. Permission to reprint in whole or in part is hereby granted, provided full credit is given.

Is Greater Productivity a Danger? – Article by David Gordon

Is Greater Productivity a Danger? – Article by David Gordon

The New Renaissance Hat
David Gordon
July 4, 2012
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It is bad enough that opponents of the free market wrongly blame capitalism for environmental pollution, depressions, and wars. Whatever the failings of their causal theories, at least they are focused on undoubtedly bad things. We have really gone beyond the pale, though, when the market is blamed for something good.

Tim Jackson, a professor of sustainable development at the University of Surrey, does just that in his article. “Let’s Be Less Productive,” which appeared in the New York Times, May 26, 2012.

Jackson suggests that greater productivity may have reached its “natural limits.” By productivity, he means “the amount of output delivered per hour of work in the economy.” He acknowledges that as work has become more efficient, substantial benefits have resulted: “our ability to generate more output with fewer people has lifted our lives out of drudgery and delivered us a cornucopia of material wealth.”

Despite these benefits, danger lies ahead:

Ever-increasing productivity means that if our economies don’t continue to expand, we risk putting people out of work. If more is possible each passing year with each working hour, then either output has to increase or else there is less work to go around. Like it or not, we find ourselves hooked on growth.

If financial crisis, high prices of resources like oil, or damage to the environment make continued growth unattainable, we risk unemployment. “Increasing productivity threatens full employment.”

What then is to be done? Jackson has an ingenious remedy. We should concentrate on jobs in low-productivity areas. “Certain kinds of tasks rely inherently on the allocation of people’s time and attention. The caring professions are a good example: medicine, social work, education. Expanding our economies in these directions has all sorts of advantages.” A cynic might wonder whether it is altogether a coincidence that Jackson is himself employed in one of these professions.

Jackson has in mind other reforms besides greater emphasis on the “caring professions.” (One wonders, by the way, whether by this name Jackson intends to suggest that those engaged in high productivity occupations do not care about human beings. To say the least, that would be a rather bold suggestion.) We should also devote more resources to crafted goods that require substantial time to make and to the “cultural sector” as well.

Jackson’s program raises a question: how can these changes be achieved? He stands ready with an answer. Of course, a transition to a low-productivity economy won’t happen by wishful thinking. “It demands careful attention to incentive structures — lower taxes on labor and higher taxes on resource consumption and pollution, for example.”

Jackson is certainly right that if labor becomes more efficient, workers must find other uses for the time they now have available. But why is this a problem? Human beings have unlimited wants, and there are always new uses for human labor.

As Murray Rothbard notes,

Labor needs to be “saved” because it is the pre-eminently scarce good and because man’s wants for exchangeable goods are far from satisfied.… The more labor is “saved,” the better, for then labor is using more and better capital goods to satisfy more of its wants in a shorter amount of time.…

A technological improvement in an industry will tend to increase employment in that industry if the demand for that product is elastic downward, so that the greater supply of goods induces greater consumer spending. On the other hand, an innovation in an industry with inelastic demand downward will cause consumers to spend less on the more abundant products, contracting employment in that industry. In short, the process of technological innovation shifts work from the inelastic-demand to the elastic-demand industries. [1]

Financial crises may interrupt growth, but given the unlimited character of human wants, they cannot permanently supplant it. Jackson has offered us a cure, but he has failed to show that a disease exists that requires his remedy.

[1] Murray Rothbard, Man, Economy, and State, Scholar’s Edition, pp. 587–88, emphasis omitted.

David Gordon covers new books in economics, politics, philosophy, and law for The Mises Review, the quarterly review of literature in the social sciences, published since 1995 by the Mises Institute. He is author of The Essential Rothbard, available in the Mises Store. Send him mail. See David Gordon’s article archives.

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Copyright © 2012 by the Ludwig von Mises Institute. Permission to reprint in whole or in part is hereby granted, provided full credit is given.

Wall Street Math – Article by Douglas French

Wall Street Math – Article by Douglas French

The New Renaissance Hat
Douglas French
April 11, 2012
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There’s plenty of blame for the financial crisis being spread around. Those on the left say Wall Street wasn’t regulated enough, while those on the right claim government mandates required lenders to make bad loans. The argument is made that the Federal Reserve was too loose, while the other side says Bernanke wasn’t loose enough. Some blame greed. Others blame Wall Street’s investment products. And then there’s mathematics.

Wall Street has become a numbers game played at high speed by powerful computers trading complex derivatives utilizing even more complex mathematical modeling. Writing for the Huffington Post, Théo Le Bret asks the reader to

Take the Black-Scholes equation, used to estimate the value of a derivative: it is actually no more than a partial differential equation of the financial derivative’s value, as a function of four variables, including time and “volatility” of the underlying asset (the derivative being a ‘bet’ on the future value of the asset). Differential equations are well-known to physicists, since such fundamental properties of nature as the wave equation or Schrodinger’s equation for quantum mechanics are given in the form of differential equations, and in physics their solutions seem to be very reliable: so why is this not always the case in finance?

Mr. Le Bret quotes Albert Einstein for his answer: “as far as the laws of mathematics refer to reality, they are not certain; and as far as they are certain, they do not refer to reality.”

Murray Rothbard put it another way:

In physics, the facts of nature are given to us. They may be broken down into their simple elements in the laboratory and their movements observed. On the other hand, we do not know the laws explaining the movements of physical particles; they are unmotivated.

Rothbard goes on to make the point that human action is motivated and thus economics is built on the basis of axioms. We can then deduce laws from these axioms, but, as Rothbard explains, “there are no simple elements of ‘facts’ in human action; the events of history are complex phenomena, which cannot ‘test’ anything.”

Using the models that work so well for physicists, mathematicians on Wall Street got it spectacularly wrong in the mortgage and derivatives markets, just as mathematical economists can never predict the future with any accuracy. Motivated human behavior cannot be modeled.

But the mathematicians or “quants” underscore all of Wall Street’s financial engineering, a process that takes a few pieces of paper and folds their attributes together to make new products, most times hoping to avoid taxes and regulation. Author Brendan Moynihan describes this engineering in his book Financial Origami: How the Wall Street Model Broke.

Origami is the traditional Japanese art of paper folding wherein amazing shapes and animals are created with just a few simple folds to a piece of paper. Moynihan cleverly extends the metaphor to the financial arena, pointing out that stocks, bonds, and insurance are pieces of paper simply folded by the Wall Street sales force into swaps, options, futures, derivatives of derivatives, and the like.

The author is adept at describing derivatives in terms a person can understand. Health-insurance premiums are a call option to have the insurance company pay for our medical care. Auto insurance premiums are like put options, allowing the insured to sell (put) his or her car, if it’s totaled, to the insurer at blue-book value.

Nobel Prize winners have played a big hand in the creation of derivatives. Milton Friedman’s paper on the need for futures markets in currencies paved the way for that market in 1971. But as Moynihan points out, it was Nixon’s shutting of the gold window that created the need to mitigate currency and inflation risk.

Nobel Laureate Myron Scholes was cocreator of the Black-Scholes-Merton option-pricing model. He and cowinner Robert Merton used their model to blow-up Long Term Capital Management.

But it was little-known economist David X. Li’s paper in the Journal of Fixed Income that would provide the intellectual foundation for Wall Street’s flurry into mortgages. “On Default Correlation: A Copula Function Approach” became “the academic study used to support Wall Street’s turning subprime mortgage pools into AAA-rated securities,” writes Moynihan. “By the time it was over, the Street would create 64,000 AAA-rated securities, even though only 12 companies in the world had that rating.”

Robert Stowe England, in his book Black Box Casino: How Wall Street’s Risky Shadow Banking Crashed Global Finance, says Li’s model “relied on the price history of credit default swaps against a given asset to determine the degree of correlation rather than rely on historical loan performance data.”

“People got very excited about the Gaussian copula because of its mathematical elegance,” says Nassim Nicholas Taleb, “but the thing never worked.” Taleb, the author of The Black Swan, claims any attempt to measure correlation based on past history to be “charlatanism.”

Subprime mortgages were bundled to become collateralized mortgage obligations (CMOs), which are a form of collateralized debt obligation(CDO). CDOs weren’t new; the first rated CDO was assembled by Michael Milken in 1987. But instead of a mixture of investment-grade and junk corporate bonds, in the housing bubble, CDOs were rated AAA based upon Li’s work.

Mr. England wryly points out, “A cynic might say that the CDO was invented to create a place to dump lower credit quality or junk bonds and hide them among better credits.”

England quotes Michael Lewis, author of The Big Short: “The CDO was, in effect, a credit laundering service for the residents of Lower Middle Class America.” For Wall Street it was a machine that “turned lead into gold.”

Wall Street’s CDO mania served to pump up investment-bank leverage. England explains that if level-3 securities were included (level-3 assets, which include CDOs, cannot be valued by using observable measures, such as market prices and models) then Bear Stearns sported leverage of 262 to 1 just before the crash. Lehman was close behind at 225, Morgan Stanley at 222, Citigroup at 212, and Goldman Sachs was levered at 200 to 1.

Leverage like that requires either perfection or eventual government bailout for survival.

The CDO market created the need for a way to bet against the CDOs and the credit-default-swap (CDS) market was born. Bundling the CDS together created synthetic CDOs. “With synthetic CDOs, Wall Street crossed over to The Matrix,” writes England, “a world where reality is simulated by computers.”

It’s England’s view that the CDO market “was the casino where the bets were placed. Wall Street became bigger and chancier than Las Vegas and Atlantic City combined — and more.” According to Richard Zabel, the total notional value of the entire CDS market was $45 trillion by the end of 2007, at the same time the bond and structured vehicle markets totaled only $25 trillion.

So the speculative portion of the CDS market was at least $20 trillion with speculators betting on the possibility of a credit event for securities not owned by either party. England does not see this as a good thing. It’s Mr. England’s view that credit default swaps concentrated risk in certain financial institutions, instead of disbursing risk.

In “Credit Default Swaps from the Viewpoint of Libertarian Property Rights and Contract Credit Default Swaps Theory,” published in Libertarian Papers, authors Thorsten Polleit and Jonathan Mariano contend, “The truth is that CDS provide investors with an efficient and effective instrument for exposing economically unsound and unsustainable fiat money regimes and the economic production structure it creates.”

Polleit and Mariano explain that credit default swaps make a borrower’s credit risk tradable. CDS is like an insurance policy written against the potential of a negative credit event. These derivatives, while being demonized by many observers, serve to increase “the disciplinary pressure on borrowers who are about to build up unsustainable debt levels to consolidate; or it makes borrowers who have become financially overstretched go into default.”

Mr. England concludes his book saying, “We need a way forward to a safer, sounder financial system where the power of sunlight on financial institutions and markets helps enable free market discipline to work its invisible hand for the good of all.”

Polleit and Mariano explain that it is the CDS market that provides that sunlight.

The panic of 2008 was the inevitable collapse of an increasingly rickety fiat-money and banking system — a system where the central bank attempts to direct and manipulate the nation’s investment and production with an eye to maximize employment. In a speech delivered to the Federal Reserve Bank of New York, Jim Grant told the central bankers that interest rates should convey information. “But the only information conveyed in a manipulated yield curve is what the Fed wants.”

Wall Street’s math wizards convinced the Masters of the Universe that their numbers don’t lie, believing they could model the Federal Reserve’s house-of-mirrors market. Maybe the numbers don’t lie, but the assumptions do.

Advising about mathematical economics, Rothbard wrote, “ignore the fancy welter of equations and look for the assumptions underneath. Invariably they are few in number, simple, and wrong.” The same could be said for Dr. Li’s model and Scholes’s model before him.

Until the era of unstable fiat-money regimes ends, the search for scapegoats will continue — because the crashes will never end.

Douglas French is president of the Mises Institute and author of Early Speculative Bubbles & Increases in the Money Supply and Walk Away: The Rise and Fall of the Home-Ownership Myth. He received his master’s degree in economics from the University of Nevada, Las Vegas, under Murray Rothbard with Professor Hans-Hermann Hoppe serving on his thesis committee. French teaches in the Mises Academy. See his tribute to Murray Rothbard. Send him mail. See Doug French’s article archives.

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