The Banking Crisis; H. Sennholz

Such a view is extremely optimistic. After all, interest rates are likely to rise again during the 1990s as a result of two Federal policies. The budget deficits are likely to continue to consume business capital en masse, crowding out private demand and frightening creditors Dr. Sennholz heads the Department ofEconomics at Grove City College in Pennsylvania. He is a noted writer and lec turer on monetary affairs. who finance the deficits. Moreover, the rate of price inflation is likely to rise during the 1990s because the extenuating circumstances of the 1980s are drawing to a close, such as the agri cultural depression in the U.S. and falling en ergy prices. A more realistic appraisal of the financial sit uation would consider additional factors. Since 1982, the U.S. has experienced one of the longest booms in recent history. And yet, the u.S. government had to rescue the deposits of millions of savers from 620 commercial bank failures and forced mergers. Some 100 Savings and Loan Associations failed and were liqui dated; another 505 are officially insolvent. Fed eral agencies had to make good some $200 bil lion of depositors' savings lost in failures in volving 7 per cent of some $3 trillion deposits in U.S. savings institutions. If this is peace time prosperity, what is to become of the finan cial institutions during the 1990s when the great boom is likely to give way to a recession?

After all, recessions follow booms as night follows day. Persistent economic instability is aggravating the financial situation. The federal government is suffering huge budget deficits that are draining the capital markets, boosting interest rates, and causing large trade imbalances, which in tum are threatening free-trade rela tionships. Similarly, third-world debt, which has more than quintupled during the 19708 and 1980s, is casting a shadow on the banking system. The funds have been wasted on gov ernment enterprises and political largesse, lost in a fruitless effort to export American know how and prosperity. The policy has cost Americans hundreds of billions of dollars and now is jeopardizing the solvency of the financial insti tutions that extended the credits. The American financial structure is teetering on the edge of disaster.2 A time bomb is ticking away under both domestic banking and interna tional finance. Ticking loudly, it makes us wonder when it will go off. It may explode suddenly in the form of a classic "bank-run"

or an international panic. Depositors filled with fear and in doubt about deposit insurance and government guaranties, may suddenly rush to withdraw their funds from all savings and loan associations. They may lose faith in the central pillar of the American financial structure, the Federal guaranty, which is bending and cracking under the heavy load of bank losses and Congressional reluctance to cover those losses. The run would be like a bolt from the blue, spreading from the thrifts to all banking, and from the U.S. to all comers of world fi nance. Private foreign investors may suddenly bail out, frightened by a sudden outbreak of U.S. inflation, by poor trade figures or harmful gov ernment policies, or merely by some unfortu nate pronouncement by foolish officials. Sudden foreign withdrawals of large funds would strain the American system and test the solvency of many institutions. Without imme diate support by the U.S. Congress, many un doubtedly would fail.

The bomb may explode when foreign central banks abandon their dollar-support operations. Stephen N. Morris, an economist at Wash ington's Institute for International Economics, estimates that major foreign central banks bought $130 billion last year to support the U.S. dollar and that, by the end of 1987, the 20 largest foreign banks were sitting on a stockpile of more than $454 billion.3 If these holders of dollar reserves should lose confidence in our fi nancial structure or in the resolve of our finan cial authorities to correct its lingering defects, a crisis may erupt. When the financial wheels grind to a halt, the system that was born of gov ernment thus will return to government for re pair and restructure. We must not allow it to perish suddenly, which would not only spell ruin to many sound institutions alongside the failures, but also 437 ravage the capital market and depress economic activity. It would tum today's creeping nation alization into galloping regimentation. Indeed, a financial crash would have ominous conse quences for our economic, social, and political lives.

An Artifact of Government The American financial edifice was built by legislation and is maintained by regulation. It is as rigid and inert as politics, and as complex as the tangled web of bank regulation. Designed by the New Deal politicians of the 1930s and embellished by their successors in the '40s and '50s, it is clearly incapable of coping with the market forces of the 1980s and '90s. It is des tined to give way to a new order. The edifice that was built during the 1930s replaced the regulatory structure of earlier years, which was the product of a myriad of Federal and state banking regulations. It practi cally collapsed in 1931 and 1932. By scores and by hundreds the banks closed their doors. Banks that remained open were forced to cur tail their operations sharply. Indeed, banking weakness was a prime factor that added im petus to the Great Depression. The new system was organized as a cartel like order, complete with all the characteristics of a monopoly.4 Rigid entry barriers protected its members from "destructive" competition, as did government regulation of production, pricing, and marketing. The Banking Act of 1933, which also created the Federal Deposit Insurance Corporation (FDIC), separated com mercial banking from certain investment banking activities. The portion of the law that effected the separation is commonly called "the Glass-Steagall Act." It was to give sta bility to the system and guarantee the safety of every bank. Toward that end, the law sought to discourage competition and to set narrow limits on branching. It imposed a "needs test" for the issue of new charters, and fixed interest-rate ceilings to prevent the competition of banks for funds. Deposit insurance by the FDIC, finally, was to make all banks equally safe.

New Deal legislation effectively segmented the financial industry. It created the Securities and Exchange Commission to oversee the se438 THE FREEMAN. NOVEMBER 1988 curities industry. To facilitate more credit ex pansion, it granted additional powers to the Federal Reserve System, such as the powers to mandate reserve requirements and to extend credit on government obligations, not just on "real bills." In 1956 Congress passed the Bank Holding Company Act, extending the Glass Steagall Act's restrictions to corporate owners of banks. Amendments to the Act, passed in 1966 and 1970, further tightened the restric tions. They limited the expansion of multibank holding companies by requiring Federal Re serve Board approval for new acquisitions, and ordered the companies to divest themselves of ownership in businesses deemed "unrelated" by the Federal Reserve Board. All interstate banking was prohibited.

Throughout the years Federal regulators and special-interest banks lobbied Congress to pass more restrictive legislation. After lengthy hearings, Congress usually complied by re moving exemptions and broadening regulatory authority. The 1970 amendments sought to bring one-bank holding companies under Fed eral regulation and impose additional criteria to the "needs test" for permissible activity. Charter applications henceforth had to prove not only that the planned activity was "closely related" to banking, but also of "positive ben efit to the public. " It also instructed the Federal Reserve Board to determine which activities were permissible for bank holding companies. The Gam-St. Germain Depository Institutions Act of 1982 permitted bank holding companies to engage in some limited "nonbanking ac tivity" provided it was "closely related" to banking. It is amazing that, after nearly 200 years of banking legislation and regulation, the U. S.

government continues to wrestle with the defi nition of "banking." The 1970 legislation modified the definition of a bank to include all institutions that both accept demand deposits and extend commercial loans. Thereafter, many new institutions sprang up that either ac cept deposits or extend commercial loans, but not both. Commonly known as "nonbank banks," they could pursue most financial activ ities without coming under the restrictions and regulations of financial authorities. As "non bank banks" became increasingly popular during the 1980s, competing most effectively with banking institutions, Congress proceeded to close the regulatory loophole by passing the Competitive Equality Banking Act of 1987. The Act extended the definition of a bank to all FDIC-insured institutions and subjected them all to Federal regulation. 5 Winds, of Change The financial cartel system worked for a while. But, like all other cartels, the financial cartel was destined to degenerate as soon as its members were no longer prepared to live by the ,'stabilization" arrangements and found ever new ways of competing with each other. Even a thick blanket of cartel regulation cannot sup press competition for long. It springs to life in countless forms because man is ever eager to improve his lot. In an economic order based on private property in the means of production, he can do so best by rendering better services to his fellowmen; that is, he competes with other producers in serving consumers. He does so even within a cartel.

When newcomers are permitted to join the organization, they are likely to add competitive fervor. Foreign bankers are very anxious to enter the U.S. market for obvious reasons: to join the cartel and enjoy its advantages, to out strip the older members through greater effort and efficiency, and to place their funds at ex ceptionally high interest rates. The spirit of competition is gnawing at the foundation of the financial cartel. It is weak ening the structure from within and from the outside. Throughout the world, massive capital formation in private-property economies has given rise to new financial centers that compete vigorously with New York. Tokyo, Hong Kong, Singapore, London, and Frankfurt are financial centers that "globalize" the capital market and erode competitive barriers. Shackled and handicapped at home, many U.S. banks have chosen to go offshore and compete in foreign financial centers. Similarly, foreign banks have come to compete vigorously in American markets through branches, agencies, subsidiaries, Edge corporations (which cannot accept deposits from U.S. residents unless the deposits are linked to international trade), and representative offices. In short, the new world of international competition is seriously threat ening the old world of protection and insula tion.

The spirit of internal competition is clearly visible in the frantic search for new ways to di versify. It is visible in the rise of "nonbank banks" that render financial services formerly reserved to commercial banks. Brokerage houses, money market mutual funds, finance and insurance companies, and retail establish ments compete effectively, offering cash man agement accounts, other liquid accounts, credit card services, and loan services. Merrill Lynch, American Express, and Sears are pointing the way. Financial competition is alive although the regulatory apparatus is fighting it every step of the way. Technological innovations are forcing their way through the thicket of regulations. The THE BANKING CRISIS 439 computerization of many financial operations has greatly reduced transaction costs, which is enabling nondepository institutions to offer many bank-like services. The use of automated teller machines (ATMs) has grown dramati cally since the late 1970s. Individual ATM systems may soon link up with national and in ternational networks. Thousands of point-of sale terminals may serve millions of customers using a great variety of credit cards. On the fi nancial horizon, in-home banking promises to offer all the essential banking services, in cluding bill payment, electronic purchases and sales of securities, and so on. Telephone or cable hookups, satellite linkages, and home computers are destined to play important roles in the financial system of the future.

Keen competition is bound to separate the successful enterprises from the failures. The former succeed by best serving consumers; the latter fail because they fail to serve consumers satisfactorily. They may misjudge or ignore consumer choices and preferences, or mis manage their resources, or allow themselves to be misled by political machinations. To rely on cartel regulation and insulation is to invite fi nancial disappointment in the end. Regulatory Restructuring Financial observers of all persuasions and ideologies are in full agreement that the Amer ican edifice is in urgent need of restructuring. A healthy and viable banking industry needs to generate returns that not only cover its costs but also attract new capital to support moderniza tion and expansion. It must be able to compete with other financial institutions and other busi ness enterprises. Most legislators and regulators readily admit that a safe and sound system should not be un duly hampered by regulation and supervision.

They may even favor some measure of "de control" and "banking freedom to operate in the marketplace." They may advocate "product liberalization" by eliminating some restrictions imposed by the Glass-Steagall Act and certain provisions of the Bank Holding Company Act. Yet, they all envision a restruc turing that would strengthen the supervisory and regulatory restrictions on banks. They em440 THE FREEMAN. NOVEMBER 1988 phasize "prudent supervision," "careful moni toring, " and "limiting the risks" posed by new bank services. In short, the old regulators would like to replace the crumbling cartel wall with a new supervisory safety and soundness wall.6 The world is a scene of changes. We change and our policies change. But we should always ascertain the direction of the change. To re place one wall with another is to reinforce the old direction. To substitute prudent regulation for imprudent regulation is to continue the reg ulation; it does not reverse the direction. We may wonder about our destination, but it is rather obvious that legislators and regulators will always be in the driver's seat.

Most writers about financial matters accept it as a self-evident truth that legislators and regu lators need to manage the people's finances. They are convinced that no one ought to be free because no one is fit to use his financial freedom responsibly and beneficially. This is why they favor a mandatory deposit insurance system with Federal guarantees. They advocate the separation of banking and securities activi ties, the separation of banking from commerce, and careful supervision of them all. They prefer a financial structure with thousands of small banks to one characterized by large financial institutions. In short, they thoroughly distrust men of finance, but place their trust in legis lators and regulators. To embark upon financial reform and revival is to discard many false beliefs about finance and the role of government intervention. In fi nance as in all other pursuits, man is free to Money Follows Commerce choose between two basic systems of economic organization: the individual enterprise system and the command system. Throughout their short history Americans generally opted for the former, the system of private property and indi vidual enterprise. In all matters of finance, un fortunately, they frequently succumbed to the lures and temptations of political command. In money and banking they generally preferred politicians and government officials over bankers and entrepreneurs.

After 200 years of countless banking scandals and unending financial crises it is ap propriate to reconsider the direction of the road we are travelling. After thousands of bank failures and billion-dollar losses we may want to reverse our financial direction, turn away from the command system, and seek individual freedom. It is eminently effective and benefi cial in all other pursuits; it is likely to be the same in financial matters. No man is free who is not master of his fi nances. The American command system is an abomination to all friends of freedom. They will not rest until financial commands finally give way to individual freedom. D 1. The New York Times, May 20, 1988, pp. Dl, D3. 2. Edward J. Kane, The Gathering Crisis in Federal Deposit In surance (Cambridge, Mass.: MIT Press, 1985). 3. Business Week, May 23, 1988, p. 27. 4. Franklin R. Edwards, "Can Regulatory Reform Prevent the Impending Disaster in Financial Markets?" in Restructuring the Fi nancial System, The Federal Reserve Bank of Kansas City, 1987, pp. 1-17.

5. Federal Deposit Insurance Corporation, Mandate for Change (Washington, D.C.), October 1987, pp. 29-33. 6. Ibid., pp. 98-102. IDEAS ON LIBERTY M oney, it should be remembered, is not the leader of commerce, but the follower. It comes, legitimately, only to the individual or to the community as the result of industry and good manage ment; industry and good management do not result from the possession of money. -CHARLES HOLT CARROLL (1799-1890) 441 Decentralization: Freedom by Diffusion by David C. Huff O ne of the beneficial aspects of national election campaigns is their reminder to us that America is becoming danger 0usly enamored with the false hope of political salvation. The finances, energy, media atten tion, and zealous devotion heaped upon candi dates for high office at times reaches messianic proportions. They provide further evidence that what was once a valid political process now borders on idolatry.