Are Trade Sanctions Ever Worth It: Part III

In tonight’s post, I’d like to focus on the role that trade sanctions played in the U.S. involvement in WWII. In so doing, I’m going to probably hew more closely to the historical rather than the analytical, but I will do some sheer praxeological analysis of sanctions later on in the week.

I think that, to start off with, it’s important to contextualize America’s entry into the Second World War within the wider history of the twentieth century. In order to do this, I’m going to draw on the historical findings of primarily John V. Denson in “Roosevelt and the First Shot: A Study of Deceit and Deception” in Reassessing the Presidency: The Rise of the Executive State and the Decline of Freedom and Robert Higgs in his “How U.S. Economic Warfare Provoked Japan’s Attack on Pearl Harbor” and “Truncating the Antecedents.”

In order to appropriately broach this topic, it’s necessary, as Higgs notes, to appreciate Japan’s place in the world leading up to the Second World War. Since the end of the 1800s, the industrialized Japanese economy had been an isle of substantial growth in the east. As many of us know, however, Japan is a small island state with a limited raw materials supply. As such, their economy relied increasingly on imports from abroad. (This should all be taken as a value-free assessment; the following statements should in no way be taken as an endorsement of the Japanese military-industrial complex or of any of the major military powers involved in WWII).

At the same time, America was under the rule of Franklin Delano Roosevelt, who had, for whatever reason, a sharpened interest in aiding the Allied powers in their war effort against Germany. FDR, however, was hindered with regards to this by an American consciousness that was still wary of international conflict after the WWI era just two decades earlier. It would have been politically unworkable for FDR to ask Congress for a declaration of war against any nation that had not actively attacked the United States, no matter what sort of regime it was running at the time. (It should also be noted that many were not fully aware of the gravity of Nazi atrocities until years later).

In an effort to quietly circumvent this unfortunate reality, Roosevelt attempted to supply aid to the British and the French in any way that he could. According to John W. Wheeler-Bennett–King George’s biographer–in 1939, for example, Roosevelt made secret agreements to King George VI to “set up a zone in the Atlantic to be patrolled by the U.S. Navy, and the king’s notes show that Roosevelt intended to sink German U-boats and await the consequences.” Unfortunately for Roosevelt, Hitler refused to take his bait, leaving the former without a pretense on which he could reasonably declare war.

In June of 1940, Henry L. Stimson became secretary of war. Stimson, as Higgs notes, was a supporter of sanctioning the Japanese. The United States eventually began pursuing such measures. From Higgs:

In 1939, the United States terminated the 1911 commercial treaty with Japan. “On July 2nd, 1940, Roosevelt signed the Export Control Act, authorizing the President to license or prohibit the export of essential defense materials.” Under this authority, “on July 31st, exports of aviation motor fuels and lubricants and No. 1 heavy melting iron and steel scrap were restricted.” Next, in a move aimed at Japan, Roosevelt slapped an embargo, effective October 16, “on all exports of scrap iron and steel to destinations other than Britain and the nations of the Western hemisphere.” Finally, on July 26, 1941, Roosevelt “froze Japanese assets in the United States, thus bringing commercial relations between the nations to an effective end. One week later Roosevelt embargoed the export of such grades of oil as still were in commercial flow to Japan.

As Higgs goes on to note, the United States began intercepting intelligence suggesting Japan’s distress and consideration of aggressive action as early as July 31st, when American forces intercepted the following message from Japanese Foreign Minister Teijiro Toyoda to Ambassador Kichisaburo Nomura:

Commercial and economic relations between Japan and third countries, led by England and the United States, are gradually becoming so horribly strained that we cannot endure it much longer. Consequently, our Empire, to save its very life, must take measures to secure the raw materials of the South Seas.

In a perhaps unrelated note, President Roosevelt stated publicly the following September that he would “not participate in foreign wars and we will not send our army, naval or air forces to fight in foreign lands outside of the Americas, except in case of attack .” On November 25, 1941, just thirteen days before Pearl Harbor, secretary of war Stimson famously wrote in his diary as follows:

There the president…brought up entirely the relations with the Japanese. He brought up the event that we were likely to be attacked, perhaps [as soon as] next Monday, for the Japanese are notorious for making an attack without warning and the question was what we should do. The question was how we should maneuver them into the position of firing the first shot without allowing too much danger to ourselves.

Later, after the war, Stimson also revealed the following to a congressional committee investigating the attack:

If war did come, it was important, both from the point of view of unified support of our own people, as well as for the record of history, that we should not be placed in the position of firing the first shot, if this could be done without sacrificing our safety, but that Japan should appear in her true role as the real aggressor…If there was to be war, moreover, we wanted the Japanese to commit the first overt act.

There is an almost obscene amount more of historical detail that could be provided here. Denson harvests multitudinous sources to suggest that Roosevelt secretly implicated the United States in the war before Pearl Harbor in a number of other ways, and also provides a strong evidence for the fact that top officials in the government knew about the attack before it occurred, and chose not to act on that information. For more on that, however, I encourage readers to look into Denson’s essay in Reassessing the Presidency , as my intention here is not to fully recapitulate the American involvement in the Second World War.

Instead, I wanted only to provide a compelling enough picture that the United States was interested in provoking attacks to get them into the war, in order to make the observation that the state decided that sanctions would be the most efficacious means of making this happen . It should be clear that, far from the unquestionably “peaceful” means that sanctions are typically seen to be, there is an act of force behind them that often leads to war. I will go into this further in my praxeological examination of sanctions later this week.

And, again, none of this should in any way be taken as defense of or apologism for the state of Japan. It has merely been written in order to provide evidence for the idea that sanctions can provoke hostilities more easily than they can provoke capitulation to demands, and that this reality is often a factor in their consideration.

As Bastiat once said, “if goods don’t cross borders, armies will.”

Are Trade Sanctions Ever Worth It: Part II

In researching American sanctions against Japan prior to World War II, I was taken by John Denson’s essay all the way back to the First World War. Denson argues in his essay that a proper understanding of WWII requires a recognition of the role that the international relations in Europe at the end of the nineteenth century had in shaping the First World War, and the ensuing Treaty of Versailles.

This post will not be on trade sanctions per se , but will deal with the related topic of the English blockade of Germany during (and, importantly, even after ) World War I. I think that, even though it is slightly off topic, it provides an important illustration of the unintended consequences of economic warfare and, even more than that, should be considered highly historically relevant.

Denson begins his story with an argument pertaining to the strategy of economic and naval dominance that was pursued by the British Empire up through the end of the nineteenth century. Since this is not absolutely relevant to my case, I will not elaborate here, but will simply say that Denson provides evidence to suggest that one of Britain’s major motivations for pursuing war in the early twentieth century was to stave off German economic dominance. He does provide some convincing primary sources for this point, and the early portion of his essay is devoted to it, so I’d encourage you to explore for yourself if you are interested.

Anyway, Denson eventually makes his way to mentioning the British blockade of Germany that occurred over the course of the First World War. At the outbreak of war in 1914, the British used their superior naval fleet to establish blockades preventing any “contraband” materials from entering Germany. Although this in and of itself is not really surprising, Ralph Raico notes in his review of C. Paul Vincent’s The Politics of Hunger: Allied Blockade of Germany 1915-1919 that civilian food supplies were included on the last of contraband materials. Winston Churchill himself, “First Lord of the Admiralty in 1914 and one of the framers of the scheme,” gloated that the goal was as follows:

to starve the whole population–men, women, and children, old and young, wounded and sound–into submission.

Raico points out that this policy actually violated two international agreements to which Britain was party–the Declaration of Paris of 1856 and the Declaration of London of 1909–and that the British increasingly expanded definitions of contraband while at the same time “putting pressure on neutrals (particularly the Netherlands, since Rotterdam more than any port was the focus of British concerns over the provisioning of the Germans) to acquiesce in its violation of the rules.” America readily went along (although Secretary of State William Jennings Bryan chose to resign in protest of the war in 1915).

As for the heightening of the blockade, Raico quotes from Vincent’s book:

All food consigned to Germany through neutral ports was to be captured and all food consigned to Rotterdam was to be presumed consigned to Germany…The British were determined on the starvation policy, whether or not it was lawful.

By 1915 and 1916, rationing had set in for the civilian population of Germany. By 1917, German civilians were allowed a diet of roughly 1,000 calories per day and, by 1918, the civilian mortality rate had risen by 38% since the beginning of the war.

All of this is bad enough but could, conceivably, be rationalized as strategy from the point of view of a military professional or war hawk. (That is not to absolve those responsible for the 430,000-800,000 deaths that resulted from the policy, but simply to suggest that it could at least then be construed as an ill-advised tactical course). Raico really drops the bomb next, however:

When the Germans surrendered in November 1918, the armistice terms, drawn up by Clemenceau, Foch, and Petain, included the continuation of the blockade until a final peace treaty was ratified.

Thus, despite the suspension of hostilities and the declaration of the armistice, the Allied forces maintained the starvation blockade for an extra 5-9 months, resulting in an estimated additional 100,000 civilian deaths from starvation . (I say 5-9 because food shipments began arriving at the end of March, but it was not until the summer, following the signing of the Treaty of Versailles, that general bans on imports and exports were lifted).

Again, as if this weren’t all bad enough, there is more, and this is where the starvation blockade of the First World War really helps to illustrate the unintended consequences of trade sanctions. Raico points out that both Vincent as well as Peter Loewenberg reach the conclusion that the social, physical, and psychological effects of the blockade on German young people could be perceived as a major contributor to the later enthusiasm of German youth for the Nazi movement. Loewenberg also observed of Theodore Abel’s 1936 Why Hitler Came into Power: An Answer Based on the Original Life Stories of Six Hundred of His Followers that “the most striking emotional affect expressed in the Abel autobiographies are the adult memories of intense hunger and privation from childhood.” Denson also notes independently that a German boy ten-years-old at the time of the Treaty of Versailles would have been 22 during the rise of the Nazis to power.

Now, Hitler came into power for several reasons, not all of which necessarily have to do with the much maligned Treaty of Versailles (although I do tend to agree with the historians who suggest that the treaty played a significant role). That, however, is not the subject of this series of post. What is the subject of this series of posts happens to be the unintended consequences of trade sanctions, and the starvation blockade of World War I represents an extreme, but extremely enlightening example.

Trade sanctions and blockades are typically depicted as unified events that play out on national scales, i.e. an “American” sanction against trade with “Japan,” or “Iraq,” or “Iran.” This, however, is not actually how things really play out, and the thinking behind this falls prey to the problems of viewing collective actions as aggregates that are somehow something more than the sum of individual actions. Anyway, what is functionally going on in a sanction situation is not an “American” refusal to trade with “Iran,” but rather a forceful moratorium by the United States federal government on any exchange between civilian citizens of the United States and the civilian citizens of Iran. There are a number of problems with this reality.

First of all, there are problems and inconsistencies that can be exposed by a basic praxeological examination of the nature of sanctions in general, which I plan to go into either tomorrow or, more likely, on Monday (I will probably use tomorrow’s post to go into sanctions on Japan leading up to our involvement in World War II). To briefly close out this post, however, I think it’s important to note that, although sanctions are almost always rationalized as this sort of peaceful measure against an opposing regime, they are really anything but. First of all, sanctions can only be enforced by threat of force and so, almost by definition, cannot be peaceful. And, on top of that, they are only rarely entirely successful in undermining the regime they seek to topple.

In order to make this point, I think it’s important to use a hypothetical scenario. Imagine that another nation–let’s say China–voluntarily elected to join some other enemy in a war against us. Then, suppose that China set up some devastating starvation blockade against us, in an effort to undermine our resolve for the war. Imagine that sanctions lasted for years and years, and that many in our population–friends, lovers, family members–died of starvation and other indirect causes related to the blockade. (I realize that I am using sanctions and blockade interchangeably for the moment, but bear with me). Is it likely that we would primarily blame our own government for this? It’s likely that we would place some of the blame with them, but wouldn’t most of us blame China more? After all, it would have been China who would have executed this blockade, and whose actions would have directly resulted in the deaths of our loved ones. And, again, would our regime really have been all that weakened? Sure, it’s possible, however not to the same extent as our civilian population .

This is the crucial thing to know about sanctions and blockades: they primarily impact civilian populations who usually are more or less powerless to topple the regime under which they live, and thus usually succeed in nothing more than fomenting hatred of the blockading nation in the citizens of the blockaded.

Are Trade Sanctions Ever Worth It: Part I

I’m thinking that, over the course of the next couple of days, I’m going to another “series” of posts like I did for my discussion of the FDIC last week. This time, however, the topic is going to be the historical implementation of trade sanctions by the United States against its political enemies. I intend for this to culminate in my column for the next issue of the Chronicle.

I’ve pulled a few essays that I’m going to use to refresh my memory on these things. Among them are two from Robert Higgs– “How U.S. Economic Warfare Provoked Japan’s Attack on Pearl Harbor” as well as “Truncating the Antecedents: How Americans Have Been Misled About World War II” –which are available either online or also as chapters 10 and 11 in Higgs’ newest book, Delusions of Power (which I can recommend quite highly). I will also be reading for the first time an essay by John V. Denson taken from the Mises Institute’s Reassessing the Presidency: The Rise of the Executive State and the Decline of Freedom . The essay is entitled “Roosevelt and the First Shot: A Study of Deceit and Deception,” and is available in .pdf form as chapter 16 of the aforementioned text.

I will provide a more detailed post on all of this tomorrow evening, but to give a brief overview of my thoughts on the subject, I’ll elaborate just a little bit here. Higgs, and actually a whole host of other scholars, argues that Japan was not targeting the US out of the blue in its attack on Pearl Harbor. Higgs points out that, up until that point, President Roosevelt had formulated a policy in both the Pacific as well as the Atlantic that endeavored to induce either Japan or Germany to fire the first shot, thereby drawing the US into what would otherwise have been an unpopular effort amongst the American public. Higgs draws from the memoirs of those close to the President to provide support for this position, and does so convincingly. Again, I will elaborate more on this tomorrow night.

In addition to fleshing out the historical considerations here, I’m also going to try to delve more into sanctions on the level of economics alone, and examine whether or not they can really be expected to achieve the ends that usually are ascribed to them. I’ll end with a verdict on the US sanctions against Iran, and perhaps some general predictions moving forward.

I got a lot of positive feedback for my last series of posts on the FDIC, so I’m hoping that this one will work as nicely!

The Chronicle: The Voting Fetish

My column in today’s Chronicle.

Stephan Kinsella Elaborates on Ayn Rand and IP

In a post I wrote a week ago , I criticized Ayn Rand for depicting state recall of patents as an injury to the property rights of the patent holder. At the time, I suggested that this was indicative of Rand’s confused approach to patents and IP in general, and linked to a column of mine as well as the extensive work of Stephan Kinsella.

Kinsella, in an article published both at the Libertarian Standard and the Center for the Study of Innovative Freedom , has picked up my post and pooled it with the responses of several other writers. He then takes a far more detailed approach to Ayn Rand’s confusion on the subject of intellectual property, and provides an extensive reading list of his own blog posts, speeches, and scholarly articles. He points to a number of logical and factual errors on the part of Rand, citing them even out of Atlas Shrugged directly.

The post is in-depth and informative; I’d recommend it to anyone interested in Rand, intellectual property, or libertarian approaches to property rights in general. I have to say that a lot of the Ayn Rand criticism out there is either ill-informed or unwarranted, but this is neither.

From a Mises Circle meeting in Manhattan this past September:

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Tonight’s post will not actually deal with the FDIC directly, but rather with a specific historical problem related to banking in the United States (and elsewhere). That problem is known as the “suspension of specie payments,” and is seen in the years in between America’s central banks. In order to back in to this issue, I’ll start with what Murray Rothbard identifies as the one central obligation of a deposit bank:

All these limits, of course, rest on one fundamental obligation: the duty of the banks to redeem their sworn liabilities on demand. We have seen that no fractional reserve bank can redeem all its liabilities and we have also seen that this is the gamble that every bank takes. But it is, of course, essential to any system of private property that contract obligations be fulfilled. The bluntest way for government to foster inflation, then, is to grant the banks the special privilege of refusing to pay their obligations, while yet continuing in their operation. While everyone else must pay their debts or go bankrupt, the banks are permitted to refuse redemption of their receipts, at the same time forcing their own debtors to  pay when their loans fall due. The usual name for this is a “suspension of specie payment.”

As a brief aside, this passage is taken from Rothbard’s What Has Government Done to Our Money , which is both short and brilliant. It is a really fascinating introduction to the topic of money, that I think even laypeople will find extremely enjoyable. I have linked to a .pdf version of the book, provided free online by the Mises Institute.

Rehashing this in plain terms, just so that we are all on the same page, a “suspension of specie payments” occurs when depositors begin to withdraw their deposits from a fractional reserve bank en masse . This would not pose any problems for a 100% reserve bank, of course, since a 100% reserve bank safeguards all of its customers deposits. For a fractional reserve bank, however–which only keeps a small portion of its customers deposits–it can trigger a bank run, as more and more depositors fear that they will be last in line to withdraw their money and thus nothing will be left for them. In order to prevent the bank from failing, the government might allow it to refuse such redemption to its depositors, thus breaking the terms of its contract without any negative repercussions. This is also sometimes called a “bank holiday.”

It’s a central tenet of the conventional wisdom on banking that bank panics were worse in the years without significant government regulation of the banking sector. In fact, it is often argued that similar problems plagued banks in both eras, and therefore the mitigating effects of institutions such as the Federal Reserve legitimize their existence. (I am always a little confused by this argument, seeing as the worst economic crisis in the history of our nation–the Great Depression–occurred in 1929, a full 16 years after the establishment of the Federal Reserve. This is all part of a pretty complicated relationship, of course, so I’m not saying that this is in any way a home-run point, but I still always find it a little bit silly that this fact is so often overlooked. It is in some ways similar to the idea that President Roosevelt was the one who got us out of the depression, when it’s also plainly true that he held office as it persisted, suggesting the possibility that his policies were themselves part of the problem). Anyway, to return to this discussion of the suspension of specie payments, the government of the United States often employed this practice in the 19th century.

As Rothbard also notes, this practice began on a widespread scale as an indirect consequence of the War of 1812. The United States government sought to borrow funds for its war effort, but the banks of New England did not wish to lend. The government then turned to banks in the more newly created states, which responded by printing money unbacked by gold or silver to finance the war effort. Apparently, this was so aggressive as to trigger an inflation that prompted depositors to demand redemption of their deposits, thereby inducing the government to forcibly intervene with a bank holiday that actually lasted for years. This extended holiday allowed old and new banks to issue scrip that was completely unbacked by anything, showing that the suspension of specie payment can function as, in certain ways, an analogue to a system of central bank enforced fractional reserve banking. (This paragraph is almost entirely paraphrased from the same Rothbard passage quoted above, but are not his direct words).

The most important element of the War of 1812 suspension of specie payments, however, was not immediate. Rather, it was the message that it sent to unscrupulous banks, who wished to engage in unsafe practices behind their depositors’ backs. In fact, it is a message similar to the one that was sent to the financial sector in 2008: do what you please, since the state will back you up. Rothbard, in The Mystery of Banking (also available for free in .pdf format from the Mises Institute) writes:

Whether the U.S. had a central bank or not, the banks were assured that if they inflated together and then got in trouble, government would bail them out and permit them to suspend specie payments for years. Such general suspensions of specie payments occurred in 1819, 1837, 1839, and 1857, the last three during an era generally considered to be that of “free banking.”

The War of 1812 and its suspension of specie payment was followed, in 1816, by a decision on Congress’ part to install a new central bank. The Second Bank of the United States, as it was called, quickly embarked on a path of inflation that led to what Rothbard dubs the nation’s first “boom-bust cycle.” By 1818, the bank, feeling that it was overextended, began a contraction that precipitated the panic of 1819. (For more on this, see the Austrian Business Cycle Theory, or ABCT. I would also be happy to do a post on my understanding of that, if there is some interest out there). Although many institutions failed, banks in many states were permitted to suspend specie payments. (More on the Panic of 1819 specifically can be found in Rothbard’s book The Panic of 1819: Reactions and Policies , which is also, of course, free from the Mises Institute).

Then, in 1829, Andrew Jackson was elected president. Jackson is perhaps most famous for his obsession with destroying the Second Bank of the United States, a feat which he accomplished in the early 1830s. (Jackson’s is a complicated presidency: his opposition to the bank, his espoused philosophy of individual liberty, his conviction in states’ rights, and his doctrine of equal rights–different from the variant espoused today–are all attractive; support for slavery, forced relocation of Native Americans, and opposition to Nullification are decidedly less so). Jackson at one point during his struggle against the bank fell ill, and told Martin van Buren that “the Bank is trying to kill me, but I will kill it!”

I digress. The takeaway for tonight is this: the ostensibly “free banking” period in America was no such thing. The suspension of specie payments protects risky banks from the consequences of their actions on the free market, and it is always good to be a little suspicious when the 19th century is characterized in such a way.

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At the end of yesterday’s post on the topic of the FDIC, I promised to spend tonight’s post dealing with the consequences of deposit insurance and federal reserve banking. I got an e-mail today, however, dealing with the post I made last night, and think that I’ll use this post to address two points raised in that e-mail instead.

1) 100% Reserves versus Free Banking

In the e-mail, the writer made the point that he saw nothing fundamentally wrong with fractional reserve banking, so long as both parties understood the terms of the contract and the depositor thus willingly agreed to the arrangement. This would essentially be a free banking arrangement, in which a range of banks could offer different levels of reserve ratios to target different markets. Thus, one bank might keep 100% reserves in order to capture the market for a safe and reliable warehousing of savings while another might offer 90% reserves in exchange for the potential for higher return. (Those holding lower reserves are able to loan out and collect interest on more of their deposits, and can thus pay their earnings out to depositors in the form of a higher interest return). This would empower depositors to choose the arrangement that worked best for them, and no one would be forcibly precluded from an entrance into a contract to which both parties agreed.

To clarify, I agree with the basic reasoning behind this premise. I do not believe, as some do, that 100% reserves should be enforced by  rule of law (a point that I may have glossed over yesterday). In response, however, I would argue that in the absence of state support, banks would eventually “drift” towards full reserves, or at least might have a tendency to do so. Walter Block makes some persuasive arguments to this effect in a paper entitled “In Defense of Fiduciary Media–A Comment.” One of these is particularly convincing.

Block suggests a hypothetical society under an arrangement of free banking. In such a society, he unobjectionably suggests, 100% reserve banks exist alongside banks that hold fractional reserves. Assuming, for the sake of argument, that these latter banks hold 99% reserves–so that they are as solid for most intents and purposes as the full reserve banks, and their services are slightly cheaper (resulting from the higher profit off of increased lending)–they will have no choice but to move in a direction of either higher or lower reserves. This is because, as both banks operate, their depositors will move throughout the economy, using their deposit slips as stands-in for the gold in their vaults. Eventually, a depositor at a 99% reserve bank will pay a depositor at a 100% reserve bank with a note from the 99% reserve bank. The second depositor will take this note to the 100% reserve bank and try to redeem it for his gold. The 100% reserve bank will then take the 99% reserve note to the 99% reserve bank to redeem it for gold.

This is not a problem on an individual scale, since the 99% reserve bank has more than enough in deposits to cover individual cases. It is important to keep in mind, however, that by definition the 99% reserve bank has issued more notes to gold than it has gold in the first place, and so it cannot possibly provide gold to all those who are entitled to it. As a result, its reserves will continually be depleted by a collection of 100% reserve banks. At this point, the 99% reserve bank will be faced with two options: it can either contract by reducing the supply of its notes that exceeds holdings (in which case it will start to move toward a full reserve bank), or it can continually lower its reserve ratio in order to maintain its ratio as reserves are further and further depleted.

(This is a nice place to mention that these banks would be unstable, in a scientific sense. Slight perturbations do not move them back towards where they started–as you might see with a ball that starts off in a ditch and is pushed slightly up to one side–but rather begin them on a path toward an ever expanding deviation from that center–as in the case of a ball at the top of a hill).

Block also points out that, ironically, those 99% reserve banks that were most successful in attracting customers would actually be the first to go. This is because they would then have the biggest number of  depositors, which means that their notes would be circulating more frequently than those of the lesser competitors. This would lead to earlier and more frequent demands for redemption by the full reserve banks, thus driving them out of business more quickly.

As a result of all of this, I take a position in the middle: FRB should not be forcibly obstructed, but will still have a tendency to undermine and destabilize itself within a system of free banking.

2) Shouldn’t everyone be able to practice FRB if they understand and agree to it?

The next point gets at the crux of a finer part of the opposition of FRB. It can actually be seen as a logical impossibility that both parties could fully understand and agree to fractional reserve banking per se. This is because fractional reserve banking is, by definition, a process under which a demand deposit–which the bank is obligated to redeem in full to the depositor at any time he wishes–is then lent out to other borrowers. Thus, the depositor understands his relationship to the bank as that of a true depositor: he can go at any time to get his gold out of the vault. The bank does not see it this way, as his gold at any given time may have been lent out to someone else.

If both parties truly understand what is going on here, then that changes the essence of the deposit. It’s no longer really a demand deposit, since an informed and contractually assenting depositor must, by definition, understand that he cannot always redeem his deposit on demand. This renders it more a loan than a demand deposit, thus “legitimizing” the practice and resolving the issue. Since the deposit is now a de facto loan, however, it cannot really be called fractional reserve banking. It’s really just an area of lending at that point.

The writer brings up the point of CDs, in which a depositor places his money with the bank at an agreed upon rate of interest, with the caveat that he cannot remove that money until a certain date or face a penalty if he chooses otherwise. Is it really so different? The answer is yes, because a certificate of deposit is defined according to those terms. The defining characteristic of a demand deposit is that it must be redeemed to the depositor on demand. Fractional reserve banking violates this condition, so a resolution is necessary.

That’s all for tonight. More on all this for the next few nights to come, though.

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As I mentioned yesterday, a friend of mine e-mailed me this week with questions concerning the Austrian position on the FDIC and deposit insurance in general. Now, to be clear, I am no economist, and I study the Austrian School in my free time, so my word should not be taken as gospel on this. (And, to anyone who might spot an error or two in my analysis, please jump in with a comment). I’m going to break up my discussion into parts over the course of this week, since I think that it can actually be used as a good introduction to a lot of Austrian principles in general.

First of all, I’d like to take tonight to mainly discuss the issue within a framework of positive versus normative analysis. I’ll briefly define these issues on a general basis. Positive analysis is an analysis that seeks to describe the world around us on the basis of our observations. I might say, for example, that the sky is blue. This statement is no more than a matter of fact, which can be affirmed or overturned on the basis of observations and evidence. It’s also a “value-free” statement: I am making no judgment on what color the sky should be, or whether or not it is “good” that the sky is blue. Rather, I am simply stating, on the basis of my observations, that it is blue. In order to successfully or effectively rebut this statement, a critic could use conflicting observations to expose flaws in my handling of what it was that I observed in the first place.

On the other hand is normative analysis. A normative analysis is one that is based on values, and seeks to describe the world as it should be. So, I might use a positive analysis to arrive at the conclusion that the sky is blue, and then I might use a normative analysis to say that this is a good thing, since blue is the best color for the sky. It rests on my value system with regards to the colors of the sky. These things, I think, will become even more clear over the course of my discussion here.

To begin with a positive analysis, then, my friend and I are in more or less complete agreement on the ways that FDIC insurance functions in a market. I’m going to go through that analysis now.

In a free market, citizens at one point or another will wish to store their money in a safe and reliable place. In order to fulfill this function, “safe houses” for their money will arise, where a citizen can store his money indefinitely and redeem it at any point in time, for the full amount, on demand. This is called a demand deposit. Over time, the story goes, bankers will realize that they often hold way more cash than their customers ask for at any given time, and it’s just sitting in the vaults. Bankers may begin to loan this money out to other individuals, although it’s guaranteed to the holder of the demand deposit at the same time . This creates a system under which there are more titles to money in the bank than there is money (more on this later this week). If the depositors begin to realize this, maybe through a devaluation of that bank’s bank notes relative to those of other, non-inflationary institutions, then they may begin to fear that their money is not safe at that bank. As more and more consumers fall prey to this fear, more and more of them will withdraw their money. This induces something of a “tragedy of the commons,” in which all depositors run to the bank to withdraw their deposits before it is too late. Since the bank inherently owes more money to depositors than it actually controls, it will fail as a result of this bank run.

One element of free banking such as this is that it provides an important check on risky bank behavior. Although it is possible that free banks will band together to form a private central bank–the long-term efficacy of this strategy is a topic for another post–which can hide the effects of inflationary policies from consumers, it would still be the case that depositors would be attuned to the behavior of their given bank. They might also shop around for banks, picking a high-risk bank for the rewards it promises or a low-risk competitor for the peace of mind it provides. In either case, however, they stand to lose money if they fail to adequately assess the policies and practices of a given bank.

Under a system of FDIC deposit insurance–in which the government guarantees all demand deposits–this check becomes severely attenuated. If a depositor knows that he risks losing money by placing his savings in a bank, then he will be prone to investigate the nature of that bank. If he is told by the state that his money is safe no matter what then the policies of the bank won’t much matter to him. Since his deposit is insured at all banks, he does not stand to gain from choosing to place it with a relatively risk-free bank. And, since his deposit is insured at all banks, he takes no risk by placing it with a risky and unscrupulous one. The fact of consumer preference, at least within the realm of lending practices, is effectively dampened by FDIC deposit insurance.

(A corollary to this is that fractional reserve banking–or FRB–is encouraged by such a policy, since banks don’t stand to lose clients by pursuing risky practice. Since FRB is profitable and the immediate risks are mitigated, this behavior is incentivized by the FDIC).

This is, for now, the end of my positive analysis. He and I are in agreement on these points.

Where we disagree, however, is within the realm of normative analysis. In order to say whether the FDIC is “good” or “bad,” we will need to adopt a set of values that can guide us in those assessments. My friend, for instance, says that the FDIC is “good,” since it incentivizes depositor apathy and thereby contributes to bolstering an FRB system that fuels leverage intensive industries. I argue, however, that it is “bad,” since it incentivizes depositor apathy and thereby contributes indirectly to the business cycle, not to mention a crony capitalist system in which the financial sector is held to entirely its own standard with respect to property rights.

His point is primarily that the FDIC contributes to leverage intensive industries, which make money by going into debt now in order to realize a return later on. This is done in any industry–airlines, construction, mining, etc.–in which costs are heavy up front and returns are light until the end of some production process. He sees the increase with regards to leverage intensive industries that results from FDIC deposit insurance as a “good” thing, validating the practice in his eyes. I have a couple of points on this.

The first of these is that, although many of us are grateful for these industries, that feeling itself is bound up in our own, personal values scales. It is conceivable that someone, for whatever reason, might loathe a leverage intensive industry, and therefore would be staunchly opposed to the FDIC system. This may not seem like an important point, but it is useful nonetheless in identifying the assumptions that underlie my friend’s argument.

My second point deals with the idea that, in the absence of the FDIC, financial institutions would not be as incentivized to lend to producers in leverage intensive industries. This may or may not be true–I don’t have the experience or expertise in this area to really say–but, from what I understand, that’s not really at the heart of the Austrian criticism of the FDIC. The Austrian criticism is more concerned with the fact that these loans are being made with demand deposits , which means that they are engaging in a practice in which two separate people are both entitled to the same collection of cash. On top of that, a demand deposit–speaking both philosophically and contractually–is best thought of as the sort of “vault” I mentioned earlier. In a normative, libertarian analysis, (the Austrian school generally seeks to maintain positive analysis), it might be considered fraudulent to violate such an arrangement on the basis of said loans.

In short, I don’t think it’s enough to say that the FDIC is a good thing, because it enables leverage and many of us benefit from leverage intensive industries. This really skirts the issue of logic that is at the core of my problems with the FDIC. Is it legitimate, on a rights basis, to insure a behavior that erodes property rights simply on the basis of its financial expediency? Is it legitimate to make guarantees in the financial sector that could not conceivably fly in any other industry? (As Tom Woods says, your dry cleaner can’t wear your pants around and refuse to give them to you if his brother then wants to wear them for a few weeks).

So, just to frame my following posts, this discussion is not about how the FDIC operates. We are in agreement on that. It will, from here on out, deal with two issues: 1) what is it about the FDIC that, under a normative libertarian analysis based on positive Austrian assumptions, can be construed as illegitimate; and, 2) would leverage intensive industries have developed as “robustly” in the absence of the FDIC?

Tomorrow–or whenever I am next able to post–I will try to deal with the various problems associated with the deposit insurance and the state-backed fractional reserve system it promotes aside even from the question of these leverage intensive industries. Basically, I will grant for the sake of argument the assumption that the FDIC is most effective in promoting leverage intensive industries, and will go on to argue that it still has vast repercussions in any number of other areas of the economy.

As always, feel free to let me know if I’ve missed and/or botched anything.

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FDIC and the Austrian School

Working late tonight, but I wanted to float an idea relating to an e-mail I received over the weekend from a friend of mine. He asks, basically, how certain industries (such as airlines, for example) that rely mainly on borrowing up front and realizing a return far in the future could exist without the FDIC. (This is an oversimplification; I am just going to briefly touch on it now, and I’ll get more into it and my responses later in the week, when I have a little more free time).

His argument goes like this: government deposit insurance provides a service that no insurer on the market would. Namely, that service is extending insurance to all depositors at no immediate cost. This relieves them of their risk aversion, thus incentivizing them to freely deposit their savings in any bank, scrupulous or otherwise. These banks, then, are able to turn around and lend out these massive savings to producers in these leverage intensive industries. Without FDIC guarantees, however, none of this would be possible and, since the government is the provider solely capable of behaving in this way, it follows that it should provide said service.

I’ll point out briefly that this logic, divorced from the banking specifics, is actually frequently used to defend universal healthcare. I’ll get back to that later in the week, but for now I think there are also more relevant concerns. I think, for example, that my friend and I may be “thinking past” each other on this issue. His e-mail seems mostly centered on the question of whether or not leverage intensive industries could have developed without something like FDIC guarantees, and he seems to lean against that possibility. I, frankly, don’t know the answer to that question. I think that it would be possible that they might have, but I really don’t have enough knowledge about these things to say. On top of that, of course, is the problem of the counterfactual.

To me, though, the more interesting question here has to do with the way in which the “insurance” is functioning, and with larger questions of fractional reserve banking in general. I am not totally decided on where I stand with regards to these issues but, for now, I’ll just say that I am very intrigued by Walter Block’s arguments. Specifically, I think he is on the right track when he suggests that the fundamental problem at the heart of FRB is that it creates more titles to property than property actually exists. If I deposit $100 and the bank loans $90 of it to you, and yet we still have full command over $100 and $90 in our checking accounts, respectively, then a title has been created for you (on the order of $90) to property that is also entitled to me (as part of my $100). Thus, more titles to property now exist ($190) than actual property (the original $100).

These points may seem disparate now, but I will link them together and try to flesh out a pretty solid discussion of this as the week goes on.

No Chronicle column this week, by the way, so be on the lookout for more on this kind of stuff here this week.

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