Bankers/FED/Treasury say "What Free Market?"
I'm sitting here at my desk observing the Gold Spot Market Close in New York. It was another day of re-establishing the pattern - overseas gold buying/New York gold selling. The market was up several dollars early this morning, then came the NY open, and the usual result followed. I, along with several others, have established that this pattern has been in existence over the last several years.
The examination of the pattern began as an academic exercise, but soon turned into an experience of personal frustration and exasperation as I tried to explain the market rigging to friends. Three factors contributed to this experience. One was that people had been exposed all of their lives to the myth that the U.S. is a basically free market society. The second was that they could not believe that the government would engage in such behavior. And finally, since our economic education is the worst of all our educational endeavors, they could not understand the logic of why it would be done.
Searching for ammunition to fight the first two factors I selected another realm where government overrides the free market. This other realm is known as the beloved Federal Deposit Insurance Corporation (FDIC). This is a Federal Corporation that "insures" savings deposits up to $100,000. per account.
In a free market investment money should more easily flow towards the less risky endeavors. It should also cost those that run risky operations more to borrow money. That is, the borrower should pay a higher interest rate to compensate for the higher risk of the lender. Therefore, in a normal insurance business those who wish to be insured pay according to their risk category. Statisticians known as actuaries spend their careers trying to allocate insurance charges according to the risk levels of various insured sub-populations. This is sometimes known as paying according to the moral hazard of an enterprise.
That is NOT how the FDIC operates! The FDIC charges the banks a nominal insurance fee that is based on the size of the bank. It does NOT include any consideration of the risk level at which the bank makes its loans.
What is the consequence of this aberrant insurance scheme? What is the consequence of removing the cost of moral hazard in this market place? First, it means that the banks that engage in more risky lending practices are charged exactly the same as those who engage in safer lending practices. The effect is to make the safer banks underwrite the lending risks of the dangerous loans made by other banks. Their lower than free-market costs to making risky loans encourage those high risk taking banks to make more such loans.
In the second place, since depositors get $100,000 insurance regardless of the nature of the loan portfolio risk of the bank, they obviously shop for the highest interest rate. Since the safer banks underwrite their risk costs, high-risk banks can pay subsidized higher interest rates. This results in the high-risk banks drawing in even more capital to expand those questionable loans.
Aside from turning the free-market concept of moral hazard on its head, the FDIC fees charged have resulted in a much lower than prudent cash reserve. The last estimate that I saw indicated an FDIC reserve of a fraction of 1% of insured deposits. The final spike in any concept of a free-market activity is that it will only take a few bank failures at the same time to use up all of the reserve funds. Who will pay the balance in such a situation? Surprise, it will be you, the taxpayer! No matter how careful you are with YOUR money, you will pay for the risk that the bankers take!
This non-statistical example should begin to make the case of how the government distorts the free-market to put the prudent at risk for the high-roller banker.
Harry J. Clawar Ph.D.
hjc@angelfire.com
December 1, 2001
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