How Things Used to Be

Returning to the reality of how things have been for at least the last century and a half, banks have, as a matter of course, borrowed short and lent long. Indeed, this “maturity transformation” is commonly viewed as their principle raison d’etre. There is still a quantitative difference, however, between the way the process operates today and the way it did prior to the advent of central banks as lenders of last resort and sundry other government support schemes.

Back then, banks were constrained in their creation of credit (and in the degree of maturity transformation) because of deep-seated liquidity concerns (it wasn’t uncommon, even as recently as a hundred years ago, for banks to operate with a capital to assets ratio of 25-30%, as against current levels of 10% or less, sometimes much less). The merest hint of doubt about a bank’s solidity could bring on disaster. Given that even then many of their long-term loans were funded with short term borrowings, and that their own capital was at risk as a guarantee that depositors would be repaid, the very structure of banking was inherently fragile. If a bank faced with a crisis of confidence couldn’t liquidate assets (or borrow from other, less threatened banks) quickly enough to meet depositor demands, then failure loomed.

This discipline was brutal but effective. Up until the early part of the 20th century, prices fluctuated and markets and the economy went through periodic booms and busts but each time they found their way back to some sort of equilibrium. Indeed the general level of prices was much the same at the end of the 19th century as it had been at the beginning.

There’s no great mystery as to why. For most of that period, not only were banks operating without much of a safety net but the world was also on the gold standard. On those occasions when a nation felt compelled to abandon it (generally because of war), prices usually rose until its discipline was reintroduced. It was a harsh standard which for the most part did its work automatically. Remarkable though it may seem from our perspective, there were also long fruitful periods of gradual deflation when economic growth (as a result of savings based productivity improvements) exceeded monetary growth.

Many saw the workings of the gold standard as cruel, or “barbarous” to use Keynes’ expression (much as some still view the workings of nature). It was, in truth, neither cruel nor kind, it was simply remorseless. We get some idea of how remorseless through viewing the effects of its abandonment over the last century. Thus consumer prices in the US (despite continuous expressions of concern about the dangers of inflation), have risen by well over twentyfold in the last hundred years.

It is, of course, deeply unfashionable today to refer to the gold standard or specie-based money in anything but critical (or better yet dismissive) terms and I can’t see that changing any time soon. Maybe never. Even after the recent spectacular failures, the conviction that we can manage money and credit without resort to such antediluvian aids (or at least that we should be able to manage them) remains an article of faith.

Although the general run of prices during the heyday of the gold standard did return to a sort of equilibrium after each digression, it was hardly a time of serene tranquility. Financial markets, and the underlying economies, experienced remarkable swings, with periodic outbreaks of contagious and excessive animal spirits followed by times in which they were notably absent (we are, after all, dealing with human nature). Still, if only with the benefit of hindsight, these swoops and dives were, like consumer prices, simply deviations around a long-term, relatively stable, trend. The blunt strictures of the gold standard (and the then minimal reach of government) precluded the sort of cumulative excess that has characterised recent generations.

Or, put another way, negative feedback was allowed to work.

Not so in recent decades. Indeed, with the brief exception of Volcker’s early years at the Fed, one could argue it hasn’t been allowed to work for well over half a century. And here, finally, we’re ready to undertake a closer examination of our own period and the nature of the credit it produced in such profusion.

Was it good, was it economically productive, did it in any meaningful sense represent savings, or was it, for the most part, an insidious and deceptive blight on the economic landscape?

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