Sunday, 30 March 2008

How to stabilise the economic system

The origin of the boom and bust business cycle and the inherent instability of the modern financial system is due to the fractional-reserve banking system.

Banks and investment houses borrow short-term and lend long-term. This undercuts the very foundation of capitalism by distorting the price of long-term credit. For capitalism to work, the term structure of credit should accurately reflect the economy's time preference for future consumption - i.e. how much are people are putting away for future consumption and in what time frame.

Industry relies on an accurate signal from the capital markets to plan future production. Easy availability of long-term capital for industrial projects implies future demand. Scarcity of long-term capital implies no new projects should be undertaken because there are no savings which will absorb the additional production.

Borrowing short-term to lend long term creates an illusion of long-term savings where there are none. The resulting economic activity is doomed to fail because the consumption promised by the capital markets will never materialize. The bust that we face now is a necessary corollary to the boom. Nothing can be done to prevent it. All that the central bank and government interventions will do is to redistribute (read socialize) the pain.

To fix the system we have to take away the powers of banks to change the term structure of capital. After that laissez-faire policies with suffice.

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