Big Bad Banks

Elizabeth Warren, a Harvard law professor and commenter of some distinction, wrote in a Feb. 8 Wall Street Journal op-ed: "JPMorgan Chase (NYSE:JPM) CEO Jamie Dimon recently explained this brave new world, saying that crises should be expected 'every five to seven years.'"

Well, not exactly. Here's Dimon in his own words: "My daughter called me from school one day and said, 'Dad, what's a financial crisis?' And, without trying to be funny, I said, 'This type of thing happens every five to seven years.' "

Warren's quoting skills are harmlessly off-kilter. Unfortunately, I can't say the same of her interpretative skills. In the same op-ed, she wrote," ... new laws that came out of the Great Depression ended 150 years of boom-and-bust cycles and gave us 50 years with virtually no financial meltdowns."

Reality writ large
I couldn't disagree more. If recessions are byproducts of expanding and contracting monetary cycles, as I and many Austrian-schooled theorists believe, then the track record of the "new laws" is dismal: After the Great Depression, the United States experienced recessions in 1949, 1953, 1958, 1960-61, 1969-70, 1973-75, 1981-82, 1990-91, 2001, 2007-09.

As for "virtually no financial meltdowns," Warren notes, "The stability ended as we dismantled those laws and failed to replace them with new laws that reflected modern business practices." True, some dismantling occurred, driven largely by the rampant inflation and bank dis-intermediation of the late 1970s (arguably driven by abandoning the gold standard in 1971).

But asking legislators to then enact laws that reflect modern business practices is naive.

Legislators have never been, and never will be, prescient and proactive.

In short, financial meltdowns don't occur because of lagging laws or any of the lazily invoked human shortcomings -- greed, avarice, hubris, rapacity -- that have always plagued mankind. No, financial meltdowns occur because of the basic rules of the game: fiat money, fractional reserve banking, and government guarantees.

Fiat money ensures intractable government profligacy, which leads to inflation. Dollars lent today will be repaid in depreciated dollars tomorrow. This grinding loss of value also taxes savers, and thus, encourages consumption and speculation. If your dollars won't hold their value, why keep them?

Fractional reserve banking only supercharges the inflationary bias. Under a fractional reserve system, banks are the de facto regulators of money supply. What is more, fractional reserve banking permits them to expand the supply many multiples beyond the base money -- fiat or otherwise. In most commercial niches, lending what you lack is fraud, but not banking.   

Unfortunately, when the loans go bust, which Dimon has noted "happens every five to seven years," the federal government -- excuse me, the United States taxpayer -- is left to ensure depositors are made whole and that the financial institutions, for the most part, survive. This moral hazard leads to the heads-I-win-tails-you-lose-and-let's-flip-again paradigm Dimon so quaintly refers to.  

They'll survive, for now
I'm not blaming the banks; they're simply playing by the rules (which, of course, they invented). At times, these rules can prove quite remunerative, especially for management, but also for investors.

After the latest financial debacle we see whom government has ordained survivors. They are dinged and damaged, to be sure, but they'll likely be around and prosper until the next boom goes bust. Saudi Prince Al-Waleed bin Talal realized as much with his 1990 investment (a combination of preferred and common stock) in serial boom-bust survivor Citicorp (now Citigroup (NYSE:C)). Warren Buffett exploited a similar opportunity (a combination of preferred stock and warrants) with Goldman Sachs (NYSE:GS) in 2008.

Call the following financial institutions either too big, too politically connected, or too lucky to fail, it doesn't matter. They survived; thus, they are an opportunity for investors.

Warren expounds the need for "new laws," to which I would say "hear, hear" if they addressed my aforementioned issues. Unfortunately, they don't. Her laws further entrench the status quo. Only laws that "throw the bums out" and rely on free markets -- commodity-based money, full-reserved banking, and free-market oversight -- will alter the outcome.  

We'll see reform, to be sure. Resist the hype. Given the underlying, unchanging rules of the game, another financial bust is inevitable. That's not my admonition, that's Dimon's. But that doesn't mean you can't make money in the interim.