Does the “fallacy of composition” apply to the banking sector?

The fallacy of composition misleads you into thinking that you can infer the property of the whole by the property you can observe in its parts considered individually. This fallacy leads you to think that what is true for the parts must be true for the whole.

In economics, one of the most popular examples of the fallacy of composition is the “paradox of thrift,” popularized by Keynesian economics. If thrift is good for an individual, it should be good for the economy as a whole. Wrong, because if everyone saves more, this will bring down consumption, cause aggregate demand to fall, hamper any economic growth and, paradoxically, a rise in individuals’ thrift would lead to less saving on the whole and harm the economy. Policymakers believing in the paradox of thrift, particularly in times of recession, would look in horror at people saving more while trying to find their way out of the hole. Yet, despite what we can argue using curves that sometimes saving is equal to investment and sometimes is not, sound capital theory reminds us of the basic fact that an economy needs a boost in real saving for capital formation to bring about a real recovery (not a nominal or a statistical one). For those critics of Keynesian economics, the paradox of thrift is not an example of the fallacy of composition but one of bad economics.

Recently, the fallacy of composition has been also widely argued as a theoretical flaw in public policies that explains the current financial crisis. As the argument goes, regulators were misled since they assumed that recommending what seemed right for a single bank should be right for the whole banking sector. Supervisors were also misled by this same fallacy: checking individual banks’ soundness made them infer that the system was sound as a whole. This misconception left traditional regulators and supervisors, solely focused on the safety and soundness of individual banks, ill-equipped to prevent the systemic collapse seen at the end of 2008. Thus, a fresh conception of “macro-prudential supervision and regulation” is needed: a system-wide, top-down approach to regulation and supervision.

However, does this fallacy of composition really apply to the banking sector? If we look at other industries, a fallacy of composition does not seem to be the case. For example, if all individual fishing companies run their business in a safe and sound manner, we can infer that the fishing industry is safe and sound on the whole. The issue is, what do we mean by running an individual fishing company in a safe and sound manner. Even if it were profitable for an individual company to go carelessly about polluting waters, fishing out of season and in non-fishing areas, we could not call this a safe and sound way of running an individual business, so it would be unfounded to infer that the fishing industry is safe and sound on the whole.

In the banking industry something similar happens and the fallacy of composition might not be obvious at first sight. The two distinctive activities of banks are cash and payment services and credit intermediation. It is not easy to grasp how individual safe and sound “cash and payment agents” and individual safe and sound “credit intermediaries” can become a source of global systemic collapse when compounded as a whole.

Fierce critics of how banking operates today would argue that there is no such fallacy of composition, but a big misconception of what a sound individual bank should be. These critics would question whether we can call “sound” institutions that systematically borrow short-term and lend long-term, hold low capital, and intermingle socially-essential “utility” activities with highly risky trading and credit operations. Banks, for them, are so unsound in their present form that they can only operate if they are heavily propped up by the State. Without central banks’ ability to print as much money as needed, and in the absence of State-funded implicit and explicit deposit guarantees and State-promoted “too-big-to-fail” doctrines, modern banking industry simply could not exist.

Modern banking theory, however, would have it that there is little we can do. Banks have a social function of maturity transformation. They are expected “to allow individuals ready access to their money, while at the same time allowing most of that money to be invested in illiquid assets” (P. Krugman). For this Nobel Laureate the way to go with this intrinsically but economically desirably unstable banking industry is through “Government backing — the 21st -century version of deposit insurance — plus regulation so that the backed institutions don’t abuse the privilege”. Fierce critics would argue that maturity transformation is not a function for banks to do but for the society itself. Time preferences of savers and investment projects of entrepreneurs simply fall into banks’ hands. Their essential social function is to intermediate credit according to savers’ time preferences and borrowers’ funding needs.

Modern banking theory would continue saying that bank credit has to remain “flexible enough” to promote economic growth. Nobody questions the fact that bank credit is vital for capital accumulation that promotes economic growth. The question is when “flexible credit” stops promoting economic growth and starts creating a global financial meltdown. Our fierce critics, following Mises’ and Hayek’s business cycle theories, would argue that enough is enough when credit expansion does not follow the sustainable path marked by real savings. Cobden Center’s Senior Fellow Prof Huerta de Soto sets all of this out in great detail in his must-read book “Money, Bank Credit, and Economic Cycles”.

Milder critics, on the other hand, would also argue that there was no such fallacy of composition, but a systematic distortion of how to assess individual banks’ risk. They accept current unstable banking characteristics and State support, but question whether criteria to assess individual banks’ level of risk were correct. For them, regulators, supervisors and bankers simply failed to include a system-wide perspective in the individual assessment of risk. As a result, systemic risk was not the consequence of a fallacy of composition, but rather of poor assessment of individual banks’ risk, which failed to consider the fact that the collective behaviour of financial institutions was an important driver of risk.

No doubt there are good reasons to change many of the current approaches to banking regulation and supervision, but maybe the fallacy of composition is not one of them. And we should not be oblivious to the fact that in the financial system its opposite, ”fallacy of division”, would have even more damaging effects if policymakers were misled by assuming that, if the whole looks sound, all individual banks should be sound as well.


What the pound has still to learn from gold

Today, as there are so many politicians meddling around trying to get things right in our economies, people are concerned about money; not only about having more (or any), but also about having a sound currency.

Where can we find good quality money? For centuries, and civilization after civilization, gold (and silver too) have consistently won out in the long-running contest against livestock, grain, cowrie shells, feathers, etc., to find an economic good that people can use as “money” for their trades. Something valuable and stable in its value to organise complex divisions of labour in societies. So if the pound and the other fiat currencies want to replace gold as money for the next 3,000 years, they had better listen to what this “barbarous relic”, in Keynes’ words, has to teach them.

First of all, no rulers or brilliant minds ever had the great idea that gold could play the role of money in society. Instead, they had to accept what people used and agreed to in their trades. In fact, rulers have always hated gold as money because of the power it has taken from them. They tried to bypass the laws of physics and chemistry and create gold from nothing, but the most they achieved was to debase their currencies, a blatant trick that has been condemned since time immemorial. They also tried to replace gold with something of low value they could control. Something that they could give to people (or force them to accept) in exchange for their properties and labour so they could continue with their grandiose schemes, wars and white elephants. Rulers had to wait until they invented fiat money (backed only by governments’ promises to maintain its purchasing power) for their dreams to come true.

We accept fiat money and the rationale behind it. It is true to say that if central banks print paper money, an economic good devoid of any other utility (except for collectors), this fiat money releases gold from its social function as money, and becomes more available for other purposes. Jewellery, ornaments, medallions and many other beautiful things you can make with gold are, thus, more affordable. However, we accept this rationale with a serious note of caution. Behind fiat monies there are governments historically eager to indulge in public spending and irresistibly tempted to create money by simply running the central bank’s printing press.

If we compare fiat money with gold, there are a few lessons that fiat money has already learnt from gold –namely, its physical characteristics. Fiat monies, like gold, tend to be scarce, valuable, divisible, transportable and incorruptible, which makes them as efficient means of exchange as gold.

However, physical characteristics alone were not all that made gold the most efficient means of exchange. Gold production is also limited and not manipulable. To produce this scarce, valuable, divisible, transportable and incorruptible substance it must be mined from the ground, which is a slow, expensive and risky business. In stark contrast, producing fiat money is not a slow, expensive and risky process. It is simply a political decision that only requires an accounting entry in the central bank’s books. This makes fiat currencies political creatures more than anything else, which gives them a nasty taste (except for those in with the political power). And here is where the serious lessons from gold start kicking in.

As counterfeiters know, central banks have the monopoly over fiat money production. They produce it on the basis of their “monetary policy” decisions, which are taken by top-ranked official committees based on the research of highly-trained central bank staff. Monetary policy is discretionary but not capricious. It is governed by general rules and objectives, and legal provisions ensure that central banks have independence to resist political and industry pressures, and this is a good thing. Monetary policy is at the core of central banks, and all economists (except, perhaps, the Austrian School) cannot conceive a modern economy without a centrally planned monetary policy that exercise an effective influence over interest rates, the prices at which people are willing to lend and borrow funds and clear the “available-funds-to-lend” markets.

However, if we again put fiat money and gold together, we see that gold has been able to act as sound money without centrally planned production decisions taken by top-ranked official committees. Gold has been produced simply by mining it from the ground, perhaps the most credible measure to ensure that money creation is going to be free from political an industry pressures.

This “mining-from-the-ground” lesson to produce sound money could be a tough lesson for today’s mainstream monetary theorists, but if central banks wished to replicate it for their fiat money production, they would, first, have to establish the strictest possible operational independence that ensures low and predictable fiat money creation, free from any political and industry pressures; and, second, they would have to abandon any idea of conducting a scientific monetary policy as a means to justify discretionary money production, and simply let the supply and demand of loanable funds determine interest rates.

In addition to monetary policy, central banks today can also produce fiat money when they are instructed to monetise public debt. In contrast to monetary policy, this is not elegant economics. If abused, this is plain State villainy but it is something that may happen with fiat money. If ancient rulers, no matter how powerful they were, had problems paying their debts, they opened their vaults, counted how much gold there was, and decided whether to tax their subjects more or to tell creditors that they would have to wait. If modern governments have problems paying their debts, they can tax their people further, declare default, or ask their central banks to print more fiat money and avoid unpopular announcements.

Removing from fiat monies their ability to monetise whatever deficit might be needed to keep governments profligate and in power is another tough lesson that gold would pass on to fiat money production. However, for those who want currencies “as good as gold,” central banks must turn a deaf ear to the requests of government, the mighty and the powerful to produce more fiat money for them (and to the detriment of everyone else), and remain steadfast gatekeepers of the fiat money they produce.

Does current fiat money production wish to learn these lessons from gold production, and set low, predictable, and non-manipulable paths of fiat money creation? Will central banks abandon monetary policy and the monetization of deficits? Are these wise moves? This is something to be discussed. As a final consideration, though, in a world of honest money, when people want more pounds, what they do is not lobby the Bank of England or influence its monetary policy decisions, but instead to work hard and exchange the wealth they have produced for pounds. This is the way by which they will have many pounds more.