Natural interest rates are dead, the BIS (indirectly) says

In May (I only found out a couple of weeks ago), the BIS released a big report titled Regulatory change and monetary policy, in which it investigates the effects of the new banking regulatory framework on market interest rates and the implied consequences for the conduct of monetary policy. By the BIS’ own admission, the whole yield curve has nothing ‘natural’ left.

The report is an interesting, though pretty technical read. It is also scary. Scary to see how much banking regulation is affecting interest rates all along the yield curve across most banking products. Scary to see that the suggested remediation by the BIS is more central bank involvement to counteract the effects of those regulations.

Of course, the Basel framework originates from… Basel in Switzerland, where the BIS is located, and where BIS experts have spent years drafting apparently clever rules to make our banking system apparently safer, in spite of all historical evidences and what we’ve learned about the spontaneous order of free markets (remember: “banking is different” they say). So I wasn’t expecting this BIS report to declare that the very rules it put in place was endangering the economy. And indeed it doesn’t. But it does admit that there will be ‘impacts’, which of course will be ‘limited’ and ‘manageable’. They always are.

I won’t replicate here everything that’s in that report. It’s way too long and I’ll let you take a look at it if you’re interested. There is a quite detailed description of the potential effects of the Liquidity Coverage Ratio, the Net Stable Funding Ratio, the Leverage Ratio and the Large Exposure Limits on banks’ product pricing and volume and the impact on central bank’s monetary policy operations. And despite its 30+ pages, the report isn’t even comprehensive. It forgets to look at the large distortive effects of risk-weighted assets and credit conversation factors.

What I’m going to show you below is merely the BIS researchers’ own conclusions, which they neatly summarised in handy tables. This is what they view as the potential changes in money market interest rates:

BIS IR shifts

By their own admission, the cumulative effect of those new rules is unclear. And even when they believe they know which way the interest rate will move, it remains a best guess. To this table you can add the hugely distortive effects of RWAs and CCFs, which I have described on this blog a number of times.

The only conclusion is that there is no free market-defined Wicksellian ‘natural’ interest rate anymore in the marketplace. As interest rates are manipulated by regulatory measures in myriads of ways, entire yield curves across the whole spectrum of banking products and asset classes stop reflecting the pricings that market actors would normally agree on in an unhampered market. The result is a large shift in the structure of relative prices in the economy.

The economic consequences are likely to be damaging (and it is clear, at least to me, that RWAs have already done a lot of damages, i.e. the financial crisis), even though the BIS reckons that central banks could potentially offset some of those interest rates movements:

More central bank intermediation: Many of the new regulations will increase the tendency of banks to take recourse to the central bank as an intermediary in financial markets – a trend that the central bank can either accommodate or resist. Weakened incentives for arbitrage and greater difficulty of forecasting the level of reserve balances, for example, may lead central banks to decide to interact with a wider set of counterparties or in a wider set of markets.

In addition, in a number of instances, the regulations treat transactions with the central bank more favourably than those with private counterparties. For example, Liquidity Coverage Ratio rollover rates on a maturing loan from a central bank, depending on the collateral provided, can be much higher than those for loans from private counterparties.

Problem is (and the BIS also admits it): there is no way non-omniscient central bankers know by how much and in what direction rates should be offset. We here get back again to the knowledge problem. There is no way the central bank can act in a timely manner. It is also unlikely that central bankers could act free from any political interference. Finally, even if central banks managed to figure out what the ‘natural’ rate is for a given asset at a given maturity, central banks’ policies are likely to have unintended consequences by altering the rates of other products and maturities.

The effectiveness of the transmission mechanism (banking channel) of monetary policy is more than ever questioned. Rates will move in unexpected ways. And, as the BIS describes, banks could simply opt out of monetary programmes altogether:

The question is whether there are exceptional situations in which banks would refrain from subscribing to fund-supplying operations because concerns over the LR impact of the reserves that would be added to the banking system in aggregate outweigh the financial benefits accrued by participating in the operations. If so, this lack of participation could prevent a central bank whose operating framework entailed increasing the quantity of reserves from meeting its operating target.

The BIS believes that “the changing regulatory environment will, by design, affect banks’ relative demand across various types of assets and liabilities”. It summarises the potential changes in the demand for central bank tools below:

BIS CB Tools Demand shifts

Here again, a lot of uncertainties remain.

Something looks certain however. The involvement of central banks in the financial and economic system is likely to become more intense. As regulations bound banks’ behaviour and prevent an effective allocation of capital, central banks are increasingly going to step in to boost or restrict the supply of credit to certain market actors and asset classes. See what happened with SMEs, starved of credit as Basel makes it too expensive to extend credit to such customers, while central banks attempted to offset this effect by starting specific lending programmes (such as the Funding for Lending scheme in the UK). We are here again back to Jeff Hummel’s arguments of the central bank as central planner.

Nonetheless, I am certain that capitalism and free markets will get blamed for the next round of crisis. It is becoming urgent that we replicate the achievement of academics such as Friedman and Hayek, who managed to overturn the nonsense post-War Keynesian consensus. Sadly, free markets academics seem to have virtually disappeared nowadays or at least cut off from most policymaking positions and public debate.

Financial knowledge dispersion and banking regulation

I have never hidden my admiration for Hayek’s work, in particular over the last few weeks. The name of this blog is itself derived from Hayek’s concept of spontaneous order. I view Mises as having laid the foundations of a lot of Hayek’s and modern Public Choice theory thinking (see Buchanan’s admission that Mises “had come closer to saying what I was trying to say than anybody else”). He was to me a more comprehensive theorist than Hayek, and made us understand through his methodological individualism method that human action was at the heart of economic behaviour. But Hayek’s brilliant contribution is to have built on Mises’ business cycle, market process and entrepreneurship insights to develop a coherent and deep philosophical, legal, political and economic paradigm. While some would argue that he didn’t push his logic far enough (see here or here), it remains that reading the whole body of Hayek’s work is truly fascinating and enlightening. It suddenly feels like everything is connected and that “it now all makes sense”.

Some of Hayek’s insights are verified on a day-to-day basis. He repeatedly emphasised that knowledge was dispersed throughout the economy and that no central authority could ever be aware of all the ‘particular circumstances of time and place’ in real time. This knowledge problem was core to his spontaneous order theory, which describes how market actors set up plans independently of each other according to their needs and coordinated through the price system and respect for the ‘meta-legal’ rules (what he later called ‘rules of just conduct’) of the rule of law.

Hayek glasses quote

I have very recently offered a critique of macro-prudential regulation based on Hayek’s and Public Choice’s insights. But his description of the knowledge problem also applies. Zach Fox, on SNL (link gated), reports that the whole of macro-prudential regulatory framework may be useless because the US agency in charge of tracking the data can only access outdated, if not completely wrong, datasets. This agency calculates ‘systemic risk’ scores from a number of data points sent by various banks. Problem: those figures keep being revised by many banks, sometimes radically, leading to large fluctuations in ‘systemic risk’ scores and regulators keep using outdated data:

SNL has only been able to track the movements by scraping each bank’s individual filing periodically over the last year. U.S. banks filed their 2013 systemic risk reports by July 2014, at which point SNL reported on the data. After noticing some differences, SNL followed up Jan. 13, 2015. In total, 12 data points had changed across the filings for eight different banks. Then, in July 2015, SNL noticed yet more revisions to the 2013 filings.

Fox concludes:

When a bank’s derivative exposure shrinks by $314 billion — roughly half the size of Lehman when it filed bankruptcy — it raises questions about the company’s ability to model accurately in real-time. When that change does not come until 16 months after the initial filing, it raises questions about the Fed’s vigilance. And when the government’s office established to track systemic risk uses incorrect, outdated data, it raises questions about the entire theory of macroprudential supervision.

(one could add: “and of micro-prudential supervision”)

In short, due to dispersed nature of financial knowledge (i.e. data) across the whole banking sector and the inherently bureaucratic nature of the data collection and analysis process, regulatory agencies do not have ability to collect accurate data in a timely manner, and hence act when really necessary.

Of course, some banks also seem to struggle to report the required data. But they are much closer to their own ‘particular circumstances of time and place’ and hence can take action way before the data even reach the regulator. Moreover, banks are organisations that comprise several layers of individuals, each of them facing their own particular circumstances. Knowledge is dispersed among bankers who deal with clients on a daily basis and goes up the hierarchical chain if and when necessary. Governmental agencies are at the very end of this chain and informed last, way after the actions have taken place (or the disaster occurred).

Of course, this does not mean that commercial banks are always effective in dealing with data and that all their decisions are taken rationally. But a central regulatory agency would not have the ability to make the bank safer either. Forcing banks to adopt certain standards in advance could help solve the problem to an extent only, as circumstances vary and standards may not be appropriate for all situations or could even exacerbate problems as I keep emphasising on this blog (and are likely to be a harmful and unnecessary drag on economic performance).

PS: The Chinese central bank is about to cut reserve requirements to boost lending according to the WSJ. Clearly China hasn’t been infected by the MMT/endogenous money virus yet.

PPS: Kinda related to this post, but definitely related to this blog, see this Hayek’s quote of the day:

Above all, however, I am bound to stress that in the course of the work on this book I have been, by the confluence of political and economic considerations, led to the firm conviction that a free economic system will never again work satisfactorily and we shall never remove its most serious defects or stop the steady growth of government, unless the monopoly of the issue of money is taken from government. I have found it necessary to develop this argument in a separate book, indeed I fear now that all the safeguards against oppression and other abuses of governmental power which the restructuring of government on the lines suggested in this volume are intended to achieve, would be of little help unless at the same time the control of government over the supply of money is removed. Since I am convinced that there are now no longer any rigid rules possible which would secure a supply of money by government by which at the same time the legitimate demands for money are satisfied and the value of that money kept stable, there appears to me to exist no other way of achieving this than to replace the present national moneys by competing different moneys offered by private enterprise, from which the public would be free to choose which serves best for their transactions.

It comes from the chapter 18 of Law, Legislation and Liberty (which I have now read), and highlights a significant evolution in Hayek’s thinking since The Constitution of Liberty, in which he had argued in favour of government managing the money supply (but should do it well of course).

Leveraged housing bubbles are the most damaging ones

Jordà and his colleagues are quickly becoming some of my favourite economic researchers. Not because we necessarily share the same fundamental economic believes (probably not, at least to my knowledge) but because they keep publishing remarkable pieces of financial data gathering.

In their most recent publication, titled Leveraged Bubbles, they reached a conclusion that could sound relatively obvious to most people versed in Austrian or Minskyite business cycle theories, namely that

what makes some bubbles more dangerous than others is credit. When fueled by credit booms asset price bubbles increase financial crisis risks; upon collapse they tend to be followed by deeper recessions and slower recoveries. Credit-financed house price bubbles have emerged as a particularly dangerous phenomenon.

But, as usual, it’s their dataset that’s the most interesting, and on which further empirical research can be based. They provide a dataset of bank credit, real estate and stock prices across 17 different countries, starting around 1870.

What do they find? That combined housing and equity bubbles leading to financial recession are a characteristic of the post-WW2 world:

Whereas equity price booms play a prominent role in those financial recessions associated with a bubble episode before WW2 (8 out of 12 bubble related financial crisis recessions involve equities alone), after WW2 it appears that most episodes involved bubbles in both equity and house prices—11 out of 21 episodes are linked to bubbles in both asset classes.

And that, this is necessarily linked to the huge mortgage lending growth of the era:

Building on the original data collected by Schularick and Taylor (2012), Jorda, Schularick and Taylor (2014) break-down bank lending into mortgage and non-mortgage lending. While both types of bank lending experienced rapid growth in the post-WW2 era, the share of mortgages relative to other types of lending grew from a low point of less than 20% in the 1920s to the nearly 60% in the Great Recession.

As I have pointed out in a review of their previous research publications, this isn’t surprising at all given that the whole Basel regulatory framework has made it much easier (and more rational) for banks to maximise their lending allocation to the real estate sector. In short, Basel has institutionalised the debt-fuelled housing bubble.

And this made the whole economy more vulnerable. They point out that housing bubbles are

considerably more damaging events. The drag on the economy is nearly twice as big when accompanied by higher than average credit growth. In terms of the path of the recession and recovery, we note that it can sink the economy for several years running so that even by year 5 the economy is still operating below the level at the start of the recession.

In other words (not theirs, but mine), Basel, by attempting to make the financial system safer, has made it (and the whole economy) weaker (and it would actually be better to live in a stock bubble-prone world). And the impact on economic growth is dramatic:

Equity Housing debt bubbles

Given that housing prices have been strongly increasing again in many countries since the onset of the crisis, there is nothing reassuring in their results.

The Hayek quote I came across last week is more relevant than ever. Micromanagement of the banking system is bound to disappoint its supporters.

A few things I read elsewhere

Just a quick few points today.

Scott Sumner has a few posts on whether or not growth is inflationary. He says:

If NGDP growth rose by 4%, and both RGDP growth and inflation rose by 2%, it would look like growth was inflationary. But in fact the NGDP growth (i.e. monetary policy) was causing 4% higher inflation, ceteris paribus, and the extra 2% RGDP growth was holding down the inflation rate, limiting the increase in inflation to 2%.

If this is the way the world works then one might expect many cognitive illusions to form. People would think growth was inflationary, whereas in fact it would be deflationary, as the regression in the previous post showed, and as our theoretical model predicts. Procyclical inflation would reflect bad monetary policy (unstable NGDP growth) and inflation would be strongly countercyclical under a sound monetary policy regime (stable NGDP growth.) If the central bank predicts that inflation will pick up during a boom period, they are predicting their own incompetence.


I have grown tired over the past few years of economists, analysts and journalists predicting that inflation would be back because RGDP growth was coming back.

I missed another very confusing post by Izabella Kaminska (referring to a blog post by Peter Stella) a few days ago about ‘hyper liquidity’. To make it short, I agree about the term ‘hyper liquid’, but the rest of the post seems to be way off the mark. I say ‘seems’, because I’m really unsure I understand what the h*ll she’s trying to say.

Can someone translate this for me please:

As Stella notes, this is why the common conception that banks lend reserves “out” to non-banks is simply nonsense. Reserves are not for lending. At best they’re part of a penalty system, representing the amount of value/capital that needs to be withheld to protect the system from bad agents. It’s a cover. Insurance.

Indeed, re-lending reserves would defy the point of holding reserves in the first place.

What banks actually lend out is credit.

Credit represents a guarantee that the bearer of a bank’s coupons (who has been vetted) will not squander the assets/goods provided to him, but work to replace them in a meaningful value-adding way which grows the system as a whole rather than contracts it.

That doesn’t mean funding isn’t important! It is hugely important. We simply mustn’t confuse funding for something it isn’t. When a bank’s credit is well funded (so, the new assets it creates through lending), this means the current coupons (liabilities) it issues to the borrower for use in the real economy are guaranteed to square with what the system has available for sale within that timeframe. The funding represents a “store of anything to be drawn upon.” Funding can and is relent. But it’s what a bank doesn’t lend out, but keeps in its own reserve at an opportunity cost to itself, which counts as a bank capital reserve. It’s pre-funding.

When banks issue unfunded liabilities, there is no guarantee that the system is able to service them. Thus, there may be inflationary consequences.

The whole thing doesn’t make any sense to me, from an accounting or an economic point of view. Apparently, funding can be relent, but what is not relent is a capital reserve, which is pre-funding. Wait… what? I really don’t get it. Perhaps I just need holidays.

The assumption in the post that the bank reserve system is ‘closed’ is simply wrong. Reserves leak all the time, at least through deposit withdrawal (you don’t withdraw credit at the ATM. You withdraw high-powered money, deducted from the bank’s reserve account at the central bank). Stella (and possibly Kaminska) also seems to forget that it can take many decades for the money multiplier to recover. Banks don’t really lend out reserves: they extend credit on top of those reserves. Hence the money multiplier. And this funding/pre-funding/re-funding/asset funding/capital funding/ultra funding/turbo funding story is just crazy.

Finally, in light of my fights against Basel’s RWAs, I stumbled upon the following very relevant quote from F.A. Hayek:

The contention often advanced that certain political measures were inevitable has a curious double aspect. With regards to developments that are approved by those who employ this argument, it is readily accepted and used in justification of the actions. But when developments take an undesirable turn, the suggestion that this is not the effect of circumstances beyond our control, but the necessary consequence of our earlier decisions, is rejected with scorn.

This perfectly fits the RWAs example. Well-meaning regulators came up with a system that would reduce the accumulation of risk in our banking system. Events didn’t turn the way they expected, but it wasn’t the fault of the original rules of course (even if they massively favoured real estate lending over corporate lending). But don’t worry citizen: they are working on making those rules even better. See the result on this brand new chart from the WSJ:


We already knew that all residential property markets were cooling down all around the world. Now it looks like the CRE market is also calming down. The new rules are indeed working. Good job folks!*

*I hope you got the irony

Macro-pru, regulation, rule of law and public choice theory

Another rule of law-related post. It might be the anniversary of the Magna Carta that brought this topic back in fashion. Consider it as a follow-up post to my Hayekian legal principles post of a couple of weeks ago.

John Cochrane has a very long post on the rule of law on his blog (which could have been an academic article as the pdf version is 18-page long) titled The Rule of Law in the Regulatory State.

His vision is a little gloomy, but spot on I believe:

This rule of law always has been in danger. But today, the danger is not the tyranny of kings, which motivated the Magna Carta. It is not the tyranny of the majority, which motivated the bill of rights. The threat to freedom and rule of law today comes from the regulatory state. The power of the regulatory state has grown tremendously, and without many of the checks and balances of actual law. We can await ever greater expansion of its political misuse, or we recognize the danger ahead of time and build those checks and balances now.

He believes the rise of the regulatory state does not fit the standard definitions of socialism, regulatory capture or crony capitalism. He believes that we are

headed for an economic system in which many industries have a handful of large, cartelized businesses— think 6 big banks, 5 big health insurance companies, 4 big energy companies, and so on. Sure, they are protected from competition. But the price of protection is that the businesses support the regulator and administration politically, and does their bidding. If the government wants them to hire, or build factory in unprofitable place, they do it. The benefit of cooperation is a good living and a quiet life. The cost of stepping out of line is personal and business ruin, meted out frequently. That’s neither capture nor cronyism.

He thinks the term ‘bureaucratic tyranny’ could be appropriate to describe the situation, and that it is the ‘greatest danger’ to our political freedom. That is, opposing or speaking out against a regulatory agency, a politician or a bureaucrat might prevent you from obtaining the required regulatory approval to run your business.

He takes what seems to be a Public Choice view when he states that “the regulatory state is an ideal tool for the entrenchment of political power was surely not missed by its architects.”

While his post covers all sorts of industries, and while his definition of the rule of law (and its difference with mere legality) isn’t as comprehensive as Hayek’s, it remains pretty interesting. He actually has a lot to say on the current state of banking and financial regulation:

The result [of Dodd-Frank] is immense discretion, both by accident and by design. There is no way one can just read the regulations and know which activities are allowed. Each big bank now has dozens to hundreds of regulators permanently embedded at that bank. The regulators must give their ok on every major decision of the banks.

While he says that, for now, Fed staff involved in bank stress tests are mostly honest people, he is wondering how long it will take before the Fed (pushed by politicians or not) stop resisting the temptation to punish particular banks by designing stress tests (whose methodology is undisclosed) to exploit their weaknesses.

While Cochrane laments the rise of discretionary ruling and its consequences on freedom, The Economist also just published a warning, albeit a less-than-passionate one. Since the crisis, The Economist has always taken a somewhat ambivalent, if not completely contradictory double-stance (for instance, it takes position against rules in monetary policy in the same weekly issue). Here again, the newspaper believes that the crisis made new rules ‘inevitable’, because taxpayers ‘need protection from the risks of failure’. And that, as a result, regulators needed ‘flexible’ rules (MC Klein made a similar point some time ago – see my rebuttal here).

By and large, The Economist has approved that sort of rulemaking, as well as the use of macro-prudential policies (something I have regularly criticised on this blog). Nevertheless, the newspaper also complains about abuse of discretionary decision-making and the effect of regulatory regime uncertainty (a term originally coined by Robert Higgs). It doesn’t seem to have realised that the nature of what it was requesting (i.e. respect of the rule of law and control of the industry and of the monetary system by regulatory agencies) was by nature antithetical. Cochrane’s fears (as well as mine) thus seem justified if such a classical liberal newspaper cannot even realise this simple fact.

Public Choice theory could be used as a strong rebuttal to the regulatory discretion rationale. As Salter points out in a remarkable paper titled The Imprudence of Macroprudential Policy, the economic and political science behind discretionary macro-pru policies taken by bureaucratic agencies suffers from major flaws that regulators or academics haven’t even tried to address.

Buchanan Quote

He highlights the fact that, as Mises and Hayek had already mentioned decades ago during the socialist calculation debate, regulatory agencies lack the information signalling system to figure out what the ‘right’ market price should be and hence act in the dark, possibly making the situation even worse* (and empirical evidences do show that it doesn’t work), and that the assumption of the macro-pru literature that capitalist (and financial) systems are inherently unstable is at best unproven. A typical example is Basel’s capital requirements: as I have long argued on this blog, RWAs incentivise the allocation of credit towards asset classes that regulators deem safe. The fact that they are aware of the allocative power that they have is clearly illustrated by the recent news that EU regulators would lower capital requirements on asset-backed securities to persuade insurance firms to invest in them! Yet they continue to blame banks for over-lending for real estate purposes and not enough ‘to the real economy’. Go figure.

Worse, Salter continues, macro-pru regulation (and his critique also applies to all other regulatory agencies) assumes away all Public Choice-related issues, taking for granted omniscient regulators always acting in the ‘public interest’. Yet proponents of strong regulatory agencies seem to ignore (voluntarily or not – rather voluntarily if we believe Cochrane) that regulatory agencies themselves can fall prey to the private interests of regulators, whether those are power, money, job… If not directly to the regulators, regulatory agencies can fall prey to voters’ irrationality, as Caplan would argue (but also Mises and Bastiat), leading elected politicians to put in place regulators executing the irrational wishes of the voters. The resulting naïve line of thought of the macro-pru and regulatory oversight school is dangerous and goes against the body of knowledge that Western civilization has accumulated since the Enlightenment period.

And such occurrences are not only present in the minds of Public Choice theorists. They are happening now. The case of the head of the British Financial Conduct Authority directly comes to mind: whether or not one agreed with his “shoot first, ask questions later” method (and many didn’t), he was removed from office by the new UK government as he didn’t fit in the new political ‘strategy’.

What can we do? Cochrane proposes a Magna Carta for the regulatory state, in order to introduce the checks and balances that are currently lacking in our system (for instance, appeals are often made with the same regulatory agency that took the decision in the first place). Buchanan would certainly argue for a similar constitutional solution that would attempt a return to the ‘meta-legal’ principles of the rule of law described by Hayek, with an independent judiciary as the main arbitrator.

The wider public certainly isn’t ready to accept such changes given its negative opinion of particular industries (they’d rather see more regulatory oversight). Consequently, the only way to convince them that constitutional constraints on regulatory agencies are necessary seems to me to remind them that regulatory discretion negatively affects them as well (and day-to-day examples of incomprehensible regulatory decisions abound). If broad principles can be agreed upon from the day-to-day experience of millions of people, they should apply more broadly to all types of sectors. As Salter concludes for macro-prudential policies (although it applies to any regulatory agency):

Market stability is ultimately to be found in institutions, not interventions. Institutions that are robust to information and incentive imperfections must be at the heart of the search for stable and well-functioning markets. Robust monetary institutions themselves depend on adherence to the rule of law and the protection of private property rights, which are the cornerstone of any well-functioning market order. Since macroprudential policy relies on unjustifiably heroic assumptions concerning the information and incentives facing private and public agents, its solutions are fragile by construction.

*Cowen and Tabarrok take another angle here by arguing that the problem of ‘asymmetric information’, which underlies most regulatory thinking, almost no longer exists in the information/internet age.

Cryptosolutions and cryptolimitations

Over the past few weeks I’ve read quite a few articles and papers on Bitcoin and cryptocurrencies. Some positive, some negative, some providing useful insights as to how finance can evolve in the future. Here is a little summary that illustrates rather well the concept of ‘spontaneous order’ in financial services.

On Coin Center, Juan Llanos argues that Bitcoin and the blockchain could revolutionise financial regulation, by providing real-time accounting information, which would replace than the current invasive, after-the-fact, often paper-based, regulatory oversight. Forget about the ‘information asymmetry’ nonsense (in my view) of the article. But he really has a point: transparency and processing speed and effectiveness would be considerably enhanced. There are limitations to this process however: the valuation of a number of financial instruments (what is often called ‘Level 2’ and ‘Level 3’ fair valued assets in the jargon) remains quite subjective. It remains to be seen how any automated blockchain or IT-based system can solve this subjectivity problem.

On Coin Center again, Chris Smith explains how Bitcoin addresses micropayments, which are regularly subject to transaction fees in store. Bitcoin radically reduces the fee, but does not eliminate it. According to him, Bitcoin offers an alternative solution: micropayment channels. They are “a cryptocurrency specific technology that allows for the aggregation of many small transactions into a single transaction, turning many fees into a single fee.” He goes on to explain the underlying technology and provides examples. Interesting read.

In City AM, Jerry Norton says that the blockchain will help you buy your house. He explains that the blockchain transforms the traditional ‘Delivery versus Payment’ protocol, which could particularly come in handy in the case of real estate transactions:

Today, when you’re buying a house you need to do so within working hours and with your solicitor acting as a mechanism for DVP. When the buyer transfers the money to the seller’s solicitor, his or her own solicitor receives the deeds. This process of ‘exchange and completion’ can take several weeks, and only happens during business hours, usually involving a CHAPS payment made in a branch.

With the blockchain concept of a smart contract, the exchange of the deeds and the funds transfer could be proven, linked together automatically, whilst happening in near real time and theoretically on a 24/7 basis.. The same principles are true for many asset types and purchases, such as buying a second-hand car – a process fraught with risk today.

On Alt-M, Larry White believes that cryptocurrencies don’t need regulation but more competition because innovators “need freedom to discover and pursue the most beneficial technologies.” He also thinks that, in a free society, there is no evidence that people prefer a currency that produces a stable price level and, consequently, Bitcoin could well become widely adopted.

On Coindesk, Stan Higgins reports a survey on blockchain technologies conducted by Greenwich Associates (Blomberg also does here). It is clear that bankers are currently reviewing options to implement blockchain-based solutions. However, Bitcoin itself seems to be of little interest. I unfortunately don’t have access to the report, but it seems full of interesting charts such as this one:
Blockchain survey
It is clear that blockchain-based technologies have multiple financial applications. I’m a little confused about ‘counterparty risk’ though, which seems to me to rely more on qualitative assessment than on automation and transaction recordings. But I might be missing something.

In the latest Cato journal, Larry White published a paper called The Market for Cryptocurrencies. Interesting paper, in particular the description of the cryptocurrency market and the various alternatives to Bitcoins (and their tech differences). He also repeats what he declared about regulatory intervention in the Alt-M interview above:

The market for cryptocurrencies is still evolving, and (to most economists) is full of surprises. Policymakers should therefore be very humble about the prospects for improving economic welfare by restricting the market. Israel Kirzner’s (1985) warning about the perils of regulation strongly applies here: Interventions that block or divert the path of entrepreneurial discovery will prevent the realization of potential breakthroughs such that we will never know what we are missing.

In the same journal, Kevin Dowd and Martin Hutchinson published a rather negative, but very interesting, view of Bitcoin titled Bitcoin Will Bite the Dust, in which they list of the ‘defects’ (at least in their view) of Bitcoin. In particular, they focus on the flaws of the mining system, which they view as leading to natural monopolies leaving the door open for 51% attacks. They however declare that other cryptocurrencies could be technically more elaborated and secure. They conclude:

we should remember that a recurring theme in the history of innovation is that the pioneers rarely, if ever, survive. This is because early models are always flawed and later entrants are able to learn from the mistakes of their predecessors. There is no reason why Bitcoin should be an exception to this historical rule.

Hayekian legal principles and banking structure

The latest CATO journal contains a truly fascinating article (at least to me) of George Selgin titled Law, Legislation, and the Gold Standard. Selgin roots his arguments in Hayekian legal theory, as developed by Hayek in his books The Constitution of Liberty and Law, Legislation and Liberty*.

Hayek differentiates ‘law’ (that is, general backward-looking ‘meta-legal’ rules that follow the principle of the rule of law) from forward-looking ‘legislation’, which is unfortunately too often described as ‘law’ despite not respecting the very fundamentals of the rule of law. As such, Hayek describes the rule of law as being

a doctrine concerning what the law ought to be, concerning the general attributes that particular laws should possess. This is important because today the conception of the rule of law is sometimes confused with the requirement of mere legality in all government action. The rule of law, of course, presupposes complete legality, but this is not enough: if a law gave the government unlimited power to act as it pleased, all its actions would be legal, but it would certainly not be under the rule of law. The rule of law, therefore, is also more than constitutionalism: it requires that all laws conform to certain principles.

Therefore, the rule of law, according to Hayek, relies on general ‘meta-legal’ rules that have progressively, spontaneously, if not tacitly, been discovered and evolved in a given society to facilitate social interactions and exchanges between individuals (“a government of law and not of men”). Those custom-based rules have certain attributes, namely that they be “known and certain”, apply equally to everyone, define a clear limit to the coercive power of government, require the separation of power and finally only allow the judiciary to exert discretionary rulemaking (within the boundaries of those meta-legal rules). Hayek explains that “under a reign of freedom the free sphere of the individual includes all action not explicitly restricted by a general law.”

Law Legislation and Liberty

Within this framework, Selgin describes the appearance of the gold standard as following the generic principle described by Hayek:

The difference between private or customary law and public law or legislation is, I submit, one of great importance for a proper understanding of the gold standard’s success. For, despite both appearances to the contrary and conventional wisdom, that success depended crucially upon the gold standard’s having been upheld by customary law rather than by legislation. It follows that any scheme for recreating a durable gold standard by means of legislation calling for the Federal Reserve or other public monetary authorities to stand ready to convert their own paper notes into fixed quantities of gold cannot be expected to succeed.

According to him, the gold standard and its definition was mostly a spontaneous monetary arrangement rooted in private commercial customs, and enforced through the private law of contracts. He sums up:

In short, countries abided by the rules of the gold standard game because that game was played by private citizens and firms, not by governments.

Consequently, a gold standard put in place and enforced by governments is unlikely to work. He continues:

Although it may seem paradoxical, our understanding of the classical gold standard suggests that, if that standard had been deliberately set up by governments to enhance their borrowing ability, it is unlikely that it would have worked as intended. This conclusion follows because, once public (or quasi-public) authorities, governed by statute law rather than the private law of contracts, become responsible for enforcing the rules of the gold standard game, the convertibility commitments crucial to that standard’s survival cease to be credible.

He, as a result, doubts about the ability of the gold standard to be ‘forced’ to return through government policy, and demonstrates that post-WW1 attempts to reinstate the gold standard were doomed from the start as states “tragically misunderstood the true legal foundations” of the famous 19th century monetary arrangement. But Selgin also believes that a ‘spontaneous’ return to gold would be unlikely because the public has been ‘locked-into’ a fiat money standard, and that customary law tends to reinforce that trend – by legitimizing the practice over time – rather than providing a way out. Moreover, he concludes, if a new commodity-like standard were to emerge, nothing guarantees that it wouldn’t be based on another sort of medium (including synthetic commodities such as cryptocurrencies).

Now that I have explained the basics of Selgin’s reasoning, I will try to understand what it involves for banking structure and regulation. While free banking systems, such as Scotland’s, have arguably spontaneously evolved following a custom-based legal framework, the structure of the whole of today’s financial system comprises barely anything ‘natural’ left, as Bagehot would point out. Banking, as we know it, is a pure product of decades, if not centuries, of accumulating layers of positive legislation and government discretionary policies. In short, there is now little overlap between banking and the rule of law**.

The inherent instability of banking systems regulated by statute-based law, as opposed to the relative stability of free banking systems (which Larry White referred to as ‘anti-fragile banking and monetary systems’), is therefore unsurprising seen through Hayek’s and Selgin’s lens: governments, even with the best of all possible intentions, could simply not come up with a banking arrangement that could outperform decades or centuries of experience and decentralised knowledge gains that were reflected in rule of law-compliant free banking. Their attempt at centralising and harmonising the “particular circumstances of time and place” were self-defeating.

But the question isn’t what’s wrong about today’s financial system, but can we do anything about it? Can we get back to a rather ‘pure’, rule of law-compliant, free banking system? And my answer is, unfortunately, rather Bagehotian: despite how much I wish to witness the re-emergence of a financial structure based on laissez-faire principles, I believe it’s unlikely to happen… (but wait, there’s a new hope)

Why? For the very reason mentioned by Selgin: regulations have shaped the financial structure for such a long time that innovations and practices have been established that seem now unlikely to disappear. Let me give two examples:

  1. Money market funds were originally created to bypass the US regulation Q, which has since then been abolished. But MMF are still major financial players and unlikely to disappear any time soon. They have become an established part of the financial structure.
  2. Mathematical model-based risk frameworks, which existed before the introduction of Basel regulations but were not as widespread, and certainly not as uniform. Basel rules and domestic regulators required common standards that are now used both by analysts and commentators as data, and by bankers for internal risk, capital and liquidity management purposes, despite their limitations and the distortion they insert into the decision-making process. Abolishing Basel and its local implementations (such as CRD4 or Dodd-Frank) are unlikely to remove what is now accepted as market practice. However, less uniformisation in models and uses are likely to appear over time.

What about the very basic component of our modern banking system, the main beneficiary of statutory law, namely the central bank? Bagehot declared that “we are so accustomed to a system of banking, dependent for its cardinal function on a single bank, that we can hardly conceive of any other”, and opposed a radical transformation of the system which, unfortunately, was there to stay. Yet I believe the probability of getting rid of central banks without causing too much disruption is higher than what Bagehot believed. There are a number of countries that do not rely on any central bank, use foreign currencies as medium of exchange, and seem to do perfectly fine (such as Panama). This seems to show that market practices and relationships with central banks aren’t that entrenched and other models currently do exist, and which could spread relatively quickly.

But what is, in my view, our best hope of getting back to a financial system that follows Hayekian legal principles is Fintech. While Fintech firms have to comply with a number of statute-based laws, they nevertheless remain relatively free (for now) of the all intrusive banking rulebooks and discretionary power of regulators. As such, the multiple IT-enabled Fintech firms and decentralised technologies offer us the best hope of reshaping the financial system in a rule of law-based, spontaneously-emerging, manner. Of course, there will be bumps along the road and some business models will fail and other succeed, but this learning process through trial and error is key in shaping a sustainable system along Hayekian decentralised and experience-based principles. For the sake of our future, let’s refrain from the temptation of legislating and regulating at the first bump.

*At the time of my writing, I have only read the first one, although the second one is next on my reading list

**Although I am not an expert, the evolution of accounting standards over time seems to me to have mostly happened along rule of law principles (although Gordon Kerr, and Kevin Dowd and Martin Hutchinson, would perhaps argue otherwise, which is understandable as IFRS comes from statute-based law systems).

Update: See this follow-up post, which includes some Public Choice theory insights

Photo: Bauman Rare Books

LSE and GMU vs. regulatory logic

The Telegraph, in an article titled Regulators could be responsible for the next financial crash, pointed last week at a new report by the Systemic Risk Centre of the London School of Economics that is highly critical of recent regulatory developments.

Many of their arguments are actually reminiscent of those of this blog, or of other scholars such as Kevin Dowd (see his last year paper, Math Gone Mad). They criticise: regulators’ reliance on models and their attempt at harmonizing models across the banking sector, the ‘fallacy of composition’ that making each banking entity safe separately will make the whole system safe, the effectiveness of macro-prudential measures and financial transaction taxes, and the pro-cyclical nature of politics. The whole report is quite long, but provides a handy summary at the beginning (which I attach at the bottom of this post), which highlights well their rather negative view of what regulators and politicians are currently trying to achieve:

Society faces a difficult dilemma when it comes to systemic risk. We want financial institutions to participate in economic activity and that means taking risk. We also want financial institutions to be safe. These two objectives are mutually exclusive.

This sounds like the very antithesis of every single central banker speech and regulatory report I have read over the past few years…

Meanwhile, the McLaughin and Sherouse from the Mercatus Center of George Mason University published a new blog post pointing out that Dodd-Frank “may be the biggest law ever”. They came up with stupefying data: Dodd-Frank actually comprises more restrictions than… all the other laws passed during the Obama administration:

C2-Dodd-Frank-all-lawsTheir post is also useful in debunking the myth of banking deregulation. They provide the following chart, which tracks regulatory restrictions on banks since 1970:

C3-regulatory-restrictions-title-12Now we have to keep in mind that this chart only reflects restrictions (and there are limits to their methodology, which involves counting all sentences that includes certain words). Banks are also required to follow rules that do not qualify as restrictions, but still guide the way they should account for various financial items. Risk-weighted assets, for instance, aren’t restrictions per se. But they are classifications that banks had to follow when maintaining certain amounts of capital against certain types of assets. Nevertheless, it is clear from the chart that, when the crisis struck, banks were subject to more restrictions than ever!

The contrast between regulators’ actions and LSE’s complaints could not be starker, and is in fact worrying…

SRC July 2015 1SRC July 2015 2

Contra Axel Leijonhufvud’s banking theory

I have a lot of respect for Axel Leijonhufvud. While I disagree with some of his economics, he mostly gets it. He’s a member of the monetary disequilibrium team, a sort of crossover between the Austrian/paleomonetarist/Keynesian world, a genius economic UFO. But his latest paper for the latest CATO Journal, titled Monetary Muddles, is just…weird. It demonstrates at the same time good insights, misunderstandings and lack of banking knowledge.


Leijonhufvud’s insight is that an Austrian business cycle-type crisis, such as our previous crisis (at least in his view), involves a redistribution of income:

Changes in financial regulation and in the conduct of monetary policy have not only played a very significant role in generating the financial crisis but have also been important in bringing about a large shift in the distribution of income over the last two or three decades.

This, at first, sounds very true to me (and I’ll get back to that later in the post). But the devil is in the details. Leijonhufvud gets almost his whole banking theory wrong. Yes you read correctly: (almost*) the whole of it.

First, he seems to adhere to the endogenous money theory. The culprit? Inflation targeting, which makes “bank reserves in highly elastic supply” at “the ruling repo rate”:

In my view, the complete endogeneity of the monetary base associated with inflation targeting has failed us.

I won’t repeat again why this isn’t accurate (see here, here, here, here, here, here, here…).

Second, all banking regulations and reforms that actually have endangered the banking system (he’s focusing on the US), are for him sources of stability. So the Glass-Steagal act “successfully constrained the potential instability of fractional reserve banking” and the restrictions on interstate banking/branching “gave the [US financial sector] great resilience.”

This is how he explains it:

I used the metaphor of a ship with numerous watertight compartments. If one compartment is breached and flooded, it will not sink the entire vessel. In the field of system design, this would be seen as an example of modularity (Baldwin and Clark 2000). Modular systems have several advantages over integral system. The one relevant here is that failure of one module leaves the rest of the system intact whereas failure in some part of an integral system spells its total breakdown. In the old U.S. modular system of financial intermediaries, the collapse of the S&Ls in the 1970s and early ’80s was contained to that industry. It did not bring down other types of financial intermediaries and it had no significant repercussions abroad. In the recent crisis, losses on mortgages of the same order of magnitude threatened to sink the entire American financial system and to spread chaos worldwide.

And deregulation broke this successful model:

The deregulation that turned the U.S. financial industry into an integral system is one of several instances where the economics profession failed spectacularly to provide a reasonable understanding of the subject matter of their discipline. The social cost of the failure has been enormous. At the time, the abolishment of all the regulations that prevented the different segments of the industry from entering into one another’s traditional markets was seen as having two obvious advantages. On the one hand, it would increase competition and, on the other, it would offer financial firms new opportunities to diversify risk. Economists in general failed to understand the sound rationale of Glass-Steagall. The crisis has given us much to be modest about.

Regular readers of this blog already know that the real story is pretty much the exact opposite of what Leijonhufvud believes, that financial deregulation is a myth (unless you wish to leave aside the whole Basel framework) and that US banking sector has always been fragilised by its granularity and lack of nationwide integration (you can see why here and here). His ‘watertight compartment’ metaphor isn’t applicable: banks evolve within economic systems that are not ‘watertight’, people, capital and income flow from one compartment to the other. If S&Ls failed in the US, it was because of regulations that applied specifically to them.

However, he does have some good insights when he remarks that the latest crisis implies consequences that were not originally foreseen by Mises and Hayek when they theorised the Austrian business cycle theory. This is why I called some time ago for it to be ‘updated’ in order to remain relevant and academically serious.

He is also right that the crisis implied a redistribution of income and that the pre-2008 boom involved “change in income distribution in favour of income classes whose marginal propensity to spend on the goods in the CPI basket is low.” But he sees bankers and financers as the main beneficiaries of the redistribution. While it is undeniable that the finance sector generates supranormal profits when interest rates are maintained below their natural Wicksellian level, the latest boom witnessed a much more economically damaging type of income and capital redistribution. And this one wasn’t due to monetary policy (although amplified), but to banking regulation: risk-weighted assets distorted the allocation of credit and allowed a major redistribution of capital towards real estate investors and sovereign borrowers, all of which benefited from below-equilibrium borrowing rates. This is the true issue of the latest crisis, the one that generated the malinvestments that eventually triggered our economic collapse.

I nevertheless still have a lot of respect for Axel (and will definitely keep my old copy of his book On Keynesian Economics and the Economics of Keynes: A Study in Monetary Theory on my shelve).

PS: Another minor issue with Leijonhufvud’s banking theory is his belief that banks “banks leverage their capital by a factor of 15 or so, thus earning a truly outstanding return from buying Treasuries with costless Fed money or very nearly costless deposits.” In reality, banks are often more leveraged than that but complain that, due to the low interest rate environment, they earn almost nothing on assets such as Treasuries and hence see their profitability depressed.

*His argument about the incorporation into limited liability companies of formerly fully-liable partnership investment banks is more debatable.

Austria misunderstands Hayek

A very recent speech on Austrian economics by Ewald Nowotny, Governor of the Austrian central bank, piqued my curiosity (see speech here and extra slides here). I ended up very disappointed.

Nowotny’s speech is actually very interesting from a historical perspective. He goes over the structure of the 19th century Austro-Hungarian Empire, its limited liberalism, over-regulation, rigid societal structure, economic interventionism and limited entrepreneurial and commercial development, and describes how this influenced the individualistic state of mind of early economists of the early Austrian school, such as Carl Menger, Eugene Bohm-Bawerk and Friedrich Wieser. They introduced such critical concepts as the law of diminishing marginal utility (which entered the mainstream economic framework following the so-called ‘marginal revolution’ of Menger, Jevons and Walras), methodological individualism, and the fact that all economic activity involves uncertainty and time.

The disintegration of the empire following WW1, the hyperinflation experience, the rise of socialism and later the Great Depression reinforced this individualistic, anti-state intervention trend and led to the dynamic capital, entrepreneurial, business cycle, market structure, knowledge and law theories (all very laissez-faire) of Ludwig von Mises, Joseph Schumpeter and Friedrich Hayek. Nowotny very usefully summed up the historical events using the two following timelines:

Austrian econ timeline

Austrian econ timeline 2

But that’s about it. The rest of the speech is desperately anti-Austrian school, and completely misrepresents the views of some of its most famous proponents.

According to Nowotny:

contrary to more recent definitions that would define freedom as the free availability of opportunities, the definition of the Austrian school of economics always remained a negative one that exclusively defined freedom as the absence of constraints. This should become decisive for the spin that later Austrian economists took toward analytical nihilism.

While there are many definitions of ‘freedom’ within the Austrian school, not all scholars agreed with what Nowotny characterises as “the absence of constraints”. Even Murray Rothbard and his brand of anarcho-capitalism involves some constraints (via the market process or natural law). On the contrary, Hayek was very clear in The Constitution of Liberty that freedom was defined within a given general ruleset, under the framework of the rule of law. Whether analytical nihilism applies to Austrian scholars is also debatable (and it is unclear what he meant by that). The fact that they mostly rejected mathematics as an analytical tool to represent the economy does not imply that their reasoning was non-analytical (on the contrary) or that they also rejected maths as an analytical tool for economic calculation at the micro (company) level.

Nor did the statements that Hayek “completed [the Austrian school] transformation toward the libertarian fringe in which it is situated today” and that he “developed the economic concept of knowledge that already had been present in Menger’s thought into a full-blown attack against any public interventions” true. In reality, Hayek has often been slightly milder in his attacks against the state than Mises. It is clear from books such as The Road to Serfdom or The Constitution of Liberty that he considered the state as having a role in society, as long as it obeyed the rule of law and operated on the same conditions as private enterprises (although he later admitted – in a later preface to The Road to Serfdom – that he had put too much faith in the ability of government to perform a number of tasks). Some even called Hayek a “moderate social democrat” (a more than excessive statement in my view).

Equally, Hayek didn’t seem to be a great fan of free, or laissez-faire, banking either as George Selgin just pointed out (see also White’s great article Why Didn’t Hayek Favor Laissez Faire in Banking)*. The Austrian business cycle theory did not, as Nowotny asserts,

in his hands turned into a theory that regarded credit creation by public authorities as the main source of economic fluctuations. Completely ignoring that problems of this kind might also arise in the private sector, Hayek thus fervently argued for an absolute minimum state.

This was rather Mises’ view. In Monetary Theory and the Trade Cycle, Hayek seemed to believe that private commercial banks could naturally overexpand, without a central currency issuer (i.e. central bank) injecting extra cash into the economy.

Were Austrian scholars guilty of ‘therapeutic nihilism’? While they indeed declared that government treatments would in the end make things worse, they argued for the implementation of free market measures to render the economy healthier and more stable in the long run.

But the real nature of Nowotny’s ideology, which (mis)guides his destruction of Austrian scholars, remains in the single following statement:

As early as in 1930 Hayek’s prime policy recommendation to fight the crisis – published in his book “Prices and Production” – was to refrain from any interventions and wait for markets to stabilise themselves. This was a recommendation whose devastating effect only becomes clear when it is contrasted with the beneficial effects of the successful New Deal in the USA that did exactly the opposite.

Is it necessary to emphasise that the myth of the beneficial effects of the New Deal during the 1930s has been debunked by many economists over the past decades, both mainstream and unorthodox? For one thing, the New Deal surely lengthened the Great Depression in the US (see a summarised version of the arguments against the New Deal by Steve Horwitz here).

While I am not an expert on post-WW2 Austria and its economic performance, I still find it slightly ironic that Governor Nowotny, despite its obvious Keynesian tendencies, argued that ‘hard currency’ policies were in large part the reason underlying the economic revival of his country. This seems to me to be the sort of policy advocated by…Hayek or Mises, but not by Keynes.

After finishing reading the speech, it becomes clear that Nowotny has likely never read the authors he criticises. One cannot seriously declare that “uncertainty was handled by stabilizing expectations through corporatist institutions and by a generous social state” and that “knowledge dispersion was promoted by centralized collective bargaining institutions” after reading Austrian authors. This is a complete misunderstanding of Hayek’s depiction of a spontaneous order that relies on the knowledge of the “particular circumstances of time and place”. And indeed, the literature to which Governor Nowotny refers does not include any book or article from any of the authors mentioned above…

We would really have enjoyed a deep discussion of the Austrian conception of time and dynamic analyses (which Nowotny mentions) and their impact on the capital structure and the conduct of monetary policy. Instead, we end up with a traditional static equilibrium Keynesian misunderstanding of Austrian theories. Austria has sadly lost its Austrian tradition.

*Although I have to admit that Hayek’s position isn’t very clear. He seems to take a Bagehotian position: he didn’t like the way the banking system had evolved, hence he recommended (mistakenly or not ) against ending central banking

PS: See this great blog post from David Glasner on Israel Kizner, and his Austrian approach to entrepreneurship. A stark contrast with Nowotny’s speech.

PS2: I’m back from short holidays, so will blog more frequently from now on.

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