Confused Sumner on banking reform

(Very busy period for me, so blogging frequency is low and I have literally a ton of things to catch up with)

Scott Sumner just wrote a couple of posts about banking on Econlog. And there is quite a bit to say about them.

A few days ago, he published a first post on 100%-reserve banking that built on Alex Tabarrok’s. There are a number of good points in his post, in particular when he points out that

And I don’t understand the point about “creating such accounts out of thin air”. The whole subject of “money creation” and the “money multiplier” is surrounded by confusion, and quite frankly, stupidity. All well-informed observers understand what banks do. Whether you prefer to call that money creation, a money multiplier, or something else depends on how you prefer to define terms. I prefer to define ‘money’ as the monetary base, but most economists prefer a broader definition of money—cash plus bank deposits. No one claims that banks create base money out of thin air. I happen to think the term ‘money multiplier’ should be dropped as it causes more confusion than it is worth.

I totally agree with this. Well, apart from the fact that there are indeed people who really believe that banks create money out of thin air. And some others, such as most elaborate endogenous money theorists, who believe (also wrongly) that banks create money out of thin air, but only indirectly, through extending credit and only then borrowing the required reserves at the central bank, which has to oblige to maintain money market rates within its target range.

But I am a little bewildered by the fact that a libertarian such as Sumner would be willing to reform and constrain banking in a top-down, Keynesian and Martin Wolf-type, fashion. This sounds really contradictory to me. He wishes to exclude banks as much as possible from the monetary system, thereby giving the central bank (a centralised institution outside of the market realm and which has no real independence from the state unlike many people believe) a very large power over money and credit. This also goes against Milton Friedman’s late views that we should end central banking.

In his post, Sumner claims that “multiplier instability is not a problem today, under our current fiat money regime. The Fed can offset any fall in the multiplier, keeping the money supply unchanged.” It can of course, but doesn’t mean that this new money circulates in the real economy. And IOR is not the only factor that drives whether or not banks hold a large share of the monetary base or not.

Martin Wolf’s banking reform proposal isn’t recent and I have already commented on it. But Sumner doesn’t seem to get the accounting behind Wolf’s (or indeed Positive Money’s) investment accounts. He claims that:

Under Wolf’s proposal, banks would be creating deposits “out of thin air” just as much as today. You could deposit $1000 in a bank investment account. Someone might borrow $900 of that money. The borrower might then deposit that $900 in another bank, which then loans out $810, etc., etc. As long as you have bank accounts not backed by reserves (i.e. investment accounts), banks will be creating deposits in pretty much the same way they do today.

No. Investment accounts are effectively like mutual funds or P2P lending or direct investment in bonds, etc. It is a reserve transfer. You know that you don’t have access to your cash anymore. You just end up with a claim on this cash that has a maturity date (i.e. a financial asset), which could possibly be marketed later to try to recover reserves before maturity, at risk of losses. Investment accounts involve an asset swap on the asset side of a balance sheet. Purchasing a house is the same thing as putting your money in an investment account. The borrower, on the other hand, credits both the asset side of his balance sheet (i.e. he acquires some new cash) and his liability side (i.e. he now also owes an equivalent amount plus interests). If the borrower makes the choice to place this newly acquired cash into his investment account, then the same process starts over again: an asset swap for him, and a double entry on the new borrower’s balance sheet. Most importantly, there is normally no maturity mismatch in those accounts. Only one person has an on-demand claim on those reserves at any one time.

What Sumner is describing is a normal fractional-reserve account. Money placed in those are still supposed to be available on demand (or at short-notice) to the depositor. But in reality, they are ‘loaned out’ to borrowers, creating a maturity mismatch, and hence the so often confusing and misunderstood money multiplier (as several people effectively hold claims to the exact same reserves).

When he says that investment accounts should be backed by reserves, he is confused. Any account, or indeed investment, backed by reserves implies no cash transfer. And hence no investment in the first place. One cannot buy a house and keep the cash used to buy that house. One cannot have his cake and eat it. Of course some particular assets are near-money. But they are nevertheless not reserves.

As for his proposal that banks should be required to back bank accounts with T-bonds, I agree with Bill Woolsey’s comment:

Requiring transaction accounts to be “backed” by T-bills or reserves is not at all the same thing as requiring FDIC insured accounts to be “backed” by T-bills or reserves.

It would be possible to have transaction accounts that are not FDIC insured. They could be used for transactions but could be “backed” by a variety of assets. In my view, trying to prevent runs by regulating bank assets is unlikely to be effective. It just drives financial innovation aimed at regulatory arbitrage.

And not all FDIC insured accounts are transactions accounts. Savings accounts and Certificates of Deposit that are FDIC insured would be matched on bank balance sheets by reserves or T-bills under such a proposal.

Sumner’s second piece, published a few days ago, is also rather curious. It tries to explain that the 2008 crisis could have been avoided if stricter capital requirements had been applied to banks. First, this is another strange libertarian position, and second, I thought Sumner used to argue instead that banking was irrelevant and that the crisis could have been avoided if the Fed had offset the NGDP fall.

Scott is (and many commenters are) unfortunately quite confused here, mixing up things like subordinated debt, contingent convertible (CoCo) bonds, TLAC requirements… Some sub debt had been accounted for as regulatory capital since Basel was first introduced several decades ago, as Tier 1, 2 or 3 capital depending on their features. They miserably failed to absorb losses during the crisis. CoCos are not an idea of Calomiris and Herring. Some banks have been issuing them since 2009 and regulators have progressively devised rules to include them as part of regulatory capital. High conversion trigger CoCos are now usually considered ‘additional Tier 1 capital’ (AT1). There remains a lot of doubts as to how those instruments will perform during a crisis, and as to whether or not there is no legal recourse to prevent conversion (also see some criticisms against CoCos here).

Finally, TLAC (‘Total Loss Absorbing Capacity’) is regulators’ latest invention: a layer of debt that is senior to CoCos but junior to senior debt and which is ‘bail-inable’ in case of bankruptcy (in order to reduce the amount of losses that the bank’s equity base, and hence depositors, has to bear). Banks’ capital requirements have become ridiculously complex (see my earlier post on this topic) and no one has any idea how things will unravel during a crisis (see this interesting PwC publication on TLAC limitations). Whether CoCo or TLAC bonds are the miraculous tools that could have prevented the crisis is highly unclear (see this older post on the limitations of artificial regulatory capital triggers).

Sumner wishes (rightly) to reduce moral hazard in the banking system. But those recently taken banking capital reforms do not really solve that problem, and in fact adds a lot more complexity and opacity to the system.

More on the natural rate of interest

Since my recent post on Wicksell, a number of famous economists have also blogged on the Wicksellian ‘natural’ rate of interest.

Tyler Cowen asked ‘what’s the natural rate of interest?’ and has a few interesting points. Paul Krugman responds to Cowen by making the usual mistake (albeit shared by most mainstream academics) of defining the natural Wicksellian rate as the “the rate of interest at which the economy would be more or less at full employment, which in turn implies that inflation will be more or less stable.” He adds that there is no reasonable case that interest rates are kept artificially low. Meanwhile, on Econlog, Scott Sumner added that there was “nothing natural about the natural rate of interest” and added some comments and charts on his own blog, declaring that the natural rate is surely negative.

Cowen in turn responded to Krugman, highlighting that risk was not a good reason to justify low risk-free natural rates. He elaborates on a few points, but one in particular was, I believe, spot on: what he calls “growing legal and institutional requirements for T-Bills as collateral”. While he believes that this hypothesis still has to be demonstrated empirically, he linked to a 2-year old post of his I had missed in which he discusses this theory in more detail.

Here are his first few points:

1. Imagine that financial institutions and traders have to hold large quantities of T-Bills (and similar assets) to participate in financial markets. That may be to satisfy collateral requirements, to meet government regulations, to be credible in private market transactions, and so on.

2. The demand for these assets is now so high and so persistent that the assets have persistently low nominal returns and often negative real returns.

3. The holders of these assets do not however receive negative returns on their portfolio as a whole, when deciding to hold these T-Bills. Holding the T-Bills is like paying an entry fee into financial markets. And once they are in financial markets of the right kind, these market players can earn high returns by possessing special trading technologies (the technology may vary across market participants, but think HFT, hedge funds, prop trading, employing quants, and so on).

4. Let’s say you are not a major financial institution. Then you really will earn negative returns on your safe saving. You might try holding equities, but a) you are not wealthy and thus you are fairly risk averse, and b) as a small player you do not have access to these special trading technologies and indeed you must trade against those who do. You thus will often earn negative or low returns on your portfolio no matter what.

5. The implied prediction is that differential rates of wealth accumulation will be a driver of inequality over time. This seems to be the case.

It is sad that Cowen is not an expert in banking and financial regulation, because he had a remarkable insight there.

US Treasury yields (as well as most government-issued securities and a number of highly-rated corporate ones) do not reflect the ‘natural’ supply and demand of the market. Instead, demand is artificially raised by financial regulation, as I have explained in a number of posts (see this previous blog post on the BIS, which explained how its recent financial reforms will impact a number of reference rates, and also this post for instance). This is where Krugman is wrong when he says that interest rates are not kept artificially low. While we can argue whether or not the Fed and other central banks manipulate rates downward, there is no argument here: regulation does push a number of reference interest rates down.

This was also the case (to a lesser extent) in the post-war era, making Scott Sumner’s reasoning inaccurate, as pointed out by one his commenters. Remarkably, Scott seemed to agree that this might indeed be a good point. Over the past three decades, regulation has fundamentally influenced the demand for a number of assets, modifying their market prices/yields in the process. Any comprehensive analysis, from the causes of the crisis to secular stagnation, should take those microeconomic changes into account. I have read countless academic papers over the past few years, and almost none did. They seemed to consider that banking behaviour and incentives were (mostly) constant over time. They weren’t.

So a number of economists might be slowly waking up to the fact that financial market prices are not freely determined, which seriously constrains our ability to reach conclusions based on market trends. There are many other underlying drivers (the ‘microeconomics of banking’ that I keep mentioning) that are at play.

PS: Marcus Nunes has an interesting post on determining (or not) the natural rate of interest. I agree that there is no point trying to determine the rate to target it.

TLTRO, a predictable failure

Almost a year and a half ago, I predicted the failure of the ECB’s TLTRO measure:

Finally, the ECB has launched its own-FLS style ‘TLTRO’, a scheme that provides cheap funding to banks if they channel the funds to businesses. Similarly to the BoE’s FLS, I believe such scheme suffers from delusion. Banks are currently deleveraging to lower their RWAs in order to comply with the harsher capital requirements of Basel 3. If there is one thing banks want to avoid, it is to lend to RWA-dense customers such as SMEs… (and instead focus on better RWA/risk-adjusted profitable lending such as… mortgages). Banks can also already extract relatively low wholesale funding rates by issuing secured funding instruments such as covered bonds.

I then came up with rough calculations that showed that the cheap TLTRO funding was highly unlikely to offset the negative effects of the Basel regulatory framework on business lending.

Now Fitch, the rating agency, just published a piece confirming that the TLTRO effects were ‘modest’ at best. I don’t have access to their whole report, but the FT, commenting on the same piece of research, reported that:

A total of €400bn has been injected into the banking system through five TLTRO auctions since September 2014, with demand predominantly from Spanish and Italian institutions. By contrast, bank corporate lending grew by just €4bn between September 2014 and August 2015.

Now compares this €4bn with stats from the ECB (see table below) that show that total lending grew by €279bn in the Eurozone over the same time period, of which €175bn was extended to non-financial private individuals and businesses.

ECB Aggregate Eurozone Bank Balance Sheet

Fitch reports that corporate lending grew in a few northern European countries, and that lack of demand is likely a cause of the slow lending growth across most Eurozone countries. While there is definitely some truth to this, we have to keep in mind that the causation in this case may well go the other way around: demand may be low because rates on business loans are too high to justify borrowing.

TLTRO (as well as the British FLS) is a prime example of how deluded central bankers and policymakers are if they expect monetary policy and unconventional bank funding measures to bypass the negative effects that banking regulation has at the microeconomic level on the banking channel of monetary policy. Throw in as much stimulus as you wish, the money will always flow towards points of the economic system where micro resistance is the weakest. And, that is, money will flow to low-RWA asset classes (ahem…mortgages…ahem).

PS: I really have little time for blogging at the moment. Doing what I can to post updates!

Will Switzerland reveal the lower bound?

Given that a number of central banks have moved some of their monetary policy tools into negative territory for the first time in their history, many people have questioned the assumption that the zero lower bound is effectively the lower bound that conventional economic theory describes. However, most economists do think that the lower bound exists; it is simply negative (as storing cash also involves a cost) and nobody really knows what its precise level is.

Hence the interesting experiment now happening in Switzerland, which seems to provide us with some indications. The SNB target range has now been in negative territory for a little while, and demand deposits at the central bank are currently charged a negative rate of 0.75%:

SNB Rates

This is causing some issues for Swiss banks, in particular those that don’t have any international presence. SNL (link) reports that overall Swiss net interest income is declining by 6% this year and net interest margin is down from 1.8% in 2007 to less than 1.3% in 2014. Including the two largest and international Swiss lenders, NIM drops to 60pb, lower than in Japan. Between 2013 and 2015, NIM is forecasted to fall by 11%. Unsurprisingly, profitability is low. Add the harsh Swiss banking regulation and SNL now calls Swiss banks ‘low-return low-risk utilities’. This is a typical effect of the margin compression effect I keep mentioning on this blog.

Evidently, many Swiss banks are private entities that don’t really enjoy this situation. First, despite the lowest interest rates ever, banks have increased rates on mortgages; a phenomenon I had predicted in a margin compression period (see my discussion with Ben Southwood, who believes that competitive pressure cannot allow banks to raise rates). Second, a number of Swiss banks have been charging negative rates on large corporate deposits for several months already. Recently. a small Swiss bank revealed it would charge 0.125% on slightly less than a third of its clients’ accounts.

SNL reports that a large pension fund attempted to withdraw physical cash earlier in the year. Attempt that failed. But there is apparently growing demand for safe deposit boxes in the country, although demand remains limited as negative rates are only charged on corporate, and now some large retail, deposits.

While those are early signs, they remain important signs that we are getting closer to the actual lower bound. Various types of customers can also have different lower bound tolerance, and small retail depositors, for now unconcerned by negative rates, may be less tolerant of such charges. Once negative rates generalise, we’ll find out how deep the lower bound really is.

Central bankers, who believe they can stabilise the economy by imposing negative rates, might well endanger it in reality. If negative rates generalise, the banking sector will be weakened: not only its profitability will get depressed (and you need a healthy banking system to extend credit for productive purposes), but also its funding structure will become much more unstable. Indeed, depositors will be more likely to withdraw their deposits and avoid getting locked in longer maturity saving products, exacerbating banks’ maturity mismatches. Eventually, the net effect of negative rates might not be that positive.

PS: I’d like to know what the proponents of ‘the Wicksellian natural rate of interest is negative because of our depressed economy’ think in the case of Switzerland. Its economy doesn’t look particularly under stress, yet it is imposed negative rates by its central bank to control FX fluctuations. George Selgin also has a nice post on deflation in Switzerland, which, unlike conventional wisdom, doesn’t seem to be damaging.

This is the quarterly Swiss NGDP since 2000, extracted from the SNB website:

Swiss NGDP

Note that the post-crisis NGDP trend has not caught up with pre-crisis trend. Very far from that (also note that the growth trend changed twice over the past 15 years). I suspect that some would advocate a much larger SNB stimulus to cause inflation to get NGDP back on track (but on which track?). Despite this ‘output gap’, the Swiss economy seems to be relatively healthy, at least for European standards.

PPS: an analyst, interviewed by SNL on the topic of the abolition of cash cherished by Kimball or Buiter, perfectly answered:

“That,” said Maier, “would be my definition of hell.”

Wicksell is hiding; the real estate boom isn’t

The Wicksellian natural rate of interest remains an economic mystery. No one knows what its level is. That wouldn’t be a problem if no one tried to emulate (or voluntarily tried to manipulate it downward or upward), that is, if we had a free market for money. But we don’t and a number of central banks attempt to estimate what this interest rate is so they can play with their own monetary policy tools.

Problem is, no one has a proper definition, and we often hear about a ‘neutral’ rate of interest, or a ‘natural’ rate that would maintain CPI stable or on a stable growth trend, and/or a rate that would be consistent with ‘full employment’ or that would allow GDP growth in line with an often ill-defined ‘potential output’. This is all very confusing, and doesn’t seem to accurately represent what Wicksell originally called the ‘natural rate of interest’, that is, the rate whose level would not affect ‘commodity prices’ and is similar to the rate of interest of a money free world (see Interest and Prices). Some believe the natural rate to be relatively stable; others believe it to fluctuate in line with business cycles. This Bruegel post sums up quite well the differing views that a number of current economists hold.

A common view today is that the natural rate has turned negative in most of the Western world since the financial crisis. It’s a view held by a wide range of economists, from Keynesians to Market Monetarists. Scott Sumner believes that the rate is firmly negative (David Beckworth too, and he denies that central banks affect interest rates – see also my response to Ben Southwood on the same topic) because

Since 2008, the inflation rate has usually been below the Fed’s 2% target, and if you add in employment (part of their dual mandate) they’ve consistently fallen short. This means that money has been too tight, i.e. the actual interest rate has clearly been above the Wicksellian equilibrium rate.

He is therefore surprised by a new piece of research by two Richmond Fed economists, who came up with very different conclusions.

First, they remind us of an estimate of the natural rate made by Laubach and Williams, which shows the nominal rate to have fallen into negative territory since the crisis, but also that the real rate is too loose:

LW Natural Rate US

Using a different methodology, which they believe more accurately reflects Wicksell’s original vision, the authors estimate the natural rate of interest to be higher than that estimated by LW. They also point out that it never turns negative.

TVP Natural Rate US

This demonstrates how tricky it can be to estimate this rate (see their lower/upper bound estimates…), and how easily central bankers could make policy mistakes as a result. (See also estimates from Thomas Aubrey’s methodology, i.e. ‘Wicksellian differential’)

Interestingly, all Fed economists above estimate the natural rate to be below the real money rate of interest from around 1994 to 2002, that is, money was too tight during the period. Thomas Aubrey, by contrast, finds the opposite result, with a positive Wicksellian differential over the period, meaning that money was too loose. Similarly, Anthony Evans writes on Kaleidic Economics that his own estimate of the UK natural rate is 2.3%; much higher than the current BoE rate.

If the Fed economists are right, it means that the classic Austrian Business Cycle theory (i.e. malinvestments originating in economic discoordination due to money rate of interest below the natural rate) cannot apply to most of the two decades preceding the crisis (it can in the case of Aubrey’s theory however).

As some readers already know, malinvestments and economic discoordination can still happen independently of the level of the risk-free natural rate of interest. This is what I theorised in my RWA-based ABCT: Basel banking regulations add another layer of distortion to the credit allocation process.

Where it gets scary is that, according to the same Fed economists, the current monetary policy stance is too loose. I find it hard to understand the outright dismissal of those estimates by a number of economic commentators and professors. Some commenters on Sumner’s post don’t even try to discuss the theoretical basis of this Richmond Fed paper. They see some sort of conspiracy or whatever. Not really the highest sort of intellectual debate to say the least. When some ‘evidence’ seems to challenge your theoretical framework, don’t dismiss it outright. Address it.

Personally, I have repeated a number of times that I find it hard to believe that our recent economic woes were so severe that they led to a market clearing, natural, Wicksellian rate below zero for the first time in the history of mankind. I have also tried to show elsewhere that a free banking system would be highly unlikely to drop rates below the zero-lower bound.

Now, if the estimates highlighted above are right, I fear possibly huge distortions in the real estate market. Let’s define a simplified free-market mortgage interest rate as

MR = RFR + IP + CRP – C,

where MR is the mortgage rate, RFR is the applicable, same maturity, risk-free rate, IP the expected inflation premium, CRP the credit risk premium that applies to that particular customer and C the protection provided by the collateral (that is, house value, with lower LTV loans leading to higher C).

Ceteris paribus, if the RFR is pushed downward, MR goes down, likely stimulating the demand for real estate credit. But this can also apply to all sort of lending. Enter Basel.

In a Basel world, the favourable capital treatment of such loans increases the supply of loanable funds towards the real estate sector. MR is pushed down even further, leading to an increase in demand for mortgages, in turn pushing house prices up, which raises the value of collateral C, which lowers MR further. It’s a virtuous (or rather vicious) circle. On the other hand, the stimulating effect of the lower RFR applied to SME lending gets ‘suppressed’ by the reduced supply of loanable funds for that type of credit. (and there are many other impacts on the RFR emanating from Basel)

I warned more than two years ago that this situation would continue. And this is precisely what has been happening. While the media complain on a weekly basis that SMEs are starved of bank credit and turn to alternative lenders (while regulators attempt to revive the market for securitised corporate loans), the Economist reports that housing markets are either strongly recovering or even way overvalued in most advanced economies. This sort of continuous and rapid house prices booms and busts was unknown in history before the 80s/90s (see also here).

It is unclear what the exact contribution of low risk-free rates is, relative to Basel’s. What is certain is that, if Richmond Fed economists are right, we’re in for another housing disaster as Basel’s effects get amplified by monetary policy (which doesn’t necessarily imply that the effects would be similar to those of the 2008/9 crisis, although historical evidence shows that housing bubble are the most damaging types of ‘bubbles’).

Hillary Clinton gets everything wrong about banking

In a column published last Friday on Bloomberg, Hillary Clinton is trying to build her credentials for the US presidential election. Sadly, her quite populist tone is let down by the quality of her arguments and the accuracy of her facts.

Let’s deconstruct her piece step by step.

She starts with a comment that could be interpreted as ironic if it were not in fact serious:

Before the crisis hit, as a senator from New York, I was alarmed by this gathering storm, and called for addressing the risks of derivatives, cracking down on abusive subprime mortgages and improving financial oversight. Unfortunately, the Bush administration and Republicans in Congress largely ignored calls for reform.

Interestingly ‘abusive subprime mortgages’ were in fact first pushed by the…..Clinton administration in 1990s (and then continued under Bush), and banks were literally forced to maintain a quota of such mortgages to obtain various regulatory approvals (including merging with other banks, during the consolidation period that followed the end of interstate banking restriction). This whole very political process was clearly outlined and very well documented in Calomiris and Haber’s Fragile by Design (see my review here).

But don’t get my word (or Calomiris and Haber’s) for it. See this 1999 NYT article, a newspaper that hardly qualifies as banking and free market lover (my emphasis):

Fannie Mae, the nation’s biggest underwriter of home mortgages, has been under increasing pressure from the Clinton Administration to expand mortgage loans among low and moderate income people and felt pressure from stock holders to maintain its phenomenal growth in profits.

When politics trumps economics. (and then blames ‘irrational’ economic actors for the catastrophic outcome)

She later attacks high-frequency trading and shadow banking (she wants more ‘oversight’ – how? – and she forgets that regulators still have no idea how to follow a continuously morphing shadow banking sector), apparently without realising that HFT and shadow banking were reactions to government regulations (the so-called Reg NMS in the case of HFT) and not free market creatures.

Clinton wants to ‘rein in the complexity and riskiness’ of financial institutions. Good. Surely this means getting rid of the tens of thousands pages of complex rules that banks have had to accommodate and that fundamentally reshaped their business model? No, she actually means adding another layer of rules, as she seems to consider Dodd-Frank as ineffective (how ironic).

Consequently, she wishes to reinstate the Glass-Steagall act (which was repealed under her husband’s watch) (and strengthen the Volcker rule – how?), even though there is now no real clear boundary between commercial and investment banking (hence why it was repealed: when the small business, to which you just extended credit to purchase inventory from abroad, seeks to hedge its future expenses by entering into an FX derivative contract with you, or simply when you lent in another currency and wish to hedge FX fluctuations, well, you need a trading book and trading counterparties to take the other side of the trades…).

But Glass-Steagall just misses the whole point: the financial crisis wasn’t an investment banking crisis; it was originally a plain vanilla mortgage lending crisis. Many banks that had no real IB activity suffered or collapsed due to the bad loans they are extended or the fall in value of the securitised products based on bad quality mortgages they had purchased. In short, IB wasn’t the root cause of the crisis.

Where it gets really dangerous is when she wants to give regulators even more authority and power than they already have. The opacity and the lack of respect for the rule of law is already a characteristic of our regulatory system. More discretion is not welcome unless we wish to build a world led by all-powerful but flawed economic administrators that need to get ‘pleased’ if one desires to avoid negative consequences. This would be the end of the Law, and the end of economic efficiency. And this is what happens in a number of developing countries that struggle to develop the sort of solid institutional framework and rules that would allow them to finally thrive. And this is what Clinton is suggesting.

As usual with such wishful political thinking, it ignores all public choice issues: give them all powers, and they’ll work for the greater good:

We need to find the best, most independent-minded people for these important regulatory jobs — people who will put consumers and everyday investors ahead of the industries and institutions they’re supposed to oversee.

Regulatory capture? Personal utility maximisation? Human ignorance/lack of omniscience? Unknown concepts. As Milton Friedman adequately remarked: “and where in the world do you find these angels who are going to organise society for us?

The only thing I agree with is that financial crimes/frauds should be punished, although in order to respect the rule of law, financial services employees should be judged on the same basis as the employees of any other sector.

Granted, she’s a politician in campaign and not a banking/economic expert. But a more moderate tone and a little more fact-checking would help the US economy more in the long-run than vengeful finger-pointing that will only result in more distrust.

The inherent contradiction of regulation exposed (again)

A few weeks ago, Reuters reported that a new research report (I can’t seem to find the original paper, which is still a work in progress) published by two German academics (Wolfgang Gick and Thilo Pausch) recommended that bank supervisors “withhold some information when they publish stress test results to prevent both bank runs and excessive risk taking by lenders”.

I have pointed out multiple times that this was an intrinsic problem to bank regulation, and that Bagehot had correctly identified the issue already in his time. Our societies have, since then, tried to conveniently forget Bagehot’s wise remarks.

Reuters continues:

If depositors know from the watchdog that banks are in trouble, they will withdraw their cash, threatening lenders’ survival and causing the panic the supervisor is trying to avoid, the paper said.

Exactly. And wholesale markets are even more at risk. The authors then recommend that “the amount of information disclosed by supervisors should decrease the more vulnerable the banking sector is expected to be.” Is this going to correct the problem? Evidently not. As the public starts to understand that ‘less information about a given bank’ equals ‘riskier bank’, withholding information from the public domain will become self-defeating.

The authors also correctly highlight that

giving banks a clean bill of health also carries risks, according to Gick and Pausch, by encouraging depositors to leave their money in banks. That would undermine market discipline and lead lenders to take excessive risks, they wrote.

In the end, whatever regulators do, negative consequences follow.


Another contradiction was exposed last month when Ewald Nowotny, Governor of the Austrian central bank, warned that proposed changes to the Basel regulatory regime were “dangerous” because borrowing “could become harder for SMEs.” He added that the revised Basel framework had “a sort of bias against bank lending”, and that “banking regulators should analyze the combined effect on the real economy of the multitude of rules that are due to come into force.”

He is both right and wrong. Wrong because the Basel rules have not been loose for corporate lending since Basel was put in place in the 1980s. It’s precisely the opposite. Rules were stricter than for many other lending types, such as real estate lending, leading to the great credit distortion we have experienced over the past couple of decades, and the slow recovery as corporations were starved of credit (see many many of my previous blog posts for details).

But he’s right that the revised Basel framework will perhaps exacerbate this situation by widening the spread between the capital cost of SME lending and that of real estate lending.

This is where the great contradiction lies. Nowotny is one of the first top regulators to underline a part of the credit allocation distortion. Yet most regulators believe that higher capital costs are justified on the basis that SME/corporate lending is inherently riskier. They never admit that the Basel framework played a major role in creating the great real estate credit bubble that led to the crisis. They constantly, and stubbornly, deny that Basel’s risk-weights could have any impact on the credit supply (and hence the sectorial interest rate). Yet, they contradict themselves when, at the same time, they consider lowering those same risk-weights on a number of products (such as securitisations) to boost…their supply and demand!

Let me get this straight: risk-weights are an instance of price control (in this case, capital cost control). And economic theory clearly demonstrates that price controls are both inefficient and leads to economic distortions. You can’t stabilise the financial system using price control tools, and then blame financial institutions and economic agents for rationally reacting to your measures. You just can’t.

Update: I originally used the term ‘price-fixing’ above. I then thought ‘price control’ was more appropriate, so I modified the post.

Economists and banking: why such misunderstanding?

I had a curiously contrasting week. A few days ago, I attended a private conference organised by the Adam Smith Institute with Bob Hetzel, of the Richmond Fed. The following day I attended the annual Moody’s banking conference. Both events talked about the financial crisis and low interest rate environment, yet illustrated the huge gap between both worlds.

In his explanation of what went wrong in 2008/9, Bob Hetzel never mentioned the words ‘banks’ or ‘financial system’ even once (at least from what I can remember). Consumer demand, investment, liquidity, monetary policy, central banks were the terms used. This is typical. Too many economists nowadays seem to have forgotten that banks exist and that the traditional way of implementing monetary policy has been for central banks to deal with commercial banks (primary dealers, lending facilities…). Of course, the financial crisis also saw central banks use extraordinary measures by buying other types of assets resulting in the impact of the asset price channel of monetary policy grow.

Still, over the last couple of weeks, a number of famous economists and economic commentators have written articles showing their limited understanding of how banks really work.

First in line is Scott Sumner. While Scott is one of my favourite economists, who opened my eyes on a number of things over the past few years, his stubborn dismissal of the importance of banks is unfortunate. In an Econlog column published a few days ago, Scott urges us to “stop talking about banking”. Monetary policy is independent he says, a separate phenomenon.

He gives the following example:

You print more currency than the public wants to hold, and they’ll bid up prices. How do you inject it without banks? Simple, pay government worker salaries in cash. Or buy T-bonds for cash. Cantillon effects don’t matter, unless the central bank is doing something bizarre, like buying bananas.

This is an unrealistic story. Does any central bank print money and pay government salaries? No. At least not in the developed world. From whom do central banks buy T-bond? From…banks, and from funds, which then leave the newly acquired cash in…banks. Or which purchase other assets to replace those T-bonds, in which case this cash also ends up in banks. And in truth, the hot potato effect described by Leland Yeager can easily get interrupted by the operational realities of the financial sector. In short, financial institutions can wear heat protection gloves. There is no need for IOR for excess reserves to build up. The implementation of monetary policy remains subject to strong structural rigidities (it isn’t the goal of this post to list such rigidities, although it may be the topic of a later one).

Against all evidence, Sumner keeps denying that banks, their business models, their regulation, and their accounting standards, play a role in transmitting monetary policy, booms and busts. He (as well as Hetzel) considers himself a follower of Milton Friedman’s monetarism. Yet Friedman seemed to understand more about banks than Sumner does. Indeed, Friedman and Schwartz partly blamed bank accounting standards (in particular mark-to-market accounting) for the catastrophic banking collapse (and money supply collapse) of the Great Depression.

In A Monetary History of the United States, he explains that due to tight liquidity levels, and “whatever the quality of assets held by banks”,

banks had to dump their assets on the market, which inevitably forced a decline in the market value of those assets and hence of the remaining assets they held. The impairment in the market value of assets held by banks, particularly in their bond portfolios, was the most important source of impairment of capital leading to bank suspensions, rather than default of specific loans or of specific bond issues.

Hence Friedman describes a self-reinforcing insolvency issue that originates in a liquidity problem, and which led to a contraction of the money supply. He also thinks that outright defaults of bad loans made in the 1920s, while limited, could have been the trigger that led to the tight liquidity situation. He adds that large open market purchases of those assets could have maintained their market value and prevented a number of bank failures (although I have to object that this is akin to a bailout of the system, with strong associated moral hazard).

Now, Friedman may have understated the extent of the solvency crisis during the Great Depression. What is certain is that the Great Recession involved a larger insolvency component. In the US, default rates started to increase by end-2006, and house prices by end-2005 (see charts below), way before liquidity conditions tightened as a result of this large-scale solvency issue. But overall, Friedman was wiser than many of his followers as he understood the role of banking in amplifying (if not creating) crises.

default rates USus-house-prices

Against this background, it is unsurprising that many other economists seem clueless about banking. Krugman is bewildered that banks demand higher rates (see also here). He understands that banks experience margin compression (a rarity among economists though…), but doesn’t seem to get that a healthy economy needs healthy banks and that unhealthy banks disrupt the money creation process (and hence the inflation that he wants to see appear). He also misses the fact that low central bank base rates could simply just stop being transmitted to the economy.

Instead, he uses his usual personal attacks (‘permahawkery’, ‘interest group’, easily influenceable Fed and BIS officials – really? After all the regulatory rounds of those past few years? – ‘lobbyists’, ‘corrupt’…). Of course banks are going to lobby. This doesn’t imply that we should simply dismiss those claims without even attempting to analyse their substance.

The same effect is occurring in Europe. Bundesbank’s Andreas Dombret declared that the impact of low interest rates on German banks was “truly worrying” following a Bundesbank stress test. SNL (gated link) reports that:

According to the worst-case scenario involving a 100-basis-point reduction in the interest rate, these German banks could see a 75% drop in pretax profit by 2019. Even if they adjusted their balance sheet structure, the decline would still be 60%.

Under assumptions based on 2014-end rates and business plans, the cohort of German banks expects its pretax profits to decline by 25% by 2019 despite the solid economy and current cost-cutting targets. Remarkably, profits would fall even in the event of a 200-basis-point rate rise. […]

“I found results of the survey alarming for the large banks,” Kepler Cheuvreux bank analyst Dirk Becker told SNL Financial. “The effect of low interest rates will kill the banks at some stage if this continues. The study said that so much money is lost on the deposit margins that cannot be made good on lending margins. That is truly dramatic.”

Surely Krugman could explain to us how an economy can thrive with a dying banking system. Dombret, while worried, nevertheless warned banks that low rates in Europe were here to stay.

And what about Noah Smith? After a misguided article some time ago on the same topic, he now points out that some “commentators say they believe that they have hit upon the answer — it’s all about net interest margins, or the spread between a bank’s borrowing costs and lending rates.” Good to know that ‘commentators’ have to teach economists about banking mechanics… (and I might well be one of those, given my reply and interactions with Smith after his first article)

Unfortunately, he keeps misunderstanding the drivers of margin compression. He states that:

Then there’s the lack of a good theory for why lower interest rates should compress banks’ margins. Changes in the fed funds rate should affect both long-term and short-term rates equally. If the Fed tightens, depositors will demand higher deposit rates from banks, and banks will demand higher interest from borrowers. After an initial period of adjustment (to allow for existing loans to roll over), the effect of rate changes on spreads shouldn’t be substantial.

Really? As I explained now some time ago (see chart below from this old post), above a certain threshold the nominal level of interest rates is irrelevant (the real level might be to an extent). It is when deposit funding reaches the zero lower bound that banks start experiencing troubles, in particular if their loan books are composed of a lot of variable-interest loans (the worst case scenario being loans contractually based on the central bank base rate, such as what happens in the UK mortgage industry with loans being priced at BoE base rate + spread).

Bank net profit profile - compression

The result of this is that the spreads between deposit rates and lending rates narrow while banks’ cost structure doesn’t change. A simple P&L analysis shows why this is an issue. In the absence of other major sources of revenue growth, and independently of credit risk considerations**, banks (which are stuck with portfolios of multi-decade maturities low rate variable mortgages) have to start increasing the spreads on new lending to rebalance their revenue stream in line with their cost of intermediation. Which defeats the purpose of lowering the central bank base rate to stimulate lending.

Smith adds that a Fed tightening would increase banks’ interest expense. This is inaccurate. Deposit-funded banks don’t have to raise deposit rates unless under competitive pressure if and when they try to attract more funds to grow their lending business. But on the other hand variable rate lending automatically generates higher interest income***.

There is indeed an argument that monetary easing helps banks by lowering default rates, and hence banks’ cost of risk, which boosts their bottom line. But the net effect is far from clear, especially in the long run when banks have fully repriced their books to factor in wider credit risk spreads.

And in the end, it all demonstrates that understanding banking mechanics is crucial to monetary policy.

*Or banks can lend to capital light sectors, such as real estate, which isn’t included in inflation measures such as the CPI, while avoiding capital intensive asset classes, such as SME lending. Consequently, new money keeps being recycled in housing, and never shows up in CPI figures.

**Don’t get fooled by sudden changes upwards in net interest margins. NIMs aren’t risk-adjusted. When credit risk rises, banks increase the cost of credit to offset the increased cost of risk and likely loan impairment charges. NIMs then look like they improved. But ‘real NIMs’ (ie, risk-adjusted NIMs) didn’t. Compare Germany and Spain for instance: German NIMs have fallen as credit risk has remained low, whereas Spanish NIMs seem to hold up well, but this hides a decline in risk-adjusted margins.

***He also referred to Japan as a counter example of a rate rise that did not help banks. But in this case, rates didn’t rise above the threshold I was talking about above, so the example is still irrelevant.

Update: Scott Sumner’s reponse at Econlog. I think I really have to write a post on the structural rigidities at the micro level that I mention above (when I find the time…).

Carney attacks the ‘pretence of knowledge’ of free markets

Some speeches make you want to scream. Mark Carney’s latest is one of those.

In a recent speech titled Three truths for finance, Carney, the governor of the BoE, explains that those ‘truths’ are in fact ‘lies’, and those three lies are “this time is different”, “markets always clear”, “markets are moral”. Where to start?…

According to Carney:

The first lie is the four most expensive words in the English language: “This Time Is Different.”

I can only agree with Carney here. He continues:

This misconception is usually the product of an initial success, with early progress gradually building into blind faith in a new era of effortless prosperity.

He mentions the pre-crisis debt bubble, which ‘financial innovation’ and a ‘ready supply of foreign capital from the global savings glut’ made cheaper. Yet he never mentions central banks’ policies, which kept interest rates low over the whole period, or the fact banking regulation was the very reason behind the cheap credit supplied to a few particular sectors of the economy or also the fact that high saving rates in countries such as China mostly financed high investment rates in the same countries. No, this is due to private actors’ irrationality, who of course believed that this time was different.

But Carney’s logic is faulty. Over the recent years, it is him, and his fellow central bankers, who have kept arguing that “this time was different”, and that we needed to maintain interest rates below the lowest levels ever recorded in human history.

It gets worse when Carney mentions the second ‘lie’, which reveals his deep Keynesian thinking:

Beneath the new era thinking of the Great Moderation lay a deep-seated faith in the wisdom of markets. Policymakers were captured by the myth that finance can regulate and correct itself spontaneously. They retreated too much from the regulatory and supervisory roles necessary to ensure stability.

That “markets always clear” is the second lie, one which gave rise to the complex financial web that inflated the debt bubble.

In markets for goods, capital, and labour, evidence of disequilibria abounds.

In goods markets, there is ‘sluggishness everywhere’. Left to themselves, economies can go for sustained periods operating above or below potential, resulting, ultimately, in excessive or deficient inflation.

He adds:

If markets always clear, they can be assumed to be in equilibrium; or said differently “to be always right.”

First, it is clear that Carney does not understand the dynamic entrepreneurship process that characterises a capitalist economy. Equilibrium does not exist, and markets are in constant fluctuations as entrepreneurs and investors try to identify and benefit from what they perceive as mispricings and profit opportunities (see Israel Kirzner). Equilibrium is at best a theoretical construct, and most economists (mainstream or not) who have studied entrepreneurship and markets know this. In short, the market is a dynamic price discovery mechanism.

As a result, accusing markets of not being in equilibrium completely misses the points of having markets in the first place. If markets are in equilibrium, there is no need to act anymore. No need to come up with new ideas, create and invest.

Second, he mentions financial innovations and their effects as if they had existed in a vacuum, independently of any sort of regulation incentivising their use and distorting market outcomes. But it would mean admitting that policymakers can be dead wrong. Possibly not the message he is trying to convey.

It gets absurd when Carney uses the phrase ‘pretence of knowledge’ (his emphasis):

More often than not, even describing the universe of possible outcomes is beyond the means of the mere mortal, let alone ascribing subjective probabilities to those outcomes.

That is genuine uncertainty, as opposed to risk, a distinction made by Frank Knight in the 1920s. And it means that market outcomes reflect individual choices made under a pretence of knowledge.

I have to applaud. Carney, a Keynesian, used Hayek’s Nobel speech title, to express the exact opposite of Hayek’s idea. In his 1974 speech, Hayek explains that central planners attempting to control the economy were victim of a pretence of knowledge, because it was impossible for them to be aware of all the ‘particular circumstances of time and place’ (a phrase that he uses in most of its post-WW2 literature). Only the private market actor, who was in direct connection to his local market, could attempt to come up with the solution that satisfied the demand expressed by this market.

Yet Carney turned Hayek’s reasoning on its head. According to Carney, it is private market actors who demonstrate this pretence of knowledge as they believe they know what is right for them or what the market actually demands! He seems to assume (wrongly) that economic agents believe they are omniscient and not aware of the uncertainty inherently linked to the economic decisions they take.

Hayek facepalm

Hayek would turn in his grave. He would probably tell Carney that market outcomes are the result of millions of individuals who acted on different assumptions, different risk-assessments, different knowledge and skillsets, and that this is the aggregation of all those various local variables that lead to a market outcome that can more efficiently coordinate dispersed knowledge, skills and demand than any central authority ever can. He would probably add that Carney keeps mentioning market failures without ever referring to most of the reasons underlying those failures, that is, artificial restrictions and distortions that originate in government activity (…and central banks…).

But Carney is likely to never admit such things as he is no free-market lover:

In the end, belief in the second lie that “markets always clear” meant that policymakers didn’t play their proper roles in moderating those tendencies in pursuit of the collective good.

And how would you even know how to ‘moderate’, or simply how to identify, those negative tendencies, Mr Carney? And how do you define what this so-called ‘collective good’ is? ‘Pretence of knowledge’ you said?

He then insists (his own emphasis, which says a lot):

Despite these shortcomings, well-managed markets can be powerful drivers of prosperity.

Carney’s last ‘lie’, that markets are moral, suffers from a lack of arguments. He seems to base most of his ‘markets are amoral’ rhetoric on recent examples of price-fixing in a number of rates and commodities markets. He is right that fraud is reprehensible. Yet, in those cases, it was not markets that were to blame, but a few abusers who tried to benefit at the expense of the markets. Here again Hayek would argue that there is nothing more ‘moral’ than unhampered markets that distribute services to those that need them and reward those that provide them, within the framework of the rule of law.

At the end of his speech, Carney introduces the recent BoE initiative to open a forum on re-building ‘real markets’ (his emphasis again). You want ‘real’ markets Mark? Just release them from their constraints. It’s as simple as that.

Another nail (or two) in the coffin of endogenous money theory?

Ben Southwood sent me the following new piece of research. The abstract is telling:

We provide empirical evidence for the existence, magnitude, and economic cost of stigma associated with banks borrowing from the Federal Reserve’s Discount Window (DW) during the 2007–2008 financial crisis. We find that banks were willing to pay a premium of around 44 basis points (bps) across funding sources (126 bps after the bankruptcy of Lehman Brothers) to avoid borrowing from the DW. DW stigma is economically relevant as it increased some banks’ borrowing cost by 32 bps of their pre-tax return on assets (ROA) during the crisis. The implications of our results for the provision of liquidity by central banks are discussed.

MMTers and other endogenous money theorists are very mistaken to ignore this very important phenomenon, which questions the very validity of their whole theoretical framework.

Meanwhile, SNL reports (via Valor Econômico) that Brazil is weighing up relaxing reserve requirements to boost the supply of credit. Impossible according to endogenous money theory. Unless…

In fact, Brazil plays with reserve requirements all the time. It already lowered them in May this year, in July 2014, and even in September 2012. In contrast, it had raised them in 2010 to counter inflationary pressure. Perhaps those policies did not have any effect, as endogenous money theory would speculate. In fact, research published in June 2015 on the effects of Brazil reserve requirement changes does highlight impacts on lending:

We compare the macroeconomic effects of interest rate and reserve requirement shocks by estimating a structural vector autoregressive model for Brazil. For both instruments, discretionary tightening results in a credit decline. Contrary to an interest rate shock, however, a positive reserve requirement shock leads to an exchange rate depreciation, a current account improvement, and an increase in prices.

Endogenous theorists (including some economists at the BoE) claim that their models reflect the reality of ‘modern’ fiat monetary and banking systems. A quick look at the facts seems to prove them wrong.

PS: the Farmer Hayek blog published a short interview of me over three posts. The first post covers why inflation seems low in the US. The second post what economists get wrong about banking. And the last post what my thoughts were on NGDP targeting and free banking.

Uneasy Money

Commentary on monetary policy in the spirit of R. G. Hawtrey

Spontaneous Finance

When financial markets spontaneously emerge through voluntary human action


Volatility Is The Energy That Drives Returns

The Insecurity Analyst

When financial markets spontaneously emerge through voluntary human action

Sober Look

When financial markets spontaneously emerge through voluntary human action

Social Democracy for the 21st Century: A Post Keynesian Perspective

When financial markets spontaneously emerge through voluntary human action

EcPoFi - Economics, Politics, Finance

When financial markets spontaneously emerge through voluntary human action

Coppola Comment

When financial markets spontaneously emerge through voluntary human action


Finding patterns in finance, econ and technology -- probably where there are none

Lend Academy

When financial markets spontaneously emerge through voluntary human action

Credit Writedowns

Finance, Economics and Markets

Mises Institute

When financial markets spontaneously emerge through voluntary human action

Paul Krugman

When financial markets spontaneously emerge through voluntary human action

Free exchange

When financial markets spontaneously emerge through voluntary human action


When financial markets spontaneously emerge through voluntary human action


When financial markets spontaneously emerge through voluntary human action

Cafe Hayek - Article Feed

When financial markets spontaneously emerge through voluntary human action

Coordination Problem

When financial markets spontaneously emerge through voluntary human action

Consulting by RPM || Free Advice Blog

When financial markets spontaneously emerge through voluntary human action


Get every new post delivered to your Inbox.

Join 77 other followers