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.
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.