Archive | November 2015

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.

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