Tag Archive | Bubbles

The era of the neverending bubble?

The IMF got the timing right. It published last week a new ‘Global Housing Watch‘, and warned that house prices were way above trend in a lot of different countries all around the world. The FT also reports here:

The world must act to contain the risk of another devastating housing crash, the International Monetary Fund warned on Wednesday, as it published new data showing house prices are well above their historical average in many countries.

Global property prices

As I said, perfect timing, as this announcement follows my previous post on the influence of Basel’s RWAs on mortgage lending.

As long as international banking authorities don’t get rid of this mechanism, we are likely to experience reoccuring housing bubbles with their devastating economic effects (hint for Piketty: and investors/speculators will have an easy life making capital gains).


PS: I am on holidays until the end of the week, so probably not many updates over the next few days.

Basel vs. ECB’s TLTRO: The fight

(and vs. BoE’s FLS)

Following my previous post on the mechanics of ECB negative deposit rates, I wanted to back my claims about the likely poor effect of the central bank TLTRO measure on lending.

I argued that despite the cheap funds provided by the ECB to lend to corporate clients (particularly SMEs), Basel’s risk-weighted assets would stand in the way of the scheme as they keep distorting banks’ lending incentives (same is true regarding the BoE and the second version of its Funding for Lending Scheme).

I extracted all the most recent new business and mortgage lending rates from the central banks’ websites of several European countries. Unfortunately, business lending rates are most of the time aggregates of rates charged to large multinational companies, SMEs, and micro-enterprises. Only the Banque of France seemed to provide a breakdown. So most business lending rates below are slightly skewed downward (but not by much as you can see with the French case).

European New Lending Rates

Using this dataset, I built a similar scenario to the one I described in my first RWAs and malinvestments post (as it turned out, I massively overestimated business lending rates in that post…). I wanted to find out what would be the most profitable option for a bank: business lending or mortgage lending, given RWA and capital constraints (banks target a 10% regulatory Tier 1 capital ratio). The results speak for themselves:

Basel vs TLTRO

Despite the cheap ECB loans, and given a fixed amount of capital, banks are way more profitable raising funding from traditional sources to lend to households for house purchase purposes…

Admittedly, the exercise isn’t perfect. But the difference in net interest income and return on capital is so huge that tweaking it a little wouldn’t change much the results:

  • I assume that all business lending is weighted 100%. In reality, apart from the French SME scenario, large corporates (often rated by rating agencies) benefit from lower RWA-density under a standardised method. This would actually raise the profitability of business lending through higher volume (and increased leverage), though not by much. Mortgages are weighted at 35% under that method.
  • I assume that all banks use the standardised method to calculate RWAs. In reality, only small and medium-sized banks do. Large banks use the ‘internal rating based’ method, which allows them to risk-weight customers following their own internal models. Here again, most corporates can benefit from lower RWAs. But mortgages also do (RWA-density often decreases to the 10-15% range).
  • Cross-selling is often higher with corporates, which desire to hedge and insure their financial or non-financial business positions. Corporates also use banks’ international payment solutions. This adds to revenues.
  • Business lending is often less cost-intensive than retail lending. Retail lending indeed traditionally requires a large branch network, which is less the case when dealing with corporates (often grouped within regional corporate centres, though not always for tiny enterprises). However, retail banking is progressively moving online, providing opportunities to banks to cut costs and improve their profitability.
  • The lower RWA-density on mortgages allows banks to increase lending volume and leverage. However, this also requires higher funding volumes. In turn, this should increase the rate paid on the marginal increase in funding, raising interest expense somewhat in the case of mortgages.

In the end, even if the adjustments described above reduce the profitability spread by 10 percentage points, the conclusion stands: banks are hugely incentivised to avoid business lending, facilitating misallocation of capital on a massive scale, in particular in a period of raising capital requirements… Moreover, banks also benefit from favourable RWAs for securitised products based on mortgages (CMBS, RMBS…), compounding the effects.

To tell you the truth, I wasn’t expecting such frightening results when I started writing that post… Please someone tell me that I made a mistake somewhere…

Central banks, regulators and politicians will find it hard to prop up business lending with regulations designed to prevent it.

The political banking cycle

A couple of weeks ago, The Economist reported that Mel Watt, the new regulator of the US federal housing agencies Fannie Mae and Freddie Mac, wanted those two agencies to stop shrinking and continue purchasing mortgage loans from banks in order to help homeowners and the housing market (also see the WSJ here). To twist the system further, the compensation of the agencies’ executives will be linked to those political goals. Mr Watt used to be one of the main proponents of more accessible house lending for poor households through Fannie and Freddie before the crisis.

As The Economist asks, “what could go wrong?”…

Lars Christensen and Scott Sumner also find this ridiculously misguided government intervention horrifying. I find myself in complete agreement (and this is an understatement). Who could still honestly say that we are (or were) in a laissez-faire environment?

This, along with UK’s FLS and Help to Buy schemes, made me think that there has been a ‘political banking cycle’ throughout the 20th century. Why 20th century? From all the banking history I’ve read so far, populations seemed to better understand banking before the introduction of safety net measures such as central banks, deposit insurances or systematic government bail-outs. When financial crashes occurred, blame was usually shared between governments and banks, if not governments only. This is why many crises triggered deregulation processes rather than reregulation ones. This contrasts with the mainstream view our society has had since the Great Depression: when a financial crash happens, whatever the government’s responsibility is, banks and free market capitalism are the ones to blame.

This political cycle looks like that:

Political Banking Cycle

The worst is: it works. Politicians escaped pretty much unscathed from the financial crisis despite the huge role they played in triggering it*. The majority of the population now sincerely believes that the crisis was caused by greedy bankers (see here, here, here and here). This is as far from the truth as it can be (I don’t deny ‘greed’ played a role though, but channelled through and exacerbated by a combination of other factors, i.e. moral hazard etc.). Unfortunately, it is undeniable: politicians won. And not only politicians won, but they also managed to self-convince that they played no role in the crisis, as the example of Mr Watt shows (he either truly believes that government intervention in the US housing market was a good thing, or he has an incredibly cynical short-term political view).

The crucial question is: why did 19th century populations seem more educated about banking? The answer is that the lack of state paternalism through various protection schemes forced bank depositors and investors to oversee and monitor their banks. Once protection is implemented, there is no incentive or reason anymore to maintain any of those skills.

Who is easier to manipulate: a knowledgeable electorate or an ignorant one?


PS: This chart is mostly accurate for democracies that have a populist tendency. Not all countries seem to be prone to such cycle (this can be due to cultural or institutional arrangements).

* I won’t get into the details here, but if you’re interested, just read Engineering the Financial Crisis, Fragile by Design or Alchemists of Loss……. or simply this NYT article from 1999.

A new regulatory-driven housing bubble?

The FT reported today that house prices were booming in many different countries, in particular in Israel, Norway, Australia, Canada…

FT House Prices

There is nothing surprising at all in what’s happening. As I have already pointed out several times, Basel regulations are still incentivising banks to channel the flow of new lending towards property-related sectors. A repeat of what happened, again and again, since the end of the 1980s, when Basel was first introduced. I cannot be 100% certain, but I think this is the first time in history that so many housing markets in so many different countries experience such coordinated waves of booms and busts.

So far we’ve had two main waves: the first one started when Basel regulations were first implemented in the second half of the 1980s. It busted in the first half of the 1990s before growing so much that it would make too much damage. The second wave started at the very end of the 1990s, this time growing more rapidly thanks to the low interest rate environment, until it reached a tragic end in 2006-2008. It now looks like the third wave has started, mostly in countries where house prices haven’t collapsed ‘too much’ during the crisis.

The Economist House Prices

Sam Bowman was indeed right that lack of supply (through planning restrictions) is a real factor in driving up house prices in the UK. However, this cannot be the only issue at play here. A chronic lack of supply would lead to chronically increasing housing prices, not to wave-like variations, especially when those waves happen to be very well coordinated with those of other countries.

I still have to dig more in details into the data of each country, and I’ll do it in subsequent posts. For sure, some countries seemed to ‘skip’ one wave or to experience a mild one, but banking regulation is only part of the explanation. Local factors such as monetary policy, population growth, building restrictions, etc., are also important in determining local prices.

What’s interesting in the FT article is also the fact that a lot of countries have implemented macro-prudential policies over the last few years. Their effects on house bubbles seemed to have been close to nil… Indeed, low real interest rates compounded by regulatory-boosted mortgage lending supply still make housing an attractive asset class.

As long as this deadly combination remains in place, brace yourself for a recurring pattern of housing bubble cycles.


RWA-based ABCT Series:

  1. Banks’ risk-weighted assets as a source of malinvestments, booms and busts
  2. Banks’ RWAs as a source of malinvestments – Update
  3. Banks’ RWAs as a source of malinvestments – A graphical experiment
  4. Banks’ RWAs as a source of malinvestments – Some recent empirical evidence
  5. A new regulatory-driven housing bubble?

A UK housing bubble? Sam Bowman doubts it

On the Adam Smith Institute’s blog, Sam Bowman had a couple of posts (here and a follow-up here, and mentioned by Lars Christensen here) attempting to explain that there might not have been any house price bubble in the UK. He essentially says that there was no oversupply of housing in the 1990s and 2000s. Here’s Sam:

These charts show that housing construction was actually well below historical levels in the 1990s and 2000s, both in absolute terms and relative to population. It is difficult to see how someone could claim that the 2008 bust was caused by too many resources flowing toward housing and subsequently needing time to reallocate if there was no bubble in housing to begin with.

What this suggests is that the Austrian story about the crisis may be wrong in the UK (and, if Nunes’s graphs are right, the US as well). The Hayek-Mises story of boom and bust is not just about rises in the price of housing: it is about malinvestments, or distortions to the structure of production, that come about when relative prices are distorted by credit expansion.

Well, I think this is not that simple. Let me explain.

First, the Hayek/Mises theory does not apply directly to housing. In the UK, there are tons of reasons, both physical and legal, why housing supply is restricted. As a result, increased demand does not automatically translate into increased supply, unlike in Spain, which seems to have lower restrictions as shown by the housing start chart below:

UK Spain Housing Starts

Second, Sam overlooks what happened to commercial real estate. There was indeed a CRE boom in the UK and CRE was the main cause of losses for many banks during the crisis (unlike residential property, whose losses remained relatively limited).


UK Commercial_property

Third, the UK is also characterised by a lot of foreign buyers, who do not live in the UK and hence not included in the population figures. Low rates on mortgages help them purchase properties, pushing up prices, triggering a reinforcing trend while supply in the demanded areas often cannot catch up.

Fourth, the impact of Basel regulations seems to be slightly downplayed. Coincidence or not, the first ‘bubble’ (in the 1980s) appeared right when Basel’s Risk Weighted Assets were introduced. And it is ‘curious’, to say the least, that many countries experienced the same trend at around the same time. Would house lending and house prices have increased that much if those rules had never been implemented? I guess not, as I have explained many times. I have yet to write posts on what happened in several countries. I’ll do it as soon as I find some time.

I recommend you to take a look at my RWA-based Austrian Business Cycle Theory, which seems to show that, while there should indeed be long-term real estate projects started (depending on local constraints of course), there is also an indirect distortion of the capital structure of the non-real estate sector.

While there may well be ‘real’ factors pushing up real estate prices in the UK, there also seems to be regulatory and monetary policy factors exacerbating the rise.

Blame the rich for the next asset bubble. Or not.

First of all, happy new year to all of you! Fingers crossed we don’t witness another market crash this year! 🙂

Indeed, credit markets are hot. Equity markets are also hot. The FT published an article yesterday with some striking facts about the ‘improvements’ in credit markets over the past couple of years. Some would say that it’s encouraging. I am not convinced…

Most credit indicators are close to or above their pre-credit crisis high. Sales of leveraged loans and high-yield bonds are above their pre-crisis peak. The average leverage level of US LBOs is back to 2006 level. Issuance of collateralised loan obligations is close to its pre-crisis peak. Even CCC-rated junk bonds are way above their previous peak. I’ve already mentioned some of those facts a few months ago.



In a relatively recent presentation, Citi’s strategist Hans Lorenzen confirmed the trend: central banks are indirectly suppressing most risky investments’ risk premia. Most investors expect junk bonds’ spreads to tighten further or at least to stabilise at those narrow levels and emerging markets bonds and equities, as well as junk bonds are now among investors’ top asset classes .



My ‘theory’ at the time was that (see also here), if investors were piling in increasingly riskier asset classes, bringing their yield down to record low levels in the process, and nonetheless accepting this level of risk for such low returns, it was because current central bank-defined nominal interest rates were below the Wicksellian natural rate of interest. Inflation, as felt by investors rather than the one reported by national statistics agencies, was higher than most real rates of return on relatively safe assets. In order to see their capital growing (or at least to prevent it from declining), they were forced to pick riskier assets, such as high-yield bonds, which were not really high-yield anymore as a result but remained junk nonetheless. This would result in capital misallocation as, under ‘natural’ interest rate conditions, those investments would have never taken place. Thomas Aubrey’s Wicksellian differential, an indicator of the likely gap between the nominal and the natural rates of interest, was, in line with credit markets, reaching its pre-crisis high and seemed to confirm that ‘theory’.

Well, I now think that not all investors are responsible for what we are witnessing today. The (very) rich are.

This came to my mind some time ago while reading that FT piece by John Authers. This was revealing.

“Their wealth gives them scope to try imaginative investments, but they are terrified of inflation, even as deflation is emerging as a greater risk. That is in part because inflation for the goods and services bought by the very rich is running about 2 percentage points faster than retail inflation as a whole in the UK.” (my emphasis)

In the UK, real gilts’ yields were already in negative territory: adjusted by the (potentially underestimated) consumer price index, gilts were yielding around -1% early 2013. Savers were effectively losing money by investing in those bonds. Now think about the rich: by investing in such bonds, they would get a real return of around -3% instead.

UK Gilts CPI

Moreover, “71 per cent of respondents said they were more worried now about a steep rise in inflation than they were five years ago.”

Does it start to make sense? The cost of living I was mentioning earlier is increasing particularly quickly for the rich. And… they are the ones who own most financial assets. In order to offset those rising living costs, they naturally look for higher-yielding investments. And it is exactly what the FT reports:

“Their favourite asset classes for the next three decades are emerging markets equities, developed equities and agricultural land, in that order. Private equity comes close after farmland, while art and collectables were also a more popular asset class than any kind of bonds. […]

Hedge funds, as a group, have not fared well since the crisis. But wealthy investors preoccupied by inflation, and robbed of the easy option of bonds, are evidently disposed to give them a try, with an average projected allocation for the next three decades of 25 per cent. Meanwhile, the chance of a bubble in agricultural land prices, or in art, looks very real.”

Are the rich responsible for our current frothy markets then? Obviously not. They are acting rationally in response to central banks’ policies. Nonetheless, this raises an interesting question. Mainstream economics only considers a high aggregate inflation rate as dangerous. What about ‘class warfare’-type inflation? It does look like inflation experienced by one socioeconomic class could inadvertently lead to asset bubbles and bursts, despite aggregate inflation remaining subdued. This may be another destabilising effect of monetary injections on relative prices.

Granted, central banks possibly are on a Keynesian’s ‘euthanasia of the rentier’-type scheme in order to try to alleviate the pain of over-indebted borrowers (and/or to encourage further lending). But financial repression avoidance might well end-up coming back with a vengeance if savers’ reactions, and in particular, rich savers’, make financial markets bubble and crash.

Charts: FT (link above), Citi and Societé Générale

The Financial Times on Bitcoin, P2P lending and secular stagnation

The FT has a few articles on some of my favourite topics today.

John Authers argue that it is time to take Bitcoin seriously. Who would say that I disagree? In his article he refers to several points I had already mentioned in some of my previous posts. He adds an interesting analogy with previous internet firms and concepts:

[…] even if Bitcoin is as successful as it is possible now to imagine, it looks overvalued at recent prices. It is in a bubble.

But this does not prove that the concept has no future. Shares in Amazon.com were also in a bubble in the late 1990s, and yet proved a great long-term investment after the bubble burst. Wild swings in value are typical when new technologies arrive.

A commenter also had a very good point, which highlighted Bitcoin’s (or other similar alternative digital currencies’) potential trade-boosting abilities:

Can you imagine a world where anyone can set up a shop on the internet and instantly accept payments from all over the world to sell its product or service without any intermediary? Well that’s only one face of what Bitcoin enables.

Naysayers will keep saying that Bitcoin is useless or only diverts wealth from ‘productive opportunities’ anyway.


FT Alphaville continued its long tradition of confused/confusing posts with this one on P2P lending today. I don’t know about you, but it does look to me that everything in the financial world that’s innovative and far from regulators’ grip is now under attack from Alphaville bloggers. They could have a point. But in this case, they don’t. They completely miss the point. The author misunderstands the financial crisis and draws the wrong conclusions from it.

According to the author, P2P is ‘pro-cyclical’ and has ‘no skin in the game’, which makes this asset class of systemic risk. He’d like to see P2P platforms to hold capital buffers to absorb losses. This makes no sense whatsoever. P2P is an investment. There are tons on possible investments. Anybody can invest directly in equities or bonds or FX or whatever, or through mutual funds/investment managers. P2P works the same way. Are we asking mutual funds to hold a capital buffer to absorb losses suffered by their clients’ portfolio? Of course not.

Banks need to retain capital as they hold deposits, which are part of the money supply and can be drawn down at any time by depositors, and also because they play a critical role in the payment system. If banks make losses on lending, capital allows them not to transfer the loss onto customers, who often just wanted to store their money there. This has absolutely nothing to do with the kind of voluntary investments I described above. Moreover, some P2P platforms have already set up loss-absorbing funds anyway… Platforms also have their ‘skin in the game’: if everybody stops lending through them, they don’t earn any revenue and go out of business. While I agree that platforms should not hide the fact that losses could occur on P2P investments, paternalism and regulation is the wrong way to go. Education and responsibility should be the goals.


In another Alphaville blog post, Izabella Kaminska reports the arguments of two economists against the Summers/Krugman secular stagnation story. And it basically reflects mine: it doesn’t exist. It also has a particular Austrian flavour: savings and productivity generate long-term economic growth, and low interest rates caused the economy to boom above potential (debt accumulation) and caused malinvestments (investments that generated short-term growth but that no one wanted in the end).

    • There is no shortage of high return investment projects in the world. And the dearth of global corporate investment, which drove the great recession, means that productive potential is shrinking despite corporate profitability, leverage and cash balances being sound.

• The three ingredients for growth are a) a stable macro environment; b) a sound banking system; c) economic reforms that encourage entrepreneurship. What is missing right now is private sector confidence in the ability of governments and central bankers to provide all three.

• Credit bubbles can boost growth only temporarily and incur heavy costs in terms of subsequent deleveraging and misallocation of resources.


Hedge funds keep attracting new money (assets under management are up 16% since end-2012)… I won’t remind you that I’m wondering whether or not this is a sign that nominal interest rates are lower than their Wicksellian natural rates, forcing investors to take extra risk to achieve the real rates of return they would normally obtain from safer investments. But I guess that Summers and Krugman would say that, anyway, bubbles are necessary for the economy. Another side of the story is that not that many people seem to believe anymore in hedge funds outperforming the markets. Hedge funds seem to be transformed into mutual funds… But in this case, why paying such high management and performance fees? This doesn’t make so much sense.

Statism and the ideological war against Bitcoin

While the US Senate provided some support to Bitcoin and other digital alternative ‘currencies’, most of central banks and regulatory authorities around the world seem to have declared war against them. Yesterday, Alan Greenspan, the former Fed Chairman, said that Bitcoin was a bubble and that it had no intrinsic value. Although his track record at spotting bubbles is rather… poor.

Bitcoin Price

China’s central bank, the PBoC, banned financial institutions from doing any kind of business with it. Is it surprising from a country in which citizens are subject to financial repression and capital controls and who as a result see Bitcoin as a step towards financial freedom? It was very unlikely that China would endorse a medium of exchange over which it has no control. This is also true of other central banks. Today, Business Insider reported that the former Dutch central bank president declared that Bitcoin was worse than the 17th century Tulip mania. FT Alphaville continued its recurrent attacks against Bitcoin. The Banque de France also published a very bearish note on the now famous digital currency. The title couldn’t be more explicit: “The dangers related to virtual currencies’ development: the Bitcoin example”. What’s striking with the Banque de France note is that it pretty much sums up all criticisms (misplaced or not) against the virtual currency.

They start with the fact that Bitcoin is “not regulated.” Horror. Well, not only it is the goal guys, but it‘s not even completely true: Bitcoin’s issuance is actually very tightly regulated by its own algorithm, which replaces the discretionary powers of central banks. They add that Bitcoin provides “no guarantee of being paid back” and that its value is volatile. Yes, this is what happens when we invest in any sort of asset. To them, Bitcoin’s limited growth and resulting scarcity was intentionally introduced by its designer to provide it with a speculative nature. Not really… The design was a response to central banks’ lax use of their currency-issuing power. Moreover, Bitcoin’s value is the “exclusive result of supply and demand”! I guess that, for central bankers, this is indeed shocking. For classical liberals like me, or libertarians, this is the way it should be.

I think the ‘best’ argument against Bitcoin is the fact that, as it is anonymous, it can be used in criminal and fraudulent activities and money laundering. Wait… isn’t central bank cash even more anonymous? Hasn’t central bank cash been used in fraudulent activities and money laundering for decades, if not centuries? Are central banks involved in Know Your Customer practices? Finally, another argument of the Bank de France is: there is no authority safeguarding the virtual wallets, exposing them to hackers and other potential threats. True, there is no example in history of ‘authorities’ stealing, debasing or manipulating the reserves of media of exchange they were supposed to ‘safeguard’…* The central bank harshly concludes that Bitcoin’s use “presents no interest to economic agents beyond marketing and advertising, while exposing them to large risks.”

As I have said several times, Bitcoin is surely not perfect. But neither are our current official fiat currencies. I am neither for nor against Bitcoin or any digital currency. I am in favour of letting the markets experiment and pick the currency they judge appropriate. I am against a central authority forcing the use of a certain currency.

Let’s debunk a few other myths.

First, Bitcoin is not money. It is at best a commodity-like asset, such as gold, or a very limited medium of exchange. But it is not a generally accepted medium of exchange, the traditional definition of money. Perhaps someday. But not at the moment. Current institutional frameworks also make it very difficult for it to become generally accepted: legal tender laws, taxation in official currencies, and central banks’ monopoly on the issuance of money severely slow down the process.

As a result, the complaints that we keep hearing that its value is volatile and doesn’t allow for stable prices and economic efficiency through menu costs is completely misplaced. For a simple reason: apart from a few exceptions, there is no price denominated in Bitcoin! When you want to buy a good using Bitcoin, Dollar or Euro (or whatever) prices are converted into Bitcoins. Because Bitcoin has its own FX rate against those various currencies, when its value against another currency fluctuates, the purchasing power of Bitcoin in this currency fluctuates and prices converted into Bitcoins fluctuate! Prices originally denominated in Bitcoin would not fluctuate however.

What happens when you are an American tourist visiting Europe? Your purchasing power is in USD. But you have to buy goods denominated in EUR. As a result, your purchasing power fluctuates every day as you use USD to buy EUR goods. It is the same with Bitcoin. For now Bitcoin effectively involves FX risk. Either the consumer bears the risk of seeing its purchasing power fluctuates, or the seller/producer bears it, knowing that his own input prices were not in Bitcoin. At the moment, in the majority of cases, consumers/buyers bear the risk. Perhaps a bank could step in and start proposing Bitcoin FX derivatives for hedging purposes to its clients? Actually, a Bitcoin trading platform actually already offers an equivalent service.

Something that is really starting to annoy me every time I hear it is that Bitcoin is not like traditional fiat money, as it is not backed by anything and thus has no intrinsic value. Sorry? The very definition of fiat money is that it is not backed by anything! And none of the efforts of some Modern Monetary theorists, chartalists, or FT Alphaville bloggers will manage to convince us of the contrary. They claim that fiat money has intrinsic value as it is backed by “the government’s ability to tax the community which bestows power on it in the first place. This tax base represents the productive capacity of the collective wealth assets of the US community, its land and its resources. The dollar in that sense is backed by the very real wealth and output of the system. It is not just magic paper”, as described by the FT Alphaville blog post mentioned above. Right. This all sounds nice and abstract but can I show up at my local central bank and redeem my note for my share of “the productive capacity of the country”?**

A fiat money isn’t backed by anything at all but by faith. The only thing that gives fiat money its value is economic agents’ trust in it. When this trust disappears the currency collapses. It happened numerous times in history but I guess it is always convenient for some people to forget about those cases. A recent example was the hyperinflation in Zimbabwe: despite legal tenders laws and the fact that taxes were collected in Zimbabwean Dollars, the population lost faith in the currency and turned towards alternatives, mainly USD, EUR and South African Rand. People could well lose faith in advanced economies’ official currencies and start trusting Bitcoin (or any other medium of exchange) more. At that point, Bitcoin would still be fiat but become effectively ‘backed’ by the faith of economic agents and could well trigger a switch in the money we use on a day to day basis.

Another (half) myth is that Bitcoin is only a tool for speculation that diverts real money from real ‘productive purposes’. It is true that, as an asset, Bitcoin will always attract speculators. But it doesn’t necessarily divert money from the real economy: 1. when Bitcoins are sold, they are swapped for real money, money that does not remain idle but then can be used for ‘productive purposes’ by the new holder (or his bank) and 2. as a medium of exchange, Bitcoin can actually facilitate trade and hence ‘productive activities’. Don’t get me wrong: this does not mean that there are no better investment opportunities than Bitcoin. Investors will decide, and if the digital currency is destined to fail, it will, and the markets will learn.

There are other problems with Bitcoin, one of which being that it provides an inelastic currency as its supply is basically fixed. However, in a Bitcoin-standard world (as opposed to a gold-standard), we could probably see the emergence of fractional reserve banks that would lend Bitcoin substitutes and issue various liabilities (notes and deposits mainly) denominated in Bitcoin and redeemable in actual Bitcoin (which would then play the role of high-powered money). This mechanism would then provide some elasticity to the currency (and therefore to the money supply) to respond to increases and decreases in the demand for money.

Bitcoin seems to enrage central bankers, regulators, Keynesians (particularly post-Keynesians), chartalists, Modern Monetary theorists and other statists. Consequently they resort to myths and misconceptions in order to threaten its credibility. As I have already said, my stance is neutral. Alternative currencies will come and go. Some will fail. Others will succeed. Markets will decide. I argue that alternative currencies contribute to the greater good as they all of a sudden introduce monetary competition between emerging private actors and traditional centralised institutions. If alternative currencies can eventually force central banks and states to better manage their own currencies, it would be for the benefit of everyone.

To end this piece, let me quote Hayek:

But why should we not let people choose freely what money they want to use? By ‘people’ I mean the individuals who ought to have the right whether they want to buy or sell for francs, pounds, dollars, D-marks or ounces of gold. I have no objection to governments issuing money, but I believe their claim to a monopoly, or their power to limit the kinds of money in which contracts may be concluded within their territory, or to determine the rates at which monies can be exchanged, to be wholly harmful.

Well said mate.

* This was irony, for those who didn’t get it.

** The spontaneous development of alternative local currencies (such as this one) by individuals lacking balances in the official currency of the country but willing to trade goods or to propose services, is another example of a non-state issued money (and not collected to pay taxes) that facilitate economic output and the generation of wealth, in direct contradiction to the state theory exposed above.

Chart: CNN

Banks’ RWAs as a source of malinvestments – Some recent empirical evidence

A recent study by academics from the Southern Methodist University and the Wharton School of the University of Pennsylvania had very interesting findings (the actual full paper can be found here): banks based near booming housing markets charged higher interest rates and reduced loan amounts to companies, which ended up investing less than companies borrowing from banks located in stable (or falling) housing markets. They called this the “crowding-out effect of house-price appreciation”. The study gathered data from 1988 to 2006 in the US, during the Basel period. It would have been interesting to compare with the pre-Basel era and replicate it with European markets.

Conventional economic knowledge seemed to think that “to the extent that home prices begin to rise, consumers will feel wealthier; they’ll feel more disposed to spend…that’s going to provide the demand that firms need in order to be willing to hire and to invest.” (This is Ben Bernanke as quoted by The Economist, which mentioned this study a few weeks ago)

But our academics instead found an inverse relationship:

We estimate that a one standard-deviation increase in housing prices (about $79,700 in year 2000 dollars) that a bank is exposed to decreases investment by firms related to that bank by almost 6.3 percentage points, which is approximately 12% of a standard deviation for firm investment. Banks also increase the interest rate charged by 9 basis points, reduce outstanding loans by approximately 9%, and reduce loan size by approximately 4.5%. These results are consistent with banks reducing the supply of capital to firms in response to increased housing prices.

So much for the Keynesianism of housing bubbles…

Their findings was summarised in an easier to read single chart by The Economist:

mortgage business lending

I think they are spot on in identifying this crowding out effect but overlook the underlying importance of Basel’s risk-weighted assets in triggering the boom and forcing the reallocation of capital towards housing. In their paper, there is not a single reference to Basel, banks’ capital requirements (apart from one related to MBS) and RWAs. But their story matches almost perfectly the RWA-based ABCT model I described in my previous post on the topic.

What did my model say? That the supply of loanable funds would be reduced to businesses and increased to real estate as a result of capital-optimising choices made by banks (because of RWAs capital constraints). That consequently, interest rates would increase for businesses and be reduced for real estate. This is exactly what they found.

But it doesn’t stop here. The model also said that an increase in interest rates to businesses would shorten their structure of production as interest-sensitive long-term investments become unprofitable. What did they find? That businesses reduced investments despite the temporary boost in consumption due to the well-referenced wealth effects (which they also mentioned)…

However, they missed the deeper implications of banking regulation on the reallocation of capital from businesses to real estate. To them, house price increases seems to be the only factor diverting capital towards housing. I don’t deny that increasing house prices would bring about self-reinforcing house lending, even in a free market: as house prices increase, lending gets facilitated and speculators are attracted, pushing prices up even further. But my point is that regulation and RWAs can both trigger and exacerbate the process way beyond the self-correcting point at which it would normally stop (and collapse) in a free market environment.

There is catch though… If RWAs do indeed trigger a boom in house lending, how could they find some areas in the US within which the process actually wasn’t triggered (no increase in house prices/lending) despite being subject to the same regulatory framework? Well, there are possibly a few answers to that question. Some local banks could actually be in an area experiencing falling house prices for some reason (even though they increase nationally) and low mortgage demand. This would automatically limit the amount they lend and push RWAs on real estate up, making housing less attractive from a capital-optimisation point of view. Another possibility would be that those local banks are actually subsidiaries of other banks that try to optimise capital usage on an aggregate (national) basis. However, it is hard to say as the criteria used to build the sample of banks are not clear.

There is another, simpler, possible explanation: even in falling housing prices areas, local banks’ business lending was still constrained and mortgage lending still supported! Meaning that, in a RWA-free world (and excluding a recessionary environment), a decline in housing prices would have triggered an even sharper decrease/increase in mortgage/business lending. This cannot be proved with this study however. There could also be other explanations that haven’t come to my mind yet.

Overall, I remain slightly sceptical of statistical/regression/correlation-based economic studies and I’ll take this one with a pinch of salt, especially as they use various assumptions and proxies that could easily distort the outcome. Nonetheless, the results they obtained were quite significant. And they provide some empirical evidences to my very theoretical model.

Meanwhile, Nouriel Roubini on Friday, in a piece called Back to Housing Bubbles, listed all the markets in which there are signs of bubbles:

[…] signs of frothiness, if not outright bubbles, are reappearing in housing markets in Switzerland, Sweden, Norway, Finland, France, Germany, Canada, Australia, New Zealand, and, back for an encore, the UK (well, London). In emerging markets, bubbles are appearing in Hong Kong, Singapore, China, and Israel, and in major urban centers in Turkey, India, Indonesia, and Brazil.

Real estate bubbles existed before Basel introduced risk-weighted assets, but nothing on that scale and in so many countries at the same time. Time for policy-makers to wake up.


RWA-based ABCT Series:

  1. Banks’ risk-weighted assets as a source of malinvestments, booms and busts
  2. Banks’ RWAs as a source of malinvestments – Update
  3. Banks’ RWAs as a source of malinvestments – A graphical experiment
  4. Banks’ RWAs as a source of malinvestments – Some recent empirical evidence
  5. A new regulatory-driven housing bubble?

Cato Institute’s 31st Monetary Conference – Was the Fed a good idea?

About two weeks ago, the US-based think tank Cato organised its annual monetary conference. Great panels and very interesting speeches.


Three panels were of particular interest to me: panel 1 (“100 Years of the Fed: What Have We Learned?”), panel 2 (“Alternatives to Discretionary Government Fiat Money”), panel 3 (“The Fed vs. the Market as Bank Regulator”).

In panel 1, George Selgin destroys the Federal Reserve’s distorted monetary history. Nothing much new in what he says for those who know him but it just never gets boring anyway. He covers: some of the lies that the Federal Reserve tells the general public to justify its existence, pre-WW2 Canada and its better performing monetary system despite not having a central bank, the lack of real Fed independence from political influence and……the Fed not respecting Bagehot’s principles despite claiming to do so. In this panel, the speech of Jerry Jordan, former President of the Federal Reserve Bank of Cleveland, is also very interesting.

In panel 2, Larry White speaks about alternatives to government fiat money, counterfeiting laws and state laws making it illegal to issue private money. Scott Sumner describes NGDP level targeting. Here again, nothing really new for those who follow his blog, but interesting nonetheless (even though I don’t agree with everything) and a must see for those who don’t.

In panel 3, John Allison provides an insider view of regulators’ intervention in banking (he used to be CEO of BB&T, an American bank). He argues that mathematical risk management models provide unhelpful information to bankers. He would completely deregulate banking but increase capital requirements, which is an original position to say the least. Kevin Dowd’s speech is also interesting: he covers regulatory and accounting arbitrage (SPEs, rehypothecation…) and various banking regulations including Basel’s.

Overall, great stuff and you should watch the whole of it (I know, it’s long… you can probably skip most Q&As).

PS: Scott Sumner also commented on the Pope’s speech on “evil incarnate”. Reminds me of the vocabulary I used


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