Tag Archive | Central Banking

A central banker contradiction?

Last week, Mark Carney, the governor of the Bank of England, was at Cass Business School in London for the annual ‘Mais Lecture’. Coincidentally, I am an alumnus of this school. And I forgot to attend… Yes, I regret it.

Carney’s speech was focused on past, current, and future roles of the BoE. In particular, Carney mentioned the now famous monetary and macroprudential policies combination. It’s a classic for central bankers nowadays. They all have to talk about that.

In January, Andrew Haldane, a very wise guy and one my ‘favourite’ regulators, also from the BoE, made a whole speech about the topic. As Jens Weidmann, president of the Bundesbank, did in February.

I am not going to come back to the all the various possible problems caused and faced by macroprudential policies (see here and here). However, there seems to be a recurrent contradiction in their reasoning.


This is Carney:

The transmission channels of monetary and prudential policy overlap, particularly in their impact on banks’ balance sheets and credit supply and demand – and hence the wider economy. Monetary policy affects the resilience of the financial system, and macroprudential policy tools that affect leverage influence credit growth and the wider economy. […]
The use of macroprudential tools can decrease the need for monetary policy to be diverted from managing the business cycle towards managing the credit cycle. […]
That co-ordination, the shared monitoring of risks, and clarity over the FPC’s tools allows monetary policy to keep Bank Rate as low as necessary for as long as appropriate in order to support the recovery and maintain price stability. For example expectations of the future path of interest rates – and hence longer-term borrowing costs – have not risen as the housing market has begun to recover quickly.

First, it is very unclear from Carney’s speech what the respective roles of monetary policy and macroprudential policies are. He starts by saying (above) that “monetary policy affects the resilience of the financial system”, then later declares “macroprudential policy seeks to reduce systemic risks”, which is effectively the same thing. At least, he is right: both policy frameworks overlap. And this is the problem.

This is Haldane:

In the UK, the Bank of England’s Monetary Policy Committee (MPC) has been pursuing a policy of extra-ordinary monetary accommodation. Recently, there have been signs of renewed risk-taking in some asset markets, including the housing market. The MPC’s macro-prudential sister committee, the Financial Policy Committee (FPC), has been tasked with countering these risks. Through this dual committee structure, the joint needs of the economy and financial system are hopefully being satisfied.

Some have suggested that having monetary and macro-prudential policy act in opposite directions – one loose, the other tight – somehow puts the two in conflict [De Paoli and Paustian, 2013]. That is odd. The right mix of monetary and macro-prudential measures depends on the state of the economy and the financial system. In the current environment in many advanced economies – sluggish growth but advancing risk-taking – it seems like precisely the right mix. And, of course, it is a mix that is only possible if policy is ambidextrous.

Contrary to Haldane, this does absolutely not look odd to me…

Let’s imagine that the central bank wishes to maintain interest rates at a low level in order to boost economic activity after a crisis. After a little while, some asset markets start looking ‘frothy’ or, as Haldane says, there are “renewed signs of risk-taking.” Discretionary macroprudential policy (such as increased capital requirements) is therefore utilised to counteract the lending growth that drives those asset markets. But there is an inherent contradiction here: one of the goals that low interest rates try to achieve is to boost lending growth to stimulate the economy…whereas macroprudential policy aims at…reducing it. Another contradiction: while low interest rates tries to prevent deflation from occurring by promoting lending and thus money supply growth, macroprudential policy attempts to reduce lending, with evident adverse effects on money supply and inflation…

Central bankers remain very evasive about how to reconcile such goals without entirely micromanaging the banking system.

I guess that the growing power of central bankers and regulators means that, at some point, each bank will have an in-house central bank representative that tells the bank who to lend to. For social benefits of course. All very reminiscent of some regions of the world during the 20th century…

Weidman is slightly more realistic:

We have to acknowledge that in the world we live in, macroprudential policy can never be perfectly effective – for instance because safeguarding financial stability is complicated by having to achieve multiple targets all at the same time.



Photograph: Intermonk

Could P2P Lending help monetary policy break through the ‘2%-lower bound’?

The ‘cut the middle man’ effect of P2P lending is already celebrated for offering better rates to both lenders and borrowers. But what many people miss is that this effect could also ease the transmission mechanism of central banks’ monetary policy.

I recently explained that the banking channel of monetary policy was limited in its effects by banks’ fixed operational costs. I came up with the following simplified net profit equation for a bank that only relies on interest income on floating rate lending as a source of revenues:

Net Profit = f1(central bank rate) – f2(central bank rate) – Costs, with

f1(central bank rate) = interest income from lending

= central bank rate + margin and,

f2(central bank rate) = interest expense on deposits

= central bank rate – margin

(I strongly advise you to take a look at the details here, which was a follow-up to my response to Ben Southwood’s own response on the Adam Smith Institute blog to my original post…which was also a response to his own original post…)

Consequently, banks can only remain profitable (from an accounting point of view) if the differential between interest income and interest expense (i.e. the net interest income) is greater than their operational costs:

Net interest income >= Costs

When the central bank base rate falls below a certain threshold, f2 reaches zero and cannot fall any lower, while f1 continues to decrease. This is the margin compression effect.

Above the threshold, the central bank base rate doesn’t matter much. Below, banks have to increase the margin on variable rate lending in order to cover their costs. This was evidenced by the following charts:

Rate floor

Rate floor 4

As the UK experience seems to show, banks stopped passing BoE rate cuts on to customers around a 2% BoE rate threshold. I called this phenomenon the ‘2%-lower bound’. I have yet to take a look at other countries.

Enter P2P lending.

By directly matching savers and borrowers and/or slicing and repackaging parts of loans, P2P platforms cut much of banks’ vital cost base. P2P platforms’ online infrastructure is much less cost-intensive than banks’ burdensome branch networks. As a result, it is well-known that both P2P savers and borrowers get better rates than at banks, by ‘cutting the middle man’. This is easy to explain using the equations described above, as costs approach zero in the P2P model. This is what Simon Cunningham called “the efficiency of Peer to Peer Lending”. As Simon describes:

Looking purely at the numbers, Lending Club does business around 270% more efficiently than the comparable branch of a major American bank

Simon calculated the ‘efficiency’ of each type of lender by dividing the outstanding loans of Wells Fargo and Lending Club by their respective operational expenses (see chart below). I believe Lending Club’s efficiency is still way understated, though this would only become apparent as the platform grows. The marginal increase in lending made through P2P platforms necessitates almost no marginal increase in costs.

Wells vs Lending Club

Perhaps P2P platforms’ disintermediation model could lubricate the banking channel of monetary policy the closer central banks’ base rate gets to the zero bound?

Possibly. From the charts above, we notice that the spread between savings rates and lending rates that banks require in order to cover their costs range from 2 to 3.5%. This is the cost of intermediation and maturity transformation. Banks hire experts to monitor borrowers and lending opportunities in-house and operate costly infrastructures as some of their liabilities (i.e. demand deposits) are part of the money supply and used by the payment system.

However, disintermediated demand and supply for loanable funds are (almost) unhampered by costs. As a result, the differential between borrowers and savers’ rate can theoretically be minimal, close to zero. That is, when the central bank lowers its target rate to 0%, banks’ deposit rates and short-term government debt yield should quickly follow. Time deposits and longer-dated government debt will remain slightly above that level. Savers would be incentivised to invest in P2P if the proposed rate at least matches them, adjusting for credit risk.

Let’s take an example: from the business lending chart above, we notice that business time deposit rates are currently quoted at around 1%. However, business lending is currently quoted at an average rate of about 3%. Banks generate income from this spread to pay salaries and other fixed costs, and to cover possible loan losses. Let’s now imagine that companies deposit their money in a time deposit-equivalent P2P product, yielding 1.5%. Theoretically, business lending could be cut to only slightly above 1.5%. This represents a much cheaper borrowing rate for borrowers.

P2P platforms would thus more closely follow the market process: the law of supply and demand. If most investments start yielding nothing, P2P would start attracting more investors through arbitrage, increasing the supply of loanable funds, and in turn lowering rates to the extent that they only cover credit risk.

The only limitation to this process stems from the nature of products offered by platforms. Floating rate products tend to be the most flexible and quickly follow changes in central banks’ rates. Fixed rate products, on the other hand, take some time to reprice, introducing a time lag in the implementation of monetary policy. I believe that most P2P products originated so far were fixed rate, though I could not seem to find any source to confirm that.

In the end, P2P lending is similar to market-based financing. The bond market already ‘cuts the middle man’, though there remains fees to underwriting banks, and only large firms can hope to issue bonds on the financial markets. In bond markets, investors exactly earn the coupon paid by borrowers. There is no differential as there is no middle man, unlike in banking. P2P platforms are, in a way, mini fixed-income markets that are accessible to a much broader range of borrowers and investors.

However, I view both bond markets and P2P lending as some version of 100%-reserve banking. While they could provide an increasingly large share of the credit supply, banks still have a role to play: their maturity transformation mechanism provides customers with a means of storing their money and accessing it whenever necessary. Would P2P platform start offering demand deposit accounts, their cost base would rise closer to that of banks, potentially raising the margin between savers and borrowers as described above.

It seems that, by partly shifting from the banking channel to the P2P channel over time, monetary policy could become more effective. I am sure that Yellen, Carney and Draghi will appreciate.

Is the zero lower bound actually a ‘2%-lower bound’?

Following my recent reply to Ben Southwood on the relationship between mortgage rates, BoE base rate and banks’ margins and profitability (see here and here), a question came to my mind: if the BoE rate can fall to the zero lower bound but lending rates don’t, should we still speak of a ‘zero lower bound’? It looks to me that, strictly in terms of lending and deposit rates, setting the base rate at 0% or at 2% would have changed almost nothing at all, at least in the UK.

The culprit? Banks’ operational expenses. Indeed, it looks like the only way to break through the ‘2%-lower bound’ would be for banks to slash their costs…

Let’s take a look at the following mortgage rates chart from one of my previous posts:

Rate floorFrom this chart, it is clear that lowering the BoE rate below around 2.5% had no further effect on lowering mortgage rates. As described in my other posts, this is because banks’ net interest income necessarily has to be higher than expenses for them to remain profitable. When the BoE rate falls below a certain threshold that represents operational expenses, banks have to widen the margins on loans as a result.

What about business lending rates? Since business lending is funded by both retail and corporate deposits (and excluding wholesale funding for the purpose of the exercise), the analysis must take a different approach. Banks don’t often disclose the share of corporate deposits within their funding base, but I managed to find a retail/corporate deposit split of 75%/25% at a large European peer, which I am going to use as a rough approximation to estimate banks’ business lending margins. Here are the results of my calculations (first chart: margin over time deposits, second chart: margin over demand deposits):

Rate floor 2

Rate floor 3No surprise here, the same margin compression effect appears as a result of the BoE rate collapsing (as well as Libor, as floating corporate lending is often calculated on a Libor + margin basis, unlike mortgages, which are on a BoE + margin basis). Before that period, changes in the BoE and Libor rates had pretty much no effect on margins. After the fall, banks tried to rebuild their margins by progressively repricing their business loan books upward (i.e. increasing the margins over Libor).

Here again we can identify a 1.5% BoE rate floor, under which lowering the base rate does not translate into cheaper borrowing for businesses:

Rate floor 4This has repercussions on monetary policy. The banking/credit channel of monetary policy aims at:  1. easing the debt burden on indebted household and businesses and, 2. stimulating investments and consumption by making it cheaper to borrow. However, it seems like this channel is restricted in its effectiveness by banks’ ability in passing the lower rate on to customers. Banks’ short-term fixed cost base effectively raises the so-called zero lower bound to around 2%. The only way to make the transmission mechanism more efficient would be for banks to drastically improve their cost efficiency and have assets of good-enough quality not to generate impairment charges, which is tough in crisis times. Unfortunately, there are limits to this process, and a bank without employee and infrastructure is unlikely to lend in the first place…

Don’t get me wrong though, I am not saying that lowering the BoE rate (and unconventional monetary policies such as QE) is totally ineffective. Lowering rates also positively impact asset prices and market yields, ceteris paribus. This channel could well be more effective than the banking one but it isn’t the purpose of this post to discuss that topic. Nevertheless, from a pure banking channel perspective, one could question whether or not it is worth penalising savers in order to help borrowers that cannot feel the loosening.

PS: I am not aware of any academic paper describing this issue, so if you do, please send me the link!

The central bank funding stigma

Yesterday the Federal Reserve Bank of New York published a brand new study about the stigma associated with banks borrowing from the central bank’s discount window. That was a nice coincidence following my response to Scott Fullwiler on the MMT and endogenous money theory, which seems to ignore this stigma (or at least to downplay its impact) and to consider that banks freely borrow from the central bank, providing a perfectly elastic high-powered money (reserves) supply. On the contrary, in my view, the stigma is one of the fundamental reasons that undermine the endogenous money theory.


Essentially, the NY Fed does not see much reason for this stigma to exist, but acknowledges that it does exist… I think they entirely forgot the possible impacts on a bank and its stakeholders of being considered illiquid, which I described in my previous post. Nonetheless, they made some good points (see below). A key point in my opinion is that banks are willing to pay more for other sources of funding than use the cheaper discount window.

The four main hypotheses they tested were very US-centric but interesting nonetheless. They found that:

  • Banks inside the New York District were 14% less likely to experience the stigma than banks outside of the district (admittedly not that much difference)
  • Foreign banks were 28% more likely to experience the stigma than similar US peers
  • The largest the financial markets disruption, the higher the stigma
  • The stigma does not decline when more banks utilise the discount window


Photo: MoneyAware

A response to Scott Fullwiler on MMT banking theory

Following my post about the problems with the MMT and endogenous money banking theory, Scott Fullwiler, one of its proponents, briefly (and very nicely) commented on it, suggesting that I was not criticising the theory and that we were in fact in agreement. I beg to differ.

Another commenter, JH, also left a link to a much more comprehensive article describing the theory, written by Scott (you can find it here). I recommend this article to everyone. It is a very interesting piece about banking, and Scott clearly demonstrates in it that his knowledge of the banking system is superior to most of his fellow economists.

I had started to write a fairly long post criticising the (few, but in my view, important) errors in Scott’s paper, but decided against it eventually, and deleted most of it to get directly to the main point. I could probably write a whole academic article about the topic but I have no idea how to get it published so won’t do it! (any advice appreciated though!)

Overall, I agree that Scott’s description of the lending process is largely accurate. However, I believe that the conclusions that seem to ‘naturally’ follow fall into a fallacy of composition. The endogenous money theory correctly assumes that the lending decision regarding a single loan is independent of the reserve status of the bank. However, the theory incorrectly assumes that this description also applies to lending as a whole.

The endogenous money theory correctly describes one-off borrowings from banks that temporarily lack reserves for some technical reasons. But this lack of reserves is only temporary as they have the necessary liquid holdings to generate new primary reserves. If banks can lend independently of their reserve status, it is because they have beforehand secured enough liquidity (= claims on primary reserves) to face settlements.

The fallacy of composition involves applying this reasoning to a bank’s aggregate lending. What happens as a one-off event cannot happen continuously, as it would progressively deplete the bank’s secondary reserves until it ends up only relying on interbank or central bank funding for marginal lending, assuming funding costs were maintained at a stable level. But they are not. The more secondary reserves fall, the more the bank’s ratings are cut, its cost of funding increases and its share price falls. At some point, not only the marginal increase in lending is not profitable anymore, but also the bank might have endangered its very existence by becoming borderline liquid resulting in all market actors getting hesitant to provide it with any fund.

Therefore, Scott is right when he says that we agree that banks are pricing-constrained. Indeed. But we disagree on the backstop mechanism. The endogenous view considers central bank funding (and pricing) as the backstop mechanism, against which banks are going to benchmark their new lending to assess its profitability (the interest rate spread) if other sources of funds are unavailable. As Scott says:

Borrowings and reserve balances can always be had at some rate of interest; the question is whether or not this rate of interest is one at which the bank can make a profit that provides a sufficient return on equity.

Scott here mainly refers to the lender of last resort, the central bank. This implies that the supply of reserve by the central bank is perfectly elastic at a given interest rate, and therefore entirely driven by demand. But he does not take into account the impact for a bank of being able to raise funds only from a central bank. Sure, a bank that cannot seem to find any reserve anywhere else can still usually borrow from the central bank. Nonetheless, this bank, is, well… screwed. It just committed suicide.

By overexpanding, it depleted its liquidity position (through adverse clearing) to such an extent that no market actor was willing to lend to it anymore. By admitting its new reliance on central bank funding for survival, it admits its failure. As I have already said in my previous post, this is why banks are doing their best to avoid using central banks’ facilities. Nonetheless, this bank has the possibility to regain market confidence: it can reduce its lending in order to generate new liquidity. This shows the limit of the endogenous money theory: in the medium-term, lending is indirectly reserve-constrained.

We can see that the benchmark against which banks assess the profitability of new lending isn’t the central bank’s rate. It is the various market rates. Even without the central bank changing its target rate, an overexpanding bank will inevitably be forced to contract its lending by market forces, and consequently, the money supply.

Endogenous money theorists could respond that financial markets act irrationally: there is no point in punishing banks that could actually obtain funding from the central bank, making liquidity risk irrelevant (at least as long as they are only illiquid and not insolvent).  But investors have very good reasons: illiquid banks are usually either bailed-out or left to fail, with in either case serious consequences for shareholders, bondholders, and sometimes depositors. Think about Northern Rock and Bear Stearns. Those two banks were notoriously illiquid (rather than insolvent). You know what happened next.

Regarding the treatment of reserve requirements, I am not going to come back to the evidence from countries that actively use them as a policy tool. Nonetheless, the endogenous theory concludes that reserves are basically useless, except for interbank settlements and to comply with reserve requirements when needed (even cash withdrawals by customers are downplayed). I disagree; reserves are the most liquid asset banks can hold. When uncertainty increases in the markets and when even liquid securities suddenly become illiquid, banks increase their reserves holdings, which become precautionary reserves. Banks thus sacrifice some yield for liquidity. This does not mean that banks would not invest those reserves in loans or in securities should the economic conditions be normal.

I am going to stop here for today. There are a few other points I could have covered but as I said at the beginning of this post, this would require a 20-page article… Some of those include an overexpanding banking system as a whole (not just a single bank), the fact that, unlike what is implied in Scott’s article, banks are not maximising leverage, that leverage does seriously impact banks’ ratings, that deposits aren’t always the cheapest funding source, and even some details about banks’ regulatory capital calculations. Those are less important (or even very minor) points.

Update: See this post on the central bank funding stigma.

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 problems with the MMT-derived banking theory

(Update: Following Scott Fullwiler’s comment, I published an update here, in which I provide extra clarifications and introduce what I see as the fallacy of composition of the endogenous money theory (I moved this update to the top of my post following a few questions I received).)

Today will be a little long and technical… Many people have heard of the classic textbook story of the banking money multiplier, a characteristic of fractional reserve banking systems. Banks obtain reserves (i.e. central bank-issued high-powered money – HPM, which forms the monetary base) as customers deposit their money in, then lend out a fraction of those deposits that gets redeposited at another bank, effectively creating money in the process, and so on. In fine, reserve requirements at central banks prevent banks from expanding lending (and hence money supply) beyond a certain point. This led to the view that banks’ expansion is reserve-constrained.

But proponents of Modern Monetary Theory (MMT), and others who have no idea what MMT is, but who have been convinced by the argument, have been shouting out for a while now that this view is wrong. Banks do not lend out reserves they assert. Banks aren’t reserve-constrained but capital-constrained. Therefore, lending is endogenous, the supply of bank loans is almost perfectly elastic and the quantity supplied only driven by demand. Scott Fullwiler described the process on Warren Mosler’s (aka current MMT Guru) website. Cullen Roche has also been a strong proponent of this view (see here and here for example).

I managed to find a relatively good detailed summary of this view here:

[…] we had discussed the orthodox belief that the government controls the money supply through control over bank reserves. This position is rejected by Post Keynesians, who argue that banks expand the money supply endogenously. How is this possible in nations with a legally required reserve ratio? Banks, like other firms, take positions in assets by issuing liabilities on the expectation of making profits. Much bank activity can be analyzed as a “leveraging” of HPM–because banks issue liabilities that can be exchanged on demand for HPM on the expectation that they can obtain HPM as necessary to meet withdrawals–but many other firms engage in similar activity. For our purposes, however, the main difference between banks and other types of firms involves the nature of the liabilities. Banks “make loans” by purchasing IOUs of “borrowers”; this results in a bank liability–usually a demand deposit, at least initially–that shows up as an asset (“money”) of the borrower. Thus, the “creditors” of a bank are created simultaneously with the “debtors” to the bank. The creditors will almost immediately exercise their right to use the created demand deposit as a medium of exchange.

Indeed, bank liabilities are the primary “money” used by non-banks. The government accepts some bank liabilities in payment of taxes, and it guarantees that many bank liabilities are redeemable at par against HPM. In turn, reserves are the “money” used as means of payment (or inter-bank settlement) among banks and for payments made to the central bank; as bank “creditors” draw down demand deposits, this causes a clearing drain for the individual bank. The bank may then operate either on its asset side (selling an asset) or on its liability side (borrowing reserves) to cover the loss of reserves. In the aggregate, however, such activities only shift reserves from bank-to-bank. Aggregate excesses or deficiencies of reserves have to be rectified by the central bank. Ultimately, then, reserves are not discretionary in the short run; the central bank can determine the price of reserves–admittedly, within some constraints–but then must provide reserves more-or-less on demand to hit its “price” target (the fed funds rate in the US, or the bank rate in the UK). This is because excess or deficient reserves would cause the fed funds rate (or bank rate) to move away from the target immediately.

This means that central banks cannot control the money supply.

I am going to argue here that this view is at best inexact. And that, if the textbook description is outdated, it is still mostly right.

Scott Sumner argued on his blog that lending was effectively endogenous in the short-run but not in the long-run. I only partially agree, as even in the short-run in-built markets limits are in place.

Banks raise funding to obtain reserves

My arguments come both from my theoretical knowledge and from my practical experience of analysing banks all day long and meeting banks’ management, including treasurers/ALM managers. On a side note, the MMT story is wrong in a commodity-backed currency environment. But its proponents reply that it is only valid in our modern fiat money-based banking systems. Fair enough.

The reality is… banks do obtain funding (hence reserves) before lending in most cases. The opposite would be suicidal. Equity funding is obvious: a bank issues equity liabilities in exchange for cash that it then invests/lends. Non-equity funding, by far the largest component of banks’ funding structure (around 95% of funding), mainly comes from two sources: customer deposits and wholesale funding. Banks primarily rely on deposits to fund their lending activities. They try to attract depositors as they provide banks with more funds to lend. Of course they don’t lend out the deposits but the increase in reserves that comes along an increase in deposits allows the bank to lend more without risking a depletion of its reserve base.

Banks at the same time try to minimise the interest rate they pay on deposits in order to minimise their funding costs and maximise their net interest margin (basically the margin between the rate at which banks lend and the rate at which they borrow from depositors and other creditors). They also try to attract sticky saving and term deposits, rather than more volatile (but cheaper) demand deposits.

When banks want to lend more than what their deposit base allows them to lend, they need to turn to wholesale funding. Wholesale funding roughly comprises senior and subordinated liabilities (bonds) issued on the markets as well as interbank borrowings and repurchase agreements. Bond issues are quite simple: the bank issues its liabilities on the financial markets in exchange for cash. Cash that will then complement its existing cash reserves, and that the bank consequently lends out at a margin (unless of course the purpose of the issue was to refinance existing bonds). Interbank borrowings and repos are usually minimally used by banks as a source of funding, as they are very often short-term and unstable (i.e. can be withdrawn by other banks or not rolled over). Interbank funding (and borrowing from central banks) is the cheapest source of funds (although continuously rolling over this type of funding makes it expensive in the end). Deposits and other wholesale issues are more expensive.

What do banks do with the cash/reserves/HPM that they acquire through their various funding sources? Well, as you guessed, they lend. But not only. Banks invest. In order to maintain an adequately liquid balance sheet at all times to face withdrawals and settlements, banks mostly 1. keep some cash in hands and at the central bank, which represents their official reserves (as specified by reserve requirements), 2. invest the remaining of their cash in liquid securities, often sovereign bonds or highly-rated firms’ debt securities, which represent their ‘secondary reserves’, and 3. place some cash at other banks (interbank lending mainly).

In the end, all banks hold a liquidity buffer that represents between around 10% and 25% of their assets (and between 10 and 40% of their deposit base), under the form of both primary and secondary reserves. Why not keeping all as cash? Because of the opportunity cost of holding cash. To maximise their margins, banks prefer to invest that cash in liquid, easily marketable, interest-bearing securities. Why even keeping reserves in the first place? To minimise the probability of a liquidity crisis (i.e. not being able to face deposit withdrawals, interbank settlements or other liability maturity). If liquidity were not a constraint and banks’ only goal was to maximise profits independently of liquidity risk, they would simply avoid investing in low-yielding securities and lend at a higher margin instead. In order to maintain their net interest margin, it also happens that banks try to slow the pace of deposit inflows by lowering their rates on saving accounts, if they don’t have enough lending opportunities.

Are you starting to see the differences with the MMT/endogenous lending story?

Let’s take a real life example (figures at end-2012): Wells Fargo (a large bank that does not have oversized investment banking activities that distort its balance sheet,  which makes it similar to smaller-sized banks as a result). What does its funding structure (liability side of the balance sheet) look like? Unsurprisingly, 83% of its non-equity funding comes from customer deposits. Long-term senior and wholesale funding represents 9% of its funding structure. What about short-term wholesale and interbank funding? 6% only of its total funding. Clearly, Wells Fargo does not fund its lending by borrowing from other banks. Its loans/deposits ratio is 84%. It gets its reserves from other sources.

Let’s pick another similar bank that has a 126% loans/deposits ratio, UK-based Lloyds Banking Group. In this case, deposits could obviously not fund all lending. Did the bank fund its additional lending through interbank borrowing? No. Interbank borrowing only represents 2% of its funding structure. Adding other short-term wholesale funding makes it 10%.

A few points directly stand out:

  • Why would banks try to attract depositors, or even bother issuing expensive debt on the bond markets, if all they have to do to fund their lending is an accounting entry followed by some interbank or central bank borrowing?
  • Why would banks bother attracting expensive stable funding sources if all they have to do is to continuously increase (or roll over) short-term interbank or central bank borrowings?
  • Why are banks even keeping such amounts of primary and secondary reserves if, once again, reserves are not a constraint and all they have to do is to go ask fellow banks or central banks for reserves, which they have to provide to stick to their monetary policy?

From all those points, MMTers could reach the conclusion that bankers don’t seem to know what they’re doing.

There is a relatively straightforward answer to those questions: reserves still matter. Reserves are not directly lent out. They are indirectly lent out. When a bank credits the account of a customer out of thin air following a loan agreement, it exposes itself to a flight of reserves whose amount is equal to the loan, as correctly described by MMTers. Therefore, banks need to maintain an adequate level of reserves, as represented by their primary and secondary reserve buffers. If their primary reserves are low, banks can sell some of their secondary reserves to get hold of new cash for settlements. No need to borrow from the interbank market. However, there is a limit to this process: at some point, secondary reserves will also be exhausted. This is extremely unlikely though. Such a fall in balance sheet liquidity would be punished by financial markets (see below), incentivising banks to retain enough liquidity.

Moreover, banks usually try to avoid borrowing more than a limited amount on the interbank/money market. Why?

  1. Because this is a suicidal way of funding banking activities. A bank that would only rely on short-term and volatile interbank borrowing to fund its lending would expose itself to market actors’ furore: banks would start reducing their exposures to it, rating agencies would downgrade it, its share price would fall, and its cost of borrowing on the interbank market (or anywhere else) would rise.
  2. Because borrowing at very short-notice on wholesale markets would expose the bank to penalty interest rates. Most central banks also apply penalty rates to banks short of reserves.

But, the central bank has a target rate and needs to stick to it, MMTers are going to reply, thereby providing all the required reserves to this bank. What are the implications of such a claim?

Implications for a single bank

A bank that would have single-handedly increased its lending, and hence its liabilities, without securing reserves in the first place, is at risk of experiencing adverse interbank clearing and losing some of its reserves. At some point, its reserves could fall below the required amount. However, as we have seen above, the bank holds secondary reserves that it can deplete before running out of primary reserves. What the MMT story overlooks is market reactions to a bank losing its liquidity. I know no investor or no banker that would provide funds to a bank running out of liquid reserves, unless at increasingly high interest rates, even if they know that the bank could obtain reserves from the central bank. As a result, a bank single-handedly expanding beyond what its reserve would normally allow it to is going to experience a quickly rising marginal cost of funding as a response to the loss of its liquid holdings, pressurising its net interest margin and stopping its expansion.

If the bank reaches the point at which it has to borrow directly from the central bank as it has no other choice, it is already too late: markets are aware of its lack of primary or secondary reserves and won’t deal with it anymore. As a result, central banks’ overnight lending in such conditions is self-defeating. Banks, which is an industry based on trust and reputation, will do everything they can to prevent this situation from occurring in order to avoid the stigma associated with it, as we’ve seen many times during the crisis (see also a Fed study here, as well as this one). However, a bank in good financial health could well borrow from the central bank’s discount window from time to time to optimise its liability structure and cost of funding. In the end, a single bank might not technically be reserve-constrained, but it becomes reserve-constrained through market discipline! Of course, in good times, market participants can become more tolerant towards less-liquid balance sheet structures, but the principle still applies.

We could apply the same line of reasoning to asset quality. As a bank expands, the marginal return on lending diminishes and it has to lend to increasingly less creditworthy borrowers. The resulting pressure on its asset quality starts worrying market actors, impacting its cost of funding and slowing its expansion.

Moreover, the interbank lending rate need not rise if a single bank is having difficulties to fund itself. Other banks could actually see their borrowing cost fall as they see massive money market deposit inflows, keeping the aggregate rate stable. Second, central banks clearly cannot completely control the rate: it jumps way above target from time to time.

Implications for the system as a whole

There seems to be an inherent implication to the MMT/endogenous lending story: all banks have a natural incentive to expand as they can freely borrow reserves from the central bank. By literally following their description, it seems that most, if not all banks are fully loaned up as there is no risk of becoming illiquid. Although in such a case, there is no way they can borrow and lend from the interbank market: none of them has excess reserves. The only thing they can do is borrow from the central bank, which cannot refuse if it wants its target interest rate to remain on target. Consequently, the central bank cannot control the money supply as demand for commercial loans is out of its control.

There are a couple of contradictions here. If all banks are short of reserves, there is no interbank market anymore. Nonetheless, it is true that money markets can still exist with money market funds and other non-bank financial institutions and businesses supplying short-term cash to banks. However, this situation is unlikely to happen: as described above, increasing marginal cost of funding for all the banks trying to expand beyond reasonable will slow and eventually stop the process. Only a simultaneous increase in lending by all banks could lead to all banks expanding beyond the limit. In such a case, interbank settlements would cancel out, leaving the reserve positions of each bank unaffected, with no need to borrow for settlements. In practice, banks never expand at the exact same time: some banks are aggressive, some banks are conservative.

What about empirical evidence?

The evident conclusion that MMTers reach is that reserve requirements are ineffective in reducing loan growth. Is there any empirical evidence to confirm this claim? There is. But it doesn’t exactly reach the same conclusion. A few central banks actively use reserve requirements as a monetary policy tool, such as China’s, Russia’s, Brazil’s and Turkey’s. Take a look at the charts from this recent Gavyn Davies article in the FT on China:

China RR

China RR2China RR3

From those charts, we can see that every time reserve requirements are cut (mid-2008, early 2012), loan growth surges temporarily while the newly-available reserves are released. When reserve requirements are increased (early 2010, early 2011), loan growth slightly falls relative to trend. Granted, those charts do not show us the whole picture: other factors may well impact loan growth.

Another FT blog post summarised the trend, although the chart stops in 2010:

China RR4

A BIS study on Chinese reserve requirements also found a link:

China RR5

I don’t have data for Turkey and Russia, but this study found that increases in reserve requirements led to a contraction in domestic credit in Brazil.

What about interbank lending rate? It is pretty well reported that banks in worse financial health have to pay more for reserves on the interbank market (or on any other market). This should not be a surprise to financial markets actors: everyone knows that illiquid and/or insolvent banks have wider credit spreads. Does it necessarily mean that, as soon as a bank has to pay more than the target rate, it should instead borrow from the central bank? Obviously not. And we have already mentioned the stigma associated to this.

Finally, what about the moral hazard associated with unrestricted supply of reserves? If this were true, surely this is a very bad way of designing and managing a banking system?

This leaves us with the good’ol money multiplier textbook explanation. As I said at the beginning of this (long) post, it is quite outdated, but it remains essentially right, albeit in an indirect way. Nowadays, banks engage in what they call ALM (asset/liability management) through specific departments that identify and manage mismatches between the maturities of assets and liabilities and their respective cash inflows and outflows. As a result of this dynamic and active management, banks try to economise on reserves and take slightly more funding and liquidity risks than 19th century “collect and lend”-type banks. Nonetheless, reserves still matter and ALM bankers and treasurers also set up contingency liquidity plans, which would not make sense if they could freely access interbank or central bank funding without repercussions.

There are probably other things I could say about the MMT/endogenous money story. I may follow-up later, but for now this post is long enough… I just thought that some reality had to be reintroduced into the story, which sounds theoretically as pleasant as a fairy tale but doesn’t seem to stand its ground when you dig a little deeper.

Update: I initially quoted Frances Coppola in this post as her view seemed to be pretty similar to the quoted MMT story. She told me it wasn’t the case, and I updated the post as a result. There are still several things she said that I don’t agree with though.

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

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

News digest (Krugman and deregulation, central banking for Bitcoin…)

A looooooooot of news since the beginning of the week. So I’ll just quickly go over a few of them. Guys please, next time, spread your news more evenly over time. There was nothing to comment on recently!

Not new news but the Swedish bank regulators are thinking of increasing RWAs on mortgages to fight a growing housing bubble. Well, raising them to 25% (from 15% floor…) would still not change much: they would remain below most other asset classes’ level and securitisation (RMBS) would allow banks to bypass the restrictions.

Meanwhile, Yves Mersch, member of the Executive Board of the ECB, spoke about how to revive SME lending in bank-reliant Europe. His solutions involve: strengthening banks, securitisation and… banking union. Any word of capital requirements/risk-weighted assets? Not a single one. When I told you that central bankers don’t seem to get it…

But the UK government wants to ditch the household lending side of the Funding for Lending Scheme! They now only want to provide cheap funding to banks if they prove that they lend to SMEs. Why not, but I doubt it would really work for a few reasons: 1. demand for loans remains quite low, 2. market funding remains cheap (it was cheaper than FLS), 3. banks haven’t drawn much on it anyway, 4. RWAs are still in place! Mortgage and household lending will still attract most of lending volume as it is more profitable from a capital point of view.

Meanwhile (again), SME financing from alternative lenders not subject to RWAs and other stupid capital rules, keeps growing in the UK. However, it is still tough for those lenders to assess the health of the companies that would like to lend to.

Erkki Liikanen, the Governor of the central bank of Finland, told us about his ideas to improve financial stability. Surprise: they haven’t changed. So macroprudential policy starts interfering with macroeconomic policies and financial regulation, with possibly opposite effects that don’t seem to bother him much. Look at that slide, which is the very definition of a messy policy goal, with multiple targets and interferences:

Liikanen Macroprudential

A very strange piece in the Washington Post: Bitcoin needs a central banker. Wait a second. No, it’s definitely not the 1st of April. First, the author asserts that Bitcoin’s wild changes in value make it difficult to be adopted as a currency. This is extraordinary. Does the author even understand FX rates? If the author wishes to purchase his coffee using Euros, despite the coffee being priced in Dollars, will he also declare that the fact the Euro’s value is unstable (making the effective Euro price of its coffee volatile) makes the currency improper for use? When prices are originally denominated in Bitcoin, the change in the value of the digital currency won’t affect them. When prices are actually denominated in USD, but converted into Bitcoin, then yes, changes in the value of the digital currency will affect them. But this is hardly Bitcoin’s fault… Then he gets mixed up with ‘menu costs’, ‘hyperinflation’, ‘money demand’, etc. Wow. Just one last thing: has he even understood that Bitcoin was designed to be free from central bankers and government intervention in the first place?

Izabella Kaminska in the FT wrote a new piece on Bitcoin and other alternative electronic currencies. She complains about the multiplication of such currencies that nothing backs and pretty much only see speculative motivations underlying them. I am not going to comment on the whole thing, but whether right or wrong, she should ask herself why there is such frenzy about those currencies at the moment. My guess is that, governments’ and central banks’ manipulation of their own currencies have unleashed a beast: people afraid to hold classic currencies started to look for alternatives, pushing up their prices, in turn attracting speculators. The process is similar to ‘bad’ financial innovations (the ones designed specifically to bypass restricting regulation): they often start as a benign innovation for the ‘common good’, but the surprising demand for them and large profits attract speculators until the market crashes. Not the fault of the innovation, but the fault of the regulation that triggered them…

Paul Krugman thinks that “the trouble with economics is economists”, and that mainstream economics is not to blame for the financial crisis. I partly disagree: 1. there are various schools of thought within mainstream economics that often disagree with each other altogether and 2. most (all?) of them cannot fully explain the crisis anyway. But, and this is where Krugman shows his limited knowledge of banking and therefore the limit of his reasoning, he declares that “the mania for financial deregulation, for example, didn’t come out of standard economic analysis.” I’m sorry? Which mania for financial deregulation? The international banking sector had never been as regulated in history as on the eve of the crisis! (even taking into account of the few one-off deregulations) I need to come back to this in a subsequent post. Really, Paul, you have to revise your history. And your reasoning.

On Free Banking, George Selgin urges Scots to ‘poundize’ unilaterally if ever they declare independence from the UK. And “if the British Parliament refuses to cooperate, so much the better. Who knows: Scotland could even end up with a banking system as good as the one it had before 1845, when Parliament, which knew almost as little about currency then as it does now, began to bugger it up.” If only Scotland could enlighten the world a second time and get back to a free banking system!


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