The demand for cash and its consequences
I came across this very interesting chart on Twitter (apparently actually coming from JP Koning’s excellent blog) showing the demand for cash over time in various countries.
The demand for cash is a form of money demand. And it varies over time and across cultures and evolves as technology changes. In most countries, the demand for cash increases around times when the number of transactions increases (Christmas/New year for instance, although some countries, such as South Korea, present an interesting pattern – not sure why). But there are very wide variations across countries: notice the difference between the Brazilian and the Swedish, British or Japanese demand for cash. Countries that have implemented developed card and/or cashless/contactless payment systems usually see their domestic demand for cash decrease and banks less under pressure to convert deposits into cash.
Overall, this has interesting consequences for the financial analysis of banks, bank management, and for the required elasticity of the currency. Every time the demand for cash peaks, banks find themselves under pressure to provide currency. Loans to deposit ratios increase as deposits decrease, making the same bank’s balance sheet look (much) worse at FY-end than at any point during the rest of the year. A peaking cash demand effectively mimics the effect of a run on the banking system. Temporarily, banks’ funding structure are weakened as reserves decrease and they rely on their portfolio of liquid securities to obtain short-term cash through repos with central banks or private institutions (or, at worst, calling in or temporarily not renewing loans)*. Central bankers are aware of this phenomenon and accommodate banks’ demand for extra reserves.
In a free banking system though, banks can simply convert deposits into privately-issued banknotes without having to struggle to find a cash provider. This ability allows free banks to economise on reserves and makes the circulating private currencies fully elastic. In a 100%-reserve banking system, cash balances at banks are effectively maintained in cash (i.e. not lent out). Therefore, any increase in the demand for cash should merely reduce those cash balances without any destabilising effects on banks’ funding structure (which aren’t really banks the way we know them anyway). However, if some of this demand for cash is to be funded through debt, this can end up being painful: in a sticky prices world, as available cash balances (i.e. loanable funds not yet lent out) temporarily fall while short-term demand for credit jump, interest rates could possibly reach punitive levels, with potentially negative economic consequences (i.e. fewer commercial transactions).
However, technological innovations can improve the efficiency of payment systems and lower the demand for cash in all those cases. Banks of course benefit from any payment technology that bypass cash withdrawals, alleviating pressure on their liquidity and hence on their profitability. Unfortunately not all countries seem willing to adopt new payment methods. The cases of France and the UK are striking. Despite similar economic structures and population, whereas the UK is adopting contactless and innovative payment solutions at a record pace, the French look much more reluctant to do so.
As the chart above did not include France, I downloaded the relevant data in order to compare the evolution and fluctuations of cash demand over the same period of time vs. the UK. Unsurprisingly, the demand for cash has grown much more in France than in the UK and fluctuations of the same magnitude have remained, despite the availability of internet and mobile transfers as well as contactless payments, which all have appeared over the last 15 years**. What this shows is that the demand for cash had a strong cultural component.
*Outright securities sale can also occur but if all banks engage in the sale of the same securities at the exact same time, prices crashes and losses are made in order to generate some cash.
** I have to admit that the cash demand growth for the UK looks surprisingly steady (apart from a small bump at the height of the crisis) with effectively no seasonal fluctuations.
Negative interest rates and free banking
Is the universe about to make a switch to antimatter? Interest rates in negative territory is the new normal. Among regions that introduced negative rates, most have only put them in place on deposit at the central bank (like the -0.2% at the ECB for instance). Sweden’s Riksbank is innovating with both deposit and repo rates in negative territory. It now both has to pay banks that borrow from it overnight and… charge commercial banks that deposit money with it, like a mirror image of the world we used to know. However, like antimatter and matter and the so-called CP violation (which describes why antimatter has pretty much disappeared from the universe), positive rates used to dominate the world. Until today.
Many of those monetary policy decisions seem to be taken in a vacuum: nobody seems to care that the banking regulation boom is not fully conductive to making the banking channel of monetary policy work (and bankers are attempting to point it out, but to no avail). In some countries, those decisions also seem to be based on the now heavily-criticised inflation target, as CPI inflation is low and central bankers try to avoid (whatever sort of) deflation like the plague.
As I described last year with German banks, negative rates have….negative effects on banks: it further amplifies the margin compression that banks already experience when interest rates are low by adding to their cost base, and destabilise banks’ funding structure by providing depositors a reason to withdraw, or transfer, their deposits. Some banks are now trying to charge some of their largest, or wealthiest, customers to offset that cost. At the end of the day, negative rates seem to slightly tighten monetary policy, as the central bank effectively removes cash from the system.
It is why I was delighted to read the below paragraphs in the Economist last week, a point that I have made numerous times (and also a point that many economists seem not to understand):
In fact, the downward march of nominal rates may actually impede lending. Some financial institutions must pay a fixed rate of interest on their liabilities even as the return on their assets shrivels. The Bank of England has expressed concerns about the effect of low interest rates on building societies, a type of mutually owned bank that is especially dependent on deposits. That makes it hard to reduce deposit rates below zero. But they have assets, like mortgages, with interest payments contractually linked to the central bank’s policy rate. Money-market funds, which invest in short-term debt, face similar problems, since they operate under rules that make it difficult to pay negative returns to investors. Weakened financial institutions, in turn, are not good at stoking economic growth.
Other worries are more practical. Some Danish financial firms have discovered that their computer systems literally cannot cope with negative rates, and have had to be reprogrammed. The tax code also assumes that rates are always positive.
In theory, most banks could weather negative rates by passing the costs on to their customers in some way. But in a competitive market, increasing fees is tricky. Danske Bank, Denmark’s biggest, is only charging negative rates to a small fraction of its biggest business clients. For the most part Danish banks seem to have decided to absorb the cost.
Small wonder, then, that negative rates do not seem to have achieved much. The outstanding stock of loans to non-financial companies in the euro zone fell by 0.5% in the six months after the ECB imposed negative rates. In Denmark, too, both the stock of loans and the average interest rate is little changed, according to data from Nordea, a bank. The only consolation is that the charges central banks levy on reserves are still relatively modest: by one estimate, Denmark’s negative rates, which were first imposed in 2012, have cost banks just 0.005% of their assets.
Additionally, a number of sovereign, and even corporate, bonds yields have fallen (sometimes just briefly) into negative territory, alarming many financial commentators and investors. The causes are unclear, but my guess is that what we are seeing is the combination of unconventional monetary policies (QE and negative rates) and artificially boosted demand due to banking regulation (and there is now some evidence for this view as Bloomberg reports that US banks now hoard $2Tr of low-risk bonds). Some others report that supply is also likely to shrink over the next few years, amplifying the movement. There are a few reasons why investors could still invest in such negative-yielding bonds however.
As Gavyn Davies points out, we are now more in unknown than in negative territory. Nobody really knows how low rates can drop and what happens as monetary policy (and, I should add, regulation) pushes the boundaries of economic theory. At what point, and when, will economic actors start reacting by inventing innovative low-cost ways to store cash? The convenience yield of holding cash in a bank account seems to be lower than previously estimated, although it is for now hard to precisely estimate it as only a tiny share of the population and corporations is subject to negative rates (banks absorb the rest of the cost). The real test for negative rates will occur once everyone is affected.
Free markets though can’t be held responsible for what we are witnessing today. As George Selgin rightly wrote in his post ‘We are all free banking theories now’, what we currently experience and the options we could possibly pick have to measure up against what would happen in a free banking framework.
Coincidentally, a while ago, JP Koning wrote a post attempting to describe how a free banking system could adapt to a negative interest rates environment. He argued that commercial banks faced with negative lending rates would have a few options to deal with the zero lower bound on deposit rates. He came up with three potential strategies (I’ll let you read his post for further details): remove cash from circulation by implementing ‘call’ features, cease conversion into base money, and penalize cash by imposing through various possible means what is effectively a negative interest rate on cash. I believe that, while his strategies sound possible in theory, it remains to be seen how easy they are to implement in practice, for the very reason that the Economist explains above: competitive forces.
But, more fundamentally, I think his assumptions are the main issue here. First, the historical track record seems to demonstrate that free banking systems are more stable and dampen economic and financial fluctuations. Consequently, a massive economic downturn would be unlikely to occur, possibly unless caused by a massive negative supply shock. Even then, the results in such economic system could be short-term inflation, maintaining nominal (if not real) interest rates in positive territory.
Second (and let’s leave my previous point aside), why would free banks lend at negative rates in the first place? This doesn’t seem to have ever happened in history (and surely pre-industrial rates of economic growth were not higher than they are now, i.e. ‘secular stagnation’) and runs counter to a number of theories of the rate of interest (time preference, liquidity preference, marginal productivity of capital, and their combinations). JPK’s (and many others’) reasoning that depositors wouldn’t accept to hold negative-yielding deposits for very long similarly applies to commercial banks’ lending.
Why would a bank drop its lending rate below zero? In the unrealistic case of a bank that does not have a legacy loan book, bankers would be faced by two options: lend the money at negative rates, during an economic crisis with all its associated heightened credit and liquidity risk, or keep all this zero-yielding cash on its balance sheet and make a loss equivalent to its operating costs. If a free bank is uncertain to be able to lower deposit rates below lending rates, better hold cash, make a loss for a little while, the time the economic crisis passes, and then increase rates again. This also makes sense in terms of competitive landscape. A bank that, unlike its competitors, decides to take a short-term loss without penalising the holders of its liabilities is likely to gain market shares in the bank notes (and deposits) market.
Now, in reality, banks do have a legacy loan book (i.e. ‘back book’) before the crisis strike, a share of which being denominated at fixed, positive, nominal interest rates. Unless all customers default, those loans will naturally shield the bank from having to take measures to lower lending rates. The bank could merely sit on its back book, generating positive interest income, and not reinvest the cash it gets from loan repayments. Profits would be low, if not negative, but it’s not the end of the world and would allow banks to support their brand and market share for the longer run*.
Finally, the very idea that lending rates (on new lending, i.e. ‘front book’) could be negative doesn’t seem to make sense. Even if we accept that the risk-free natural rate of interest could turn negative, once all customer-relevant premia are added (credit and liquidity**), the effective risk-adjusted lending rate is likely to be above the zero bound anyway. As the economic crisis strikes, commercial banks will naturally tend to increase those premia for all customers, even the least risky ones. Consequently, a bank that lent to a low-risk customer at 2% before the crisis, could well still lend to this same customer at 2% during the crisis (if not higher), despite the (supposed) fall of the risk-free natural rate.
I conclude that it is unlikely that a free banking system would ever have to push lending (or even deposit) rates in negative territories, and that this voodoo economics remains a creature of our central banking system.
*Refinancing remains an option for borrowers though. However, in crisis times, it’s likely that only the most creditworthy borrowers would be likely to refinance at reasonable rates (which, as described above, could indeed remain above zero)
**Remember this interest rate equation that I introduced in a very recent post:
Market rate = RFR + Inflation Premium + Credit Risk Premium + Liquidity Premium
Photo: MIT
Santa bank notes
A curious short post was published on the NY Fed’s Liberty Street Economics blog. Apparently, during the so-called ‘free banking’ era, some US banks printed Santa bank notes:
During the unregulated 19th century, a variety of banks issued their own holiday-themed currency. One popular figure featured on many bills was Santa Claus. Christmas was declared an official holiday in many northern states in the mid-1800s, and some banks celebrated by creating Santa Claus currency. This was a very popular time for Santa in the United States, spurred on by the publication of “A Visit from St. Nicholas” by Clement Clarke Moore in 1823.
The Santa Claus bank notes became very popular as keepsakes, because denominations were typically small and the subject was at the forefront of peoples’ minds given the brand-new official holiday. One motivation for the banks to release these and other collectible currencies was to dissuade people from redeeming the bills for their underlying gold value.
(on a side note: the “unregulated 19th century”? ahem…)
Here is an example of one of those private Santa notes:
Merry Christmas!
The Great Depression and the money multiplier
The money multiplier has collapsed following the introduction of new reserves as central banks engaged in quantitative easing. This has led many economic commentators to declare that the money multiplier did not exist.
While I have several times said that this wasn’t that straightforward, I stumbled upon a post by Mark Sadowski, on Marcus Nunes’ blog, which includes a very interesting graph of the M2 money multiplier (blue line below) from 1925 to 1970 (I have no idea how he obtained this dataset as I can’t seem to be able to go further back than 1959 on the FRED website).
The multiplier collapsed from 7 in 1930 to a low 2.5 in 1940 and banks that had not disappeared had plenty of excess reserves, which they maintained for a number of reasons (precautionary, lack of demand for lending, low interest rates, Hoover/FDR policies…). This situation looks very similar to what happened during our recent crisis. However, what’s interesting is that the multiplier did eventually increase. In 1970, 30 years after reaching the bottom, the multiplier was back at around 6, meaning a large increase in the money stock. This is what most people miss: it doesn’t just take a few years for new reserves to affect lending; it can take decades.
Unless the Fed takes specific actions to remove (or prevent the use of) current excess reserves, the money multiplier could well get back to its historical level within the next few decades.
The rather curious and awkward alliance between statists and libertarians against free banking
Free banking has a very bad reputation within mainstream economics. As free banking scholars such as George Selgin, Larry White, Kevin Dowd or Steve Horwitz have been demonstrating over the past 30 years, this is mostly due to a misunderstanding of history. The track record of the systems that were as close as possible to free banking is crystal clear however: free banking episodes were more stable than any alternative banking frameworks.
However, this doesn’t seem to please many, from both sides of the political spectrum. Izabella Kaminska, a long-time libertarian critic from FT Alphaville, wrote a piece on the Alphaville blog partly criticizing non-central banking-based banking systems. In two separate replies (here and here), George Selgin highlighted all the self-serving ‘inaccuracies’ of her post (this is a euphemism). He also wrote a rebuttal in a follow-up post. Izabella skipped the interesting bits, accused Selgin of ad hominem, and wrote in turn another unsourced name-calling post on her own private blog. So much for the academic debate.
Perhaps more surprisingly, David Howden just posted a curious article on the Mises Institute website, which described the Fed as arising from “fractional-reserve free banks”. I say surprisingly, because Howden and the Mises Institute are at the other end of the political spectrum: libertarians, and often anarcho-capitalists. Nevertheless, he seemed to agree with Izabella Kaminska to an extent.
Unfortunately, Howden and Kaminska make the same mistake: they misread history, and/or focus far too much on US banking history. First, Howden claims that:
The year 1857 is a somewhat strange one for these clearinghouse certificates to make their first appearance. It was, after all, a full twenty years into America’s experiment with fractional-reserve free banking. This banking system was able to function stably, especially compared to more regulated periods or central banking regimes. However, the dislocation between deposit and lending activities set in motion a credit-fuelled boom that culminated in the Panic of 1857.
This could not be more inaccurate. The so-called ‘US free banking era’ had nothing much to do with free banking. And the credit boom and crises that follow were unrelated to either free banking or fractional reserves (see here for details, as well as below). I’d like Howden to explain why other fractional reserve free banking systems did not experience such recurring crises…
I have been left bewildered by Howden’s claim that privately-created clearinghouses were ‘illegal’ entities involved in ‘illegal’ activities (i.e. issuing clearinghouse certificates to get bank runs under control). Not only does this ironically sound like contradicting laissez-faire principles, but his whole argument rests on a lacking understanding of 19th century US banking.
What Howden got wrong is that, if American banks had such recurring liquidity issues before the creation of the Fed, it wasn’t due to their fractional reserve nature, but to the rule requiring them to back their note issues with government debt, thereby limiting the elasticity of those issues and the ability of banks to respond to fluctuations in the demand for money. Laws preventing cross-state branching also weakened banks as their ability to diversify was inherently limited. Banks viewed local clearinghouses as a way to make the system more resilient. It was a free-market answer to a state-created problem. This does not mean that the system was perfect of course. But Howden the libertarian blames a free-market solution here, and completely ignores the laws that originally created the problem.
Moreover, clearinghouses weren’t only a characteristic of the 19th century US banking system. They were present in several major free banking systems throughout history and set up by private parties (Scotland being a prime example). Their original goal wasn’t to create ‘illegal money claims’, but to help settle large volume of interbank transactions and economise on reserves: they were a necessary part of a well-functioning privately-owned free banking system. US clearinghouse certificates were merely a private solution to tame state-created liquidity crises. Those solutions were not perfect, but Howden is guilty of shooting the messenger here.
Clearinghouse-equivalents still exist today: the German savings and cooperative banks, as well as the Austrian Raiffeisen operate under the same sort of model, in which multiple tiny institutions park their reserves at their local central bank/clearinghouse. Finally, it is necessary to point out that clearinghouse would also surely exist in a full reserve banking system and would have the same basic goal: settle interbank payments.
Why a libertarian such as Howden would be against this natural laissez-faire process is beyond me. My guess is that at the end of the day, it all goes down to the fractional/full reserve banking debate within the libertarian space. Howden is trying at all costs to justify his views that full reserve banking would be more stable. But this time, such rhetoric is counter-productive and only demonstrates Howden’s ignorance of the issue (at least as described in this article). Using the fractional reserve argument to explain the 19th century US crises is self-serving and wholly inappropriate. Blaming a free-market reaction (i.e. the clearinghouse system) to such crises for the creation of the Fed completely misses the point. By doing so, and cherry-picking facts, Howden helps Kaminska’s arguments (despite fundamentally disagreeing with her) and shoots himself in the foot.
Update: I mistakenly thought that Peter Klein had written the article as his profile appeared on it. I should have paid more attention, but David Howden was the author. I have updated the post and apologised to Peter.
Update 2: I only just found out that David Glasner and Scott Sumner also wrote two good posts on free banking and Iza Kaminska/Selgin, followed by very interesting comments (here and here).
Photo: Marvel
How short is the economics profession’s memory?
Although prices were not perfectly steady, it is true, they were relatively stable for a period of time longer than any prior period involving comparable conditions. Yet depression ensued, in the face of what the advocates of the older form of monetary theory of the business cycle regarded as the sine qua non of freedom from depression.
It follows particularly from the point of view of the monetary theory of the trade cycle, that it is by no means justifiable to expect the total disappearance of cyclical fluctuations to accompany a stable price-level.
Where do these quotes come from? From any recent critic of inflation targeting, such as David Beckworth, referring to our latest crisis (which followed around two decades of inflation targeting by central banks)?
No. The first one is a 1937 quote from Chester Arthur Phillips, in his Banking and the Business Cycle. The second one is from F.A. Hayek, in his 1933 Monetary Theory and the Trade Cycle. I am sure it is possible to find tons of similar quotes from the pre-WW2 era.
In his book, Phillips has a sub-chapter called ‘Policy of Stabilization of Price Level Tends Towards its Own Collapse’, which is worth quoting here:
The endeavor has been to show that stabilization of the wholesale price level, or of any one price index, is not a proper objective of banking policy of credit control, because aberrations continue to occur in the case of particular types of prices when any one index is sought to be stabilized. […]
Stability of the price level is no adequate safeguard against depression, it is contended, because any policy aimed at stabilizing a single index is bound to set up countervailing influences elsewhere in the economic system. Although the policy of stabilization may appear to be successful for a time, eventually it will break down, because there is no way of insuring that the agencies of control will be able to make their influence at precisely those “points” of strategic importance. As long as economic progress is maintained, resulting in increasing productivity and an expanding total output, there will be an ever-present force working for lower prices. Any amount of credit expansion which will offset that force will find outlets unevenly in sundry compartments of the economic structure; the new credit will have an effect upon the market rate of interest, upon the prices of capital goods, upon real estate, upon security prices, upon wages, or upon all of these, as happened during the late boom. A policy which seeks to direct credit influences at any single index, whether it be of prices, either wholesale or retail, or production, or incomes, in the interest of stabilization, will result in unexpected and unforeseen repercussions which may be expected to prove disastrous in the long run.
What about the following one?
During recent years a number of pseudo-economists have indulged in much glibness about the passing of the “economy of scarcity” and the arrival of the “economy of abundance.” Sophistry of this sort has claimed the public ear far too long; it is high time that the speciousness of such fantastic views be clearly and definitely exposed.
An angry economist about some FT Alphaville blogger? No. Phillips again, in the same 1937 book.
George Selgin posted an old Keynes’ quote two days ago, which may be relevant for some of today’s theorists. Backhouse and Laidler also published a very good paper describing everything that has been ‘lost’ with the IS-LM framework following the post-war Keynesian revolution.
It is slightly scary to see that economics tends to easily forget more ‘ancient’ theories in favour of recent and trendy ones. The same is true regarding banking history: listening to most policymakers makes it clear that past experiences and knowledge have mostly been lost. With such short memories, it is unsurprising that crises occur.
PS: On a side note, George Soros completely misunderstands Hayek. I cannot even believe he could write this article. No, Hayek wasn’t a member of the Chicago School. No, Hayek never believed in the efficient market hypothesis (Hayek didn’t believe in rational expectations). No, Hayek didn’t believe in equilibrium economics but in dynamic frameworks that completely include uncertainty and perpetually fluctuating conditions and agents’ expectations, as well as entrepreneurial experiments (including failures, which are indeed healthy). So… basically the exact opposite of what Soros claims Hayek believed in.
Martin Wolf’s not so shocking shocks
Martin Wolf, FT’s chief economist, recently published a new book, The Shifts and the Shocks. The book reads like a massive Financial Times article. The style is quite ‘heavy’ and not always easy to read: Wolf throws at us numbers and numbers within sentences rather than displaying them in tables. This format is more adapted to newspaper articles.
Overall, it’s typical Martin Wolf, and FT readers surely already know most of the content of the book. I won’t come back to his economic policy advices here, as I wish to focus on a topic more adapted to my blog: his views on banking.
And unfortunately his arguments in this area are rather poor. And poorly researched.
Wolf is a fervent admirer of Hyman Minsky. As a result, he believes that the financial system is inherently unstable and that financial imbalances are endogenously generated. In Minsky’s opinion, crises happen. It’s just the way it is. There is no underlying factor/trigger. This belief is both cynical and wrong, as proved by the stability of both the numerous periods of free banking throughout history (see the track record here) and of the least regulated modern banking systems (which don’t even have lenders of last resort or deposit insurance). But it doesn’t fit Wolf’s story so let’s just forget about it: banking systems are unstable; it’s just the way it is.
Wolf identifies several points that led to the 2000s banking failure. In particular, liberalisation stands out (as you would have guessed) as the main culprit. According to him “by the 1980s and 1990s, a veritable bonfire of regulations was under way, along with a general culture of laissez-faire.” What’s interesting is that Wolf never ever bothers actually providing any evidence of his claims throughout the book (which is surprising given the number of figures included in the 350+ pages). What/how many regulations were scrapped and where? He merely repeats the convenient myth that the banking system was liberalised since the 1980s. We know this is wrong as, while high profile and almost useless rules like Glass-Steagall or the prohibition of interest payment on demand deposits were repealed in the US, the whole banking sector has been re-regulated since Basel 1 by numerous much more subtle and insidious rules, which now govern most banking activities. On a net basis, banking has been more regulated since the 1980s. But it doesn’t fit Wolf’s story so let’s just forget about it: banking systems were liberalised; it’s just the way it is.
Financial innovation was also to blame. Nevermind that those innovations, among them shadow banking, mostly arose from or grew because of Basel incentives. Basel rules provided lower risk-weight on securitized products, helping banks improve their return on regulatory capital. But it doesn’t fit Wolf’s story so let’s just forget about it: greedy bankers always come up with innovations; it’s just the way it is.
The worst is: Wolf does come close to understanding the issue. He rightly blames Basel risk-weights for underweighting sovereign debt. He also rightly blames banks’ risk management models (which are based on Basel guidance and validated by regulators). Still, he never makes the link between real estate booms throughout the world and low RE lending/RE securitized risk-weights (and US housing agencies)*. Housing booms happened as a consequence of inequality and savings gluts; it’s just the way it is.
All this leads Wolf to attack the new classical assumptions of efficient (and self-correcting) markets and rational expectations. While he may have a point, the reasoning that led to this conclusion couldn’t be further from the truth: markets have never been free in the pre-crisis era. Rational expectations indeed deserve to be questioned, but in no way does this cast doubt on the free market dynamic price-researching process. He also rightly criticises inflation targeting, but his remedy, higher inflation targets and government deficits financed through money printing, entirely miss the point.
What are Wolf other solutions? He first discusses alternative economic theoretical frameworks. He discusses the view of Austrians and agrees with them about banking but dismisses them outright as ‘liquidationists’ (the usual straw man argument being something like ‘look what happened when Hoover’s Treasury Secretary Mellon recommended liquidations during the Depression: a catastrophe’; sorry Martin, but Hoover never implemented Mellon’s measures…). He also only relies on a certain Rothbardian view of the Austrian tradition and quotes Jesus Huerta de Soto. It would have been interesting to discuss other Austrian schools of thought and writers, such as Selgin, White and Horwitz, who have an entirely different perception of what to do during a crisis. But he probably has never heard of them. He once again completely misunderstands Austrian arguments when he wonders how business people could so easily be misled by wrong monetary policy (and he, incredibly, believes this questions the very Austrian belief in laissez-faire), and when he cannot see that Austrians’ goals is to prevent the boom phase of the cycle, not ‘liquidate’ once the bust strikes…
Unsurprisingly, post-Keynesian Minsky is his school of choice. But he also partly endorses Modern Monetary Theory, and in particular its banking view:
banks do not lend out their reserves at the central bank. Banks create loans on their own, as already explained above. They do not need reserves to do so and, indeed, in most periods, their holdings of reserves are negligible.
I have already written at length why this view (the ‘endogenous money’ theory) is inaccurate (see here, here, here, here and here).
He then takes on finance and banking reform. He doubts of the effectiveness of Basel 3 (which he judges ‘astonishingly complex’) and macro-prudential measures, and I won’t disagree with him. But what he proposes is unclear. He seems to endorse a form of 100% reserve banking (the so-called Chicago Plan). As I have written on this blog before, I am really unsure that such form of banking, which cannot respond to fluctuations in the demand for money and potentially create monetary disequilibrium, would work well. Alternatively, he suggests almost getting rid of risk-weighted assets and hybrid capital instruments (he doesn’t understand their use… shareholder dilution anyone?) and force banks to build thicker equity buffers and report a simple leverage ratio. He dismisses the fact that higher capital requirements would impact economic activity by saying:
Nobody knows whether higher equity would mean a (or even any) significant loss of economic opportunities, though lobbyists for banks suggest that much higher equity ratios would mean the end of our economy. This is widely exaggerated. After all, banks are for the most part not funding new business activities, but rather the purchase of existing assets. The economic value of that is open to question.
Apart from the fact that he exaggerates banking lobbyists’ claims to in turn accuse them of… exaggerating, he here again demonstrates his ignorance of banking history. Before Basel rules, banks’ lending flows were mostly oriented towards productive commercial activities (strikingly, real estate lending only represented 3 to 8% of US banks’ balance sheets before the Great Depression). ‘Unproductive’ real estate lending only took over after the Basel ruleset was passed.
The case for higher capital requirements is not very convincing and primarily depends on the way rules are enforced. Moreover, there is too much focus on ‘equity’. Wolf got part of his inspiration from Admati and Hellwig’s book, The Bankers’ New Clothes. But after a rather awkward exchange I had with Admati on Twitter, I question their actual understanding of bank accounting:
While his discussion of the Eurozone problems is quite interesting, his description of the Eurozone crisis still partly rests on false assumptions about the banking system. Unfortunately, it is sad to see that an experienced economist such as Martin Wolf can write a whole book attacking a straw man.
* In a rather comical moment, Wolf finds ‘unconvincing’ that US government housing policy could seriously inflate a housing bubble. To justify his opinion, he quotes three US Republican politicians who said that this view “largely ignores the credit bubble beyond housing. Credit spreads declined not just for housing, but also for other asset classes like commercial real estate.” Let’s just not tell them that ‘Real Estate’ comprises both residential housing and CRE…
New research confirms the role of regulation and housing in modern business cycles
I think readers will find it hard to imagine how excited I was yesterday when I discovered (through an Amir Sufi piece in the FT) a brand new piece of research called: The Great Mortgaging: Housing Finance, Crises, and Business Cycles
(The authors, Jordà, Schularick and Taylor (JST), also published a free version here, and a summary on VOX)
I wish the authors had read my blog before writing their paper as it confirms many of my theses (unless they had?). It’s so interesting that I could almost quote two thirds of the paper here. I obviously encourage you to read it all and I will selectively copy and paste a few pieces below.
In my recent piece on updating the Austrian business cycle theory (ABCT), I pointed out that the nature of lending (and banks’ balance sheets) had changed over time since the 19th century (and particularly post-WW2), mainly due to banking regulation and government schemes. I had already provided a revealing post-WW2 chart for the US to demonstrate the effects of Basel 1 on business and real estate lending volumes.
JST went further. They went further back in time and gathered a dataset of disaggregated lending figures covering 17 developed countries over close to 140 years. Their conclusions confirm my views. Regulations – and in particular Basel – changed everything.
Here is their aggregate credit to GDP chart across all covered countries, to which I added the introduction of Basel 1 as well as pre-Basel trends:
I don’t think there is anything clearer than this chart (I’m not sure that securitized mortgages are included, in which case those figures are understated). Since the 1870s, non-mortgage lending had been the main vector of credit and money supply growth, and mortgage lending represented a relatively modest share of banks’ balance sheet. Basel turned this logic upside-down. How? I have already described the process countless times (risk-weights and capital regulation), so let see what JST say about it:
Over a period of 140 years the level of non-mortgage lending to GDP has risen by a factor of about 3, while mortgage lending to GDP has risen by a factor of 8, with a big surge in the last 40 years. Virtually the entire increase in the bank lending to GDP ratios in our sample of 17 advanced economies has been driven by the rapid rise in mortgage lending relative to output since the 1970s. […]
In addition to country-specific housing policies, international banking regulation also contributed to the growing attractiveness of mortgage lending from the perspective of the banks. The Basel Committee on Bank Supervision (BCBS) was founded in 1974 in reaction to the collapse of Herstatt Bank in Germany. The Committee served as a forum to discuss international harmonization of international banking regulation. Its work led to the 1988 Basle Accord (Basel I) that introduced minimum capital requirements and, importantly, different risk weights for assets on banks’ balance sheets. Loans secured by mortgages on residential properties only carried half the risk weight of loans to companies. This provided another incentive for banks to expand their mortgage business which could be run with higher leverage. As Figure 1 shows, a significant share of the global growth of mortgage lending occurred in recent years following the first Basel Accord.
I wish they had expanded on this topic and made the logical next step: Basel helped set up the largest financial crisis in our lifetime through regulatory arbitrage. Nevertheless, the implications are crystal clear.
To JST, this growth in real estate lending is the reason underlying our most recent financial crises:
We document the rising share of real estate lending (i.e., bank loans secured against real estate) in total bank credit and the declining share of unsecured credit to businesses and households. We also document long-run sectoral trends in lending to companies and households (albeit for a somewhat shorter time span), which suggest that the growth of finance has been closely linked to an explosion of mortgage lending to households in the last quarter of the 20th century. […]
Since WWII, it is only the aftermaths of mortgage booms that are marked by deeper recessions and slower recoveries. This is true both in normal cycles and those associated with financial crises. […]
The type of credit does seem to matter, and we find evidence that the changing nature of financial intermediation has shifted the locus of crisis risks increasingly toward real estate lending cycles. Whereas in the pre-WWII period mortgage lending is not statistically significant, either individually or when used jointly with unsecured credit, it becomes highly significant as a crisis predictor in the post-WWII period.
JST confirm what I was describing in my post on updating the ABCT: that is, that banks don’t play the same role as in early 20th century, when the theory was first outlined:
The intermediation of household savings for productive investment in the business sector—the standard textbook role of the financial sector—constitutes only a minor share of the business of banking today, even though it was a central part of that business in the 19th and early 20th centuries.
JST describe the post-WW2 changes in mortgage lending originally as a result of government schemes to favour home building and ownership, followed by international regulatory arrangements (Basel) from the 1980s onward. Those measures and rules led to a massive restructuring of banks’ balance sheet, as demonstrated by this chart:
While the empirical findings of this paper will be of no surprise to readers of this blog, this research paper deserves praise: its data gathering and empirical analysis are simply brilliant, and it at last offers us the opportunity to make other mainstream academics and regulators aware of the damages their ideas and policies have made to our economy over the past decades. It also puts the idea of ‘secular stagnation’ into perspective: our societies are condemned to stagnate if regulatory arbitrage starve our productive businesses of funds and the only way to generate wealth is through housing bubbles.
Why the Austrian business cycle theory needs an update
I have been thinking about this topic for a little while, even though it might be controversial in some circles. By providing me with a recent paper empirically testing the ABCT, Ben Southwood, from ASI, unconsciously forced my hand.
I really do believe that a lot more work must be done on the ABCT to convince the broader public of its validity. This does not necessarily mean proving it empirically, which is always going to be hard given the lack of appropriate disaggregated data and the difficulty of disentangling other variables.
However, what it does mean is that the theoretical foundations of the ABCT must be complemented. The ABCT is an old theory, originally devised by Mises a century ago and to which Hayek provided a major update around two decades later. The ABCT explains how an ‘unnatural’ expansion of credit (and hence the money supply) by the banking system brings about unsustainable distortions in the intertemporal structure of production by lowering the interest rate below its Wicksellian natural level. As a result, the theory is fully reliant on the mechanics of the banking sector.
The theory is fundamentally sound, but its current narrative describes what would happen in a relatively free market with a relatively free banking system. At the time of Mises and Hayek, the banking system indeed was subject to much lighter regulations than it is now and operated differently: banks’ primary credit channel was commercial loans to corporations. The Mises/Hayek narrative of the ABCT perfectly illustrates what happens to the economy in such circumstances. Following WW2, the channel changed: initiative to encourage home building and ownership resulted in banks’ lending approximately split between retail/mortgage lending and commercial lending. Over time, retail lending developed further to include an increasingly larger share of consumer and credit card loans.
Then came Basel. When Basel 1 banking regulations were passed in 1988, lending channels completely changed (see the chart below, which I have now used several times given its significance). Basel encouraged banks’ real estate lending activities and discouraged banks’ commercial lending ones. This has obvious impacts on the flow of loanable funds and on the interest rate charged to various types of customers.
In the meantime, banking regulations have multiplied, affecting almost all sort of banking activities, sometimes fundamentally altering banks’ behaviour. Yet the ABCT narrative has roughly remained the same. Some economists, such as Garrison, have come up with extra details on the traditional ABCT story. Others, such as Horwitz, have mixed the ABCT with Yeager’s monetary disequilibrium theory (which is rejected by some other Austrian economists).
While those pieces of academic work, which make the ABCT a more comprehensive theory, are welcome, I argue here that this is not enough, and that, if the ABCT is to convince outside of Austrian circles, it also needs more practical, down to Earth-type descriptions. Indeed, what happens to the distortions in the structures of production when lending channels are influenced by regulations? This requires one to get their hands dirty in order to tweak the original narrative of the theory to apply it to temporary conditions. Yet this is necessary.
Take the paper mentioned at the beginning of this post. The authors find “little empirical support for the Austrian business cycle theory.” The paper is interesting but misguided and doesn’t disprove anything. Putting aside its other weaknesses (see a critique at the bottom of this post*), the paper observes changes in prices and industrial production following changes in the differential between the market rate of interest and their estimate of the natural rate. The authors find no statistically significant relationship.
Wait a minute. What did we just describe above? That lending channels had been altered by regulation and political incentives over the past decades. What data does the paper rely on? 1972 to 2011 aggregate data. As a result, the paper applies the wrong ABCT narrative to its dataset. Given that lending to corporations has been depressed since the introduction of Basel, it is evident that widening Wicksellian differentials won’t affect industrial structures of production that much. Since regulation favour a mortgage channel of credit and money creation, this is where they should have looked.
But if they did use the traditional ABCT narrative, it is because no real alternative was available. I have tried to introduce an RWA-based ABCT to account for the effects of regulatory capital regulation on the economy. My approach might be flawed or incomplete, but I think it goes in the right direction. Now that the ABCT benefits from a solid story in a mostly unhampered market, one of the current challenges for Austrian academics is to tweak it to account for temporary regulatory-incentivised banking behaviour, from capital and liquidity regulations to collateral rules. This is dirty work. But imperative.
Major update here: new research seems to confirm much of what I’ve been saying about RWAs and the changing nature of financial intermediation.
* I have already described above the issue with the traditional description of the ABCT in this paper, as well as the dataset used. But there are other mistakes (which also concern the paper they rely on, available here):
– It still uses aggregate prices and production data (albeit more granular): the ABCT talks about malinvestments, not necessarily of overinvestment. The (traditional) ABCT does not imply a general increase in demand across all sectors and products. Meaning some lines of production could see demand surge whereas other could see demand fall. Those movements can offset each other and are not necessarily reflected in the data used by this study.
– It seems to consider that aggregate price increases are a necessary feature of the ABCT. But inflation can be hidden. The ABCT relies on changes in relative prices. Moreover, as the structure of production becomes more productive, price per unit should fall, not increase.
Free banking: the track record
Sam Bowman, from the Adam Smith Institute, just published a very good paper arguing that, in case it decides to declare its independence, Scotland should ‘sterlingise’ and recreate a free banking system similar to the one it used to have in the 18th and 19th century. This report has been featured in many newspapers today (BBC, City AM, The Scotsman, The Guardian, The Wall Street Journal, The Huffington Post, The Telegraph…). Whether or not the current socialist-minded Scottish government is likely to implement such radical liberalisation of its banking system is another issue…
In this report, Sam Bowman also reproduces two very important tables (originally from George Selgin’s article Are banking crises free markets phenomena) highlighting the track record of free (or mostly free) and regulated banking from the late 18th till the early 20th century. Guess which type of banking system was more stable…
‘Unfree’/regulated banking:
Free/lightly regulated banking:
Spontaneous Finance 
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