Theoretical economic worlds are so nice. Only equations and equilibria, and no need to bother about empirical evidences or simply historical facts: you design your nice imaginary world and you reach conclusions from it. Conclusions that have the potential to influence policymaking or economic teaching.
A new paper produced by a Philly Fed economist illustrates exactly that (see one of its nice systems of equations above). The paper is titled On the inherent instability of private money. Here is the abstract (my emphasis):
A primary concern in monetary economics is whether a purely private monetary regime is consistent with macroeconomic stability. I show that a competitive regime is inherently unstable due to the properties of endogenously determined limits on private money creation. Precisely, there is a continuum of equilibria characterized by a self-fulfilling collapse of the value of private money and a persistent decline in the demand for money. I associate these equilibrium allocations with self-fulfilling banking crises. It is possible to formulate a fiscal intervention that results in the global determinacy of equilibrium, with the property that the value of private money remains stable. Thus, the goal of monetary stability necessarily requires some form of government intervention.
That’s it. He just validated the existence of central banking. No need to go any further, the mathematics just demonstrated it: private currencies are unstable and we need government intervention for the better good.
What’s interesting though is that this paper does not contain a single reference to the now relatively large free banking literature of the likes of White, Selgin, Horwitz, Dowd, Salter, Sechrest, Cachanosky… Which, you’d admit, is curious for a paper discussing precisely that topic. Perhaps this would have helped him avoid the embarrassment of discovering that historical reality was, well, the exact opposite of the conclusions his equations reached. That in fact, private currency-based systems had been more stable than monopoly issuance-based ones (see here for the track record, but everywhere on this blog for other evidences, as well as numerous papers and books such as Selgin’s The Theory of Free Banking: Money Supply under Competitive Note Issue).
Coincidentally, George Selgin published a new post a couple of days ago criticising the current state of monetary economics which, in his opinion, rely too much on abstract maths and not enough on historical evidence. Ben Southwood also mentioned this paper, along with the fact that even ‘far from perfect’ free banking systems (i.e. the 19th century US experience) outperformed central banking ones. He also asks a very good question:
My real issue is why this evidence isn’t breaking through? Why are so many smart, knowledgeable people opposed to free banking? Why is the ruling tendency now towards practically outlawing bank/debt finance altogether in favour of steps toward equity financing everything? I don’t have a good answer.
This is also something that worries me. Why does a paper on free banking not reference (let alone discuss) a single free banking paper or book? Why is this literature avoided? Is it inconvenient? Unless ignorance is the culprit, despite the fact that quite a few articles show up after a quick Google search for the terms ‘free banking’ or ‘competitive private note issuance’. What’s wrong with the mainstream academic world?
Modeling a Free Banking economy and NGDP: a Wicksellian portfolio approach (guest post by Justin Merrill)
My friend Alex Salter and his coauthor, Andrew Young, have an interesting new paper called “Would a Free Banking System Target NGDP Growth?” that I believe was presented at a symposium on monetary policy and NGDP targeting.
I too have wondered the same question. I believe there are real reasons why a dynamic economy might not have stable NGDP. One reason is demographic changes (maybe target NGDP per capita?). Another reason is problems with GDP accounting in general such as the underground economy, changes in workforce participation of women and the vertical integration of firms. Another micro-founded effect might be the income elasticity of demand and substitution effects. But even abstracting from these problems, it is still a worthy question to ask if monetary equilibrium is synonymous with stable NGDP and its relationship to free banking. If they are synonymous, we might expect stable NGDP from free banking. In my paper on a theoretical digital currency called “Wixle” I outline a currency that automatically adjusts its supply to respond to demand by arbitraging away the liquidity premium over a specified set of securities. This is a way to ensure monetary equilibrium without regard for aggregate spending, which is particularly useful if the currency is internationally used.
A small criticism I have of my free banking and Market Monetarist friends is that they often assert that monetary equilibrium and stable NGDP are the same thing, usually by applying the equation of exchange. As useful as the equation of exchange is, it is tautologically true as an accounting identity. But just as we know from C+I+G=Y, accounting identities’ predictive powers are limited when thinking about component variables. I have argued for the conceptual disaggregation of the money supply and money demand, because the motives for holding currency and deposits are different and the classification of money is more of a spectrum. So I was pleased to see that Salter and Young did this in their paper and added the transaction demand for money into their model. This leads them to conclude that a free banking system will respond to a positive supply shock, which results in an increased transaction demand for money, by stabilizing the price level rather than NGDP. This might be true, and whether this is good or bad is another question. Would this increase in currency lead to a credit fueled boom, or is this a feature and not a bug?
I have long been upset with the way that economists overly focus on reserve ratios and net clearings from a quantity perspective. This abstracts away from the micro-foundations of the banking system and ignores the mechanics of banking. This is the point I made at the Mises Institute when I rebutted Bagus and Howden. My moment of clarity for the theory of free banking actually came from reading the works of James Tobin and Gurley & Shaw, as well as Knut Wicksell. The determination of the money supply is the public’s willingness to hold inside money, and this willingness creates the profit opportunity for the financial sector to intermediate by borrowing short and lending long. I believe the case for free banking can be made more robust by adding the portfolio approach, as well as the transactions approach. I will outline here what that would look like without sketching a formal model.
The Model is a three sector economy: households, corporations and banks. Households hold savings in the form of corporate and bank liabilities and have bank loans as liabilities. Corporations hold real capital, bank notes and deposits as assets and bank loans, stocks and bonds as liabilities. Banks hold reserves, securities and loans as assets and net borrowed reserves, notes, deposits and equity as liabilities.
Households can hold their wealth in risky securities or safe, but lower yielding interest paying deposits that pay the risk-free rate in the economy or non-interest paying notes used for transactions. The model could include interest-free checking accounts, but these are economically the same as notes in my model.
Banks can then choose to invest in loans, securities or lending reserves. They fund investments largely by borrowing at the risk-free rate and borrowing reserves at the margin. Logically then, the cost of borrowed reserves will be higher than deposits but lower than that of loans and securities and arbitraging ensures this. If the cost of reserves goes above the return on securities, banks will sell bonds to households and lend reserves to each other. If the cost of reserves goes below the rate on deposits, banks will borrow reserves and deposit with each other. The return on loans and securities (adjusted for risk) will tend towards uniformity because they are close substitutes. Also, as Wicksell pointed out, if loan rates are below the return on securities or the return on real capital, households and firms would borrow from banks and invest.
Empirical evidence for the interest rate channels is provided here. Interestingly, the rules set out above were only violated in times of monetary disequilibrium, such as the Volcker contraction:
The natural rate of interest is equal to the return on assets for corporations. Most economists that try to model the natural rate mistakenly do it as the risk free rate or the policy rate. This is a misreading of Wicksell since he identified the “market rate” as the rate which banks charge for loans, and the important thing was the difference between the market rate and the natural rate. If the market rate is too low, people will borrow from banks and invest, increasing the money supply.
We can now apply the framework to the CAPM model and conceptualize the returns on various assets:
The slope of the securities market line (SML) is determined by the risk aversion/liquidity preference of the public. Should the public become more risk averse and demand a larger share of their wealth be in the form of money, they will sell securities in favor of deposits. If in aggregate, the household sector is a net seller, the only buyers are banks (ignoring corporate buybacks since this doesn’t change the results since corporations would end up needing to finance the repurchases with bank loans). So the banking sector would purchase the securities (at a bargain price) from households, crediting their accounts and simultaneously increasing the inside money supply. This becomes more lucrative as the yield curve steepens or other kinds of risk premia widen, increasing the net interest margins (NIMs). As the banking sector responds to changes in demand it equilibrates asset prices.
This is another way of coming to the same conclusion: that a free banking system would tend to stabilize NGDP in response to endogenous demand shocks. But how about supply shocks? We know that when the spread between the banks’ return on assets and costs of funding widens, the balance sheet will increase. An increase in productivity will raise both the return on new investments and the rate the banks have pay on deposits. We can assume for now these cancel out. But the public will have a higher demand for notes, and since notes pay no interest, they are a very cheap source of funding. This lowers the average cost of funding overall. However, more gross clearings will increase the demand for reserves and their cost of borrowing relative to the yield on other assets. This would put a check on overexpansion and excess maturity transformation. The net effect on the total inside money supply is uncertain, but probably positive assuming the amount of currency held by the public is larger than borrowed reserves by banks.
Another thing to consider about supply shocks: despite the lower funding costs of increased note issuance, an increase in the natural rate of interest will decrease banks’ net interest margins because their loan book will be locked in at the old, lower rate, but the rate on deposits will have to go up. This is a counter-cyclical effect (in both directions) that may outweigh the transaction demand effect. Another possible counter-cyclical effect is the psychological liquidity preference effect that accompanies optimism associated with supply shocks. So in a strong economy individuals will be more willing to hold the market portfolio directly, which flattens the SML. Depending on the strength of these effects, it may lead to different results than Salter and Young.
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.
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.
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
Nicolas Cachanosky and I should get married (intellectually, don’t get overexcited). Some time ago, I wrote about his very interesting paper attempting to start the integration of finance and Austrian capital theories. A couple of weeks ago, I discovered another of his papers, published a year ago, but which I had completely missed (coincidentally, Ben Southwood also discovered that paper at the exact same time).
Titled Hayek’s Rule, NGDP Targeting, and the Productivity Norm: Theory and Application, this paper is an excellent summary of the policies named above and the theories underpinning them. It includes both theoretical and practical challenges to some of those theories. Cachanosky’s paper reflects pretty much exactly my views and deserved to be quoted at length.
Cachanosky defines the productivity norm as “the idea that the price level should be allowed to adjust inversely to changes in productivity. […] In other words, money supply should react to changes in money demand, not to changes in production efficiency.” Referring to the equation of exchange, he adds that “because a change in productivity is not in itself a sign of monetary disequilibrium, an increase in money supply to offset a fall in P moves the money market outside equilibrium and puts into motion an unnecessary and costly process of readjustment”, which is what current central bank policies of price level targeting do. The productivity norm allows mild secular deflation by not reacting to positive ‘real’ shocks.
He goes on to illustrate in what ways Hayek’s rule and NGDP targeting resemble and differ from the productivity norm:
There are instances where the productivity norm illuminated economists that talked about monetary policy. Two important instances are Hayek during his debate with Keynes on the Great Depression and the market monetarists in the context of the Great Recession. Both, Hayek and market monetarism are concerned with a policy that would keep monetary equilibrium and therefore macroeconomic stability. Hayek’s Rule and NGDP Targeting are the denominations that describe Hayek’s and market monetarism position respectively. Taking the presence of a central bank as a given, Hayek argues that a neutral monetary policy is one that keeps constant nominal income (MV) stable. Sumner argues instead that
“NGDP level targeting (along 5 percent trend growth rate) in the United States prior to 2008 would similarly have helped reduce the severity of the Great Recession.”
Hayek’s Rule of constant nominal income can be understood in total values or as per factor of production. In the former, Hayek’s Rule is a notable case of the productivity norm in which the quantity of factors of production is assumed to be constant. In the latter case, Hayek’s rule becomes the productivity norm. However, for NGDP Targeting to be interpreted as an application that does not deviate from the productivity norm, it should be understood as a target of total NGDP, with an assumption of a 5% increase in the factors of production. In terms of per factor of production, however, NGDP Targeting implies a deviation of 5% from equilibrium in the money market.
Cachanosky then highlights his main criticisms of NGDP targeting as a form of nominal income control, that is the distinction between NGDP as an ‘emergent order’ and NGDP as a ‘designed outcome’. He says that targeting NGDP itself rather than considering NGDP as an outcome of the market can affect the allocation of resources within the NGDP: “the injection point of an increase in money supply defines, at least in the short-run, the effects on relative prices and, as such, the inefficient reallocation of factors of production.” In short, he is referring to the so-called Cantillon effect, in which Scott Sumner does not believe. I am still wondering whether or not this effect could be sterilized (in a closed economy) simply by growing the money supply through injections of equal sums of money directly into everyone’s bank accounts.
To Cachanosky (and Salter), “NGDP level matters, but its composition matters as well.” He believes that targeting an NGDP growth level by itself confuses causes and effects: “that a sound and healthy economy yields a stable NGDP does not mean that to produce a stable NGDP necessary yields a sound and healthy economy.” He points out that the housing bubble is a signal of capital misallocation despite the fact that NGDP growth was pretty stable in pre-crisis years.
I evidently fully agree with him, and my own RWA-based ABCT also points to lending misallocation that would also occur and trigger a crisis despite aggregate lending growth remaining stable or ‘on track’ (whatever that means). I should also add that it is unclear what level of NGDP growth the central bank should target. See the following chart. I can identify many different NGDP growth ‘trends’ since the 1940s, including at least two during the ‘great moderation’. Fluctuations in the trend rate of US NGDP growth can reach several percentage points. What happens if the ‘natural’ NGDP growth changes in the matter of months whereas the central bank continues to target the previous ‘natural’ growth rate? Market monetarists could argue that the differential would remain small, leading to only minor distortions. Possibly, but I am not fully convinced. I also have other objections to NGDP level targeting (related to banking and transmission mechanism), but this post isn’t the right one to elaborate on this (don’t forget that I view NGDP targeting as a better monetary policy than inflation targeting but a ‘less ideal’ alternative to free banking or the productivity norm).
Cachanosky also points out that NGDP targeting policies using total output (Py in the equation of exchange) and total transactions (PT) do not lead to the same result. According to him “the housing bubble before 2008 crisis is an exemplary symptom os this problem, where PT increases faster than Py.”
Finally, he reminds us that a 100%-reserve banking system would suffer from an inelastic money supply that could not adequately accommodate changes in the demand for money, leading to monetary equilibrium issues.
I can’t reproduce the whole paper here, but it is full of very interesting (though quite technical) details and I strongly encourage you to take a look.
George Selgin wrote a very true post on Freebanking.org. He claims that we are all, in a way or another, free banking theorists. Why? As Selgin very well explains:
Consider: an economist says that central banks prevent or limit the severity of financial crises, or that without mandatory deposit insurance even sound banks are likely to face runs, or that banks can never be expected to hold enough capital unless we force them to, or that commercially-supplied banknotes will tend to be discounted. All such claims–which is to say any claims about the need for or consequences of government intervention in banking–depend, if not on an explicit understanding of the nature and workings of a laissez-faire banking system, then on some implicit understanding. And this understanding in turn implies a theory of some sort, for reference to experience alone won’t suffice for drawing the sort of sweeping conclusions I’m talking about. It follows that all economists who have anything to say about the effects of government intervention in the banking system are either self-proclaimed free banking theorists or are free banking theorists who don’t admit (and perhaps don’t realize) it.
Indeed, most banking academic research studies and banking reform proposals base their ideas and models on certain assumptions of how the banking system, left to its own device, would behave, and how to correct the market failures that could possibly arise from such systems.
As my (and most people’s) experience can also testify, this tacit conventional wisdom is present in the mind of the general public and finance practitioners (I can still remember my father’s face when I told him we should get rid of central banks. Like he had just spotted some sort of ghost). The success of the usual US-centric misrepresentation of banking history is almost complete.
With this blog, I have been trying to explain what would (not) have happened if we had left banking free of all the rules that distort its natural behaviour. Seen this way, I am also a free banking theorist. I am trying to get back to the roots, asking questions such as: let’s supposed we never implemented Basel rules, would have real estate lending grown that much over the past three decades? What about securitization? Or interest rates on sovereign debt? And banks’ capital and liquidity buffers? What if we hadn’t had central banks nor deposit insurance over the period? What compounded what?
A lot of this is counterfactual, hence uncertain. Still, the intellectual challenge this represents is worth it, as current banking reformers and regulators still rely on and take for granted the inaccurate conventional story to justify the exponential growth of increasingly tight rules. Rules which, as I explain on this blog, are more likely to harm the banking system than to make it safer.
Larry White once says that free banks should be ‘anti-fragile’, and that the only reason they remain fragile is because of government-institutionalised rules that prevent them from self-correcting and learning. I have also already said that this does not mean that banks would never fail or that no crisis would ever occur. But it is likely that the accumulation of financial imbalances, which under our current system slowly emerge hidden behind the regulatory curtain until it is too late, would appear much sooner, limiting the destructive potential of any crisis. The market process, in order to become anti-fragile, needs to learn through experience. The more ‘safety’ rules one implement the less likely market actors will learn and the more likely the following crisis is going to be catastrophic. Institutionalised paternalism is self-defeating.
Unfortunately, the conventional story has seriously twisted everyone’s mind, and it is highly likely that any government announcing the end of the Fed/ECB/BoE/deposit insurance/currency monopoly would trigger market crashes and a lack of confidence in banks. Most commentators would describe the move as “crazy given what we’ve learnt from history”. In short, it would be a ‘history misreading-induced’ panic. While this would be short-lived, this would also be damaging. It is our role to tell the public that, in fact, it should not fear such changes. It should welcome them.
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.
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…
Free/lightly regulated banking:
I recently finished reading Fragile by Design, the latest book of Charles Calomiris and Stephen Haber.
Let’s get to the point: it’s one of the best books of banking I’ve had the occasion to read. It is a masterpiece of banking and political history and theory.
Calomiris and Haber describe the stability and efficiency of banking systems in terms of local political arrangements and institutions, which contrasts with most of nowadays’ theories that don’t distinguish between banking systems in various countries and way too often seem to draw conclusions on banking from the US experience only.
They describe banks’ stability in terms of a ‘Game of Banks Bargains’: the tendency for populists and bankers to form coalitions that aren’t favourable for society as a whole but favourable for politicians’ short-term political gains and bankers’ short-term profits. Needless to say, this alliance is built at the expense of long-term stability and efficiency. Only countries that have built political institutions to counteract the effects of populist policy proposals have experienced a stable financial environment since the early 19th century.
This thesis is extremely convincing and, while I find it unsurprising, it is so well documented that it is sometimes almost shocking. It clearly goes against mainstream Keynesian and Post-Keynesian theories, which consider financial collapses as a result of the normal process of human ignorance and panics. According to those theories, banks will fail at some point, hence the need for regulation and intervention early on. From most Keynesian books and articles I’ve read so far, collapses just happen. I’ve always been bewildered by the lack of underlying explanation: “that’s just the way it is”. Hyman Minsky’s Stabilizing an Unstable Economy is the perfect example: it draws general conclusions about the banking sector and the economy from a period of a couple of decades in the US… Knowledge of financial history quickly proves those arguments wrong.
The book isn’t without flaws however. It describes and compares the history of banking systems in England, the US, Canada, Mexico and Brazil. I found that either Brazil or Mexico could have been skipped (as covering both didn’t bring that much more to the thesis) in order to study more in depth another European (French, German, Italian) and/or Asian (Japanese, Indian…) banking system.
Also, while the (long) description of the political ramifications that led to the US subprime crisis is stunning, I believe the authors’ thesis is incomplete. There is no doubt that the populists/housing agencies/bankers alliance (or forced alliance) amplified the crisis by generating way too many low-quality housing loans through declining underwriting standards. However, this cannot be the only reason behind the crash. As I have described in many posts, properties have boomed and crashed all around the world in a coordinated fashion during the same period due to regulations incentivising house lending (and securitized products based on housing loans), as well as low interest rates. It is hard to argue that the Irish or the Spanish housing markets were the victims of US populists and US subprime lending…
Finally, what Calomiris and Haber describe is that free-market banking systems are less prone to systemic failures. From their work, it is clear that: 1. the fewer rules the banking system is subject to and 2. the less government intervention in the finance industry, the more stable the financial system. They demonstrate that the more lightly regulated Canadian system and the Scottish free-banking system were seen as almost ideal. Nevertheless, they seem to refrain from explicitly argue in favour of free-banking systems for some reason. I found this a little odd.
I certainly disagree with their view that banks can only exist when the state exists and charter them because of their interrelationship (i.e. states can raise financing through banks and banks get competitive advantages in return). Their arguments are really unconvincing: 1. it isn’t because such occurrences are rare in recent history that they cannot happen and 2. we have consistently witnessed throughout history, and in particular over the past decades, the spontaneous emergence of unchartered financial institutions (from money market funds to P2P lending firms) that respond to a private need for financial services. I do not think those are ‘utopian fantasies’ as this is happening right in front of us right now… States started to select, allow, charter and regulate those institutions when they needed finance. This does not imply that a limited and pacifistic state necessarily needs to use the same constraining tools.
In the end, those flaws remain minor and the book is easily one of my favourites. It deserves much more attention than what the media have given them so far (indeed, they go against the traditional ‘banking is inherently unstable’ tenet…). Unfortunately, the media are more interested in bank-bashing stories, putting in the spotlight much weaker books such as The Bankers’ New Clothes (by Admati and Hellwig)…
PS: FT’s John Kay also talks about the book here.
I really hesitated to write this post. For the last 10 days my blogging frequency has been close to nil as I re-read and gave a thought to James Tobin’s Commercial Banks as Creators of Money, Leland Yeager’s What are Banks, as well as several blog posts, including David Glasner’s (here, here and here). In the end, it looked to me that everything that could be said had already been said. But I’ve been asked to provide my opinion. Moreover, I believe that most of what has been said so far derived from economists’ point of view (which doesn’t mean this is wrong per se) and that a financial analyst/practitioner could potentially bring useful points to the debate.
As I said, I’ve been asked to provide my opinion. Let me give you a quick answer. I believe that both Tobin’s New View and Yeager’s Old View (?) are right. I also believe they are both wrong. Some of their arguments are true. Some others seem to contradict other points they make.
I believe that banks’ expansion is indeed limited by economic constraints. Perhaps just not the exact ones Tobin was thinking of. I also believe banks can and usually indeed do fully ‘loan up’. But perhaps not exactly the way Yeager was seeing it as I believe that reserve requirements (in particular, internally-defined ones, see below) are part of banks’ economic constraints.
A lot of the discussion surrounding the debate in the economic area/blogosphere rests on the nature of bank inside money and whether it is subject to the ‘hot potato’ effect. This is very clear in David Glasner’s posts. I encourage you to take a look at them (including their comment sections) although this can be a little technical for non-economists. But here I am going to take a slightly different approach, more finance theory-based.
First, I don’t believe in Tobin’s arguments that demand deposits’ yields are key. Tobin says:
Given the wealth and the asset preferences of the community, the demand for bank deposits can increase only if the yields of other assets fall. […] Eventually, the marginal returns on lending and investing, account taken of the risks and administrative costs involved, will not exceed the marginal cost to the banks of attracting and holding additional deposits.
I don’t know anyone who keeps his/her money in demand deposit accounts because of their yield (by ‘demand deposit’ I mean checkable deposits, not saving deposits available on demand, this is an important distinction). People maintain real balances in demand deposits to cover their cost of living (i.e. expected cash outflows over a given month). Here, on the ‘hot potato’ issue, I side with Yeager. Demand deposits provide a convenience yield. Nominal yields are pretty much unimportant. It is only when banks’ customers have surplus balances in their account that yields become important in the choice between using them for consumption or investment (and to pick the type of investment). But this does not concern demand deposits. It is hard to imagine anyone transferring most (or all) of his money from a demand to a saving account (or any other sort of investment) for yield purposes…
In addition, banks always pay close to nothing on demand deposits. In order to grow their deposit base, banks barely vary rates on demand deposits. Saving accounts and related financial products (retail bonds, certificates of deposit, etc.) that are not media of exchange are the ones used by banks to attract customers.
But the Tobin/Yeager debate focuses on demand deposits due to their very nature. And there seems to be some confusion in both Tobin’s article and Glasner’s posts. Tobin explicitly refers to demand deposits, and how competition from non-bank FIs would push up their interest rates. This is unlikely as described above. Saving deposits would be the ones to suffer. But they are not media of exchange and not the topic of the discussion. As a result, I find myself in general agreement with Bill Woolsey, who commented on Glasner’s posts.
Second, Tobin seems to downplay the role of reserve requirements. What he fails to see is that they also are part of banks’ economic constraints. He also contradicts himself when he declares that reserve requirements are only a legal constraint that kicks in before natural economic constraints prevent the bank from expanding, only to say a few pages later that reserves…aren’t a constraint on lending (which I believe is wrong as I have already said many times).
Some readers already know the simple bank accounting profit equation I referred to in a couple of previous posts:
Net Profit = Interest Income from lending – Interest Expense from deposits – Operational Costs
Let’s now move on to a slightly more complex version.
In the short-term, banks survive by making accounting profits. However, in the long-term, banks survive by making economic profits (= at least covering their cost of capital). And, unlike accounting-based financial statements, the cost of capital incorporates risk.
The risk I am particularly interested in today, and which is the most relevant for the Tobin/Yeager debate is liquidity risk. Let’s now modify the profit equation using White’s The Theory of Monetary Institutions. A bank’s economic profit equation thus becomes:
Economic Profit = II – IE – OC – Q, where Q represents liquidity cost.
Liquidity cost isn’t a ‘tangible’ cost and is therefore excluded from a bank’s accounting profit. Nevertheless, the less liquid a bank becomes, the riskier it becomes, and investors demand as a result appropriate compensation for bearing that extra risk, reflected in a higher demanded return on capital. Eventually, liquidity cost can also impact accounting profitability through higher cost of funding (i.e. interest expense).
Why I am referring to liquidity risk? Because liquidity risk becomes a direct economic constraint on bank expansion. Individual banks maintain a liquidity buffer to face redemptions and interbank settlements. The traditional view is that reserves play this role, through the exogenously-defined reserve requirements. Without them, banks would turn ‘wild’ and become way too risky. This view is inaccurate.
Indeed, banks in free banking systems during the 19th century used to maintain a high level of reserves, despite the absence of reserve requirements (though this level used to vary with technological advancement and demand for banks’ liabilities). With the development of capital markets, banks found another solution: swap some of their reserve holdings for highly-marketable and high quality securities, which effectively became reserve-replacements, or claims on reserves.
In order to maximise economic profitability, modern banks now usually maintain their (primary) reserves to a minimum while also holding secondary reserves (that is, in a non-interest on excess reserves world). In a way, banks are never fully loaned-up. From a primary reserves point of view, they indeed are. From a total reserves point of view, they are not. Banks sacrifice higher yields on loans for lower yields on safe and liquid securities. However, I have to admit that, from a risk-adjusted point of view, banks could be considered fully loaned-up*.
Seen that way, Tobin was right to believe that economic constraints would prevent bank expansion, but was wrong in believing that reserve requirements merely prevented the expansion from reaching its natural economic limits and that banks’ special status was only derived from this legal restriction**:
In a régime of reserve requirements, the limit which they impose normally cuts the expansion short of this competitive equilibrium. […] In this sense it is more accurate to attribute the special place of banks among intermediaries to the legal restrictions to which banks alone are subjected than to attribute these restrictions to the special character of bank liabilities.
If anything, economic constraints kick in before reserve requirements***, and internally-defined reserve requirements are part of economic constraints.
On the other hand, Yeager sometimes seems to overstate the effects of reserve requirements and underplay economic constraints in limiting expansion:
Proponents of this view are evidently not attributing “the natural economic limit” to limitation of base money and to a finite money multiplier, for that would be old stuff and not a new view. Those familiar limitations operate on the supply-of-money side, while the New Viewers emphasize limitations on the demand side.
To be fair, Yeager’s exact point of view isn’t entirely clear in his article. He seems to reject the ‘natural economic limits’ only to later endorse them, though this might be due to the facts he does not view liquidity cost as an economic constraint in his reasoning:
It is hard to imagine why a bank might find it more profitable to hold reserves in excess of what the law and prudence call for than to buy riskless short-term securities with them.
I also partially disagree with Yeager’s point that “the real marginal cost of expanding the system’s nominal size is essentially zero.” This is true… in the long run. But in the short-term extending credit often involves growing operational costs (i.e. hiring further loan officers for example), which weigh on banks’ accounting profitability in real terms, and growing liquidity costs, which weigh on banks’ economic profitability, before the nominal size of the system is finally expanded.
I might be missing something, but the ‘hot potato’ effect of banks’ inside money and the natural economic constraints on banks expansion do not look irreconcilable to me. This is also the view that White seems to take in his book. Furthermore, only this view seems to be able to explain the behaviour of free banks. Banks loan up to a degree that maximise economic profitability (which includes safety/risk) but any exogenous increase in reserves can also bring about an expansion of banks’ inside money (money multiplier effect) that results in a new nominal paradigm.
It’s funny but I have the feeling that this debate will make me think for much longer.
** In addition, the margin between interest income and interest expense isn’t the only way to generate revenues. In fact, many banks accept to extend credit to customers at a loss, in order to generate profits through cross-selling of other financial products (derivatives, insurance, clearing and custody services…). This effectively pushes back the economic limits of expansion (without taking account liquidity cost). A traditional (i.e. non-IB) bank’s economic profit equation would then become:
Economic Profit = II – IE + CS – OC – Q, where CS represents revenues from cross-selling.
*** Some of you might believe that this is in contradiction with my claim that reserve requirement policies have been successfully implemented in various countries. It isn’t. Primary reserves that are not in excess are essentially ‘stuck’ at the central bank. As banks fully ‘loan-up’ on them, increasing reserve requirements merely reduce lending expansion unless banks decide to slash their secondary reserves (which essentially replace excess reserves), which would in turn increase liquidity cost.