Tag Archive | Free Banking

Some ‘good’ principles of financial regulation

Readers of this blog know the extent of my love for banking regulation. I love regulation. I really do. Otherwise I wouldn’t have much to write about.

Irony aside, I recently read a very good paper by Calomiris (Financial Innovation, Regulation, and Reform, 2009, which you can find here) that made me give regulation a rethink (to be frank, I was disappointed that there’s not much about financial innovation in this paper, but the rest is pretty good).

Calomiris is a free-market guy. He makes it clear is most of his papers, this one included:

The risk-taking mistakes of financial managers were not the result of random mass insanity; rather they reflected a policy environment that strongly encouraged financial managers to underestimate risk in the subprime mortgage market. Risk-taking was driven by government policies; government’s actions were the root problem, not government inaction.

He is right. But he also seems to be a ‘realist’ (if ever this really means anything). He considers that, given our current distortive institutional framework, the best thing we can do is to mitigate its effect through proper regulation. He writes:

If there were no governmental safety nets, no government manipulation of credit markets, no leverage subsidies, and no limitations on the market for corporate control, one could reasonably argue against the need for prudential regulation. Indeed, the history of financial crises shows that in times and places where government interventions were absent, financial crises were relatively rare and not very severe.

[…But] it is not very helpful to suggest only regulatory changes that are very far beyond the feasible bounds of the current political environment. […] Absent the elimination of [all the policies described above], government prudential regulation is a must.

In a way, he has a point. Whereas I’d like to see the implementation of a free banking system, I also have to admit that this possibility is pretty unlikely to ever reoccur (unless a once in a thousand years financial collapse suddenly strikes). Which led me to think about a ‘second best’. This ‘second best’ solution should follow the principles I described here (where I argued in favour of a stable rule set and regulatory framework) and here (where I agreed with Lars Christensen and John Cochrane and argued against macro-prudential regulations). This is what I wrote:

Stable rules are a fundamental feature of intertemporal coordination between savers and borrowers, between investors and entrepreneurs. In order for economic agents to (more or less) accurately plan for the future, for entrepreneurs to develop their business ideas and anticipate future demand, for savers to invest their money and know that their property rights are not going to disappear overnight and accordingly plan their own delayed consumption and provide entrepreneurs with directly available funds, the economic system needs a stable and predictable rule framework. Production and investments take time and as a result involve uncertainty, which should not be exacerbated by an instable rule set. The rule of law is part of this framework. Monetary policy, financial regulation and government policies should follow the same pattern, instead of being discretionary.

What I am about to describe is a non-exhaustive list of ‘good’ principles of regulation that fit (to an extent) a free-market framework. I may update the list over time. Following the principles above, and even though not perfect, a ‘second best’ solution would have to be:

  1. As least distortive as possible (i.e. introducing as few loopholes and incentives to game the rules as possible)
  2. As stable as possible (i.e. no discretionary powers), and
  3. As simple, transparent and clear as possible (i.e. a few clear and straightforward rules are better than a multitude of obscure and complex ones)

On the monetary policy side, despite its flaws, NGDP targeting seems to be the only ‘easily implementable’ policy that meets the three criteria. I won’t discuss it here (see The Money Illusion, The Market Monetarist, Worthwhile Canadian Initiative, and many other blogs for more information). On the slightly ‘less easily implementable’ side, the ‘productivity norm’ would nonetheless be an even better alternative (see George Selgin’s implementation here, from page 64 onwards).

What about financial and banking regulation? In order to respect the three fundamental rules described above, regulators should:

  1. Define few transparent, straightforward limits and ratios based on objective and easily measurable criteria that are neither pro- nor counter-cyclical
  2. Not impose their own perception of risk to the market
  3. Not vary regulatory limits and requirements over time
  4. Not publicly shame financial institutions that respect regulatory requirements even if borderline-compliant: the regulators’ role is to make sure that institutions respect the requirements, period
  5. Publicly make clear that regulations only represent minimums, that regulators are only here to make those minimums respected, and that it is the role of market actors to identify stronger from weaker institutions within those regulatory-defined limits
  6. Not interfere with financial institutions’ strategy and internal organisational structures: harmonising business models takes the risk of weakening the whole system
  7. Refrain from making any comment unrelated to the (non)compliance of institutions to regulatory requirements
  8. Allow the market process to run its course and not institutionalise moral hazard by implementing bailout and other backstop mechanisms

Banking regulation is divided into micro-prudential and macro-prudential regulation. The former provides individual banks with rules they have to respect at all times, independently of the performance of the whole economy. The latter provides all banks with rules that vary according to the state of the economy, independently of the performance of each bank. Following the principles above, fixed and straightforward sets of micro-prudential regulations may be acceptable. On the other hand, most macro-prudential regulations would be eliminated given their discretionary component and their variability over time. It is indeed very hard for regulators to identify bubbles and other excesses (see White, 2011, here). They have a poor track record at it. Discretion could well prevent a bubble from growing too much but it could also prevent a genuinely growing market to reach its full potential. Regulators suffer from the central planner’s problem. As Hayek said in his essay The Use of Knowledge in Society:

The peculiar character of the problem of a rational economic order is determined precisely by the fact that the knowledge of the circumstances of which we must make use never exists in concentrated or integrated form, but solely as the dispersed bits of incomplete and frequently contradictory knowledge which all the separate individuals possess.

I can already hear the rebuttals: “but counter-cyclical macro-prudential policies would help mitigate the bust after the boom!” To which I would respond: “how do you identify a ‘boom’?” For a bust to occur, a boom must be unsustainable. Solid and sustainable growth may well happen and should not be interfered with by counter-cyclical regulations that would in fact not be counter-cyclical at all in this case. Nominal stability is primarily the role of monetary policy, which should promote a stable framework to the real economy. An unsustainable boom is likely to emanate from nominal instability. The goal of regulation is not to mitigate the effects of destabilising monetary policies.

Of course, this does not mean that one should not strive to reduce political and regulatory distortions. ‘Idealists’ (if ever this also means anything) are a necessary part of a healthy democratic process. Moreover, too much compromise can be dangerous: where to fix the limit? Because the very distortive sources are still present, crises can still occur and provide extra arguments to further expand the regulatory burden.

PS: I’ll provide examples of regulations that comply or not with those principles in a subsequent post. This post would have been too long otherwise!

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

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


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

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

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

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

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

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

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

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

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

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

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

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

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

Liikanen Macroprudential

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

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

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

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

News digest

I have been so busy since last week that I didn’t have much time to write for this blog… And, to tell you the truth, I was almost shocked: barely any news on banks capital, regulation, monetary policy, etc, over the past few days. Sure, the ECB cut its rate by 25bp to 0.25%, but I’m not sure I should comment within the scope of this blog: I am still not convinced by such such a diverse monetary union as the Eurozone and find it hard to believe we can actually set a common interest rate for all country members within the union… Anyway, today I only wish to comment on a few articles published over the last few days.

A very interesting article published on SNL (subscription required) called Everybody wants to rule the world, including bank regulators, in which an analyst argued that “Banks are not only facing over-regulation. They are also emerging as a convenient channel through which regulators can extend their reach far beyond their legal writ.” You probably understand as well as I do how dangerous this is.

I found out yesterday that Bear Stearns liquidators filed a lawsuit against the three credit rating agencies for alleged manipulation of structured products’ ratings. They are basically arguing that, if ratings had been right, Bears Stearns’ hedge funds would not have collapsed. Blaming the rating agencies because…..hedge funds collapsed? We are not talking about simple retail investors here. We are talking about sophisticated investors. Aren’t hedge funds supposed to undertake their own analysis? Are they just blindly investing in various assets? If hedge funds managers and analysts did not believe in rating agencies’ ratings, why did they invest in those assets the first place? Or perhaps they indeed did not believe in those ratings and took on the risk on purpose. In both cases, we cannot blame the agencies for the lack of competence of those highly-remunerated hedge funds employees.

Yesterday, the FT reported that shadow banks had been among the biggest beneficiaries of the Fed’s monetary policies. I’ve already argued that it might well be a sign that real interest rates are too low (i.e. lower than the equilibrium natural rate of interest). As a result, regulators wish to regulate (of course) this segment of the financial system. My guess is that surplus liquidity would then shift to another less-regulated sector or asset class, as it always does.

A few days ago, I read in horror that Germany may start backing the financial transaction tax. A tax of 0.1% of the value of the transaction (as is proposed on cash instruments) would be a massive drain of wealth: just imagine what would happen to a newly set-up EUR100bn mutual fund (ok, no new fund would ever be of that size, but follow me just for the intellectual exercise). The fund has evidently to invest those 100bn on behalf of its clients, meaning they have to buy EUR100bn of assets. Taxing 0.1% off the total value of the transactions would mean…EUR100m to pay in taxes. This is EUR100m that EU states would withdraw from people’s savings and pensions. Bad idea.

In the Wall Street Journal, a Fed insider described how disillusioned he was from the Fed and QE: he ‘apologises’ to Americans (Scott Sumner comments on this) for QE’s bad or lack of effects. While I do not necessarily share everything he said, I also dislike the Fed’s large scale market manipulation.

On Free Banking, George Selgin criticised this Business Insider piece about airlines debasing their reward points. Reminds me of my own response to Matt Klein on the exact same topic a few weeks ago. No guys: those cases do not reflect free banking and private currencies.

Well, that’s all for the catch up.

What Walter Bagehot really said in Lombard Street (and it’s not nice for central bankers and regulators)

(Warning: this is quite a long post as I reproduce some parts of Bagehot’s writings)

As I promised in a post a few days ago, I am today getting back to the common ancestor of all of today’s central bankers, Walter Bagehot.

Walter Bagehot

Bagehot is probably one of the most misquoted economist/businessmen of all times. Most people seem to think they can just cherry pick some of his claims to justify their own beliefs or policies, and leave aside the other ones. Sorry guys, it doesn’t work like that. Bagehot’s recommendations work as a whole. Here I am going to summarise what Bagehot really said about banking and regulation in his famous book Lombard Street: A description of the Money Market.

Let’s start with central banking. As I’ve already highlighted a few days ago, Bagehot said that the institution that holds bank reserves (i.e. a central bank) should:

  1. Lend freely to solvent banks and companies
  2. Lend at a punitive rate of interest
  3. Lend only against good quality collateral

I can’t recall how many times I’ve heard central bankers, regulators and journalists repeating again and again that “according to Bagehot” central banks had to lend freely. Period. Nothing else? Nop, nothing else. Sometimes, a better informed person will add that Bagehot said that central banks had to lend to solvent banks only or against good collateral. Very high interest rates? No way. Take a look at what Mark Carney said in his speech last week: “140 years ago in Lombard Street, Walter Bagehot expounded the duty of the Bank of England to lend freely to stem a panic and to make loans on “everything which in common times is good ‘banking security’.”” Typical.

Now hold your breath. What Bagehot said did not only involve central banking in itself but also the banking system in general, as well as its regulation. Bagehot attacked…regulatory ratios. Check this out (chapter 8, emphasis mine):

But possibly it may be suggested that I ought to explain why the American system, or some modification, would not or might not be suitable to us. The American law says that each national bank shall have a fixed proportion of cash to its liabilities (there are two classes of banks, and two different proportions; but that is not to the present purpose), and it ascertains by inspectors, who inspect at their own times, whether the required amount of cash is in the bank or not. It may be asked, could nothing like this be attempted in England? could not it, or some modification, help us out of our difficulties? As far as the American banking system is one of many reserves, I have said why I think it is of no use considering whether we should adopt it or not. We cannot adopt it if we would. The one-reserve system is fixed upon us.

Here Bagehot refers to reserve requirements, and pointed out that banks in the US had to keep a minimum amount of reserves (i.e. today’s equivalent would be base fiat currency) as a percentage of their liabilities (= customer deposits) but that it did not apply to Britain as all reserves were located at the Bank of England and not at individual banks (the US didn’t have a central bank at that time). He then follows:

The only practical imitation of the American system would be to enact that the Banking department of the Bank of England should always keep a fixed proportion—say one-third of its liabilities—in reserve. But, as we have seen before, a fixed proportion of the liabilities, even when that proportion is voluntarily chosen by the directors, and not imposed by law, is not the proper standard for a bank reserve. Liabilities may be imminent or distant, and a fixed rule which imposes the same reserve for both will sometimes err by excess, and sometimes by defect. It will waste profits by over-provision against ordinary danger, and yet it may not always save the bank; for this provision is often likely enough to be insufficient against rare and unusual dangers.

Bagehot thought that ‘fixed’ reserve ratios would not be flexible enough to cope with the needs of day-to-day banking activities and economic cycles: in good times, profits would be wasted; in bad times, the ratio is likely not to be sufficient. Then it gets particularly interesting:

But bad as is this system when voluntarily chosen, it becomes far worse when legally and compulsorily imposed. In a sensitive state of the English money market the near approach to the legal limit of reserve would be a sure incentive to panic; if one-third were fixed by law, the moment the banks were close to one-third, alarm would begin, and would run like magic. And the fear would be worse because it would not be unfounded—at least, not wholly. If you say that the Bank shall always hold one-third of its liabilities as a reserve, you say in fact that this one-third shall always be useless, for out of it the Bank cannot make advances, cannot give extra help, cannot do what we have seen the holders of the ultimate reserve ought to do and must do. There is no help for us in the American system; its very essence and principle are faulty.

To Bagehot, requirements defined by regulatory authorities were evidently even worse, whether for individual banks or applied to a central bank. I bet he would say the exact same thing of today’s regulatory liquidity and capital ratios, which are essentially the same: they can potentially become a threshold around which panic may occur. As soon as a bank reaches the regulatory limit (for whatever reason), alarm would ring and creditors and depositors would start reducing their lending and withdrawing their money, draining the bank’s reserves and either creating a panic, or worsening it. This reasoning could also be applied to all stress tests and public shaming of banks by regulators over the past few years: they can only make things worse.

Even more surprising: the spiritual leader of all of today’s central bankers was actually…against central banking. That’s right. Time and time again in Lombard Street he claimed that Britain’s central banking system was ‘unnatural’ and only due to special privileges granted by the state. In chapter 2, he said:

 I shall have failed in my purpose if I have not proved that the system of entrusting all our reserve to a single board, like that of the Bank directors, is very anomalous; that it is very dangerous; that its bad consequences, though much felt, have not been fully seen; that they have been obscured by traditional arguments and hidden in the dust of ancient controversies.

But it will be said—What would be better? What other system could there be? We are so accustomed to a system of banking, dependent for its cardinal function on a single bank, that we can hardly conceive of any other. But the natural system—that which would have sprung up if Government had let banking alone—is that of many banks of equal or not altogether unequal size. In all other trades competition brings the traders to a rough approximate equality. In cotton spinning, no single firm far and permanently outstrips the others. There is no tendency to a monarchy in the cotton world; nor, where banking has been left free, is there any tendency to a monarchy in banking either. In Manchester, in Liverpool, and all through England, we have a great number of banks, each with a business more or less good, but we have no single bank with any sort of predominance; nor is there any such bank in Scotland. In the new world of Joint Stock Banks outside the Bank of England, we see much the same phenomenon. One or more get for a time a better business than the others, but no single bank permanently obtains an unquestioned predominance. None of them gets so much before the others that the others voluntarily place their reserves in its keeping. A republic with many competitors of a size or sizes suitable to the business, is the constitution of every trade if left to itself, and of banking as much as any other. A monarchy in any trade is a sign of some anomalous advantage, and of some intervention from without.

As reflected in those writings, Bagehot judged that the banking system had not evolved the right way due to government intervention (I can’t paste the whole quote here as it would double the size of my post…), and that other systems would have been more efficient. This reminded me of Mervyn King’s famous quote: “Of all the many ways of organising banking, the worst is the one we have today.” Another very interesting passage will surely remind my readers of a few recent events (chapter 4):

And this system has plain and grave evils.

1st. Because being created by state aid, it is more likely than a natural system to require state help.


3rdly. Because, our one reserve is, by the necessity of its nature, given over to one board of directors, and we are therefore dependent on the wisdom of that one only, and cannot, as in most trades, strike an average of the wisdom and the folly, the discretion and the indiscretion, of many competitors.

Granted, the first point referred to the Bank of England. But we can easily apply it to our current banking system, whose growth since Bagehot’s time was partly based on political connections and state protection. Our financial system has been so distorted by regulations over time than it has arguably been built by the state. As a result, when crisis strikes, it requires state help, exactly as Bagehot predicted. The second point is also interesting given that central bankers are accused all around the world of continuously controlling and distorting financial markets through various (misguided or not) monetary policies.

For all the system ills, however, he argued against proposing a fundamental reform of the system:

I shall be at once asked—Do you propose a revolution? Do you propose to abandon the one-reserve system, and create anew a many-reserve system? My plain answer is that I do not propose it. I know it would be childish. Credit in business is like loyalty in Government. You must take what you can find of it, and work with it if possible.

Bagehot admitted that it was not reasonable to try to shake the system, that it was (unfortunately) there to stay. The only pragmatic thing to do was to try to make it more efficient given the circumstances.

But what did he think was a good system then? (chapter 4):

Under a good system of banking, a great collapse, except from rebellion or invasion, would probably not happen. A large number of banks, each feeling that their credit was at stake in keeping a good reserve, probably would keep one; if any one did not, it would be criticised constantly, and would soon lose its standing, and in the end disappear. And such banks would meet an incipient panic freely, and generously; they would advance out of their reserve boldly and largely, for each individual bank would fear suspicion, and know that at such periods it must ‘show strength,’ if at such times it wishes to be thought to have strength. Such a system reduces to a minimum the risk that is caused by the deposit. If the national money can safely be deposited in banks in any way, this is the way to make it safe.

What Bagehot described is a ‘free banking’ system. This is a laissez faire-type banking system that involves no more regulatory constraints than those applicable to other industries, no central bank centralising reserves or dictating monetary policy, no government control and competitive currency issuance. No regulation? No central bank to adequately control the currency and the money supply and act as a lender of last resort? No government control? Surely this is a recipe for disaster! Well…no. There have been a few free banking systems in history, in particular in Scotland and Sweden in the 19th century, to a slightly lesser extent in Canada in the 19th and early 20th, and in some other locations around the world as well. Curiously (or not), all those banking systems were very stable and much less prone to crises than the central banking ones we currently live in. Selgin and White are experts in the field if you want to learn more. If free banking was so effective, why did it disappear? There are very good reasons for that, which I’ll cover in a subsequent post on the history of central banking.


I am not claiming that Bagehot held those views for his entire life though. A younger Bagehot actually favoured monopolised-currency issuance and the one-reserve system he decried in his later life. I am not even claiming that everything he said was necessarily right. But Bagehot as a defender of free banking and against regulatory requirements of all sort is a far cry from what most academics and regulators would like us to believe today. Personally, I find that, well, very ironic.

Matthew Klein is drawing the wrong lessons on private currencies

Matthew C. Klein is a columnist for Bloomberg. He used to write on The Economist’s economic blog, Free Exchange. Despite not agreeing with him most of the times, I found that he had some of the most provocative and interesting pieces among the usually quite dull Economist posts. And I used to comment on those pieces. A lot.

He today published a new piece on the Bloomberg website, arguing that the ‘devaluation’ of US-based Southwest Airlines’ frequent flier reward points explains why private currencies (including free banking, Bitcoin and equivalents) have never taken off: they have unstable and unpredictable purchasing power.

His argument is really misguided. Let me explain why.

  1. First, I would not really call reward points currency. They are media of exchange of very limited use. They are definitely not generally accepted media of exchange (to be honest, Bitcoins aren’t either, as George Selgin explains).
  2. Bitcoins cannot even lose purchasing power unpredictably: its algorithm has been defined so that new Bitcoins are created following a very steady pattern. So I don’t see why Klein even mentions them…
  3. Matthew Klein seems to have limited knowledge of banking history: free banking systems have been very stable where and when they existed (White, Selgin, Dowd, Horwitz, and others have published enough on the topic). It is the state that monopolised currency issuance for its own benefits which very often led to financial crises. Currency depreciation has also been much more acute under government’s fiat currency systems.
  4. Finally – and this is where Klein’s argument really breaks down, the Southwest frequent-flier points devaluation is linked to the devaluation of the dollar! How? Like free banks’ private currency issuance is based on outside money reserve (usually gold or some other commodities), frequent-flier points are also based on another type of outside money (here, the US Dollar) although the analogy is not exact. Basically, every time a customer pays X USD to Southwest, Southwest generates Y reward points. As a result, there is an ex-ante Y/X exchange rate, which is supposed to remain constant over time. Issuing those points is a cost for the company, but which is offset by the potential profit of keeping loyal customers, at this specific exchange rate. When enough reward points have been accumulated, they can then be exchanged for a flight (which are priced in terms of both USD and reward points separately). While Southwest does control the reward points supply, it does not control the outside money supply. And unfortunately, the USD is slowly depreciating thanks to the Fed, thereby increasing the ex-post Y/X exchange rate and the relative purchasing power of the reward points… Like any price, reward points-based prices are sticky, and have to be revaluated over time to reflect the change in the medium of account (which is also USD) that Southwest uses to report its profits. It looks like in this case that reward points-based prices are stickier than USD-based prices, making devaluations both less frequent and sharper in order to catch up with the depreciation of their underlying outside money.

This phenomenon isn’t isolated. My internet monthly bill was recently increased by….25%! I was shocked for a few minutes when I found out. But it is easily explained: internet bills aren’t revaluated every month or even every year, despite the fact that inflation depreciates the currency’s purchasing power every month. At some point, internet firms have to readjust the prices that they charge in order to respond to the increase in their own supply costs and maintain their margins. And when it happens, increases are usually big. This is also valid for many other goods.

So Matt, you’re going to have to find another argument to justify government-controlled currencies!


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