Some speeches make you want to scream. Mark Carney’s latest is one of those.
In a recent speech titled Three truths for finance, Carney, the governor of the BoE, explains that those ‘truths’ are in fact ‘lies’, and those three lies are “this time is different”, “markets always clear”, “markets are moral”. Where to start?…
According to Carney:
The first lie is the four most expensive words in the English language: “This Time Is Different.”
I can only agree with Carney here. He continues:
This misconception is usually the product of an initial success, with early progress gradually building into blind faith in a new era of effortless prosperity.
He mentions the pre-crisis debt bubble, which ‘financial innovation’ and a ‘ready supply of foreign capital from the global savings glut’ made cheaper. Yet he never mentions central banks’ policies, which kept interest rates low over the whole period, or the fact banking regulation was the very reason behind the cheap credit supplied to a few particular sectors of the economy or also the fact that high saving rates in countries such as China mostly financed high investment rates in the same countries. No, this is due to private actors’ irrationality, who of course believed that this time was different.
But Carney’s logic is faulty. Over the recent years, it is him, and his fellow central bankers, who have kept arguing that “this time was different”, and that we needed to maintain interest rates below the lowest levels ever recorded in human history.
It gets worse when Carney mentions the second ‘lie’, which reveals his deep Keynesian thinking:
Beneath the new era thinking of the Great Moderation lay a deep-seated faith in the wisdom of markets. Policymakers were captured by the myth that finance can regulate and correct itself spontaneously. They retreated too much from the regulatory and supervisory roles necessary to ensure stability.
That “markets always clear” is the second lie, one which gave rise to the complex financial web that inflated the debt bubble.
In markets for goods, capital, and labour, evidence of disequilibria abounds.
In goods markets, there is ‘sluggishness everywhere’. Left to themselves, economies can go for sustained periods operating above or below potential, resulting, ultimately, in excessive or deficient inflation.
If markets always clear, they can be assumed to be in equilibrium; or said differently “to be always right.”
First, it is clear that Carney does not understand the dynamic entrepreneurship process that characterises a capitalist economy. Equilibrium does not exist, and markets are in constant fluctuations as entrepreneurs and investors try to identify and benefit from what they perceive as mispricings and profit opportunities (see Israel Kirzner). Equilibrium is at best a theoretical construct, and most economists (mainstream or not) who have studied entrepreneurship and markets know this. In short, the market is a dynamic price discovery mechanism.
As a result, accusing markets of not being in equilibrium completely misses the points of having markets in the first place. If markets are in equilibrium, there is no need to act anymore. No need to come up with new ideas, create and invest.
Second, he mentions financial innovations and their effects as if they had existed in a vacuum, independently of any sort of regulation incentivising their use and distorting market outcomes. But it would mean admitting that policymakers can be dead wrong. Possibly not the message he is trying to convey.
It gets absurd when Carney uses the phrase ‘pretence of knowledge’ (his emphasis):
More often than not, even describing the universe of possible outcomes is beyond the means of the mere mortal, let alone ascribing subjective probabilities to those outcomes.
That is genuine uncertainty, as opposed to risk, a distinction made by Frank Knight in the 1920s. And it means that market outcomes reflect individual choices made under a pretence of knowledge.
I have to applaud. Carney, a Keynesian, used Hayek’s Nobel speech title, to express the exact opposite of Hayek’s idea. In his 1974 speech, Hayek explains that central planners attempting to control the economy were victim of a pretence of knowledge, because it was impossible for them to be aware of all the ‘particular circumstances of time and place’ (a phrase that he uses in most of its post-WW2 literature). Only the private market actor, who was in direct connection to his local market, could attempt to come up with the solution that satisfied the demand expressed by this market.
Yet Carney turned Hayek’s reasoning on its head. According to Carney, it is private market actors who demonstrate this pretence of knowledge as they believe they know what is right for them or what the market actually demands! He seems to assume (wrongly) that economic agents believe they are omniscient and not aware of the uncertainty inherently linked to the economic decisions they take.
Hayek would turn in his grave. He would probably tell Carney that market outcomes are the result of millions of individuals who acted on different assumptions, different risk-assessments, different knowledge and skillsets, and that this is the aggregation of all those various local variables that lead to a market outcome that can more efficiently coordinate dispersed knowledge, skills and demand than any central authority ever can. He would probably add that Carney keeps mentioning market failures without ever referring to most of the reasons underlying those failures, that is, artificial restrictions and distortions that originate in government activity (…and central banks…).
But Carney is likely to never admit such things as he is no free-market lover:
In the end, belief in the second lie that “markets always clear” meant that policymakers didn’t play their proper roles in moderating those tendencies in pursuit of the collective good.
And how would you even know how to ‘moderate’, or simply how to identify, those negative tendencies, Mr Carney? And how do you define what this so-called ‘collective good’ is? ‘Pretence of knowledge’ you said?
He then insists (his own emphasis, which says a lot):
Despite these shortcomings, well-managed markets can be powerful drivers of prosperity.
Carney’s last ‘lie’, that markets are moral, suffers from a lack of arguments. He seems to base most of his ‘markets are amoral’ rhetoric on recent examples of price-fixing in a number of rates and commodities markets. He is right that fraud is reprehensible. Yet, in those cases, it was not markets that were to blame, but a few abusers who tried to benefit at the expense of the markets. Here again Hayek would argue that there is nothing more ‘moral’ than unhampered markets that distribute services to those that need them and reward those that provide them, within the framework of the rule of law.
At the end of his speech, Carney introduces the recent BoE initiative to open a forum on re-building ‘real markets’ (his emphasis again). You want ‘real’ markets Mark? Just release them from their constraints. It’s as simple as that.
Business Insider reported that Mark Carney, the BoE Governor, said last week at the World Economic Forum in Davos that IT and online-enabled new financial business models could lead to “an Uber-type situation” in financial services, unless government acted fast to regulate those new firms. Carney worries that those financial entrepreneurs will damage banks’ established model.
I am a little shocked by Carney’s remark. To be fair, it is possible that BI reported those comments out of context, so I’ll give Carney the benefit of the doubt. But I find it hard to understand why Carney would intervene, or simply comment, on the normal laissez-faire Schumpeterian creative destruction process. If banks are to be superseded by more efficient business models (and potentially more stable?), why objecting to that? Why protecting banks? Unless protecting banks is a way of maintaining central banks’ powers (which could also potentially be affected by technological disruptions)?
A further divide between Carney and the private sector (here: banks) appeared in Davos. Carney appeared worried that there used to be an “illusion of liquidity” in financial markets, which is now “gradually being disabused.” This contrasts with what private banks and fund managers believe, as exemplified by Deutsche Bank’s co-CEO Jain, who reportedly clashed with Carney and Jack Lew (US Treasury Secretary) behind closed doors “over whether recent violent market swings were caused by a liquidity crisis fuelled by onerous regulation”, as reported by the FT. Both officials rejected this conclusion.
Carney may well be right when he says that there used to exist an illusion of liquidity. But perhaps not for the reasons he thinks. ‘Excess’ liquidity in markets in the pre-crisis era is likely to have emanated from central banks’ actions. In a free market, liquidity might have indeed been scarcer and markets a little more volatile, reflecting a rougher price discovery process (rather than a one way bet). But, as I have also described in a relatively recent post, regulation is definitely responsible for the liquidity deficiency that we now experience. Regulation created silos that effectively entrapped vast amounts of liquid assets. There isn’t much point denying it really. Regulation has drawbacks and regulators should instead acknowledge them and announce what they can do to alleviate the situation. If they don’t, we are likely to see an increasing number of clashes between the private sectors and regulators, which aren’t going to help our economic recovery much.
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)
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:
- Lend freely to solvent banks and companies
- Lend at a punitive rate of interest
- 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.
Banks were partying on Thursday. Mark Carney, the new governor of the Bank of England, decided to ‘relax’ rules that had been put in place by its predecessor, Mervyn King. From now on, the BoE will lend to banks (as well as non-bank financial institutions) for longer maturities, accept less quality collateral in exchange, and lower the interest rate on/cost off those facilities. Mervin King was worried about ‘moral hazard’. Mark Carney has no idea what that means.
According to the FT, Barclays quickly figured out what this move implied: “it reduces the need for, and the cost of, holding large liquidity buffers.” Just wow. So, while we’ve just experienced a crisis during which some banks collapsed because they didn’t hold enough liquid assets on their balance sheet as they expected central banks and governments to step in if required, Carney’s move is expected to make the banks hold……even less liquidity.
It’s obviously nothing to say that this goes against every possible piece of regulation devised over the last few years. While the regulators were right in thinking that banks needed to hold more liquid assets, they took on the wrong problem: it was government and central bank support that brought about low liquidity holdings, and not free-markets recklessness. Anyway, Carney’s move kind of undermines that effort and risks rewarding mismanaged banks at the expense of safer ones.
Carney’s decision also goes against all the principles devised by the ‘father’ of central banking: Walter Bagehot. I guess it is time to decipher Bagehot, as he has been constantly misquoted since the start of the crisis by people who have apparently never read him. As a result he was used to justify what were actually anti-Bagehot policies. Bagehot’s principles are underlined in his famous book Lombard Street, written in 1873. What should a central bank do during a banking crisis? According to Bagehot (as described in chapters 2, 4 and 7), it should:
- Lend freely to solvent banks and companies
- Lend at a punitive rate of interest
- Only accept good quality collateral in exchange
For instance, in chapter 2:
The holders of the cash reserve must be ready not only to keep it for their own liabilities, but to advance it most freely for the liabilities of others. They must lend to merchants, to minor bankers, to ‘this man and that man,’ whenever the security is good.
In chapter 7:
First. That these loans should only be made at a very high rate of interest. This will operate as a heavy fine on unreasonable timidity, and will prevent the greatest number of applications by persons who do not require it. The rate should be raised early in the panic, so that the fine may be paid early; that no one may borrow out of idle precaution without paying well for it; that the Banking reserve may be protected as far as possible.
Secondly. That at this rate these advances should be made on all good banking securities, and as largely as the public ask for them. The reason is plain. The object is to stay alarm, and nothing therefore should be done to cause alarm. But the way to cause alarm is to refuse some one who has good security to offer… No advances indeed need be made by which the Bank will ultimately lose.
No central bank applied Bagehot’s recommendations during the financial crisis. Granted, given the organisation of today’s financial system, it is difficult for central bank to lend to non-financial firms. Nonetheless, it took them a little while to start lending freely and lent to insolvent banks as well. They also started to accept worse quality collateral than what they used to (think about the Fed now purchasing mortgage/asset-backed securities for example). Finally, central banks have never charged a punitive rate on their various facilities. Quite the contrary: interest rates were pushed down as much as humanly possible on all normal and exceptional refinancing facilities.
While the ECB and the Fed have made clear that some of those were temporary measures, Carney now seems to imply that, not only are they here to stay, but they also will be extended in non-crisis times. He calls that being “open for business”. Poor Bagehot must be turning in his grave right now.
According to Carney, those measures will reinforce financial stability. Really? So no moral hazard involved? no bank taking unnecessary risks because it knows that the BoE has its back? If Mervyn King didn’t do everything perfectly while in charge, at least he had a point. Carney, after overseeing a large credit bubble in Canada over the past few years (he first joined the Bank of Canada in 2003, then rejoined it as Governor in 2008), is now applying his brilliant recipe to the UK.
I think that Carney’s decisions introduce considerable incentive distortions in the banking system. This is clearly not what a free-market should look like. In any case, if a new crisis strikes as a result, I am pretty sure that laissez-faire will be blamed again. It is ironic to see that some of those central bankers destroy faith in free-markets while trying to protect them.
Bagehot also said other things that go against the principles driving our current banking and regulatory system. More details in another post!
Chart: The Big Picture