The rather curious and awkward alliance between statists and libertarians against free banking
Free banking has a very bad reputation within mainstream economics. As free banking scholars such as George Selgin, Larry White, Kevin Dowd or Steve Horwitz have been demonstrating over the past 30 years, this is mostly due to a misunderstanding of history. The track record of the systems that were as close as possible to free banking is crystal clear however: free banking episodes were more stable than any alternative banking frameworks.
However, this doesn’t seem to please many, from both sides of the political spectrum. Izabella Kaminska, a long-time libertarian critic from FT Alphaville, wrote a piece on the Alphaville blog partly criticizing non-central banking-based banking systems. In two separate replies (here and here), George Selgin highlighted all the self-serving ‘inaccuracies’ of her post (this is a euphemism). He also wrote a rebuttal in a follow-up post. Izabella skipped the interesting bits, accused Selgin of ad hominem, and wrote in turn another unsourced name-calling post on her own private blog. So much for the academic debate.
Perhaps more surprisingly, David Howden just posted a curious article on the Mises Institute website, which described the Fed as arising from “fractional-reserve free banks”. I say surprisingly, because Howden and the Mises Institute are at the other end of the political spectrum: libertarians, and often anarcho-capitalists. Nevertheless, he seemed to agree with Izabella Kaminska to an extent.
Unfortunately, Howden and Kaminska make the same mistake: they misread history, and/or focus far too much on US banking history. First, Howden claims that:
The year 1857 is a somewhat strange one for these clearinghouse certificates to make their first appearance. It was, after all, a full twenty years into America’s experiment with fractional-reserve free banking. This banking system was able to function stably, especially compared to more regulated periods or central banking regimes. However, the dislocation between deposit and lending activities set in motion a credit-fuelled boom that culminated in the Panic of 1857.
This could not be more inaccurate. The so-called ‘US free banking era’ had nothing much to do with free banking. And the credit boom and crises that follow were unrelated to either free banking or fractional reserves (see here for details, as well as below). I’d like Howden to explain why other fractional reserve free banking systems did not experience such recurring crises…
I have been left bewildered by Howden’s claim that privately-created clearinghouses were ‘illegal’ entities involved in ‘illegal’ activities (i.e. issuing clearinghouse certificates to get bank runs under control). Not only does this ironically sound like contradicting laissez-faire principles, but his whole argument rests on a lacking understanding of 19th century US banking.
What Howden got wrong is that, if American banks had such recurring liquidity issues before the creation of the Fed, it wasn’t due to their fractional reserve nature, but to the rule requiring them to back their note issues with government debt, thereby limiting the elasticity of those issues and the ability of banks to respond to fluctuations in the demand for money. Laws preventing cross-state branching also weakened banks as their ability to diversify was inherently limited. Banks viewed local clearinghouses as a way to make the system more resilient. It was a free-market answer to a state-created problem. This does not mean that the system was perfect of course. But Howden the libertarian blames a free-market solution here, and completely ignores the laws that originally created the problem.
Moreover, clearinghouses weren’t only a characteristic of the 19th century US banking system. They were present in several major free banking systems throughout history and set up by private parties (Scotland being a prime example). Their original goal wasn’t to create ‘illegal money claims’, but to help settle large volume of interbank transactions and economise on reserves: they were a necessary part of a well-functioning privately-owned free banking system. US clearinghouse certificates were merely a private solution to tame state-created liquidity crises. Those solutions were not perfect, but Howden is guilty of shooting the messenger here.
Clearinghouse-equivalents still exist today: the German savings and cooperative banks, as well as the Austrian Raiffeisen operate under the same sort of model, in which multiple tiny institutions park their reserves at their local central bank/clearinghouse. Finally, it is necessary to point out that clearinghouse would also surely exist in a full reserve banking system and would have the same basic goal: settle interbank payments.
Why a libertarian such as Howden would be against this natural laissez-faire process is beyond me. My guess is that at the end of the day, it all goes down to the fractional/full reserve banking debate within the libertarian space. Howden is trying at all costs to justify his views that full reserve banking would be more stable. But this time, such rhetoric is counter-productive and only demonstrates Howden’s ignorance of the issue (at least as described in this article). Using the fractional reserve argument to explain the 19th century US crises is self-serving and wholly inappropriate. Blaming a free-market reaction (i.e. the clearinghouse system) to such crises for the creation of the Fed completely misses the point. By doing so, and cherry-picking facts, Howden helps Kaminska’s arguments (despite fundamentally disagreeing with her) and shoots himself in the foot.
Update: I mistakenly thought that Peter Klein had written the article as his profile appeared on it. I should have paid more attention, but David Howden was the author. I have updated the post and apologised to Peter.
Update 2: I only just found out that David Glasner and Scott Sumner also wrote two good posts on free banking and Iza Kaminska/Selgin, followed by very interesting comments (here and here).
Tobin vs. Yeager, my view
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.
* See banks in Panama, which don’t have access to a central bank and maintain higher level of liquidity reserves as a result.
** 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.
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…
The ‘great search for yield’ update, Taleb on bank disintermediation and Coeuré on Wicksell
This is a quick update on my post of last week on the rush for yield among private investors and what it meant in terms of interest rate disequilibrium.
Following my post, Thomas Aubrey from Credit Capital Advisory kindly provided me with an update of his ‘Wicksellian differential’ chart. You can also find it here.
As you can see the differential between the estimated natural rate and the money rate of interest in the US have kept increasing and almost reached pre-crisis peak. According to his calculation, the potential differential now reaches………10%. It’s indeed huge. Try for a second to imagine the Fed all of a sudden increasing their target interest rate by 10%…… No you’re right, we just can’t imagine it. Frankly, I hope his calculation is wrong but…I wouldn’t bet my life on it. Consequently, Thomas Aubrey believes that it backs up my claim about malinvestments.
Meanwhile, in a speech called ‘The economic consequences of low interest rates’ at the International Center for Monetary and Banking Studies on the 9 October, Benoit Coeuré, member of the Executive Board of the European Central Bank, misunderstood Wicksell and inflation, justifying very low interest rates. Not only Mr Coeuré seems to believe that CPI adequately reflects inflation, but also, according to him, inflation is always zero when the money rate of interest equals the natural rate. This is not true: real shocks can temporarily push inflation one way or another, but over the longer term productivity becomes the main driver behind inflation and deflation. In a world of productivity increases (and increasing output), deflation should be the norm (as it was the case at the end of the 19th century and early 20th). A zero level of inflation in this context would actually mean that there is hidden inflation. George Selgin has written a lot on this. See his Less than Zero book or this video.
Last Friday, FT’s Henny Sender discussed the Fed’s impact on markets. According to a Hong Kong-based hedge fund “the Fed is always there. It is clear that it will not tolerate a decline in asset values. If you sell in the face of QE, you look like an idiot.” Sounds like the best way to completely distort markets. Free markets you said?
Today, John Authers, in another FT piece, says that “Western economy is overcentralised, creating extra risk”. I obviously won’t disagree with him. He cites Nicholas Taleb (reminding me of Larry White). But one thing particularly struck me: Taleb seems to think that hedge funds “are developing strategies that aim to disintermediate the banks, such as loan funds.” This is very, very close to my own opinion, which I haven’t mentioned yet on this blog: technological developments will enable shadow banking to grow under one form or another to desintermediate credit creation. This is something big, and it will require many blog posts and possibly a research paper…and some time.