Alt-M Ideas for an Alternative Monetary Future Fri, 22 Jul 2016 20:05:50 +0000 en-US hourly 1 Friday Flashback: Parliament to Scottish Nationalists: "Get Your Own B__y Money!" Fri, 22 Jul 2016 13:14:25 +0000 (Originally published on November 27, 2013 .) There are, I'm sure, some parts of the Scottish National party's recent blueprint for an independent Scotland to which the British government might reasonably take umbrage.   But the plan's call for Scotland's continued use of the pound sterling, which...

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Scottish Pounds(Originally published on November 27, 2013 .)

There are, I'm sure, some parts of the Scottish National party's recent blueprint for an independent Scotland to which the British government might reasonably take umbrage.   But the plan's call for Scotland's continued use of the pound sterling, which has drawn the most criticism, isn't one of them.

The pound sterling has been Scotland's monetary unit since 1707, when the Act of Union led to its adoption in place of the Pound Scots.  Scotland's actual paper currency, on the other hand, has mainly consisted of sterling-denominated notes supplied by several of its own commercial banks.  The nationalists' proposal is therefore  largely (though not entirely) a call for adhering to the status quo, and a rejection of the alternatives of either adopting the Euro or having Scotland once again establish an independent monetary standard.

How has such a seemingly reasonable and innocuous plan managed to ruffle Parliament's feathers? According to The New York Times, the British government

says it is unlikely to agree to share the pound with an independent Scotland, citing the problems experienced by the 17-nation euro zone to illustrate the dangers of a common currency without political union. London says it would be difficult to have the Bank of England act as guarantor of the pound if Scotland had a different fiscal policy from Britain, for example. Nationalists hint that if Scotland cannot keep the pound, it will not accept its share of Britain’s debt.

Now I've no dog in the fight over Scottish independence, but it seems to me that the folks who are saying this hae git thair bums oot the windae. For starters, an independent Scotland would hardly need the British government's permission to go on using the pound sterling: it's hard to imagine how the U.K.-sans-Scotland could prevent Scottish citizens and banks from continuing to use the pound without resort to such Draconian legislation as would make U.S. money-laundering laws seem toothless in comparison. In both England and Scotland today, for example, it's perfectly legal for banks to offer foreign currency demand deposit accounts, not to mention other sorts of foreign currency services. Just how would a truncated British government contrive to prevent, and to justify preventing, an independent Scotland from continuing to enjoy the right to offer such services, while adding the pound sterling to the list of "foreign" currencies to which the right pertains?

If the Brits were really willing to play hardball, I suppose they could try placing an embargo on shipments of Bank of England currency to Scotland, like the one the U.S. imposed, as part of its effort to topple Manuel Noriega's government, on shipments of fresh Federal Reserve notes to Panama. But whereas Federal Reserve notes had long been the only form of paper currency known in Panama's dollarized economy, the Scots, as I've already observed, have long managed without Bank of England notes, and could easily continue doing so, especially once freed from British-imposed banking regulations. Settlements and redemptions of Scottish bank balances would presumably have to be done using London funds. But unless the Brits wanted to impose severe exchange controls, which besides being embarrassing would harm English citizens no less than Scottish ones, that option would pose no great difficulty.

And the Eurozone comparison? A load of mince! The reason the Eurozone is a mess is because the Euro isn't the German mark–that is, because it's a multinational currency supplied through a multinational central bank, rather than a national currency that happens to be employed by several nations. Creditors to profligate Eurozone nations, or to irresponsible Eurozone banks, have therefore had reason to hope that the ECB might ultimately come to their aid, and especially so since the Growth and Stability Pact became a dead letter in 2003. Creditors to dollarized countries, on the other hand, have no reason to count on Fed bailouts. Were either Ecuador or El Salvador unable to service its debt, or were a Panamanian bank teetering at the brink of insolvency, it would be of no concern to the Fed, or the FDIC, or any other U.S. government agency. Dollarized or not, Ecuador, El Salvador and Panama have to manage on their own.

And how have those countries been doing despite having no lender of last resort to turn to in a crisis? Just dandy, as a matter of fact. Indeed, it seems that not having a lender of last resort has proved to be something of a boon to dollarized economies, because, by doing away with, or at least greatly limiting, any prospect of a bailout, it has caused creditors and banks to behave more prudently.

If the experience of dollarized countries can be relied upon, Scotland, besides not needing England's permission to go on using the British pound, would be better off not having such permission. It stands to benefit, in other words, by steering clear of any formal arrangements that might appear to make the Bank of England, or any other non-Scottish authority, responsible in any way for the safety and soundness of Scottish bank liabilities or government securities. Let the Scots follow the example of Ecuador and El Salvador, and "poundize" unilaterally. 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.

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Why the Money Multiplier Remains so Low Thu, 21 Jul 2016 13:17:59 +0000 George Selgin’s latest monetary policy primer was a very good explanation of the money multiplier in fractional reserve banking systems. He also suggested that a number of factors may be affecting the current surprisingly low level of the multiplier; a fact that prompted a number of endogenous...

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Rabbits 7-20

George Selgin’s latest monetary policy primer was a very good explanation of the money multiplier in fractional reserve banking systems. He also suggested that a number of factors may be affecting the current surprisingly low level of the multiplier; a fact that prompted a number of endogenous money theorists to (wrongly) assert that the multiplier was "dead."

In this post, I wish to elaborate on the reasons behind the low multiplier. And those reasons are, in my view, related to banking mechanics and regulatory dynamics.

Let’s first start with a little bit of history to put things in perspective. Some time ago, and following one of my blog posts on the topic, Levi Russel from the Farmer Hayek blog – who is much better than I am at manipulating FRED data – kindly sent me the following chart representing the M2 multiplier ("MM") since 1920:


As you can see, the MM also experienced a huge fall during the Great Depression. It then took about forty years for the MM to progressively get back to its pre-Depression level.

Independently of regulatory frameworks, there is a simple underlying reason behind this long recovery time: banking mechanics. As corporations, banks are subject to operating constraints that limit the short run supply of credit. Banks employ a number of bankers, analysts, risk experts and so forth that are in limited numbers and already working full time to extend loans to creditworthy customers in adequacy with the bank’s risk appetite. The client onboarding process, the analysis of his risk, as well as the negotiations of legal agreements, aren’t instantaneous. The funding process itself isn’t either: despite what endogenous money experts assert, extending new loans still require looking for additional non- central bank funding before or shortly after putting the credit line in place.

At any point in time, it is likely that banks are close to the microeconomic equilibrium ideal of having marginal revenues equal to the marginal economic costs of employing staff and retaining adequate levels of capital and liquidity, and that its managers decided not to extend credit further on purpose: additional revenues were not attractive enough to justify the costs of acquiring them.

The implication of a fall in the MM is that liquidity (under the form of bank reserves/high-powered money) is now abundant in the system relative to the amount of bank money in circulation. Liquidity cost not being an issue anymore, banks nevertheless remain subject to operational and credit risk constraints, implying that they cannot put this liquidity to work rapidly.

Indeed, this situation is amplified during a crisis, as the number of creditworthy borrowers falls and banks lay off some of their employees to offset the fall in revenues and rising loan losses. Moreover, liquidity costs also rise and banks decide to hold on to higher liquidity buffers than they used to, mechanically lowering the MM. Consequently, there is no way the MM can rapidly rise. It takes time.

And this was the mistake made by a number of economists who wrongly predicted that hyperinflation would strike in the years following the implementation of quantitative easing policies. Credit cannot mechanistically and instantaneously grow. The financial system is a source of sticky constraints and rigidities. Of course we did see periods of above average MM growth (like just before the Depression or between 1980 and 1987*). But even if those particular growth rates were applied to today’s world, it would take more than twenty years for the MM to get back to its pre-crisis level.

Some could reply that banks don’t need extra resources to invest their liquidity into government bonds. While this is true some constraints remain in place: 1. the supply of government bonds is limited, and buying large quantities of them would become uneconomical for banks’ margin as bonds yield fall towards zero; 2. only a handful of governments have top credit ratings, and this rating fall as they issue more debt; 3. banks want to diversify their portfolio and certainly do not wish to only be exposed to sovereign risk.

The description above effectively applies to banking systems free of exogenous regulations. But regulatory dynamics can dramatically hinder the money creation process and hence the return of the MM to more normal levels.

Following the 2008/9 crisis, the Western world has been quick at altering regulatory requirements despite the weak economic recovery. In the decade following the crash, Basel 3 (implemented in the US under Dodd-Frank and in the EU under CRD4) built on previous versions of the Basel framework to progressively tighten operating restrictions – thereby reducing banks’ ability to generate marginal revenues – as well as capital, liquidity and funding requirements.

This regulatory package made it even more complex for bank to engage in lending. These are some of the steps that bankers now typically have to take in order to set up a new committed credit line:

  1. Client onboarding/Know-Your-Customer, which is getting increasingly tightened by authorities due to international sanctions, tax evasion and terrorism
  2. Credit analysis/risk assessment facility type/comparison with risk appetite and internal risk management guidance
  3. Estimate what the regulatory liquidity (LCR) and funding (NSFR) requirements are going to be for this specific credit facility.
  4. Estimate the cost of getting hold of the specific liquid assets and funding instruments (which both are in limited supply on the market and hence costly to acquire) that rules require
  5. Estimate the amount of regulatory capital (also in limited supply) required for such a facility
  6. Estimate total risk-adjusted revenues of the new credit facility (plus any other revenues from this customer), deduct total costs, and compare with required regulatory capital
  7. If return on capital too low vs. management policy, decide whether or not to extend credit based on relationship
  8. Negotiate loan agreement/covenants

Those steps require human resources in relationship management, risk management, legal and treasury. As the process has been lengthened and complexified by Basel 3 in the post-crisis years, it is unsurprising that banks, already facing declining revenues and costs-cutting (i.e. staff), haven’t been able to grow their balance sheet as rapidly as bank reserves were flowing into the system. Moreover, faced with harsher capital regulations and unending litigation costs in a world of low or negative interest rates, banks found it extremely hard to find remunerative lending opportunities. Consequently, many banks have now entirely exited a number of lending products whose marginal costs have been pushed up by regulation above their marginal revenues. They have deleveraged in order to be compliant with capitalization rules rather than raise capital to avoid diluting shareholders already suffering from  zero return (therefore at risk of exiting their investment altogether). I guess I don’t have to explain that a deleveraging banking system is antithetical with a rising MM.

Finally, I shall include monetary policy in the "regulatory dynamics" category, and more particularly the decision by a number of central banks to pay interests on excess reserves. It is not the purpose of this post to focus on this rather strange monetary tool; George Selgin wrote plenty of excellent posts deconstructing its rationale.

A last note however. While we’ve mostly been describing the factors influencing the supply of credit, let’s not forget to factor in the other side of the equation: demand for credit. During or following a credit crisis, borrowers often attempt to repair their balance sheets by deleveraging, affecting the demand for new loans.

In the end, it looks unsurprising to see the money multiplier remaining so low and taking decades to recover following a rapid fall. As history shows, this is a recurring fact, dictated by the day to day operating rigidities of the business of banking, and with consequences for the bank lending channel of monetary policy. Our dear multiplier isn’t dead; it is just sleeping and merely unlikely to reach pre-crisis levels for another few decades.


*Such rapid growth rate in the 1980s is probably linked to banks trying to add more remunerative lending to their portfolio as rapidly as possible. This is because, as both nominal interest rates and inflation were shooting up, banks’ margins were becoming rapidly compressed due to legacy lending extended in earlier periods of lower nominal rates.

[This article originally appeared on Spontaneous Finance]

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Futures Unbound Tue, 19 Jul 2016 13:06:13 +0000 Futures Unbound, this year’s Cato-CMFA Summit on Financial Regulation, took place in Chicago on June 6th. The event consisted of lectures from five speakers; Congressman Blaine Leutkemeyer, CMFA’s Thaya Brook Knight and George Selgin, the Federal Reserve’s Thomas Sullivan, and University of Chicago Law Professor Omri-Ben Shahar....

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DiscolsureFutures Unbound, this year’s Cato-CMFA Summit on Financial Regulation, took place in Chicago on June 6th. The event consisted of lectures from five speakers; Congressman Blaine Leutkemeyer, CMFA’s Thaya Brook Knight and George Selgin, the Federal Reserve’s Thomas Sullivan, and University of Chicago Law Professor Omri-Ben Shahar. Here, I supply synopses of these talks. Complete podcasts can be found here.[1]

Congressman Blaine Leutkemeyer (R-Missouri) reported that every financial services professional he has recently spoken to, from large firm executives to community bankers, is complaining about the increasing onerousness of federal regulation. Although insurance is mostly regulated at the state level, Dodd-Frank dramatically increased the Federal government’s role in insurance, transferring “a third of the insurance industry to federal supervision.” Leutkemeyer also mentioned a notable Dodd-Frank statistic, that the percentage of checking accounts with free checking dropped from 75% to 35% since that law was enacted. He closed by calling attention to the FDIC/DOJ’s Operation Choke Point, which he described as a “shadow regulatory system” that intimidates banks.

Negative reactions to financial speculation have a long history. Old Testament, New Testament, Roman, and other ancient and classical sources decry speculatory practices. Why does speculation have such a “bad rap?” Thaya Brook Knight compared a common view of speculators to the dog in the “dog in the manger” parable. Speculators do not produce mangers, but they do take hay away from wolves that actually need them. Even today, proclamations against speculation persist. Pope Francis recently blamed speculators for high food prices, and many commentators blamed the ‘07-‘08 crisis on speculation.

Commodities and securities market regulation attempts to discourage speculation. In securities markets, speculation is regulated through the tax code.  Short term investments are taxed at a higher rate than long term investments. In commodities markets, the law differentiates between legitimate hedging by producers and excessive speculation by investors. This election cycle, candidates and advocacy groups proposed reducing speculation via a financial transactions tax.

Knight showed that many of the commonly assumed negative characteristics of speculation are actually beneficial. Speculation stabilizes prices, not only because of the well known ability for say, agricultural producers to hedge against seasonal fluctuations, but also because of the role speculation plays in price discovery. What about speculating during a commodity shortage? As the pejorative term “price gouging” demonstrates, betting on shortages is often thought of as a particularly immoral form of price destabilization.[2] Knight counters that price gouging is an incentive for the production increases necessary for shortages to clear. What about in securities markets, does speculation disrupt the pricing mechanism by driving bubbles? Knight suggests we consider what equity markets would look like if all investors “bought and held,” news about a company’s health and development be damned. In general, traders’ ability to react to information and change positions frequently leads to more accurate pricing.  

George Selgin discussed clearinghouses' role in the pre-Fed American financial system, which came to include providing liquidity during panics. After the failure of the Ohio Life and Trust Insurance Company in 1857 led to a system wide suspension of specie payments in New York, the recently formed New York Clearing House issued temporary loan certificates to member banks for use in settling transactions. This emergency measure prevented a complete halt in the flow of payments and credit during the Panic of 1857. Financial turmoil only became more frequent after the Civil War due to the National Currency Act, which tied bank note issue to the quantity of government bonds a bank held as reserves. As in the 1857 case, the clearinghouse dealt with post-bellum panics by providing troubled banks with loan certificates. These certificates were a way for banks to extend credit to one another. Participating banks essentially stretched their collective reserves and dispersed risk throughout the system. Clearinghouses, as mere facilitators of credit between member banks, did not assume any centralized risk.

Selgin emphasized that clearinghouses did not provide emergency loan certificates to every troubled bank. Clearinghouses made sure that banks receiving the loans were solvent, and that banks using the certificates to meet obligations would be forced to eventually pay a high, “penalty” interest rate. Also, clearinghouses ensured that banks stayed open during crises, even if specie payments were suspended. This meant that disastrous complete closures of banks, like those that characterized the worst periods of the Great Depression, were avoided.

Selgin closed by noting the advantages of the 19th century’s spontaneous and private clearinghouses relative to today’s government imposed and run versions. In addition to the Fed, Dodd-Frank’s mandated central clearinghouses for OTC derivatives will socialize risk and create moral hazard, removing an incentive for the private sector innovation that might actually improve payments and settlement in the derivatives market.

Omri Ben-Shahar investigated mandated disclosure in regulatory regimes. While his presentation covered American regulatory law in broad, disclosure has a particular importance to capital markets, where Louis Brandeis’s idea that “sunlight is the best disinfectant” has underpinned  regulation since the Securities Act of 1933. Asking “are we doomed to drown in disclosure?” Ben-Shahar points out disclosure’s absurdities and questions whether mandated disclosure is ever necessary.

Some of the most egregious examples of the disclosure overload are on the Internet. By law, a website’s terms and conditions and privacy policy must be disclosed to users. Ben-Shahar notes that not only are such notices rarely skimmed, from a practical standpoint it is essentially impossible for anyone to closely read them. An average Internet user would have to spend three months out of the year reading privacy notices to actually understand what each “I agree” click means.

Are the Internet’s disclosures simply an outlier? What about nutrition product labels, or medical informed consent? Even if these disclosures seem more intuitively necessary, research shows we don’t read these disclosures either, nor do they affect our behavior. Disclosure, therefore, should no longer be used as a de-facto regulatory solution to information asymmetry problems. Fans of disclosure, energized by Cass Sunstein’s “nudge” ideas, think disclosure can affect behavior if done simpler and smarter. Ben-Shahar cautions against viewing simplification as a panacea. Simplified, nudge style disclosures, designed to be easily understood and to encourage a desired outcome, like nutrition labeling, often don’t change behavior. Since mandatory nutrition labeling, for example, Americans eat less calories per meal but eat more meals, which comes out to a slight overall increase in calorie intake.

In close, Ben-Shahar warns that any future attempts by policymakers to mandate the disclosure of information would represent “the triumph of hope over experience.”

Again, you can find more information about Futures Unbound and links to all available audio here!


[1] Unfortunately, we do not have a written or audio version of Sullivan’s remarks.

[2] This view  has been held even by some of  world history’s best regarded thinkers, for example Knight’s PowerPoint included a reference to the great medieval philosopher Maimonides, who argued that prices should never deviate by 1/6th due to temporary changes in supply.

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Dodd-Frank, Lending, and Slow Growth Thu, 14 Jul 2016 13:17:54 +0000 On Tuesday, John Allison, chair of CMFA’s executive advisory board, former president of Cato, and 20-year CEO of BB&T, testified before the House Financial Services Committee. The hearing was on the recently proposed Financial CHOICE Act, which aims to reform Dodd-Frank. Beyond discussing the potential efficacy of that bill, Allison’s testimony...

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Bank Capital, bank lending, Basel III, John Allison, Sarbanes-OxleyOn Tuesday, John Allison, chair of CMFA’s executive advisory board, former president of Cato, and 20-year CEO of BB&T, testified before the House Financial Services Committee. The hearing was on the recently proposed Financial CHOICE Act, which aims to reform Dodd-Frank. Beyond discussing the potential efficacy of that bill, Allison’s testimony pithily describes the connection between financial regulation, monetary policy, the financial crisis, and today's low economic growth. For our readers benefit, his written testimony is reproduced below. A clip of Allison's oral testimony can be found here. For the hearing in its entirety, see here.


I was the longest serving CEO in the US of a major financial institution, BB&T, at the time of the recent financial crisis. BB&T went through the financial crisis without experiencing a single quarterly loss. I had the unique experience and perspective of leading BB&T’s lending business during the severe correction of the early 1980’s and was CEO during the early 1990’s recession.

The Federal Reserve’s monetary and regulatory policies were major contributors to the 2007-2009 Great Recession. On the regulatory side an excessive focus on Sarbanes-Oxley, the Patriot Act, and the Privacy Act created a total lack of safety and soundness regulation. Investors, rightly so, assumed bank regulators were controlling industry risk and the investors were lulled to sleep. Without the perception that regulators knew what the risk were, investors would have studied the industry far more carefully. The market was fooled by banking regulators.

In addition, the implementation by the banking regulators of the Basel capital standards increased leverage (less capital) in large financial institutions. Using extremely complex mathematical models,large banks, with support from the banking examiners, convinced themselves they could take high risk with little capital because they could manage the risk. In addition, banking regulators were motivated to underestimate risk for political purposes. A financial institution was required to hold half as much capital for an affordable housing (subprime mortgage) as for a loan to Exxon. In Europe, banks were not required to hold any capital for a loan to Greece.

The financial industry regulators seriously mishandled the 2007-2009 economic correction which is continuing to negatively impact economic growth. The regulators made the correction far worse than it needed to be. During the early 1980’s and 1990’s recessions the bank examiners let unhealthy banks and savings and loans fail. However, they did not interfere with healthy banks’ lending practices. They allowed healthy financial institutions with rational lending standards to continue to make loans and support their customers and also to finance good customers who were leaving unhealthy banks. Unfortunately, this time, the examiners forced healthy institutions like BB&T to unnecessarily put out of business many small businesses who we would have supported and who would be in business today. These businesses would be creating good jobs and economic growth. The regulators destroyed many entrepreneurs unnecessarily.

The banking regulators tightened lending standards at exactly the wrong time. They closed the barn door after the horse was out of the barn. These very tight lending standards remain in place for venture capital small business loans. Venture capital small business loans are when the lender while considering the financial projections primarily makes the loan based on a judgement of the borrower and the concept. In the current regulatory environment, while existing slow growing small businesses can often obtain financing, small business startups are frozen out of the market and highly innovative aggressive expansion plans for existing small firms will not be financed significantly slowing the growth of the firms.

I began my banking career as a small business/middle market lender. I was fortunate to help a number of small businesses which have expanded significantly and created thousands of jobs. These loans which were critical to the growth of these firms could not be made today. Bernie Marcus, the founder of Home Depot, has told me on several occasions that he could not have started and grown Home Depot in the current regulatory environment.

The lack of small business venture capital funding from banks and the inability of banks to finance the expansion of more aggressive entrepreneurs has slowed innovation (in all industries except technology)and thereby significantly reduced competition. Because of the lack of competitive pressure existing firms are not motivated to invest for the future. They would rather cut cost and buy back shares of stock. The effect is to slow the growth in productivity which ultimately determines economic well being because we cannot consume more than we produce. In the financial services industry, firms are focused on compliance instead of innovation and productivity.

One tragic irony is that by tightening lending standards the Federal Reserve has undermined its monetary policy. They cannot get the money supply to grow because the velocity of money (the money multiplier) has slowed because bank’s are only making loans to large businesses. The Federal Reserve is effectively subsidizing large firms.

Unfortunately, Dodd Frank and the related regulatory regime has not only slowed economic growth, it has not effectively dealt with the issues which caused the financial crisis. The “too big to fail” problem has not been solved.

We all want a safe and sound financial system. However, history shows that it is naive to believe that excessive regulation will accomplish this goal. The Federal Reserve economist and the banking regulators did not foresee the recent financial crisis. In fact, they made the crisis much worse by using Basel capital rules and risk weighting assets for political not economic reasons (affordable housing,Greek debt). Why would anyone believe regulators will not make the same mistake in the future or the opposite mistake which they are making today by requiring excessively tight standards for small business loans? Markets participants make mistakes, but they pay the price. Government regulators force all firms to make the same mistakes and the whole economy to pay the price.

History has consistently shown that the best method to reduce the risk of bank failures is strong capital positions. During the recent correction, which was the worst recession since the Great Depression, very few properly capitalized banks failed. In my 40 plus year career, I do not know of a single case where banking regulators knew a bank was in trouble before we did and few cases where properly capitalized banks could not handle economic corrections.

By far the most important aspect of this proposed legislation is the provision which allows properly capitalized banks to opt out of the regulatory nightmare which is paralyzing the industry and slowing innovation, creativity and thereby economic growth. Lower income individuals are the most negatively damaged by this sad situation.

For those primarily focused on safety and soundness, there can be a debate about which is the best capital standard. However, it is enlightening to note that after massive regulatory cost and intrusion over almost 8 years, Citigroup has a leverage ratio according to their recent quarterly report of only 6.4%. If I were CEO of Citi I could not sleep at night with this low of leverage ratio. I will state with certainty after many years in the banking industry that raising Citi’s leverage ratio to 10% would reduce the risk of Citi failing far more then hiring 5,000 or 10,000 more regulators to micromanage the company. It is important that the capital ratio be reasonably simple and understandable or large banks will game the system.

Also, for those who want to break up large banks logically raising capital requirements is a far more rational approach then arbitrarily deciding on a maximum size. Economic analysis will force the banks to decide to divest business segments which do not earn satisfactory returns which will significantly enhance the allocation of resources in the economy.

However, there must be a trade off between regulatory cost and stronger capital. Financial institutions cannot survive with the stifling cost of Dodd Frank and higher capital. Interestingly, the regulators know this even those they will not admit it. Why have they not insisted on more capital already? Because they know the regulatory cost/capital equation implied in Dodd Frank will not work. They have chosen more regulation over more capital because that is their job and expands their perceived importance.

The opt out provision instead of a forced strategy is an optimal concept. I believe that markets will quickly conclude that those institutions which do not opt out are weak. Who would voluntarily participate in the regulatory quagmire of Dodd Frank? The opt out process will increase capital in the industry thereby reducing risk. The reduced regulatory cost will make financial intermediaries far more efficient and encourage innovation in the industry. Core financial institutions, such as community banks, will be able to get back to their business of growing their communities.

There are no examples of healthy economies without healthy banks.

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A Monetary Policy Primer, Part 6: The Reserve-Deposit Multiplier Tue, 12 Jul 2016 13:09:39 +0000 In my last post in this series, I observed that an economy's "base" money serves as the "raw material" that commercial banks and other private-market financial intermediaries employ in "producing" deposits of various kinds that can themselves serve as means of exchange. If they could do so...

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Multiplier2In my last post in this series, I observed that an economy's "base" money serves as the "raw material" that commercial banks and other private-market financial intermediaries employ in "producing" deposits of various kinds that can themselves serve as means of exchange.

If they could do so profitably, these private intermediaries would,  by making their substitutes more attractive than base money itself, collectively gain possession of every dollar of base money in existence. In some past monetary arrangements, most notably that of Scotland before 1845, banks came very close to achieving this ideal, thanks to the their freedom to supply their customers with circulating paper banknotes as well as with deposits, and to the fact that between them these two substitutes could serve every purpose coins might serve, and do so more conveniently than coins themselves.

All save a handful of commercial banks today are, in contrast, able to supply deposits only, so that only base money itself can serve as currency, that is, circulating money. The extent to which national money stocks have been "privatized," in the sense of being made up mainly of private IOUs of various kinds rather than officially-supplied base money, has been correspondingly limited, as has the extent to which private money holdings have served as a source of funding for bank loans.

When banks and other private-market intermediaries acquire base money, they do so, not for the sake of holding on to it, as they might were they mere warehouses, but in order to lend or otherwise invest it. More precisely, they do so in order to lend or invest most of the base money that comes their way, while keeping some on hand for the sake of either meeting their customers' requests for currency, or for settling accounts with other banks, as they must do at the end of each business day, if not more frequently. While banks' own substitutes for base money may serve in place of base money for all sorts of transactions among non-banks, those substitutes won't suffice for settling banks' dues to one another, for every bank is anxious to grab for itself as large a share of the market for money balances as possible, while contributing as little as possible to the shares possessed by rival banks.

Bankers have also learned, through hard experience, that by accumulating the IOUs of other banks, and thereby allowing other banks to accumulate their own IOUs in turn, they expose themselves to grave risks, which risks are best avoided by taking part in regular interbank settlements. Because even the most carefully-managed banks cannot perfectly control or predict the value of their net dues at the end of any particular settlement period, all would tend to equip themselves with a modest cushion of cash reserves even if they did not have to do so for the sake of stocking their ATM's or accommodating their customers' over-the-counter requests for cash.

Because banks typically receive fresh inflows of reserves every day, as a result of ordinary deposits, loan repayments, or maturing securities, a responsible banker, once having set-aside a reasonable cushion of reserves, has only to see to it that the lending and investment that his or her bank engages in just suffices to employ those inflows, in order to succeed in keeping it sufficiently liquid. Greater reserve inflows, if judged likely to be persistent, will inspire increased lending or investment, while reduced ones will have the opposite effect.* The bankers' general goal is to keep funds that come the bank's way profitably employed, while holding on to just so many reserves as are needed to accommodate fluctuations of net reserve drains around, and therefore often above, their long-run (zero) mean. More precisely, bankers' strive to keep reserves on hand sufficient to reduce the probability of losses exceeding available reserves to a (usually modest) level,  reflecting both the opportunity of holding reserves, which is to say the interest that might be earned on other assets, and the costs involved in making-up for reserve shortages, by borrowing from other banks or otherwise.

Throughout the history of banking, and despite laws that have suppressed commercial banknotes while often imposing minimum (but never maximum) reserve ratios on banks, bank reserves have generally constituted a very modest part of banks' total assets, and therefore a modest amount compared to their their total liabilities. Indeed, bank reserves have generally been but a small fraction of banks' readily redeemable or "demandable" liabilities. England's early"goldsmith" banks are supposed to have held reserves equal to only a third of their demandable liabilities — a remarkably low figure, given the circumstances; at the other extreme, Scottish banks at the height of that nation's pre-1845 "free banking" episode often managed quite well with gold or silver reserves equal to between one and two percent of their outstanding notes and demand deposits. Modern banks, even prior to the recent crisis, have generally had to keep somewhat higher reserve ratios than their pre-1845 Scottish counterparts, mainly owing to the fact, mentioned above, that they must stock their cash machines and tills with base money, instead of being able to do so using their own circulating banknotes.

Between 1997 and 2005, for instance, U.S. depository institutions' reserves ranged, with rare exceptions,  between 11 and 14 percent of their demand deposits (see figure below). Put another way, for every dollar of base money "raw material" they acquired, U.S. commercial banks were able to "manufacture" (that is, to create and administer) just under 10 dollars of demand deposits.  That figure, the inverse of the banking system reserve ratio, is what's known as the reserve-deposit "multiplier."

Depository Institutions' (Demand Deposit) Reserve Ratio, 1997-2005

The multiplier's significance to monetary policy is, or used to be, straightforward: it indicated the quantity of additional bank deposits that monetary authorities could expect to see banks produce in response to any increment of new bank reserves supplied them by means of either open-market operations or direct central bank loans. If, around 2000 (when the reserve-demand deposit multiplier was about 14), the Fed wanted to see bank's demand deposits increase by, say, $10 billion, it had only to see to it that they acquired $(10/14) billion in fresh reserves, which meant creating a somewhat larger quantity of new base dollars — the difference serving to make up for the tendency of some of any newly created bank reserves to be converted into currency. The ratio of the total amount of new money, including both currency and bank deposits, generated in response to any new increment of base money, to that increment of base money itself, is known as the "base money multiplier."

Since the recent crisis, all sorts of nonsense has been written about the "death" of the reserve-deposit and base-money multipliers, and even (in some cases) about how we ought to be glad to say "good riddance" to them. I say "nonsense" because, first of all, the multipliers in question, being mere quotients arrived at using values that are themselves certainly very much alive, cannot themselves have "died," and because the working of these multipliers does not, as some authorities suppose, depend on the particular operating procedures central banks employ. Finally, although it's true that, until the recent crisis, economists were inclined, with good reason, to take the stability of the reserve-deposit and base-money multipliers for granted, it doesn't follow that they (or good ones, at least) ever regarded these values as constants, as opposed to variables the values of which depended on various determinants that are themselves capable of changing.

What certainly has happened since the crisis is, not that the reserve-deposit and base-money multipliers have died, but that their determinants have changed enough to cause them to plummet. U.S. bank reserves, for example, have (as seen in the next picture) gone from being equal to a bit more than a tenth of demand deposits to being about twice the value of such deposits!  The base-money (M2) multiplier, shown further below, has, at the same time, fallen to below half its pre-crisis level, from about 8 to 3.5 or so (not long ago it was less than 3).

The Reserves-to-Demand-Deposits Ratio Since 2005


The Base-Money M2 Multiplier since 2005

These are remarkable changes, to be sure.  But they are hardly inexplicable. Banks' willingness to accumulate reserves depends, as I've already noted, on the cost of holding reserves, which itself depends on the interest yield of reserves compared to that of other assets banks might hold instead. Before the crisis, bank reserves earned no interest at all. On the other hand, banks had all sorts of ways in which to employ funds profitably, especially by lending to businesses both big and small. Consequently, banks held only modest reserves, and bank reserve and base-money multipliers were correspondingly large.

The crisis brought with it several changes that are more than capable of accounting for the multipliers' collapse.  The recession itself has, first of all, resulted in a general reduction in both nominal and real interest rates on loans and securities, to the point where some Treasury securities are now earning negative inflation-adjusted returns. Regulators have in turn responded to the crisis by cracking-down on all sorts of bank lending, making it costly, if not impossible, for banks, and smaller banks especially, to make many of the higher-return loans, including  small business loans, they would have been able to make, and to make profitably, before the crisis. (More here.) U.S. bank regulators have also begun to enforce Basel III's new "Liquidity Coverage Ratio" rules, compelling banks to increase the ratio of liquid assets, meaning reserves and Treasury securities, to less-liquid ones on their balance sheets. Finally, since October 2008, the Fed has been paying interest on bank reserves, at rates generally exceeding the yield on Treasury securities, thereby giving them reason to favor cash reserves over government securities for all their liquidity needs.

Whatever their cause, today's very low money multiplier values mean that commercial banks have ceased to contribute as they once did to the productive employment of scarce savings. Instead, those savings have been shunted to the Fed, and to other central banks, which use them to purchase government securities, and also for other purposes, but never, with rare exceptions (and with good reason), to fund potentially productive enterprises. Although discussions of monetary policy since the crisis have mainly had to do with the quantity of money, and central banks' efforts to expand that quantity so as to stimulate spending, the effects of the crisis, and of governments' response to it, on the quality of money, and especially on the investments its holders have been funding, deserve at least as much attention.


*Besides funding loans with retail deposits banks can and do fund them by borrowing on wholesale markets.  In that case, loans may be arranged in anticipation of a bank's acquisition of funds. Either way, banks must acquire base-money sufficient to finance their lending (that is, to cover their settlement dues) if they are to avoid having to rely too often on funding from last-minute interbank loans.

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"Boss" Aldrich and the Founding of the Fed Fri, 08 Jul 2016 13:12:31 +0000 America's Bank, Roger Lowenstein's 2015 book on the founding of the Fed, is, as I said in reviewing it for Barron's, both well-written and well-researched.  Few pertinent details of the story appear to have escaped Lowenstein's notice. However, in assembling and interpreting these details, Lowenstein appears not to...

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America's Bank, Roger Lowenstein'sAldrich5 2015 book on the founding of the Fed, is, as I said in reviewing it for Barron's, both well-written and well-researched.  Few pertinent details of the story appear to have escaped Lowenstein's notice. However, in assembling and interpreting these details, Lowenstein appears not to have entertained the slightest doubt that the Federal Reserve Act, for all the political maneuvering that led to it, was the best of all possible means for ending this nation's periodic financial crises.

Instead of turning a critical eye toward the 1913 Act, Lowenstein writes as if history itself were a reliable judge.  What it has condemned he condemns as well; and what it has favored he favors.  Consequently he treats all those persons who contributed to the Federal Reserve Act's passage as right-thinking progressives, while regarding those who favored other solutions to the nation's currency and banking ills as so many reactionary bumpkins.

That some strains of triumphalism should have found their way into Lowenstein's account of the Fed's origins is hardly surprising.  Though research by economic historians and others supplies precious little support for it, the view that the Fed has been a smashing success is, after all, a well-established element of conventional wisdom, and one that Fed officials themselves never cease to promote.  Nor have those officials ever devoted more effort to doing so than in the course of celebrating the Fed's recent centennial.  Even a much more hard-bitten journalist than Lowenstein could hardly have been expected to resist setting considerable store by an institution so universally (if undeservedly) hallowed.

Still, one might have expected a note of skepticism, if no more than that, to have found its way into America's Bank.  Lowenstein was, after all, writing about an institution that was supposed to end U.S. financial crises once and for all, and doing so in the wake of a crisis at least as bad, in many respects, as those that inspired its creation.  (Those who suppose that the Fed did all it could and should have done to combat the recent cataclysm are encouraged to read this, this, this, and this.)  He had, furthermore, encountered the many arguments — and most were far from being plainly idiotic — of pre-1913 experts who favored other reforms, as well as those of some of the pending Federal Reserve Act's critics, who predicted, correctly, that it wouldn't be long before its results would acutely disappoint those of its champions who sincerely yearned for financial and economic stability.

Perhaps most importantly, Lowenstein knew very well that Nelson ("Admit nothing.  Explain nothing") Aldrich, whom he (following Elmus Wicker) rightly regards as the man most responsible for clearing the way for the Fed's establishment, was the  outstanding crony capitalist politician in an epoch when such politicians were thicker on the ground than ever before or since.  Although Aldrich presented the plan known by his name, much of which ended up being incorporated into the Federal Reserve Act, as a product of the collective efforts of the National Monetary Commission's 16 members, the plan was actually one he himself drafted, with the help of several Wall Street bankers, in secret at Jekyll Island. The commission's other members contributed nothing save their rubber stamp.

It's wise to view Lowenstein's assessment of Aldrich's contribution in light of what other journalists have had to say about the long-serving Rhode Island Senator.  Consider, for starters, Lincoln Steffens' opinion, as expressed by him in a 1908 letter to Teddy Roosevelt.  "What I really object to in him," Steffens wrote, "is something he probably does honestly, out of general conviction. … He represents Wall Street; corrupt and corrupting business; men and Trusts that are forever seeking help, subsidies, privileges from government."

Bad as this sounds, it's nothing compared to the portrait muckraking journalist David Graham Phillips drew of Aldrich in The Treason of the Senate, his sulphurous 1906 exposé of an upper-house rife with corruption:

Various senators represent various divisions and subdivisions of this colossus.  But Aldrich, rich through franchise grabbing, the intimate of Wall Street's great robber barons, the father-in-law of the only son of the Rockefeller — Aldrich represents the colossus.  Your first impression of many and conflicting interests has disappeared.  You now see a single interest, with a single agent-in-chief to execute its single purpose — getting rich at the expense of the labor and the independence of the American people.

"Aldrich's real work," Phillips went on to write, consisted of "getting the wishes of his principals, directly or through their lawyers, and putting these wishes into proper form if they are orders for legislation or into the proper channels if they are orders to kill or emasculate legislation."  The work was "all done, of course, behind the scenes."  As chairman of the Senate Finance Committee Aldrich labored to "concoct and sugar-coat the bitter doses for the people — the loot measures and the suffocating of the measures in restraint of loot."

Although the opinions of Steffens and Phillips might be dismissed as yellow journalism, the same cannot be said for similar verdicts reached by academic historians, including that of Jerome Sternstein, in his article "Corruption in the Gilded Age Senate: Nelson W. Aldrich and the Sugar Trust."  According to Sternstein, "far from insulating the legislative process from big business and reducing the incentives for corruption, the concentration of institutional authority in the hands of senators like Nelson W. Aldrich had precisely the opposite effect":

Aldrich was wedded ardently to the concept that legislation affecting businessmen should be drawn up in close collaboration with businessmen. … America's productive economy was not the work of politicians and theorists, but of innovative businessmen making business decisions in a most practical, efficient way.  Members of Congress, therefore, had an obligation to clear appropriate legislation with them.  Effective lawmaking, he held, especially that required to carry out the Republican gospel of prosperity and economic growth through vigorous state action in the form of protective tariffs and subsidies, was next to impossible otherwise. …

Thanks to his success in achieving the legislative goals of his corporate clients, Aldrich "found money and favors flowing to him.  Businessmen did not bribe him, they did not dominate him — they simply rewarded and supported him."  In return for his efforts to shunt monetary reform onto a spur favoring the big Wall Street banks, for instance, Aldrich earned a token of gratitude from Henry P. Davison, a partner in J. P. Morgan & Company, who arranged and took part in the Jekyll Island meeting:

The enclosed [Davison wrote to Aldrich] refers to the stock of the Bankers Trust Company, of which you have been allotted one hundred shares.  You will be called upon for payment of $40,000… It will be a pleasure for me to arrange this for you if you would like to have me do so.

I am particularly pleased to have you have this stock, as I believe it will give a good account of itself. I t is selling today on the basis of a little more than $500 a share.  I hope, however, you will see fit to put it away, as it should improve with seasoning.  Do not bother to read through the enclosed, unless you desire to do so.  Just sign your name and return to me.

In view of Aldrich's notoriety, Lowenstein might have suspected that, whatever its merits, the Aldrich Plan was bound to be compromised by its authors' desire to look after Wall Street's interests.  He might therefore have entertained the possibility that neither it nor the Federal Reserve Act that drew so heavily from it was ideally suited to putting a stop to financial crises.  But rather than proffer a revised (and not-so-triumphant) view of the Fed's origins, Lowenstein elected instead to revise the record concerning Aldrich himself, turning him into his story's unlikely hero.  Just as some bolting horses supposedly turned Pascal into a religious mystic, the Panic of 1907 "jolted" Aldrich sufficiently, according to Lowenstein, to inspire his conversion, from Wall Street's Man in Washington to high-minded proponent of monetary reform.

But did it?  The facts suggest otherwise.  Of the many shortcomings of the pre-Fed currency and banking system, none struck sincere reform proponents of all kinds as being in more dire need of correction than the tendency of the nation's bank reserves to flow into the coffers of a handful of New York banks during seasons apart from the harvest, combined with the annual (and occasionally mad) harvest-time scramble for those same reserves.  That ebb and flow of reserves from countryside to New York City and back again was the sine qua non of the crises that periodically rocked the U.S. economy.  Unfortunately, that same ebb and flow was, so far as New York's major banks themselves were concerned, good business, for it was the source of funds they lent on call to stock investors, by which they made a tidy profit.  Any reform that might undermine their status as the ultimate custodians, for most of the year, of the nations' bank reserves was, so far as they were concerned, anathema.

Until the Panic of 1907, Aldrich was able to satisfy his Wall Street clients simply by blocking — with the help of fellow standpatters — every monetary reform measure that came his committee's way. The panic changed things, not by convincing Aldrich to clean up his act, but by forcing him to change his tactics.  Realizing that reform could no longer be held off, he resolved to assume control of the reform movement, and to have it result in changes that, however sweeping, would nonetheless preserve, and even enhance, both the dangerous "pyramiding" of reserves in New York and his Wall Street chums' bottom lines.

Just how Aldrich managed to achieve this goal — and to do so despite the rejection of his own plan in favor of a Democratic alternative — is a story too long to be told here.  Interested readers will find it, and many other details besides, in my recent Cato Policy Analysis, "New York's Bank: The National Monetary Commission and the Founding of the Fed," which they can view by clicking on the image below.  The information there will, I hope, allow them to conclude that, to gain a proper understanding of Aldrich's part in the Fed's establishment, one needn't alter a single brushstroke in muckrakers' portraits of him.



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Why are Interest Rates so Low? Wed, 06 Jul 2016 13:18:05 +0000 Since the financial crisis of 2007-09, and especially in recent months, Europe and the United States have seen zero and even slightly negative short-term nominal interest rates, and sub-zero risk-free real interest rates (see the figure below). In June I participated in a conference on “Zero Interest...

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X aggregate demandX credit booms and bustsX natural rate of interestX secular stagnationX ZIRPSince the financial crisis of 2007-09, and especially in recent months, Europe and the United States have seen zero and even slightly negative short-term nominal interest rates, and sub-zero risk-free real interest rates (see the figure below). In June I participated in a conference on “Zero Interest Rate Policy and Economic Order” at the University of Leipzig, organized by Gunther Schnabl (U Leipzig), Ansgar Belke (U Duisburg-Essen), and Thomas Mayer (Fossback von Storch Research Institute).  The topic faced participants with the need to make a key judgment call: Are ultralow rates the new normal, i.e. are they long-run equilibrium rates determined by market fundamentals, or are they so low because of ultra-easy monetary policies and other policies?  In Wicksell’s terminology, is the real “natural rate” currently below zero, or are central banks holding market rates below the current natural rate? We cannot directly observe the natural rate, but we can look for indirect indicators.

In Wicksell’s famous and now-standard analysis, a central bank can drive (or hold) the market rate of interest below the natural rate by injecting money, which shifts the supply of loanable funds curve to the right, increasing the quantity of loanable funds and lowering the interest rate (the “liquidity effect”).  As the new money circulates it drives up prices and nominal incomes, however, which shifts the nominal demand for loanable funds curve to the right, raising the market interest rate (the “nominal income effect”).  If the central bank wants to keep the market rate low in the face of the nominal income effect, it must accelerate the money injection.  Short-term real rates have been negative, and nominal rates near zero, for eight years now with little sign of accelerating broad money growth or a rising inflation rate.  Thus the Wicksellian cumulative-process scenario does not seem to be a viable candidate for explaining why current rates have remained so low since 2008.

Lukasz Rachel and Thomas D Smith, in a widely cited Bank of England working paper, spell out the market-fundamentals view: “The co-movement in rates across both advanced and emerging economies suggests a common driver: the global neutral real rate may have fallen.”  They try to quantify changes over the last 30 years in the various factors shifting the supply of loanable funds rightward (population bulge nearing retirement, larger income share of the well-to-do, the “glut” of “precautionary saving by emerging markets”) and the demand leftward (depressed investment, higher risk premia) for loanable funds.  Larry Summers, particularly in his Homer Jones lecture at the St. Louis Fed in April, has proposed that the demand for loanable funds curve has shifted leftward due to “secular stagnation.”

Several participants at the Leipzig conference offered an alternative view, particularly William R. White (formerly of the Bank for International Settlements, now at the OECD, and a member of the CMFA academic advisory board) and Andrew Filardo (BIS).  Their view is spelled out in the new (unsigned) BIS Annual Report released on 26 June, just days after the conference.  The Report argues that zero rates are not the permanent new normal, but are the lingering aftermath of the financial boom-bust cycle that developed economies have gone through.  To quote (p. 14): “unchecked credit booms can be part of the problem and leave a long shadow after the bust, sapping productivity growth.  In addition, debt overhangs depress investment, which weakens productivity further.”  In a passage that bears quoting at length, the Report (p. 14) contrasts its view with the view that secular stagnation is the main force keeping interest rates low.  The secular stagnation view fails to square with the fact that a credit boom preceded the bust:

[Our] interpretation of the post-crisis global growth slowdown differs in key respects from one that has been gaining currency – secular stagnation.  It suggests rather that the world is better regarded as having suffered a series of financial booms gone wrong.  Consider, admittedly in a very stylised form, the main differences in the two views.  The most popular variant of the secular stagnation hypothesis posits that the world has been haunted by a structural deficiency in aggregate demand.  This deficiency predates the crisis and is driven by a range of deep-seated factors, including population ageing, unequal income distribution and technological advances.  In this view, the pre-crisis financial boom was the price to pay for having the economy run at potential.  The key symptom of the malaise is the decline in real interest rates, short and long, which points to endemic disinflationary pressures.  In the hypothesis proposed here, the world has been haunted by an inability to restrain financial booms that, once gone wrong, cause long-lasting damage. The outsize and unsustainable financial boom that preceded the crisis masked and exacerbated the decline in productivity growth.  And rather than being the price to pay for satisfactory economic performance, the boom contributed, at least in part, to its deterioration, both directly and owing to the subsequent policy response.

The BIS, whose clients are the worlds’ central banks, does not directly blame central banks’ easy credit policies for fueling financial booms.  But the reader is free to read the argument that way. When it comes to policy recommendations, the Report (p. 20) does call for tighter monetary policy (that is, tighter than inflation targeting suggests) to avoid feeding incipient booms: “monetary frameworks should allow for the possibility of tightening policy even if near-term inflation appears under control.”  Rather than describe this as “using monetary policy to lean against financial imbalances” of unspecified origin as the Report does, I would characterize such an approach as using indicators other than only consumer prices (namely asset prices and/or nominal GDP) as indicators to judge when monetary policy is too loose.  Rather than describing the practical policy-making task as developing guidelines to help central banks “more effectively tackle the financial booms and busts,” I would say that we need guidelines to stop central banks from fueling financial booms and busts.  Thus the BIS Report supports the case for nominal GDP as a less hazardous central bank target than the CPI or other inflation index, since an NGDP level target does not call for expansionary monetary policy to offset the benign price-lowering effects of productivity improvements.

The BIS Report deserves our serious attention.  Its approach is more promising, to be sure, than the secular stagnation approach of Summers, who judges the last eight years of economic performance sub-par by reference to the extrapolated bubble path (aka the CBO’s 2007-estimated path of real potential output).  His diagnosis: chronically insufficient nominal aggregate demand.  This diagnosis implies that the price level has failed to approach its equilibrium level in the seven to eight years since the 2008-09 velocity shock, which violates our standard understanding about how long the price level takes to adjust to nominal shocks.  It approaches incoherence to suppose that real interest rates have approximately reached long-run equilibrium in intertemporal markets, and simultaneously that the level of prices has not yet approximately reached long-run equilibrium in the spot market where money balances exchange against goods.

Global 10-year real government bond rates

10 Year Global Bond Yields

Source: Summers (2015, p. 100)

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Brexit and Beyond Thu, 30 Jun 2016 13:17:51 +0000 In this post, I will stray a bit from monetary issues but not too far.  The British people voted last Thursday (June 23rd ) to exit the European Union.  How should that decision be viewed by classical liberals?  Do Americans have a stake in the outcome?  Should...

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Brexit, currency area, England, European Union, Pound Sterling

In this post, I will stray a bit from monetary issues but not too far.  The British people voted last Thursday (June 23rd ) to exit the European Union.  How should that decision be viewed by classical liberals?  Do Americans have a stake in the outcome?  Should the readers of Alt-M care?

The political classes on both sides of the Atlantic are appalled at the voters’ decision.  The peasants have risen up in revolt and their decision cannot be allowed to stand.  There are already calls for a political mulligan in the form of a second referendum.  Others have called for the British Parliament to nullify the vote.  Both suggestions reveal the low regard for democratic decision making among Britain’s and Europe’s political elites.  No one can predict the outcome at this point.

Let us pause for a moment and consider what the vote’s outcome says about the prescience of the ruling class in Britain, on the Continent and, yes, over here.  (President Obama interjected himself into the vote and appeared dumbstruck last Friday when British voters rejected his advice.)  Political leaders pretend to be wiser and better able to look into the future and discern what is best for the people.  But almost to a person, they were unprepared for the referendum’s outcome.  That speaks both to their distance from the people they claim to represent and their ability to forecast events even 24 hours in advance.  So much for the wisdom of the elites.

(I am perplexed by just how surprised political and business leaders were.  I was in Europe the weekend before and was briefed by a veteran British MP, who was firmly in the Remain camp.  He called the election too close to call.  He said that victory by the Leave side was entirely possible.)

What was at stake in the election?  The leaders of the European Union portray it as promoting free trade and economic liberalism.  It is far from that.  The bureaucracy in Brussels has created an overbearing regulatory super-state, against which the British voters rose up.  To classical liberals, since the demise of the Soviet Union, the European Union is the last bastion of central planning.

As is always true, there were multiple motivations to those wanting to breakaway.  One group certainly felt that Britain could be more economically free out than in.

Immigration was an important issue there, as it has become here.  Voters opposed an immigration policy imposed from afar.  Additionally, Britain as an island had heretofore been largely immune from the mass migration from the Middle East, North Africa and elsewhere.  It appeared that would no longer be true.  Again, there is an echo in the United States in the debate over accepting Syrian refugees.  Being emotion-laden, immigration can be the leading edge of popular discontent.

One thing not at stake in the election was the hoary issue of the currency.  That issue had already been decided soon after the euro’s introduction as a currency on January 1, 1999.  There was a move for Britain to adopt the euro, but it was strongly rebuffed.  I am not usually an advocate of floating currencies.  Faced with a monetary straightjacket of the euro, however, Britain wisely chose the flexibility of keeping the pound sterling.  I helped make that case in Britain, and history has shown it to be a good decision.  The pound was a monetary safety valve for Britain.  But the political differences remained and eventually boiled over in this vote.

The core monetary issue is that no monetary policy could be the correct one for countries as economically diverse as those comprising the European Union (now numbering 28).  The area did not meet the criteria of being an optimal currency area.  Given those facts, Britain was better off conducting its own monetary policy.[1]  There are now a total of nine countries within the EU that do not use the euro.[2]

Prime Minister Cameron was the architect of the referendum and, hence, his own demise.  He advocated remaining in the EU but wanted to end the debate over the issue within the Conservative Party.  He did not even consult his own Cabinet over the decision.  For Cameron, it was a massive political blunder.  He compounded that blunder by announcing his resignation, effective in October, at a news conference the day after the referendum.  That rendered him the lamest of political ducks.

But the method by which the referendum got on the ballot put supporters of an EU exit at a profound disadvantage.  They had no strategic economic plan in the event the referendum passed. That is why there is such extreme political and economic uncertainty.  No one has exited the EU before.  Neither the yet-undecided new British Prime Minister nor the EU leaders know what comes next.  That is a situation of extreme economic uncertainty, which markets hate.  We see this in the volatility in financial markets.  Blame not British voters, however, but Cameron’s political stunt.

Fifteen years ago, two colleagues and I first proposed a global free trade association.[3]  It would be a coalition of the willing, the most free-trading countries in the world.  Some, but not all members of the EU would have qualified.  That created the very problem now facing Britain: how can it trade more freely with the rest of the world and also trade preferentially with EU countries.  The answer we eventually hit on was that Britain (and other qualifying EU members) could move from membership in the EU to membership in the broader European Economic Area (as Iceland, Liechtenstein and Norway are today).

The key point was that Britain would have had a plan and first have negotiated with the EU.  Only then would it (and possibly other countries) have exited as members of the EU.  Had it been done in that fashion, we would not be facing the global turmoil we are right now.  It would have been Brexit with a plan.

We are where we are, however, and Britain’s new leadership must make the best of it.  Assuming they honor the vote, they need to try to negotiate the best possible deal with the EU.  It would be in Europe’s economic interests to negotiate the closest possible economic relationship.  Financial markets have signaled that Continental European countries have more potentially to lose than does Britain.  Some EU leaders have suggested, in effect, that Britain be punished for leaving.  German Chancellor Merkel has called for calm and a sensible negotiating position.  One hopes her good counsel prevails.

If the EU hotheads prevail, they will be cutting off their noses to spite their faces.  As with all trade barriers, Britain’s “punishment” will inure to the harm of their own citizens as much as Britain’s.[4]  I personally believe that Britain will prosper with or without a special relationship with the EU.

The divisions within the United Kingdom of England, Wales, Scotland and Northern Ireland were not created by the Brexit vote, but have been exacerbated by it.  Scotland voted heavily to Remain, and Northern Ireland somewhat less heavily so.  There is a move afoot for Scotland to hold a second referendum on its independence so it can join the EU on its own.  I offer no opinion on whether Scotland will or should enter into disunion with the rest of the United Kingdom.  If the union no longer benefits the British peoples, I wish them peace and prosperity as they chart their own courses.  It would be difficult for an American of Irish heritage to say otherwise.

I conclude by answering my three questions.  First, classical liberals should always applaud when a people chooses its own political future.  This is especially so when they do so peacefully.  Second, the United States has a special relationship with Britain, and it is in our interest to maintain that whether Britain is inside or outside the EU.  Doing that may be complicated, and I only wish that the Obama administration had drawn up contingency plans for a Brexit vote.  Finally, Britain’s choice to retain the pound is a test case for advocates of floating currencies.  There are some problems they can address, but they are not a panacea.


[1] The Bank of England always had the option to track the monetary policy of the European Central Bank.  Some countries outside the euro effectively peg to it, which means they are importing ECB monetary policy.

[2] Besides the United Kingdom, they are Bulgaria, Croatia, the Czech Republic, Denmark, Hungary, Poland, Romania and Sweden.

[3] See Chapter 3, "The Free Trade Association: A Trade Agenda for the New Global Economy" by John C. Hulsman, Gerald P. O’Driscoll, Jr., and Denise H. Froning in 2001 Index of Economic Freedom, Gerald P. O’Driscoll, Jr., Kim R. Holmes and Melanie Kirkpatrick, eds.,(Washington, D.C. The Heritage Foundation and The Wall Street Journal, 2001): 43-62.

[4] One argument to punish Britain is to make it an example to others who might exit the EU. It is a curious position to take by those claiming the EU is a good deal for its members.

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Finance for All: Kenya's M-PESA Tue, 28 Jun 2016 13:16:32 +0000 A surprising aspect of modern life in Africa is that, thanks to the telecom deregulations of the early 2000s, cell phones are as pervasive in its Sub-Saharan savannahs as they are in the urban jungles of the United States.  More intriguingly still, African mobile network operators (MNOs)...

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M-PESA With CaptionA surprising aspect of modern life in Africa is that, thanks to the telecom deregulations of the early 2000s, cell phones are as pervasive in its Sub-Saharan savannahs as they are in the urban jungles of the United States.  More intriguingly still, African mobile network operators (MNOs) are leveraging their extensive networks to offer fast, reliable, and cheap mobile payment services to millions of customers beyond the reach of formal banks.

Kenya has been ground zero for this digital financial revolution.  In 2007, the nation’s dominant cellular provider, Safaricom, launched M-PESA.  M-PESA allowed users to send and receive digital payments anywhere in the country as simply as they send a text message.  It also enabled customers to safely store money in their mobile wallet, pay for goods and services at virtually any retail shop, and deposit and withdraw cash from thousands of “agents” located across the country — all without ever stepping foot in a physical bank branch.  Today, Kenya is one of the world’s leaders in mobile money with roughly 26.2 million accounts — more active accounts than adults in its population.

Why did mobile money first take off in Kenya?  A variety of factors, such as its very high rates of theft and low rates of financial inclusion, helped create a latent demand for alternative financial services.  However, the key to its success was its “enabling” regulatory environment. Unlike governments elsewhere, Kenya's took a fairly "hands-off" approach, exempting innovative payments products offered by non-bank companies from many of the burdensome regulations that made it too costly for banks and traditional financial services providers to serve low-income customers.

In particular, MNOs like Safaricom were allowed to enter the market for payment services and issue digital claims that could circulate as money.  They were also permitted to license part-time or full-time employees, or “agents,” to perform basic banking services (open new accounts, accept cash deposits and withdrawals, register customers, facilitate money transfers, etc.) on behalf of their customers.

Under this new "agent banking" model, MNOs were not only able to leverage their extensive networks of retail shops but also enlist other retail shops and upstart entrepreneurs to set up thousands of “mini-bank” branches throughout the country.  Like Uber or Lyft drivers, these agents are independent contractors paid on commission.  Since many agents operate out of small huts or as a side business at their existing retail shops, agent branches conduct business at a small fraction of the cost of traditional banks, making it a far more economical way to extend basic financial services to unbanked customers in remote regions.

At first, established banks weren’t happy about the Kenyan government issuing these regulatory exemptions.  But once their lobbying efforts to ban M-PESA failed to overcome the tidal wave of public support for the revolutionary product, many banks began partnering with Safaricom, establishing their own agent branches, and offering a fuller array of services to attract unbanked customers.

The most famous example is M-Shwari, a partnership between the Commercial Bank of Kenya and Safaricom.  Since its inception in 2013, more than 10 million Kenyans have gained access to interest-bearing mobile savings accounts (Cook & McKay, 2015).  Customers also have access to mobile credit and insurance products.  Since mobile providers can digitally collect and share information on how often customers pay their bills, which enables banks to construct reliable credit ratings, customers can apply for and receive up to $1,200 in loans (at 7.5 percent interest) with just a few clicks.  Today, virtually every Kenyan commercial bank offers “branchless banking” services through a mobile money platform.

Thanks to these partnerships, the cell phone has become a catalyst for promoting financial development.  Since the inception of M-PESA, financial inclusion rates — that is, the percentage of Kenyans with any sort of access to formal financial institutions — have nearly tripled from fewer than 25 percent in 2006 to 67 percent in 2013 (GSMA, 2014).  Kenya has also experienced increased financial deepening, defined as the ratio of private bank liabilities to GDP.  The ratio rose from roughly 33 percent to 44 percent in the five years after M-PESA (Ndirangu & Nyamongo, 2013, p. 3). The Economist Intelligence Unit projects that thanks in large part to mobile banking the amount of private bank credit and deposits will rise as much as 300-500 percent by 2020 (The Economist, 2011).

What lessons should economists draw from the mobile money revolution?  For decades, many economists and policymakers assumed the private market would fail to profitably extend services to poor, unbanked customers.  This is why many development officials in the postwar era have played an active, “hands-on” role in trying to engineer both financial and economic development.  This government-led approach is what prevailed, incidentally, in Sub-Saharan Africa in the post-independence era.  During the 1960s and 1970s, many newly established governments nationalized foreign-owned banks and used foreign aid to launch state-owned commercial banks.  Unsurprisingly, these initiatives were an abject failure.  Only 1 in 7 adults had access to a bank account before the advent of mobile money, giving Sub-Saharan Africa by far the lowest financial inclusion rate in the world.

The mobile money revolution provides a compelling example of a “market-led approach” to financial development.  Based on Kenya’s success, the best thing governments can do to promote financial innovation and development is create a more enabling — that is, laissez-faire — regulatory environment, promoting what Mercatus’s Adam Thierer calls “permissionless innovation” and encouraging entrepreneurs to experiment with transformative new business models.  Safaricom founder and CEO Michael Joseph aptly summarized this lesson:

I wouldn’t say the government needs to do anything.  I would say the government just needs to have a "light touch" regulatory environment in order to encourage entrepreneurship and innovation.

Beyond mobile money and banking, the digital financial revolution also matters because it could help contribute to more rapid economic development.  Economists from Adam Smith to Walter Bagehot to Joseph Schumpeter to more recent scholars like Rondo Cameron, Ronald McKinnon and Edward Shaw have argued that more developed private financial systems play a direct causal role in fostering economic growth and development.[1]

One reason the private financial system sparks more rapid growth is because the private sector can better allocate credit.  The more people who hold their monetary wealth in the form of bank-issued liabilities such as mobile savings and checking accounts as opposed to government-issued currency, the more loanable funds they in effect provide to private financial intermediaries instead of governments and central bankers (Selgin & Lastrapes, 2012).  These private banks can, in turn, intermediate these savings into productive loans in commercial investments.  In fact, some authors have noted that Kenyans have reduced their demand for cash, opting instead to hold their savings in the form of mobile bank accounts.  This, in turn, has been associated with a notable rise in loans to the private sector (Ndirangu & Nyamongo, 2013).

Today, mobile money is spreading like wildfire across the developing world.  There are now 271 mobile money services available in 93 countries servicing more than 411 million customers (GSMA 2015).  More than half of these services are connected to mobile banking accounts.  The World Bank’s Global Financial Inclusion Database (2015) reports that mobile money is now available in 81 percent of low-income countries.  Despite such rapid growth, the service has failed to gain traction in countries whose governments prohibit competitors from offering mobile money and strictly regulate agent banks.  As the writers at The Economist (2012) aptly noted, "many of the poor countries that would most benefit from mobile money seemed intent on keeping its suppliers out — mainly by insisting they should be regulated like banks." Due in large part to these repressive policies, mobile money has still only reached less than one-tenth of the unbanked population in the developing world.

Fortunately, a number of countries have begun emulating Kenya’s “hands-off” approach, arguably the strongest predictor of a successful mobile money launch.  In fact, in countries that have adopted an enabling regulatory environment, active mobile money accounts are 220 percent higher (Di Castri, 2015).  With a little insight from free banking theory, and practical experiences like Kenya’s, perhaps regulators could be encouraged to take their financial liberalization even further.


[1] Over the past two decades, the “finance matters” theme has received an ample amount of empirical support in the development finance literature.  See, for instance, the work of David Fry, Robert King, and Ross Levine, among others.  Indeed, the link between a well-developed private banking system and the process of economic development has been stressed on this very blog here and here.  These authors argue that developed financial systems help increase not only the total volume of loanable funds that banks have at their disposal to intermediate into productive investments, but also the marginal efficiency of investment and capital allocation.

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Friday Flashback: Free Banking and Classical Liberalism, a Potted History Fri, 24 Jun 2016 13:13:57 +0000 (It occurred to us that some of our early posts, and especially ones from Alt-M’s predecessor,, may deserve a new airing, as they remain pertinent, but haven’t been seen by many of our newer readers.  With that in mind, we’re pleased to introduce Friday FLASHBACKS: an...

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(It occurred to us that some of our early posts, and especially ones from Alt-M’s predecessor,, may deserve a new airing, as they remain pertinent, but haven’t been seen by many of our newer readers.  With that in mind, we’re pleased to introduce Friday FLASHBACKS: an occasional weekend dip into our archives.  Enjoy!)

Oresme new with captionSkipping over ancient thinkers, early modern expressions of classical liberal thought on money may be found in the writings of Nicholas Oresme and other Scholastics who denounced the sovereign’s debasement of the coinage as a dishonest and tyrannical, a violation of the sanctity of contract that a just sovereign must respect.  David Hume in the 1750s refuted the Mercantilist fear that unless the sovereign interfered with freedom of trade and payments the nation’s economy would retain too little silver and gold.  Adam Smith in 1776, and later defenders of free banking in Britain, on the Continent, and in the Americas (my favorite being William Leggett), applied free-trade doctrines to banking and bank-issued currency.  Thomas Hodgskin and Herbert Spencer even dared to defend private coinage.  Walter Bagehot defended the principles of free banking, though he thought it a lost cause politically.  In the twentieth century the Austrian economist Ludwig von Mises gave new subtlety and rigor to the case for free banking.  Friedrich Hayek made somewhat ambivalent cases for gold and free banking earlier in his career, but in the 1970s forcefully called for Choice in Currency and The Denationalisation of Money.  Free banking as a policy ideal is the result of applying the norms of classical liberalism to money and banking.  Classical liberalism upholds individual liberty and private property rights, including freedom of contract, under the rule of law.  It opposes rule by unconstrained authorities.

Many leading classical liberals over the centuries, however, have failed to apply their free-trade principles consistently to money.  David Ricardo favored nationalization of coinage and banknote issue, and the forced substitution of redeemable paper notes for coins in all but the largest payments.  Richard Cobden, the free trader, supported the nationalization of banknotes.  After the Second World War, most of the German Ordoliberals and the Monetarists, led respectively by Walter Eucken and Milton Friedman, made peace with central banking and fiat money.  (Although Friedman, it should be noted, reconsidered his position in the 1980s and began favoring free banking and the abolition of the central bank.)  The otherwise radically free-market theorist Murray Rothbard favored a 100% reserve requirement, with no allowance for capitalist acts among mutually consenting adults who want to contract around that rule.  Alternatives to fiat money, central banking,  and deposit insurance were not on the program of the Mont Pelerin Society, a leading international society of classical liberal intellectuals, at its special meeting to discuss the financial crisis in 2009.

A century ago, before the First World War, economic classical liberals almost unanimously supported the ideals of the international gold standard.  The “classical” period of the gold standard is usually dated from the United States’ resumption of gold payments in 1879 until the suspensions of payments in the First World War.  The gold standard was fatally wounded in the First World War and never fully recovered.  In practice it had not been a completely market-regulated system even before the war.  National governments had long banned market competition in coining by giving themselves a monopoly in the minting of coins.  Many similarly banned market competition in the issue of gold-backed banknotes and gave a monopoly to a government-sponsored central bank.  National central banks violated the “rules of the game” by interfering with, overriding, or suspending the automatic operation of international gold flows.  The centralization of gold reserves, a characteristic feature of central banking, altered the operation of the international gold standard for the worse.

Nonetheless the classical gold standard more nearly approached a self-regulating international monetary system than anything that has followed.  Monetary nationalism and monetary statism since the First World War has brought us to our present system of national fiat monies, central banking, and extensive government interference in financial markets everywhere in the world (with the exception of offshore banking havens).  The global financial crisis that began in 2007 has exposed the weakness and non-self-regulating character of the present system for all to see.

Our challenges for the present day, and for this blog, are to discover how we might reform the system in manner consistent with the ideals of freedom.  How might we restore healthy self-regulation to our local and international monetary and banking systems?

Here are some references for the above history, which may also begin to answer Brad Jansen's request for recommendations of classic readings.

Nicholas Oresme, De Moneta (Of Currency) [c. 1355], translated by Charles Johnson, in Lawrence H. White, ed., The History of Gold and Silver (London:  Pickering and Chatto, 2000), vol. 1;  David Hume, “Of the Balance of Trade,” in Essays, Moral, Political, and Literary, ed. Eugene F. Miller (Indianapolis:  Liberty Fund, 1987); Adam Smith, An Inquiry into the Nature and Causes of the Wealth of Nations, ed. R. H. Campbell, A. S. Skinner, and W. B. Todd. (Oxford: Oxford University Press, 1976); Vera Smith, The Rationale of Central Banking [1936] (Indianapolis: Liberty Fund, 1990); William Leggett, Democratick Editorials (Indianapolis: Liberty Fund, 1984); Thomas Hodgskin, Popular Political Economy (London: Charles Tait, 1827); Herbert Spencer, “State-Tamperings with Money and Banks,” in Essays Scientific, Political and Speculative, vol. 3 (London:  Williams and Norgate, 1891); Ludwig von Mises, The Theory of Money and Credit [1912] (Indianapolis:  Liberty Fund, 1980); Mises, Human Action, 3rd ed. (Chicago: Henry Regnery, 1966); F. A. Hayek, Choice in Currency (London: Institute of Economic Affairs, 1976); Hayek, Denationalisation of Money, 2nd ed. (London:  Institute of Economic Affairs, 1978).  David Ricardo, Plan for the Establishment of a National Bank [1824] in The Works and Correspondence of David Ricardo, ed. Piero Sraffa with the Collaboration of M.H. Dobb (Indianapolis: Liberty Fund, 2005),vol. 4, Pamphlets and Papers 1815-1823;  Richard Cobden in 1840 Parliamentary testimony cited by Lawrence H. White, Free Banking in Britain, 2nd. ed (London: Institute of Economic Affairs, 1995), p. 84; Walter Eucken, Grundsätze der Wirtschaftspolitik (Tübingen:  J. C. B. Mohr, 1952); Milton Friedman, A Program for Monetary Stability (New York:  Fordham University Press, 1960); Friedman,  “Monetary Policy for the 1980s” in John H. Moore, ed., To Promote Prosperity(Stanford: Hoover Institution Press, 1984); Murray N. Rothbard, “The Case for a 100 Percent Gold Dollar” in Leland Yeager, ed., In Search of a Monetary Constitution (Cambridge, MA: Harvard University Press, 1962).

[This article originally appeared at, the predecessor site to, on June 4, 2011]

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