Alt-M Ideas for an Alternative Monetary Future Fri, 06 May 2016 13:12:32 +0000 en-US hourly 1 Competition in (British) Banking Fri, 06 May 2016 13:12:32 +0000 Writing for’s “The Exchange” blog, economists Diane Coyle and Jonathan Haskel suggest that Britain’s regulators — namely, the Competition and Markets Authority and the Bank of England — have got it wrong on competition in banking.  The authors argue that “the CMA and the BoE” have overlooked “the ruinous effect on...

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Pink Piggy BankWriting for’s “The Exchange” blog, economists Diane Coyle and Jonathan Haskel suggest that Britain’s regulators — namely, the Competition and Markets Authority and the Bank of England — have got it wrong on competition in banking.  The authors argue that “the CMA and the BoE” have overlooked “the ruinous effect on competition of the ‘too big to fail’ subsidy” in their recent reports and policy announcements, and that, if anything, it is becoming “harder than ever for new entrants to gain a foothold” in the banking market.

In my view, Coyle and Haskel are right, but their argument doesn’t go far enough.

Let’s start with the basics: what is the too-big-to-fail subsidy, and how does it affect competition in banking?  The fundamental idea is that the bigger a bank is, the more likely it is to be bailed out if it runs into trouble.  The events of the 2008 financial crisis seem to confirm this, as do the assumptions of government assistance that some rating agencies build into their “support” ratings.  And as the 2011 report of Britain’s Independent Commission on Banking points out:

If one bank is seen as more likely to receive government support than another this will give it an unwarranted competitive advantage.  As creditors are assumed to be less likely to take losses, the bank will be able to fund itself more cheaply and so will have a lower cost base than its rival for a reason nothing to do with superior underlying efficiency.

The result is that small banks struggle to compete against larger rivals, while market entrants have difficulty establishing themselves against privileged incumbents.  All of this makes the banking sector less dynamic — and more comprehensively dominated by large, established firms — than it might otherwise be.

As Coyle and Haskel see it, however, Britain’s CMA thinks the problem has already been solved: that the competitive playing field has been leveled by the Bank of England’s proposed “systemic risk buffer,” according to which larger banks must hold more equity capital against their risk-weighted assets than smaller competitors.  In consequence, the CMA’s October 2015 provisional report on Britain’s retail banking market mostly ignored the too-big-to-fail problem, focusing instead on the rather more mundane question of how consumers can be encouraged to switch bank accounts more often.

Yet the CMA’s position is mistaken, say Coyle and Haskel, for three reasons.  First, switching bank accounts doesn’t always make sense for consumers: in the UK, at least, one bank account is pretty much the same as another, so consumers’ status quo bias is often quite rational.  Second, the level of additional capital big banks must hold as a systemic risk buffer is not high enough to outweigh the funding benefits that accrue from being too-big-to-fail.  Third, the stepped schedule of systemic risk buffer requirements outlined by the Bank of England might make big banks less likely to compete with each other, by effectively creating high marginal tax rates when banks move from one “systemic risk buffer” tier to another.  As Coyle and Haskel say, “This might restrain the emergence of gargantuan banks, but the purpose of competition is to promote rivalry, not hold up expansion at arbitrary regulator-determined thresholds.”

So far, so good.  But there’s a bigger picture here that Coyle and Haskel don’t see, or at least fail to mention.  For one thing, it isn’t just lower funding costs that make too-big-to-fail such an anti-competitive doctrine.  In fact, the very act of bailing out a failing institution itself constitutes a powerful strike against market competition.  As Europe Economics’ Andrew Lilico has put it, “company failure is an essential and ineliminable part of the competition process.  One of the most important obstacles to new entry in the banking sector, impeding competition, is that failing banks are saved by the government.”  If you want smaller banks to grow, and new banks to prosper, in other words, you can’t keep saving their bigger rivals from the consequences of bad investments.

More important still are the grounds upon which banks compete.  And it’s here that our financial regulatory authorities have the most to answer for.  Yes—of course—banks should compete with one another to provide the best possible service at the best possible price.  In an ideal world, however, banks would compete on something else as well: namely, their safety, stability, and reliability.  That banks do not tend to compete on these grounds today is testament to the fact that their depositors, bondholders, and shareholders do not see the need to pay attention to such things.  “Regulatory badging,” that illusory sense that banks must be safe because they are subject to regulators’ oversight, means that people seldom ask how highly-leveraged their banks really are.  Deposit insurance means they might not care about the answer, even if they ask the question.  And too-big-to-fail compounds the problem: if your bank is going to be bailed out, why worry about its risk profile?  No amount of regulatory oversight can compensate for this loss of competitive market discipline.

Ultimately, then, Coyle and Haskel are right to stress the importance of competition: if financial stability is the goal, then competition must be central to any banking reform agenda worthy of the name.  But before regulators can be part of the solution, they must understand the ways in which they are part of the problem.  And that, alas, has yet to happen.

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Japan: The Way Out Tue, 03 May 2016 13:13:45 +0000 "Helicopter money" started out as, and long remained, nothing more than a heuristic device — and a brazenly counterfactual one at that — employed by monetary economists as a means for gaining a better theoretical understanding of the consequences of changes in the stock of money.  "Suppose," the analysis went,...

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"Helicopter money" started out as, and long remained, nothing more than a heuristic device — and a brazenly counterfactual one at that — employed by monetary economists as a means for gaining a better theoretical understanding of the consequences of changes in the stock of money.  "Suppose," the analysis went, that instead of increasing the monetary base by buying bonds in the open market, central banks dropped new supplies of currency from helicopters, thereby instantly increasing everyone's money balances.  What would that do to spending and, eventually, to prices?

Lately, however, helicopter money has made its way from the inner recesses of economics textbooks to the financial pages of major newspapers and magazines, where a debate has been joined concerning its merits, not as an abstract analytical tool, but as an actual policy tool for relieving Japan, and perhaps some other economies, of their deflationary woes.  Look, for some examples, here, here, and here.  And see as well this recent blog post by our dear friend Jerry Jordan, written for the Atlas Foundation's Sound Money Project.

Yet for all the controversy surrounding the suggestion that Japan should actually try dropping money from helicopters (or something close to that), my own response to it consisted, not of either surprise or dismay, but of a strong sense of déja vu.  For I myself wrote an op-ed proposing helicopter money for Japan in the spring of 1997, that is, almost exactly 19 years ago.  I never tried to publish it, in part because I myself couldn't quite decide just how firmly my tongue was poking my cheek as I wrote it, and because I had then as I do still an abiding dislike of  "clevernomics," which is the sort of stuff economists write to show people how smart they are, and not because they are seriously trying to help the world along.  Fearing that I was myself lapsing into clevernomics, I stuffed the essay into a file cabinet, where it has been buried ever since.

All the recent writing on the subject has, however, emboldened me to resurrect my dusty old essay and to publish it here on Alt-M under its original title.  I don't pretend that it adds anything to what recent commentators have had to say on the topic.  Consider it a bagatelle, if you like: you'll get no argument from me.


They said it was like "pushing on a string."  It was the middle of the 1930s, and the U.S. and much of the rest of the world were in the midst of an unparalleled deflationary crisis.  Normally the way out of such a crisis would have been for central banks, including the Federal Reserve, to inject more reserves into their banking systems by buying securities in the open market and paying for them with central bank credits.  That policy would do provided banks put the new reserves to work by lending them out, thereby stimulating an increase in demand for investment or consumer goods.  But in the U.S. interest rates on loans and securities had fallen so low, the Fed claimed, that adding to bank reserves no longer helped: the new reserves “pushed” into commercial banks would simply pile-up there, instead of causing the banks to extend more private credit.  Hence, “pushing on a string.”  Economists, following John Maynard Keynes, referred to the conundrum in question as a "liquidity trap."

Whether the U.S. economy was really stuck in a liquidity trap during the Great Depression remains controversial.  For several decades afterwards, however, the issue was moot, as inflation replaced deflation throughout the world's economies.  Only recently it has again taken on practical significance, with economists and Japanese monetary authorities pointing to Japan today as another instance of an economy faced with an insatiable demand for liquidity.  Japanese consumer and producer spending has been shrinking for months, causing wholesale prices to decline and inventories to accumulate.  The overnight call loan rate has hit zero, and short-term lending rates are at historically low levels.  Although the Bank of Japan has been pumping reserves into the banking system, bank lending remains sluggish.  The banks have more reserves than ever, but seem to lack any incentive for putting them to use.

Japan's dilemma has at least one Federal Reserve official worried that the same thing might happen again (or, as some would have it, for the first time) in the United States.  Marvin Goodfriend, a Vice-President of the Richmond Fed, proposes in a recent paper that, in the event that we should fall into a liquidity trap, Congress should grant the Fed authority to tax bank reserves, causing them, in effect, to earn a negative return.  Since even a zero interest rate on loans beats a negative return on reserves, the banks would have reason to lend even at zero rates.  For good measure, Goodfriend recommends that public currency holdings be taxed as well, so as to discourage hoarding by the public.

Goodfriend's proposed taxes are meant to be emergency measures only, which would be removed in good times.  Still, one shudders to think what might happen should the government decide to take advantage of the new measures' capacity for enhancing its share of the profits from the Fed's money monopoly.

Fortunately, central banks don't need new taxing powers to free their economies from liquidity traps.  All they need to do is to supply new money directly to the public, instead of trying to get it to them indirectly by first adding it to bank reserves.  Individual citizens, unlike commercial banks and other financial firms, do not have to decide either to hoard money or to lend it at some trivial rate of interest.  They have a third, more tempting, option, namely, that of spending unwanted money balances directly on goods and services.  Central banks, on the other hand, don't have to issue new money in exchange for securities or collateral owned by private financial firms: they can simply give it away to citizens, avoiding the middlemen.

In Japan today, the strategy could work as follows: the Bank of Japan could announce its intention of giving away, say Y5000 (roughly $50 U.S.) to every Japanese citizen each month until private spending picks up, bringing Japan's deflationary crisis to an end.  The giveaway could be engineered in a manner similar to that employed during the 1990 German monetary unification, when the Bundesbank supplied East German citizens with limited quantities of Deutsche marks in exchange for Ostmarks.  The policy would assure Japan's citizen's that, one way or another, their money earnings were about to permanently increase, giving them ample reason to consume more.  Given Japan's population, the promised rate of new money creation would increase Japan's monetary base by around ten percent after a year — a substantial rate, but not large compared to recent annual figures.  Moreover, the mere announcement of the policy might suffice to revive spending quickly, allowing the policy to expire in relatively short order.

Critics of the monetary giveaway proposed here might fear that it would ultimately trigger inflation.  The same sort of thinking led the Federal Reserve, in the mid 1930s, to actually raise bank reserve requirements out of fear that banks might change their minds any minute and begin lending their hoards of cash.  The Fed's fears turned out to be exaggerated, to put it charitably: its decision actually helped to keep the U.S. depression going for several more years.  Of course, if spending had actually revived on its own, surpassing the level necessary to revive the economy, the Fed could have dealt with the "problem" easily enough, by reabsorbing excess money by means of bond sales.

Keynes had a good quip about Fed officials who worried, in 1936, about inflation: they “professed to fear that for which they dared not hope.”  Let's hope that the Bank of Japan won't harbor such misplaced fears, and that it doesn't otherwise allow the liquidity-trap bogey to keep it from doing all it can to revive Japan's economy.

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A Monetary Policy Primer, Part 2: The Demand for Money Thu, 28 Apr 2016 13:14:10 +0000 Although there's no such thing as a straightforward measure of the quantity of money in an economy, monetary policy is nonetheless about managing that quantity.  How ought it to be managed?  The (misleadingly) simple-sounding answer is: so that it neither falls short of nor exceeds the quantity of money demanded...

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DickVanDykeAlthough there's no such thing as a straightforward measure of the quantity of money in an economy, monetary policy is nonetheless about managing that quantity.  How ought it to be managed?  The (misleadingly) simple-sounding answer is: so that it neither falls short of nor exceeds the quantity of money demanded by the public.

So much for a summary of Part 1.  Now for the hard part: dealing with the many questions this summary raises.  How can a central bank manage a quantity without being certain just how to define, let alone measure, that quantity?  How is it possible for the quantity of money supplied to differ from the quantity demanded?  When those things do differ, how can one tell?  Finally, just what does "the demand for money" mean?

The Demand for Money isn't Unlimited

The suggestion that there's such a things as a "demand for money," comparable to the demand for, say, heating oil, is one that many people find hard to accept.  But in truth the demand for money is a lot more like the demand for heating oil than many suppose.  Just as anyone with an oil furnace needs to keep some heating oil on hand in case the temperature drops, allowing the furnace to consume it gradually, while counting on regular deliveries to replenish the supply, people who can afford to keep some money — currency and bank deposits and checkable money funds and the like — on hand, drawing down the inventory to pay for other things, and replenishing it now and then out of their earnings, or perhaps by selling some non-monetary assets.  Notice that it's by holding  on to money rather than by spending it that people evince a demand for the stuff.

Money's role as a generally-accepted means of payment means that the real demand for it (that is, the average sum of monetary purchasing power people like to have on hand) tends to increase along with the amount of real purchasing to be done.  But just as the demand for heating oil in a city can increase independently of the total volume of inhabited interior space in that city (owing, say, to a decline in average temperature), so too can the demand for money vary independently of the total volume of an economy's output, becoming more intense, for example, when interest rates on non-monetary assets are relatively low, and during times of greater economic uncertainty.

One difference between money and heating oil that tends to obscure the fact that people demand one no less than they do the other is that people actually purchase heating oil, whereas they seldom purchase money except when trading one sort of cash (say, dollars) for another (say, Euros).  The reason for this is simple: because an economy's generally accepted means of payment is also what most people earn in exchange for their labor, or for goods they sell, no one has to "shop" for money.  Instead, they get paid in money, and then trade whatever they don't wish to keep on hand for other things.  In other words, people contribute to the overall demand for goods and services, or "aggregate demand," whenever they trade money for other stuff, whereas they contribute to the overall demand for money to the extent that they refrain from trading money for other things.

Receiving Money isn't the same as Demanding It

The fact that the public's demand for money consists of its willingness to hold on to monetary assets instead of spending them is important for several reasons.  First, it allows us to distinguish the demand for money from mere willingness to receive money in payments.  The fact that money is a generally accepted means of payment means that no one is likely to refuse to accept it in payments, let alone as a gift.  But this doesn't mean that there's no meaningful sense in which the public's demand for money can be said to be limited or finite.  People may accept all the money they can get their hands on; but they "demand" money only to the extent that they refrain from spending it, and only for precisely as long as they refrain from spending it.

The insight also allows us to distinguish between the demand for money and the demand for credit, that is, the demand for various sorts of loans.  Here again, money's role as a generally accepted means of payment can be confusing, because it means that a loan is likely to consist of a loan of money.  Yet most borrowers borrow, not to add to their money holdings, but to acquire other things, like cars and real estate, or (if they are business borrowers) to pay for labor, raw materials, or other inputs.  The fact that the demand for credit is distinct from the demand for money, and that the two things can change independently, means, among other things, that interest rates, which adjust to "clear" markets for various kinds of credit, cannot also be counted on to "clear" the market for money balances.  No matter what all too many textbooks say, interest can't be the "price" of money, since it is busy being the price of credit, which is something else again; and perhaps no belief in the history of monetary economics has done more damage than the belief that monetary expansion is a reliable means for reducing interest rates.  In fact the relation between monetary changes on one hand and interest rate movements on the other is, as I'll explain in a later segment, far more complicated than that.

Look, Ma: No Monetary Aggregates!

Finally, the fact that an increased demand for money manifests itself in peoples' refraining from spending the stuff, while a decline in the demand for money translates into increased spending, means that one can get a handle on whether an economy has too much, too little, or just enough money without having to decide just what "money" consists of.  One need only keep track of overall spending or aggregate demand.  Whenever overall spending goes up, that's a sign that the supply of money is growing faster than the demand for it.  When it shrinks, it's a sign that demand for money is growing relative to the available supply.  In short, there's no need to keep track of any particular monetary measure, or to estimate the public's demand for the stuff that makes up that measure.  The behavior of spending supplies most of the information central bankers need to manage their nations' money supplies responsibly.

We are still a long way, though, from being able to say anything — or anything compelling — about the proper conduct of monetary policy.  That changes in spending tend to imply that the demand for money is increasing or declining relative to some given supply doesn't necessarily mean that a stable level of spending is ideal, much less that monetary policy should be conducted  with the aim of keeping spending stable. That's so for two reasons.  First, a person's demand for money is, strictly speaking, not a demand for any particular number of money units, such as dollars, but a demand for a certain amount of purchasing power.  If, at some given level of prices, I consider an average money balance of $1000 adequate for my needs, then, if prices fall to half that original level, $500 will serve me just as well as a $1000 did before.

It follows — and this is the second point — that there are, in principle, two different ways in which any shortage or surplus of dollars can be corrected.  One is to eliminate the shortage or surplus by means of an appropriate change in the available number of dollars of different sorts; the other is to eliminate it by means of an appropriate change in the general level of prices, and hence in every dollar's purchasing power.  Other things equal, the higher the price level, the greater the quantity of money people will wish to hold; and the lower the price level, the smaller the quantity of money needed.  In principle, then, instead of attempting to prevent changes to the supply of or demand for money balances from leading to changes in the flow of spending, monetary authorities might be inclined to allow total spending to either rise or decline, perhaps at a rapid rate, or even to fluctuate willy-nilly, while relying on changes in the price level to keep the demand for money from veering for long, if ever, from the supply.  If they could get away with that, there would be no need to manage the supply of money after all.

There's no doubting that, when monetary authorities allow spending in their economies to rise or decline substantially, and even dramatically, the changes in spending eventually promote such price level adjustments as are required to return to a state of monetary equilibrium.  It's also true that, were prices all "perfectly flexible," so that they responded both immediately and adequately to any change in the overall flow of spending, there could be no such thing as shortages or surpluses of money.  In such a world, a money supply that responded to changes in the demand for money wouldn't be much of an improvement, assuming that it would improve at all, upon a money stock that was absolutely constant, or one that varied arbitrarily.[1]

Then again, in a world of perfectly flexible prices, an accommodative monetary arrangement could hardly be worse than any other.  And our price system is not, in fact, one that can be expected to instantly accommodate every sort of change to the supply of or demand for money.  Why that is so, and why some monetary policies are in fact a lot better than others, will be the subjects of the next installment.

Next:  The Price Level.

1. In fact even perfectly flexible prices wouldn't necessarily suffice to avoid troubles connected to changes in the flow of spending so long as those changes are not fully anticipated and contracts are not fully "indexed" so as to mimic contracts that would have been written in a world of perfect foresight.  Consider the case in which an unanticipated halving of the money stock results in an immediate halving of all prices. The halving of prices would suffice to keep the nominal quantity of money supplied equal to the quantity demanded.  But it could hardly serve to make up for losses connected to any fixed nominal contracts outstanding at the time of the monetary collapse.

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Why Financial Regulators Are Warming to Blockchains – And Rightfully So Tue, 26 Apr 2016 13:03:37 +0000 Financial industry regulators around the world are beginning to embrace the reality that blockchain technology will help them do their jobs, as well they should.  I write this post as a 22-year veteran of Wall Street who is passionate about market structure, and who has seen the blockchain space from...

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Blockchain, Chris Giancarlo, collateral chains, rehypothecation, systemic leverageFinancial industry regulators around the world are beginning to embrace the reality that blockchain technology will help them do their jobs, as well they should.  I write this post as a 22-year veteran of Wall Street who is passionate about market structure, and who has seen the blockchain space from the inside for two years.  Blockchains will finally give financial regulators the tools they’ve needed but never had: sufficient information to keep financial markets safe and sound.

1. A Not-So-Secret Secret: No One Really Knows How Leveraged the Financial System Is

This may surprise you, but more than 8 years after the financial crisis no one really knows how leveraged the financial system is.  Regulators and industry players are working hard to fix this, but in truth they haven’t had the tools.  Blockchains will give them the tools.

CFTC Commissioner J. Christopher Giancarlo described the problem in a recent speech, in which he detailed the “practical impossibility of a single national regulator collecting sufficient quality data…to recreate a real-time ledger of the highly complex, global swaps trading portfolios of all market participants.”  In the Q&A afterward, he continued:

At the heart of the financial crisis, perhaps the most critical element was the lack of visibility into the counterparty credit exposure of one major financial institution to another.  Probably the most glaring omission that needed to be addressed was that lack of visibility, and here we are in 2016 and we still don’t have it.

He’s right.

Why is systemic leverage so hard to track?  First, some background.

Much of the credit created by the financial system these days is created outside of traditional banks, in what’s colloquially called the “shadow banking system.”  The shadow banking industry is highly fragmented, global, interconnected and regulated by multiple  regulators that can see only pieces of the total puzzle.  No  mechanism exists for rolling its pieces up into an accurate, real-time

Long gone are the days when the corner bank simply made loans and ​regulators could track systemic leverage by adding up those loans.

What is it about the shadow banking system that makes systemic leverage so hard to track?  Answer:  the shadow banking system’s lifeblood is collateral, and the issue is that market players re-use that same collateral over, and over, and over again, multiple times a day, to create credit.  The process is called “rehypothecation.”  Multiple parties’ financial statements therefore report that they own the very same asset at the same time.  They have IOUs from each other to pay back that asset — hence, a chain of counterparty exposure that’s hard to track.  Although improving, there’s still little visibility into how long these “collateral chains” are.

That’s right.  Multiple parties report that they own the same asset, when only one of them truly does.

On normal trading days this isn’t a problem, but if markets seize it can become a big problem.

Manmohan Singh at the IMF is the foremost expert on collateral chains in the shadow banking system.  He has combed through the footnotes of banks’ financial statements around the world, and he estimates “collateral velocity” is about twoThis means only one of the 3 people who think they own a U.S. Treasury bond, for example, actually does own it (by my translation).  Singh’s data show this situation has improved since the financial crisis, when 4 parties reported that they owned the same asset.  Herehere, here, here and here are among the many insightful writings by Singh on this topic.  Singh has recommended that regulators’ financial stability assessments be adjusted to back out “pledged collateral, or the associated reuse of such assets,” which has not been standard practice.

Again, this issue is obvious to those who know where to look.

Wall Street critics may jump to criticize, but the industry is working to fix this problem too.  No one has had perfect visibility into the industry’s leverage because it was technologically impossible — until blockchains came along — to aggregate multiple trading portfolios on a real-time basis.

And no one has more incentive to understand their counterparties’ true financial pictures than the big banks, insurers, pensions and hedge funds themselves.  Industry players have the same information regulators have, for the most part — but it’s sparse, disclosed in footnotes of the banks’ financial statements and inconsistent around the world.  Some banks disclose it only once a year.

It’s no accident that industry players are focused on the multi-trillion dollar repo market as a use case for blockchains, because the repo market is where much of the leverage in the shadow banking system originates.  In fact, industry players have shown interest in blockchain technology that will help them restrict which counterparties along the collateral chain can borrow their securities — a desirable feature that simply wasn’t possible until blockchains came along.

Rehypothecation is just one of many flavors of systemic leverage that don’t show up on the financial statements of individual financial institutions, but exist in the financial system as a whole — and into which no one has good visibility into the overall picture.  Other flavors are fractional reserve banking within traditional banks and naked short selling within securities lending markets.  Blockchain companies are working on all of these use cases, and regulators should view these start-ups as sources of tools that can finally give them true visibility into the safety and soundness of the financial system.

So, again…multiple parties report that they own the very same asset.  Regulators work to limit the practice, but have no way to measure it accurately and are themselves fragmented.  The industry spends a small fortune to track counterparties’ creditworthiness, with incomplete information.  Blockchains can fix all of this, and regulators should welcome them.

2. A Few Things Regulators Can Do to Access These Powerful Tools Faster

The financial sector is already highly motivated to explore blockchain technology, owing to its cost-saving and capital-reduction benefits.  Yet regulators can speed it up and guide its development in a way that helps achieve their duty of keeping the financial system safe and sound.  For example, financial regulators could:

  • clarify that blockchain technology companies are not themselves regulated financial institutions (such as custodians or money transmitters) if they only administer a blockchain — i.e., if they merely provide the technology as a service but do not themselves touch customer assets.
  • enable blockchains to be virtual custodians/clearinghouses/transfer agents/escrow agents.  Blockchains can automate all of these services without middlemen and the attendant counterparty risk such middlemen needlessly introduce, in stark contrast to today’s market structure.
  • enable blockchains to have access to payment systems, so that both the cash and asset legs of financial transactions can happen on the same ledger (i.e., true “delivery-versus-payment”).  Unless the cash and asset legs of trades settle on the same ledger, securities regulators cannot achieve a true, real-time view into systemic risk.  Other countries are ahead of the U.S. on this topic.
  • encourage private blockchain providers not to store information that regulators need off the chain itself, thus clouding the view into systemic risk.  If regulated financial institutions implement the technology in a compartmentalized way that shields regulators’ mission-critical information, then regulators will have missed the once-in-a-lifetime opportunity to gain necessary tools for keeping the system safe and sound.
  • “serialize” assets while keeping them fungible.  Physical dollar bills have serial numbers, but that does not affect their fungibility.  Custodians and brokers today usually hold securities in omnibus accounts, rather than individual accounts on behalf of the owner, and the securities are not “serialized” so it’s impossible to track them accurately.  “Serializing” securities would allow regulators to see through the opacity inherent in these omnibus accounts, ensuring compliance with existing regulations and minimizing hidden systemic leverage.
  • clarify that banks are allowed to do business with blockchain companies, including bitcoin-related businesses.  Countless blockchain start-ups have had endless trouble opening basic bank accounts, since most banks are avoiding the space due to regulatory uncertainty.
  • allow banks to provide bank-like services to customers without requiring them to hand control over their assets to their bank, as required today.  Same for securities firms.  Allow new generations of financial institutions that give customers a choice whether to engage them as “warehouses” of customer assets rather than as customers’ creditors, which they are today — and let these new companies compete for customers on a level playing field with existing ones.  Blockchain technology makes this possible.

3. Where Next?

The list of regulators warming to blockchains is growing, albeit at different paces, as evidenced by the SEC chair here on March 31, a Federal Reserve governor here on April 15, and the CFTC commissioner here on April 12.  The Bank of England is thinking especially big about potential uses for this technology, as evidenced in this speech from March 2.

I’ll close by sharing more insightful comments from CFTC Commissioner Giancarlo:

The benefit of DLT [blockchain] technology is to provide a comprehensive market view so that regulators can then make recommendations to Congress and other policymakers about what to do about the inter-locking relationships.  But before we can even get to the policy concerns we need to first have that comprehensive, consistent view, which we don’t have today.

He believes, “if allowed to thrive, blockchain may finally give regulators transparency.”

I’ll go a step further and predict blockchain technology WILL give regulators transparency, and will make the financial system safer and sounder in the process.

[This article originally appeared on Caitlin Long]

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Academics’ Unhealthy Obsession with Bank Opacity Fri, 22 Apr 2016 19:44:42 +0000 I just read a January 2015 paper (not very recent, I know, but my reading list is huge) that was not only curious, but also plain wrong.  The paper, titled Understanding the role of debt in the financial system and written by Bengt Holmstrom, illustrates a curious belief among a...

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cabinet_001I just read a January 2015 paper (not very recent, I know, but my reading list is huge) that was not only curious, but also plain wrong.  The paper, titled Understanding the role of debt in the financial system and written by Bengt Holmstrom, illustrates a curious belief among a number of academic economists: that banking, in order to be stable, should be opaque.

The abstract sets the tone:

Money markets are fundamentally different from stock markets.  Stock markets are about price discovery for the purpose of allocating risk efficiently.  Money markets are about obviating the need for price discovery using over-collateralised debt to reduce the cost  of lending.

Later, he adds that

Without the need for price discovery the need for public transparency is much less.  Opacity is a natural feature of money markets and can in some instances enhance liquidity

His views about the stock market/money market differences are summarized in the following table:


Now let me say that there is virtually nothing in his arguments that is grounded in reality.  This theory is completely disconnected from the day-to-day routine of finance workers.

Let’s start with Holmstrom’s definition of ‘money markets’.  Following his paper, money markets only involve repurchase agreements.  This cannot be further from the truth.  Money markets (which we can also call interbank markets) not only involve repos, but also uncommitted and unsecured interbank placements (which include Fed funds).  In fact, for many banks, those placements represent the bulk of their money market exposures.  For instance, according to the financial database Bankscope, JPMorgan’s assets comprised $213Bn of reverse repos and $340Bn of interbank placements.  Citigroup: $120Bn and $112Bn.  Deutsche Bank: EUR107Bn and EUR13Bn. HSBC: $147Bn and $96Bn*.  Small banks, that have very limited trading activities, have almost no reverse repo transactions outstanding.

So the unsecured, relatively longer-term, interbank market is at the least a sizeable portion of money markets.  And it is completely ignored by Holmstrom’s generalization.  Given that his arguments rest on the ability of the lender to over-collateralize his exposure, they suddenly weaken considerably.

More fundamentally, Holmstrom really misunderstands the differences between stock and money markets.  In reality, both markets are very information sensitive and require transparency.  Both markets rely on fundamental financial analysis to assess the riskiness of any investment.  Equity markets are more liquid because they involve only a single instrument by issuing firm; instrument whose value is highly sensitive to the profitability of the firm because its yield depends on it.

Credit markets are much, much, larger and involve a multitude of instruments by issuing firm, covering a broad spectrum of hybrids from pure credit to almost equity-like debt.  Those debt instruments are ranked differently in the hierarchy of creditors.  Senior creditors, including unsecured money market placements, have the first claim on a bankrupt firm’s assets.  Does this mean they are information insensitive?  Certainly not.  But the market value of a firm’s assets fluctuates less than the same firm’s profits/cash flows.  Price discovery is continuous; either at issuance (the higher the risk, the higher the interest rate), or on the ‘secondary’ market: given that interest rates on issues are usually fixed, a decline or improvement in the risk profile of the issuer triggers a change in the market price of related issues.  Therefore information, and indeed transparency, is crucial in this continuous risk assessment process.

So Holmstrom’s generalized arguments about ‘money markets’ are simply wrong.  But are secured credit markets, including reverse repos, devoid of the above rules?  Does collateral-posting allow the lender to avoid assessing the inherent riskiness of his counterparty?

While it is true that collateral mitigates risk, no serious lender would ever blindly lend merely on the basis of collateral availability.  There are a number of reasons for that.  First, collateral is also subject to credit risk, and needs separate assessment.  Second, collateral is subject to market risk (i.e. market price fluctuations), requiring the application of a haircut.  Despite the haircut, when a crisis strikes and markets all fall simultaneously, the value of your collateral can potentially collapse as fast, if not faster, than the amount you lent.  Third, legal risk means that there can be a delay between the insolvency event and the moment you can legally take possession of the collateral (depending on the original contract).  And fourth, the news that you had exposure to a collapsing firm, even if you were secured, can easily raise risk-aversion towards you and trigger financial difficulties.

In the end, even in the case of secured lending, fundamental analysis, which relies on transparent information, is necessary.  Opacity, unlike what our economists believe, is usually ‘credit negative’ and accentuates the compensation and/or the collateralisation that the lender requires.  Moreover, how can the collateralisation level of a transaction be determined without some sort of initial price discovery?  Holmstrom does not answer this question.

Unfortunately, Holmstrom’s piece is full of facts that are grounded in an imaginary world. For instance, see his claim that

When new bonds are issued, the issue is typically sold in a day or less.  Little information is given to the buyers.  It is very far from the costly and time-consuming road shows and book-building that new stock issues require in order to convey sufficient information.

Please, I beg you never to say that sort of things at a financial conference if you don’t want to get laughed at.  The truth is that specific roadshows targeting fixed income investors are regularly organised by companies.  Fixed income managers also employ buy-side analysts who spend their day analysing those firms, as well as reading pieces of financial research published by sell-side analysts. According to Holmstrom, those people do not seem to exist.

He also claims that bond ratings are ‘coarse’, and that this is “another example of what appears to be purposeful opacity.”  I find this amazing, given that rating agencies have about 22 different base rating notches, to which a multitude of extra ratings are added in order to provide the information Holmstrom believes is opaque.  Now compare this with the usual three-notch stock rating system of Buy/Hold/Sell and you might conclude he got seriously mixed up here.

This tendency to believe that opacity ‘helps’ markets seems to be spreading.  In 2014, Gorton et al (which included, unsurprisingly, Holmstrom) published a very weird paper titled Banks as Secret Keepers, which argues precisely that:

Banks are optimally opaque institutions.  They produce debt for use as a transaction medium (bank money), which requires that information about the backing assets — loans — not be revealed, so that bank money does not fluctuate in value, reducing the efficiency of trade.  This need for opacity conflicts with the production of information about investment projects, needed for allocative efficiency.  Intermediaries exist to hide such information, so banks select portfolios of information-insensitive assets.  For the economy as a whole, firms endogenously separate into bank finance and capital market/stock market finance depending on the cost of producing information about their projects.

The paper is based on a mathematical model that seems unable to describe what happens in real financial and deposit markets.  And indeed they don’t bother providing much empirical evidence of their claims (as I am writing this post, Kadhim Shubber of FT Alphaville quotes the exact same paper rather uncritically).

At the end of the day, Holmstrom’s and Gorton’s theories seem to justify government intervention in deposit and money markets.  But as Kevin Dowd just brilliantly reminded us, those ‘opacity’, ‘information asymmetry’ and ‘market failures’ in no way justify banking regulation, unless you disregard all empirical and historical evidences.  And, of course, unless you don’t believe in government failure.  Sadly, it seems that imagination wins over reality nowadays in academia.


*Moreover, some of the ‘reverse repo’ figures might include collateral posted against other sort of trades, as well as transactions with non-financial counterparties, implying that the ‘pure’ money market reverse repo portion mentioned here is likely smaller.

[This article originally appeared on Spontaneous Finance]

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A Monetary Policy Primer, Part 1: Money Thu, 21 Apr 2016 13:12:39 +0000 It occurs to me that, despite the unprecedented flood of writings of all sorts — books, blog-posts, newspaper op-eds, and academic journal articles —  addressing just about every monetary policy development during and since the 2008 financial crisis, relatively few attempts have been made to step back from the jumble...

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WizardIt occurs to me that, despite the unprecedented flood of writings of all sorts — books, blog-posts, newspaper op-eds, and academic journal articles —  addressing just about every monetary policy development during and since the 2008 financial crisis, relatively few attempts have been made to step back from the jumble of details for the sake of getting a better sense of the big picture.

What, exactly, is "monetary policy" about?  Why is there such a thing at all?  What should we want to accomplish by it — and what should we not try to accomplish?  By what means, exactly, are monetary authorities able to perform their duties, and to what extent must they exercise discretion in order to perform them?  Finally, what part might private-market institutions play in promoting monetary stability, and how might they be made to play it most effectively?

Although one might devote a treatise to answering any one of these questions, I haven't time to write a treatise, let alone a bunch of them; and if I did write one, I doubt that policymakers (or anyone else) would read it.  No sir: a bare-bones primer is what's needed, and that's what I hope to provide.

The specific topics I tentatively propose to cover are the following:

  1. Money.
  2. The Demand for Money.
  3. The Price Level.
  4. The Supply of Money.
  5. Monetary Control, Then and Now
  6. Monetary Policy: Easy, Tight, and Just Right.
  7. Money and Interest Rates.
  8. The Abuse of Monetary Policy.
  9. Rules and Discretion.
  10. Private vs Official Money.

Because I eventually plan to combine the posts into a booklet, your comments and criticisms, which I'll be sure to employ in revising these essays, will be even more appreciated than they usually are.


"The object of monetary policy is responsible management of an economy's money supply."

If you aren't a monetary economist, you will think this a perfectly banal statement.  Yet it will raise the hackles of many an expert.  That's because no-one can quite say just what a nation's "money supply" consists of, let alone how large it is.  Experts do generally agree in treating "money" as a name for anything that serves as a generally-accepted means of payment.  The rub resides in deciding where to draw a line between what is and what isn't "generally accepted."  To make matters worse, financial innovation is constantly altering the degree to which various financial assets qualify as money, generally by allowing more and more types of assets to do so.  Hence the proliferation of different money supply measures or "monetary aggregates" (M1, M2, M3, MZ, etc.).  Hence the difficulty of saying just how much money a nation possesses at any time, let alone how its money stock is changing.  Hence the futility of trying to conduct monetary policy by simply tracking and regulating any particular money measure.

For all these reasons economists and monetary policymakers have tended for some time now to think and speak of monetary policy as if it weren't about "money" at all.  Instead they've gotten into the habit of treating monetary policy as a matter of regulating, not the supply of means of payment, but interest rates.  We all know what interest rates are, after all; and we can all easily reach an agreement concerning whether this or that interest rate is rising, falling, or staying put.  Why base policy on a conundrum  when you can instead tie it to something concrete?

And yet…it seems to me that in insisting that monetary policy is about regulating, not money, but interest rates, economists and monetary authorities have managed to obscure its true nature, making it appear both more potent and more mysterious than it is in fact.  All the talk of central banks "setting" interest rates is, to put it bluntly, to modern central bankers what all the smoke, mirrors, and colored lights were to Hollywood's Wizard of Oz: a great masquerade, serving to divert attention from the less hocus-pocus reality lurking behind the curtain.

But surely the Fed does influence interest rates.  Isn't that, together with the fact that we can clearly observe what interest rates are doing, not reason enough to think of monetary policy as being "about" interest rates?  And doesn't money's mutable nature make it inherently mysterious — and therefore ill-suited to serve as the polestar of central bank policy, let alone as a concept capable of  demystifying that policy?

No, and no again.  Although central banks certainly can influence interest rates, they typically do so, not directly (except in the case of the rates they themselves charge in making loans or apply to bank reserves), but indirectly.  The main thing that central banks directly control is the size and make up of their own balance sheets, which they adjust by buying or selling assets.  When the FOMC elects to "ease" monetary policy, for example, it may speak of setting a lower interest rate "target." But what that means — or what it almost always meant until quite recently — was that the Fed planned to  increase its holdings of U.S. government securities by buying more of them from private ("primary") dealers.  To pay for the purchases, it would wire funds to the dealers' bank accounts, thereby adding to the total quantity of bank reserves.[1]   The greater availability of bank reserves would in turn improve the terms upon which banks with end-of-the-day reserve shortages could borrow reserves from other banks.[2]  The "federal funds rate," which is the average ("effective") rate that financial institutions pay to borrow reserves from one another overnight, and the rate that the Fed has traditionally "targeted," would therefore decline, other things being equal.

Because the Fed's liabilities consist either of the deposit balances kept with it by other banks and by the central government (the only other entity that banks with the Fed), or of circulating currency, and because commercial banks' holdings of currency and central-bank reserve credits make up the cash reserves upon which their own ability to service deposits of various kinds rests, when the Fed increases the size of its own balance sheet, it necessarily increases the total quantity of money, either indirectly, by increasing the amount  of cash reserves available to other money-producing institutions, or directly, by placing more currency into circulation.

Just how much the nation's money supply changes when the Fed itself grows depends, first of all, on what measure of money one chooses to employ, and also on the extent to which banks and other money-creating financial institutions lend or invest rather than simply hold on to fresh reserves that come their way.  Before the recent crisis, for example, every dollar of "base" money (bank reserves plus currency) created by the Federal Reserve itself translated into just under 2 dollars of M1, and into about 8 dollars of M2.  (See Figure 1.)  Lately those same base-money "multipliers" are just .8 and 3.2, respectively.  Besides regulating the available supply of bank reserves, central banks can influence banks' desired reserve ratios, and hence prevailing money multipliers, by setting minimum required reserve ratios, or by either paying or charging interest on bank reserves, to increase or lower banks' willingness to hold them. [3]

Figure 1: U.S. M1 and M2 Multipliers


If the money-supply effects of central bank actions aren't always predictable, the interest rate effects are still less so.  Interest rates, excepting those directly administered by central banks themselves, are market rates, the levels of which depend on both the supply of and the demand for financial assets.  The federal funds rate, for example, depends on both the supply of "federal funds" (meaning banks' reserve balances at the Fed) and the demand for overnight loans of the same. The Fed has considerable control over the supply of bank reserves; but while it can also influence banks' willingness to hold reserves, that influence falls well short of anything like "control."  It's therefore able to hit its announced federal funds target only imperfectly, if at all. Finally, even though the Fed may, for example, lower the federal funds rate by adding to banks' reserve balances, if the real demand for reserves hasn't changed, it can do so only temporarily.  That's so because the new reserves it creates will sponsor a corresponding increase in bank lending, which will in turn lead to an increase in both the quantity of bank deposits and the nominal demand for (borrowed as well as total) bank reserves. As banks' demand for reserves rises, the federal funds rate, which may initially have fallen, will return to its original level.  More often than not, when the Fed appears to succeed in steering market interest rates, it's really just going along with underlying forces that are themselves tending to make rates change.

I'll have more to say about monetary policy and interest rates later.  But for now I merely want to insist that, despite what some experts would have us think, monetary policy is, first and foremost, "about" money.  That is, it is about regulating an economy's stock of monetary assets, especially by altering the quantity of monetary assets created by the monetary authorities themselves, but also by influencing the extent to which private financial institutions are able to employ central bank deposits and notes to create alternative exchange media, including various sorts of bank deposits.

Thinking of monetary policy in this (admittedly old-fashioned) way, rather than as a means for "setting" interest rates, has a great advantage I haven't yet mentioned.  For it allows us to understand a central bank in relatively mundane (and therefore quite un-wizard-like) terms, as a sort of combination central planning agency and factory.  Central banks are, for better or worse, responsible for seeing to it that the economies in which they operate have enough money to operate efficiently, but no more.  Shortages of money wastes resources by restricting the flow of payments, making it hard or impossible for people and firms to pay their bills, while both shortages and surpluses of money hamper the correct setting of individual prices, causing some goods and services to be overpriced, and others underpriced, relative to others.  Scarce resources, labor included, are squandered either way.

Though they are ultimately responsible for getting their economies' overall money supply right,  central banks' immediate concern is, as we've seen, that of controlling the supply of "base" money, that is, of paper currency and bank reserve credits — the stuff banks themselves employ as means of payment.  By limiting the supply of base money, central banks indirectly limit private firms' ability to create money of other sorts, because to create their own substitutes for base dollars private firms must first get their hands on some of the real McCoy.

But how much money is enough?  That is the million (or trillion) dollar question.  The platitudinous answer is that the quantity of money supplied should never fall short of, or exceed, the quantity demanded.  The fundamental challenge of monetary policy consists, first of all, of figuring out what the platitude means in practice and, second, of figuring out how to make the money stock adjust in a manner that's at least roughly consistent with that practical answer.

Next: The Demand for Money.


1. Although people tend to think of a bank's reserves as consisting of the currency and coin it actually has on hand, in its cash machines, cashiers' tills, and vaults, banks also keep reserves in the shape of deposit credits with their district Federal Reserve banks. When the Fed wires funds to a bank customer's account, the customer's account balance increases, but so does the bank's own reserve balance at the Fed. The result is much as if the customer made a deposit of the same amount, using a check drawn on some other bank, except that the reserves that the bank receives, instead of being transferred to it from some other bank, are fresh ones that the Fed has just created.

2. Although amounts that banks owe to one another are kept track of throughout the business day, and settlement is instantaneous, the Fed itself takes responsibility for whatever part of their obligations banks themselves cannot immediately cover.  It is only at the end of the business day that banks that end up owing money to the Fed must come up with the reserves they need both to settle up with it and to meet any overnight reserve requirements.

3. The Fed first began paying interest on bank reserves in October 2008.  Although some foreign central banks are now charging interest on reserves, the Fed has yet to take that step; nor is it clear whether it has the statutory right to do so.

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Do Market Failures Justify Bank Capital Adequacy Regulation? Tue, 19 Apr 2016 13:11:16 +0000 One of the most important elements of contemporary financial regulation is bank capital adequacy regulation — the regulation of banks’ minimum capital requirements.  Capital adequacy regulation has been around since at the least the 19th century, but whereas its previous incarnations were relatively simple, and usually not very burdensome, modern capital...

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Tinted Mechanics-national-bank-advertisement-1884-tn1One of the most important elements of contemporary financial regulation is bank capital adequacy regulation — the regulation of banks’ minimum capital requirements.  Capital adequacy regulation has been around since at the least the 19th century, but whereas its previous incarnations were relatively simple, and usually not very burdensome, modern capital adequacy regulation is vastly both more complicated and more heavy-handed.

After I first began research on this subject years ago, I watched the Basel Committee take part in a remarkable instance of mission creep: starting from its original remit to coordinate national banking policies, it expanded into an enormous and still growing international regulatory empire.  Yet I also noticed that no-one in the field seemed to ask why we needed any of this Basel regulation in the first place.  What, exactly, were the market failure arguments justifying Basel’s interventions generally, and it’s capital adequacy regulation in particular?

On those occasions when regulatory authorities make any attempt to justify capital regulations, they typically settle for mere assertion.  The following little gem from a recent Bank of England Discussion Paper on the implementation of Basel in the UK is typical:

Capital regulation is necessary because of various market failures which can lead firms on their own to choose amounts of capital which are too low from society’s point of view.[1]

The authors don’t bother to say what the market failures consist of, let alone prove that they actually are present.  Nor do they even hint at the possibility that banks may choose unduly low levels of capital, not because of market failure, but because they are encouraged to do so by government deposit insurance or central banks’ offers of last-resort support.  Instead, there is a mere appeal to that ethereal entity, “society,” the incontrovertible opinion of which is that financial institutions ought to hold more capital than they would be inclined to hold if left to their own devices.  Policymakers are, furthermore, privy to this opinion, though why they should be so is also left unexplained.

On those rare occasions when genuine market-failure arguments for capital adequacy regulation are put forward, they are less than compelling.  An example was recently provided by my friend, the former Bank of England economist David Miles.  In an appendix to his thoughtful valedictory speech as a member of the Monetary Policy Committee last summer, David sketches out a simple model to “illustrate the tendency for unregulated outcomes to create too much risky bank lending.”

In his model, banks operate under limited liability, which allows them to pass on high losses to their creditors.  They also take risky lending decisions, but depositors do not see the riskiness of the loans that their bank makes.  Miles then obtains an equilibrium in which banks with lower capital are more prone to excessively risky lending, and he suggests that the solution to this problem (of excessively risky bank lending) is to increase capital requirements.

Let’s grant the point that banks with low capital levels would be prone to excessively risky lending. Let’s also agree that the solution is higher capital.  Miles would have this solution implemented by regulators increasing minimum capital requirements.

However, the same solution could also be implemented by depositors themselves.  They could choose not to make deposits in banks with low capital levels.  In a repeated-game version of the model, they could also run on their bank if their bank’s capital levels fell below a certain threshold.  Weakly capitalized banks would then disappear and so, too, would the excessively risky bank lending.

The mistake here — and it is a common one among advocates of government intervention — is to come up with a solution to some problem, but then assume that only the government or one of its agencies can implement that solution.  To make a convincing case for state intervention, they have to explain why only the government or its agencies can implement that solution: they have to demonstrate a market failure.[2]

A more substantial argument for capital adequacy regulation, also by David Miles, was published in the European Economic Review in 1995.  (See also here.)  The essence of this argument is that if depositors can assess a bank’s capital strength, a bank will maintain a relatively strong capital position because greater capital induces depositors to accept lower interest rates on their deposits.  However, if depositors cannot assess a bank’s capital strength, then a bank can no longer induce depositors to accept lower interest rates in return for higher capital, and the bank’s privately optimal capital ratio is lower than the socially optimal capital ratio.[3]  Information asymmetry therefore leads to a bank capital adequacy problem.  Miles’s solution is for a regulator to assess the level of capital the bank would have maintained in the absence of the information asymmetry, and then require it to maintain this level of capital.

There is, however, a problem at the heart of this analysis.  Consider first that the technology to assess and convey the quality of bank assets either exists or it does not.  If the technology does exist, then the private sector can use it, and there is no particular reason to prefer that the government use it instead.  There is then no market failure.  On the other hand, if the technology does not exist, then no-one can use it, not even the government.  Either way, there is no market failure that the government can feasibly correct.  To assume that the technology exists, but that only the government can use it, is not to demonstrate the presence of a market failure, but to assume it.

Of course, we all know that the technology in question does exist, albeit in imperfect form.  The traditional solution to this asymmetric information problem is for the shareholders (or, more accurately, bank managers acting on behalf of shareholders) to provide externally audited reports.  These reports are made credible by the managers and the auditors being liable to civil penalties in the event that either party signs off on statements that are materially misleading.  If they issue misleading statements, aggrieved creditors could then pursue them through the courts.

A potential objection is that this solution requires a high level of financial competence among depositors that cannot be expected of them.  In fact, it does not.  Instead, all it requires is that there are analysts who can interpret audited reports, and that they, in turn, convey their opinions to the public in a form that the public can understand.  The average depositor does not have to have a qualification in chartered accountancy; instead, they only need to be able to read the occasional newspaper or internet piece about the financial health of their bank and then make up their minds about whether their bank looks safe or not.  If their bank looks safe, they should keep their money there; if their bank does not, they’d better run.

One should also compare the claims underlying any model and the predictions generated by it against the available empirical evidence.  In this case, the claim that depositors cannot assess individual banks’ balance sheets is empirically falsified, at least under historical circumstances where the absence of deposit insurance or other forms of bailout gave depositors an incentive to be careful where they put their deposits.  To quote George Kaufman on this subject:

There is . . . evidence that depositors and noteholders in the United States cared about the financial condition of their banks and carefully scrutinized bank balance sheets [in the period before federal deposit insurance was introduced].  Arthur Rolnick and his colleagues at the Federal Reserve Bank of Minneapolis have shown that this clearly happened before the Civil War.  Thomas Huertas and his colleagues at Citicorp have demonstrated the importance of [individual] bank capital to depositors by noting that Citibank in its earlier days prospered in periods of general financial distress by maintaining higher than average capital ratios and providing depositors with a relatively safe haven.[4]

The Miles position is also refuted by the empirical evidence on the bank-run contagion issue.  If Miles is right and depositors cannot distinguish between strong and weak banks, then a run on one bank should lead to runs on the others as well.  Yet the evidence overwhelmingly indicates that bank runs do not spread in the way that the Miles hypothesis predicts.  Instead, there occurs a “flight to quality,” with depositors withdrawing funds from weak institutions for redeposit in stronger ones.  The “flight to quality” phenomenon demonstrates the very point that Miles denies, i.e., that depositors have been able to tell the difference between strong and weak banks.

So, once again, there is no market failure.

I should add, in concluding, that I’ve addressed these two arguments by David Miles because they are the best market-failure arguments for capital adequacy regulation that I’m aware of.  I invite readers to point me to stronger arguments if they can find any. 


[1] Bank of England, “The Financial Policy Committee’s review of the leverage ratio,” October 2014, p. 12.

[2] There are also two other "first-best" solutions in Miles' model that do not involve government or central bank capital regulation.  The first is where a bank has a 100 percent capital ratio, in which case the risk of loss to depositors would be zero, but only because there would no longer be any depositors.  The "bank" would no longer be a bank either, because it would no longer issue any money: instead, it would become an investment fund.  The second is to eliminate limited liability to prevent bank shareholders walking away from their losses.  In this context, one should recall that limited liability is not a creature of the market, but a product of the limited liability legislative interventions in the 19th century.

[3] The fact that there is a suboptimal equilibrium in which banks maintain lower-than-optimal capital levels is also a little odd, and would appear to reflect the informational assumptions that Miles made in his model.  If depositors are not sure of the quality of their bank’s assets, we might have expected them to insist that their banks maintain higher rather than lower capital levels, or else keep their money under the mattress instead.  I thank George Selgin for this point.

[4] Kaufman, G. G. (1987) “The Truth about Bank Runs.” Federal Reserve Bank of Chicago. Staff Memorandum 87–3, pp. 15-16.

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Cryptocurrency: The Policy Challenges of a Decentralized Revolution Sat, 16 Apr 2016 14:38:24 +0000 Over two hundred people gathered at the Cato Institute for Tuesday’s conference, “Cryptocurrency: The Policy Challenges of a Decentralized Revolution.”  Three keynote speakers and four panel discussions investigated the public policy implications of cryptocurrencies like Bitcoin and the underlying distributed ledger blockchain technology.  If you couldn’t make it to Cato...

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CryptoCato Blog ImageOver two hundred people gathered at the Cato Institute for Tuesday’s conference, “Cryptocurrency: The Policy Challenges of a Decentralized Revolution.”  Three keynote speakers and four panel discussions investigated the public policy implications of cryptocurrencies like Bitcoin and the underlying distributed ledger blockchain technology.  If you couldn’t make it to Cato and missed the livestream, video and podcast recordings are now available on the event website.  Or keep reading for a synopsis of the day’s program.

Cryptocurrencies and Public Policy, Where Things Stand

Before the featured speakers and panels commenced Jerry Brito gave an overview of cryptocurrencies and the current public policy stance towards them.  Brito is a leading advocate for a hands-off regulatory approach to cryptocurrencies.  In 2014 he launched the Coin Center, a non-profit devoted to educating policymakers and the public about cryptocurrency issues.  The staff here at CMFA worked closely with Brito and Coin Center to assemble the conference program.  Our sincere thanks to Jerry and his team for their immense help and expertise.

Brito began by saying that digital currency is itself old-hat: banks, credit card companies, and PayPal have offered versions of it since the 1990s.  Bitcoin was the first decentralized, peer-to-peer digital currency.  Because it was also pseudonymous, public authorities mainly saw it as something useful to criminals.  Nowadays they’re starting to see its open-source software as a way of revolutionizing payments.

Brito warned that complex regulations  are causing the US to fall behind countries that welcome cryptocurrency startups, including the UK, where MPs have stated their wishes for London to be the epicenter of fintech.  One major problem in the US is that money transmitting is regulated at the state level, making it so that firms involved in moving cryptocurrencies have to comply with fifty different sets of laws.

Panel I – The Consumer Protection Challenge

The issue of state level money transmitting laws related directly to the first panel’s topic:  cryptocurrencies and consumer protection regulation.  Moderated by the Coin Center’s Peter Van Valkenburgh, the panel featured Margaret Liu of the Conference of State Bank Supervisors, Marco Santori, Global Policy Counsel for Blockchain Inc., Melanie Shapiro, CEO of Case Wallet, and Dana Syracuse, attorney with Buckley Sandler who helped draft the New York BitLicense when he was at the New York Department of Financial Services.

The panelists discussed the contrast between regulators’ impulses to protect consumers from the dangers of a new technology and the flexibility startup firms need to develop their products.  Shapiro noted that the peer-to-peer validation model of blockchain transactions is self-governing.  Santori echoed those sentiments, claiming that the technology’s self-governing nature was “turning regulatory principles on their head.”

Santori also agreed with Brito’s point that firms engaging with the technology might relocate abroad if US regulators are hostile towards cryptocurrencies.  Syracuse mentioned that focusing on consumer protection can cause lawmakers to overlook consumer benefits, especially benefits to worldwide consumers priced out of traditional financial services.  Liu, providing a regulator-oriented perspective, seemed sympathetic to the industry’s concerns.  She agreed that many regulations, designed for yesterday’s issues, can be ill-suited for new technologies and business models.

Keynote Address: Commissioner J. Christopher Giancarlo

For the keynote, Commissioner Giancarlo, one of three currently on the Commodity Futures Trading Commission, argued that regulators should adopt “do no harm” as their first principle when making blockchain policy.  Giancarlo compared this idea of “do no harm” to Internet policy in the 1990s, which, according to Giancarlo, was based on the idea that, “the Internet was to progress through human social interaction, voluntary contractual relations, and free markets.”  Giancarlo called on regulators and policymakers with jurisdiction over DLT (Digital Ledger Technology) to establish uniform principles that ensure blockchain innovation can occur without government permission.  You can read Giancarlo’s full speech here.  Coinciding with his speech at Cato, Giancarlo published an op-ed emphasizing his point in the Financial Times.

Panel II – The Financial Services Challenge: Permissioned and Permissionless Blockchains

The second panel discussed blockchain technology’s effect on the financial services industry.  Marc Hochstein, editor in chief of American Banker, moderated the panel, which featured Paul L. Chou, CEO of LedgerX, Jacob Farber, general counsel at R3CEV, Joseph Lubin, co-founder of Ethereum, and Ryan Zagone of Ripple.

Each of the speakers represent organizations that develop financial services products using blockchain.  Ripple, LedgerX, and R3CEV attempt to leverage blockchain for use in global payments, settlements, and financial asset trading.  The Ethereum Project is a non-profit foundation that allows developers to build blockchain-based applications.

The financial industry is paying more attention to permissioned blockchains, or access-restricted distributed ledgers.  Ryan Zagone pointed out that payments are settled much faster on private blockchains than existing systems.  Jacob Farber added that permissioned blockchains allow for automated, smart contracts to govern financial transactions.  Joseph Lubin compared the permissioned v. permissionless distinction to internet v. intranet, arguing that some institutions and networks need closed blockchains, but this won’t affect the openness of the underlying technology.

Luncheon Address: Patrick Byrne

We were fortunate to have Patrick Byrne speak.  Just the day before he announced an indefinite medical leave of absence from his two pioneering companies:, a major online retailer and the first to accept bitcoin, and the recently founded , a blockchain-based trading and settlement platform for financial securities.  Byrne recounted his longstanding appreciation for Cato, beginning with the small-dollar donations he made while a college student.  Upon his announcement, he canceled all other professional engagements besides his keynote.  He said it was fitting to make his last public speech (for awhile at least) at Cato.  We are truly honored.

Byrne offered a concise and poignant explanation of his bullish take on the social value of cryptocurrency and blockchain.  Blockchain solves what Byrne called a “6,000” year old problem: the inability for strangers to verify the value of the exchanged assets without a trusted, intermediating third party.  This problem contributed to the rise of states and their monopoly on the issue of currency.  Blockchain’s disruptive potential might even exceed that of the Internet, according to Byrne.  The Internet provided a dispersed method for transmitting information, but blockchain goes a step further by providing a dispersed method of transmitting value.

Panel III – The Monetary Challenge

Discussing the monetary side of the cryptocurrency revolution were Kenyon College economics professor Will Luther, Chamber of Digital Commerce president Perianne Boring, and the Mercatus Center’s Eli Dourado, moderated by our own George Selgin.  The panelists began by evaluating Bitcoin’s use as a currency.  That use is presently limited.  Luther pointed out that Bitcoin processes around 200,000 transactions a day, a high number, but miniscule compared to the 150 million Visa handles.  Boring added that merchants hesitate to take Bitcoin now because of its volatile price.  At the same time, Bitcoin and the blockchain provide some advantages for merchants.  The public ledger might eliminate chargeback fraud in online transactions, for example.  The panelists also touched on potential innovative monetary uses for cryptocurrencies.  Dourado touted the potential for a self-driving car paying for its own gas in Bitcoin in an “Internet of Things” future.  Selgin noted the possibility for cryptocurrency technology to be used as a means for enforcing a monetary rule, à la Friedman’s famous proposal.

Panel IV – The Fourth Amendment Challenge: Financial Privacy and Freedom of Speech

On the day’s last panel, moderated by Coin Center’s Jerry Brito, Andrea Castillo of Mercatus, Cato’s Jim Harper, Eric Lorber of the Financial Integrity Network, and Zooko Wilcox-O’Hearn, founder and CEO of Zcash, weighed the privacy enhancing aspects of cryptocurrencies versus potential criminal exploitation.  Harper argued that Bitcoin and blockchain’s privacy benefits exceed any potential value for criminals, pithily claiming that the existence of data “doesn’t entitle the government to have it.”  Lorber pointed out that the Bitcoin community has an incentive to self-police against criminal use.  Castillo emphasized the real, positive benefits of financial privacy, remarking that authoritarian governments think of Bitcoin as “public enemy number one.”  Wilcox-O’Hearn had a unique perspective, given his founding role in the cryptocurrency Zcash, which facilitates completely anonymous transactions.  Wilcox-O’Hearn pointed out that media reports implying a connection between bitcoin and terrorist finance are all unproven.

Closing Address: Hon. Mick Mulvaney (SC-05)

Mick Mulvaney, representative for the 5th district of South Carolina and Vice Chairman of the House Subcommittee on Monetary Policy and Trade, closed out the conference.  Mulvaney argued that the federal government must take a policy stance on cryptocurrencies.  Ignoring the technology would be tantamount to a confusing and obstructionist regulatory stance, given uncertainty about bitcoin’s status as either a commodity or security, and the aforementioned state law issue.  Mulvaney, himself a fan of the technology, emphasized his hope for US centrality in future financial technology innovation.  He also mused about the implications of cryptocurrencies on the state’s monopoly of official currency issue, even referencing Hayek’s "Denationalization of Money."

Videos and Podcasts:

Check out all the videos, or download them as podcasts, here.  And don’t forget the special after-event podcast interviews, over here!

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On Free Banking, Monetary Rules, and Crusades Fri, 08 Apr 2016 13:07:52 +0000 I often find myself described, not as a monetary economist, plain vanilla or otherwise, but as a "free banker," and (therefore) as someone who wants to "abolish" the Fed.  Yet I've also been accused of lacking consistency, and even of being an outright apologist for monetary central planning, because I...

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Crusaders2I often find myself described, not as a monetary economist, plain vanilla or otherwise, but as a "free banker," and (therefore) as someone who wants to "abolish" the Fed.  Yet I've also been accused of lacking consistency, and even of being an outright apologist for monetary central planning, because I also have some nice things to say about monetary rules in general, and about nominal spending rules in particular.

So, am I a free banker or not?  The short answer is…well, there isn't a short answer other than "it's complicated."

First of all, I don't much like being called a "free banker," or a free banking "advocate."  Yes, I have a soft spot for free banking; yes, I think that the Scottish and Canadian systems of yore, which approximated it most closely, performed a helluva lot better than their modern, centralized counterparts; and yes, I think more people should study those systems, and free banking more generally, so as to better appreciate the extent to which competitive market arrangements are capable of producing stable and efficient systems of money and banking.

Yet these beliefs of mine don't mean that I'm not interested in reforms that fall short of any sort of free-banking ideal.  Still less do they mean that I imagine that, were we to simply get rid of the Fed, root and branch, a set of currency-issuing private banks would rush in at once to fill the void. Nor do I suppose for a moment that allowing commercial banks to issue their own notes, and otherwise deregulating them, while leaving the Fed's current money-creating powers unchanged, would put an end to monetary instability.  Finally, despite having moved from the academy to Cato, I'm more interested in promoting a proper understanding of the economic implications of free banking than I am in leading a crusade of any sort.  (Then again, I'm confident that, if more people understood free banking, we'd have crusaders aplenty for it.)

But there's a more fundamental reason why partiality to free banking today doesn't automatically translate into a desire to annihilate central banks.  When banknotes were still redeemable claims to some "outside" money, like gold or silver coin, to favor free banking — that is, to favor having rival banks issue redeemable notes over having a single bank alone do so — was equivalent to being opposed to having a central bank.  In a metallic standard context, freedom of entry into the currency business sufficed to keep any one bank's actions from provoking a general expansion or contraction, because while a monopoly issuer might count on other banks treating its IOUs as cash reserves, a bank enjoying no monopoly privileges could expect rival issuers to treat its notes like so many checks, to be promptly presented to it for redemption.  Subjecting a formerly privileged bank of issue to competition therefore served, no less than abolishing it altogether might, to deprive the bank of its short-run ability to influence aggregate nominal magnitudes.  Were the bank to be abolished, on the other hand, other banks, perhaps including new entrants, could readily make up for its absence, because the economy's (metallic) monetary standard would remain intact.

The situation becomes quite different once metallic standards give way to fiat money.  In a fiat system free banking ceases to be a straightforward alternative to, or substitute for, central banking.  That's so because the monopoly bank of issue is now responsible, not just for issuing paper currency, but for supplying the economy's standard money.  There is, in other words, no monetary standard apart from that embodied in the central bank's liabilities.  A "standard" U.S. dollar today is no longer a quantity of silver or of gold; it is a one-dollar Federal Reserve Note, or a one-dollar credit on the Fed's books.  It follows that, to simply abolish the Fed, in the strict sense of liquidating it (that is, parceling-out its assets to its creditors, and destroying and retiring its paper liabilities),  would be tantamount to abolishing the U.S. dollar itself.  Though it's still possible, and perhaps even likely, that some sort of new new banking and currency system would arise, that development would have to be accompanied by the prior or concurrent development of a new monetary standard or standards — a potentially fraught proposition.  Some may well be willing to risk such a radical change; but no one could predict its results with any degree of confidence.

In contrast, a free-banking reform that left the Fed's money-creating powers unchanged, while allowing private firms to issue dollar-denominated paper currency in competition with it, wouldn't make a big difference, even supposing that the new currency would be so attractive that no one bothered holding Federal Reserve notes at all.  The change wouldn't be entirely without significance.  For one thing, it would substantially reduce the Fed's, and therefore the Treasury's, seignorage revenue, converting it from producers' to consumers' surplus.  The reform would also relieve the Fed of the burden of providing for seasonal and cyclical changes in currency demand.  Finally, for reasons I've spelled-out in The Theory of Free Banking and elsewhere, the change could make for a more stable relationship between the quantity of base money and the volume of aggregate spending or NGDP.  But so long as paper currency consists either of Federal Reserve dollars themselves or of dollar-denominated private banknotes, a competitive banknote regime alone would not reduce, let alone undermine, the Fed's general ability to influence nominal magnitudes by buying or selling assets, and perhaps by other means.  Nominal values would be no less dependent than before on the size of the Fed's balance sheet, holding other determinants of the real demand for reserves (including interest rates on reserves and alternative assets) constant.  It follows that allowing other banks to issue currency would not rule out undesirable central-bank sponsored changes in spending, output, and the rate of inflation.

It follows from this that, so long as an economy relies on fiat money, the quantity of standard money itself, instead of being regulated by private market forces, has to be regulated by some other means.  That must either mean discretionary control by bureaucrats, or control by means of some sort of monetary rule.  The rule might itself replace the fiat standard with a revived commodity standard, by turning purely nominal official monetary liabilities into genuine claims to definite quantities of gold or silver.  But that is only one possibility among many — and an especially difficult one to pull off.  Most rules would instead preserve the standard money's "fiat" status.  And most would preserve the rumps, if nothing else, of established central banks.  Call it central banking, night-watchman style.

In short, although a century or more ago, free banking and monetary rules were rival ideas for guarding against abuses of discretionary monetary policy, today they are properly seen as complementary schemes, one for improving the performance of the banking system, the other for reforming the base-money regime.  Therefore there's no reason why one can't favor, and even crusade for, both.

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Bank Regulation and the Financial Crisis Wed, 06 Apr 2016 13:16:12 +0000 Editor's note:  For some years now, Julien Noizet has been writing about the financial crisis and its aftermath for his blog, Spontaneous Finance. Having first come across that blog a year or so ago, I have been impressed by Julien’s insightful commentary, informed as it is  by his interest in...

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NoizetEditor's note:  For some years now, Julien Noizet has been writing about the financial crisis and its aftermath for his blog, Spontaneous Finance. Having first come across that blog a year or so ago, I have been impressed by Julien’s insightful commentary, informed as it is  by his interest in the writings of Mises, Hayek, Buchanan, and Friedman, among other great classical liberals, no less than by information gathered “on the street,” as a working financial analyst.  I’m therefore very pleased to report that Julien has given us permission to occasionally re-post his work on Alt-M, while also offering to pen a post just for us introducing his work on the crisis.  


Many discussions of the causes of the worst financial crisis in decades focus on macroeconomic indicators, while overlooking fundamental changes in the mechanics of the financial  system that have occurred over the past three decades.  That focus has, in my opinion, given rise to two fallacies.  The first of these holds the financial crisis to have been unforeseeable.  The second has it originating in the US.  In truth the crisis was a foreseeable consequence of financial developments common to most of the industrialized world.

Rather than taking a step back and attempting to understand the underlying drivers of the boom and  bust, politicians, central bankers and many members of the general public were quick to attribute  them to “inherently unstable” and insufficiently regulated financial (and especially banking) industries.  This perspective led to the introduction of unprecedentedly sweeping financial reforms.

Was banking an inherently unstable industry that needed stronger oversight?  As a financial analyst spending all day looking at banks’ balance sheets and speaking to bankers about their business model, this understanding made little sense to me.  My peers and I could see the hundreds of pages of regulation that banks had to comply with.  Banking was hardly an unregulated industry.

Might the crisis have instead had its source in developments outside the private financial industry? Some economists, but also many commentators of the finance industry, were quick to accuse monetary authorities of bringing about the boom.  While I do think there is some truth to this, my experience led me to believe that there was much more to the story than that.  Asset bubbles did not appear at random but involved similar asset classes simultaneously around the world, implying a common denominator.  One such common denominator consisted of the Basel accords, an international agreement on banking regulation first implemented in the 1980s, and revised on numerous occasions since.  I also noticed that new start-ups, free from Basel regulatory constraints, seemed to be thriving in areas and products avoided by mainstream banks, indicating a supply side rather than a demand side issue.

Equipped with these observations, and inspired as well by the Free Banking literature arguing that past financial crisis were rooted in badly-designed rules, I decided, in 2013, to found the blog ‘Spontaneous Finance,’ with the aim of coming to grips with our recent disaster.  I here offer a brief review of some of my postings there, with apologies for the perhaps cryptic nature of the necessarily brief summaries.

About  a year after the creation of my blog, and confirming a trend I had already noticed in the case of the US, Jordà et al published an excellent piece of research that seemed to supply statistical, as opposed to merely anecdotal, support for my theories in the shape of a chart that aggregated lending types across 17 different countries over 140 years, to which I added trend lines as well as a vertical line showing the introduction of Basel 1:


During the 1980s, real estate lending started to accelerate, outpacing other types of credit, whose growth actually slowed down.  The acceleration coincided with the introduction of the Basel banking regulatory framework.  Theoretically, this makes sense:  Basel 1 established fixed capital requirements for various types of bank assets, thereby inspiring regulatory arbitrage.

Not surprisingly, the asset classes that boomed in the decades leading up to the crisis, including mortgages, all benefited from low capital requirements.  Sectors with relatively high regulatory capital requirements such as small and medium-sized corporations, were instead starved of funds.  That bankers responded to Basel’s incentives was unsurprising.  Even assuming that monetary policy was itself neutral, low-risk-weighted asset classes were bound to have more loanable funds allocated to them, pushing interest rates down, while high-risk-weighted asset classes in turn suffered.

To the extent that monetary policy was also excessively easy, the problem was exacerbated.  Unfortunately, the combination of Basel capital regulations, easy monetary policies, and bank accounting rules proved a recipe for disaster.  As the real estate market collapsed, the market price of a many securities held at fair value on banks’ balance sheet fell.  This decline, combined with exploding mortgage-related loan loss provisions, triggered catastrophic losses.  In turn, those losses forced banks to contract their loan book in order to comply with capital ratios defined by their regulators, thereby putting pressure on the money supply.

Nor have matters improved much since the crisis.  Instead of correcting past mistakes, Basel is putting the world economy at risk once again through new and more diversified requirements that once again amplify artificially the demand for certain assets while simultaneously creating liquidity shortages in the marketplace.

Many central bankers and economists haven’t fully realized what the microeconomic rigidities introduced by those rulesets imply for monetary policy.  The predictable failures of misguided policies such as the BoE’s FLS and the ECB’s TLTRO, as well as the weak outcome of QE, partly rest on this ignorance of banking mechanics.  Furthermore, regulators have again fallen for the discredited central planning myth, albeit under a new and more subtle form, and despite the very limited evidence that it can exert much control on asset prices:  macro-prudential regulation.

The consequence of all this is that interest rates and market prices are now manipulated in myriad ways.  Yet many influential economists aren’t even aware of it.  Entire yield curves across the whole spectrum of banking products and asset classes have stopped reflecting the pricings that market actors would normally agree on in an unhampered market.  The result is a very opaque financial system and a large shift in the structure of relative prices.  Within that system the free market has vanished, while malinvestments rule.

Is there anything we can do?  Might deregulation give us an antifragile banking system?  Fintech — the various alternative financial start-ups that are starting to reshape financial services, which are (so far) mostly free from the red tape that constrains (and protects) established banking behemoths — may offer another way.  Innovations like marketplace lending and cryptocurrencies might conceivably give birth to a new system of relatively free banking.  Although remote, the possibility is no less exciting, as it would represent an emergent order capable of responding to changing market demand for funds and money — something that traditional banking has ceased to be.

Of course, arriving at such a new system will also take time.  But as Israel Kirzner and Immanuel Kant have taught us, patience is required if private-market entrepreneurs are to have a chance of coming up with better solutions to current financial-market disorders than we’ll ever get from government regulators.

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