Alt-M http://www.alt-m.org Ideas for an Alternative Monetary Future Thu, 28 May 2015 22:09:13 +0000 en-US hourly 1 http://wordpress.org/?v=4.1.5 The Futility of Stimulus http://www.alt-m.org/2015/05/27/the-futility-of-stimulus/ http://www.alt-m.org/2015/05/27/the-futility-of-stimulus/#comments Wed, 27 May 2015 19:21:02 +0000 http://www.alt-m.org/?p=8994 George Selgin has recently focused on the failure of Federal Reserve policy to finance a normal recovery.  The Fed has greatly expanded its balance sheet and created a large quantity of excess reserves, which, for a variety of reasons, commercial banks have not mobilized into credit creation.  Instead, banks seem...

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federal reserve, sisyphus, monetary stimulusGeorge Selgin has recently focused on the failure of Federal Reserve policy to finance a normal recovery.  The Fed has greatly expanded its balance sheet and created a large quantity of excess reserves, which, for a variety of reasons, commercial banks have not mobilized into credit creation.  Instead, banks seem content to earn the 25 basis points of interest the Fed now pays on reserves.

This anomalous behavior shows up in the M1 money multiplier, which is at record lows – less than half its value before the financial crisis.  The Fed is creating reserves, but commercial banks are not creating as much bank money as has been historically true.  Compounding this is the fact that the velocity of M1 – the rapidity with which each dollar is spent annually – has hit a 40-year low.  Consequently, the Fed’s efforts to produce monetary stimulus have failed.

(A similar story can be told for other money supply measures.  Data and charts can be found at FRED, the online data center at the Federal Reserve Bank of St. Louis.)

I do not think economists fully understand all of the factors contributing to this policy failure.  But Selgin has surely identified one relevant factor, the payment of interest on reserves.  On the margin, it creates a disincentive for commercial banks to create money and credit in a normal fashion.  There are also fiscal reasons for ending the payments, as they reduce the payments the Fed makes to the Treasury.  As it is, the payment of interest on reserves constitutes a fiscal transfer from taxpayers to commercial banks.  In a normal world, I would endorse his call to end the interest paid on reserves.

We do not live in a normal world.  The Fed has replaced liquid, short-term assets on its balance sheet with illiquid, long-term assets.  Normally, to raise the Fed Funds rate, the Fed would sell Treasury bills.  It has none to sell.  Analysts and pundits speculate on when the Fed will raise interest rates.  They should be asking how the Fed will raise interest rates.

Stanford’s John Taylor thinks the Fed will need to increase the interest rate paid on reserves to accomplish that goal.  Markets through arbitrage would then increase the interest rates banks pay each other to borrow reserves.  I suspect he is correct, with two caveats.  First, there is no longer much of a market for federal funds.  Banks aren’t lending each other reserves.  Second, there are other possible mechanisms for raising short-term interest rates like the tri-party, reverse repo facility at the New York Fed.  This, and other facilities, are untested as a means to implement a policy change.  Their use would put monetary policy in unchartered waters.

To sum up, monetary policy has failed to simulate economic activity.  It has failed even to finance a normal economic recovery.  In pursuing a failed stimulus policy, the Fed has tied its policy hands going forward.  At some point, interest rates will need to rise.  The Fed will need to rely on novel means to accomplish a turn in policy.  Paying higher interest rates on bank reserves may be one method.  It is an unpleasant reality.  It is only one consequence of the Fed’s experiment with extraordinary monetary policy.

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Is the Fed on Track? http://www.alt-m.org/2015/05/23/is-the-fed-on-track/ http://www.alt-m.org/2015/05/23/is-the-fed-on-track/#comments Sat, 23 May 2015 13:38:46 +0000 http://www.alt-m.org/?p=8473 That's more-or-less the question that Bankrate.com asked Dean Baker, co-founder of the Center for Economic and Policy Research, and me after last month's FOMC press release.  Dean said yep.  I said…uh, not really.   Our full answers appeared recently in the online publication's  "Wealth of Opinions" column.  There's even a little...

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federal reserve, monetary policyThat's more-or-less the question that Bankrate.com asked Dean Baker, co-founder of the Center for Economic and Policy Research, and me after last month's FOMC press release.  Dean said yep.  I said…uh, not really.   Our full answers appeared recently in the online publication's  "Wealth of Opinions" column.  There's even a little poll at the end, allowing you to pick your favorite answer.  Of course you don't have to vote.  It's really entirely up to you.  I mean, I'm not trying to pressure you or anything like that.

Honest.

No, really!

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Is Bitcoin Doomed? http://www.alt-m.org/2015/05/21/is-bitcoin-doomed/ http://www.alt-m.org/2015/05/21/is-bitcoin-doomed/#comments Thu, 21 May 2015 13:07:46 +0000 http://www.alt-m.org/?p=8154 OK, I'm being melodramatic.  But the question actually posed by the PanAm Post, "Will Bitcoin's Fixed Money Supply Be Its Downfall?", was only slightly less so.  They had me take the "yes" position.  But as my doubts about Bitcoin's future are far from certain,  I was delighted to see that...

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BitcoinUnemploymentOK, I'm being melodramatic.  But the question actually posed by the PanAm Post, "Will Bitcoin's Fixed Money Supply Be Its Downfall?", was only slightly less so.  They had me take the "yes" position.  But as my doubts about Bitcoin's future are far from certain,  I was delighted to see that they got Konrad Graf, a Bitcoin fan who has done some very good work on that cybercurrency's early development, to oppose me.

The crucial questions, I believe, are whether any exchange medium can become widely adopted without also serving as an economy's medium of account–that is, the medium to which prices and other payment contracts refer–and whether a new unit is likely to displace an established one unless it's purchasing power is considered to be relatively stable and predictable.  Think about your own employment contract, and of the alternative of having a contract written in Bitcoin, and you have some idea of the challenge.  Of course, Bitcoin's value is bound to be less predictable now than it would be were bitcoins more widely employed in making payments.  But its popularity must remain limited unless it can somehow be perceived as offering a relatively stable unit of account.

In this regard it is worth considering Leland Yeager's plea, in several of his writings, for "separating" the medium of exchange from the unit of account.  (Here is a good summary by Bill Woolsey, comparing Yeager's ideas to those of Market Monetarists.)  Although Yeager's perspective, which argues that it's better to have a medium of exchange that isn't also an economy's medium of account,  superficially appears to hold out more promise for Bitcoin than my own arguments, the appearance is deceiving.  For what Yeager has in mind is a system in which the unit of account is a stable-value unit, with the value of actual exchange media fluctuating relative to the fixed nominal value of that unit.  So while Yeager's argument does suggest the desirability of a "separated" system,  it is only for the sake of being able to have a more stable unit of account that he favors such an arrangement.  Otherwise separation doesn't achieve much, for macroeconomic problems can still arise in consequence of unanticipated changes in the value of the medium of account, and the consequent disruption of contracts that such changes will entail, regardless of the media actually employed in making payments and in settling accounts due.  That's one reason why I, for one, look forward to seeing further experimentation and innovation in the cybercurrency world.

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The Very Model of a Modern Monetary Economist http://www.alt-m.org/2015/05/18/the-very-model-of-a-modern-monetary-economist/ http://www.alt-m.org/2015/05/18/the-very-model-of-a-modern-monetary-economist/#comments Mon, 18 May 2015 19:38:16 +0000 http://www.alt-m.org/?p=8062 I'm very well acquainted… with matters mathematical, I understand equations, both the simple and quadratical, About binomial theorem I'm teeming with a lot o' news, With many cheerful facts about the square of the hypotenuse. I'm very good at integral and differential calculus; I know the scientific names of beings...

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Major General Stanley

I'm very well acquainted… with matters mathematical,
I understand equations, both the simple and quadratical,
About binomial theorem I'm teeming with a lot o' news,
With many cheerful facts about the square of the hypotenuse.
I'm very good at integral and differential calculus;
I know the scientific names of beings animalculous:
In short, in matters vegetable, animal, and mineral,
I am the very model of a modern Major-General.[1]

One of the chief goals of Cato’s Center for Monetary and Financial Alternatives is to make people aware of alternatives to conventional monetary systems—that is, systems managed by central bankers wielding considerable, if not unlimited, discretionary authority.  The challenge isn’t just one of informing the general public: even professional monetary economists, with relatively few exceptions, are surprisingly ill-informed about such alternatives.

I recently came across a document that perfectly illustrates this last point: a power point presentation by a senior Federal Reserve Bank research economist, given at a conference aimed at school teachers specializing in economics.

I have no desire to single-out the economist in question, who I will therefore refer to simply as “our economist."  On the contrary: I offer his presentation as an example of the all-too common tendency for otherwise competent monetary economists (and our economist is in fact very accomplished) to misread the historical record regarding potential alternatives to central banking and to otherwise give such alternatives short shrift.

This unfortunate tendency rests in part on the fact that most economics graduate programs stopped teaching any sort of economic history decades ago (our economist earned his PhD in the early 1990s), while burdening their students with enough mathematics and statistics to all but guarantee that they never so much as crack open a book on the subject.  But the trouble isn’t just that many monetary economists don’t know their monetary history: it's that they know, and teach, monetary history that ain't so.  That’s what our economist did when he lectured a roomful of teachers on the merits of central banks and “Alternative Monetary Systems.”

The first sign of our economist’s limited awareness of “Alternative Monetary Systems” appears in a slide listing the topics he plans to address.  These are: (1) “What is Money?”; (2) “Methods of Monetary Policy”; (3) “Central Banks”; and (4) “Central Banks vs. Commodity Standard.”  The last dichotomy makes little sense, both because central banks and commodity standards, far from being mutually exclusive, coexisted for much of the early history of the former, and because one can have a fiat monetary standard without having a central bank—as the U.S. did between 1863 and 1879 and as Hong Kong and other places equipped with currency boards do today.

On a later slide our economist does at least mention currency boards.  But he still fails to recognize explicitly the distinction between monetary systems—whether commodity or fiat—in which paper currency is monopolized and those in which it is competitively supplied.  The only reference he makes to the competitive alternative is an implicit one, in a slide referring to the instability of the pre-1914 U.S. economy.

I’ll have more to say about that slide in a moment.  But before he comes to it, our economist takes up the topic of commodity standards.  According to him, under such standards, the money supply changes only as “People dig holes in the ground, haul out ore and turn it to the central bank for money."  That will do, I suppose, if one’s purpose is to make such standards appear hopelessly primitive compared with ones that allow for monetary “fine tuning.”[2]  But as a summary of how actual commodity standards, and the classical gold standard in particular, worked, it is extremely misleading.  Although the mining of new gold was an important determinant of long-run gold-standard money supply changes, in the short run it was far less important than international gold flows, movements of gold from non-monetary to monetary uses and vice versa, and changes in bank reserve ratios and other determinants of base-money multipliers.[3]

Rather than mention any of these often stabilizing determinants, our economist invites his audience to imagine what would happen, under a gold standard, to the price level (among other things) if “we just conquered a good portion of the New World.”  Although his slide doesn’t say what visions he helped his listeners to conjure up, I will bet you top dollar (1) that he told them about the great “Price Revolution” of the 15th-17th centuries, when specie shipments from Mexico caused prices in Western Europe increased six-fold; and (2) that he did not tell them that this six-fold increase over the course of 150 years amounted to an annual inflation rate of between 1 and 1.5 percent, that is, a rate that the Fed and other central banks now consider dangerously low.

Our economist next makes a case for central banking, by arguing that there must be a lender of last resort.  Like many monetary economists whose understanding of bank panics is informed by Diamond and Dybvig’s (1983) ingenious but extremely misleading article on the subject, he asserts that “Bank runs can be self-fulfilling,” ignoring evidence that, in the U.S. at least, they have seldom been so.  Rather than consult that evidence he refers to the bank-run scene in It’s a Wonderful Life.[4] Ben Bernanke would later take the same tack in the course of his GWU lectures.[5]  Whether our economist has read Bagehot’s Lombard Street is unclear.  In any event there’s no evidence that he share’s Bagehot’s understanding that a lender of last resort is something a country needs only once it has taken the unfortunate step of establishing a privileged bank of issue in the first place.

We thus arrive at our economist’s review of pre-Fed experience, which he summarizes with a slide showing the gyrations of U.S. GDP between 1880 and 1914, and highlighting the panic years 1884, 1890, 1893, and 1907.  The slide’s title asks “Why Do We Need a Lender of Last Resort?”  The implicit answer is: “Look at all the panics we had when we didn’t have one!”

To draw lessons from history is a fine thing.  But it is not fine to look only a selective bits of history, ignoring other bits and even some large chunks, depending on which pieces do or do not affirm one’s prior beliefs.  For his part our economist selects the 34 years prior to the Fed’s establishment, while setting aside the 34 following its establishment.  He is thus able to overlook some awkward facts, to wit: that the number of banking crises was actually greater after 1914 than before; and that on three occasions (1920, 1930-33, and 1937-8) the percentage decline in output was greater than it had been in any of the pre-Fed crises.  Indeed, even setting the tumultuous interwar period aside, while employing the best available statistics, it isn’t clear that the Fed has brought any substantial improvement in macroeconomic stability.

Because our economist refers only to U.S. experience, his listeners may also not have learned that banking crises were far more common in the pre-1914 U.S. than they were in other nations that l lacked central banks.  In particular, they may not have been told that Canada altogether avoided the crises by which the U.S. was buffeted, and did so despite being on the same gold-based dollar standard and despite being a much smaller and less-diversified economy.  Indeed, it seems quite unlikely that our economist told them, for doing so would have reduced his argument for having a central bank into a transparent non sequitur.  Nor was there any peculiar or mysterious reason for Canada’s having managed to avoid crises without a central bank such as might justify setting its example aside.  The Canadian system was stronger because, unlike their U.S. counterparts at the time, Canadian banks were allowed to establish nationwide branch networks, and were free from regulations limiting their ability to issue circulating banknotes.  Restrictions of the latter sort, dating from the Civil War, were the fundamental cause of frequent U.S. currency shortages and occasional currency “panics” like the one in 1893.

In short, far from proving that the U.S. needed a lender of last resort, a careful look at U.S. monetary experience reveals (1) that what “we” really needed was to deregulate U.S. banks by letting them branch and by letting them issue notes backed by their general assets; and (2) that a “lender of last resort” was not just a poor substitute for such deregulation, but one that was tragically flawed.

The rest of our economist’s talk is devoted to the question of optimal inflation and alternative monetary policy targets, including the Taylor Rule. Here, too, his understanding is at best highly conventional and, at worst, extremely indulgent of the Fed’s shortcomings.  He never considers the very different implications of productivity- and demand-driven deflation, much less the possibility that there might be some advantage to having either a variable inflation rate or one that’s ever negative.  He makes no mention of the sharp increase in price-level uncertainty that has occurred since the Fed’s establishment, and especially since 1971.  And he shrugs off the even more serious decline of the dollar’s purchasing power, blandly observing that practically all economists these days believe “that low and stable inflation has very low costs” (as if U.S. inflation has always been “low and stable”); that it isn’t useful to compare price level measures across long intervals because they involve different baskets of goods (as if most of the 96 percent decline in the dollar’s purchasing power since 1914 could be written-off to what ought to be unbiased statistical errors ); and that inflation is often due to wars (as if the Fed’s role as handmaiden to the U.S. Treasury had nothing to with past wartime price increases).

Enough.  By now it should be perfectly obvious that our economist doesn’t really give a toss about “Alternative Monetary Systems.”  The Federal Reserve System is, so far as he’s concerned, the best of all possible monetary systems.   He gathers together hackneyed arguments in its defense, including just as much economic history as serves to affirm, but never to challenge, received opinion.  He believes that he’s being objective, when in reality he’s got a severe case of status quo bias.  He asserts that the opinions he expresses are his own, rather than those of a spokesman for the Federal Reserve System, without appearing to realize that a Fed spokesman would be hard-pressed to paint the Fed in more glowing colors.

But my intent, as I said at the onset, isn’t to single out our economist for a rebuke.  His understanding of history and of alternative monetary systems is no worse than that of a thousand other otherwise competent monetary economists.  It is proof, not of his own failure, but of the sad state of contemporary monetary economics.  Above all, it underscores the dire need for an organization devoted to taking alternative monetary systems seriously.

[1] The Major-General’s song, from Gilbert and Sullivan’s Pirates of Penzanse.

[2] And hyperinflation.

[3] For a discussion of some of these determinants see chapter 2 of Lawrence White’s The Theory of Monetary Instututions (London: Blackwell, 1999).

[4] Most historical bank runs have been informed by prior information suggesting that the afflicted institutions might be insolvent.

[5] As they never refer to the bank run depicted in it, I suppose that Fed experts consider Mary Poppins to offer insufficiently “rigorous” evidence of how and why runs happen.

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Wasting a Crisis: A Book Forum http://www.alt-m.org/2015/05/15/wasting-a-crisis-a-book-forum/ http://www.alt-m.org/2015/05/15/wasting-a-crisis-a-book-forum/#comments Sat, 16 May 2015 00:12:56 +0000 http://www.alt-m.org/?p=8111 This is a story we all know: the Great Depression was caused by market failure, the predictable fall-out from the excesses of the unrestrained, unregulated, Wild West that was the securities markets at the dawn of the 20th century.  After all, before the 1930s, there was no Securities and Exchange...

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Wasting a CrisisThis is a story we all know: the Great Depression was caused by market failure, the predictable fall-out from the excesses of the unrestrained, unregulated, Wild West that was the securities markets at the dawn of the 20th century.  After all, before the 1930s, there was no Securities and Exchange Commission.  The state securities laws, the so-called “blue sky laws,” were also products of the early 20th century, largely implemented between 1911 and 1931.  These laws, as well as the Securities Act of 1933 and the Securities Exchange Act of 1934, tamed the wild speculators that had been defrauding the American public by requiring transparency in the markets and promoting thorough disclosure in securities offerings.

But is that story true?  Paul Mahoney, Dean of the University of Virginia School of Law, has dug deeply into this narrative in his recent book, Wasting a Crisis: Why Securities Regulation Fails.  The results of his research and analysis reveal a mismatch between the received wisdom about the causes of the Depression and the actual data, and a pattern of crisis-narrative-regulation that has persisted through the recent Great Recession and the implementation of Dodd-Frank.

Dean Mahoney recently shared his thoughts on these and related issues at a book forum at the Cato Institute.  Joining us was also banking regulation scholar Heidi Schooner of the Columbus School of Law at the Catholic University of America, leading to an interesting discussion of the externalities of bank failures and the application of banking regulation principles to non-bank entities.

Watch the video of the event:

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Too Big to Punish http://www.alt-m.org/2015/05/14/too-big-to-punish/ http://www.alt-m.org/2015/05/14/too-big-to-punish/#comments Thu, 14 May 2015 19:33:42 +0000 http://www.alt-m.org/?p=8045 The Federal government sees itself leading the fight against discrimination, and has even fallen in love with the notion of “disparate impact,” a concept that suggests businesses should be held liable for actions that have a disproportionate effect on a particular class even if there was no demonstrable intent to...

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Big and Small BanksThe Federal government sees itself leading the fight against discrimination, and has even fallen in love with the notion of “disparate impact,” a concept that suggests businesses should be held liable for actions that have a disproportionate effect on a particular class even if there was no demonstrable intent to discriminate.  Yet since the financial crisis of 2008–09, the Federal government has itself engaged in quite deliberate discrimination in the commercial banking sector.

In this post, I’ll examine how the Federal government has handled the alleged misconduct of large banks differently from the alleged misconduct of small banks.  In doing so, I’ll explain who actually bears the cost of resolving misconduct in large banks versus in small banks.  And as you’ll see, the Federal government’s actions in the world of “too-big-to-fail” and “too-small-to-save” have discrimination written all over them.

Let’s start with the large banks.  In an internal JP Morgan Chase memo written before the onset of the 2008 financial crisis, an employee reported to her bosses that very low quality mortgage loans were being included in the mortgage-backed securities (MBS) created by the bank.  These securities were then sold to a variety of investors around the world.  The U.S. Attorney’s Office found this memo during their preliminary investigation of alleged misrepresentation of the quality of MBS created from pools of mortgage loans.  Subsequent searches, both at JP Morgan Chase and elsewhere, led to lawsuits being filed by the U.S. Attorney’s Office against a number of large banks.  After several years of back and forth between the banks’ attorneys and the U.S. Attorney’s Office, the cases were ultimately concluded by monetary settlements with each bank, adding up to a total of approximately $37 billion.

Many saw this and concluded that the Federal government “won.”  But there is a completely different side to the story.  No individual officer or director of a large bank was ever personally cited as a party to these lawsuits under a claim of breach of fiduciary duties, let alone found guilty of fraudulent activity or required to personally pay some of the settlement costs.  At worst, an officer or executive’s bonus might have been reduced; the directors likely benefited from director fees generated by extra meetings to discuss the suits against their bank.

So who actually bore the cost of the lawsuits and the dollar amount of the settlement?  The mainstream media merrily reported that “the banks” paid.   In reality, however, the shareholders of the banks bore the cost even though no outside shareholder ever contributed to the bank behavior that led to the lawsuit.  Every decision-maker in the bank, from top management to directors, skated away freely.  What’s more, when a bank arrives at a settlement price, some of the settlement costs may actually be deductible as a business expense, thereby reducing taxable income and tax liability.  In short, some of the settlement costs were shifted to the taxpayer.

Contrast this with how the Federal Deposit Insurance Corporation (FDIC) typically handles the cases of failed smaller banks.  Assume for the moment that the FDIC discovered an internal memo from a junior loan officer to his or her boss stating that loans being made by the bank were of exceptionally low quality and very likely to default.  And assume the FDIC also discovered that neither the senior management of the bank nor the directors took any action.  In other words, imagine a memo similar to the one described above, which was found at JP Morgan Chase.  Clearly, this would be a very incriminating piece of evidence.  Upon such a discovery, the FDIC would almost immediately file a lawsuit against the officers and directors of the bank, most likely alleging a breach of fiduciary duties under an ordinary negligence standard in the hope of penetrating the directors’ and officers’ liability insurance and getting to them individually and personally.

In fact, even without such evidence, the FDIC has filed numerous lawsuits against officers and directors of failed small banks on precisely these grounds, alleging they knew at the time of origination that the loans were bad and that borrowers were likely to default.  Furthermore, the FDIC has often contended that the officers and directors should have known financial collapse was coming and therefore discontinued the bank’s lending activity.  That is, the FDIC has argued that directors and officers in smaller banks should have had better economic forecasting ability in anticipating the onset of the financial crisis than the FDIC itself, as well as the Federal Reserve and a host of other economic experts.

Note the extreme difference between how officers and directors are treated in large banks versus in smaller banks.  In the large banks, the lawsuits were simply turned over to lawyers (another cost ultimately borne by shareholders and taxpayers), and settled at zero personal cost to officers and directors.  The contrast with the case of a failed smaller bank couldn’t be clearer: by definition, shareholder equity has been extinguished, so the lawsuit is not filed against the bank itself but rather against its officers and directors, each of whom is named explicitly and personally in the filing.  For months, and in some cases years, after the failure of the bank, the officers and directors may hear nothing from the FDIC, but the threat of the lawsuit is always there.  Finally, when a lawsuit is filed and the allegations are laid out, additional months, or even several years, will be consumed by discovery, depositions of individuals, expert witness reports, settlement discussions, and perhaps a jury trial.  Lives are disrupted as the final outcome remains uncertain.

None of this is an accident.  The Federal government, through its various agencies, has deliberately set out to treat the officers and directors of failed smaller banks much more harshly than their counterparts at large ones.  Why?  Well, the too-big-to-fail doctrine, which protects the largest financial institutions from failure, is one obvious reason.  Another is that large banks have greater political clout than smaller ones, and can therefore defend the interests of their officers and directors much more effectively in Washington.  A third reason might be that large banks have virtually unlimited resources to hire lawyers to fight their corner, whereas failed smaller banks have to rely on liability insurance policies—or the personal wealth of their officers and directors—to fund their defense.

That’s not to say that the officers and directors of failed small banks are always defeated when their case makes it to court.  In fact, a striking statement on the discrimination inherent in Federal government policy towards commercial banks is contained in the conclusion of an order handed down by Judge Terence W. Boyle in the matter of FDIC as Receiver of Cooperative Bank, NC, which granted summary judgment in favor of a failed small bank’s officer and director defendants:

In short, the FDIC claims that defendants were not only more prescient than the nation’s most trusted bank regulators and economists, but that they disregarded their own foresight of the coming crisis in favor of making risky loans.  Such an assertion is wholly implausible.  The surrounding facts and public statements of economists and leaders such as Henry Paulson and Ben Bernanke belie FDIC’s position here.  It appears that the only factor between defendants being sued for millions of dollars and receiving millions of dollars in assistance from the government is that Cooperative was not considered “too big to fail.” . . . Taking the position that a big bank’s directors and officers should be forgiven for failure due to its size and an unpredictable economic catastrophe while aggressively pursuing monetary compensation from a small bank’s directors and officers is unfortunate if not outright unjust.

“Unfortunate if not outright unjust” is a good way of describing the Federal government’s approach to commercial banking in the wake of the financial crisis.   And for now, at least, that approach looks set to continue.  The FDIC has appealed Judge Boyle’s decision.

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Instead of the Fed http://www.alt-m.org/2015/05/13/instead-of-the-fed/ http://www.alt-m.org/2015/05/13/instead-of-the-fed/#comments Wed, 13 May 2015 14:01:52 +0000 http://www.alt-m.org/?p=8032 That, some of you may recall, was the name of a November 1, 2013 conference put on by the Mercatus Center.  (The full name was actually "Instead of the Fed: Past and Present Alternatives to the Federal Reserve System").  The proceedings of that conference–or most of them, at any rate–are...

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FedForSale2That, some of you may recall, was the name of a November 1, 2013 conference put on by the Mercatus Center.  (The full name was actually "Instead of the Fed: Past and Present Alternatives to the Federal Reserve System").  The proceedings of that conference–or most of them, at any rate–are now available in a special issue of the Journal of Financial Stability, edited by yours truly.

Although online access to the articles is by subscription only, individual contributors have temporary, open links to their own articles.  Here is mine on "Synthetic Commodity Money."

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Lessons from the Ayr Bank Failure http://www.alt-m.org/2015/05/11/lessons-from-the-ayr-bank-failure-2/ http://www.alt-m.org/2015/05/11/lessons-from-the-ayr-bank-failure-2/#comments Mon, 11 May 2015 16:56:19 +0000 http://www.alt-m.org/?p=8027 One consequence of the financial crisis of 2008-09 has been renewed interest in the merits of contingent convertible debt as a mechanism for equity bail-ins at moments of acute financial distress.  Should it fail, a financial institution's contingent bonds are automatically converted into equity shares.  History suggests that convertible debt...

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Ayr BanknoteOne consequence of the financial crisis of 2008-09 has been renewed interest in the merits of contingent convertible debt as a mechanism for equity bail-ins at moments of acute financial distress.  Should it fail, a financial institution's contingent bonds are automatically converted into equity shares.  History suggests that convertible debt can help to preserve financial stability by limiting the spillover effects of individual financial institution failures.

A particularly revealing historical illustration of this advantage of contingent debt comes from the Scottish free banking era.  From 1716 to 1845, the Scottish financial system functioned with no official central bank or lender of last resort, no public (or private) monopoly on currency issuance, no legal reserve or capital requirements, and no formal limits on bank size, at a time when Scotland’s was a classic emerging economy with large speculative capital flows, a fixed exchange rate, and substantial external debt.  Despite this, Scotland’s banking sector survived many major shocks, including two severe balance of payments crises arising from political disturbances during the Seven Years’ War.

The stability of the Scottish banking system depended in part on the use it made of voluntary contingent liability arrangements.  Until the practice was prohibited in 1765, some Scottish banks included an “optional clause” on their larger-denomination notes.  The clause allowed the banks' directors to convert the notes into short-term, interest-bearing bonds.  Although the clause was seldom invoked, it was successfully employed as a means for preventing large-scale exchange rate speculators from draining the Scottish banks' specie reserves and remitting them to London during war-related balance of payments crises–that is, as a private and voluntary alternative to government-imposed capital controls.

Contingent debt also helped to make Scottish bank failures less costly and  disruptive.  If an unlimited liability Scottish bank failed, its shorter-term creditors were again sometimes converted into bondholders, while its shareholders were liable for its debts to the full extent of their personal wealth.  Although the Scottish system lacked a lender of last resort, the unlimited liability of shareholders in bankrupt Scottish banks served as a substitute, with sequestration of shareholders’ personal estates serving to "bail them in" beyond their subscribed capital.  The issuance of tradeable bonds to short-term creditors, secured by mortgages to shareholders’ estates, served in turn to limit bank counter-parties' exposure to losses, keeping credit flowing despite adverse shocks.

A particularly fascinating illustration of how such devices worked came with the spectacular collapse in June 1772 of the large Scottish banking firm of Douglas, Heron & Co., better known as the Ayr (or Air) Bank, after the parish where its head office was located.  The Ayr collapsed when the failure of a London bond dealer in Scottish bonds caused its creditors to panic.  The creditors doubted that the bank could could meet liabilities that, thanks to its reckless lending, had ballooned to almost £1.3 million.  The disruption of Scottish credit ended quickly, however, when the Ayr's partners resorted to a £500,000 bond issue, secured by £3,000,000 in mortgages upon their often vast personal estates—including several dukedoms.  By this means the Ayr Bank managed to satisfy creditors, at 5% interest, as the Ayr's assets, together with those of its partners, were gradually liquidated.  In modern parlance, the Ayr Bank had been transformed into a “bad bank,” whose sole function was to gradually work off its  assets and repay creditors while the immense landed wealth of its proprietors’ personal estates provided a financial backstop.  Creditors were thus temporarily satisfied with fully secured, negotiable bonds, which were eventually redeemed in full, with interest.

We are unlikely today to witness a return to unlimited liability for financial institution shareholders.  The extensive and effective use of contingent liability contracts during the Scottish free banking episode nevertheless offers important evidence concerning private market devices for limiting the disruptive consequences of financial-market crises.  When compared to the contemporary practice of public socialization of loss through financial bail-outs, such private market alternatives appear to deserve serious consideration.  Most importantly, perhaps, by encouraging closer monitoring of financial institutions by contingently liable creditors and equity holders, these private alternatives appear, in the Scottish case at least, not only to have made crises less severe, but also to have made them far less common.

This post is based on Tyler Goodspeed's doctoral dissertation, a revised version of which is under consideration at Harvard University Press under the title Legislating Instability: Adam Smith, Free Banking, and the Financial Crisis of 1772.

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Capital Unbound: The Cato Summit on Financial Regulation http://www.alt-m.org/2015/05/08/capital-unbound-the-cato-summit-on-financial-regulation/ http://www.alt-m.org/2015/05/08/capital-unbound-the-cato-summit-on-financial-regulation/#comments Fri, 08 May 2015 13:36:20 +0000 http://www.alt-m.org/?p=7990 Interested in how to advance economic growth?  Join the Cato Institute’s Center for Monetary and Financial Alternatives in New York on June 2nd for a day examining the current state of U.S. capital markets regulation at Capital Unbound: The Cato Summit on Financial Regulation. We've assembled an impressive list of...

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Community chestInterested in how to advance economic growth?  Join the Cato Institute’s Center for Monetary and Financial Alternatives in New York on June 2nd for a day examining the current state of U.S. capital markets regulation at Capital Unbound: The Cato Summit on Financial Regulation.

We've assembled an impressive list of distinguished speakers to discuss efficient capital markets and offer proposals to unleash a new engine of American economic growth.

Our lineup includes such notables as Commissioner of the U.S. Commodity Futures Trading Commission J. Christopher Giancarlo, Commissioner of the U.S. Securities and Exchange Commission Michael Piwowar, and our very own CMFA Director George Selgin.

The speakers will explore a wide variety of topics, including alternative vehicles for small business capital, the failure of mathematical modeling, and alternative solutions to monetary and financial instability.

Click here for the full schedule and to register for the event.  We hope to see you in New York on June 2nd!

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Hayek-Style Cybercurrency http://www.alt-m.org/2015/05/06/hayek-style-cybercurrency/ http://www.alt-m.org/2015/05/06/hayek-style-cybercurrency/#comments Wed, 06 May 2015 13:40:20 +0000 http://www.alt-m.org/?p=7948 In his ground-breaking work, Denationalisation of Money: the Argument Refined, F.A. Hayek proposed that open competition among private suppliers of irredeemable monies would favor the survival of those monies that earned a reputation for possessing a relatively stable purchasing power. One of the main problems with Bitcoin has been its...

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In his ground-breaking work, Denationalisation of Money: the Argument Refined, F.A. Hayek proposed that open competition among private suppliers of irredeemable monies would favor the survival of those monies that earned a reputation for possessing a relatively stable purchasing power.

One of the main problems with Bitcoin has been its tremendous price instability: its volatility is about an order of magnitude greater than that of traditional financial assets, and this price instability is a serious deterrent to Bitcoin’s more widespread adoption as currency.  So is there anything that can be done about this problem?

Let’s go back to basics.  A key feature of the Bitcoin protocol is that the supply of bitcoins grows at a predetermined rate.1 The Bitcoin price then depends on the demand for bitcoins: the higher the demand, the higher the price; the more volatile the demand, the more volatile the price.  The fixed supply schedule also introduces a strong speculative element.  To quote Robert Sams (2014: 1):

If a cryptocurrency system aims to be a general medium-of-exchange, deterministic coin supply is a bug rather than a feature. . . . Deterministic money supply combined with uncertain future money demand conspire to make the market price of a bitcoin a sort of prediction market [based] on its own future adoption.

To put it another way, the current price is indicative of expected future demand.  Sams continues:

The problem is that high levels of volatility deter people from using coin as a medium of exchange [and] it might be conjectured that deterministic money supply rules are self-defeating.

One way to reduce such volatility is to introduce a feedback rule that adjusts supply in response to changes in demand.  Such a rule could help reduce speculative demand and potentially lead to a cryptocurrency with a stable price.

Let’s consider a cryptocurrency that I shall call "coins," which we can think of as a Bitcoin-type cryptocurrency but with an elastic supply schedule.  Following Sams, if we are to stabilize its price, we want a supply rule that ensures that if the price rises (falls) by X% over some period, then the supply increases (decreases) by X% to return the price back toward its initial or target value.  Suppose we measure a period as the length of time needed to validate n transactions blocks.  For example, a period might be a day; if takes approximately 10 minutes to validate each transactions block, as under the Bitcoin protocol, then the period would be the length of time needed to validate 144 transactions blocks.  Sams posits the following supply rule:

(1a) Qt=Qt-1(Pt/Pt-1),

(1b) ΔQt=Qt-Qt-1.

Here Pt is the coin price, Qt is the coin supply at the end of period t, and ∆Qt is the change in the coin supply over period t. There is a question as to how Pt is defined, but following Ferdinando Ametrano (2014a), let’s assume that Pt is defined in USD and that the target is Pt=$1. This assumed target provides a convenient starting point, and we can generalize it later to look at other price targets, such as those involving price indices. Indeed, we can also generalize it to targets specified in terms of other indices such as NGDP.

Another issue is how the change in coin supply (∆Qt) is distributed.  The point to note here is that there will be occasions when the coin supply needs to be reduced, and others when it needs to be raised, depending on whether the coin price has fallen or risen over the preceding period.

Ametrano proposes an elegant solution to this distribution problem, which he calls ‘Hayek Money.’ At the end of each period, the system should automatically reset the price back to the target value and simultaneously adjust the number of coins in each wallet by a factor of Pt/Pt-1.  Instead of having k coins in a wallet that each increase or decrease in value by a factor of Pt/Pt-1, a wallet holder would thus have k×Pt/Pt-1, coins in their wallet, but the value of each coin would be the same at the end of each period.

This proposal would stabilize the coin price and achieve a stable unit of account.  However, it would make no difference to the store of value performance of the currency: the value of the wallet would be just as volatile as it was before.  To deal with this problem, both Ametrano (2014b) and Sams propose improvements based on an idea they call ‘Seigniorage Shares.’ These involve two types of claims on the system—coins and shares, with the latter used to support the price of the former via swaps of one for the other.  Similar schemes have been proposed by Buterin (2014a),2 Morini (2014),3 and Iwamura et al. (2014), but I focus here on Seigniorage Shares as all these schemes are fairly similar.

The most straightforward version of Seigniorage Shares is that of Sams, and under my interpretation, this scheme would work as follows. If ∆Qt is positive and new coins have to be created in the t-th period, Sams would have a coin auction 4 in which ∆Qt coins would be created and swapped for shares, which would then be digitally destroyed by putting them into a burning blockchain wallet from which they could never be removed. Conversely, if ∆Qt  is negative, existing coins would be swapped for newly created shares, and the coins taken in would be digitally destroyed.

At the margin, and so long as there is no major shock, the system should work beautifully.  After some periods, new coins would be created; after other periods, existing coins would be destroyed.  But either way, at the end of each period, the Ametrano-style coin quantity adjustments would push the price of coins back to the target value of $1.

Rational expectations would then come into play to stabilize the price of coins during each period.  If the price of coins were to go below $1 during any such period, it would be profitable to take a bullish position in coins, go long, and profit when the quantity adjustments at the end of the period pushed the price back up to $1.  Conversely, if the price of coins were to go above $1 during that period, then it would be profitable to take a bear position and sell or short coins to reap a profit at the end of that period, when the quantity adjustments would push the price back down to $1.

These self-fulfilling speculative forces, driven by rational expectations, would ensure that the price during each period would never deviate much from $1.  They would also mean that the length of the period is not a critical parameter in the system.  Doubling or halving the length of the period would make little difference to how the system would operate.  One can also imagine that the period might be very short—even as short as the period needed to validate a single transactions block, which is less than a minute.  In such a case, very frequent rebasings would ensure almost continuous stability of the coin price.

The take-home message here is that a well-designed cryptocurrency system can achieve its price-pegging target—provided that there is no major shock.

References

Ametrano, F.A. “Hayek Money: The Cryptocurrency Price Stability Solution.” August 19, 2014. (a)

Ametrano, F. M “Price Stability Using Cryptocurrency Seigniorage Shares.” August 23 2014. (b)

Buterin, V. “The Search for a Stable Cryptocurrency.” November 11, 2014. (a)

Buterin, V. “SchellingCoin: A Minimal-Trust Universal Data Feed.” March 28, 2014. (b)

Iwamura, M., Kitamura, Y., Matsumoto, T., and Saito, K. “Can We Stabilize the Price of a Cryptocurrency? Understanding the Design of Bitcoin and Its Potential to Compete with Central Bank Money.” October 25, 2014.

Morini, M. “Inv/Sav Wallets and the Role of Financial Intermediaries in a Digital Currency.” July 21, 2014.

Sams, R. “A Note on Cryptocurrency Stabilisation: Seigniorage Shares.” November 8, 2014.

[1] Strictly speaking, the supply of bitcoins is only deterministic when measured in block-time intervals. Measured in real time, there is a (typically) small randomness in how long it takes to validate each block. However, the impact of this randomness is negligible, especially over the longer term where the law of large numbers also comes into play.

[2] Buterin (2014b) examines three schemes that seek to stabilize the cryptocurrency price: BitAsset, the SchellingCoin (first proposed by Buterin (2014b)) and Seigniorage Shares. He concludes that each of these is vulnerable to fragility problems similar to those to be discussed in my next post.

[3] In the Morini system, participants would have a choice of Inv and Sav wallets, the former for investors in coins and the other for savers who want coin-price security. The Sav wallets would be protected by the Inv wallets, and participants could choose a mix of the two to meet their risk-aversion preferences.

[4] In fact, Sams’ auction is unnecessarily complicated and not even necessary. Since shares and coins would have well-defined market values under his system, it would suffice merely to have a rule to swap them as appropriate at going market prices without any need to specify an auction mechanism.

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