The Perils of Financial Over-Regulation

Bray Hammond, financial innovation, FinTech, Kenneth Rogoff, private clearinghouses
George Selgin speaking at the International Finance Corporation FinTech CEO Summit, 10/21/2016. Courtesy of Amandine Lobelle.

Bray Hammond, financial innovation, FinTech, Kenneth Rogoff, private clearinghousesLast Friday, I gave the opening remarks at the International Finance Corporation's annual FinTech CEO Summit — a meeting of many of the top executives involved in developing cutting-edge alternatives to conventional means for raising capital and making payments, among other things. Because the event wasn't recorded, I thought I'd share the remarks with you here.


I’m honored to be able to address an audience consisting of many of the world’s leading financial-market innovators. I don’t often get invited to speak on the subject of financial technology. That’s probably because the most advanced piece of financial technology concerning which I possess any real expertise is the steam-powered coining press that James Watt and his business partner Matthew Boulton designed more than two centuries ago.

Still I know enough about more recent developments to realize that, so far as the future progress of financial innovation is concerned, these are critical times. Never has there been a more crying need for financial innovation — innovation to overcome the infirmities, not only of conventional private-market capital-harnessing and payments systems, but also of the world’s official monetary systems. Yet never has the threat government regulators and their academic advisors pose to the unfolding of such innovations been so obvious.

Consider Harvard (and former IMF) economist Ken Rogoff’s proposal for doing away with official paper money, as presented in his new book, The Curse of Cash, which I happened to be reading when I was asked to speak to you today. A decision by the Fed to quit issuing paper currency would ordinarily create new opportunities for private-market innovators to supply new and perhaps superior substitutes for cash.  But so far as Rogoff is concerned, for his plan to succeed in cutting back on crime and tax evasion, the government would have to be “vigilant about playing Whac-a-mole as alternative transaction media come into being,” by making it difficult if not impossible for retailers and financial institutions to accept them. That sort of talk sends chills up my spine; it ought to scare you as well.

Or consider this remark, also from Rogoff’s book:

As currency innovators have learned over the millenia, it is hard to stay on top of the government indefinitely in a game where the latter can keep adjusting the rules until it wins. If the private sector comes up with a much better way of doing things, the government will eventually adapt and regulate as necessary to eventually win out.

For some reason Rogoff doesn’t seem to mind this. Yet surely it ought to be obvious that, when governments “win-out” by suppressing “much better ways of doing things,” the public as a whole — and not just or mainly drug dealers and tax evaders — loses.

But the more serious consequences of a “Whac-a-mole” approach to financial innovation consist, not of its immediate costs to consumers, but to the downstream innovations that it prevents.

As economist Israel Kirzner puts it in an excellent essay, “The Perils of Regulation,” while regulations of the sort Rogoff favors are only supposed to block particular innovations that may have some undesirable features, those regulations also end up blocking desirable innovations that haven’t been foreseen by anyone, including the regulators. What’s more, the same regulatory interference is instead likely to “set in motion a series of entrepreneurial actions that … may well lead to wholly unexpected and even undesirable final outcomes.”

In any event, Rogoff is surely mistaken in claiming that governments are bound to prevent financial innovations from taking place even when they are desirable. Whether they do so or not depends on public opinion.

It’s true that the public has mixed feelings about financial innovation; it has seen both good and bad consequences of such. But there are good reasons for believing that unhindered financial innovation, whatever its risks, is ultimately a lot safer than heavy-handed government interference in the financial sector. Those reasons are necessarily based on the historical record, since no one, except perhaps some of you, can know just what sorts of financial innovations the future may offer.

Consider U.S. experience. Contrary to conventional wisdom, unwise regulations have  been responsible for most if not all of the 19th-century woes of the U.S. financial sector, from wildcat banking and counterfeiting prior to the Civil War to recurring banking crises afterwards. I would regale, or more likely bore you, with the details if I had time. But instead I must settle for pointing out that Canada, with its then-identical gold dollar, avoided practically all of them. Yet Canadian banks were less, not more, heavily regulated than their U.S. counterparts. Nor did Canada establish a central bank until 1935. (Can anyone guess how many of its banks failed during the 1930s?)

When regulations cause trouble, private-market financial innovation sometimes comes to the rescue. Those crises that rattled the U.S. economy in the decades before the Fed’s establishment were due in large part to government regulations that made it very costly, if not impossible, for banks to issue enough paper currency to meet their customers’ needs. Crises happened when customers, anticipating shortages, rushed to get cash before the banks ran out. In response, private clearinghouses in New York City and elsewhere began supplying their own emergency currencies to supplement banks’ supplies. In all they issued hundreds of millions of dollars worth of “clearinghouse certificates” which, believe it or not, was a lot of money back then — enough to make the panics a lot less destructive than they might have been otherwise.

Regulatory solutions to crises are, in contrast, often less reliable than private market ones. During the Great Depression, when bank failures once again threatened to trigger a rush for cash, some old-timers from the New York Clearinghouse begged for permission to issue clearinghouse certificates again. But Fed officials wouldn’t let them. “We’re in charge now,” they said. “And we can issue all the genuine currency that’s needed.” I suppose you know how well that went.

In response to crises the root causes of which are often traceable to misguided past regulatory interference, regulators also tend to erect further barriers to desirable financial innovations. Yet where one sort of innovation is prevented, other, sometimes far more dangerous innovations, often take root.

To take an extreme case, in the very earliest days of banking in the U.S., many states and territories, chose to ban banks altogether. As banking historian Bray Hammond put it, people back then were convinced that, because banks were dangerous monopolies, it was best to have as few of them as possible!

How did that go? Instead of having their own banks to turn to, and no local currency they could rely on, the citizens of those places were compelled to use the notes of far-away banks — or what they imagined to be such. For they quickly became the favorite victims of counterfeiters, who supplied them with fake currency purporting to be from the best of New England banks; and not having those banks nearby to root out the fakes, they fell for it all too often. (Those same fakes were, on the other hand, never seen in New England itself, where alert bank tellers would have spotted them in no time.)

Nor have things changed much. In the 30s, regulators decided they might protect bank customers by preventing bankers from paying interest on deposits. It took some time, and plenty of inflation, but by the mid 80s that step had given rise to Money Market Mutual Funds, which eventually came to play a central part of the “shadow banking system” the collapse of which marked ground zero of the recent financial crisis. The point isn’t that Money Market Funds are necessarily a bad thing; its simply that regulators are not very good at anticipating the ultimate consequences of the regulations they impose. Regulation weaves a tangled web, indeed.

Financial systems, like economies generally, are organic entities. They must be allowed to flourish in a natural way.  Financial innovations will, no doubt, lead to occasional troubles even absent government interference. But those troubles will in turn sponsor further innovations aimed at correcting them. Over time, a stable and highly efficient system tends to develop. That’s what happened in Canada, while its system was relatively free; and it is what happened in numerous other countries.

With your help, if we let it, it may finally happen here.

Thanks very much.

  • Spencer Hall

    "In the 30s, regulators decided they might protect bank customers by preventing bankers from paying interest on deposits."


    Great topic. But the MMMFs, and other non-banks, are not in competition with the commercial banks.

    "In a letter of March 15, 1981, Willis Alexander of the American Bankers Association claims that: "Depository Institutions have lost an estimated $100b in potential consumer deposits alone to the unregulated money market mutual funds.' As any unbiased banker should know, all the money
    taken in by the money funds goes right back into the banks, in the form of CDs or bankers acceptances or other money market instruments; there is no net loss of deposits to the banking system. Complete deregulation of interest rates would simply allow a further escalation of rates by the banks, all of which compete against each other for the same total of deposits."

    Written by Louis Stone whom the movie "Wall Street" was dedicated to
    – Vice President Shearson/American Express

    • George Selgin

      I'm afraid that Mr. Alexander is wrong here. Yes, the reserves stay in the system; but the extent to which funds are intermediated by banks, or the "real demand" for bank deposits, is a function of available close substitutes. (Real bank reserves thus may stay unchanged, while real deposits decline). The rise of the MMMFs did in fact substantially reduce the real demand for bank deposits: not for nothing did banks respond, first by lobbying Congress to suppress the MMMFs, and ultimately by establishing NOW and Money Market accounts to compete with them.

      For some details see and pp. 5-6 of

      • Spencer Hall

        Agreed, Lewis Stone was right. But I disagree with your analysis, viz., Alfred Marshall's money paradox.
        "intermediated?. How so? From the system’s modus operandi, DFIs, do not loan out IBDDs, nor any liability, asset, or equity item. Whenever CBs grant loans to, or purchase securities from, the non-bank public, they acquire title to earning assets (i.e., pay for them), by initially, the creation of an equal volume of new money (demand deposits) – domiciled somewhere within the system.

        I.e., commercial bank deposits are the result of lending, – not the other way around. Thus, bank-held savings are not a source of loan funds for the banking system. All savings originate within the system itself, and already existed before the consummation of any banks’ commitment to new loans or investments.

        Monetary savings never leave the commercial banking system, unless currency is hoarded.
        So remunerating IBDDs induces non-bank dis-intermediation (where the size of the non-banks shrink, but the size of the commercial banking system remains unaffected). So money velocity shrinks, and AD shrinks (viz., the direct cause of Larry Summer's secular stagnation c. 1981).

        Thus, the 1966 S&L credit crunch is the economic paradigm (the empiricism, positivism, and metaphysics that supports Dr. Leland James Pritchard’s savings-investment theory — where borrowing and investment, “putting voluntary savings to work”, is matched by non-inflationary saver-holders’ loanable-funds).

        Complicit reserves are the only legal credit control device in a free capitalistic society through which the volume of money and money flows can be precisely regulated.

        – Michel de Nostredame (I cracked the economic code in July 1979).

  • Spencer Hall

    "But those troubles will in turn sponsor further innovations aimed at correcting them"


    No, they won't be corrected. The oligarchs rule. We have an “elastic” currency “aided and abetted” by “elastic” legislators. We have perennial Walter Wriston caricatures pressuring the House Committee on Financial Services & the U.S. Senate Committee on Banking, Housing, and Urban Affairs. We have a conspiratorial organization that goes by the name of the American Bankers Association – with its well funded lobbyists that “routinely spends more money influencing legislation, than all other industry and labor groupings.”

    The Board of Governors is self-described as: “subject to oversight by Congress, which periodically reviews its activities and can alter its responsibilities by statute” Even so, the Fed is “connected
    at the hip” with Congressional allies, a la Greenspan, who the New York Times called a “three-card maestro”.

    The Fed’s research is politically coordinated, targeted to justify its monetary policy objectives – those that appease the banking community. It’s not a Federal Reserve System, it’s a Commercial Banker’s System.

    The great German poet and playwright Bertolt Brecht would have agreed and once said it was "easier to rob by setting up a bank than by holding up (one)."

    It’s as the university professor said: “innovate away from home”. Academic freedom has become the “barbarous relic”.

    See Frances Coppola – IN RESPONSE TO: Raising interest rates is not that simple, Lord Hague

    “There would have to be a major rethink of the way in which financial intermediaries whose job is maturity transformation (banks, pension funds, insurance companies) work.”

    An indoctrinated, populist, intractable, misconception. All rates of investor’s returns, including interest coupon payments, are lower than otherwise would be, because of secular stagflation. And we, and all Keynesian inspired disciples, have low rates of returns on our savings simply because of one huge overriding government policy blunder: Commercial banks are not financial intermediaries (buying their
    liquidity, instead of following the old fashion practice of storing their liquidity), ever functioning to match investors with creditworthy borrowers, i.e., pooled savings with investment opportunity outlets.

    And the epic error responsible for our economic malaise (lower incomes), was driven by the most dominant economic predator, the oligarch which goes by the name of the American Bankers Association, the ABA. We, as capitalists, entrepreneurs, and consumers, live in a predator society (which necessitates regulated capitalism, not laissez-faire capitalism, not Greenspanism). I.e., there is nothing “normal” about Gov’t incentives and “equilibrium” rates.

    It is a statistical fact that commercial banks, from the standpoint of the entire economy do not loan out extant deposit classifications, saved or otherwise. Commercial banks, DFIs, do not loan out reserves, nor any liability, asset, or equity item. Whenever CBs grant loans to, or purchase securities from, the non-bank public, they acquire title to earning assets, pay for them, by initially, the creation of an equal volume of new money (demand deposits) – somewhere in the interdependent member
    banking system. I.e., commercial bank deposits are the result of lending, – not the other way around.

    Larry Summer’s secular stagnation is the direct result of impounding savings within the confines of the CB system. From the system’s architecture, CB held savings are idle, un-used and un-spent (their means-of-payment velocity is zero). And unless bank-held savings are expeditiously activated and put back to work, (matched with non-inflationary real-investment outlets), money velocity shrinks, AD shrinks, and N-gDp shrinks (i.e., all incomes), i.e., ever since 1981 (c. the saturation of DD Vt, and the climax in the monetization of time deposit classifications).

    Frances Coppola expounds: “this chart shows that the real interest rate still has further to fall”

    No this will not be the outcome. This was already theoretically, and empirically discredited. And it happened long ago. The reaction of the monetary authorities is already known, indeed has a precedent, is not indeterminate. It is called stagflation, which was predicted in 1958, before the word was coined in 1965 (resulting from a fifth in a series of rate increases promulgated by the Board and the FDIC beginning in January 1957, unique in that it was the first increase that permitted the commercial banks to pay higher rates on savings than the non-banks, savings and loan s and the mutual savings banks, could competitively meet).

    It is a historical fact (and we don’t need another Great Depression), indeed empirical evidence, that the removal of the payment of interest on commercial bank’s depositors accounts, will force money to be re-routed outside the banks (through non-bank conduits). Saver-holders will then seek out higher rates of return outside of the commercial banking system. Contrary to conventional wisdom, this does
    not decrease or alter the total assets or liabilities of the commercial banking system, unless ameliorated through monetary policy objectives (which will be necessary).

    Monetary savings are never transferred to the intermediaries; rather monetary savings are always transferred through the intermediaries. Indeed, as evidenced by the existence of “float”, reserve credits tend, on the average, to precede reserve debits. Therefore, it is a delusion to assume that the intermediaries can “attract” savings from the CBs, for the funds never leave the commercial banking system.

    Shifts from time (savings) deposits, TDs, to transaction based accounts, TRs, within the CBs and the transfer of the ownership / title of these deposits to the non-banks, NBs, involves a shift in the form of bank liabilities (from TD to TR) and a shift in the ownership of (existing) TRs, from savers to NBs, et al. The utilization of these TRs by the NBs has no effect on the volume of TRs held by the CBs, or the volume of their earnings assets. I.e., the NBs are customers of the deposit taking, money creating, CBs.

    …When you drive the CB's out of the savings business. Rates become higher and firmer and there is subsequently a lower loss from bad debt. I.e., the CBs, NBs, and their customers have a symbiotic relationship. The welfare of the CBs is dependent upon the welfare of the NBs, which in turn benefits saver-holders, and all participants' incomes, NIMs, ROA, ROI, and real rates of interest.

  • JoeEsty

    I'm unfamiliar with 1930s Canadian banks. I'd be interested to know their business formation. Were they organized as limited-liability C-corps, or were they organized as partnerships (or some such), which imbues more personal liability? The reason I'm curious and ask is that the large Wall Street investment banks were organized mostly as partnerships until the late 1990s. A few survived nearly a century when organized as partnerships with partners with considerable skin (and personal liability) in the game. But when these Wall Street investment banks organized as C-corps. and could disperse their liabilities and risks to faceless shareholders and CYA regulators, nearly all were bankrupt within a decade.

    • George Selgin

      Canadian banks were double-liability institutions, as were U.S. "national" banks prior to the Fed's establishment.

  • Aajaxx

    As I understand it, though Canada had no formal central bank, the Conservative government had an explicit policy of protecting depositors by providing reserves necessary to keep banks from failing and/or forcing mergers with stronger banks, pretty much what the US Treasury did in response to the 2008 crisis. So, ok, they didn't so much 'regulate; their way through the crisis as much as they bailed out the system. And after that experience, Canada decided it would be better to have a central bank.

    • George Selgin

      You are correct that the Canadian government did allow mergers as a way to deal with failing banks. But in most cases the mergers required no special government encouragement. They were in the interest of the acquiring banks. And no, the government did not bailout banks or otherwise supply emergency reserves.

      As for your claim that "after that experience, Canada decided it would be better to have a central bank." it is one of those tempting myths that seems to fit the facts readily, but is nonetheless without foundation. For the truth about Canada's decision to establish a central bank, read Bordo and Redish,

      Finally, I don't buy the "culture" argument in this case. Instead I think that our bad banking culture has itself been fostered by reckless government interference. We have had pockets of sound banking in the U.S. (e.g., the New England Suffolk System); it is when government regulation replaces market discipline that the culture seems to go awry.

  • Benjamin Cole

    Great post. And Rogoff's dreams for a panopitican state are terrifying.

    Still, in a modern state, even wll-run with reasonable taxes, can cash co-exist with zero inflation?

    Once people accumulate cash, it becomes preferred for transactions to avoid taxes. A large untaxed cash economy will likely result (and is as we speak) alongside a more-heavily taxed aboveground economy. Cash in circulation is exploding at $4500 per US resident. Ditto Europe and Japan.

    I prefer to avoid Rogoff-world. Mild inflation will reduce cash balances and yes taxes should be as low as possible.

  • Per Kurowski

    So, when in 1988 the Basel Accord signed up on that the risk weight of sovereigns was 0%, and that of We the People 100%, where were you?

    • George Selgin

      In Hong Kong, I believe. And why didn't you sound the alarm then, instead of waiting until a week ago to clue us in? ;)

      Anyway, I'm sure you know that I've never been a fan of the Basel risk weighting system.

      • Per Kurowski

        George, Until 2002 I was in Venezuela and had no idea about what was going on with bank regulations. When I came up to the World Bank as an ED, I was astonished and protested as much as I could, with no success. I did not belong to any network of influence. And in October 2004, in a letter in FT I asked "how many Basel propositions it will take before they start realizing the damage they are doing by favoring so much bank lending to the public sector?" And besides, already in 2009, I sent you some observations to your email on the craziness of current bank regulations

      • Gary Anderson

        Prof, clearly Basel 1 took down Japan and Basel 2 took down the West, including the USA. You probably noticed that China didn't sign the Basel accords and appears to be healthier than either Japan or the United States. I am thinking that Basel is a tool for central banks to liquidate the regular folk from time to time, which is why so many people hate banks. JMO.

  • Gary Anderson

    Nice article. But dubious financial innovations like structured finance certainly should be regulated. I agree that we cannot labor under the curse of Rogoff. And we have to realize that once upon a time, in a Depression long ago, the government had more power than the globalist banks. And they passed some good laws to curb them. Government, if anything is too weak to do so now.

    Cato knows Rothbard would rather have no government. We certainly can't go there.

  • Len Blake

    Wells Fargo Bank is proof that there are no regulations. Fat Dumpy Janet Yellen, is a Puppet of
    the Fossil Plutocrat who owns large stake in Wells Fargo and she rants and raves and does nothing.