Saturday, 22 November 2014

Farcical bank regulations.

Regulators have spent millions of hours and dollars recently hunched over their calculators, trying to work out just how far bank capital should be raised so as to improve bank safety, without demanding TOO HIGH a level of capital because that would allegedly raise the cost of funding banks by too much.
There is of course a well-known answer to the latter “cost” point, namely the Modigliani Miller theory (MM). MM basically says that if the amount of capital used to fund a bank is for example doubled, that will halve the risk per share. Ergo doubling bank capital has no effect on the TOTAL CHARGE made by shareholders for funding the bank. Ergo raising bank capital costs nothing.
A large amount of effort has been devoted to working out whether MM is 100% valid, or whether it does not actually work as per theory in the real world. For example David Miles of the Bank of England Monetary Policy Committee claimed that while the MM theory was basically right, that MM “is not likely to hold exactly”.
Why not? He doesn’t say.
But I’ll take a different approach and hopefully show that MM is indeed 100% valid, and hence that having a bank or “lending entity” funded JUST BY CAPITAL (which is what is involved in full reserve banking incidentally) would involve no additional costs at all. The different approach is thus.
Take two hypothetical banks which engage in the same type of lending (risky or safe – whatever you like). One bank is funded almost entirely by capital and the other almost entirely by depositors or other types of debt. Now assuming no taxpayer or government support for banks, what’s the difference between the risks run by those funding those two banks? The answer is “absolutely none”. Ergo there is no difference in the cost of funding the two banks! Simple.
There are of course differences between shareholders and depositors / debt, but the differences are irrelevant. To illustrate, say a bank’s assets decline to 90% of book value, that just means in the case of the shareholder funded bank that the shares would drop to about 90% of initial value. While in the case of the depositor funded bank, and assuming the bank is declared insolvent, depositors would get about 90 cents in the dollar. So shareholders and depositors are in the same position to all intents and purposes.
So where does this idea that bank capital is inherently expensive come from? Well I suspect numerous economists have been misled by various artificial and politically inspired interferences in the free market which have artificially boosted the cost of capital relative to the cost of debt.
For example some countries have deposit insurance funded by taxpayers. Now in that case obviously funding via capital will be more expensive than funding via depositors! The depositors are subsidised. In other words in such a country, to get at REAL COSTS, deposit insurance should be ignored.
Another distortion that artificially boosts the cost of capital comes from the different tax treatment of capital and debt. Indeed that seems to be the most popular criticism of MM. But of course the criticism is complete nonsense because tax is an ENTIRELY ARTIFICIAL imposition. You really have to wonder whether so called professional economists can think their way out of a paper bag. The latter nonsensical tax criticism of MM was made for example by David Elliot, of the Brookings Institution, Lev Ratnovoski, Anil Kashyap, and Urs Birchler.   

The bank regulators mentioned at the outset above,  hunched over their calculators have been wasting their time. They might just as well have implemented the VERY LARGE increase in bank capital advocated by for example Martin Wolf, chief economics commentator at the Financial Times, and by Anat Admati. To repeat, that would not have raised bank funding costs.
Indeed, the process can be taken much further: have lending entities funded JUST BY SHARES, which is what is involved in full reserve banking (FR), or at least some versions of FR. That of course raises an obvious question: how about depositors? Well the answer is that under FR, depositors (i.e. people who want to be guaranteed to get $X back for every $X they deposit) simply have their money lodged at the central bank and/or put into short term government debt. No risks are taken with their money.
The net result is that banks are failure proof. The lending half of the banking industry cannot go insolvent because by definition, an entity funded just by capital cannot go insolvent. And as to depositors, their money is totally safe (or at least as safe as is possible in this imperfect world).

Friday, 21 November 2014

Mankiw and Krugman and on full reserve banking.

Mankiw expresses sympathy with full reserve banking. He says, “Suppose we were to require banks to hold 100 percent reserves against demand deposits. And suppose that all bank loans had to be financed 100 percent with bank capital. A bank would, in essence, be a marriage of a super-safe money market mutual fund with an unlevered finance company. (This system is, I believe, similar to what is sometimes called “narrow banking.”) It seems to me that a banking system operating under such strict regulations could well perform the crucial economic function of financial intermediation. No leverage would be required.” (Narrow banking is just another name for full reserve banking, btw.)
Krugman answers that by saying “Where Greg goes astray here, I think, is by trying to apply Modigliani-Miller, which says that capital structure doesn’t matter. If you look at the assumptions behind that argument, you realize that it requires that all assets be perfectly liquid.”
 “I think of the whole bank regulation issue in terms of Diamond-Dybvig which sees banks as institutions that allow individuals ready access to their money, while at the same time allowing most of that money to be invested in illiquid assets. That’s a productive activity, because it allows the economy to have its cake and eat it too, providing liquidity without foregoing long-term, illiquid investments. If you were to enforce narrow banking, you would be denying the economy one of the main ways we manage to reconcile the need to be ready for short-term contingencies with the payoff to making long-term commitments.”
Well the answer that is that you don’t need conventional banks, or indeed any sort of bank, to obtain a good degree of liquidity. Your car and house are moderately liquid in that cars can be turned into cash within 24 hours and houses normally in a month or so. Plus the stock exchange funds investments in ILLIQUID assets while ensuring that those who fund those investments enjoy a high degree of liquidity: you can turn your stake in General Motors into cash within 24 hours, though the actual number of dollars you’ll get is not totally predictable.
As to liquidity in the sense of a fixed number dollars, or a liquid asset which is guaranteed to hold its value (inflation apart), traditional commercial banks are just not needed for that purpose. That is, government and central bank can provide an economy with whatever amount of money the economy needs. Indeed, central banks are doing just at the time of writing on an unprecedented scale in that there is a record amount of base money sloshing around thanks to QE.  
Or that “central bank money administering” job can be partially farmed out to commercial banks: that is what Mankiw meant by “Suppose we were to require banks to hold 100 percent reserves against demand deposits.” I.e. the safe half of the banking industry under full reserve deals just in base money or money which is backed 100% by reserves.
Moreover, if a private bank is going to provide customers with what might be called “extreme liquidity”, i.e. a fixed number of actual dollars, that NECESSARILY makes banks’ balance sheets fragile, as indeed Douglas Diamond himself eloquently pointed out.
As he and his co-author put it, in reference to the liquidity / money creation that private banks offer: “We show the bank has to have a fragile capital structure, subject to bank runs, in order to perform these functions.”
That is, if a banks’ liabilities consist of dollars / money, then those liabilities are FIXED in value (inflation apart). In contrast, its assets (the loans it makes) can fall in value. That equals fragility. It’s asking for trouble.

Traditonal commercial banks with their money creation activities are a complete pain in the whatsit and for the following reasons.
The stock exchange, or more generally shares, provide a degree of liquidity. Of course banks provide a better way of transferring and storing money that dealing just in physical cash kept under the mattress. But so far as the provision of liquidity goes, commercial banks add nothing. They cannot give us liquidity without at the same time giving us fragility, and possible bank runs, credit crunches, etc.

Tuesday, 18 November 2014

Daniel Aronoff versus Positive Money.

It’s game set and match to PM, if you want to know the final score. But details are as follows.

Fran Boait of PM in the letters section of the Financial Times cited a Bank of England publication which pointed out that commercial banks create deposits when they lend.

Daniel Aronoff responded (his 2nd paragraph) by saying that when the DO LEND, that changes the ratio of deposits to bank reserves (which is obviously true, given more or less constant bank reserves).

But he then jumps to the conclusion that that shows that the cause effect relationship can run the other way, i.e. that expanding reserves enables banks to lend more. Unfortunately it is widely accepted by economists that there is only one significant determinant of bank loans: the availability of credit worthy borrowers. I.e. reserves are well nigh irrelevant.

Certainly a large increase or decrease in reserves from their present level is irrelevant so far as bank loans go. In contrast, given the sort of level of reserves that existed prior to the crisis (i.e. about one tenth their present level), banks are then near the minimum stock of reserves that they need for settling up with each other, so the volume of reserves might be argued to be relevant there.

However, even that argument has been widely criticised. Just one example: as Bill Mitchell puts it, “As we have discussed many times banks seek to attract credit-worthy customers to which they can loan funds to and thereby make profit…..These loans are made independent of the banks’ reserve positions.”

Thursday, 13 November 2014

More reaction to Adair Turner’s FT article.

Adair Turner in the Financial Times recently advocated a kind of merge between monetary and fiscal policy (or if you like a merge between central bank (CB) and treasury). That is, given a need for stimulus, Turner suggested having the state simply create new money and spend it, or cut taxes: i.e. fund the deficit with new money rather than with debt.

Many others (e.g. Positive Money and Richard Werner) have suggested the same, and one advantage is that if there is less state debt, then there is less of an interest rate burden.

Simon Ward in a letter to the FT disputes that on the grounds that interest rates still have to be adjusted and if the stock of state issued money expands, the CB will have to pay interest on that (as indeed many CBs currently do).

The answer to that is that IDEALLY, i.e. if the state gets it just right, it will issue just enough money to give us full employment without any need to pay any interest on any of that money. Of course, irrational exuberance will occur periodically, and the state will need to impose some sort of deflationary measure. That COULD TAKE THE FORM of raising taxes and “unprinting” the money collected. But if that’s not enough, then having the state offer to borrow back some of the money it has issued is obviously an additional deflationary tool that can be used.

But that does not invalidate Turner’s initial point, namely that given the need for stimulus, it’s bizarre to do something which has a DEFLATIONARY effect, namely have the state BORROW MONEY! Why borrow money when you can print the stuff?

Fifteen love to Turner so far.

Daniel Aronoff.

Aronoff also questions Turner’s proposal in a letter in the FT. His first objection is that the historical record on debt monetisation or giving politicians access to the printing press is not encouraging.

The flaw in that argument is that advocates of the “print” option are well aware of that danger, and propose a system that deals with that problem. (See the submission to the Vickers commission by Richard Werner and others, in particular bottom of p.10-p.12).

Aronoff’s second objection is that “helicopter money is very difficult to take out of circulation once it has been created”. And he goes on to laud the ease with which a CB can withdraw money from circulation by re-selling bonds.

Well it’s true that raising taxes (with a view, as suggested above, to “unprinting” the money collected) can be politically difficult.

However, even if there were no state issued bonds at all, there’d be nothing in principle to stop a CB just announcing, “We’re in the market for money, and we’re paying above the going rate. Hurry, hurry while this too-good-to-miss offer lasts”.

Doubtless some CBs are not allowed to do that under the legislation in their country, but that’s a technicality: the law can be changed.


Adair Turner is right: the best form of stimulus is simply to have the state create money and spend it, and/or cut taxes. IDEALLY the state issues just enough to give us full employment. But private sector demand is never predictable: bouts of irrational exuberance do occur. And when that happens, it may be necessary to supplement attempts to withdraw money via tax with raised interest rates. But that does not invalidate Turner’s basic point, namely that IN THE FIRST INSTANCE and given a need for stimulus, the best option is simply “print and spend and/or cut taxes”. 

(Incidentally, having said "Turner is right", I still don't agree with his claim that PERMANENTLY higher interest rates are desirable, as I pointed out here.)

Endnote: state borrowing to fund infrastructure.

A legitimate querie here is that even if we rule out state borrowing to fund deficits, that does not necessarily rule out state borrowing to fund infrastructure and other state owned investments.

The answer to that point is perhaps that the state AS CURRENCY ISSUER, should be kept separate from the state AS ENTREPRENEUR (i.e. builder and operator of roads, etc).

If it’s legitimate for a private contractor to borrow so as to fund a road, bridge etc, it’s hard to see why it doesn’t make sense for the state to do likewise. But to repeat, that’s all separate from the state as currency issuer.