Bank regulation is a farce.

 
 

The basic objective of bank regulation is to ensure banks are reasonably safe, i.e. that they are unlikely to do a repeat of the 2007/8 bank crisis.

The first questionable aspect of that whole effort is that the chairman of the main UK investigation into banks in the wake of the latter crisis, Sir John Vickers said that regulations are still nowhere near good enough. See article of his article entitled “Storm is coming….”.

But a more fundamental and nonsensical aspect of bank regulation is as follows.

The main element of those regulations consists of trying to ensuring that banks have enough capital to withstand a crisis, i.e. the objective is to ensure they do not take their “borrow short and lend long” activity too far. Borrow short and lend long is also known as “maturity transformation” (MT).

MT is profitable for banks because they can charge a higher rate of interest on “long loans” (e.g. mortgages) than they themselves have to pay to borrow funds short term (e.g. from bog standard bank depositors).

But MT allegedly has a merit, namely that it creates liquidity / money, as pointed out by Messers Diamond and Rajan in the abstract of their NBER working paper No. 7430.   So banks and bank regulators spend tens of thousands of hours arguing about how much of a constraint there needs to be in MT to give us reasonable safety without cutting too much into the apparent merit of MT, namely money / liquidity creation.

But wait a moment: it’s not only private / commercial banks that can create money / liquidity. Governments and their central banks (henceforth “the state”) can do that. Indeed, the state can create and issue whatever amount of money is needed to give us full employment! Plus that’s exactly what states have had to do in reaction to the latter crisis and Covid. So why bother with private / commercial banks’ money creation activities at all!

I.e. why not go for TOTAL AND COMPLETE SAFETY by simply banning all money creation by private banks? Put another why not adopt full reserve banking where loans are funded 100% by equity rather than deposits?  Moreover, private banks’ money creation efforts are basically just a nuisance: they create and lend out money like there’s no tomorrow in a boom, thus exacerbating booms. Then come a recession, they cut down on the latter activity, or even call in loans: again, exactly what is not wanted.

And that simply increases the amount of counter cyclical activity that states have to engage in.

As the Nobel Laureate economist, Merton Miller, put it reference to and in support of full reserve, “Think how much national economic welfare could rise . . . . . when thousands of no longer needed bank regulators (and hundreds of academic banking economists) find themselves forced at last to seek more socially productive lines of economic activity.”.

For more on the above points, see this recent article of mine.

Feeble criticisms of CBDC by Stephen Cecchetti and Kim Schoenholtz.

That’s in their Financial Times article, 28th July 2021, entitled “Now is not the time for central bank digital currencies”.

One of their arguments is that “By their nature CBDCs risk disintermediation…”. Well what of it? In other words what’s so wonderful about intermediation?

For example anyone can buy bonds in a corporation or alternatively they can buy a stake in a mutual fund which invests in those corporate bonds, in which case the mutual fund acts as an intermediary between them and the corporation. Now there’s nothing inherently wrong with mutual funds: they suit some people rather than buying bonds or shares DIRECT, i.e. without intermediation. But if there is a general move away from intermediation, what of it? That’s a choice which consumers / savers are fully entitled to make.

Next, Cecchetti and Schoenholtz say “Suppose there’s a bank run. It’s not hard to imagine that uninsured deposits would flee from private banks to the central bank, exacerbating the strains on the financial system.”
 

Now wait a moment. One of the promises that commercial banks make to their depositors,  with a view to making depositing money at a bank a more attractive proposition, is that those banks will turn deposited money into central bank issued money whenever those depositors so wish. Indeed, you exercise your right to turn money in your bank account, or some of it, into central bank issued money whenever you go to an ATM and withdraw £10 notes, $100 bills etc.

What on earth is wrong with people exercising a right they have under any contract they have with a bank or any other entity? Absolutely none! If banks want to make themselves less prone to runs, they are always free to place restrictions on withdrawals: there is no obligation on government to skew public policy in such a way as actually help commercial banks in that process.

Of course the result of a mass exodus from commercial bank accounts into CBDCs could well “exacerbate strains on the financial system” as the FT authors say. But that’s the fault of commercial banks for allowing customers a quick exit.

Next, the FT authors claim a big inflow of funds to CBDCs would tempt central banks to LEND OUT funds. Well that’s a strange argument. Central banks do not normally lend to private sector entities, and as for central banks buying up GOVERNMENT bonds, central banks only do that when they think stimulus is needed (which equals QE of course).

Next, they say “Finally, there’s the issue of privacy. As using CBDC means everything we do becomes traceable, it poses serious threats to personal liberty. In theory, outsourcing compliance to “narrow banks” holding CBDC could secure privacy, but that wouldn’t stop authoritarian states.”

Well the latter “outsourcing”, as the authors rightly say, does stop states having immediate access to details of account holders’ accounts – indeed, that sort of system where accounts fully backed by central bank money are actually administered by commercial banks has long been advocated by supporters of full reserve banking, e.g. Positive Money and Lawrence Kotlikoff.

But what on earth is the very vague phrase “that wouldn’t stop authoritarian states” supposed to mean? Obviously technical adjustments to how the bank system works does not stop some sort of Stalin or Hitler coming to power. Is that what they mean? Darned if I know.

The important point surely is that “outsourcing” makes CBDC similar to existing bank accounts where, at least in most countries, government or its agencies can spy on people’s bank accounts, though the state has to get permission first from a judge or magistrate and provide a good reason for wanting that access, e.g. a suspicion that the account holder is engaged in tax avoidance.
 
And the FT authors last sentence is “In our view, that means stopping well short of issuing universal, unlimited, interest-bearing CBDC.” Er – whence the assumption that CBDC accounts pay any interest? MMTers and Milton Friedman argued that ideally the state should pay NO INTEREST on its liabilities. I agree.
 

Government borrowing raises interest rates?

 

Numerous economists are less than entirely as to when government borrowing raises interest rates and when it doesn’t, for example the four economists pictured above in this SUERF article (2019). The economists are Elga Bartsch, Jean Boivin, Stanley Fischer, Philipp Hildebrand. They claim that “With global debt at record levels, major fiscal stimulus could raise interest rates…”. (Article title: “Dealing with the next downturn….”)

Perhaps I can clarify matters.

If a government relies exclusively on fiscal stimulus, a scenario the above authors consider, then it might seem that the extra borrowing needed “could raise interest rates”. But wait: if extra stimulus is needed then the central bank is not going to let interest rates rise!!!  Put it another way, it will simply QE most if not all the extra government bonds.

And what do you know? Since the above article was published, Covid has arrived and governments have done even more borrowing than the above authors probably envisaged. Lo and behold: central banks have QEd most of, indeed pretty much all of the additional government bonds!

OMG: Mervyn King opines on QE.

 
Danny Blanchflower, former external member of the Bank of England's Monetary Policy Committee, recently described Mervyn King on Twitter as “the clueless clown who missed the great recession and supported failed evil reckless austerity”. Can’t say I flatly disagree with Blanchflower.

At any rate, King and his fellow members of the House of Lords Economic Affairs Committee make four main points in their recent report of QE – see Bloomberg article by King entitled “Quantitative Easing is a Dangerous Addiction” for more detail.

King’s first point is that central banks are not taking inflation seriously enough. Well that happens from time to time even in the absence of QE!  So it’s not a SPECIFIC criticism of QE!

His second point is that not all problems merit a monetary response, e.g. QE. Well true. But the main alternative response is FISCAL, and central banks can’t do fiscal.!!!  So what are central banks supposed to do given what they see (rightly or wrongly) as inadequate aggregate demand?

His third point reads thus. “QE poses risks for central-bank independence. The committee looked closely at the relationship between QE and the public finances. QE has made it easier for governments to finance exceptionally large budget deficits in the extraordinary circumstances of Covid-19. But when the central banks reduce this support, will they come under pressure to help finance ongoing budget deficits or to keep short-term interest rates close to zero? It’s possible they will. Central banks today operate in a more difficult political environment than 20 years ago.”

Now why exactly has QE made it “easier for governments to finance large deficits”? Of course if the relevant central bank is in thrall to politicians who aren’t too bothered about inflation, then clearly there’s a problem. But that’s a problem that often arises even in the absence of QE!  I.e. a central bank can always be pressured (and indeed central banks often are pressured by politicians) into not doing anything about the inflationary effect of an excessive deficit. Donald Trump tried that trick.

Again, Mervy King and his fellow doddering Nobel Lordships seem incapable of distinguishing between problems which are SPECIFIC to QE, and problems which are of a more general nature and which can and/or do arise ANYWAY.

And their fourth point starts thus: “. QE tends to be deployed in response to bad news, but isn’t reversed when the bad news ends. As a result, the stock of bonds held by central banks ratchets up…”.

Now wait a moment: QE was only implemented for the first time between five and ten years ago, so how can anyone make generalisations about it along the lines that it tends not to be reversed? I.e. if there were instances in say the 1960s, 70s, 80s or 90s of it not being reversed, then that generalisation might be valid. But there were no such instances!

Moreover, if a central bank thought there was a clear need to damp down what it saw as excess demand and excess inflation, then the first step would be to reverse QE, i.e. sell debt back in to the market and mop up excess money.  But central banks just at the moment (rightly or wrongly) do not think there is excess demand and inflation, so they aren’t doing that.

That’s what explains the lack (so far) of any “QE reversal”, not the fact that there is some sort of reluctance on the part of central banks to ever reverse QE.

Conclusion.

While Mervyn King has produced some worthwhile material in the past, he seems to have gone a bit soft in the head in recent years, as I’ve noted before on this blog. Looks like Danny Blanchflower’s opinion on Mervyn King isn't wholly inaccurate.

Ann Pettifor objects to QE.

 
That’s in a Prospect Magazine article entitled “Quantitative easing: how the world got hooked on magicked-up money.”

As the title implies, she seems to think there is something inherently wrong with QE. Well we all know QE has problems, but few people deny it has a finite stimulatory effect. What were governments and central bank supposed to do in reaction to the 2007/8 bank crises and Covid? Implement no stimulus at all?

Also, interest rate adjustments are a well established method of imparting stimulus or doing the opposite, that is damping down an economy which is overheating. And QE is simply a method of forcing down interest rates to their lowest possible level once traditional methods of interest rate cuts have lost traction. Thus interest rate cuts when interest rates were higher, i.e. before the 2007/8 bank crisis, have much the same effect as QE, e.g. encouraging asset price speculation. So if Ann  Pettifor is going to be consistent, she needs to explain what’s wrong with the latter TRADITIONAL interest rate cuts.

But ironically, both MMTers and Positive Money, both of whom Ann Pettifor disapproves of have actually set out detailed reasons as to why interest rate adjustments come a poor second to fiscal adjustments. And therein lies a problem for AP: if she goes along with MMT and Positive Money there then she’s in danger of contradicting herself.  

Second, she doesn’t mention the fact that there is a good argument for taking QE much further and “QEing” the ENTIRE national debt. Reason for that, as argued by Milton Friedman and MMTers, there are no brilliant arguments for any sort of interest bearing government debt. That is, the only form of state liability (if you can call it a liability) ought to be zero interest yielding base money. As David Hume suggested around three hundred years ago, the ACTUAL REASON for government debt is that it enables politicians to ingratiate themselves with voters because voters clearly attribute increased taxes to politicians, whereas they tend not to attribute a rise in interest rates stemming from more government borrowing to politicians.  (See Hume’s work “Of Money”, passage starting “It is very tempting….”).
 
Third, she seems to think central bank issued money “e.g. £10 notes” are a “promise to pay”.  See her para starting “To the extent…”.  The reality is that (although £10 notes do say that the BoE “promises to pay the bearer £10”) you won’t actually get £10 worth of gold or anything else if you turn up at the BoE and demand to be “paid”.  You’ll actually be told to shove off.

Fourth, her concluding para starts, “The only way to call time on QE, if that is what we truly want, is to deconstruct and then reconstruct, regulate and stabilise the whole financial system, so that the extraordinary privilege of credit creation is always balanced by a responsibility not to take undue risks.”

Now why on Earth would stricter rules on credit creation mean less QE? If anything, those stricter rules would mean less lending which would have a demand REDUCING effect, which would mean that MORE stimulus (in the form of QE or in other forms) would be required!!

Moreover, governments have actually made some progress in tightening up on credit creation (surprise surprise) since the 2007/8 bank crisis in that banks for example are now required to hold more capital. Though clearly many argue that nowhere near enough progress has been made (including the chairman of the Vickers commission, Sir John Vickers).

As to the idea that those who are into credit creation should not take “undue risks”, that’s hopelessly vague, plus it sniffs very much like Nirvana for lawyers. That is, the possible complexities involved in defining what constitutes “undue risks” are limitless.

Far simpler is, when it comes to credit in the LENDING sense of the word, to simply to let any person or institution which wants to lend take any risk they like, long as THEY THEMSELVES carry the can if it goes wrong. Indeed, people and institutions are already free to take any risk they like in the form of setting up risky businesses and projects, or buying shares in near bankrupt corporations. (Incidentally AP does not distinguish between the two meanings of the word “credit”.)

In contrast, when it comes to credit in the “money” sense of the word, any form of money not 100% backed by central bank reserves should be openly and loudly declared to be of the latter nature: e.g. all publicity issued by that form of money issuer should make it very clear that there is no form of state rescue available if such money turns out to be worthless. Indeed under full reserve banking, the only form of money that the state guarantees is bank accounts which are 100% backed by reserves at the central bank, which is simplicity itself: no need for hoards of lawyers.

That warning should be enough to ensure that Bitcoin and other “dangerous money” enthusiasts remain relatively small in number and do not pose any systemic risk. Certainly the recent collapse in value of Bitcoin and the collapse of Titan did not cause systemic problems. But clearly the authorities need to keep an eye on risky forms of money to ensure they do not become so popular and/or devious as to actually pose systemic risks.

 ___________

P.S. (11th Aug 2021).  I forgot to say that her concluding paragraph is a farce. It starts “The only way to call time on QE, if that is what we truly want, is to deconstruct and then reconstruct, regulate and stabilise the whole financial system, so that the extraordinary privilege of credit creation is always balanced by a responsibility not to take undue risks.”

That of course sounds very reasonable – particularly to the “progressive” leftie intellectuals who edit the Prospect site and other leftie intellectuals. But it’s actually nonsense. Reason is that better bank regulation, which is no doubt desirable, will actually cut demand because FEWER bank loans will be made. Ergo some form of compensating INCREASE in demand will be needed, like  -  er   -  more QE! In other words if banks are “regulated” so as “not to take undue risks” (to use her words) then all else equal, MORE QE will be needed, not less!

Bit of a faux pas that. But never mind. Almost no one is interested in technical details: to attain fame and fortune much the most important thing you need to do is appear “progressive” and concerned with social and economic problems. That’ll fool almost everyone into thinking that everything you say pretty much has divine authority.

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Full reserve wins again.

 
It’s always nice when you find that a solution to a problem which you’ve advocated for years turns out to also be a solution to an entirely new problem. The problem I have in mind is the possible systemic risks caused by the recent big increase in crypto currencies (especially the stablecoin variety), a possible problem which others are concerned about. And the solution I have in mind is full reserve banking.

The basic rules of full reserve were actually imposed on mutual funds in the US a few years ago: that is, funds which did not have $X of US government debt for every $X deposited in those funds where barred from claiming they would not “break the buck”, i.e. that they would never fail to repay depositors $Y for every $Y deposited / invested.

Exactly the same rule would probably solve the “crypto systemic risk” problem. The result would be a clear distinction between on the one hand crypto outfits which are seen by everyone as being risky, i.e. which amount pretty much to shares / equity rather than money, and which would not cause a big disruption if they crash, and in contrast, crypto outfits which everyone DOES EXPECT to be genuinely stable, or “not break the buck”. As former governor of the Bank of England, Mervyn King said (p.2) in his “Bagehot to Basle” lecture, stock market setbacks tend not to cause as big a problem as bank crises. Certainly the recent collapse in the value of Bitcoins did not cause a big disruption: reason (to repeat) was that everyone knew that was on the cards all along.

Having claimed above that the rules of full reserve solve a “new” problem, it should be admitted that that is a slightly dishonest claim in that arguably the problem is not new at all: crypto outfits are essentially banks, thus it is perhaps no surprise that the best rules for governing banks are also the best rules for governing crypto outfits.

Stablecoin is thousands of years old.

A stablecoin organisation is one which accepts deposits from people and promises to return those deposits immediately or at short notice or transfer some of the money to a third party if the depositor so wishes. But that’s what banks have done ever since banks first appeared, which was thousands of years ago: certainly as far back as Ancient Greece and possibly earlier.  

The only difference between a stablecoin organisation and a bank is that stablecoin organisations do the above transfers electronically whereas banks used to do the transfers using paper. But even that difference has diminished in recent decades thanks to credit cards and the like issued by banks.

Thus as Martin Wolf said, stablecoin organisations should be regulated like banks. So what should be basic rules of that type of regulation be? Well here’s a very simple set of rules (approved of by Martin Wolf incidentally).

First, the only organisation (stablecoin or bank) which should be allowed to tell depositors their money is totally safe (i.e. that the “coin” is “stable”) are those which have a stock of reserves to match deposits dollar for dollar.

As for the rest, they should be allowed to do anything they like, long as they do not break the law, e.g. the law of contract. Plus the actual wording of their publicity should be constantly and carefully scrutinised to make sure banks and stablecoin organisations do not indulge in the trick that banks have tried over and over throughout history, namely to give the impression that deposits are safe when they are not.

And what do you know? That’s pretty much what full reserve banking (aka “narrow banking”, aka “sovereign money”) consists of, which is backed incidentally (as intimated above) by Martin Wolf.