Leverage and Financial Intermediation

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A bank is a financial intermediary. A financial intermediary is a “middleman,” it borrows funds from some and then lends those funds to others. The revenue of the financial intermediary is the difference between the interest rates it charges and it pays. Like other businesses, a financial intermediary has operating costs–facilities, labor, and the like.

The concept of leverage from either personal or business finance applies only loosely to financial intermediation. Compare to another type of middleman, a retail business. Retailing involves the purchase of goods at wholesale and then the resale of those goods at retail. The retailer’s revenue is the difference between the prices it charges and the prices it pays. A retailer has operating costs–facilities, labor, and the like. And the retailer must finance its inventory and operations, using either debt or equity.

The financial intermediary, on the other hand, has no need to finance its inventory because its inventory is funds borrowed by the financial intermediary. But given the nature of this business, even if all of the operating costs were financed by equity, the financial intermediary would still be “highly leveraged.”

In banking, the more common term to refer to relationship between debt and equity is the capital to asset ratio. This ratio is the net worth of the intermediary divided by its total assets. It shows the proportion of the total assets of the intermediary that are financed by equity, that is, by the owners. Since bank “capital” is the difference between assets and debt, the capital ratio is related to leverage. If that capital to asset ratio is cr, and the leverage ratio (debt/equity) is lr, then the relationship between the leverage ratio and the capital to asset ratio is:
lr = (1/cr) – 1

Before deposit insurance was instituted in the thirties, banks would typically put a very abbreviated balance sheet on their door–Assets, Deposits, and Capital. A typical capital ratio would be 15 percent. So, a bank with $100 million in loans and other assets would fund those with $85 million in deposits. The net worth, or funds provided by the stockholders, would be $15 million. The capital to asset ratio is 15 percent. The typical leverage of banks during the twenties would be (1/.15) – 1 = 5.6.

Why would banks put these balance sheets on their doors? It was to reassure their depositors. If the bank took losses from bad loans, then it would remain solvent and able to pay off the depositors eventually, as long as the losses were less than 15 percent of total assets.

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Treating this situation as being similar to an individual investor “leveraging” his bet on the stock market by taking his capital and then borrowing funds from the broker is very confused. Like any other businesses, the issue is how will these value-enhancing activities be funded–with debt or equity. The owners are residual claimants and are the first to bear losses. If the losses are too severe, then part of the losses must be suffered by those providing the debt finance. For the bank in the twenties (or before), that would be depositors. The only thing unusual about banking with regard to leverage was that the nature of the business made it high.

After deposit insurance was introduced, capital ratios soon became an element of regulation. The basic capital requirement was 6 percent, which implies a leverage ratio of 15.6. Why did depositors accept such a low capital ratio? It was because they were insured by FDIC. Depositing money into a more highly leveraged firm because the funds are insured is an example of moral hazard–taking risk because the insurer covers the loss.

The nature of the problem was made obvious when all of the banks scraped the simple balance sheets off their doors and replaced them with what remains there today, a sign that says “FDIC Insured.”

Because savings and loans institutions concentrated all of their lending in home mortgages, which were “so safe,” regulators allowed them to keep an even lower capital ratio of 4%. That was a leverage ratio of 24. When high expected inflation in the late seventies caused short term interest rates to rise into double digits, the low credit risk of the home mortgages did little to solve the massive interest rate risk created by borrowing through savings accounts and then concentrating lending in 30 year home mortgages.

After the savings and loan fiasco, regulators increased capital ratios. In the U.S., the minimum rose to 8 percent. That would be a leverage ratio of 11.5. However, banks that were “well-capitalized” were allowed more freedom to expand into “other” activities, such as underwriting securities, and that required a capital ratio of 10 percent, in other words, a leverage ratio of 9.
It seems sensible that financial intermediaries making more risky loans should be required to have more capital. Since the point of requiring capital ratios is to protect depositors, or more precisely, deposit insurers, the greater the risk of loss from the loans, the more likely the deposit insurer will have to pay off insured depositors. Of course, the extra low capital requirements for the saving and loan industry didn’t work out very well. But that just would suggest that mortgages involve more risk than had been understood, so in the future regulators would require more capital for home mortgages.

Risk based capital requirements then require different levels of capital depending on the risk of the assets. For example, vault cash or balances at the Fed require no capital. Government bonds from a developed country, like Greece, require no capital. Commercial loans to small businesses, on the other hand, are very risky, and require the full 8 percent minimum capital requirement. Incredibly, after the saving and loan mess, home mortgages require 4 percent capital. And mortgaged backed securities rated AA or AAA by S&P, Moody’s, or Fitch require only 2 percent capital!

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How does bank capital and so, bank leverage, relate to nominal expenditure in the economy? In the absence of monetary disequilibrium, there is no relationship between bank leverage and aggregate nominal expenditures. Of course, bank do some borrowing by the issue of monetary liabilities–transactions accounts these days. And banks hold vault case and reserve deposits at the central bank. Banking and monetary disequilibrium are intimately related. However, does leverage, even “excessive” leverage, generate changes in nominal expenditure independent of monetary disequilibrium? No, it does not.
It is easy to make a false analogy from the individual stock speculator leveraging his capital to a bank expanding its balance sheet. Suppose the banks are holding 15 percent capital as they did before deposit insurance, and so, are leveraged a bit less than 6 to one. Then, they decide to leverage up, to the level of well capitalized banks today, holding only 10% capital and so leveraging 9 to one. Perhaps they can go to the pre-S&L crisis capital ratio of 6 percent and so leverage their capital more than 15 times? Could they go as far as the S&L’s before the crises? A 4 percent capital ratio? Leveraging their capital 24 times? If they limited their asset portfolio to AA mortgaged back securities, why not follow the apparent advice of the regulators, keep 2% capital and leverage up 49 times?

Surely, all of that bank lending would result in a credit fueled boom? As the banks increase leverage, they are lending more and more. They might lend to households purchasing new cars or homes. Perhaps they lend to business, financing new buildings or equipment. Perhaps they lend to local government by purchasing bonds to help finance schools or road improvements.

Since nominal expenditure is made up of consumption expenditure by households, investment expenditure by firms, and government expenditure, as banks leverage up, the expansion of credit fuels an expansion of nominal expenditure on many fronts, and the economy booms. Firms can sell more, so they expand production. Profits are strong. Jobs are created.
But there is a limit to this constant expansion of credit through ever growing leverage. If leverage ratios get small enough (a tiny fraction of one percent) then any bad loan will force banks into insolvency.

So, why the bust? When the ever increasing loans slow or stop, spending slows. Firms and households that could easily make loan payments when the economy was booming, have difficulty. When debtors can’t pay, the banks have bad loans. This reduces the banks’ capital, because losses reduce net worth. Already being over-leveraged, the banks must further reduce lending.

It seems so plausible, but it just doesn’t add up. During the supposed credit fueled boom, the banks may expand their lending, but they must also expand their borrowing. In the absence of monetary disequilibrium, those lending to the banks have less money to spend on other things.

For example, a household refrains from going out to eat and thriftily puts those funds in the bank. The bank takes those funds and lends them out to another household that purchases a car. There is more consumption expenditure in the car industry, but less consumption expenditure in the restaurant industry. There is no change in aggregate consumption expenditure.
Consider another example. A profitable firm was going to retain earnings and purchase new equipment to expand output and obtain future profits. However, the firm notes that the expected profit is less than the interest that could be earned by putting money in the bank. The firm lends the money to the bank. The bank then lends the money to another firm that uses the funds to purchase equipment and expand its profit. That firm anticipates that the added profit will allow it to pay back the bank loan and make money for the owners. While investment expenditure on some types of equipment might rise, it falls for other types of equipment. Investment expenditure in aggregate isn’t changing.

Of course, the household that refrains from going out to eat might be funding some firm’s equipment purchase. Or the firm that retains earnings and puts them in the bank may be funding some household’s car purchase. But unless monetary disequilibrium is generated, there is no impact on total nominal expenditure. Credit, even if financial intermediaries are involved and are increasing their leverage, simply shifts funds between and among households and firms.

If this increase in bank leverage is taken as “exogenous,” that is, banks and depositors, (or regulators) decide that lower capital ratios are acceptable, then there remains market based limitations to bank expansion. Again, in the absence of monetary disequilibrium, a bank seeking to expand its balance sheet must attract more depositors and more borrowers. This involves paying higher interest on deposits and charging lower interest on loans. The bank’s interest margin shrinks. While an expansion in the bank’s balance sheet increases revenue, this is partly offset by the decrease in the margin between the interest rates charged and paid, (which is the standard logic of marginal revenue with monopolistic competition,) and then there are additional operating costs from servicing the additional deposits and loans. Even if capital ratios were irrelevant, banks would have no incentive to expand their balance sheets beyond the level that maximizes profit.

To the degree banking, or some elements of it, is perfectly competitive, a “price taking” bank can obtain deposits, make loans, and expand its balance sheet an “infinite” amount. But if the banks in general are reducing capital ratios and raising leverage, the added demand for deposits and supply of loans will reduce the margin between interest rates charged and paid until it equals the marginal cost of operating with larger balance sheets.

Consider the opposite scenario. The banks suffer losses–they have made some bad loans or hold some bonds that default. The banks’ capital is reduced. Suppose that the banks need to meet capital regulations or else depositors, used to observing capital ratios on the bank door, will begin to remove funds unless the banks increase their capital ratios. What if the banks must reduce leverage? The simplest approach is for a bank to refrain from making new loans as it collects on existing loans and use the funds to pay off depositors.

Doesn’t this contraction in bank credit reduce nominal expenditure? In the absence of monetary disequilibrium, an imbalance between the quantity of money and the demand to hold money, there is no impact on nominal expenditure. While those who would have borrowed from the bank and spend the funds have less money, the depositors whose funds are repaid by the bank have more money to spend.

The possibilities are endless. Perhaps the firm that had retained earnings by putting money in the bank will now invest the funds internally. So, rather than someone borrowing money to buy a car, some business purchases new equipment.
Or, perhaps the bank pays back a firm, and that firm purchases corporate bonds. The business that would have borrowed money from the bank instead issues new corporate bonds. Perhaps depositors, receiving repayment of deposits, purchase stock in banks, allowing banks to expand their capital without decreasing loans.

Since banks have a lower demand for deposits and are reducing their supply of loans, they can lower the interest rate paid on deposits and increase the interest rates charged for loans. This increases the margin between the interest rates paid and charged. While the shrinking balance sheet lowers revenue, the expansion in the interest margin raises revenue. Along with reduced operating cost because fewer deposits and loans must be serviced, operating profits could expand.

If, however, the problem really was past losses reducing bank capital, and some outside constraint is forcing banks to shrink their balance sheets, and the banks were maximizing profit before, then the result will be reduced profit for the existing banks. The solution would be for banks to obtain more equity investment, selling new shares on the market.

Consider the situation after the banks have reduced their balance sheets to return capital ratios (leverage) to what they count as an appropriate level. The banks balance sheets are too low, and expansion of both lending and borrowing would raise profit. If depositors (or regulators) require capital for this profitable expansion, then the banks can and should increase capital.

Rather than just imagining that banks decide to increase or reduce capital ratios, suppose there is a change in supply of deposits or the demand for loans. For example, suppose a new production technology is introduced–single family homes will magically begin generating output in the near future. The demand for loans to purchase the magical houses rises. The banks raise the interest rates they charge on loans, and make more profit. Competition among banks results in them also raising the interest rates paid on deposits to attract more deposits and make more loans. If the banks fail to retain part of their earnings or issue new shares, then capital ratios fall and leverage increases.

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Assuming no monetary disequilibrium, there is no impact on aggregate nominal expenditures. Some of those who would have borrowed from banks at lower interest rates are crowded out. Perhaps fewer cars are purchased with borrowed funds. Perhaps fewer machines, buildings or equipment in sectors unrelated to housing are purchased. And, of course, those depositing additional funds in the banking system must be considered. Perhaps they purchase fewer stocks and bonds. Perhaps they go out to eat less often. The end result is that some other element of investment or consumption expenditure is reduced.

Because this is a profitable expansion of the banking industry is due to increased demand for its product, there should be little problem with banks retaining earnings or selling new shares, and maintaining capital ratios. However, if they don’t, the notion that this expansion is being caused by increased leverage, or even “excessive” leverage is absurd. It is being caused by the increase demand for bank loans. And the increase in the demand for bank loans was caused by the new technology. Of course, when people discover that there is no magic in the world, some of the home buyers will be disappointed. And banks that made loans secured by homes at prices that reflected the belief in magic will take losses. And the amount of capital that the banks had will turn out to be very important for the depositors, or perhaps, the deposit insurer.

Consider another possible scenario. Rapid productivity growth in China results in rapid growth in incomes. The people expand consumption more slowly, perhaps because they can’t believe the good times will last. Some of their saving finds its way into the U.S. banking system. The supply of funds available to the banking system rises. The banks can lower the interest rates they pay on deposits. This increases the banks profits. Competitive banks will expand their balance sheets by lowering the interest rates charged on loans. If the banks don’t retain earnings or sell new shares, capital ratios will fall and leverage will rise.

In the absence of monetary disequilibrium, nominal expenditure is not effected. The Chinese export goods to obtain funds to deposit into the banks. Import competing industries sell less because domestic purchasers, say consumers of toys and underwear, purchase Chinese goods. The lower interest rate on deposits may cause some to remove funds from banks. They could use those funds to purchase financial assets like stocks or bonds. Or they could go out to eat more frequently. The banks, expand loans, and the borrowers purchase homes, cars, or machinery and equipment.

With this additional supply of funds, the banking system is more profitable. The banks should have no problem attracting increased equity investment for their expansion. If they fail to do so, the decrease in capital ratios and increase in leverage does imply an increase in the risk that losses from bad loans or investments will result in insolvency and bankruptcy. Still, it wasn’t increased bank leverage that caused the expansion in the size of banks’ balance sheets.

Does that mean that leverage is irrelevant? Of course not! The relatively safe banking system of the twenties could suffer losses equal to 15 percent of total assets before depositors would take a loss. Government regulators allowing banks to keep 2 percent capital for a portfolio of mortgage backed securities were gambling with the taxpayers money. As long as housing prices kept on rising, mortgage backed securities were perfectly safe. The taxpayers wouldn’t have to make good on deposit insurance promises because the banks wouldn’t fail. If, on the other hand, housing prices fell 30 percent, then the stockholders of banks investing in those securities lose everything, and deposit insurers will be on the hook to cover the depositors’ share of the losses.

Capital ratios and leverage are closely related to bankruptcy. How does default and bankruptcy for financial intermediaries impact the economy? And, more importantly, do capital ratios and bank leverage impact monetary disequilibrium? More later.

Financial problems at Caritas Pension Fund

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The Pension Fund of Caritas and its sister companies, the Cologne Pension Fund, are in financial distress. The health insurance funds, which organize occupational pensions for around 55,000 employees of Caritas and other Catholic institutions throughout Germany, currently do not meet the statutory requirements in terms of capital coverage, according to the Federal Financial Supervisory Authority (BaFin). Even a proposed recovery plan is insufficient, said the BaFin. For the time being, companies were banned from taking on new insured persons and entering into new insurance contracts.

A spokesman for the Cologne-based pension fund said on Wednesday that there was a “balance sheet shortfall” for the 2017 financial statements that was not covered by equity. The liquidity of the fund is by no means at risk. At present, the company is working to meet the BaFin requirements in order to be able to accept new customers. A solution should be presented in January or February. It concerns adjustments of the “contribution and achievement structure”. For the exact amount and the background of the shortfall, the spokesman gave no information. The previous CEO of the two funds, Christof Heinrich, left the company on 1 December.

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According to the most recent published Annual Report of 2016, the two pension funds have around 55,000 policyholders; including about 13,000 people who receive pensions. The total capital of the two companies is reportedly around 900 million euros.

The Caritas Pension Fund dates back to 1952. At that time, various diocesan caritas associations founded a company to organize supplementary occupational pensions. The fund is fully funded and not with a pay-as-you-go system such as the statutory pension insurance. The legal form of the pension fund is a so-called “mutual insurance association”. Thus, all contributors jointly bear the fund, and not about church institutions or Caritas associations.

Jeff Friedman on the Financial Crisis

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Jeff Friedman has a policy report on the Cato Blog about the financial crisis. He correctly emphasizes the role of the “Recourse Rule” promulgated by U.S. regulators in 1982.

The FDIC, the Fed, the Comptroller of the Currency, and the Office of Thrift Supervision issued an amendment to Basel I, the Recourse Rule, that extended the accord’s risk differentiations to asset-backed securities (ABS): bonds backed by credit card debt, or car loans — or mortgages — required a mere 2 percent capital cushion, as long as these bonds were rated AA or AAA or were issued by a government-sponsored enterprise (GSE), such as Fannie or Freddie.With commercial loans requiring 10 percent capital, and ordinary mortgage loans requiring 5 percent, this special 2 percent exception for mortgage backed securities with a AA or AAA rating explains why banks ended up with large quantities of mortgage backed securities.
As for the rest of the world, Basel II adopted the clever U.S. approach of treating mortgage backed securities as nearly risk free, and then formed the basis of banking regulation in the rest of the world as well.By steering banks’ leverage into mortgage-backed securities, Basel I, the Recourse Rule, and Basel II encouraged banks to overinvest in housing at a time when an unprecedented nationwide housing bubble was getting underway, due in part to the Recourse Rule itself — which took effect on January 1, 2002: not coincidentally, just at the start of the housing boom. The Rule created a huge artificial demand for mortgage-backed bonds, each of which required thousands of mortgages as collateral. Commercial banks duly met this demand by lowering their lending standards. When many of the same banks traded their mortgages for mortgage-backed bonds to gain “capital relief,” they thought they were offloading the riskiest mortgages by buying only triple-A-rated slices of the resulting mortgage pools.Of course, since they were rated AA or AAA, they were especially safe. We know this because the three SEC approved ratings agencies, S&P, Moody’s and Fitch, would never underestimate the risk in an entire class of securities. They would never assume that housing prices can never fall. Right?

Cantillon Effects and Public Finance

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Scott Sumner and Nick Rowe have both identified so-called Cantillon effects of money creation with “fiscal policy.”    Years ago, Martin Bailey discussed the basics of the inflation tax in 1956, and Dick Wagner at least partly identified the Austrian-type Cantillon effects with seigniorage revenue in a 1980 article.

I think that this approach is very realistic in the context of today’s monetary regimes.    The typical government runs budget deficits, monopolizes the issue of currency, and appropriates nearly all of the financial benefit from issuing currency.    The rate of inflation impacts how much revenue is generated by the currency, and how that impacts other methods of raising revenue, taxation and borrowing with interest bearding debt, or total government spending or else one type of spending or other, involve public finance.  My favorite thought experiment of newly-created money earmarked to one type of government purchase–tanks–is a bit artificial.

Much Austrian discussion of the matter, for example, Steve Horwitz’s here, is highly abstract.  The new money enters the economy in some specific place–not, the government issues new money and spends it on government programs.

Suppose issue of hand-to-hand currency is monopolized by a central bank, but the central bank is entirely independent of the government.   Further, suppose the conspiracy theorists are right, and under this institutional framework, the profits earned by the central bank are paid out as dividends to the stockholders.   

If  this monopoly were entirely unconstrained, then presumably it could just print up currency and pay it out to the stockholders.   The framing of government as counterfeiter could be applied.   But instead suppose that the central bank is constrained.   Not by some limit on the quantity of currency that it can issue, but rather a requirement that the currency maintain its value.   This could be enforced by gold, silver, or some foreign currency.   However, consider  the scenario where the central bank is required to keep inflation on target.
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With some redeemability contract, it is clear that the currency issued by the central bank is a form of debt.   The central bank can issue all it wants, but it must stand ready to pay it off on demand.   The monopoly privilege of the central bank is to be able to borrow at a zero nominal interest rate.   It actually makes money from this by lending at a positive interest rate.   (At the zero nominal bound, there is no benefit from issuing the currency.)

In my view, the inflation constraint is really no different than the redeemability constraint.   If the inflation constraint can be enforced, say by shifting the franchise for issuing currency to another bank, then the central bank is benefiting from borrowing at a zero nominal interest rate and lending at positive interest rates.

Based on the Fischer relationship, the real interest rate at which the central bank can borrow by issuing currency is the negative of the inflation rate.   It lends, let us suppose, at the real interest rate.   It’s profit margin is then the real interest rate plus the inflation rate.   Of course, the same analysis can be made in nominal terms.   It borrows at zero and lends at the nominal interest rate, and so its profit margin is the real interest rate plus the inflation rate, the nominal interest rate.   Since the real demand to hold currency is negatively related to the nominal interest rate, it would be simple to calculate the profit maximizing inflation rate.  However, there is no reason why the inflation rate imposed on the central bank as a constraint would maximize its profit.   An inflation rate of 2%, 0%, or even some mild deflation that greatly limits the profit from issuing currency would be possible.

The point of outlining this alternative monetary regime is to point out that monetary policy would have no connection with public finance.    A higher inflation rate would result in more real income for the owners of the central bank.   A lower inflation rate would result in less real income for the owners of the central bank.  

Perhaps those who sell luxury items to people owning stock in the central bank would benefit as well.   But this has nothing to do with public finance.

I would also note, however, that the stockholders of the central bank are not getting the new money first, and they profit from the inflationary policy even though prices mostly like rise before they spend their dividend payments.   Borrowing at a zero nominal interest rate is beneficial even if prices remain at their equilibrium values–even if there is no excess supply of money.

Austrian Business Cycle Theory 3: Public Finance

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Many years ago, I read a paper by Richard Wagner that applied public finance principles to the Austrian Business Cycle theory. While there are many ideas in the paper, the key idea I took from the paper is that of course inflation impacts the allocation of resources. Why would a government run an inflationary policy if not to shift resources to its supporters?
I will describe an Austrian theory that is at least loosely based upon his argument. This is an equilibrium theory that allows for a sustainable change in the allocation of resources.

Contrary to the traditional exposition of the Austrian theory, I will begin by ignoring interest rates, consumption, and investment. Instead, I will describe malinvestment in the context of the market for tanks.

The economy in question is static. There is no economic growth. The money in the economy is a tangible, hand-to-hand fiat currency. The quantity of this currency has remained constant for some time. The currency is issued by the government, and it makes no commitment regarding its purchasing power or nominal quantity. The demand to hold this money has been unchanging as well. The price level has been stable.

he government determines that national security requires that it build up large force of tanks. Or perhaps a tank salesman has friends in high places. Further, imposing an explicit tax is politically impossible.

To solve this “problem” the government decides to print new money to to purchase the desired tanks. In other words, the government decides to use an inflation tax to fund government spending.

Suppose the government decides to impose an inflation tax of 10 percent each year. The government increases the quantity of money by 10 percent each year. In equilibrium, the price level rises at an annual rate of 10 percent.

This is called an inflation tax because it makes holding real money balances costly. The cost is the decrease in the purchasing power of money held . That is, of course, the same thing as the rate of increase in the price level. The cost of holding money balances is now 10 percent per year. (It is conventional to add to this the real interest rate to get the opportunity cost of holding money relative to financial assets.)

Because holding money balances is more expensive, the demand for real money balances will fall. This involves a shift to a higher price level. The new, lower level of real balances that people choose to hold forms the base of the inflation tax. The rate is 10 percent by assumption. The real revenue generated by the tax is found by multiplying the base times the rate. Again, this revenue is earmarked to the purchase of tanks.

While it is unlikely the economy will adjust immediately into this new equilibrium, for now, suppose that it does. Prices, including wages, instantly begin rising 10 percent a year. Nominal incomes begin rising 10% per year. The nominal quantity of money is rising 10 percent. The amount of real money balances that people hold remain constant. Real output remains constant. However, the allocation of resources has changed. More tanks are produced. More resources are devoted to the production of tanks. Fewer resources are devoted to the production of other goods and services.

How is this possible? How does the tank industry capture additional resources from the rest of the economy?
The answer is simple. The inflation tax must be paid. In order to keep real balances unchanged, nominal money balances must be increased at the rate of inflation. This requires that nominal expenditures be less than nominal income. If all of nominal income were spent, nominal balances would be unchanged. With the rising price level, real balances would be falling.
For example, suppose Smith earned $50,000 per year and spent $50,000 on consumer goods and services and various securities. Smith held real money balances of $2,500. Suppose that prices and nominal incomes both rise 10%. Smith now earns $55,000. If Smith spends $55,000 on consumer goods and services and various securities, then Smith’s nominal money holdings remain $2,500. Unfortunately, that purchases 10 percent less. To maintain the same command over goods and services, Smith needs $2,750 — 10 percent more dollars. In order to obtain that, Smith must reduce nominal expenditures spending to $54,750.

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Dividing through by the price level, these relationships imply that real expenditure must be less than real income. Goods and services are produced and incomes are earned, but households and firms in the private sector purchase fewer goods and services than they produce.

How is this consistent with equilibrium? The government’s nominal and real expenditure on tanks closes the gap.
The decrease in real expenditures on various private goods and services reduces their demands. This frees up resources in order to produce the additional tanks. The government purchase of tanks creates a derived demand for the resources needed to produce the tanks.

If the economy really did immediately jump to the new equilibrium composition of demands, real expenditures on private goods and services would drop at the same time the real expenditures on tanks rises. This change in the composition of demand would result in structural unemployment. It will take time for workers to be absorbed in tank production from the other goods that are being sacrificed. Since the structurally unemployed workers aren’t producing anything (other than leisure,) aggregate output is depressed until the workers are absorbed into tank production.

What about capital goods? Since capital goods are heterogeneous, the capital goods that had been built to produce the various private goods and services that are being sacrificed might be useless in producing tanks. Others might be helpful in producing tanks to some degree, but much less appropriate to tank production than for their previous employments.
Because the productive capacity of the economy depends on the particular goods being produced, the shift from private goods and services to tanks will result in temporarily lower aggregate output. That is, in the short run, the additional tanks that can be obtained will be less than what will finally be obtained once appropriate capital goods are constructed.

After there has been a complete adjustment to the new composition of demand, unemployment and output return to their previous level. The government is getting tanks. Those using money bear the cost of inflation. The price level is rising 10 percent a year. There is no economic reason why this situation cannot be permanent.

The situation is little different from any other tax. Suppose that the tanks were funded by an income tax. Real income and output will be depressed a bit and leisure increased. The lower level of output and income is the tax base. Revenue is found by multiplying the rate times the base. After tax income is found by subtracting the revenue from income. Because of lower-after tax incomes, nominal and real expenditure on private goods and services is lower than nominal and real income. The government closes that gap by spending on the tanks. The lower demand for private goods and services and higher demand for tanks requires a reallocation of resources. Structural unemployment and the need to produce capital goods appropriate to tank production implies lower output and employment during the transition. While the lower level of output would presumably lower money demand and slightly raise the price level, there would be no persistent inflation in this scenario.

Returning the the inflation tax, suppose the taxpayers determine that whatever increase in national security the tanks provide is simply not worth the cost. Further, suppose they can influence politicians so that the inflation stops and tanks are no longer purchased.

The demand for tanks falls (to zero.) There will be layoffs in the tank producing industry. However, the inflation tax now disappears. Since holding money balances is now less costly, the demand for real balances expand. This requires a slightly lower price level. After that adjustment, the price level is stable.

No longer do household and firms need to constantly build their nominal money balances to maintain their real money balances. Prices are stable. Constant nominal money balances provide for constant real money balances. Nominal and real expenditures can now be increased to match nominal and real incomes. Whatever it is that households and firms choose to purchase with that part of real income no longer needed to pay the inflation tax enjoy increased demand.

Assuming the economy had fully adjusted to the previous composition of demand, structural unemployment will be associated with the shift in the allocation of resources. With heterogeneous capital goods, there may be a total loss in equipment suitable only to the production of tanks and partial loses with capital that is only slightly appropriate to whatever private goods and services households prefer. The result will be a temporary reduction in output and employment. Fortunately, as labor shifts and appropriate capital goods are constructed, real output should recover.

Notice that this equilibrium approach to the Austrian theory is symmetrical. There is structural unemployment in both the “boom,” and in the “bust.” Both the implementation of the inflation tax/government expenditure scheme, and its repeal, result in structural unemployment, losses for specific capital goods, and a transition period where output is depressed.
Suppose that political story is slightly different. The politicians implement a very low inflation tax. They purchase only a few tanks. Finding that low inflation tax creates little political opposition, they try a slightly higher tax and purchase more tanks. The tank industry is gradually expanding. As resources shift from various private goods and services towards tanks over the years, the somewhat higher structural unemployment and lower level of output becomes the new normal.

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Once inflation reaches 10 percent, the people rebel. They begin listening to those who claim that inflation is everywhere and always a monetary phenomenon. They begin to doubt the stories of the politicians that prices are rising due to growing greed in the private sector. Or perhaps they no longer value the tanks.

The politicians suddenly decide that inflation is politically unacceptable. They stop at once. The tank industry, after years of slow growth has grown quite large. Suddenly, it drops to zero. Since the inflation tax has dropped to zero as well, there is a substantial increase in the real demands for various private goods and services. Still, this sudden large change in the composition of real demand involves a substantial increase in structural unemployment. Combined with the complete or partial losses associated with capital goods more or less specific to the tank industry and the gradual build up of capital goods more appropriate to the production of private goods and services, the transitional decrease in output and employment looks sudden and large.

If the analysis is shifted from a static to a growing economy, there are many complications that must be added. The demand for real money balances is presumably growing. The government can issue money without there being price inflation. But rather than deal with all of those complications here, consider just the following change in the analysis. Suppose that the gradual build up in the inflation tax never required any reduction in the production of private goods and services or in the employment of labor in those sectors. Instead, real and nominal expenditures on private goods and services simply grew more slowly and employment in those areas grew more slowly. Some new entrants into the labor force began to produce tanks. Some of the new capital goods being produced were devoted to tanks. During the entire period of growing inflation, the rest of the economy is expanding, more people are hired, and more capital goods are produced. The composition of final demand and output, and of composition of the capital stock and the allocation of labor between sectors are all changing over time, but it is sufficiently gradual that there is never any absolute decrease in the demand or production of the private goods and services being sacrificed to pay the tax.

And now, suppose the voters demand an end of inflation, and the tank industry suddenly collapses. While the gradual build up of the tank industry and the gradually rising inflation tax simply implied that employment, investment and production in the private sector grew less than they would have, the shut down of the tank industry requires that workers find new jobs. Rather than simply not building fewer or no capital good specific to the tank industry, existing capital goods specific to tank production become worthless.

In other words, there is no symmetry in adjustment costs if the time taken for the adjustment isn’t symmetrical. Consider the opposite scenario. Suppose their was a crash program to build up a tank force funded by inflation. And then, the inflation tax was gradually reduced. The workforce in the tank industry shrinks by attrition. Tank specific capital goods are not replaced. As resources are freed up to produce private goods, the inflation rate is lowered, and the private expenditures can expand because their is less build up nominal balances to maintain real balances. In that situation, there could be large reductions in the real demand for private goods and services and structural unemployment and losses in capital goods specific to those industries during the buildup. On the other hand, the gradual end of the inflation tax, there could be little obvious disruption in the transition. (Of course, the taxpayers give up private goods and services to get additional tanks.)

The Austrian theory has not been about tanks. While the most abstract approaches, about money entering the economy at one place and impacting relative prices and so output, is consistent with the story about tanks, generally, the Austrian theory has focused on interest rates, saving and investment.

Suppose that rather than using the revenue created from the inflation tax to purchase tanks, the government provides a subsidy for the provision of loans. Think of it as a subsidy for production and sale. The private sector generates a loanable fund market with the interest rate being the price of those loans. Lenders receive a payment from the government equal to some fraction of the interest rate. As usual with such a subsidy, the lenders are willing to supply more loans. The equilibrium interest rate paid by the borrowers is lower. While the amount lenders receive from borrowers is less, the equilibrium net interest rate the lenders receive is higher–what is paid by the borrowers plus the subsidy. The equilibrium quantity of loans is higher.

To the degree that an inflation tax on real money balances generates a revenue that is used to subsidize the provision of loans, a persistent shift in the allocation of resources is possible. Such a tax and subsidy scheme can be permanently sustainable. If it is instituted only gradually, then the transitional disruption caused by the change in the allocation of resources could be small, and more or less nonexistent in the context of a growing economy. If, however, the inflation tax became politically unacceptable, and it suddenly dropped, then the readjustment as interest sensitive industries sharply contracted could be wrenching.

Finally, can the revenue from an inflation tax be shifted to borrowers, not by providing lenders with a subsidy for the loans made, but rather by simply lending the funds created by the central bank out in competition with other lenders? I believe that the answer is yes, and that this equilibrium process has been often mixed in with the disequilibrium process described in my previous post.

In my view, the disequilibrium process–an excess supply of money generating an increase in the real supply of credit–is likely too ephemeral to generate any significant malinvestment. On the other hand, the equilibrium process by which an inflation tax on real money balances is used to subsidize lending, can be persistent. And if it is gradually introduced, and then suddenly removed, the result can be the sudden appearance of significant structural unemployment and what it hindsight appear to be inappropriate capital goods.

The problem with the equilibrium process is that the base of the inflation tax is the monetary base. Before the current crises, the monetary base was approximately $800 billion. The inflation “tax” was perhaps 5 percent. (The price inflation rate was 2 percent and the demand for real balances was growing about 3 percent.) That generates a $40 billion revenue. Nominal income is currently $14 trillion. Gross investment is about $1.6 trillion. While a $40 billion tax and subsidy scheme almost certainly impacts relative prices, the composition of output, and the allocation of labor and other resources, even reducing this “tax” all the way to zero would seem unlikely to generate significant adjustment costs

In my judgment, both the disequilibrium and equilibrium processes are unlikely to generate significant malinvestment. I am not saying that there would be no malinvestment. In my judgement, liquidation of malinvestments generated by monetary policy do not significantly contribute to the decrease in production and increase in unemployment in recessions.

It is my view that too many single family homes were produced in the U.S. during the naughties. I think the structural unemployment and the need to construct appropriate capital goods to replace some that were specific to housing construction is a significant source of unemployment and may have absolutely reduced the productive capacity of the economy. But I don’t believe that persistent excess supplies of money in the early naughties are a plausible source of the problem. And there certainly has not been an intentional decrease in the inflation tax.

Public finances: Safely on the table

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The High Council of Public Finance has made its copy for the five-year period. It includes a commitment to return the public deficit to 2.9% in 2014. This objective more proactive than realistic, will impose additional savings to the Social Security of the order of 15 billion euros.

Economic growth is not at the rendezvous. The recovery of Social Security accounts may not be either. Despite the clear reversal in terms of medical expenses for 2012, which are growing at a slower pace than the one initially adopted for the ONDAM (900 million less than the target set in the financing law for 2012) , the deficit of the Sécu should remain the rule this year again, digging a little more that of public finances. “Despite the acceleration of reimbursements for city care over the first two months of 2013, which can be largely attributed to the influenza epidemic, health insurance spending should again be able to be achieved in 2013 significantly below the target of 175.4 billion euros, “notes the mid-April Alert Committee on the evolution of health insurance expenses. This relative good news should not, however, be of a nature to compensate for the losses of revenue due to the lack of social contributions linked to a rise in unemployment which is far from giving way. For its part, the High Council of Public Finance has just made its copy relating to the macroeconomic forecasts associated with the draft stability program for the years 2013 to 2017. It recalls the growth forecasts adopted for France in 2013 (0.1% ) and 2014 (1.2%), estimating that this last forecast is based on hypotheses that could be quickly challenged by a number of uncertainties. It states that “in a context where unemployment remains at a high level, the forecasts concerning the evolution of wages and, consequently, of the wage bill, appear optimistic”. “A slight decline in GDP in 2013 and growth significantly below 1.2% in 2014 can not be excluded,” adds the HCFP.
In order to meet the objectives it has set, the government promises a structural recovery effort of 1 percentage point of GDP in 2014, ie 20 billion euros, which will bring to 70% cuts in public spending and 30% on increases in compulsory contributions (mainly by reductions in tax and social niches). The additional savings will therefore reach 14 billion euros on public spending: 7.5 billion savings requested from the state, 1.5 billion to the communities and 5 billion to Social Security (1 billion on supplementary pensions, $ 1 billion on the family and $ 3 billion on health expenses). The biggest effort will therefore be on health insurance. The first arbitrations in view of the future law of financing of the Safely will be realized next May. On the front of the economies, the battle promises to be severe.

Kaminskia on Free Banking

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Izabella Kaminska wrote a defense of the Bank of England on her blog at the Financial Times . It was apparently motivated by the new “positive money” proposal to fully separate money from debt and banking along with those who would like to see bitcoins replace fiat currency.   (I am pretty dismissive of both of those groups as well, and might defend central banking against them, despite my free banking sympathies.)

However, she made a passing criticism of free banking:
As an aside, it’s worth pointing out that the Scottish period of free banking that preceded the great inflation — often touted by free-banking enthusiasts as an excellent example of how the free-banking model is inherently stable — revealed how cartels and monopolies could be used to stabilise the currency. In fact, it was only because the Scottish banks were so good at forging oligopolistic cartels that happily restricted competition that the Scottish free-banking period proved so stable in the first place (defeating the pro free-banking argument altogether). The link is to a blog called   “SOCIAL DEMOCRACY FOR THE 21ST CENTURY: A POST KEYNESIAN PERSPECTIVE,” which is not a title that generates much credibility with me.   Worse, when you try to find out the author of the blog, there is nothing.
However, the linked post at least cites Goodhart (1987,) which seriously critiqued free banking on a theoretical level.   Most of the rest of the post was pretty weak   The various episodes described as “free banking” were shown to have included at least some some government regulation of banking.   
George Selgin responded to Kaminska in the comments, and I thought he was much too harsh.    I admit that this is the frying pan calling the kettle black and that I am suggesting that Seglin do as  I say and not as I do, but at first pass, playing the role of the patient professor might have been a better place to start.

Still, I agree with Selgin that Kaminska’s version of 19th century British monetary history was more than a bit skewed.    She certainly seemed to suggest that Peel’s Act was a necessary corrective to inflation caused by the uncontrolled issue of paper currency by “country” banks in England.   Of course, it also spelled the end of the Scottish system of private note issue as well.   But really?  Does anyone think that Peel’s Act was necessary or even sensible?   100% marginal reserve requirements for hand-to-hand currency?  Why?

Kaminska appeared to have replied to Selgin on her blog–Dizzynomics.    She didn’t refer to him by name, and if Selgin’s comment on her original article was too harsh, her reply was absurd   Free banking advocates (Selgin?) seem to be “reason and logic deniers.”    Apparently, the key element of reason and logic they deny is:

But the main issue I have with them is that they appear to have no understanding or appreciation of the cyclicality of systems or the fact that whenever we’ve had free-banking systems they’ve resulted in chaos or alternatively co-beneficial collusion to the point the system is not free by the standard definition of free.
I don’t think the “cyclicality of systems,” is a principle of reason or logic.   The claim about “chaos” is hyperbole at best.

Kaminska writes on in a way that suggests that “free banking” means the monetary institutions of anarcho-capitalism.   Since many of the leading lights of “free banking” lean in that direction, and even more so those they have influenced, I can imagine that one can find people who will argue that all potential bank misbehavior can be handled by private arbitration.   While that may or may not be true, what I count as “free banking” hardly  requires that the banking industry be singled out for fully-privatized law enforcement.

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Perhaps more interesting is her claim that more-or-less successful free banking systems are not truly “free” but rather instances of collusive oligopoly.

Unlike many, if not most, free bankers, I see free banking as a series of reforms rather than conceiving of a banking system without any government intervention.

One key reform, and one that superficially seems radical, is the private issue of redeemable hand-to-hand currency.   In my view, redeemability is pretty much all that is necessary to keep a competitive banking system in line.   By that I mean,each bank’s market share in the issue of currency will reflect the preferences of those using the currency and the total amount of currency issued will reflect the preferences of the public to use currency relative to deposits.

Now, this constraint works though a clearing system.   And while there have been private clearinghouses that have handled the task quite well, this particular reform is consistent with having a central bank handle the clearing system–like the Federal Reserve.   The way I see it, whether or not it is desirable to privatize the clearing system or leave it in the hands of a government-run “bank” is a separate question from whether or not redeemable privately-issued hand-to-hand currency creates special problems.

A second reform, which I had thought was no longer controversial, is branch versus unit banking.   In the U.S., there were many regulations aimed at protecting unit banks.   These would be single office banks.   To bring it back to Kaminska’s history, some of the regulations of the “country banks” in 19th century England were aimed at keeping them small.   One strength of some of the “free banking” systems, including both Scotland and Canada, was widespread branching.

The key reason why branch banking is superior to unit banking is geographical diversification.   To the degree that a unit bank receives deposits locally and makes local loans, when the local economy is troubled, the bank will have trouble collecting on loans exactly when its depositors are in need of their funds.   In the U.S., a key rationale for deposit insurance was to overcome this weakness.

However, the branch banking system does make private currency more feasible.   While thousands of unit banks might each issue private currency, and the currencies might each do just fine in their local community, the experience of the U.S. “free banking” era suggests that that they were less than suitable for a national currency.

But really, unit banking was not all that suitable for promoting a payments system by check either.   And so a system of banks,each with extensive branching, not only provides geographical diversification, it also allows both privately-issued hand-to-hand currency and checkable deposits to form a national payments system.

Now, is a nationally branched system an “oligopoly?”    In fact, the unit banking system was more about protecting local monopoly than creating competition by having a large number of banks.   In practice,a system made up of a smaller number of banks, able to open and close branches in various localities, has proven more competitive than a system of many small banks each tied to a particular locality.

Would a U.S. banking structure of 20 large banks all with branches nearly everywhere be “oligopolistic?”   Well, I suppose it doesn’t meet the neo-classical definition of perfect competition.   But that is hardly a reasonable standard for real world competition.

There are more reforms that are associated with free banking.   Some are no-brainers like ending reserve requirements or allowing free entry.   Others are much more challenging, like ending deposit insurance and capital requirements.  But rather than treat them separately, I will focus on what I consider the point where the “oligopoly” and “collusion” charge is most likely to stick, and that is the clearinghouse.

This points to Goodhart’s criticism of free banking.   Consider a clearinghouse organized as a private club. (Say each bank owning stock in the clearinghouse in proportion to capital?)    For the payments system to work well for the nonbanking public, each bank needs to accept banknotes and checks drawn on other banks at par, depositing them at the clearinghouse, cancelling offsetting claims, and settling up net clearing balances.

To start with, by accepting each other’s items for deposit at par, the members of the clearinghouse serve as creditors to each other.   Goodhart, following Timberlake’s study of U.S. practice in the 19th century, argues that the clearinghouse serves as lender of last resort.  This expands the club’s role as creditor. It is important that the clearinghouse have information about its members in order to determine if they are good credit risks, but since the member banks are all competing with one another, they will not want to share that information.   QED, the Bank of England should exist.

Since Goodhart’s argument was closely tied to arguments about banks being subject to runs, I didn’t find it convincing    The solution to runs is an option clause.   They were banned long ago, because governments understood that it served as an alternative to holding reserves.   Encouraging banks to hold (gold) reserves was a key policy goal at the time.

Still, limiting membership to the clearinghouse would be an obvious mechanism to provide for a barrier to entry.   That each member is a creditor to the others provides a plausible rationale.   Perhaps membership could be limited to “sound” banks as proved by their unwillingness to pay more than a “fair”  interest rate on deposits or charge less than a “fair” interest rate on loans?

All this shows is that in a world without anti-trust, a clearinghouse association could be an avenue for collusion.  But we live in a world with anti-trust, so abuse of clearinghouse rules to organize and enforce a bank cartel would be illegal.   Unless, of course, free banking is taken to mean that the banking industry must be singled out for an exemption to anti-trust law.

However, I do think there is something very special about the clearinghouse.   It is what turns a variety of financial instruments into a medium of exchange.   Of course, it isn’t exactly homogeneous, but retailers typically accept payments by check or electronic equivalent and deposit the funds in their own banks.   Banknotes, privately-issued hand-to-hand currency, can smoothly fit into the system.

The clearing system is very effective in limiting each bank to a market share determined by the preferences of depositors.   The same should be true of banknotes, even though it has been many years since redeemable banknotes have had much circulation.   The problem is that the aggregate quantity of money of all types is limited to the demand to hold money by some kind of response to macroeconomic disequilibrium.   This response is closely tied to the determination of the nominal anchor for the system.

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Historical free banking systems were small open economies with monetary liabilities tied to gold–an international money.   As repeated by the anonymous Post-Keynesian cited by Kaminska, Goodhart’s point that much of the redeemability by these free banking systems were with credit instruments drawn on a major money center should be no surprise.   What other routine calls for redemption would exist other than a demand for foreign exchange?  And while the quantity of those securities/reserves would not be fixed, neither would the quantity of bars or even gold coins from the point of view of the banking system of a small open economy in a  gold standard world.

What we think of as monetary theory these days would best apply to the entire portion of the world using the gold standard.   The price level depends on the supply and demand for gold.   While gold strikes might be inflationary, the major source of macroeconomic disruption would be shifts in the demand for gold.   It really doesn’t matter if it is due to finance or fashion.   A shortage of gold requires a higher relative price for gold and so a lower price level.   Until prices and wages adjust, real output will be depressed.  Further, it is hard to see how liquidating debts based upon higher expectations of nominal income can be anything but disruptive and painful.   The notion that by having a “free banking system,” some portion of the gold standard world could be insulated from these problems is implausible.

According to the wiki for free banking, cited by the anonymous post-Keynesian, an alternative to a free banking system tied to gold is one tied to a fixed quantity of fiat currency.   Selgin, in his Theory of Free Banking, describes such a scenario.    While I think the market process he describes, where nominal income tends to be stabilized, is instructive, there is something very problematic about a system where the nominal anchor depends entirely upon the demand for an asset solely held by members of  a private club–the clearinghouse.   Changes in the settlement rules at the clearinghouse could have a major impact on macroeconomic conditions.

Greenfield and Yeager’s Black-Fama-Hall payments system was a type of free banking.   The constraint on the banking system was indirect convertibility.   I always argued that indirect convertibility would have its primary impact at the clearinghouse–as a practical matter, no one else would have any reason to do anything other than spend money.  In fact, I have always thought that a rule requiring indirect convertibility at the clearinghouse would be sufficient to constrain the banking system.

Practical considerations eventually convinced most of us thinking about this sort of system that indirect convertibility would need to involve some kind of index futures contract.   While Greenfield and Yeager aimed at stabilizing the price level, and Kevin Dowd has continued to promote free banking tied to that nominal anchor, I think slow steady growth of nominal income (NGDP) is a better approach.    Index futures convertibility provides tremendous flexibility regarding the nominal anchor.

I certainly don’t think that having the nominal anchor determined by a private club of banks is a sensible monetary regime, no more than giving clearinghouses the right to vary the price of gold would have been sensible in a historical free banking system.   And that is where I think free banking theory is today.   What rules should be imposed on the clearing system to keep the total quantity of money created by the banking system consistent with the nominal anchor?

And to bring this back to Kaminska, the anonymous Post-Keynesian, and Goodhart, at some fundamental level, I grant that a desirable free banking order will require a clearinghouse with appropriate rules.   Collusion?   Well, I don’t think that such rules should be anti-competitive, but they certainly involve constraining the banking system–what might broadly be described as regulation.

As for the historical record–I don’t think that the free banking portions of the world were especially chaotic or the source of instability under the gold standard.   And the actual behavior of both the proto and actual central banks of the gold standard era most certainly caused massive macroeconomic disruption.

What are Banks?

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There is a NY Times article about Adnat Admadi’s view on banking regulation.   Her focus is on increasing capital requirements.   Like most free bankers, I see increased capital as desirable.   The article mentions that most firms don’t have capital requirements at all.   Most firms are mostly funded by equity because lenders insist on it.   According to the article, banks are different because depositors are protected by the government from loss.

And that points to why I see increased capital as desirable.   Before deposit insurance, banks did keep much more capital.   At least in the U.S., it was the introduction of  deposit insurance that resulted in substantial decreases in bank capital ratios.

However, even without deposit insurance, banks were mostly funded by deposits.   Why?

It is because banks are financial intermediaries.   They are not simply suppliers of loans.   The deposits that banks issue to fund loans provide services to depositors.   Traditionally, these were monetary services.

Consider a grocery store.   It buys food products from wholesalers and then sells food, mostly to the final consumers.    The grocery store must finance its operation–the store, equipment, inventory, and so on.   The typical grocery story is mostly financed by equity, I suppose.   But there is no notion that the owners of the grocery store must have equity equal to a substantial portion of total sales of groceries.

A bank also has a building and equipment.   But its total assets also include loans and investments.   These are similar to the grocery store’s sales of food.   Further, the deposits the bank uses to fund these assets are more similar to the grocery store’s purchases of food from suppliers rather than the instruments issued toequity and debt holders that finance the grocery store.

While bank-issued currency provided important benefits in the past, and could do so in the future, for many years these monetary services involved checkable deposits.     While checkable deposits have come to make up a remarkably small portion of bank liabilities, at least part of the reason has been the development of sweep accounts.   By sweeping funds out of checkable deposits and into something else right before the time they must be reported, banks not only avoid regulation, but money and banking statistics are distorted.

However, there is little doubt banks have long issued deposit liabilities whose primary special characteristic is that they are guaranteed by the government.   Certificates of deposit have a lot in common with commercial paper, but the bank liabilities are guaranteed by the government.

While additional capital for banks is desirable, the key problem with capital requirements is that the purpose of capital should be to serve as a buffer.   That means that the buffer should be used when banks suffer losses.   And so, when a bank has exceptional difficulties, its ample capital buffer should be allowed to decrease without interfering with the continued business of the bank in both issuing deposits and making new sound loans.  Obviously, a bank should then rebuild its capital as it recovers.

Giving discretion to the regulators is probably worse than a strict rule.   During good times, when banks have few loses, so what if loose definitions of capital allow requirements to be met on paper.   And then, when banks are losing money, that is when the regulators get tough and make sure that banks rebuild their capital.   Just when banks should be using the cushion they should have built up during good times, the regulator starts strict enforcement.

The problem with a required capital ratio is that restricting new loans and using the funds to pay down deposits (or accumulating “safe assets” with low capital requirements,) is not desirable.   Of course, if it is only a single small bank in a healthy banking system that must shrink its balance sheet to meet the requirements, the effect on the economy is small.   This is especially true because other banks would be in a position to expand deposits and loans.   If necessary, they could issue new equity to take advantage of the profits from the added business.  

But what happens if many banks are in difficulty at the same time?   Having all banks shrink their balance sheets at the same time is not a good thing.

Further, as mentioned in the article, there will be a constant tendency for financial innovation aimed at getting around the regulation.    If those quasi-banks suffer runs, the run will be to the well-capitalized “safe” banking sector.   Those banks should be rapidly expanding in such a scenario.   Requiring that such banks raise capital (or even postpone paying dividends) will interfere with such a needed expansion.

For example, during the financial crisis of 2008, investment banks were issuing quasi-deposits to fund quasi-mortgage loans.   They were shadow banks.   When there was a loss in confidence, and the quasi-depositors ceased rolling over their overnight funds, they received payment in their conventional checkable accounts and simply held the funds at conventional banks.   Did the supply of money decrease?  Yes, if overnight repurchase agreements issued by investment banks are counted.   Or was it the demand for money increased?   Yes, if only checkable deposits issued by conventional banks count as money.   Regardless, what needed to happen is for conventional banks to expand their deposits and their lending.   Capital requirements made that more difficult.   (Of course, the fact that the commercial banks were also under diversified by being over invested in real estate loans made the problem doubly difficult.)

In my view, rather than requiring banks to fund their asset portfolio with some fixed ratio of capital relative to deposits, a better approach is to make the monetary liabilities that provide the rationale for banking more like equity.  

First, there should be an option clause that allows banks to stop a run.   Banks need to be able to postpone payment, though the banks should pay penalty interest.   In other words, depositors should be compensated for any postponement with bonus interest.  Further, the suspended deposits should be negotiable.   In particular, other banks should be able to accept them for deposit either at par or at a discount.  

Second, if a bank is insolvent, then each depositor should suffer a write down of their deposit balance with  compensation by equity–with the reorganized bank being well-capitalized.   And this reorganization of banks should be rapid.   Days, not months.

Kevin Dowd once explained it well.   Closing failed banks for months or more makes as much sense as wheeling out hospital patients into the street because the hospital has financial problems.

If banks have government deposit insurance, then these changes can be required as a condition of continuing that insurance.   Of course, the real point is that with these sorts of reforms, banks might be able to operate without deposit insurance.    And if banks have no deposit insurance, then they can maintain their own liquidity and capital policies in order to attract depositors.

Further, as soon as we explore systematic issues, the nature of the monetary regime becomes paramount.   A desirable nominal anchor–such as nominal GDP level targeting would help.   Further, avoiding a monetary base that has no nominal risk and a zero nominal yield is also desirable.

A century ago, the nominal anchor was the fixed price of gold, and gold served as a base money with zero nominal risk and a zero nominal yield.   Those days are gone.   The banking system does not need to be  able to withstand a massive shift from everything else to gold, which would require a massive deflation of nominal output and nominal income.  

Yes, a 30 percent capital ratio might make sense with a gold standard.   Maybe it is wise when hand-to-hand paper currency is the fundamental monetary base and central bankers insist on using a nominal interest rate instrument to target inflation.

In my view, those are the policies that need some radical revision.

Sumner on Currency, Lotteries and Free Banking

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Scott Sumner argued against the notion that because the federal government can print money, it doesn’t need to worry about the cost of providing services.   He argued that while the issue of currency allows the government to collect a small revenue–perhaps 1% of GDP–through seignorge, government spending is much greater than that, so on the margin, changes in government spending require taxes.

In response to a comment, Sumner then amended his argument to recognize that seignorage revenue is not free.   However, he argued that if we compare a scenario with no currency to one with currency, those bearing the cost of holding currency receive benefits greater than that cost.

As an analogy, he describes the introduction of a government lottery.   Those participating in the lottery get to enjoy legal gambling, and the government collects the revenue.   He notes that since private competitive lotteries are clearly possible, a more appropriate baseline shows that funds from a government monopoly lottery are not “free” but rather they come at the expense of those purchasing lottery tickets.

Sumner then considers privatized hand-to-hand currency and repeats his longstanding proposal to have the government contract out the provision of hand-to-hand currency.   He holds that competitive issue would be wasteful, pointing to the practice of banks of giving away toasters to those making deposits as a work-around interest rate ceilings.

First, the seignorage income of the government from the monopoly issue of currency is imposed on those using currency.   With a zero inflation rate and growing currency demand, those wishing to increase real currency balances must increase their nominal currency balances.  They do that by having nominal expenditures less than nominal receipts.   Real consumption plus real saving in forms other than the accumulation of money balances must be less than real income.

With inflation, say at the 2% rate Sumner favors, it is necessary to accumulate nominal balances to maintain real balances.   Again, nominal expenditures must exceed nominal receipts.   And so, real consumption plus real saving must be less than real income.   The inflation tax on real money balances is paid by those seeking to maintain their real money balances.

Evidently, people benefit from holding currency more than this cost.  But the tax on currency balances results in an excess burden like any other tax.   The conventional wisdom is that the proper baseline for comparison is a deflation rate equal to the real rate of interest so that there is no opportunity cost to holding currency.   Little seignorage revenue is possible with a deflation rate equal to the real interest rate.   If the real interest rate is equal to the growth rate of real output and the demand for currency is proportional to real income, then there is exactly no seignorage revenue–a constant nominal quantity of money is optimal.

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Just about all of this analysis is worthless when considering free banking.   Banknotes are debt instruments.    While the nominal interest rate may be zero, a bank that issues them is still borrowing and must stand ready to pay them all back.   There is nothing like seignorage revenue for any bank.

Of course, borrowing at a zero-nominal interest rate is lucrative under normal circumstances.   Banks can fund a portion of their asset portfolios with no interest cost.  The immediate effect then is to enhance the profitability of banks.

However, if banks make more than normal profits, then there will be entry into the industry.  Considering banks as financial intermediaries, the resulting increase supply of banking services will reduce the equilibrium margin between the interest rates banks charge and pay.  Entry continues until profitability returns to normal.   The impact then will be an increase in the interest rates banks pay on deposits and a decrease in the interest rates banks charge on loans.

And so, if the government monopolizes the issue of currency so that it can collect seignorage, then this comes at the expense the customers of banks–you and I.   We earn lower interest on bank deposits and pay higher interest on bank loans.  

Hand-to-hand paper currency was initially issued by private, competing banks.  The government step-by-step monopolized the issue through legal restrictions.    Since this paper currency was initially redeemable in terms of gold, it was either a liability of a private central bank or a type of government debt    By creating a monopoly, the tendency of competition to dissipate the rents made possible from borrowing at a zero nominal interest rate could be shared by the private owners of the central bank and the government   As time passed, those benefits have gone more and more to governments.   With the end of the gold standard, it became possible to think of this monopoly government currency as if it is paper gold–a pure outside money with the amount issued creating a revenue.

But the private alternative remains a competitive banking system.   My own view is that it is entirely possible to pay interest on hand-to-hand currency.   When depositors withdraw currency, they can continue to earn interest until the currency is returned to their bank.   One hundred years ago, the record keeping would have been very burdensome, but it is very feasible today.

Further, to the degree it is desirable to tie price level performance to optimal holdings of  hand-to-hand currency, how much more likely would this occur when it doesn’t involve government giving up a source of “free” revenue and instead involves shifts in how the benefits are distributed among the customers of banks?

Permanent withdrawal of real estate loans threatens to expire in 2016

It could soon be over with the indefinite right to revocation of real estate loans. If it goes to the will of the banks, the Bundestag will decide on a law change, with which the term ends to June 2016. Bank customers who have completed a construction loan between 2002 and 2010 should therefore hurry.

The Federal Government obviously plans a change to the previously eternal deadline for the revocation of real estate loans, which have a faulty cancellation policy. For borrowers, this means that they may only have until mid-June 2016 to implement a possible revocation of their real estate loan. For the banks, the amendment would be very convenient. For them, it is finally about more than a hundred billion euros .

Update 18 February 2016: The Bundestag has ended the “eternal” right of withdrawal for real estate loans. On the grounds of legal certainty, the policy limits existing rights of borrowers. Only until June 20, 2016, consumers can revoke real estate loans, which were completed between 2002 and 2010 and contain a faulty cancellation policy.

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Who can get back money with the revocation of a real estate loan?

Consumers who have made a real estate loan between November 2002 and June 2010 should review a withdrawal. Because in this time, many banks and savings banks have informed borrowers insufficiently about their two-week right of withdrawal . If there is no indication in the loan agreement or if it is inaccurately formulated, revocation is probably possible.

About 80 percent of the loans from this period can be reversed by the previously indefinite revocation . This means that the borrower repays the original loan amount to the bank or savings bank and in return receives all interest and fees paid. Even those who can not afford the loan amount in one go usually benefit from the revocation of the real estate loan. Because at present loans are to be received thanks to the low interest rates on very favorable conditions. Therefore, a revocation is recommended, even if the loan has already been repaid . Even prepayment penalties already paid must be reimbursed by the bank.


When should the new deadline for the revocation of real estate loans end?

As Stiftung Warentest reports, an amendment to the implementation of an EU directive on residential mortgage loans is currently in the works. While a first bill has not yet shaken the unlimited deadline for credit revocation , a new version provides for a cancellation of the right of withdrawal . Accordingly, the law is due to enter into force on 31 March 2016, and three months later, 20 June 2016 is planned as the last possible day for the revocation of the contracts concerned.


What can affected people do now?

If the law is implemented as planned, affected borrowers, who still want to get back money, no longer have much room for maneuver . They must quickly take care of a revocation of their real estate loan and possibly a new financing. Anyone who is unsure whether their own real estate loan falls under the scheme can have the contract checked by a lawyer or a consumer center. There are fees for this. These pay off, however, if a revocation is allowed. After all, savings of up to tens of thousands of euros are possible here . At the same time, it makes sense to look for a suitable follow-up financing by means of a credit comparison calculator. If the residual debt is still very high, it may be advisable to bid for a mortgage by an expert.