The conventional wisdom is that aggregate demand (AD) is best regulated by adjusting interest rates - or at least that interest rates should be one of the main tools used to regulate demand.
I set out numerous criticisms of this policy here. And Prof.R.A.Werner and others set out yet more reasons and evidence here.
The crunch.
Prior to the crunch, people were betting big time on house price increases, and borrowing big time so as to fund those bets.
In a genuine free market, that increased demand for borrowed funds would have caused a significant rise in interest rates. But we don’t have a free market: interest rates are rigged because the conventional wisdom is that central banks know better than the market (ho ho).
And prior to the crunch, demand and inflation were not going thru the roof, so central banks did not raise interest rates to any significant extent.
So what was the result of this “central banks know best” policy? Well borrowing continued unabated because private banks can and will create money out of thin air and lend it out, just as long as they see what looks like good collateral (like rising property prices).
The Werner regime.
In contrast, Werner & Co advocate a regime in which private banks CANNOT create money out of thin air and lend it out, and in which the government / central bank machine DOES NOT use interest rates to control demand. Instead, demand is controlled in a much more obvious, simple and straightforward way: the government / central bank machine (in a recession) just prints new money and spends it. Conversely, if inflation looms, taxes are raised and money is “unprinted”.
Incidentally Modern Monetary Theory also advocates the latter sort of policy. Great minds think alike.
Thus under a “Werner regime”, market forces prior the crunch would have raised interest rates, which would have choked off house price increases. Incidentally the “choking off” would probably have come from a QUANTITATIVE effect as well as a PRICE effect. That is, the sheer unavailability of funds to borrow might have played as big a role as interest rate increases.
Another incidental point here is that my use of the phrase “Werner regime” should not be taken to suggest that Werner himself would agree with everything in this article – though I hope he would.
Contravening Tinbergen.
The false logic behind using interest rates to adjust demand is a beautiful illustration of failure to abide by the Tinbergen principle.
This principle (or at least my interpretation of it) is thus.
1. For each policy objective, one policy instrument, and one only is needed.
2. The policy instrument chosen for each objective should be the one that most effectively influences that objective.
To illustrate, trying to pitch demand at a level that maximises employment without exacerbating inflation too much is an “objective” which no one can object to.
In the case of adjusting demand, there are basically two sources of demand in any economy. First, the public sector (demand for personnel and equipment for the state education system, the police and armed services, etc). And the second basic source of demand is the consumer.
Thus if it looks like demand needs a boost, the logical and simplest course of action is to boost public spending and put more spending power into the hands of the consumer.
AS TO INTEREST RATES, the optimum level of interest is the level at which the marginal benefit from borrowing equals the marginal “dis-benefit” or pain derived from forgoing consumption required to make funds available for borrowing. And there is NO PRIMA FACIE REASON for thinking that the optimum interest rate varies as between a boom and a recession (though there may be minor technical reasons for a small variation). That is, there is no prima facie reason to cut interest rates in a recession.
Tinbergen, car engines and brakes.
When it comes to cars, a valid objective is making the car move. The best policy instrument there is an engine. Another valid objective is slowing the car down in a hurry. The best policy instrument is brakes.
You could of course control a car’s speed by having the engine working constantly at full power while using the brakes to control the car’s speed: not a brilliant use of policy instruments.
Put another way, using interest rates to adjust demand leads to the absurdity spelled out in blue at the top right above.
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There is a great article by the above two in yesterday’s Financial Times. It says (my summary):
1. The crisis was caused by excessive private borrowing not excessive public borrowing,
2. That we need more demand,
3. The idea that deficits are excessive is nonsense,
4. Attacks the confidence fairy,
5. Attacks structural arguments,
6. Says the anti-stimulus arguments being cited nowadays are the same ones that exacerbated the 1930s decade long depression.
In their final paragraph they say, “We therefor urge all economists and others who agree with the broad thrust of this manifesto for economic sense to register their agreement online. OK I’ve done that.
They also insert the reservation that “The best policies will differ between countries….” Quite right. For example sorting out the Eurozone is not as simple as the above five points suggest. But the “broad thrust” of the article is right.
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Summary. John Kay’s paper entitled “Narrow Banking” advocates (unsurprisingly) what he calls “narrow banking”. Like Vickers, he is concerned about the low or non-existent interest that would be earned on 100% safe accounts where the relevant money is invested in 100% safe investments. He therefor advocates investing the money in ways which are about as risky as existing bank accounts. But that gives rise to all the problems that have arisen with banking to date! So what was the point of his paper?
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This Positive Money article claimed that John Kay and Lawrence Kotlikoff’s ideas on bank reform were similar to the ideas in the joint submission to the Vickers commission made by Positive Money, Prof.R.A.Werner and the New Economics Foundation. (I’ll refer to the latter work henceforth as the “submission”).
Kotlikoffs ideas are certainly similar to those in the submission. As to Kay, his ideas might seem to be similar, given that the title of his paper is “Narrow Banking”. However, the small print reveals a different story.
Incidentally I enjoy Kay’s regular articles in the Financial Times, but he definitely had an “off-day” when writing this paper on narrow banking.
In some passages he seems to advocate full-blooded narrow banking. For example he says (p.58), “The most effective way to ensure that public subsidy to failed financial institutions is not required is to insist that retail deposits qualifying for deposit protection should be 100% supported by genuinely safe liquid assets.” Agreed.
That is much the same as a point made by Mervyn King: “…eliminating fractional reserve explicitly recognises that the pretence that risk free deposits can be supported by risky assets is alchemy.”
But Kay also says (p.50), “Narrow banks might (but need not) engage in consumer lending, lend on mortgage, and lend to businesses….” Well hang on – banks that engage in the latter activities are pretty much bog standard banks!!!!
Moreover, allowing narrow banks to engage in similar activities to standard banks just gives rise to the very problems we’ve had with standard banks, and which Kay himself eloquently describes: one of these being the complexity of the regulations needed to control such banks . Indeed, he describes Basle type regulations as “worse than useless” (p.7). And on his page 5 he describes these type of regulations as “massively inadequate”. I second that.
Unsurprisingly, Kay’s own attempts to work out how his so called narrow banks should be regulated runs into exactly the same problem: complexity. He devotes about FIVE PAGES (p.53 onwards) describing such regulation.
Well banks just love complex regulations. It’s precisely the complexity that enables them to nibble away at the regulations bit by bit.
Should narrow banks invest in government securities?
Bot Kay and Vickers think they are caught between a rock and a hard place: they want to make bank accounts (or at least some bank accounts) far safer, but they realise that if this is done by putting depositors’ money into ultra-safe investments, those investments will inevitably yield little interest.
Indeed, depositors might well pay monthly bank charges. That is, they would effectively get a NEGATIVE rate of interest.
As a way out of this dilemma, they advocate that at least depositors’ money can be put into government securities. Well unfortunately even government securities are not 100% safe. Ever heard of Greece? As to more responsible countries, even there the value of government securities rises and falls.
Biting the bullet.
The idea that those who want absolute 100% safety are not entitled to interest is a big political step to take: the peasants might revolt. Thus Vickers perhaps cannot be blamed for not taking that step: i.e. perhaps Vickers cannot be blamed for producing a whitewash report.
Perhaps members of the allegedly “independent” Vickers commission were quietly told that if they didn’t rock the boat they’d all get honours. Or perhaps they were told by City of London worthies that if they advocated getting the banking system more or less “back to business as usual” they’d get lucrative bank directorships.
But John Kay has not such excuses.
Moreover, depositors have been getting approximately nothing by way of interest over the last couple of years because of the low interest rates designed to get us out of the recession, and the peasants HAVE NOT REVOLTED. To that extent, one has to wonder why Kay and Vickers are so concerned about zero interest earning accounts.
Stricter bank regulation does not harm growth.
Another reason that Vickers wanted to channel money from 100% safe accounts into risky investments was that the Vickers commission thought that tying up too much money in non-productive accounts would reduce bank lending, which would reduce economic growth. Presumably Kay thinks the same – thought I can’t actually find a passage in Kay’s paper that says this.
Well clearly any restrictions on bank lending will be deflationary ALL ELSE EQUAL. But all else does not need to be equal. That is, government can easily expand the monetary base to compensate for any deflationary effect coming from stricter bank regulation.
Conclusion.
If we are going to have a rational banking system, we will just have to get depositors used to the idea that little or no interest is earned on 100% safe accounts. And the submission to the Vickers commission by Positive Money, Prof.Werner and the New Economics Foundation was right to advocate this “little or no interest” policy.
Of course the TEMPTATION for politicians is always to promise bread and circuses: i.e. to tell the population they can have their cake and eat it. That is, politicians like to tell voters that interest can be earned on 100% safe accounts, while keeping quiet about the fact that voters as taxpayers pay for this absurdity.
The Basle Committee on Banking Supervision and the UK’s Vickers Commission on Banking have the same aim: to make banks have enough loss absorbing buffers in the form of shareholders and bond holders to ensure that the risks involved in banking are reduced to acceptable levels.
That basic idea is flawed for the following reasons.
But first, please note that it’s the BASIC or TRADITIONAL activity performed by banks that I’ll consider here: taking deposits and lending money deposited on to borrowers. Of course banks do more than that, but the latter, to repeat is the basic activity of banks and it’s the one considered here.
Buffers.
There is always a finite possibility that EVERY LOAN made by a bank goes wrong. Thus to make a bank 100% safe, it must have loss absorbing buffers EQUAL IN VALUE to loans (or equal to deposits). But that would mean a miserable return on capital for shareholders, bond holders and depositors – or a standard return on capital for share and bond holders and zero or worse return for depositors. And that is a nonsense.
So what those designing Basle or Vickers type regulations do is to go for a compromise. That is, they aim to ensure that buffers are large enough to reduce risks to an acceptable level. But that still leaves a finite risk in place: a risk that is carried by taxpayers. In other words, if depositors are to be sure of getting their money back, then banks ABSOLUTELY MUST BE underwritten or subsidised by taxpayers.
Now what do you call an entity that claims to be commercially viable (normally headed by a self-styled swash buckling proponent of capitalism) but which in reality absolutely has to be underwritten by taxpayers? The words “farce”, “nonsense” and “hogwash” spring to mind.
And this taxpayer subsidy is ASTRONOMIC. According to this study by Andrew Haldane of the Bank of England, the value of the TBTF subsidy over recent decades has amounted to more than bank profits!!!! See 3rd paragraph under the heading “Implicit subsidies” here.
I argued above on purely theoretical grounds that the basic banking activity in its present form is fundamentally a farce. It seems from Haldane’s evidence that the numbers backs this up.
What do we get from banks in exchange for the TBTF subsidy and occasional credit crunches?
The cost of the crunch has been ASTRONOMIC: GDP of countries affected is now five to ten percent below trend. We are talking hundreds of billions or trillions.
Now if this astronomic cost is matched by some equally astronomic benefit, then OK. But it’s not.
Basically the only benefit that banks can point to is that the risk they run “improves liquidity”. Or put it another way, banks claim that if regulations are too restrictive, economic growth will be impaired.
Whichever way banks put it, half the economics profession and nine out of ten politicians are fooled. As to the word “liquidity”, that’s an important technical sounding word, so that impresses the gullible. As to threats that economic growth might be impaired, well every politician wants economic growth: it wins votes. So banks only have to mention economic growth, and politicians jump to attention, salute bank CEOs, and give banks a more or less free rein.
So do restraints on bank activity ACTUALLY impair economic growth? Well OF COURSE THEY DO ALL ELSE EQUAL!!! But all else does not have to be equal. That is, given a deflationary effect of tighter bank regulation, the government / central bank machine can easily make good with some stimulus. The result is less bank funded economic activity and more equity funded activity (in the case of industries where it is difficult to cut capital intensivity). As the rest of the economy, the result is more activity based on plain simple old consumer demand, rather than based on bank loans.
Thus the central argument put by banks against tighter regulation is HOGWASH.
As this Financial Times front page lead story pointed out, banks use any old fraudulent or dishonest argument to water down bank regulations.
Conclusion: banking in its present form is a farce.
Banks don’t need to be 100% safe?
Banks could point out that having the value of buffers equal to the value of a bank’s loans is an unnecessarily high level of safety, and involves large amounts of share and bond holder capital lying idle in exchange for a very small improvement in safety (as compared to the size of buffers and levels of safety contemplated by Basle and Vickers).
Put another way, cutting the size of buffers from say 100% of the value of loans to say 50% involves a big increase in lending in exchange for very little increased risk. And that additional lending brings a large economic boost or stimulus.
True, but banks would not be doing anything there that cannot be done at zero cost and no additional bank riskiness whatever by the government / central bank machine. That is, “economic boost” or “stimulus” can be implemented by any monetarily sovereign government anytime and at no real cost and no additional risk of banks going under.
When it comes to the question as to which is the best of the above two options, there is no contest.
An arcane point – skip if you like.
However the fact that X is a better option than Y does not mean X is the BEST POSSIBLE option. Indeed, there is still a defect in a banking system that involved buffers equal to the value of bank loans (the “X” option, so to speak). And it’s not the above point about share and bond holders’ money lying idle: money is just numbers in computers. The real defect is thus.
Depositing money in a bank knowing full well that the bank will loan that money on to businesses or for mortgages, etc is a COMMERCIAL TRANSACTION. Now if buffers are equal in value to loans, there is nothing left for depositors, as pointed out above. I.e. the latter “commercial transaction” brings a zero or worse return – which makes a mockery of the allegedly commercial nature of the transaction.
Alternatively, if buffers are much smaller, the taxpayer inevitably carries the risk. But a transaction where the taxpayer carries the risk is not a commercial transaction.
This all smells of “check mate” or “false logic”. The way out of this is set out a few paragraphs hence under the heading “A simple rule”.
Glass-Steagall.
Glass-Steagall is widely seen as a cure for banking problems. Unfortunately it is not. It DOES prevent banks making INVESTMENTS which are taxpayer backed. But it does not stop them making taxpayer backed loans that are less than 100% safe. So Glass-Steagall does not solve the basic problem dealt with here.
The complexity of Glass-Steagall, Basle, Vickers, etc.
The next flaw in regulation of the Glass-Steagall / Basle / Vickers type is its complexity.
As Martin Jacomb (Chancellor of the University of Buckingham) put it in an article about Vickers in the Financial Times, “The ring-fencing proposal involves much detailed regulation.” Or to put it more bluntly, Vickers means plenty of lucrative work for lawyers.
A second problem with complexity is that it makes it easy for banks to nibble away at the regulations a bit at a time, AND THEY SUCCEED. It is a HISTORICAL FACT that Spanish banks between around 2000 and 2005 managed to get regulations watered down. Now the disastrous results are plain for all to see.
And as distinct from “nibbling”, sometimes banks manage to have large chunks of regulation removed: Glass –Steagall.
And a THIRD result of the complexity is the authorities are quite clearly incapable of distinguishing between safe and unsafe banks. See for example here and the above article on Spanish banks. See also p.5 onwards of John Kay's paper "Narrow Banking".
IN CONTRAST, if we had relatively few and simple regulations, the merits of which everyone, especially politicians, can be made to understand, banks would have much less chance of acting as parasites on the community as a whole.
Well there is a beautifully simple rule or set of rules! Read on.
A simple rule.
Depositing money in a bank, knowing full well that the bank will loan your money on and get you a better rate of interest than if the money was not loaned on is a COMMERCIAL TRANSACTION, as mentioned above. And it is not the job of taxpayers to subsidise commerce.
Ergo, there is no justification for any taxpayer backing for the latter activity.
In contrast, there are two VERY GOOD arguments for everyone having access to a 100% safe account, if that’s what they want or need. First, it can well be argued that access to a 100% safe account is a fundamental human right. Second, there are numerous firms or other entities which would be breaking the law if they took any sort of risk with various sums of money. For example, lawyers handling clients’ money have no right to take a risk with that money, absent permission from clients.
There is thus a very simple rule that can replace Glass-Steagall, Basle, Vickers, etc., and it is this.
Depositors have to choose between, first, safe accounts, money in which IS NOT INVESTED OR LOANED ON, and which thus earn little or no interest. Second, depositors can go for what might be called “investment” accounts. Here, money IS LOANED ON, or invested. But that is a COMMERCIAL transaction, and like all commercial transactions, it offers potential rewards and potential losses. That is, the money is doing something, so a significant rate of interest is earned, but if the bank goes belly up, the taxpayer does not come to the rescue.
Laurence Kotlikoff.
The latter system is pretty much the one advocated by Laurence Kotlikoff (once described as Mervyn King’s “guru”).
Kotlikoff, in Ch 5 of his book “Jimmy Steward is Dead” suggests that all money deposited in banks should be put into mutual funds (“unit trusts” in the U.K.). Depositors would be able to choose funds of varying degrees of risk, with the least risky being what he calls “cash mutual funds”. He says “These cash mutual funds would thus represent the demand deposits (checking accounts)…”
He goes on: “In requiring that cash mutual funds hold just cash, limited purpose banking effectively provides for 100 percent reserve requirements on checking accounts.”
And the latter idea in turn amounts to much the same thing as the system advocated in the first few pages of this submission to the U.K.’s Vickers Commission.
Irving Fisher also advocated 100% reserve on checking accounts.
So there is plenty of brain power behind the idea!!!!!
I’ve been a fan of Samuel Brittan for decades, and agree with the thrust of his article in today’s Financial Times. But I don’t agree with his claim that governments should expand deficits “up to the point where the gains to output and employment are offset by the inflationary effects of a fall in the exchange rate”. That should read “up to the point where the gains to output and employment are offset by inflation.” Reasons are thus.
First, it’s a good general principle that what goes for closed economies goes for open economies, only the arguments are a bit more complicated. And in the case of a closed economy it is clearly true to say “up to the point where the gains to output and employment are offset by inflation.” Reason is that exchange rate considerations just don’t come into the picture.
Second, inflation is defined as a CONTINUOUS and excessively fast rise in prices. In contrast, the “price rise” effect of an exchange rate adjustment is not continuous: it’s a once and for all adjustment.
Third, even if we ignore point No. 2 just above and assume that exchange rate adjustments DO HAVE a genuinely inflationary effect, the only limit to the size of the deficit is inflation, period. That’s “total” inflation, or “overall” inflation. Put another way, it’s the “total amount of inflation including any inflationary effects of exchange rate adjustment” that matters. I.e. the CONTRIBUTION to inflation coming from exchange rate adjustment is a complete irrelevance: it might account of 90% of inflation or it might be 10%. Who cares? The only important consideration is TOTAL inflation.
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Martin Wolf was a member of this commission, and he claims, writing in the Financial Times, “…the Independent Commission on Banking made two principal recommendations relating to financial stability: the ringfencing of domestic retail banking from other banking activities…..”.
Er, not quite. The 2nd last paragraph of p. 11 of the ICB final report says, “…lending to large companies outside the financial sector – should be permitted (but not required) within the ring-fence.” And the left hand column of p.54 repeats the point.
“Large companies” (never mind small companies) don’t sound to me like “retail”.
Moreover, half the idea of the ICB was to try to separate high street operations from investment banking. But where do you draw the line between a loan to a business and an investment in the business? If the terms of the loan make the creditor near the last in line for reimbursement in the event of the business failing, the loan becomes very near to being a shareholding.
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