Category Archives: Banking

Credit Injection, Empirically

I haven’t been too involved with the debate on Cantillon effects, largely because I’ve been busy with other things. But, I’d like to make a quick comment on a recent post by Nick Rowe (H/T Robert Murphy) on the topic, just to clarify what Hayek and other Austrians actually have in mind. Near the beginning, Rowe writes,

Hayek assumed that newly-printed money is injected via the credit market, where it pushes down the market rate of interest relative to the natural rate of interest, and this causes people’s plans and expectations to be mutually inconsistent, and this causes an unsustainable change in the time-structure of production.

But Hayek’s assumption is obviously usually wrong.

My first reaction was, “No, Rowe is obviously wrong.” My second reaction was, “In part he’s right, but there’s something about this argument that is ignoring key aspects of the Mises–Hayek theory.” Because I haven’t been involved with the debate, it’s difficult for me to frame this within the context of said debate, but I think excessive focus on the Federal Reserve (which could be the fault of any [or both] side[s]) is drawing attention away from what makes Hayek’s assumption “obviously usually right.”

When the Fed injects money, Rowe is right that it can do so through various avenues. It can buy U.S. Treasuries through open market operations, both from banks holding these assets or from the government proper (less likely?), or it can control base money through short-term interest rates, et cetera. But, the Fed, in the role of credit expansion specifically, is really a “minor player,” in that most of the credit expansion comes as a result of private bank lending — this being said, the Fed is a “major player” in that it shapes the banking industry and decides the extent of credit expansion (i.e. if Selgin’s banking model in the Theory of Free Banking is correct, credit would be much more restricted in a competitive banking system). Hayek, in “Monetary Theory and the Trade Cycle” (e.g. p. 77 [in the Mises Institute’s hardback edition of Prices and Production and Other Works]), explicitly recognizes the role of private banks (the “existing credit organization”) in perpetuating credit expansion.

So, when Hayek is talking about the “inconsistency of plans and expectations,” in the context of the business cycle, the credit injections specific to Fed action are quite limited relative to the participation of private market financial firms. Although Rowe told me he doesn’t get Hayek’s theory, the last few paragraphs of his post say otherwise — what matters is the effect of base money on the extent of private market credit expansion.

To make my point clearer, let’s reformulate my argument to directly respond to the following claim by Rowe,

If Austrian economists are right to insist that it really really matters where the new money is injected into the economy, then Hayek was making a very special assumption, one that is nearly always empirically false, and false in a way that matters a lot, and so Hayek’s analysis is mostly irrelevant.

What Rowe may not realize is that the “special assumption” is actually his: the Fed is not the only organization/firm that injects new money into the economy. Banks also create money through loan over-extension, or credit expansion, “in a way that matters a lot,” making Hayek’s analysis mostly relevant. If you want some empirical evidence,

Bank Credit of All Commercial Banks (TOTBKCR)


Treasuries and the GSEs

Don Boudreaux links to Garrett Jones’ review of Mark Zandi’s new book Paying the Price, and excerpts it at length. In the Cafe Hayek post, the second to last paragraph of the excerpted material deals with how Jones believes the GSEs, namely Fannie Mae and Freddie Mac, were involved and, at least partially, responsible for the financial crisis. I’ve already summarized the case for why these public-private firms are really a minor facet of the crisis.

That discussion has certain parallels to Robert Murphy’s comment on David Beckworth’s point about private demand for U.S. treasuries. Murphy focuses on the fact that in 2011 the Fed purchased 77-percent of long-term treasuries, in an effort to skew private holdings of public debt towards short-term bonds, as evidence that the Fedmust be a major propping force of the U.S.’ domestic sovereign bond market. While I think there is a lot of sense in Murphy’s argument — as I’ll repeat on Monday —, the underlying factor in Beckworth’s story is also accurate: during periods of depressed economic activity, safe sovereign bonds are usually purchased to accumulate safe assets that earn higher returns than simply holding cash (adjusted for inflation, real interest on U.S. debt is either close to zero or below it, but the inflation adjusted returns on holding cash are even lower). Depending on whatever other evidence is available, the Fed’s actions can be interpreted as an effort to crowd out private investors in the long-term public debt market, which is certainly consistent with the Fed’s intentions.

The role of the GSEs were similar: they bought large amounts of mortgage-backed assets, but private actors were buying even more. Loan originators were being propped not only by government institutions, but also by investment banks and other financial firms that accumulated mortgage backed assets because they were perceived to be relatively safe assets (safe enough to be considered as collateral for short-term credit transactions; a role that treasuries play in lieu of these kinds of private assets). When compared to the role played by private sector banks, it’s clear that GSEs did not play the major part in stimulating the boom. They do deserve some blame, but it’s not useful to single them out, as if there weren’t alternative institutions/firms ready to take their place.

Freddie and the Crisis

The Eugene Fama interview I linked to yesterday created some Twitter discussion that I managed to catch. There was a hint of a suggestion that government sponsored enterprises (GSEs), specifically those responsible for assisting mortgage markets, were, at least partially, responsible for the 2007–09 crisis. The reasoning is that by buying mortgage backed securities and related financial instruments the risk of these assets was transferred to the public. Since GSEs were willing to buy these assets, paying very little scrutiny, banks were willing to accept and package riskier loans that otherwise wouldn’t have been made.

The evidence, however, suggests that the role played by GSEs was relatively minor. It’s true that GSEs purchased large amounts of mortgage-backed assets and securitized private assets. This latter action, in particular, distorted risk assessment, since mortgage-backed securities were categorized under a lesser risk basket under the recourse rule. But, these distortions were relatively minor, knowing that the recourse rule already benefited investment into the mortgage market — not to stimulate mortgage creation, but because these were considered low-risk assets, at the time.

Investment banks were also loading up on mortgage-backed financial instruments, driven in large part because of the United States’ macroprudential regulations (Friedman and Kraus [2011]). These banks were preforming a role similar to that of the GSEs, and this becomes clearer when we separate the conventional banking industry into two parts: commercial and investment banks. Commercial banks were the “loan originators,” or the institutions which directly financed commercial and residential mortgages. These were then purchased by investment banks, transferring the risk of the loan away from the originator. Investment banks, and GSEs, then packaged securities to hedge risks between individual loans, with loans of different quality organized into tranches. In theory, this reduces risk, therefore reducing interest rates and benefiting borrowers. The point is, if it was risk distribution that caused the financial crisis, then investment banks were just as, or more, responsible than the GSEs.

Why did investment banks begin to concentrate their portfolios on mortgage-backed assets? As aforementioned, existing capital regulations rewarded “low-risk” investments by requiring lower reserves. Mortgage-backed assets were highly rated; individual loans that were poorly rated were simply pooled with higher quality debt, and the security received a high rating. This has led many scholars to point their fingers at rating agencies, with some authors suggesting that the system was “gamed” by investment banks. An uncompetitive rating market — since only three rating agencies are considered “nationally recognized” — may be partially at fault (White [2009]), but I don’t think it’s the full story. Rating agencies were operating under some basic assumptions, including,

  1. Housing prices were likely to continue to rise;
  2. Declines in housing prices would be local and isolated, rather than nation-wide (justifying the pooling of subprime tranches).

The crisis comes down to changes in housing prices. Why did they rise, why did they stagnate, and why did they fall? The Austrian explanation for the first part of the question is: credit expansion. Following the 01–03 recession Alan Greenspan’s Fed lowered the Federal Funds rate, stimulating loan extension, especially for investments particularly sensitive to changes in central bank policy — i.e. mortgages. Housing prices rose, especially where purchases were concentrated, and bubble began to form. The common explanation for the stagnation that occurred between 2005–06 is usually attributed to the increase in the Federal Funds rate, inciting loan originators to issue higher volumes of adjustable rate mortgages (ARMs). These had teaser rates to draw borrowers, but allowed for changes in the rate of interest in accordance with changes in Fed policy. Banks weren’t particularly worried about the risk that some borrowers wouldn’t be able to re-pay loans at higher rates, because it was assumed that the borrower would simply refinance.

In conjunction with a higher volume of ARM loans, we also see a steady rise in the rates of default. What this suggests is that housing was becoming less affordable; credit expansion slowed and the rate of price change fell and soon stagnated. Without rising prices investment in housing soon became even more unaffordable, ultimately targeting a reversal in price changes (i.e. a decline in prices). The banking crisis followed, as mortgage-backed assets plummeted in value and secondary markets dried up. The fact that multiple local markets collapsed simultaneously is a strong indication that there was a common factor, and I think the evidence favors the Austrian story of price distortion.

There is a second way of considering the role of GSEs. Remember, the idea is that GSE involvement distorted risk assessment by transferring risk to essentially public balance sheets. This implies that bankers were knowingly taking greater risks in allocating capital. While not directly commenting on the role of GSEs, there is a literature that deals with financial risk-taking before the crisis. It revolves around the question of whether CEO compensation promoted risk-taking, increasing management compensation through short-term profits at the expense of long-term health. There is strong evidence that there was no significant relationship between compensation and risk taking (see: Fahlenbrach & Stulz [2011]; Acrey, McCumber, & Nguyen [2011]; Murphy [2012]). Further, most banks were over-capitalized and management took huge hits during the crisis, usually because much of their income was in the form of claims on equity (in a paper written as a reply to Fahlenbrach & Stulz [2011], which was originally published as a working paper, Bebchuk, et. al., concede that the losses of 07–09 were greater than whatever gains CEOs earned between 2000–06). The evidence simply doesn’t support the thesis that banks purposefully, or knowingly, chose higher-risk investments. This applies to the GSE thesis as well as it does to the compensation thesis.

(Also, the evidence against the purposeful risk-taking thesis is slight support for Austrian business cycle theory, in the sense that it hurts the case of alternative explanations of unstable price bubble, viz. Minsky’s financial instability hypothesis. This doesn’t mean that some loan originators weren’t extending loans to people they knew wouldn’t be able to re-pay, but ultimately these originators are restricted or financed by investment banks.)

I certainly don’t think that GSE involvement in mortgage markets are a good thing, but history simply doesn’t support the argument that it was this involvement which caused the financial crisis. Overall, GSE involvement only accounts for a small part of the crisis, and it definitely had little to do with the root cause: price distortions caused by fiduciary over-expansion.

Modeling and Ignorance

I recently read part of a two-year old study by the IMF, “Sovereigns, Funding, and Systemic Liquidity.” In chapter two, amongst other things, it talks about modeling techniques used to rate counterparty risk, which basically means accurately gauging the value of the collateral. The financial crisis — referring to the systemic bank failures of 2008–09 — was caused by the mispricing of risk. To some people, especially those who don’t blame the market per sé, the point I’m about to make might seem obvious. On the other hand, it really is lost on the majority.

Everyone is beset by radical ignorance, or radical uncertainty: the unknown unknown. There are factors that models can’t control for, simply because their creators can’t fathom their existence. It’s simply unrealistic to argue that we need to develop better models. More than unrealistic, it’s unhelpful.

Actually, radical uncertainty speaks favorably for the market process. Jeffrey Friedman and Wladimir Kraus, in Engineering the Financial Crisis (pp. 126–128), make a good case as to why this is so. Weighing counterparty risk, to a large extent, fell on the rating agencies. The rating agency industry is heavily regulated, and is dominated by the “big three” which are given their status by the government. In a more competitive market, it’s certainly possible that better models would have been developed. This is the benefit of heterogeneity in decision-making.

At the risk of detracting from the principal point being made, it’s also worth considering the role of prices in propagating mispricing. Why were mortgage backed instruments so highly rated? Because, (i) prices were rising, and (ii) nobody expected a broad decline in these prices. Few, if any, studies have really answered the question of what caused housing prices to continue to rise. There’s a good case to be made that it was intervention, either through the Federal Reserve’s policy of lowering the Federal Funds Rate in the early 2000s, as a result of the organization of the banking industry (around a monopolized currency, as opposed to competitive currencies), or both. In any case, the evidence clearly suggests that most people were misled by prices, and this was out of their direct control.

That few economists are considering the role of price distortions, or the more general concept of radical ignorance/uncertainty, is unfortunate. It really hurts the quality of post-recession debate, and ultimately it inhibits progress towards any truly effective solution (in my opinion, the market, but you don’t have to accept this conclusion to acknowledge the importance of ignorance).

Symptoms vs. Cause

Tim Worstall summarizes the 2008–09 financial crisis as follows,

But the argument in a nutshell is this. Banks in a fractional reserve banking system are subject to runs. The solution is deposit insurance. The wholesale banking system did not have deposit insurance and what really happened in the Great Financial Crash was a wholesale banking run. The solution to that is to extend deposit insurance which we have done.

Worstall is summing up Gary Gorton for the layman. He links us to a much more technical summary, by David Warsh.

Gorton is an expert on the banking, and every single word he writes on the topic is worth reading. His understanding of the minutiae of the modern banking industry, especially the “shadow banking system,” is incredible and easy to spot. It doesn’t mean that he can’t be wrong, though.

While not an uncontroversial topic, the fact is that bank runs — whether they be traditional or a run on assets — aren’t sunspot events. They have causes. In the case of the 2008–09 crisis, the cause was an increase in default rates amongst mortgage borrowers (not just subprime, but even highly rated debt). Why did this occur? It’s a good question, and nobody seems to be able to agree on an answer (I prefer something along the lines of the Mises–Hayek explanation, but even Minsky is close enough). But, this is where the real debate is.

Can something analogous to deposit insurance on the repo market mitigate the business cycle? It can surely spread the costs of bank failure to society as a whole, but it fails to address the root causes of financial turmoil. As such, I find myself in deep disagreement with Worstall, and by extension Gorton, on deposit insurance being a “solution.”

Investment–Commercial Bank Relationship

In my attempt at a foray into explaining why Germany didn’t suffer a housing boom, I wondered why economists put so much emphasis on the role of German and French banks in providing liquidity at low interest to the peripheral countries. Paul Krugman provides a partial answer,

[Y]ou should think of it as largely taking the form of bank-to-bank lending. E.g., German Landesbanken buying covered bonds issued by Spanish cajas, with the cajas in turn using the money to finance real estate purchases.

A ‘covered bond‘ is essentially the same thing as an asset-backed security (ABS’), and during the boom most of these assets were mortgages. In a subtle sense (i.e. the initial step), I think Krugman has it backwards, though. The Spanish cajas (regional banks) and larger commercial banks would extend a loan, and when enough of these were aggregated they would be securitized. These were sold to other banks, such as Deutsche Bank, transferring the risk to these banks — ideally, risk is reduced because the pool of loans is heterogeneous (in terms of risk of default). In effect, it’s as if the loan originator is paid back in cash, allowing the same bank to extend a new loan. In other words, it lifts certain constraints on lending (it also further reduces interest rates, since it reduces risk).

It was the same process in the United States. Commercial banks and other ‘loan originators’ extend loans based on the capital available and the liquidity of their balance sheets, and these were securitized and purchased by investment banks (and government sponsored enterprises [GSEs], like the now infamous Fannie Mae and Freddie Mac). (At this point, these were usually re-sold to other financial institutions, and/or repackaged as collaterized debt obligations [CDOs] — where the ‘mezzanine’ tranches [typically, worst quality loans] were organized into even larger pools of the same type of bonds.) By injecting commercial banks with liquidity, investment banks fueled the machine by giving them the means to extend an even greater quantity of loans.

Krugman’s story isn’t the whole story, but it reveals an important part of it. If someone is wondering what a free banker thinks of it all, I caution against throwing the baby out with the bathwater. Today’s financial industry is shaped by its constraints and incentives. In a world with competitive money, commercial banks would be limited by their deposits and the volume of circulating outside money (specifically, that portion of outside money composed of their notes). Let’s suppose that an investment bank purchases an ABS; the cash used to buy the asset can either be (and it doesn’t matter if it’s physical cash or electronic cash denominated in a particular currency),

  1. The bank’s own banknotes, which means that the volume of outstanding banknotes actually falls (banknotest → loant+1 → banknotest+1 → sale of ABSt+2 → banknotest+2, where banknotest = banknotest+2);
  2. Other banks’ banknotes, which our bank uses in inter-bank clearings (either to meet returning obligations or to redeem for other banks’ outside money [assets], some of which will be met by our bank’s own notes).

So the relationship between investment and commercial banks isn’t necessarily unstable. It’s really a function of the monetary regime. This doesn’t mean that a free banking system is necessarily stable under all conditions, which is something I realized after reading Michael Lewis’ The Big Short — which I plan to review, so the following might be repeated and expanded upon. Given how new some of the asset markets were during the boom, in many cases there wasn’t a lot of heterogeneity amongst investors, which means that there wasn’t a lot of arbitrage. In turn, this caused a reduction in risk-aversity which otherwise might not have taken place. Some of this might have been mitigated had there been more competition between rating agencies (another thing which is government-constrained), but some of it also had to do with the age of the market — we can’t forget that these are evolving institutions, which presupposes failure.

We might be able to say that the boom might not have been as large as it was, or maybe it would have taken a different shape (a wider variety of investments — investment in mortgages was driven, in large part, by capital regulations), but I’m not claiming that the free market alternative is perfect.

Recessionary Free Banking

I’ve often argued that a free banking system would not be able to issue fiduciary media during the midst of an economic contraction. Let’s see if I can re-state my case briefly, clearly, and persuasively. I go over some basic ideas just for the sake of clarity. Since I want to focus entirely on this specific topic here, I’d appreciate it if we stayed away from debates on fractional reserve free banking in general — if you comment with these intentions, I most likely won’t respond.

Dramatic changes in the demand for money are not usually sunspot events. What this means is that there’s usually a reason why people want to hold money, and in recession this reason usually has to do with the decline in output, incomes, and a rise in uncertainty. People want to make sure they have enough liquidity to make it through the unforeseeable future. While only indirectly related to the demand for money, the fact that there are other forces involved is relevant to the question of how a free banking system would respond to these pressures.

Specifically, industrial fluctuations are usually characterized by sharp downward changes in the value of various kinds of assets. Financial instruments based on these assets suffer similar downward pressure. Banks hold large quantities of assets, which are needed not only as a means of wealth accumulation, but also as a means of meeting liabilities. Naturally, when a large stock of assets lose value, the bank’s ability to meet liabilities in the short-term may be compromised. This is essentially what caused the financial system to “collapse” between 2007–09.

In a free banking system, an outstanding banknote is a liability to the bank. It means that the bank is liable, at some point in the future, for accepting that note for redemption. During periods of healthy economic activity a bank will issue more banknotes if the demand for money rises. The latter essentially means that people are holding an increased amount of that bank’s banknotes — as opposed to getting rid of them by spending them —, and that since less are circulating the bank faces a reduction in volume of notes being returned for redemption. To put it in terms of liabilities and assets, the quantity of short-term liabilities the bank expects to meet decreases. Since the bank can handle a greater quantity of short-term liabilities it has room to issue more banknotes, usually through the loanable funds market.

Is the process the same during an economic contraction? Let’s assume that the bank’s liabilities remain the same — although, they usually increase since those previously believed to be long-term can become short-term (credit default swaps, early contract terminations, et cetera). During a recession, as previously pointed out, the assets side of the balance sheet essentially collapses, or at least suffers a significant drop in value. The bank’s ability to meet short-term liabilities thins — exactly why so many financial firms tend to go bankrupt —, and there is a scramble for liquidity (usually by contracting the amount of outstanding loans; i.e. turning illiquid assets into liquid assets). If the problem is suffering inadequate assets to meet liabilities, then for what reason would a bank enlarge the quantity of outstanding liabilities by issuing more banknotes?

Rather, an increase in the demand for money should be seen as a cushion for banks during periods of economic contraction. By decreasing the volume of short-term liabilities it limits the extent to which banks are desperately looking for liquidity. Ultimately, it may even help limit the habitually concurrent credit contraction by allowing banks to maintain a certain volume of outstanding loans.

Given my approach to the business cycle, which is the Mises–Hayek theory of malinvestment (although, I suppose my views on this topic wouldn’t change significantly if I adopted a Minskian approach), I see an increase in the demand for money as a positive that helps limit the credit contraction caused by bankruptcies and asset conversions (from illiquid to liquid). If you don’t accept my diagnosis, that’s fine, but don’t expect free banking to respond to crises in the way you want it to.

Evil Speculators

I don’t know what the more informed opinion is on the “shadow banking” industry, but mostly we tend to hear a lot of noise that emphasizes its “deregulated” nature and the fact that it was intimately related to the 2007–08 financial crisis. The fact is that few people, including academics, really understand what’s going on in financial markets. This isn’t a swipe, since it would include me as well; the ignorance is sensible given the subject’s complexity and the fact that the modern financial industry has developed quickly, and its history is fairly recent (~1980 to the present day). The more I read, though, the less I accept the common characterization.

Many chastise the modern financial sector for including firms that operate well beyond the “conventional” boundaries of banking. They’re commonly portrayed as institutions “betting” on assets, and their expected future values, and if the “bet” goes wrong then the rest of the world suffers. The “solution” is to regulate them, and even restrict them from operating.

Much of Michael Lewis’ The Big Short is spent talking on the market for credit default swaps (CDS’) on mortgage backed securities (MBS’) and other mortgage-related instruments, especially collateralized debt obligations (CDO’s) — the latter are just bonds composed of other bonds, such as MBS’, to more efficiently (well, that’s the intent) pool risk. During the height of the boom, roughly between 2004–06, CDS’ on mortgage bonds appeared for the first time. A CDS is essentially an insurance claim, where the seller agrees to pay the contract value of an asset in the event of bankruptcy.  An infamous firm usually associated with these assets is AIG, which I believe ended up insuring around $50 billion worth of MBS’ and CDO’s. AIG, of course, went bankrupt during the financial crisis, and was bailed out.

While CDS purchasers made billions of dollars, these speculators were operating in society’s interest. Someone who bought a CDS was a person who thought that the mortgage market was going to collapse. At the time, these assets were being sold at very low prices (imagine paying $2–4 million a year for a $1 billion CDS), meaning that few people expected a significant rise in the (cross-country) rate of default. A rising amount of CDS purchases was sending a message that there was reason to suspect the majority opinion on the state of the market. In this sense, these speculators were providing knowledge to a market that was holding on to the “phantom profits” of a mortgage market reaching its zenith.

But, because the sale of CDS’ caused the bankruptcy of various insurance firms, the entire concept is thrown down the drain. If so many firms lost so much money issuing insurance, maybe we should restrict these financial instruments. As we can see, though, such a restriction would eliminate a positive market signal — it would handicap speculators who have reason to suspect of the underlying “fundamentals.” Just as important, it underscores the misguided thought that these assets are the cause of the financial crisis, when in fact the value of financial instruments depends on the value of what they’re based on. The failure of mortgage backed securities, in other words, was caused by the failure of the housing market in general. CDS purchasers saw the true nature of the housing market and their actions spread their expectations.

Rothbardian Banking’s Nadir

Paul Krugman, without expecting a very serious answer, questions the Austrian School’s allegedly critical position on fractional reserve banking.

I don’t have much to say, and I don’t think there is much to say. I left a comment that sums it up: these Austrians are increasingly in the minority. The problem is that it certainly doesn’t seem as if this is true. The blogosphere is full of so-called “internet Austrians,” many of which affiliate themselves with Rothbardian banking theory. These tend to be very vocal, and so people basing their opinion on blogosphere reviews are getting distorted statistics. The fact is, there are increasingly few academic Austrians who still adhere to full reserve banking — usually, in some way linked to the Mises Institute, although even there the resistance to the Selgin/White model of (fractional reserve) banking is dissipating (I have in mind economists like Roger Garrison).

I usually avoid confrontation with full reservists on the topic. Those kind of discussions usually don’t go anywhere. But, from the point of view of needing to sell a different view of the broader Austrian tradition, maybe it’s time for Austrian (fractional reserve) free bankers to drown out the minority. All this being said, I don’t kid myself by thinking that Krugman might respect Austrians more if he were privy to alternative positions within the school.

Unrelated to the full reserve v. fractional reserve debate, I’d like to comment on money market funds. Krugman is essentially arguing that the modern financial system wouldn’t exist if we had a full reserve banking system. I don’t disagree, and I don’t see why it’s a problem. It would exist in a very different fashion even with fractional reserve free banking. Money market funds, for instance, were a product of the 1970s, when depositors were looking for alternatives to the tightly regulated demand deposit — remember, interest on demand deposits was (and still is) banned. Banking evolution is historically contingent.