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Why monetarist victory is necessary: so central banks cannot hide

By Lorenzo

A guest post at Marcus Nunes’s blog Historinhas (sans graphs).

In the debate about how to think about the Great Inflation of the 1970sMilton Friedman‘s policy advice–constant growth in a targeted monetary aggregate–turned out to be misplaced. Indeed, the failure of the Thatcher Government‘s monetary aggregate targeting led to the popularisation of Goodhart’s Law:

Any observed statistical regularity will tend to collapse once pressure is placed upon it for control purposes.

Ironically, the point Milton Friedman had originally made (pdf) in his critique of the use of the Phillips Curve for policy purposes–that such a use will change people’s expectations, and thus their behaviour, rendering the relationship between inflation and unemployment no longer useful for policy purposes–turned out to also apply to his own policy advice to target monetary aggregates being based, as it was, on the notion that monetary turnover (velocity) was relatively stable (or could be made so by quantitative targeting).

Victory (to a point)
Nevertheless, the wider macroeconomic victory of Milton Friedman–the acceptance that inflation is always and everywhere a monetary phenomenon–was a necessary step in the taming of inflation. Why? Because once the monetary nature of inflation was accepted, the responsibility of central banks for inflation became clear, incorporated in what is sometimes called the new neoclassical synthesis.  So the problem simply became a matter of finding a way to operationalise the responsibility of central banks. Such a way was found with inflation targeting. (Pioneered by, of all places, New Zealand under Reserve Bank of New Zealand Governor Don Brash.)

In other words, accepting that inflation was a monetary phenomenon gave the central banks no place to hide.

There were two problems which flowed from this. First, what became most widely accepted was narrow inflation targeting, where maintenance of price stability (typically defined as 2% inflation a year) became the only, or dominant, policy target of the central bank.

The second is that, in the wider economics profession, the dominant macroeconomics became New Keynesian economics, where the incorporation of monetarist notions is often glossed over: they do not play much part in David Romer’s 1993 paper (pdf), for example. The frequent use of Dynamic Stochastic General Equilibrium (DSGE) Models, which have some problems incorporating money and monetary effects, rather exacerbated this. Brad DeLong, conversely, makes explicit (pdf) the importance of what he calls Classic Monetarism in New Keynesianism.

Burdensome responsibility
Given the way central banks now pride themselves on–indeed, sometimes seem to define their role as–”taming” inflation, it is easy to forget how resistant many central banks were to the notion that inflation was their responsibility. And a major appeal of narrow inflation targeting is precisely that it minimises the responsibilities of central banks.

Which is why a new (market) monetarist victory is necessary. For the crucial step in flattening the business cycle is to gain acceptance that the intensity of the business cycle is also a monetary phenomenon: that central banks control the level of aggregate demand. Once that is accepted, the responsibility of central banks for stabilising the path of total spending on goods and services is clear, and it is just a matter of finding ways to operationalize that responsibility.

Given Scott Sumner’s very reasonable hypothesis that central banks (particularly the US Federal Reservetend to follow the macroeconomic consensus of the mainstream economics profession, this means the debate within said profession is very important; though still as part of the wider policy debate.

While central banks are not held accountable for the effects of what they do, and do not do, achieving a stable (macro)economic framework for people to go about the business of their lives is going to be a happy accident when it should be what policy makers—and specifically central bankers—are held accountable for.

ADDENDA: Noah Smith is very enthusiastic about Japanese PM Shinzo Abe because, among other reasons:

In other words, unlike everyone else in the world, Abe listened to Milton Friedman, and the results are looking good.

Hard money is not the same as sound money

By Lorenzo

A post by Jonathan Finegold on sound money pointed me towards how to express an important distinction–that hard money is not the same as sound money. JF defines sound money thusly:

a monetary system that best promotes coordination between market agents.

Unsurprisingly, a somewhat “Austrian” definition, but clear enough. I would go with the money that maximises its transaction utility, but it would come to much the same thing. Which is to say, money being sound is not merely about the exchange value of money (either for other monies or for goods and services), nor even its exchange value across time (i.e. its role as an asset), but also about the exchanges (transactions) it is used in. If money maintains or increases its exchange value against goods and services (measured by, say, the GDP deflator) but at the cost of depressing the level (measured by goods and services) of exchanges it is used in, then that is not sound money.

It is, however, hard money.

Which is the difference: hard money is money that maintains or increases its exchange value for goods and services (or other monies or both). The more it increases its said exchange value, the “harder” it is. But that does not tell us that how sound it is: indeed, often hardness and soundness are contra-indicated (more of one is less of the other). To increase money’s value as an asset is to reduce its moneyness and that way disaster (or, at least, much economic unpleasantness) lies, remembering that being an asset is the least distinctive thing about money.

Deflation distinction
The distinction between good, bad and ugly deflation is useful (pdf) here. Good deflation comes from falling prices due to increasing productivity. The IT industry is a classic example of good deflation–Moore’s law and all that. There is a sense in which the entire increase in living standards from whenever is all good deflation–if, for example, we use labour-time at average wages as our measure.

Bad and ugly deflation–what we might call monetary deflation–is all about money increasing in value relative to output, thereby depressing aggregate demand (i.e. total spending on goods and services), pushing downwards on income, raising the value of debt. Bad and ugly deflation is from hard money, from money increasing in exchange value. It is not sound money, as the actual use of money in productive transaction is trending downwards as money’s exchange value is trending up. Money-as-asset is overwhelming money-as-facilitator-of-transactions–the real point of money; what makes money, money.

Central banks should be sound, not hard
We do not want central banks to obsess over providing hard money, we want them to provide sound money. To focus on money as tool, not money as asset; to focus on its utility, its role in the economy as a whole, not on its (exchange) value. Narrow inflation targeting central banks–such as the Bank of Japan (BoJ) during the “lost decades“, the European Central Bank (ECB) since the Eurozone crisis–produce hard money. They do not produce sound money. The Reserve Bank of Australia (RBA) does that.

The most disastrous example of producing hard money which was desperately unsound was the policies of the Bank of France (BoF) in creating the Great Depression, the classic example of ugly deflation at its ugliest. Money was extremely hard (and getting harder and harder) but also catastrophically unsound. Money was “better and better” as an asset, worse and worse as a facilitator of transactions.

One problem is that hard money is actually relatively easy to produce and has a whole lot of ready-made chest-thumping rhetoric to go with it. It does not help that Austrian school theory has such a presumption towards central banks being inflationary, that the problem of hard money is simply not natural to their analytical framework. (Not a sin of all Austrian economists–several above links are to works by economists associated with the Austrian school–but one very common in the wider Austrian community.)

Disorder dangers
Another problem is the conservative penchant for producing fetishes of order–such as “preserving” the “value” (rather than the utility) of money. Hence so many conservatives riding the gold standard down to destruction in the Great Depression and so many obsessing over utterly imaginary inflationary dangers today. They focus on money as asset, losing sight of money as tool. On the thing itself and not its wider role, thereby actually failing to defend the wider system. They defend the fetish (the gold standard, narrow inflation targeting) as a bulwark of order, regardless of how much actual disorder it is creating.

Thereby, of course, undermining and discrediting the very social order they are so keen to defend.

Including the international order. Not only does the social disorder created by hard money make extremist regimes more likely, the economic contraction and stagnation hard money creates undermines the confidence and capacities of Western states. Folk have pointed to how much like a late 1930s Hitler Russian President Vladimir Putin is, except on behalf of Russians outside Rodina rather than Germans outside the Reich. That both were confronting Western Powers weakened in both strength and confidence by central bankers disastrously pursuing hard, rather than sound, money policies is another similarity less remarked upon.

Money qua money is a tool for transactions. Sacrificing its use (in transactions) for its (exchange) value is to undermine its real utility to an economy–which is to facilitate transactions, to have maximum transaction utility; to have a monetary system that best promotes coordination between market agents.

Hard money is really, really not the same as sound money.  It would be a massive step forward in public policy if more people understood that.


Too big not to fail: the rise and fall of Fannie Mae

By Lorenzo

The debate over the role (if any) of the Community Reinvestment Act (CRA) in the sub-prime crisis, and thus the Global Financial Crisis (GFC), often seems to be a stand-in for other issues. In particular, to what extent was either financial meltdown the consequences of government regulation (or the lack thereof).

The answer to the former question is: almost entirely, if by government regulation one includes the full gamut of government interventions and political game-playing. In a market economy, failures of regulation and government intervention always manifest as market outcomes. By the simple expedient of declaring such government interventions and regulations irrelevant or unimportant, said market outcomes can then be pointed to as “proof” of market failure.

But that is ideology blocking analysis. Corporations are pavlovian profit monsters–they will go where profits lead them. They act according to the incentives offered them, within the range of managerial competence. (Hence markets as economic selection processes.)

In the case of the US finance industry, particularly the US housing finance industry, various government interventions profoundly shaped the incentives facing participants in the market, with part of the problem being those being regulated having rather too much influence over how they were regulated.

With no entity playing the political game more relentlessly, narrowly effectively or ultimately self-destructedly than the Federal National Mortgage Association (FNMA) or Fannie Mae. As long-time Wall Street Journal journalist James R. Hagerty sets out in his highly readable history of Fannie Mae, The Fateful History of Fannie Mae: New Deal Birth to Mortgage Crisis Fall.

Supporting housing finance
Fannie Mae started operating in 1938, a late New Deal initiative. While fairly small in its early days, it grew until it became one of the biggest financial institutions in the world. For its first 30 years, it had a monopoly over the US secondary mortgage market. As an Australian reading the book, the idea that housing finance needed government support seems a little bizarre. We have a home-ownership rate slightly above the US’s (ex-communist countries generally top the rankings), but did not need to create anything like Fannie Mae or Freddie Mac, or the other US government founded/supported finance entities, to do it.

But such efforts suited some very politically effective interests, such as realtors. The implicit or explicit taxpayer guarantee allowed more funds to be pushed into housing at lower cost. At one point, Hagerty quotes Adam Smith‘s scepticism about government-sponsored companies:

These companies, though they may, perhaps, have been useful for the first introduction of some branches of commerce, by making at their own expense an experiment which the state might not think it prudent to make, have in the long run proved, universally, either burdensome or useless.

Fannie Mae provides a dramatic example of Adam having a point. The US$187bn the taxpayer’s invested in bailing out Fannie Mae and Freddie Mac may have been more than returned, but their role in fuelling destructive, massively over-leveraged, housing price booms imposed a much greater social cost than that.

Having previously read Fragile by Design, Hagerty’s book also put the CRA into a much more useful context, even though it plays a small role in his book. There was a long history of US federal government action to support housing finance. The CRA was a way of extending that pattern of action to urban minorities. The problem with the CRA was not the Act itself, but the way it then came to feed back into, and amplified, already existing patterns, which were also amplifying for other reasons. It was a building block in the edifice that created the sub-prime crisis, no more than that (but also no less).

Hagerty takes us through the history of Fannie Mae, with an enduring feature being attempts to either regulate it more closely, or to fully privatise it, being fought off by Fannie Mae. Fannie Mae wanted to keep its government guarantee (an implicit guarantee, once it became a company with shareholders), because that lowered the cost of its capital, but without tighter prudential regulation, because that would have reduced its ability to leverage off its government guarantee. Fannie Mae’s leadership played the political game increasingly effectively, including using such tactics as hiring as many lobbying firms as practicable, so they could not be hired to lobby against it.

To a large degree, Fannie Mae got the regulatory framework it wanted, though part of the trade-off became to expand its support for housing finance. As a result, the prudential rules covering it became increasingly vulnerable to catastrophic failure, if there was a large enough rise in interest rates or fall in house prices. Which, of course, there duly was.

Government guarantees to financial entities require matching prudential regulation if catastrophe is not to be avoided. But Fannie Mae was too politically useful; which it leveraged ruthlessly, to avoid inconvenient prudential regulation to match its government guarantee. Fannie Mae became too good at selling itself as the perfect (off-budget) housing finance problem solver.

As the various housing bubbles across the US started to deflate, a desperate housing industry lobbied hard for Congress to “do something”. And there was Fannie Mae and Freddie Mac, available to “do something” off-budget. So, as the housing bubbles deflated, Fannie Mae and Freddie Mac increased their exposure. But this was the end run of a long process of ever-lower standards of lending without compensating increases in prudential requirements.  The necessary corollary to government guarantees if said guarantees were not to make the financial system more vulnerable rather than less.

Pay and …
And then it all collapsed, wiping out Fannie Mae and Freddie Mac’s share values and requiring a $US187bn bailout of the two government-sponsored-enterprises (GSEs). It was as if nothing had been learnt from the Savings & Loans crisis. Which, in effect, it had not.

What Calomiris & Haber call the game of bank bargains has been perennially played in the US to suit narrow interests and not broad ones. As in this case, with the taxpayers left holding the bag (again) as helping the housing industry by “off-budget” measures suddenly went dramatically on-budget.

It is useless to complain that the politics was “corrupted”, as if that is the only problem: we have to deal with politics as it is, not as it might be. There is certainly a role for seeking to have better functioning institutions, for informed debate, for exposure. But to change nothing about the political institutions and framings of debate, and then expect the players to reliably and continually act differently, is naive at best.

It was not as if the housing booms themselves were not also significantly responses to regulation. Land rationing was a major driver of where the US housing booms did (or did not) occur. For any asset, if quantity responses are dampened, then price responses become more intense. That is, if supply is constrained (such as by land rationing), then the price of a class of assets (such as land-approved-for-housing) will become more susceptible to demand shocks (both upwards and downwards). Or, in this case, upwards then downwards. Especially if a government guarantee is leveraged into pumping more and cheaper finance into purchasing said asset.

So, local governments were rationing land (driving up house values and property tax revenue), Congress wanted off-budget help to the housing industry and home-owners (both middle class and those aspiring to be so), driving up the funds being pumped into supply-constrained markets, banks wanted to benefit from the too-big-to-fail subsidy, and prudential regulators either did not want to pick unfortunate fights or were overwhelmed by the superior lobbying power of those that they were attempting to regulate. With no-one playing the political game more effectively, or more ultimately disastrously, than Fannie Mae. Which became too politically big not to fail.

… then repeat
But Fannie Mae and Freddie Mac have been bailed out, not killed off. The too-big-to-fail subsidy is now absolutely established, as are the GSE‘s government guarantees. Blaming “Wall St” or “easy money”, or whatever, means that the game of helping a powerful industry off-budget–in part by not forcing sufficient prudential requirements to match the government guarantees–continues to be played. After all, the imbalance is very much based on providing (positive) externalities to those who usefully notice and passing the costs on to those who do not.

The Savings & Loans Crisis was Mark 1. The Sub-Prime Crisis was Mark 2. The pieces are being set in place to have Mark 3. With “corporate greed” the perennial theatrical villain, so that the real players can continue to play their political games, and taxpayers and home-owners can be set to take the fall, yet again.

But Hagerty’s book–clearly based on talking to everyone who matters and reading every report–provides a well-written, clear and informative history of past, present and (sadly) likely future.

The ECB’s dismal performance and the European elections

By Lorenzo

These two graphs, taken from here, express vividly how much worse the performance of the European Central Bank (ECB) has been compared to the US Federal Reserve (the Fed). Between the two of them, they caused the Great Recession, but the Fed has done much better since.

The ECB’s dismal performance also helps explain the recent European election results. Andrew Sullivan’s commentary on the EU election results is by far the most sensible thing on the results I have read, since he gets both sides and realises the underlying conflict has to be managed, not “won”. I particularly liked:

And, more to the point, Europeans increasingly feel they are not given a choice in any of this. So they vented.

Making folk feel ignored and powerless is not the path to social harmony. Also:

But when the money ran out, and the recession hit, and the EU only bailed out members on the basis of brutal austerity … the deal began to fray. Now that growth is returning, if only anemically, it appears, moreover, to be benefiting Blue Europe – the elites, the property-owners, the transnationals – while leaving ordinary, working- and middle-class Europeans in the dust. That fuels another layer of mistrust and despair.

The consequences of the ECB’s “hard money” policy continue to resonate, badly.

ADDENDA: Sociologist Frank Furedi also has very sensible things to say about the Eurosceptic vote and how not to think about it (via).

Small-yet-broad is beautiful (or why it is good to have been British)

By Lorenzo

The central purpose of Calomiris & Haber’s Fragile by Design: the Political Origins of Banking Crises is to explain to Americans why their banking system does not perform as well as other countries–particularly compared to that of their neighbour, Canada. In chapter 14, the authors put the matter quite starkly:

… if a highly stable banking system is defined as one that has been crisis-free since 1970, then only six out of 117 countries–Australia, Canada, Hong Kong, Malta, New Zealand, and Singapore–meet the threshold for being both credit abundant and crisis free.

As the authors note, all six were part of the British Empire. Three (Hong Kong, Malta and Singapore) are city-states. The other three (Australia, Canada and New Zealand) are among the world’s most stable and long-lived democracies. The authors argue that these latter three countries also have something else in common:

… the structures and political histories of these three countries tended to mitigate the ability of populists and bankers to form coalitions that disadvantage everyone else.

Something that is very clear, is that “de-regulation” is a term empty of explanatory power. All successful six have liberalised financial markets–Australia and New Zealand, for example, were leaders in financial “de-regulation”. If someone starts trying to blame the Global Financial Crisis (GFC) on “de-regulation”, you can stop reading, they have nothing useful to say.

It is very much the point of Calomiris & Haber’s Fragile by Design to look at these issues comparatively and historically, which gets in the way of all sorts of congenial ideological narratives. Their final chapter (Chapter 15) is entitled “Reality is a Plague on Many Houses” just to make that point–particularly that Americans need to look outside their own history for answers.

Playing the game
In Chapter 2, The Game of Bank Bargains, they make it quite explicit that the question is always the actual structure of financial regulation:

… the normal functioning of banks depends on three sets of property rights that only government can provide. Banks need powerful governments. But power may not be wielded in the interests of bankers unless bankers can convince the group in control of the government to partner with them.

Hence the game of bank bargains. Hence also the political origins of banking crises. Or, as they say:

… our goal is to explore why banking is all about politics–and always has been.

It is inherent in the nature of banking given that:

Any enterprise whose inputs and outputs consist primarily of promises to repay debts is inherently unstable and risky.

Banks have to deal with credit risk and liquidity risk. Hence banks are pioneers of limited liability laws:

… in the vast majority of countries, the first enterprises to seek charters granting their shareholders a limit on liability were banks: the special limited-liability acts for banks typically antedated general incorporation laws by decades.

Which brings the government into the heart of banking.

A bank cannot simply declare that its shareholders have limited liability or other legal protections. Only the government can offer these. It does so by granting privileges–through bank charters–and enforcing them in courts. A charter is not just a license; it is a contract between the bank and the government.

To have an effective bank bargain, (1) bank assets have to be protected from government expropriation, (2) minority shareholders and depositors have to be able to stop bank insiders expropriating their assets or else be compensated for accepting the risk of expropriation by bank insiders, and (3) there has to be mechanisms to protect bank insiders, minority shareholders and depositors from expropriation by borrowers or else be compensated for accepting the risk of expropriation by borrowers.

Since 1970, six jurisdictions have managed to do all that. Why so few jurisdictions? Because governments face conflicts of interest in managing the game of bank bargains. They regulate banks, but borrow from them. They discipline debtors, but often rely on them for political support. They allocates losses among creditors in cases of bank failures, but may simultaneously look to them for political support. The constant temptation is to shift the game of bank bargains to benefit those who usefully notice at the cost of those who do not; the arsonists in charge of the fire brigade problem, with government having, as Calomiris & Haber put it “multiple opportunities to behave opportunistically”.

Most governments fail this test. Hence only 6 out of 117 jurisdictions managing the game of bank bargains so as to provide abundant credit but avoiding bank crises.

If the standard is set so as to include countries that have avoided a crisis since 1970, but are only required to have a level of credit to GDP equal to the mean across all countries, we get all the way to 13 jurisdictions out of 117: the “successful six” are joined by the Bahamas, Bahrain, Barbados, Belize, Macao, Mauritius and South Africa. All are former parts of the British Empire, except Macao, and all achieved independence peacefully.

Out of the 13, all but 3 are small islands or city-states. While, like Australia and New Zealand, South Africa (since the 1997 constitution was a brokered deal with the white minority) has institutions which:

… make it hard to populist movements to form coalitions with banks to enact regulatory policies that benefit them at the expense of everyone else.

The US, by contrast, not so much.

Small islands and city-states dominate the list of the successful players of the game of bank bargains because they are simply much more likely to have broadly-based bargains. (Though Iceland is a salutary reminder that success is not guaranteed from being small.)

As for the worst performers, setting the criteria as having at least two bank crises since 1970 and credit to GDP ratio at or below average gives us: Chad, the Democratic Republic of Congo, Argentina, Bolivia, Brazil, Cameroon, the Central African Republic, Colombia, Costa Rica, Ecuador, Kenya, Mexico, Nigeria, the Philippines, Turkey and Uruguay. (Kenya is clearly letting the British-is-better side down, though its path to independence was marred by violence. [Nigeria is also letting the British-is-better side down, but it is really a mistake as a single country.]) Basically, as the authors point out, autocracies, new democracies or democracies whose institutions provide few barriers to rent-seeking.

Broadening the question

Flag_of_Barbados_(1870–1966)When we look at lists of per capita GDP on a purchasing price parity (PPP) basis, we can see that the US is the only large country in the top 10 persistently included: the others being small (less than 10 million in population) as well as oil-rich, monarchical or democratic (or some combination thereof–looking at you Norway). So, clearly the US continues to do something right.

Of course, since the US is seriously a federation, it could be argued it is really a bunch of small countries operating in close formation. That what is by far the largest state by population (California) is also something of a public-policy mess adds plausibility to the claim. As does the only two countries with populations of over 10 million to get into any of the lists being Canada and Australia (also federations).

Clearly, the trick is to have responsive states. With smaller being generally better, as information flows more easily and more inclusively. It is generally just harder to stick it to folks (either by what you do or what you don’t do) in a way that doesn’t get noticed in smaller jurisdictions. (Unless jurisdictions are so small they fly under the media radar but are big enough to be semi-anonymous–urban local government in Oz has a bit of a problem there.)

There is an important caveat though, which Calomiris & Haber identify in discussing why Canada’s “bank bargain” has consistently worked so much better than the US’s–forcing policy bargaining to be at a broad level is less likely to generate nasty externalities. The Canadian “game of bank bargains” was played at a national level in a parliamentary-and-imperial system, so created a stable, interests-encompassing bargain more sensitive to long-term consequences.

The US “game of bank bargains” was played at State and Federal levels in coalitions built by adding individual constituencies together in congressional systems, creating unstable, interests-excluding bargains less sensitive to long-term consequences. (Since banking is all about risks across time, long term consequences are a particular problem for bank bargains.) But that is not actually an argument for bigger-being-better (Canada was always a much less populous jurisdiction than the US). It is an argument for more broadly-based being better. And broader is easier if smaller.

Still, that politicians are going to be looking to craft useful (to them) externalities means we can only expect politicians to deal with awkwardly visible negative externalities, not be a general solution to the problem of externalities. And we should also be sceptical of public policy mechanisms well set up to generate politically useful externalities. My nominations:

Public ownership.
Bureaucratic approval systems. (Unconstitutional in Germany, and good on them–they get their reward in much more rational housing markets.)
Complex tax rules.
Low visibility regulations. (Which would be most of them.)

Arsonists in charge of the fire brigade

By Lorenzo

A favourite economic justification for state action is to deal with externalities–the effects on people of some action or transaction that they were not willingly a party to.  The problem with this is that the coercive nature of the state makes it a prime creator of externalities: since it has coercive power, it can force consequences on people they have not agreed to. While said coercive power makes the state, at least in theory, able to deal with externalities from private action, in practice, it makes the state a prime generator of externalities. Tyranny (taking the modern pejorative meaning, not the classical Greek technical meaning), the extreme version of forcing consequences on people they have not agreed to, is, after all, systematic negative externalities.

Democracy is supposed to make things better, by making all voters part of the political bargaining process. The problem with that is much of the art of representative politics is using the coercive power of the state to provide benefits to folk who do notice (and care and effectively politically express that noticing and caring) while shifting the costs onto those who do not. In other words, generating visible positive externalities paid for via not-usefully-noticed negative externalities. Politicians are entrepreneurs of externality. Appealing to politicians to deal with problems of externalities in general is rather like putting arsonists in charge of the fire brigade.

 Which is not to say there is no benefit to democracy: a whole lot of externalities that undemocratic regimes impose are usually avoided because visible negative externalities have a rather harder time getting through when all voters are part of the political bargaining process. Nobel Memorial Laureate Amartya Sen‘s point that democratic countries do not suffer from famines is well taken and part of a wider process. (As Calomiris & Haber point out in Fragile by Design, democracies are less susceptible to extreme versions of the inflation tax than weak autocracies, for example.)

Of course, if groups of voters are permanently locked out of the effective political process, then the advantages in political bargaining that democracy permits will be somewhat attenuated. If folk have a weak sense of there being a common public sphere in which bargaining takes places (and is supposed to be stuck to), including various categories of other folk as not acceptable bargaining partners, democracy will also have difficulties having getting social traction to operate against even obvious negative externalities.

The jihadi critique of democracy as blasphemous is precisely because changing the law to reflect social bargains is to infringe on Allah’s sovereignty, as the only legitimate law is Shariacreated by inference from the actions and words of Mohammad, God’s final Messenger and Guide. More generally, taking as an affront to treat non-believers the same as believers, or folk of x skin colour the same as folk of y skin colour, rather gets in the way of effective broad social bargaining via the democratic process.

The above thoughts on politicians in representative democracies and externalities were inspired by Calomiris & Haber’s discussion of the sub-prime crisis in Fragile by Design: the Political Origins of Banking Crises.

Imprudent community investment
Calomiris & Haber make it very clear that how the Community Reinvestment Act (CRA) came to operate was a central building block in the sub-prime crisis. Regulatory changes which (finally) allowed national branch banking in the US led to a wave of bank mergers, as firms tried to gain the too-big-to-fail subsidy–the implicit government guarantee which meant you could take higher risks with less capital coverage (i.e. seek more profits for any given level of capital backing). A classic example of what economists call moral hazard.

Mergers had to be approved, however, and so an alliance was forged between megabanks and community activists, notably ACORN. If megabanks undertook partnership arrangements with activist groups such as ACORN to have CRA programs run through said advocacy groups, then they would testify that the banks were “good citizens” and help get approval for the bank merger in question. If banks refused to play the game (or tried to have their own bank-run CRA programs), the activist groups would testify against the bank merger in question.

So, a winning political coalition was born. The banks got regulatory approval, the activist organisations got funding for their client base (and themselves) and politicians got credit support for low income constituents. All ultimately guaranteed by the taxpayer, but no-one consulted them. The megabuck-activist-urban politician coalition played the externality game very well. Positive externalities to people who noticed–and voted, donated, or advocated–and negative externalities to people who didn’t.

The Clinton and Bush II Administrations, as well as a majority in Congress, liked this game of taxpayer-sponsored cheap credit to worthy groups so much they kept upping the ante. Regulatory and other pressure was put on Fannie Mae and Freddie Macgovernment sponsored enterprises (GSEs), to “broaden” their credit provision–i.e. take on riskier and riskier low income would-be home-owners. With activist groups such as ACORN advocating and testifying in favour. The result–as having one set of standards for CRA recipients and another for other mortgagees would raise all sorts of awkward questions–was to massively shift upwards the level of risks of mortgages across the board. Which also helped protect Fannie Mae and Freddie Mac from regulatory challenge, since lots of middle class voters happily hopped on the (much) cheaper housing credit bandwagon and would not have appreciated having the cost of their home loans suddenly go up because regulators got antsie. (Thus, studies which compare CRA and non-CRA credit recipients miss the macro-point.)

As GSE’s, Fannie Mae and Freddie Mac also had (implicit) government guarantees. So, someone was paying for this upward risk spiral–the taxpayers providing the implicit or explicit guarantees. But they had not been told they were being dealt into this game.

This was all not good, but it was not enough to cause the eventual sub-prime meltdown. If prudential regulation had adjusted to force adequate capital coverage, then the final collapse would not have been anywhere near as bad. But that is precisely what the regulators did not do. They refused to pick a fight that would cause them nothing but grief–remember all those middle class voters hopping on the cheap housing credit bandwagon. Plus megabanks and activist groups all poised to testify that the nasty regulators were blocking the dream of homeownership to millions of low-income, minority Americans. And not merely poised–when various folk (Republicans representing rural electorates, concerned academics, Fed Chair Alan Greenspan) expressed concerns about the level of risk being taken on, groups such as ACORN testified and lobbied to make sure that the legislative changes from the reform push expanded the risk-taking.

It was, after all, all about helping poor Americans, particularly from minority groups, achieve the dream of home-ownership. Never mind the possible consequences, feel the noble intent.

Republican House Speaker Newt Gingrich was notably active in protecting the interests of the banking-and-housing coalition. Who were (particularly the GSEs) very good at recruiting key political staffers, putting projects in key Congressional districts, etc. As Calomiris & Haber point out, being cross-Party is part of being a successful policy coalition.

Then the house of cards collapsed and the taxpayers finally discovered what they had been dealt into. Though, because “Wall Street” and “easy monetary policy” copped the blame, the full understanding of how they had been fleeced does not seem to have sunk in. As Calomiris & Haber point out, the Dodd-Frank reforms don’t really address the key issues, because the megabank-activist-urban politician coalition still has the numbers in Congress. Indeed, the Obama Administration is still playing the same game. The housing-finance-subsidised-by-the-taxpayer-house-of-cards is being rebuilt as the “winning” coalition is still in place.

As Calomiris & Haber explain in detail, the US banking system has been perennially prone to banking crises because various winning political coalitions have ensured regulatory structures which make it so. All operating on the basis of positive externalities to people who notice (and count) and negative externalities to those who don’t. A long series of the arsonists being put in charge of the fire brigade.

Calomiris & Haber also point out that various countries have successfully avoided bank crises. But that is a matter for another post.

ADDENDA To clarify, and in response to a comment, the above is about the sub-prime crisis. The causes of the Great Recession are another matter.  (The sub-prime crisis no more caused the Great Recession than the Great Crash caused the Great Depression: both global economic downturns were the result of disastrous monetary policies by central banks.)


The Jacobin impulse

By Lorenzo

What makes the decent Left decent is not that it is Left, but what it shares with decent folk who are not of the Left. Failure to grasp that leaves one claiming that any person of the Left is morally and intellectually superior to any person of the “Right”: so Pol Pot is morally and intellectually superior to, say, Winston Churchill–which is repellent nonsense.

The problem with folk such as Pol Pot, Mao ZedongJoseph StalinKim il Sung and their ilk is not that they are not of the Left–for any such claim is nonsense on stilts–but that they are too intensively Left. That is, they partake of things which make the Left, Left but do so in unrestrained ways. They are, for example, not less committed to the ideal of material equality than other members of the Left, but more so. (No matter how profoundly self-defeating any commitment to as complete as possible material equality through state action is.) They are not less committed to the notion that the Left is where one finds moral purity and social-political understanding, but more so. They are not less committed to doing what it takes to achieve the goals of the Left, but more so.

Men of the Left.

Of course, admitting that the problem with such folk is that they are too intensively Left can be very uncongenial, for it says that not only is being of the Left not an automatic ticked to moral and intellectual superiority but that there are potentially deeply problematic things within what makes being Left, Left. That much of the appeal of being Left is a sense of moral and intellectual virtue is fairly obvious–the tendency to personal abuse in response to critiques of the Left, the insistence that one cannot critique the Left unless one makes it clear “the Right” is worse, etc are pretty good markers that a sense of superior identity is being affronted in critiques of the Left. (And the greater the fear that there is something to the critique, the more resort to exorcising emotion in response.)

It does not help that Left-and-Right is a problematic dichotomy. There is, in a (very broad) sense, the Left, because an overt commitment to equality (albeit variously conceived and to varying degrees of intensity) is a unifying value of the Left. There is no such unifying value on “the” Right, which includes folk who emphasise very different values, conceptions of people and politics. No amount of narrowing intensification of the politics of, say, Milton Friedman will get you to the politics of Adolf Hitler.

Where the Left goes seriously wrong is when it gives into the Jacobin impulse. The terms “Left” and “Right” arose in the French Revolution, that transforming accident of history, which also gave us the original Jacobins and set in motion the Jacobin impulse.

Make something worse — add Robespierre
The Jacobin impulse is to take the moral purpose and social understanding of one’s project to be so complete and all-encompassing, that no divergence from it is to be permitted and no restraint in action needs to be entertained. It is total politics–both in the ambit of its social reach and the means it is willing to employ. Adding the Jacobin impulse to any political project makes it (much) worse.

Robespierre — showed folk the make-it-much-worse way.

Thus, adding the Jacobin impulse to nationalism gives us Fascism. Adding the Jacobin impulse to Aryan racism gives us Nazism. And adding the Jacobin impulse to socialism gives us Leninism and its cognates. (As Lenin himself explained.)

The Jacobin impulse arose out of the very origins of the Left and is the most tempting to folk of the Left. Merely adding in the Jacobin impulse does not, however, make one of the Left–attempts to claim that Fascism and Nazism are “really” Left-wing movements are too tedious for words. Both movements may have appropriated their approach to the ambit and actions of politics from the Left, but their projects were not projects of the Left. There were (and are) left-nationalism and left-racism, but both nationalism and racism had long since escaped into very non-Left forms by the time Mussolini and Hitler were adapting Lenin’s political methods to their particular political projects.

Thus the realities of the Great War convinced Mussolini that the collectivism of nation was more powerful than the collectivism of class. But that moved him from the hard Left to the “third way” of Fascism, turning Mussolini-the-socialist into Mussolini-the-creator-of-Fascism.

The editor of Avanti, man of the Left. (Later, not so much.)

Nevertheless, the notion that one’s moral and political understanding is so correct, one’s goals so virtuous, and what has been created by the past so flawed, that any means can be employed to pursue them; that there is no nook or cranny of social life that should not be subject to the liberating project’s transforming touch; that is a temptation that speaks most naturally and most profoundly to people on the Left. Which is why the Jacobin impulse arose out of the origins of the Left.

But the Jacobin impulse makes any project it is added to worse, because no one has anything seriously approaching that complete a level of moral purity and social understanding. Nor is any project, or its practitioners, immune to the corruptions of power–so to seek total power is to end up totally corrupt. While to commit to unrestrained means is to commit to unrestrained evil, as the core of morality is restraint in one’s actions towards others.

Hence the Jacobin impulse is to be fought in all its forms. Even the petulant and petty Jacobinism of the US campus dis-invitation tendency. What is specifically wrong with such dis-invitations I will leave to Prof. Stephen Carter of Yale University to say much more humorously and effectively than I can.

The vicious logic of equality

By Lorenzo

The Left likes to view itself as the champions of equality, compassion, tolerance and support for the oppressed. As with many people, my most dramatic experiences of the Left are of people who are entitled, self-righteous, vicious and nasty.

Some of the latter has been on display in the recent round of commencement addresses in US campuses, where the banning of “heretics” from speaking at US campuses continues to get (via) nuttier and nuttier (while remaining nasty, entitled, self-righteous, vicious and ultimately self-destructive). The science of climate has become infected with the same vicious heretic-hunting, as the recent experience of Prof. Lennart Bengtssom has shown.

Status through equality
But I have long since realised that ostentatious commitment to equality has a huge status advantage–since social life is so, one can always find another “axis of equality” to push. Why is that a status advantage? Because the more committed to equality one is, the more morally virtuous one is.  If one sort of equality becomes generally supported, then one shifts to another to keep ahead in the moral purity stakes.

Support for equality can thus degenerate into a fairly vicious status game. A point that applies to virtues generally, including those the Left is ostentatiously attached to. So the status game of ostentatious morality–the game of feeling morally entitled and self-righteous–generates vicious and nasty behaviour in the name of compassion and tolerance.  Robespierre‘s reign of virtue (which showed how to transmute alleged virtue into terror and viciousness if enough ostentatious self-righteous entitlement is applied) resonating through history, including the pale and pathetic mirrors thereof provided by petulant and privileged youth on US campuses.

Unequal equalising power
Equality specifically has a deeply vicious potential logic to it, for if equality is applied to the material things of life (beyond welfare state redistribution), then pervasive power has to be applied to ensure people do not exchange or work their way into unequal outcomes. This then sets up a profound inequality–between those to be equalised and those who do the equalising. Not merely an inequality of power (though that drives much of the consequences) but also an inequality of status and moral-historical “understanding”.

The compulsorily equal and their equalising hereditary owner.

The most extreme version of this is in North Korea’s bizarre dynastic Stalinism, where one family is deemed to have such transcendent status and moral-historical understanding that the entire apparatus of state (which has essentially subsumed the entire society) is directed according to their purposes. A family that includes an eternal President as well as an eternal Secretary-General and whose current ruling avatar is the third generation of such transcendent guides. All in the names of creating the perfectly equal society utterly free of every last element of exploitation and alienation. But the Kim dynasty has just turned into a dynastic principle the underlying logic of complete material equality and entitled moral purity.

This dynastic Stalinism has created a Party-state-society which is, of course, also a standing offence against such complete material equality as the ruling elite (particularly the ruling dynasty) live lives of great luxury. But that is an inevitable consequence of the gulf in power and status between those to be equalised and those doing the equalising. We can see the same logic in another state committed to material equality which (not coincidentally) has also applied the dynastic principle to leadership of the state: Cuba, were an ailing Fidel Castro has been succeeded by his younger brother Raul Castro.

If people want to see the society described by the film Elysium in real life–a small elite living luxurious and privileged lives while the masses live in the midst of decaying economic ruin–then all they have to do is to go to Havana, Cuba. As writer Michael J. Totten describes in grim detail.

Elysium: presenting us with a post-Castro Los Angeles.

Great imbalances in power have consequences: a perennial consequence of huge power imbalances throughout history has been a small elite living a luxurious existence and masses living in want. Despite the worship of “correct” historical and moral “understanding” in certain circles, equalising intentions are absolutely no protection against that perennial reflection of human nature. That the logic of material equalising generates great power inequalities is much more important a causal factor than the alleged motivation behind the power inequalities. The means chosen utterly overwhelms the alleged motivation. Indeed, this is the problem with the notion that the ends justify the means: the ends are mere intentions in the mind, the means chosen are what affects the world. So, the disastrous effect of utopian ends comes from the absolute nature of the thereby justified means.

If anything, the creating-equality motivations make the effect worse, since material equality is so all-encompassing a goal there is no part of social life that power cannot justify reaching into while full equality without any exploitation or alienation is so ostentatiously “noble” a goal that almost any status game can be justified for its power-practitioners.

Elysium may or may not have been intended as critique of American capitalism: as such it is a failure. To take only one basic point, a fundamental pattern of capitalism has been the diffusion of technology through society, not its elite monopolisation.  But as a description of what a society formally dedicated to complete material equality ends up being like, the film is spot on, as North Korea and Cuba demonstrate.

The Emancipation Sequence, the long fight for equal protection of the law–from the battle against slavery and for Jewish emancipationCatholic emancipationvotes for womenwomen’s liberationcivil rightsqueer emancipation–has been a noble and ennobling series of events in human history. But that is a world away from vicious logic of equality that leads to Havanna’s Elysium on Earth, the dynastic Stalinism of North Korea or the pale, pathetic distant mirrors thereof in what the petulant and privileged fortunate heirs of other people’s struggles get up to on US campuses.

ADDENDA: Yale law Professor Stephen L. Carter provides a very funny ”thanks for not disinviting me” comment on the commencement address shenanigans which makes some serious points on the way through.

The illusion of free banking

By Lorenzo

Reading Fragile by Design: The Political Origins of Banking Crises and Scarce Credit by Charles Calomiris and Stephen Haber continues to stimulate. As one comes to appreciate how immense the damage done by central bankers has been–causing the Great Depression, Japan’s “lost decades”, the Great Recession, the Eurozone crisis–[which, I should clarify, is not the subject matter of Fragile by Designfree banking (in the sense of a banking regime without a central bank) becomes more and more attractive.

Especially as there are two excellent examples of how successful free banking can be, both covered in some detail in Fragile by Design. The first is Scotland from the late C17th until the mid C19th, when the privileges of the Bank of England were (partially) extended into Scotland, and Canada from the 1860s to the creation of the Bank of Canada in 1934. In both cases, free banking generated stable, efficient banking systems able to provide high levels of credit to their economies.

No, a monopoly in issuing banknotes is not a necessary feature of a stable banking regime.

Case closed therefore? Alas, no. Central banks are ubiquitous in modern economies and for a simple reason–no state is willing to forego the financing advantages having a central bank gives it. A tame banker is a boon during fiscal emergencies–this is why they were created, starting with the oldest, the Sveriges Riksbank (founded 1668, the fourth oldest bank still in existence), and the second oldest, the Bank of England (founded 1694, the ninth oldest bank still in existence).

In both the above cases of free banking (Canada and Scotland), the free banking regime operated under the shelter of a central-bank-financed state. In the case of Scotland, part of the United Kingdom from 1707 onwards but sharing a common monarch since 1603 (apart from the Interregnum, when they still shared a government), the English-cum-British war machine, debt-financed as necessary via the Bank of England since 1694, protected Scotland and its free banking system (as Calomiris & Haber point out). In the case of Canada, part of the British Empire, Canada and its free banking regime was protected by the Royal Navy, also debt-financed as necessary by the Bank of England since, well, 1694.

Royal Navy: financed through the Bank of England, also protecting free banking Scotland.

So, both the flagship cases of successful free banking regimes are also examples of why they are so rare. It is possible to have a free banking regime–in a subordinate jurisdiction protected by a central bank debt-financed war machine.

Since states are not going to give up their central banks, the trick becomes to determine the best policy regime for a given central bank to operate under. NGDP level targeting–maintaining a smooth trend in aggregate spending/aggregate income–is the best on offer at the moment.  As Lars Christensen points out, it would mean that the business cycle was entirely driven by supply shocks; as Scott Sumner points out, it would allow policy to largely leave things be; and, as the experience of Australia and Israel demonstrate, can lead to very flat business cycles even during other people’s (demand-shock caused) Great Recessions.  (Yes, technically, the Reserve Bank of Australia runs a broad inflation targeting policy regime, but it largely operates as an aggregate spending smoothing policy regime.)

So, free banking: lovely idea, not going to happen. And the standard examples of why it is a lovely policy idea also demonstrate why it is not going to happen (except in subordinate jurisdictions able to have their own banking arrangements protected by central bank debt-financed as necessary war machines).

Catholicism against success (bargain keeping monarchies, or not)

By Lorenzo

Protestant monarchies have a much better survival rate than Catholic monarchies.

The failed Protestant monarchy in bombastic mode.

The failed Protestant monarchy in bombastic mode.

The ultimate willingness of the British monarchy to support broader rather than narrower social interests–in the Reform Bill crisis of 1832 and Parliament Act crisis of 1911–was in stark contrast to the performance of Bourbon monarchy in 1789-1792, the Hohenzollern monarchy under Wilhelm II (despite his support for protective legislation) or the House of Romanov under Nicholas II. Of course, the execution of Charles I and deposition of James II might have been learning experiences for the British monarchy. (In 1981, Juan Carlos of Spain proved he had ”got the memo”.) If there was one thing Charles I, Louis XIV and Nicholas II had in common, it was that you could not make social deals with them that stuck.

Noting that–with the exception of the (restored) Spanish and (created) Belgium monarchies–all the surviving monarchies of Europe are either Protestant (UK, Netherlands, Denmark, Norway, Sweden) or tiny (Luxembourg, Liechenstein, Monaco), with Catholic (Italy, Portugal, France, Austria) and Orthodox (Russia, Greece) national monarchies having a much higher failure rate than Protestant ones (Germany), suggests that being able to engage in (and keep) broad social bargains is a survival trait in a monarchy. (Being overthrown by Soviet occupation or Soviet-supported post-Nazi insurrection–Bulgaria, Romania, Hungary, Yugoslavia, Albania–can be discounted.) The Protestant “naked before God” all-in-this-together outlook, including different time perspectives, being an advantage over the Catholic & Orthodox absolution-available, hierarchy-rules approach.

I once heard a Serbian historian observe that edicts of religious toleration in Protestant Europe tended to stick, while those in Catholic Europe were not worth the paper they were printed on. A point that has wider implications, perhaps.  Those absolution-granting “deals with heretics don’t count” priestly intermediaries may not have been a good long-term survival bet for monarchies.