"My provisional conclusion at the sight of this sorry spectacle is that, despite all the arguments presented by writers of a monetarist persuasion for an active monetary policy, continuous and systematic intervention by central banks is in the end counterproductive."
In this third of my columns on the contradictions of liberal democracy, I want to consider a worrying source of disorder in democracies: money and credit. This is a topic I necessarily had to deal with before closing the series. The financial upheaval which the world has suffered has dealt a body blow to liberty. I could not pass it over with a few general comments.
Let me state from the very beginning the paradox of money: that money, one of the greatest instruments of individual freedom ever invented by man should have become an instrument of political exploitation in the hands of government. The effects of this abuse go further than upsetting the financial equilibrium of market economies and reducing their productive progress. It undermines the whole philosophy of liberty. If laissez faire has to be suspended in the field of money and credit and if the most important institution for trade, contract, saving and investment cannot be left to be managed by individuals and firms, then what is left of our personal self-government? We shall have to slip through the nooks and crannies of State control to attain our goals, untiringly hounded by the henchmen of "that insidious and crafty animal, vulgarly called a statesman or politician."1 And the pretexts for public intervention in all spheres of life will be ready at hand for those who never believed in a free economy as the foundation of a free society. As David Laidler has recently said on the causes of the Great Recession:
More than competing ideas about the proper conduct of counter-cyclical economic policy were at stake here [...]. Profound and ideologically loaded questions about the capacity of the market economy to function smoothly without the benefit of constant attention from government, and hence about the appropriate political framework that should underpin macro-economic policy, were also getting renewed attention in 2008.2
I must confess that I did not expect the depth of the Great Recession that hit our world from 2008 to 2011 (to 2013 for the Eurozone). I discounted the warnings those few economists who said that another Great Depression like that of the thirties was coming. I thought central banks had the instruments to contain the recession, without having recourse to extraordinary monetary and fiscal measures. There must have been something wrong in my understanding of our financial world when I underrated the danger of the turmoil getting out of hand and paralyzing banks, stock exchanges, Treasuries and firms. I was not seeing the whole picture.
I am not alone in having failed to foresee what was coming.3 When one reads the policy declarations and academic papers of central bank officials and monetary economists when they found themselves in the middle of the maelstrom, the impression is one of improvisation and of desperately reaching for whatever tools were at hand: interest rates brought down virtually to zero, quantitative easing through central banks hugely increasing their balance sheets, governments coming to the rescue of banks before having to be rescued themselves, a helping hand proffered to quasi-banks; in the United States things went as far as rescuing GMAC and nationalizing AIG and General Motors. I understand the urgency but must point out how light-weight the explanations were of why the whole thing had happened; at most one finds allusions to imprudent deregulation, excessively low interest rates, loose money creation, disruptive speculation, financial innovations—and greed, especially bankers' greed. There was no real attempt to understand what had gone wrong with the financial and indeed economic system as a whole.
First conclusion: Government, the primary cause of the financial crisis
For more on these topics, see Financial Crisis of 2008, an Econlib Resource for college students and teachers. See also Federal Reserve System, by Richard H. Timberlake, and Monetary Policy by James Tobin in the Concise Encyclopedia of Economics. See also the various John Taylor Podcast Episodes and Charles Calomiris Podcast Episodes, plus Milton Friedman on Money.
I will now marshal the arguments that lead me to maintain that the present financial crisis was primarily caused by defects of the State. In my view, it is contrary to fact to say that the Great Recession was due to a failure of the free market. I concur with George Selgin, Larry White, John Allison and other authors who have for many years been charging governments with the same wrong, that of being the principal cause of the Great Recession.
How did we get there?
In recent years and under the chairmanship of Alan Greenspan, the Fed's policy was not to intervene when bubbles appeared to be forming but, after they burst, minimize asset corrections at any cost by 'printing' more money. The Fed would always be there to prevent significant market corrections. This became known as the 'Greenspan put'. Greenspan served from mid-1987 to the end of 2006, under four Presidents: Reagan, George H. W. Bush, Clinton, and George W. Bush. Before coming to that exalted post he had been an admirer of Ayn Rand and had written an essay in Rand's Capitalism: the Unknown Ideal (1966, New American Library), where he said that the dollar should return to the gold standard and the Federal Reserve abolished.6 Not bad for a free marketeer who then would head the Fed for eighteen and a half years!7
Paul Volcker, the preceding Fed Chairman, had expunged inflation from the United States' financial system with the hardest of medicines. Under the newly appointed Greenspan, the Fed faced the 1987 crash with a "readiness to serve as a source of liquidity to support the economic and financial system".8 This readiness was evident whenever the economy tried a small correction: in the hiccup of 1990 the Federal Funds Rate was reduced from above 8% to below 3%. The bursting of the dotcom bubble and the attack on the World Trade Center led in 2001 to 2004 to a reduction of the interest rate from above 6% to 1%, resulting in negative real interest rates. Greenspan then had no qualms about pushing it back to 4.5% before he left office. Over the whole period, the Greenspan Fed oversaw a massive (though highly irregular) increase in the money supply.
On his appointment, Bernanke proceeded along the same lines, placing the Federal Funds Rate at a peak of 5.25 % and inverting the yield curve. John Allison is at his most instructive when writing on the destructive effects of inverted yields on banking business. Bernanke held the inverted yield curve (with long term interest rates below short) for more than a year, up to January 2008.
If you are managing [...] a commercial bank [...], an inverted yield curve is a disaster. Banks borrow short (at lower interest rates) and lend long (at higher interest rates). If short term rates are higher than long term rates, banks are faced with negative margins. (Allison, page 29)
This kind of policy has two effects: it moves lending out of the regulated banking industry, and it starts a recession.
Two remarks are pertinent here. One is that I have come to agree with Allison that if the market had been allowed to set interest rates in the way it did before 1913, these rates would not have been as low as Greenspan drove them, nor would they have grown as fast as in the first years of Bernanke's tenure. The second is that such irregular and volatile moves, coupled with drastic changes in money creation must have been destructive for the economy.9
This is not the moment to go round the world and see what central banks have done in other places. In any case, the ructions started in the United States. Most other issuers of money, with the notable exception of the Central Bank of Canada, to which I have given some attention in my courses, followed suit in pursuing lenient and irregular monetary policies. The European Central Bank is especially interesting, since it issues a currency, the euro, which has tried to stay above politics and to mimic the gold standard: the ECB is not being too successful, whatever their officials may hope to achieve.10 It will have to be for another day.
My provisional conclusion at the sight of this sorry spectacle is that, despite all the arguments presented by writers of a monetarist persuasion for an active monetary policy, continuous and systematic intervention by central banks is in the end counterproductive.
B. Deposit insurance and regulation
This scheme has two negative consequences on the banking sector. The first is that it reduces the perceived need for discrimination by investors as to where to place their money. This allows more adventurous or less scrupulous bankers to solicit funds less wisely than if their clients felt less secure. This unfair competition often pushes solid banks further up the risk curve than they would like. The second is that all deposit insurance schemes are usually financed by the banking sector itself, so that solid banks have to face the cost of guaranteeing the deposits left hanging by failed banks.
This apparent security for investors is enhanced by the belief that financial corporations included in the deposit insurance schemes are overseen by regulators whose task it is to find badly run banks. The general failure of commercial banks around the world shows that in most cases regulation is no guarantee against business failure. Inspectors and regulators usually are civil servants, who are not very savvy about banking business and who tend to be more indulgent in times of boom. In this crisis, regulation has proved to be pro-cyclical, since new and stricter rules are usually applied in a reactive manner, at the bottom of the cycle: this is the case with the Basel III capital ratios for commercial banks, who are asked to increase their capital at the same time as they are told to lend more to businesses.
C. Housing programs
The Farm Credit Administration was an insurer of home mortgages. But Fannie Mae started with the purpose of taking middle class mortgages contracted by banks on their books; and Freddie to buy mortgages on the secondary market, pool them, and sell them as a mortgage-backed security to investors on the open market. So, who started the practice of selling mortgage-backed securities on financial markets? They were both Government Sponsored Enterprises, so they enjoyed an implicit government guarantee, which in fact became explicit when they had to be nationalized. In the beginning these two GSEs pushed commercial banks away from the prime market. Private banks then took to unloading mortgages on those two instead of keeping them on their books. In 1990, Clinton set Fannie and Freddie on the path to grant subprime loans, as part of the effort to make the mortgage market racially fair. This kind of competition led many commercial banks to follow suit. Interest rates were low, banks had to look for more rewarding investments, and mortgages seemed cheap to prospective homeowners. The housing market had been mined by politicians. When nationalization came, Fannie and Freddie held a $2 trillion subprime portfolio.11
The disaster I know best is that of Spain. There was a deadly combination of the constructivist introduction of the euro and politically governed local savings banks. By joining the Eurozone, Spain saw its rate of interest (government bond yields) fall from double digits to under 4%. Half the banking market was made up of savings banks that were credit cooperatives with no shareholders. They were under the direct influence trade unions, political parties, and autonomous (or state) governments. When the crash came Spain was building 850,000 homes a year for a demand reckoned to have been in the 400 thousands at most.
D. Rating Agencies and Mark-to-Market
European authorities and Eurozone member states have complained of the unfairness of such ratings and the danger negative ratings imply in moments of market instability. European Union legislation in the pipe-line will open credit rating agencies to civil liability for intentional or negligent damages; and, in the framework of a fixed calendar for issuing sovereign ratings, governments will be able to react to a change in their rating before it is made public.13 Shooting the messenger!
Another rule imposed by the SEC and generally adopted across the stock exchanges of the first world is that of forcing public companies and especially finance corporations to value their assets at their market price at the end of each year. This is contrary to the accounting assumption that companies are rated as going concerns. It is wrong to impose such a rule, especially in times of turmoil when there is no market for those assets and the company intends to keep them to maturity. I have myself as a company director in a publicly quoted group experienced the unfairness of this rule when there is no price in the market, which caused a destruction of the worth of the group.
E. Too big to fail
The severity of the turmoil can confidently be traced back to the haphazard behavior of the US authorities in the matter of who can be allowed to fail without endangering the world financial system. Citigroup was saved by the Fed but not Wachovia. Bear Sterns and Goldman Sachs were saved by the Fed but not Lehman Bros. (Lehman would have found a buyer had not Dick Fuld been confident of a last moment rescue.) The United States government saved AIG, Fannie Mae, Freddie Mac, GMAC, and General Motors, but left countless other firms to go bust without compunction. No surprise that such erratic behavior led to a general seizure of financial markets round the world.
Thirdly, there are well known ways to prepare for, and put in effect, bankruptcies, and they were simply not considered. Assets do not disappear when their owners fail: they are revalued and redeployed. One of the welcome reforms made after the crisis is the obligation of large financial institutions to prepare a last will and testament for the possibility of failure.
The question of how to deal with 'too big to fail' corporations is certainly a complicated one, about which I have not totally made my mind up. But surely John Allison's remark is to the point:
The reward for running a good business is to have your worst competitors bailed out by the US government and then to have massive new regulations that punish your company for sins it did not commit. (Allison, page 130)
F. Derivatives and shadow banking
This change of direction is the result of trying to reform without descending to fundamentals and being surprised by the results. Of course banks took refuge in mortgage-backed securities, collateralized debt obligations, or structured investment vehicles. They did so to restore their profitability eroded by low interest rates or by privileged competition from Government Sponsored Enterprises. All those were efforts to dis-intermediate deposits, that is, to invest clients' money where it could earn a little more. In origin mortgage-backed securities were a way of shifting mortgage risk to outside investors; and collateralized debt obligations were simply a form of insurance. The face value of these derivatives looks enormous but the actual money exchanged and risked is small, just as in an insurance contract, where the principal can be huge but the premiums minimal. So the real size of the derivatives market is smaller than usually held.
The call for more transparency in the issue of derivatives and of more publicity in the OTC market deserves consideration. But this should not deflect our conclusion that the fundamental flaws of this 'shadow' banking market come from fleeing the public policy interventions we have analyzed above.
Second conclusion: A spending State will not control the cycle
I studied macroeconomics under the inspiration of the great monetarists of the last quarter of the 20th century: Milton Friedman and Anna Schwartz in their explanation of the Great Depression in their Monetary History of the United States (1963), Harry J. Johnson with his monetary explanation of the balance of payments, David Laidler and his analysis of the demand and supply of money, Brunner and Meltzer when they finally codified monetarism. As I lived through Lady Thatcher's reforms in the United Kingdom in the seventies and eighties, I came to see the fight against inflation as part of the battle for economic freedom. My inclination, therefore, was to explain the late Great Recession through the inability to maintain the money supply steadily—in the belief that the transmission mechanism between the currency created by banks and the money used in the economy at large still functioned.
My studies as a young man incline me to defend monetary measures, rather than fiscal, to relieve the recession. We must not forget, however, that I now see this kind of monetary interpretation as fundamentally incomplete. I now feel that attempts to devise anti-cyclical monetary policies removing restrictions of the kind we have studied in the first part of this essay are condemned from the start.14
The debate about remedies
The evidence of the slow exit from the present crisis seems to point at the superiority of monetary measures, says Laidler in his conclusions. Tim Congdon principally has for years maintained the close connection between broad money supply and nominal GDP, as a guide for monetary policy.15 This poses two questions. The first one is, is the connection reliable between nominal GDP and GDP corrected for prices, between a higher money value of a country's production and the real goods and services it supplies to its own and foreign populations? The second is, if monetary expansion is not a reliable source of real growth, can the continuous (and hopefully steady) expansion of money in the end avoid inflation? After all, real growth does not come from money but from increases in primary goods, population, capital, technology and productivity. Making the supply of broad money grow at a steady pace may be a good anti-cyclical recipe. But what will it do to real growth? And can the modern State carry out this well designed anti-cyclical policy?
The growth of the State
Enter "financial repression", Dr. van Riet's (2013) felicitous expression, culled from many a contribution by students of public policy. He thus characterizes the financial stratagems used by authorities in the Eurozone to get over any limits to the growth of public expenditure.16 It seems that taxpayer resistance makes it difficult for States to make their total expenditure go over 40% of GDP in the United States and 50% in Europe. Policy makers then resort to regulation.17
The term "financial repression" is generally used to describe a comprehensive policy regime put in place by the government to manage the domestic financial system—with assistance from the regulator—by imposing tight restrictions on financial markets, intermediaries and services, often complemented by capital account and foreign exchange controls to prevent evasion or currency speculation. (Riet, page 4)
Van Riet, being a good mainstream economist, makes a distinction in public financial intervention that I would question. He distinguishes between "interventions in the public interest" and interventions that "privilege governments and unduly restrain market-based fiscal discipline, especially in times of funding stress". (Riet, page 3)
Against the background of these two alternative views, one may distinguish between beneficial and harmful forms of financial repression. Financial repression can be seen as a "public service" in the interest of society if the interventions are introduced with the strict objective of correcting market and regulatory failures and for financial and monetary stability as well as distributional purposes.
The clause "distributional purposes" in that passage betrays a lack of realism. The Welfare or Entitlements State is a system designed to interfere with market mechanisms in a way that spills over mere redistribution and necessarily leads to abuse of public finances. Also, the interventions under the guise of "correcting market and regulatory failures" that we have just reviewed suggest that 'justified' public policy interventions may be few and far between. Van Riet's whole purpose in his paper is to warn about the pervasive vicious interventions that take place
... when regulatory distortions undermine the ability of financial markets to send disciplinary signals about economic fundamentals and, in particular, the soundness of fiscal positions.
The list of possibly repressive interventions presented by van Riet is interesting in view of what we have been saying about the causes of the Great Recession:
If you happened to live in Greece or Cyprus during the euro crisis this list would not surprise you.
Summary conclusion: the rape of money
Money was not invented by States or central banks. As Carl Menger said, "Money has not been generated by law. In its origin it is a social, and not a state institution." It was a discovery of merchants who found that they could get a better price or pay a lower one if they used a highly saleable good as a medium of exchange. So they specialized in accumulating these acceptable tokens for their own sake.18
Sovereigns soon discovered that they could get a cut of the value supplied by money by coining these tokens for themselves: they could thus extract seignorage or the difference between the face value and the social or intrinsic value of the coin. Today seignorage or the tax on the use of money takes innumerable other forms: the inflation tax, or the finance of State activities, or the increased satisfaction among the citizenry from more jobs. It is thus that the authorities can extract income or votes with the help of money creation—for a time.
All these returns to the State from having nationalized money and determining its price (the interest rate) are difficult to turn into a steady stream of economic or political income. They are temporary and volatile because the users of money soon discover ways to minimize this underhand extraction of value by the sovereign issuer.
This is why I am now skeptical of attempts to design monetary policies that will forestall ballooning excitement or correct irrational panics among money users. When money was based on gold there were cyclical ups and downs but, as issuing money was not in the hands of the State, their span was narrow and they soon came to a halt. The evidence of the present crisis indicates that the idea of independent central banks committed to defending the value of their currency is a pipe dream, unless we go back to an automatic limit to money supply. Today's governments cannot resist the temptation to 'print' money and place bonds to finance the insatiable needs of welfare and entitlements—until they are hit by a financial crisis.
Conclusion to the Three Columns: Can the paradoxes of liberal democracy be overcome?
The review of the paradoxes of liberal democracy in my three columns poses many questions that should not be answered in a hurry. Since individual freedom is our principal and most endangered value and since democracy is ideally the expression of the self-government of individuals when they are pursuing communal goods, the study of how to avoid contradictions between freedom and democracy must have a high place in our concerns. Finding ways of containment of, or escape from, these contradictions merits long consideration.
1. The unnatural market
2. The vices of democracy
Smaller States making votes as local as possible is a solution worth considering. However, we must remember that Mancur Olson underlined the fact that large and inclusive constituencies, such as that for the presidency of the United States, weaken the force of interest groups.19 Still, smaller states are often in danger of invasion. Remember the fate of Italian merchant states in the 1400s: they could not put up significant resistance to invasion by France and Spain and in the end were (badly) governed by the Spanish for almost two centuries.
A traditional remedy is that of the separation of powers. Proposed by Montesquieu, it was enshrined in the United States Constitution. It had two dimensions: horizontal, the need to govern with the concurrence of the Presidency, Congress, and the Supreme Court; vertical, the retention by the constituent states of powers "not delegated to the United States by the Constitution" (Article X). The first one has had a little more effect than the second.
3. Patriotism and nationalism
4. The confusion of liberty with wealth
5. The role of money in a free society
At bottom, money is not allowed to function untrammeled because the modern State has needs that cannot be covered with taxes, so that it has recourse to legal money and public finance. Some radical solutions could be considered: renouncing legal tender on the part of State Treasuries; going back to the gold standard; allowing true monetary competition, opening the door to private moneys; not interfering with the creation of new forms of money and electronic payment modes.
David Laidler (2013): "Reassessing the Thesis of the Monetary History". Paper presented at the IEA Conference "The causes of the Great Recession", November, 26, 2013. The Monetary History is that of Friedman and Schwartz (1963).
For a rare early warning that monetary policy cannot be decoupled from State finance, see BIS Working Papers No 147 by Borio, Claudio and White, William (2004) "Whither monetary and financial stability? The implications of evolving policy regimes", February.
Selgin, George, Lastrapes, William D. and White, Lawrence H. (2010): Has the Fed been a Failure? CATO Institute Working Paper.
The Tinbergen Rule states that for each and every policy target there must be at least one policy tool. If there are fewer tools than targets, then some policy goals will not be achieved. Wikipedia article on Jan Tinbergen, accessed 18xii13.
John A. Allison (2013): The Financial Crisis and the Free Market Cure. Why Pure Capitalism is the World's Only Hope, McGraw Hill. Since this is not a column for specialists in monetary economics, I recommend John Allison's book. He led his bank BB&T through the crisis without showing a single quarter loss, which gives his words some authority. The book is notable for the clarity with which he explains the complicated details of the current financial crisis. This notwithstanding, may I say that I consider Adam Smith's The Theory of Moral Sentiments (1759) more encompassing than Ayn Rand's writings favored by Allison.
I have not found the strength yet to read Greenspan's memoir, The Age of Turbulence (2007), Penguin, or his answers to the Financial Crisis Panel in 2010.
The aim to keep inflation low was coupled with the firm resolution of avoiding deflation like the plague. However, there are benign deflations when it is productivity gains that would lead to falls in prices, if money supply is kept under control. See Selgin (1987): Less than Zero. The Case for a Falling Price Level in a Growing Economy. IEA, London.
The reason given for such wild changes of interest rates is that they are demanded by the so-called 'Taylor rule'. Central bankers who believe they can micromanage the monetary economy apply this rule by continuously comparing: (a) their forecast of the rate of inflation with the actual rate; and (b) the potential rate of growth (and unemployment) of the economy with the actual rate. (These forecasts are made on the basis of Dynamic Stochastic General Equilibrium models that have signally failed to forewarn the late crisis.) If the actual rate of inflation is above the desired rate; and if the economy is growing faster than its long term potential central bankers raise the interest rate; and they do the contrary if a deflation is looming and unemployment is high. No allowance is made for the possibility of a benign deflation, as per footnote 8 above. And no consideration is given to the possibility of 'stagflation'—high inflation with high unemployment. It would be better if central bankers did not micromanage and kept the money supply constant.
In my view, the ECB has not been successful in this task, whatever its officials may say. The contortions that the ECB authorities go through to preserve the independence of the bank and stop Member States from abusing the euro for their own political purposes I have touched upon in a previous column titled "The ECB Changes its Spots".
Allison (2013), pp. 82-83.
Riet, Ad van (2013): "Financial Repression to Ease Fiscal Stress: Turning Back the Clock in the Eurozone?" An ECB Draft Document. Page 20. See below for fuller attention to van Riet's paper.
Moves towards a better monetary and financial market cannot be achieved by simply removing interventions piecemeal with no regard to indirect effects and feedbacks. When immoveable constraints make it impossible to reach the free market first best, the second best solution is much more complicated than omitting this or that intervention. One might find oneself in 'third best land', far removed from what one intended. This is what Lipsey, R.G. and Lancaster, Kevin showed in their famous 1956-7 paper on "The General Theory of the Second Best." Review of Economic Studies, 24(1), pp. 11-32.
Congdon, Tim (2011): Money in a Free Society. Encounter Books.
Riet, Ad van (2013): "Financial Repression to Ease Fiscal Stress: Turning Back the Clock in the Eurozone?" An ECB Draft Document.
See my references to Stigler (1971) and Peltzman (1976) in my previous column on "The Dangers of Majoritarian Democracy".
Menger did add that the State could help the general use of money by sanctioning and regulating it. This last concession to administrative views of money was unfortunately laden with dangerous implications. Commercial money needs no other sanction than its general acceptance. See Menger, Carl (1892): "On the Origin of Money", Economic Journal, Volume 2 (1892), pp. 239-55.
U.S. Presidents are always more favorable to free trade than Congressmen. More generally, see Olson, Mancur (1965, 1998): The Logic of Collective Action: Public goods and the Theory of Groups. Harvard. Chapter I, sections D and E.
*Pedro Schwartz Pedro Schwartz is "Rafael del Pino" Research Professor of at San Pablo University in Madrid where he directs the Center for Political Economy and Regulation. A member of the Royal Academy of Moral and Political Sciences in Madrid, he is a frequent contributor to the European media on the current financial and social scene.
For more articles by Pedro Schwartz, see the Archive.