Property rights and banking crisis – towards a “Financial Constitution”

I just found a great paper – “A Coasean Approach to Bank Resolution Policy in the Eurozone” – on banking resolution by Gregory Connor and Brian O’Kelly. Here is the abstract:

“The Eurozone needs a bank resolution regime that can work across seventeen independent nations of diverse sizes with varying levels of financial development, limited fiscal co- responsibility, and with systemic instability induced by quick and low-cost deposit transfers across borders. We advocate a Coasean approach to bank resolution policy in the Eurozone, which emphasises clear and consistent contracts and makes explicit the public ownership of the externality costs of bank distress. A variety of resolution mechanisms are compared including bank debt holder bail-in, prompt corrective action, and contingent convertible bonds. We argue that the “dilute-in” of bank debt holders via contingent convertibility provides a clearer and simpler Coasean bargain for the Eurozone than the more conventional alternatives of debt holder bail-in or prompt corrective action.”

I found the paper as I was searching the internet for papers on banking regulation and property rights theory. If we fundamentally want to understand banking crisis we should understand incentives and property rights.

Who owns “profits” and “liability”? Who will be paying the bills? The banks’ owners, the clients, the employees, the bank management or the taxpayers? If property rights are badly defined or there are incentive conflicts we will get banking troubles.

In that sense banking crisis is a constitutional economics problem. Therefore, we cannot really understand banking crisis by just looking at specific issues such as how much capital or liquidity banks should hold. We need to understand the overall incentives facing all players in the “banking game” – owners, clients, employees, bank managements, regulators and politicians.

Inspired by Peter Boettke’s and Daniel Smith’s for a “Quest for Robust Political Economy” of monetary policy we could say we need a “Robust Political Economy of Financial Regulation”. I believe that Connor’s and O’Kelly’s paper contributes to this.

Another paper that helps use get a better understanding of the political economy of financial regulation and crisis is Josh Hendrickson’s new paper “Contingent Liability, Capital Requirements, and Financial Reform” (forthcoming in Cato Journal). Here is the abstract:

“Recently, it has been argued that banks hold an insufficient amount of capital. Put differently, banks issue too much debt relative to equity. This claim is particularly important because, all else equal, lower levels of capital put banks at greater risk of insolvency. As a result, some have advocated imposing capital requirements on banks. However, even if one accepts the proposition that banks hold too little capital, it does not neces- sarily follow that the correct policy response is to force banks to hold more capital. An alternative to higher capital requirements is a system in which banks have contingent liability. Under contingent liability, shareholders are liable for at least some portion of depositor losses. This alternative is not unprecedented. Historical evidence from the United States and elsewhere suggest that banks with contingent liability have more desirable charac- teristics than those with limited liability and that depositors tend to pre- fer contingent liability when given the choice. Successful banking reform should be aimed at re-aligning bank incentives rather than providing new rules for bank behavior.”

Lets just take the last sentence once again – “Successful banking reform should be aimed at re-aligning bank incentives rather than providing new rules for bank behavior.” 

Hence, if we want to “design” good banking regulation we fundamentally need a property rights perspective or even in a broader sense a “Financial Constitution” in the spirit of James Buchanan’s “Monetary Constitution”.

Concluding, yes we might learn something about banking crisis and banking regulation by studying finance theory, but we will probably learn a lot more by studying Law and Economics and Public Choice Theory.

Related posts:

“Fragile by design” – the political causes of banking crisis
Beating the Iron Law of Public Choice – a reply to Peter Boettke

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Beating the Iron Law of Public Choice – a reply to Peter Boettke

Studying Public Choice theory can be very depressing for would-be reformers as they learn about what we could call the Iron Law of Public Choice.

The students of Public Choice theory will learn from Bill Niskanen that bureaucrats has an informational advantage that they will use to maximizes budgets. They will learn that interest groups will lobby to increase government subsidies and special favours. Gordon Tulluck teaches us that groups will engage in wasteful rent-seeking. Mancur Olson will tell us that well-organized groups will highjack the political process. Voters will be rationally ignorant or even as Bryan Caplan claims rationally irrational.

Put all that together and you get the Iron Law of Public Choice – no matter how much would-be reformers try they will be up against a wall of resistance. Reforms are doomed to end in tears and reformers are doomed to end depressed and disappointed.

Peter Boettke’s defense of defeatism

In a recent blog post Peter Boettke complains about “the inability of people to incorporate into their thinking with respect to public policy some elementary principles of public choice.”

The problem according to Pete is that we (the reformers) assume that policy makers are benevolent dictators that without resistance will just implement reform proposals. Said in another way Pete argues that to evaluate reform proposals we need to analysis whether it is realistic the vote maximizing politicians, the ignorant voters and the budget maximizing bureaucrats will go along with reform proposals.

Pete uses Market Monetarists and particularly Scott Sumner’s proposal for “A Market-Driven Nominal GDP Targeting Regime” as an example. He basically accuses Scott of being involved in some kind of social engineering as Scott in his recent NGDP Targeting paper argues:

“No previous monetary regime, no matter how “foolproof,” has lasted forever. Voters and policymakers always have the last word. However, before beginning to address public choice concerns, it is necessary to think about what sort of monetary regime is capable of producing the best results, at least in principle. Only then will it be possible to work on the much more difficult question of how to make the proposal politically feasible.”

So Scott is suggesting – for the sake of the argument – to ignore the Iron Law of Public Choice, while Pete is arguing that you should never ignore Public Choice theory.

Beating the Iron Law with ideas

I must say that I think Pete’s criticism of Scott (and the rest of Market Monetarist crowd) misses the point in what Market Monetarists are indeed saying.

First of all, the suggestion for a rule-based monetary policy in the form of NGDP targeting exactly takes Public Choice considerations into account as being in stark contrast to a discretionary monetary policy. In that sense NGDP Targeting should be seen as essentially being a Monetary Constitution in exactly same way as for example a gold standard.

In fact I find it somewhat odd that Peter Boettke is always so eager to argue that NGDP targeting will fail because it as a rule will be manipulated – or in my wording would be crushed by the Iron Law of Public Choice. However, I have never heard Pete argue in the same forceful fashion against the gold standard. That is not to say that Pete has argued that the gold standard cannot be manipulated. Pete has certainly made that point, but why is it he is so eager to exactly to show that a “market driven” NGDP targeting regime would fail?

When it comes to comparing NGDP targeting with other regimes of central banking (and even free banking) what are the arguments that NGDP targeting should be more likely to fail because of the Iron Law of Public Choice than other regimes? After all should we criticize Larry White and George Selgin for ignoring Public Choice theory when they have advocated Free Banking? After all even the arguably most successful Free Banking regime the Scottish Free Banking experience before 1844 in the end “failed” – as central banking in the became the name of the game across Britain – including Scotland. Public Choice theory could certainly add to understanding why Free Banking died in Scotland, but that mean that Larry and George are wrong arguing in favour Free Banking? I don’t think so.

So yes, Scott is choosing to ignore the Iron Law of Public Choice, but so is Austrians (some of them) when they are arguing for a gold standard and so is George Selgin when he is advocate Free Banking. As Scott rightly says no monetary regime is “foolproof”. They can all be “attacked” by policy makers and bureaucrats. Any regime can be high-jacked and messed up.

Furthermore, Pete seems to fail to realize that Scott’s proposal is to let the market determine monetary conditions based on an NGDP futures set-up. Gone would be the discretion of policy makers. This is exactly taking into account Public Choice lessons for monetary policy rather than the opposite.

My second point is the Pete’s view is ignoring the importance of ideas in defeating the Iron Law of Public Choice. Let me illustrate this with a quote from Hayek. This Hayek in an interview with Reason Magazine from February 1975 on the prospects of defeating inflation:

“What I expect is that inflation will drive all the Western countries into a planned economy via price controls. Nobody will dare to stop inflation in an ordinary manner because as things are at present, to discontinue inflation will inevitably cause extensive unemployment. So assuming inflation stops it will quickly be resumed. People will find they can’t live with constantly rising prices and will try to control it by price controls and that of course is the end of the market system and the end of the free political order. So I think it will be via the attempt to regress the effects of a continued inflation that the free market and free institutions will disappear. It may still take ten years, but it doesn’t matter much for me because in ten years I hope I shall be dead.”

Here Hayek is basically making a Public Choice argument – the West is doomed. There will not be the political backing for the necessary measures to defeat inflation and instead will be on a Road to Serfdom. Interestingly enough this is nearly a Marxist argument. Capitalism will be defeated by the Iron Law of Public Choice. There is no way around it.

However, today we know that Hayek was wrong. Inflation was defeated. Price controls are not widespread in Western economies. Instead we have since the end of 1980s seen the collapse of Communism and free market capitalism – in more or less perfect forms – has spread across the globe. And during the Great Moderation we have had an unprecedented period of monetary stability around the world and you have to go to Sudan or Venezuela to find the kind of out of control inflation and price controls that Hayek so feared.

Something happened that beat the Iron Law of Public Choice. The strictest defeatist form of Public Choice theory was hence proven wrong. So why was that?

I will suggest ideas played a key role. In the extreme version ideas always trumps the Iron Law of Public Choice. This is in fact what Ludwig von Mises seemed to argue in Human Action:

“What determines the course of a nation’s economic policies is always the economic ideas held by public opinion. No government whether democratic or dictatorial can free itself from the sway of the generally accepted ideology.”

Hence, according to Mises ideas are more important than anything else. I disagree on that view, but I on the other clearly think that ideas – especially good and sound ideas – can beat the Iron Law of Public Choice. Reforms are possible. Otherwise Hayek would have been proven right, but he was not. Inflation was defeated and we saw widespread market reforms across the globe in 1980s and 1990s.

I believe that NGDP targeting is an idea that can change the way monetary policy is conducted and break the Iron Law of Public Choice and bring us closer to the ideal of a Monetary Constitution that both Peter Boettke and I share.

PS Don Boudreaux also comments on Pete’s blog post.

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Related blog posts:

Boettke and Smith on why we are wasting our time
Boettke’s important Political Economy questions for Market Monetarists
Is Market Monetarism just market socialism?

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Update: Pete has this comment on Scoop.it on my post:

“Very thoughtful reply to my CP post. I too believe in the power of ideas, but I also believe that any time we assume away public choice issues we are in effect being intellectually lazy.  I think a robust approach to institutional design would explore not only the incentive compatibility of the proposal, but an incentive compatible strategy for its implementation.  Absent that, and we aren’t thinking hard enough.  I have been as guilty as anyone else in this regard, so I am not going to point fingers.  But I’d like us to think harder and clearer about these issues.”

I very much apprecaite Pete’s kind words about my post and fundamentally think that we are moving towards common ground.

Update 2: Scott Sumner also comments on Pete’s post. Read also the comment section – George Selgin has some very insightful comments on the relationship between Free Banking and NGDP level targeting.

Boettke and Smith on why we are wasting our time

I am beginning to get a serious problem in keeping up with all the interesting papers, which are being published at the moment. The latest paper that I clearly have to read is a rather impressive paper (124 pages!) by Peter Boettke and Daniel Smith.

The topic of Pete’s and Daniel’s paper – which I still have not read – is basically a discussion of the public choice aspects of central banking. This is a topic I find extremely interesting and I look very much forward to reading the paper in the near future (I will be on vacation next week – so maybe…).

Here is the abstract of the paper “Monetary Policy and the Quest for Robust Political Economy”:

The economics profession not only failed to predict the recent financial crisis; it has been struggling in its aftermath to reach a consensus on the cause(s) of the crisis. While competing narratives are being offered and evaluated, the narrow scope of the debate on the strictly technical aspects of monetary policy that have contributed to and prolonged the crisis has precluded the a broader examination of questions of political economy that may prove to be of greater import. Attempting to find the technically optimal policy is futile when the Federal Reserve’s independence is undermined by the political influences of contemporary democracy. Nobel Laureates F.A. Hayek, Milton Friedman, and James Buchanan each sought ways to constrain and protect a monetary authority from political pressures in their research. Each one ended up rejecting the possibility of doing so without a fundamental restructuring of our monetary regime. Hayek turned to denationalization, Buchanan to constitutionalism, and Friedman to binding rules. We incorporate their experiences to make a case for applying the concepts of robust political economy to the Federal Reserve. Robust political economy calls for relaxing idealized assumptions in order to seek out institutional regimes that can overcome both the epistemic and motivational hurdles that characterize contemporary democratic settings.

Even though I have not read the paper yet I have a pretty good idea where Pete and Daniel are going – they are questioning whether we can convince central bankers to do the right thing. Market Monetarists want central banks to target the nominal GDP level. We want central banks to follow rules. However, we are up against the powers of public choice theory. One can easily argue that central bankers will never give up their discretionary powers and politicians will always interfere with the conduct of monetary policy. It is simply in their selfish interest to do so and therefore the project to convince central bankers to do the right thing – NGDP level targeting – is just a waste of time. We should rather focus on fundamental institutional reforms.

This is fundamentally the issue that any reformist in any area will have to struggle with – how can we expect those in power to give up that power? How can we implement reforms? A way to beat the logic of public choice theory is through the powers of ideas. Milton Friedman was in the business of ideas all his life. The powers of governments – and central banks – can be rolled back through the sheer power of strong arguments and good ideas. It is never going to be easing, but when Scott Sumner started to blog about NGDP targeting nobody listened. Now Federal Reserve scholars are serious talking about it and doing research about it and even the FOMC has debate NGDP targeting. There is therefore reason to be optimistic. But I will be the first to admit that I find it unlikely that the Federal Reserve or the ECB will start targeting the NGDP level anytime – neither do I find it likely that these institutions will give up their discretionary powers. That said I never had any illusions that they would and I do agree that we need to talk about the fundamental institutional issues of central banking.

We need to debate whether we should abolish central banks altogether as Free Banking proponents are favouring and I certainly do not rule out that it fundamentally is a more fruitful strategy than to continue to talk about how central banks should ideally conduct monetary policy when we full well know that central banks never can be convinced to do the right thing. Or as Boettke and Smith write in the conclusion to their paper:

“What in our contemporary history of the Federal Reserve should give us any reason to not follow Friedman and tie the hands of the monetary authority so tightly that the bonds cannot be broken to juggle, let alone Hayek and point out that the only robust political economy option when it comes to central banking is to abolish it by taking away the juggler’s balls?”

PS Boettke and Smith does not explicitly mention Market Monetarists or NGDP targeting in paper, but a draft version of the paper was presented at the 2010 Southern Economic Association Annual Meeting Session “Are There Public Choice Problems with Nominal Income Targeting?” Pete has earlier written a blog post on this issue directly challenging the Market Monetarist position: “Political Economy Questions Which Even Market Monetarists Might Want to Think About”. Here is my response to that post.

PPS I have often argued that there is certainly no conflict between favouring NGDP level targeting for central bank and favouring Free Banking as NGDP level targeting in the same way as school vouchers can be seen as a privatization strategy

Christopher Adolph on the politics of central banking

Yesterday I put out a post about central bankers as Niskanen style bureaucrats. I decided that I would look a bit more into the topic. In my browsing for more on this topic a ran into a (revised?) Ph.D. dissertation by Christopher Adolph who is now an assistant professor of political science at the University of Washington, Seattle.The title of the disserttion is “The Dilemma of Discretion: Career Ambitions and the Politics of Central Banking”

I have not yet had time to read it all, but my initial impression is that Adolph provides some very interesting insides to what motivates central bankers, but have a look for yourselves.

Adolph also has new book in the pipeline: “The Myth of Neutrality: Bankers, Bureaucrats, and Central Bank Politics” which will be published by Cambridge University Press.

William Niskanen 1933-2011

William Niskanen passed away on October 26. I have always admired Niskanen a lot. He was a champion of liberty and a great economist.

Any student of Public Choice theory would know Niskanen’s classic Bureaucracy and Representative Government from 1971 and I still think of this as his greatest contribution to economic theory. However, as Bill Woolsey reminds us William Niskanen was also a long time proponent of nominal income targeting.

Niskanen first advocated nominal income targeting or rather targeting of nominal spending in his 1992 paper “Political Guidance on Monetary Policy”. Niskanen later elaborated on the subject in his 2001 paper “A test of the Demand Rule” and further in his 2002 paper “On the Death of the Phillips Curve”.

Marcus Nunes has an insight comment on “A test of the Demand Rule” here.

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