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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Remembering the “Market” in Market Monetarism

A couple of days ago the young and talented George Mason University economist Alex Salter wrote the following statement on his Facebook account:

I wish market monetarists would put relatively more emphasis on the “market” bit.

I agree with Alex as I believe that one of the main points of Market Monetarism is that not only do money matters, but it equally important that markets matter. Hence, it is no coincidence that the slogan of my blog ismarkets matter, money matters” and it was after all me who coined the phrase Market Monetarism.

Paul Krugman used to call Scott Sumner a quasi-monetarist, but I always thought that that missed an important point about Scott’s views (and my own views) and that of course is the “market” bit. In fact Alex’s statement reminded me of a blog post that I wrote back in January 2012 on exactly this topic.

This is from my post “Don’t forget the “Market” in Market Monetarism”:

As traditional monetarists Market Monetarists see money as being at the centre of macroeconomic discussion. To us both inflation and recessions are monetary phenomena. If central banks print too much money we get inflation and if they print to little money we get recession or even depression.

This is often at the centre of the arguments made by Market Monetarists. However, we are exactly Market Monetarists because we have a broader view of monetary policy than traditional monetarists. We deeply believe in markets as the best “information system” – also about the stance of monetary policy. Even though we certainly do not disregard the value of studying monetary supply numbers we believe that the best indicator(s) of monetary policy stance is market pricing in currency markets, commodity markets, fixed income markets and equity markets. Hence, we believe in a Market Approach to monetary policy in the tradition of for example of “Manley” Johnson and Robert Keheler.

Interestingly enough Alex himself has just recently put out a new working paper - “There a Self-Enforcing Monetary Constitution?” -
that makes the exact same point. This is the abstract from Alex’s paper:

This paper uses insights from monetary theory and constitutional political economy to discover what a self-enforcing monetary constitution — one whose rules did not require external enforcement — would look like. I argue that a desirable monetary constitution (a) institutionalizes an environment conducive to economic calculation via an unhampered price mechanism and (b) enables agents acting within the system to uphold the rule even in the presence of deviations from ideal knowledge and incentive assumptions. I show two radical alternatives to current monetary institutions — a version of NGDP targeting that relies on market implementation of monetary policy and free banking — meet these requirements, and thus represent self-enforcing monetary constitutions. I ultimately conclude that the maintenance of a stable monetary framework necessitates branching out from monetary theory narrowly conceived and considering insights from political economy, and constitutional political economy in particular.

I very much like Alex’s constitutional spin on the monetary policy issue. I strongly agree that the biggest problem in the conduct of monetary policy – basically everywhere in the world – is the lack of a clear rule based framework for the monetary system and equally agree that NGDP targeting with “market implication” and Free Banking fulfill the requirement for a monetary constitution. Or as I put it in my 2012 post:

In fact we want to take out both the “central” and “banking” out of central banking and ideally replace monetary policy makers with the power of the market. Scott Sumner has suggested that the central banks should use NGDP futures in the conduct of monetary policy. In Scott’s set-up monetary policy ideally becomes “endogenous”. I on my part have suggested the use of prediction markets in the conduct of monetary policy.

…Even though Market Monetarists do not necessarily advocate Free Banking there is no doubt that Market Monetarist theory is closely related to the thinking of Free Banking theorist such as George Selgin and I have early argued that NGDP level targeting could be see as an “privatisation strategy”. A less ambitious interpretation of Market Monetarism is certainly also possible, but no matter what Market Monetarists stress the importance of markets – both in analysing monetary policy and in the conduct monetary policy.

Hence, Alex and I are in fundamental agreement, but I also want to acknowledge that we – the Market Monetarists – from time to time are more (too?) focused on the need to ease monetary policy – in the present situation in the US or the euro zone – than to talk about “market implementation” of monetary policy.

There are numerous reasons for this, but the key reason is probably one of political realism, but there is also a serious risk in letting “political realism” dictate the agenda. Therefore, I think we should listen to Alex’s advice and try to stress the “market” bit in Market Monetarism a bit more. Afterall, we have made serious inroads in the global monetary policy debate in regard to NGDP level targeting – why should we not be able to make the same kind of progress when it comes to “market implementation” of monetary policy?

I don’t care who becomes BoJ governor – I want better monetary policy rules

UPDATE: I have edited my post significantly – I misread what Scott really said. That is the result of writing blog posts very early in the morning after sleeping too little. Sorry Scott…

Scott Sumner has a blog post on who might become the next governor of Bank of Japan. Scott ends his post with the following comment:

Naturally I favor the least dovish of the three.

Note that Scott is saying “least dovish” (I missed “least” in my original post). But don’t we want a the most dovish BoJ governor? No, we want the most principled governor – or rather the governor most committed to a rule based monetary policy.

The debate over doves versus hawks is a debate among people who fundamentally think about monetary policy in a discretionary fashion. Market Monetarism is exactly the opposite. We are strongly against discretion in monetary policy (and fiscal policy for that matter).

The important thing is not who is BoJ governor – the important thing is that there are good institutions – good rules. As I have argued before – what we really want is a monetary constitution in spirit of Jim Buchanan. In that sense the BoJ governor should be replaced – as Milton Friedman suggested – by a ‘computer’ and not by the most ‘dovish’ candidate.

Market Monetarists would have been “hawks” in the 1970s in the sense that we would have argued that for example US monetary policy was far too easy and we are ‘doves’ now. But that is really a mistaken way to think about the issue. If we favour for example a 5% NGDP level target for the US today – then we would have been doves in 1974 or 1981. That would make us more or less dovish/hawkish at different times, but that debate is for people who favours discretionary monetary policies – not for Market Monetarists.

If we just want a ‘dovish’ BoJ governor then we should advocate that Prime Minister Shinzo Abe gives Zimbabwean central bank governor Gideon Gono a call. He knows all about monetary easing – and so do the central bank governors of Venezuela and Argentina. But we all know that these people are ludicrously bad central bankers.  In similar fashion Janet Yellen would not be the Market Monetarist candidate for the Federal Reserve chairman just because she tends to favour monetary easing – in fact it seems like Yellen always favours monetary easing. In fact you should be very suspicious of the views of policy makers who will always be hawks or doves.

Gideon_Gono10

The reason that Mark Carney is a good choice for new Bank of England governor is exactly that he is not ‘dovish’ or ‘hawkish’, but that he tend to stress the need for a rule based monetary policy. That said, the important thing is not Mark Carney, but rather whether the UK government is serious about introducing NGDP level targeting or not.

Monetary policy is not primarily about having the right people for the job, but rather about having the best institutions. Obviously you want to have the best people for the job, but ultimately even Scott Sumner would be a horrible Fed governor if his mandate was wrong.

If the BoJ had a rule based monetary policy and used for example NGDP futures to conduct monetary policy then it wouldn’t matter who becomes BoJ governor – because the policy would be the same no matter what. We cannot rely on central bankers to do the ‘right thing’. Central bankers only do the right thing by chance. We need to tie their hands with a monetary constitution – with strong rules.

Related posts:

Forget about “hawks” and “doves” – what we need is a “monetary constitution”
NGDP targeting is not about ”stimulus”
NGDP targeting is not a Keynesian business cycle policy
Be right for the right reasons
Monetary policy can’t fix all problems
Boettke’s important Political Economy questions for Market Monetarists
NGDP level targeting – the true Free Market alternative
Lets concentrate on the policy framework
Boettke and Smith on why we are wasting our time
Scott Sumner and the Case against Currency Monopoly…or how to privatize the Fed
NGDP level targeting – the true Free Market alternative (we try again)

 

Forget about “hawks” and “doves” – what we need is a “monetary constitution”

Even though NGDP level targeting is becoming increasingly popular I am increasingly getting worried that people don’t really understand what Market Monetarists are talking about. The problem is that most observers and participants in the monetary policy debate continue to think about monetary policy in a highly discretionary way rather think about monetary policy in terms of rules.

Keynesian economists have traditionally been much less concerned about ensuring a rule based monetary policy so it is not surprising that they continue to think in terms of different positions in the monetary policy debate in terms of “hawks” and “doves”. However, a surprisingly large number of anti-keynesian free market oriented economists have also fallen into this trap of thinking about monetary policy issues in terms of “hawks” versus “doves”. They see themselves as “hawks” who should fight the keynesian “doves”. They tend to think that central banks only err on the inflationary side and never on the deflationary side and that the important thing therefore to always argue for tighter monetary policy.

However, the problem is not that central banks are always inflationary – they are not necessarily. Just look at the Bank of Japan or the ECB. The problem is that central banks are not ruled by a “monetary constitution”. There are no clear rules guiding the game and so they mess up things.

James Buchanan who sadly died earlier this week can hardly be said to have been a great monetary theorist (his monetary thinking was “old Chicago” – Frank Knight, Henry Simons and Lloyd Mints). However, that is not really important because what Buchanan taught us about monetary policy (and about everything else) was much more important. Buchanan was a constitutionalist. He was concerned about one thing and one thing only and that was how to define the rules the game – also in monetary matters. This to me is what Market Monetarism to a large extent is about (or at least should be about).

We want central banks to stop the ad hoc’ism. In fact we don’t even like independent central banks – as we don’t want to give them the opportunity to mess up things. Instead we basically want as Milton Friedman suggested to replace the central bank with a “computer”. The computer being a clear monetary policy rule. A monetary constitution if you like.

The problem with today’s monetary policy debate is that it is not a Buchanan inspired debate, but a debate about easier or tighter monetary policy. The debate should instead be about rules versus discretions and about what rules we should have.

Obviously Market Monetarists have been arguing in favour of monetary easing in both the US and the euro zone, but the argument is made within the framework of NGDP level targeting. We are not always “dovish”. In fact most of us would probably have argued that monetary policy in the US and in most Europe have been overly easy for the last 40 years. But that is besides the point. The point is that we really should not have a discussion about easier versus tighter monetary policy. We should debate the rules of the game – James Buchanan would have told us that.

I am not trying to say James Buchanan was Market Monetarist – he was not and I am sure he would not have liked that label. But I do think that Market Monetarists’ call for a rule based monetary policy is completely in the spirit of James Buchanan.

However, many of the economists who would normally be on the same side of the argument as Market Monetarists today see us as allies of the keynesians because they see the Market Monetarist call for easier monetary policy as meaning that we are keynesians – because they equate being keynesian with easy monetary policy and therefore if you are anti-keynesian you will have to be a “hawk”.

Take some of the “hawks” on the FOMC – for example Charles Plosser. Plosser of course academically comes from an economic tradition (Real Business Cycle theory) that should lead him to stress the importance of rules. However, over the last four years I have heard very little from Charles Plosser about the need for a rules based monetary policy. Instead Plosser has been speaking in the language of discretion. In that sense he has a lot more in common with the keynesian Federal Reserve officials of the 1970s than Market Monetarists have.

That said, Market Monetarists certainly have a problem as well. If somebody wrongly sees us as the monetary version of discretionary keynesian fiscalists like Paul Krugman then we have a problem. Then we need to explain ourselves. We need to explain that we want a monetary policy based on the constitutionalist thinking of James Buchanan. We don’t care about hawks and doves – the only thing we care about is limiting the central banks ability to mess us things by introducing clear and transparent monetary policy rules that limits the discretionary powers of the central banks. In that sense we have a lot in common with Austrian gold standard proponents despite the fact we strongly disagree on the causes of the Great Recession.

So concluding, Buchanan was right – we need a monetary constitution that limits the discretionary powers for central banks. Now lets discuss what that rule should be instead of the continued fruitless discussion about easier or tighter monetary policy and stop identifying yourselves as hawks or doves. The questions is whether you believe in a monetary constitution or not.

PS I use the term “keynesian” here in a certain way that I think that most of my readers understand and agree with. However, the New Keynesian traditions would certainly be as strongly against discretionary monetary policies as Market Monetarists. I would not place for example Paul Krugman in that New Keynesian tradition as he seems very happy to endorse all kind of discretionary shenanigans.

PPS The term “constitutionalist” is not meant to mean the US Constitution and it is not some fringe US populist tradition. It a form of economic thinking.

PPPS Market Monetarism of course is not just about NGDP level targeting and rules, but also about how to think about monetary theory – for example how to think about the monetary transmission mechanism. Hence, you are not automatically a Market Monetarist just because you favour NGDP level targeting and you can think as a Market Monetarist and not necessarily favour NGDP level targeting.

See this excellent lecture by James Buchanan about the Great Recession and Economists from 2011 (Buchanan was 91 at that time!). I disagree with some of his views of the specifics of the causes of the Great Recessions, but he fully agree with his view that the fundamental reason for the Great Recession was that the failure of the “rules”.

Related posts:

NGDP targeting is not about ”stimulus”
NGDP targeting is not a Keynesian business cycle policy
Be right for the right reasons
Monetary policy can’t fix all problems
Boettke’s important Political Economy questions for Market Monetarists
NGDP level targeting – the true Free Market alternative
Lets concentrate on the policy framework
Boettke and Smith on why we are wasting our time
Scott Sumner and the Case against Currency Monopoly…or how to privatize the Fed
NGDP level targeting – the true Free Market alternative (we try again)

The last brick – RIP James M. Buchanan

Nobel Prize winning economist and founding father of the Public Choice school James M. Buchanan has died at age 93. His friends and students have already offered many kind words in his memory. Here I quote two of my friends professors Steve Horwtiz and Peter Kurrild-Klitgaard.

Here is Pete:

James M. Buchanan, RIP. If making a difference is what matters, he was one of the five most influential thinkers of the last 50 years. Sharp as a knife into his 90s and always the scholar.

And Steve:

There is much that one can say about him (Buchanan), not the least of which is that he was still intellectually sharp and active into his 90s. In short: he changed the face of economics and politics and advanced the cause of liberty as much as anyone in the second half of the 20th century…

…No one who wishes to talk responsibly about politics can be ignorant of public choice theory. No one should ever invoke the language of market failure (including externalities) without having digested his work on government failure. And people who run around talking about the constitution better be able to understand something of constitutional political economy.

Beyond all of that, he was a role model of the old school scholar: widely read and properly skeptical of turning economics into an engineering discipline. He was, at bottom, a humanist and a liberal in the oldest and best senses of the terms. And best of all: he was utterly unimpressed by degrees from fancy schools.

Buchanan produced an enormous amount of scholarly works including numerous books in his long life. Best known is probably The Calculus of Consent which he co-authored with Gordon Tullock. However, the works that had the biggest influence on my own thinking undoubtedly was “What should economists do?” and “Cost and Choice”.

Even though Buchanan primarily was a constitutional economist and a Public Choice theorist he also contributed to monetary thinking. His so-called brick standard was particularly intriguing. Here is Pete Boettke and Daniel Smith on Buchanan and the brick standard:

James Buchanan, sought to bring his extensive work on rule-making to bear in envisioning a monetary regime that could operate within a contemporary democratic setting. From the start, Buchanan (1999[1962]) eschewed the ‘presuppositions of Harvey road’ that held that economic policy would be crafted and implemented by a group of benevolent and enlightened elites. Buchanan set out to make the case for a monetary regime using comparative institutional analysis that compared monetary regimes in real, not ideal settings.

Buchanan (1999[1962]) believed that it was not so much the specific type of monetary regime adopted, but the set of rules that defined that regime. Buchanan argued that the brick standard, a labor standard, or a manager confined by well-defined rules, would all put a stop to the government growth let loose by the fiscal profligacy encouraged by the wide scale acceptance of Keynesian ideas in the political realm (see Buchanan and Wagner (2000[1977]). The brick standard, as defined by Buchanan, would be a monetary regime that allowed anyone to go to the mint with a standard building brick of a specified quality and exchange it for the monetary unit, and vice versa. As the general price level fluctuated, market forces would cause automatic adjustments as people would exchange money for bricks when the price level rose above the equilibrium level, and bricks for money when the price level fell below the equilibrium level. Under this regime, market actors, guided by profits and losses would be the mechanism that achieved price predictability, not a government-entity entrusted with the goal of achieving it. In addition, a brick standard would, most likely, divorce domestic monetary policy from international balance of payment and exchange rate policies due to the fact that a brick standard would be unsuitable for those purposes.

For Buchanan (1999[1962], 417), it came down to a toss-up between a brick type standard and a limited manager. What mattered most for monetary predictability was that the rules that set up the monetary regime must be of the ‘constitutional’ variety. In other words, the rules must be set to be ‘relatively absolute absolutes’ in order to protect them from tampering.

R.I.P. James M. Buchanan

—-

Update – other economists and scholars on James Buchanan:

Steve Horwitz

Daniel Kuehn

Eamonn Butler

Don Boudreaux (also from Don in 2005 and Don in WSJ)

Mark D. White

Grover Cleveland

Mario Rizzo

David Boaz

Robert Higgs

David Henderson

Alex Tabarrok

Randall Holcombe

Peter Boettke

Ryan Young

Bill Woolsey

Veronique de Rugy

Nick Gillespie

Arnold Kling

Brad DeLong

Christian Bjørnskov (in Danish)

Tyler Cowen (more from Tyler Cowen)

Lenore Ealy

Garett Jones

Charles Rowley

Edward Lopez

The Economist: Free Exchange

Buchanan

Economics is not an education. Economics is a state of the mind!

Some of the most clever economists I have encountered are actually not formally educated economists. In fact a number of Nobel Prize winners in Economics are not formally educated economists. One of my big heroes David Friedman is not formally educated as an economist, but to me he is certainly an economist – one of the greatest around. Another example is Gordon Tullock  who was trained as a lawyer, but he is certainly an economist – in fact to me Gordon Tullock is one of the most clever economists of his generation and it is a complete mystery to me that he has not yet been awarded the Nobel Prize in Economics. The way I perceive people’s skills as economists has nothing to do with their formal education. To me Economics is not an education. Economics is a state of mind.

Therefore, you can easily be an economist without having a formal education as an economist. As a consequence there are also people who have been able to attain a formal title as an economist without reaching that higher state of mind that a real economist has. I have unfortunately also encountered many of this kind of “economists” – economists by title, but not in mind. Many of these people are unfortunately high ranking policy makers.

Unfortunately many universities around the world today do not educate economists to be economists. They primarily educate them in technical skills – math and econometrics. And they educate them in “soft” skills and on different applied issues. A shocking amount of formally educated economists would not be able to explain comparative advantages or marginal utility to you (don’t get me stated on monetary theory). But they might be able to tell you about VAR, ARCH or GARCH – at best. Many – especially in Europe – are just educated to become government bureaucrats.

So what is the state of mind of an real economist? If you need to have that explained you are not yet an economist, but you might still become one by trying to figuring out what Gordon Tullock and David Friedman have in common. You might also read my favourite book on the topic – James Buchanan’s What Should Economists Do? 

PS This post is dedicated to all economists without formal education in economics (I miraculously became a formally educated economist in 1995, but it was not the official curriculum at the University of Copenhagen that made me an real economist – I became that by reading Gordon Tullock and David Friedman and other real economists)

PPS Yes, it is fair enough if you call me a sectarian or a cultist when it comes to Economics as a science.

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