Selgin on Haber and Calomiris

There is no doubt that I very much like Stephen Haber and Charles Calomiris’ great book “Fragile by Design” on the constitutional origin of banking crisis (take a look at my earlier posts on the book here and here)

I do, however, not agree with everything in the book and now George Selgin has a review of “Fragile by Design” that addresses some of these issues. It is a great review. The read the read book and read the review.

Here is the abstract from George’s review:

 In Fragile by Design (2014), Charles Calomiris and Stephen Haber argue that banking crises, instead of being traceable to inherent weaknesses of fractional-reserve banking, have their roots in politically-motivated government interference with banking systems that might otherwise be robust. The evidence they offer in defense of their thesis, and their manner of presenting it, are compelling. Yet their otherwise persuasive work is not without significant shortcomings. These shortcomings consist of (1) a misleading account of governments’ necessary and desirable role in banking; (2) a tendency to overlook the adverse historical consequences of government interference with banks’ ability to issue paper currency; (3) an unsuccessful (because overly deterministic) attempt to draw general conclusions concerning the bearing of different political arrangements on banking structure; and (4) an almost complete neglect the of role of ideas, and of economists’ ideas especially, in shaping banking systems, both for good and for evil. The last two shortcomings are especially unfortunate, because they suffuse Fragile by Design with a fatalism that is likely to limit its effectiveness in sponsoring needed change.

PS my recent presentation of monetary and currency reform in Iceland was very much in the spirit of Fragile by Design.

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Great, Greater, Greatest – Three Finnish Depressions

Brad DeLong has suggested that we rename the Great Recession the GreatER Depression in Europe as the crisis in terms of real GDP lose now is bigger in Europe than it was it during the Great Depression.

Surely it is a very simplified measure just to look at the development in the level of real GDP and surely the present socio-economic situation in Europe cannot be compared directly to the economic hardship during the 1930s. That said, I do believe that there are important lessons to be learned by comparing the two periods.

In my post from Friday – Italy’s Greater Depression – Eerie memories of the 1930s – I inspired by the recent political unrest in Italy compared the development in real GDP in Italy during the recent crisis with the development in the 1920s and 1930s.

The graph in that blog post showed two things. First, Italy’s real GDP lose in the recent crisis has been bigger than during 1930s and second that monetary easing (a 41% devaluation) brought Italy out of the crisis in 1936.

I have been asked if I could do a similar graph on Finland. I have done so – but I have also added the a third Finnish “Depression” and that is the crisis in the early 1990s related to the collapse of the Soviet Union and the Nordic banking crisis. The graph below shows the three periods.

Three Finnish Depressions

(Sources: Angus Maddison’s “Dynamic Forces in Capitalist Development” and IMF, 2014 is IMF forecast)

The difference between monetary tightening and monetary easing

The most interesting story in the graph undoubtedly is the difference in the monetary response during the 1930s and during the present crisis.

In October 1931 the Finnish government decided to follow the example of the other Nordic countries and the UK and give up (or officially suspend) the gold standard.

The economic impact was significant and is very clearly illustrate in the graph (look at the blue line from year 2-3).

We have nearly imitate take off. I am not claiming the devaluation was the only driver of this economic recovery, but it surely looks like monetary easing played a very significant part in the Finnish economic recovery from 1931-32.

Contrary to this during the recent crisis we obviously saw a monetary policy response in 2009 from the ECB – remember Finland is now a euro zone country – which helped start a moderate recovery. However, that recovery really never took off and was ended abruptly in 2011 (year 3 in the graph) when the ECB decided to hike interest rate twice.

So here is the paradox – in 1931 two years into the crisis and with a real GDP lose of around 5% compared to 1929 the Finnish government decided to implement significant monetary easing by devaluing the Markka.

In 2011 three  years into the present crisis and a similar output lose as in 1931 the ECB decided to hike interest rates! Hence, the policy response was exactly the opposite of what the Nordic countries (and Britain) did in 1931.

The difference between monetary easing and monetary tightening is very clear in the graph. After 1931 the Finnish economy recovered nicely, while the Finnish economy has fallen deeper into crisis after the ECB’s rate hikes in 2011 (lately “helped” by the Ukrainian-Russian crisis).

Just to make it clear – I am not claiming that the only thing import here is monetary policy (even though I think it nearly is) and surely structural factors (for example the “disappearance” of Nokia in recent years and serious labour market problems) and maybe also fiscal policy (for example higher defense spending in the late-1930s) played role, but I think it is hard to get around the fact that the devaluation of 1931 did a lot of good for the Finnish economy, while the ECB 2011’s rate hikes have hit the Finnish economy harder than is normally acknowledged (particularly in Finland).

Finland: The present crisis is The Greatest Depression

Concluding, in terms of real GDP lose the present crisis is a GreatER Depression than the Great Depression of the 1930s. However, it is not just greater – in fact it is the GreatEST Depression and the output lose now is bigger than during the otherwise very long and deep crisis of the 1990s.

The policy conclusions should be clear…

PS this is what the New York Times wrote on October 13 1931) about the Finnish decision to suspend the gold standard:

“The decision of taken under dramatic circumstances…foreign rates of exchange immediately soared about 25 per cent”

And the impact on the Finnish economy was correctly “forecasted” in the article:

“In commercial circles it is expected that the suspension (of the gold standard) will greatly stimulate industries and exports.”

HT Vladimir

Related post:
Currency union and asymmetrical supply shocks – the case of Finland

Book of the day – “Fragile by Design”

I have waited for this book for a while, but yesterday it finally arrived in the mail. It is Fragile by Design by Charles Calomiris and Stephen Haber.

I have only read a couple of pages, but so far it is very good. Extremely well-written. I look forward to reading the rest of the book soon. Fragile by Design

This is the book description:

Why are banking systems unstable in so many countries–but not in others? The United States has had twelve systemic banking crises since 1840, while Canada has had none. The banking systems of Mexico and Brazil have not only been crisis prone but have provided miniscule amounts of credit to business enterprises and households. Analyzing the political and banking history of the United Kingdom, the United States, Canada, Mexico, and Brazil through several centuries, Fragile by Design demonstrates that chronic banking crises and scarce credit are not accidents due to unforeseen circumstances. Rather, these fluctuations result from the complex bargains made between politicians, bankers, bank shareholders, depositors, debtors, and taxpayers. The well-being of banking systems depends on the abilities of political institutions to balance and limit how coalitions of these various groups influence government regulations.

Fragile by Design is a revealing exploration of the ways that politics inevitably intrudes into bank regulation. Charles Calomiris and Stephen Haber combine political history and economics to examine how coalitions of politicians, bankers, and other interest groups form, why some endure while others are undermined, and how they generate policies that determine who gets to be a banker, who has access to credit, and who pays for bank bailouts and rescues.

Recenly Charles and Stephen talked to the legendary EconTalk host Russ Roberts about their new book. Listen to the interview here.

I do not agree with everything Charles and Stephen are saying, but I fully agree with the general idea that we cannot understand banking crisis without understanding the politics of banking – or what they call The Game of Bank Bargains.

Anyway, since I have only read a small part of the book this is not a review and I am sure I will return to comment more on the ideas in the book.

I have written about the book before – see here and here.

PS Of course I would stress the role of monetary policy in banking crisis. That is another issue…

I just ordered “Fragile by Design”

I must admit that I am a bit of a “serial shopper” when it comes to buying books on Amazon. Today I (pre) ordered a book I have been waiting for some time –  “Fragile by Design: Banking Crises, Scarce Credit,and Political Bargains”  by Charles Calomiris and  Stephen Haber. I have written about the book before:

For natural reasons I have not read the book yet, but in a couple of recent papers and presentations by Calomiris and Haber have spelled out the main ideas of the book (See for example hereherehere andhere). I find their large survey of history of banking crisis tremendously interesting and I find it particularly interesting that Calomiris and Haber conclude that the root cause of banking crisis has to be found in what political institutions different countries have. Said in another way the main cause banking crisis is one of “political design”.

One of the main views of Calomiris and Haber is that some countries are a lot more prone to banking crisis than other. Calomiris and Haber list the following countries as particularly prone to banking crisis: Argentina, the Democratic Republic of the Congo, Chad, the Central African Republic, Cameroon, Guinea, Kenya, the Philippines, Nicaragua, Brazil, Bolivia, Costa Rica, Thailand, Mexico, Ecuador, Colombia, Uruguay, Chile, Turkey, Spain, Sweden and the United States.

Similarly Calomiris and Haber list a number of countries that in general have been crisis free (despite abundant credit):  Bahamas, Malta, Cyprus, Brunei, Singapore, Hong Kong, Macao, South Africa, Italy, Austria, New Zealand, Australia, and Canada.

The differences between USA and Canada seem to be particularly interesting (discussed in Chapter six of the book). Hence, since 1840 the US have had 14 banking crisis, while Canada have had none and this despite of the fact that credit have been as abundant in Canada as in the US. While the two countries have the a very similar cultural and colonial  history the political institutions in Canada and the USA are very different. These differences in political institutions according to Calomiris and the US have lead to the development of vastly different banking systems in the two countries – “branch banking” in Canada and “unit banking” in the US.

There are a lot more in the book than what I have discussed above and the papers that Haber and Calomiris already have put out are extremely interesting and insightful so I can’t wait to read the book!

What are Crashes in Cycling’s Grand Tours telling us about banking crisis?

The concept of moral hazard can often be hard to explain to non-economists – or at least non-economists are often skeptical when economists try to explain excessive risk taking in banking with moral hazard problems. Non-economists often prefer a simpler explanation to banking crisis – bankers are simply evil and greedy bastards.

But maybe if we – as economists – use something that most people would understand – sports – to explain moral hazard we might be more successful when we want to explain moral hazard in banking.

Just take a look at the abstract from a recent paper – Does the Red Flag Rule Induce Risk Taking in Sprint Finishes? Moral Hazard Crashes in Cycling’s Grand Tours – from the Journal of Sports Economics:

Sprint finishes in professional cycling are fast, furious, and dangerous. A ‘‘red flag rule’’ (RFR) seeks to moderate the chaos of these finishes, but may induce moral hazard by removing the time penalty associated with crashing. To test for moral hazard, the authors use a 2005 rule change that moved the red flag from 1 km to 3 km from the finish. Data from Europe’s Grand Tours indicate that, after the rule change, both the incidence and the size of crashes nearly doubled in the 1–3 km from the finish zone. There was no such increase in crashing rates in the 3–5 km zone.

I love Sportometrics or the Economics of Sports not only because it tells us about sports, but also because sports is a good way of testing economic theories such as moral hazard. It is real-life experimental economics.

Therefore, I think that if we can show that if you reduce the “cost” of crashing in a bike race with a rule like the “red flag rule” then you will increase “risk taking” then it is only natural also to expect bankers to take excessive risks if there is a similar “red flag rule” in banking – such as deposit insurance.

This also shows that if we try to make the “game” more safe then the end result might very well be the opposite.  Regulators and bankers alike should realise this.

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

“Fragile by design” – the political causes of banking crisis

Charles Calomiris undoubtedly is one of the leading experts on banking crisis in the world. Calomiris has a new book coming out – co-authored with Stephen Haber. The main thesis in the book – “Fragile by Design: Banking Crises, Scarce Credit,and Political Bargains” – is that banking crisis is not an inherent characteristic of a free-market financial system, but rather the outcome of what Calomiris and Haber terms the “Game of Bank Bargains” between the government and special interests and how this game lead to different incentives for excessive risk taking or not.

For natural reasons I have not read the book yet, but in a couple of recent papers and presentations by Calomiris and Haber have spelled out the main ideas of the book (See for example here, here, here and here). I find their large survey of history of banking crisis tremendously interesting and I find it particularly interesting that Calomiris and Haber conclude that the root cause of banking crisis has to be found in what political institutions different countries have. Said in another way the main cause banking crisis is one of “political design”.

One of the main views of Calomiris and Haber is that some countries are a lot more prone to banking crisis than other. Calomiris and Haber list the following countries as particularly prone to banking crisis: Argentina, the Democratic Republic of the Congo, Chad, the Central African Republic, Cameroon, Guinea, Kenya, the Philippines, Nicaragua, Brazil, Bolivia, Costa Rica, Thailand, Mexico, Ecuador, Colombia, Uruguay, Chile, Turkey, Spain, Sweden and the United States.

Similarly Calomiris and Haber list a number of countries that in general have been crisis free (despite abundant credit):  Bahamas, Malta, Cyprus, Brunei, Singapore, Hong Kong, Macao, South Africa, Italy, Austria, New Zealand, Australia, and Canada.

The differences between USA and Canada seem to be particularly interesting (discussed in Chapter six of the book). Hence, since 1840 the US have had 14 banking crisis, while Canada have had none and this despite of the fact that credit have been as abundant in Canada as in the US. While the two countries have the a very similar cultural and colonial  history the political institutions in Canada and the USA are very different. These differences in political institutions according to Calomiris and the US have lead to the development of vastly different banking systems in the two countries – “branch banking” in Canada and “unit banking” in the US.

There are a lot more in the book than what I have discussed above and the papers that Haber and Calomiris already have put out are extremely interesting and insightful so I can’t wait to read the book! The book unfortunately is not available on Amazon yet so I haven’t ordered it yet, but I hope that that will soon change.

PS If there is one thing that seems to be missing in Calomiris and Haber’s discussion of the causes of banking crisis then it is a discussion of monetary policy regimes. That is unfortunate in my opinion as there is no doubt that monetary policy failure has played a huge role in the present crisis and in historical crises – something I know at least Calomiris acknowledges.

Update: Charles Calomiris has informed me that “Fragile by Design” also include a discussion of monetary policy regime – for example in the case of Brazil.

Update 2: Here is an recent interview with Charles on Bloomberg TV.

“Monetary Policy, Financial Stability, and the Distribution of Risk”

I have recently been giving a lot of attention to the work of David Eagle and his Arrow-Debreu based analysis of monetary policy rules. This is because I think David’s work provides a microfoundation for Market Monetarism and adds new dimensions to the discussion about NGDP targeting – particularly in regard to financial stability.

I have now come across a paper that is using a similar model as David’s model. However, this might be a slightly more interesting for the conspiratorial types as this paper is written by a Federal Reserve economist – Evan F. Koeing of the Federal Reserve Bank of Dallas.

Here is that abstract of Koeing’s paper “Monetary Policy, Financial Stability, and the Distribution of Risk”:

“In an economy in which debt obligations are fixed in nominal terms, but there are otherwise no nominal rigidities, a monetary policy that targets inflation inefficiently concentrates risk, tending to increase the financial distress that accompanies adverse real shocks. Nominal- income targeting spreads risk more evenly across borrowers and lenders, reproducing the equilibrium that one would observe if there were perfect capital markets. Empirically, inflation surprises have no independent influence on measures of financial strain once one controls for shocks to nominal GDP.”

This paper obviously is highly relevant and as the euro crisis just keeps getting worse day-by-day we can always hope that some influential European policy makers read this paper.

After all the euro crisis is mostly a monetary crisis rather than a fiscal crisis – which David Beckworth forcefully demonstrates in a recent comment.

HT Arash Molavi Vasséi

Calomiris on “Contagious Events”

As we minute by minute are inching closer to the announcement of some form of restructuring/write-down of Greek Sovereign debt nervous investors focus on the risk of contagion from the Greek crisis to other European economies and contagion in the European banking sector.

In a paper from 2007 Charles Calomiris has a good and interesting discussion of what he calls “Contagious events”.

Here is the abstract:

“Bank failures during banking crises, in theory, can result either from unwarranted depositor withdrawals during events characterized by contagion or panic, or as the result of fundamental bank insolvency. Various views of contagion are described and compared to historical evidence from banking crises, with special emphasis on the U.S. experience during and prior to the Great Depression. Panics or “contagion” played a small role in bank failure, during or before the Great Depression-era distress. Ironically, the government safety net, which was designed to forestall the (overestimated) risks of contagion, seems to have become the primary source of systemic instability in banking in the current era.”

WARNING: If you are looking for a justification for bailouts you will probably not find it in this paper, but you will find some interesting “advise” on banking regulation.

Killing the messenger won’t solve the debt crisis

I don’t even want to comment on this one: “EU reaches deal on naked CDS ban law”

Shoot the messenger and the problem will go away? I think not…

Share your views of the quality of policy makers in Europe please.

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