The Real-Bills Doctrine, the Lender of Last Resort, and the Scope of Banking

Here is another section from my work in progress on the Smithian and Humean traditions in monetary economics. The discussion starts with a comparison of the negative view David Hume took toward banks and the positive view taken by Adam Smith which was also discussed in the previous post on the price-specie-flow mechanism. This section discusses how Smith, despite viewing banks positively, also understood that banks can be a source of disturbances as well as of efficiencies, and how he addressed that problem and how his followers who shared a positive view toward banks addressed the problem. Comments and feedback are welcome and greatly appreciated.

Hume and Smith had very different views about fractional-reserve banking and its capacity to provide the public with the desired quantity of money (banknotes and deposits) and promote international adjustment. The cash created by banks consists of liabilities on themselves that they exchange for liabilities on the public. Liabilities on the public accepted by banks become their assets, generating revenue streams with which banks cover their outlays including obligations to creditors and stockholders.

The previous post focused on the liability side of bank balance sheets, and whether there are economic forces that limit the size of those balance sheets, implying a point of equilibrium bank expansion. Believing that banks have an unlimited incentive to issue liabilities, whose face value exceeds their cost of production, Hume considered banks dangerous and inflationary. Smith disagreed, arguing that although bank money is a less costly alternative to the full-bodied money preferred by Hume, banks don’t create liabilities limitlessly, because, unless those liabilities generate corresponding revenue streams, they will be unable to redeem those liabilities, which their creditors may require of them, at will. To enhance the attractiveness of those liabilities and to increase the demand to hold them, competitive banks promise to convert those liabilities, at a stipulated rate, into an asset whose value they do not control. Under those conditions, banks have neither the incentive nor the capacity to cause inflation.

I turn now to a different topic: whether Smith’s rejection of the idea that banks are systematically biased toward overissuing liabilities implies that banks require no external control or intervention. I begin by briefly referring to Smith’s support of the real-bills doctrine and then extend that discussion to two other issues: the lender of last resort and the scope of banking.

A         Real-Bills Doctrine

I have argued elsewhere that, besides sketching the outlines of Fullarton’s argument for the Law of Reflux, Adam Smith recommended that banks observe a form of the real-bills doctrine, namely that banks issue sight liabilities only in exchange for real commercial bills of short (usually 90-days) duration. Increases in the demand for money cause bank balance sheets to expand; decreases cause them to contract. Unlike Mints (1945), who identified the Law of Reflux with the real-bills doctrine, I suggested that Smith viewed the real-bills doctrine as a pragmatic policy to facilitate contractions in the size of bank balance sheets as required by the reflux of their liabilities. With the discrepancy between the duration of liabilities and assets limited by issuing sight liabilities only in exchange for short-term bills, bank balance sheets would contract automatically thereby obviating, at least in part, the liquidation of longer-term assets at depressed prices.

On this reading, Smith recognized that banking policy ought to take account of the composition of bank balance sheets, in particular, the sort of assets that banks accept as backing for the sight liabilities that they issue. I would also emphasize that on this interpretation, Smith did not believe, as did many later advocates of the doctrine, that lending on the security of real bills is sufficient to prevent the price level from changing. Even if banks have no systematic incentive to overissue their liabilities, unless those liabilities are made convertible into an asset whose value is determined independently of the banks, the value of their liabilities is undetermined. Convertibility is how banks anchor the value of their liabilities, thereby increasing the attractiveness of those liabilities to the public and the willingness of the public to accept and hold them.

But Smith’s support for the real-bills doctrine indicates that, while understanding the equilibrating tendencies of competition on bank operations, he also recognized the inherent instability of banking caused by fluctuations in the value and liquidity of their assets. Smith’s support for the real-bills doctrine addressed one type of instability: the maturity mismatch between banks’ assets and liabilities. But there are other sources of instability, which may require further institutional or policy measures beyond the general laws of property and contract whose application and enforcement, in Smith’s view, generally sufficed for the self-interested conduct of private firms to lead to socially benign outcomes.

In the remainder of this section, I consider two other methods of addressing the vulnerability of bank assets to sudden losses of value: (1) the creation or empowerment of a lender of last resort capable of lending to illiquid, but solvent, banks possessing good security (valuable assets) as collateral against which to borrow, and (2) limits beyond the real-bills doctrine over the permissible activities undertaken by commercial banks.

B         Lender of Last Resort

Although the real-bills doctrine limits the exposure of bank balance sheets to adverse shocks on the value of long-term liabilities, even banks whose liabilities were issued in exchange for short-term real bills of exchange may be unable to meet all demands for redemption in periods of extreme financial distress, when debtors cannot sell their products at the prices they expected and cannot meet their own obligations to their creditors. If banks are called upon to redeem their liabilities, banks may be faced with a choice between depleting their own cash reserves, when they are most needed, or liquidating other assets at substantial, if not catastrophic, losses.

Smith’s version of the real-bills doctrine addressed one aspect of balance-sheet risk, but the underlying problem is deeper and more complicated than the liquidity issue that concerned Smith. The assets accepted by banks in exchange for their liabilities are typically not easily marketable, so if those assets must be shed quickly to satisfy demands for payment, banks’ solvency may be jeopardized by consequent capital losses. Limiting portfolios to short-term assets limits exposure to such losses, but only when the disturbances requiring asset liquidation affect only a relatively small number of banks. As the number of affected banks increases, their ability to counter the disturbance is impaired, as the interbank market for credit starts to freeze up or break down entirely, leaving them unable to offer short-term relief to, or receive it from, other momentarily illiquid banks. It is then that emergency lending by a lender of last resort to illiquid, but possibly still solvent, banks is necessary.

What causes a cluster of expectational errors by banks in exchanging their liabilities for assets supplied by their customers that become less valuable than they were upon acceptance? Are financial crises that result in, or are caused by, asset write downs by banks caused by random clusters of errors by banks, or are there systematic causes of such errors? Does the danger lie in the magnitude of the errors or in the transmission mechanism?

Here, too, the Humean and Smithian traditions seem to be at odds, offering different answers to problems, or, if not answers, at least different approaches to problems. Focusing on the liability side of bank balance sheets, the Humean tradition emphasizes the expansion of bank lending and the consequent creation of banknotes or deposits as the main impulse to macroeconomic fluctuations, a boom-bust or credit cycle triggered by banks’ lending to finance either business investment or consumer spending. Despite their theoretical differences, both Austrian business-cycle theory and Friedmanite Monetarism share a common intellectual ancestry, traceable by way of the Currency School to Hume, identifying the source of business-cycle fluctuations in excessive growth in the quantity of money.

The eclectic Smithian tradition accommodates both monetary and non-monetary business-cycle theories, but balance-sheet effects on banks are more naturally accommodated within the Smithian tradition than the Humean tradition with its focus on the liabilities not the assets of banks. At any rate, more research is necessary before we can decide whether serious financial disturbances result from big expectational errors or from contagion effects.

The Great Depression resulted from a big error. After the steep deflation and depression of 1920-22, followed by a gradual restoration of the gold standard, fears of further deflation were dispelled and steady economic expansion, especially in the United States, resulted. Suddenly in 1929, as France and other countries rejoined the gold standard, the fears voiced by Hawtrey and Cassel that restoring the gold standard could have serious deflationary consequences appeared increasingly more likely to be realized. Real signs of deflation began to appear in the summer of 1929, and in the fall the stock market collapsed. Rather than use monetary policy to counter incipient deflation, policy makers and many economists argued that deflation was part of the solution not the problem. And the Depression came.

It is generally agreed that the 2008 financial crisis that triggered the Little Depression (aka Great Recession) was largely the result of a housing bubble fueled by unsound mortgage lending by banks and questionable underwriting practices in packaging and marketing of mortgage-backed securities. However, although the housing bubble seems to have burst the spring of 2007, the crisis did not start until September 2008.

It is at least possible, as I have argued (Glasner 2018) that, despite the financial fragility caused by the housing bubble and unsound lending practices that fueled the bubble, the crisis could have been avoided but for a reflexive policy tightening by the Federal Reserve starting in 2007 that caused a recession starting in December 2007 and gradually worsening through the summer of 2008. Rather than ease monetary policy as the recession deepened, the Fed, distracted by rising headline inflation owing to rising oil prices that summer, would not reduce its interest-rate target further after March 2008. If my interpretation is correct, the financial crisis of 2008 and the subsequent Little Depression (aka Great Recession) were as much caused by bad monetary policy as by the unsound lending practices and mistaken expectations by lenders.

It is when all agents are cash constrained that a lender of last resort that is able to provide the liquidity that the usual suppliers of liquidity cannot provide, but are instead demanding, is necessary to avoid a systemic breakdown. In 2008, the Fed was unwilling to satisfy demands for liquidity until the crisis had deteriorated to the point of a worldwide collapse. In the nineteenth century, Thornton and Fullarton understood that the Bank of England was uniquely able to provide liquidity in such circumstances, recommending that it lend freely in periods of financial stress.

That policy was not viewed favorably either by Humean supporters of the Currency Principle, opposed to all forms of fractional-reserve banking, or by Smithian supporters of free banking who deplored the privileged central-banking position granted to the Bank of England. Although the Fed in 2008 acknowledged that it was both a national and international lender of last resort, it was tragically slow to take the necessary actions to end the crisis after allowing it to spiral nearly out of control.

While cogent arguments have been made that a free-banking alternative to the lender-of-last-resort services of the Bank of England might have been possible in the nineteenth century,[2] even a free-banking system would require a mechanism for handling periods of financial stress. Free-banking supporters argue that bank clearinghouses have emerged spontaneously in the absence of central banks, and could provide the lender-of-last resort services provided by central banks. But, insofar as bank clearinghouses would take on the lender-of-last-resort function, which involves some intervention and supervision of bank activities by either the clearinghouse or the central bank, the same anticompetitive or cartelistic objections to the provision of lender-of-last-resort services by central banks also would apply to the provision of those services by clearinghouses. So, the tension between libertarian, free-market principles and lender-of-last-resort services would not necessarily be eliminated bank clearinghouses instead of central banks provided those services.

This is an appropriate place to consider Walter Bagehot’s contribution to the lender-of-last-resort doctrine. Building on the work of Thornton and Fullarton, Bagehot formulated the classic principle that, during times of financial distress, the Bank of England should lend freely at a penalty rate to banks on good security. Bagehot, himself, admitted to a certain unease in offering this advice, opining that it was regrettable that the Bank of England achieved a pre-eminent position in the British banking system, so that a decentralized banking system, along the lines of the Scottish free-banking system, could have evolved. But given the historical development of British banking, including the 1844 Bank Charter Act, Bagehot, an eminently practical man, had no desire to recommend radical reform, only to help the existing system operate as smoothly as it could be made to operate.

But the soundness of Bagehot’s advice to lend freely at a penalty rate is dubious. In a financial crisis, the market rate of interest primarily reflects a liquidity premium not an expected real return on capital, the latter typically being depressed in a crisis. Charging a penalty rate to distressed borrowers in a crisis only raises the liquidity premium. Monetary policy ought to aim to reduce, not to increase, that premium. So Bagehot’s advice, derived from a misplaced sense of what is practical and prudent and financially sound, rather than from sound analysis, was far from sound.

Under the gold standard, or under any fixed-exchange-rate regime, a single country has an incentive to raise interest rates above the rates of other countries to prevent a gold outflow or attract an inflow. Under these circumstances, a failure of international cooperation can lead to competitive rate increases as monetary authorities scramble to maintain or increase their gold reserves. In testimony to the Macmillan Commission in 1930, Ralph Hawtrey masterfully described the obligation of a central bank in a crisis. Here is his exchange with the Chairman of the Commission Hugh Macmillan:

MACMILLAN: Suppose . . . without restricting credit . . . that gold had gone out to a very considerable extent, would that not have had very serious consequences on the international position of London?

HAWTREY: I do not think the credit of London depends on any particular figure of gold holding. . . . The harm began to be done in March and April of 1925 [when] the fall in American prices started. There was no reason why the Bank of England should have taken ny action at that time so far as the question of loss of gold is concerned. . . . I believed at the time and I still think that the right treatment would have been to restore the gold standard de facto before it was restored de jure. That is what all the other countries have done. . . . I would have suggested that we should have adopted the practice of always selling gold to a sufficient extent to prevent the exchange depreciating. There would have been no legal obligation to continue convertibility into gold . . . If that course had been adopted, the Bank of England would never have been anxious about the gold holding, they would have been able to see it ebb away to quite a considerable extent with perfect equanimity, . . and might have continued with a 4 percent Bank Rate.

MACMILLAN: . . . the course you suggest would not have been consistent with what one may call orthodox Central Banking, would it?

HAWTREY: I do not know what orthodox Central Banking is.

MACMILLAN: . . . when gold ebbs away you must restrict credit as a general principle?

HAWTREY: . . . that kind of orthodoxy is like conventions at bridge; you have to break them when the circumstances call for it. I think that a gold reserve exists to be used. . . . Perhaps once in a century the time comes when you can use your gold reserve for the governing purpose, provided you have the courage to use practically all of it.

Hawtrey here was echoing Fullarton’s insight that there is no rigid relationship between the gold reserves held by the Bank of England and the total quantity of sight liabilities created by the British banking system. Rather, he argued, the Bank should hold an ample reserve sufficient to satisfy the demand for gold in a crisis when a sudden and temporary demand for gold had to be accommodated. That was Hawtrey’s advice, but not Bagehot’s, whose concern was about banks’ moral hazard and imprudent lending in the expectation of being rescued in a crisis by the Bank of England. Indeed, moral hazard is a problem, but in a crisis it is a secondary problem, when, as Hawtrey explained, alleviating the crisis, not discouraging moral hazard, must be the primary concern of the lender of last resort.

            C         Scope of Banking

Inclined to find remedies for financial distress in structural reforms limiting the types of assets banks accept in exchange for their sight liabilities, Smith did not recommend a lender of last resort.[3] Another method of reducing risk, perhaps more in tune with the Smithian real-bills doctrine than a lender of last resort, is to restrict the activities of banks that issue banknotes and deposits.

In Anglophone countries, commercial banking generally evolved as separate and distinct from investment banking. It was only during the Great Depression and the resulting wave of bank failures that the combination of commercial and investment banking was legally prohibited by the Glass-Steagall Act, eventually repealed in 1999. On the Continent, where commercial banking penetrated less deeply into the fabric of economic and commercial life than in Anglophone countries, commercial banking developed more or less along with investment banking in what are called universal banks.

Whether the earlier, and more widespread, adoption of commercial banking in Anglophone countries than on the Continent advanced the idea that no banking institution should provide both commercial- and investment-banking services is not a question about which I offer a conjecture, but it seems a topic worthy of study. The Glass-Steagall Act, which enforced that separation after being breached early in the twentieth century, a breach thought by some to have contributed to US bank failures in the Great Depression, was based on a presumption against combining and investment-banking in a single institution. But even apart from the concerns that led to enactment of Glass-Steagall, limiting the exposure of commercial banks, which supply most of the cash held by the public, to the balance-sheet risk associated with investment-banking activities seems reasonable. Moreover, the adoption of government deposit insurance after the Great Depression as well as banks’ access to the discount window of the central bank may augment the moral hazard induced by deposit insurance and a lender of last resort, offsetting potential economies of scope associated with combining commercial and investment banking.

Although legal barriers to the combination of commercial and investment banking have long been eliminated, proposals for “narrow banking” that would restrict the activities undertaken by commercial banks continue to be made. Two different interpretations of narrow banking – one Smithian and one Humean – are possible.

The Humean concern about banking was that banks are inherently disposed to overissue their liabilities. The Humean response to the concern has been to propose 100-percent reserve banking, a comprehensive extension of the 100-percent marginal reserve requirement on the issue of banknotes imposed by the Bank Charter Act. Such measures could succeed, as some supporters (Simons 1936) came to realize, only if accompanied by a radical change the financial practices and arrangements on which all debt contracts are based. It is difficult to imagine that the necessary restructuring of economic activity would ever be implemented or tolerated.

The Humean concern was dismissed by the Smithian tradition, recognizing that banks, even if unconstrained by reserve requirements, have no incentive to issue liabilities without limit. The Smithian concern was whether banks could cope with balance-sheet risks after unexpected losses in the value of their assets. Although narrow banking proposals are a legitimate and possibly worthwhile response to that concern, the acceptance by central banks of responsibility to act as a lender of last resort and widespread government deposit insurance to dampen contagion effects have taken the question of narrowing or restricting the functions of money-creating banks off the table. Whether a different strategy for addressing the systemic risks associated with banks’ creation of money by relying solely on deposit insurance and a lender of last resort is a question that still deserves thoughtful attention.

69 Responses to “The Real-Bills Doctrine, the Lender of Last Resort, and the Scope of Banking”


  1. 1 Frank Restly February 3, 2021 at 6:20 pm

    David,

    Some comments:

    “It is at least possible, as I have argued (Glasner 2018) that, despite the financial fragility caused by the housing bubble and unsound lending practices that fueled the bubble, the crisis could have been avoided but for a reflexive policy tightening by the Federal Reserve starting in 2007 that caused a recession starting in December 2007 and gradually worsening through the summer of 2008.”

    And the same argument can be made about the reflexive policy of the Fed in cutting the short term interest rate from 6.5% in Nov of 2000 to 1.0% by July of 2003. Mind you that the recession of 2000 was over by Jan of 2002 and at no point from 1999 thru 2003 did we ever experience deflation.

    “Rather than ease monetary policy as the recession deepened, the Fed, distracted by rising headline inflation owing to rising oil prices that summer, would not reduce its interest-rate target further after March 2008.”

    That is quite disengenuous since the Federal Reserve started cutting interest rates in July of 2007, stopped in May of 2008, and then started again in September of 2008. Recognize that the recession didn’t officially begin until January of 2008, a full 17 months after the Fed began cutting interest rates.

    “If my interpretation is correct, the financial crisis of 2008 and the subsequent Little Depression (aka Great Recession) were as much caused by bad monetary policy as by the unsound lending practices and mistaken expectations by lenders.”

    That is certainly one way to look at it. And you can make the same case that the interest rate cuts begun by the Federal Reserve from 2000 to 2003 were also bad monetary policy. There was no discernible deflation over that time frame (other than a stock market bubble deflating) and the recession of 2000 was officially over by early 2002.

    Another way to look at things is that this all began back in 1983 when housing prices were removed from the consumer price index and replaced with owner’s equivalent rent. The question becomes, given that the central bank operates in the credit markets, should ALL goods / services / etc. that are financed with credit be incorporated into any inflation measure?

    And finally, you have not adequately explained the explosion in corporate bond spreads that began in September of 2008 at the same time that the Fed was cutting interest rates. It’s not enough for the Fed to ignore headline inflation if the rest of the bond market is paying attention to it.

    “But the soundness of Bagehot’s advice to lend freely at a penalty rate is dubious. In a financial crisis, the market rate of interest primarily reflects a liquidity premium not an expected real return on capital, the latter typically being depressed in a crisis. Charging a penalty rate to distressed borrowers in a crisis only raises the liquidity premium. Monetary policy ought to aim to reduce, not to increase, that premium. So Bagehot’s advice, derived from a misplaced sense of what is practical and prudent and financially sound, rather than from sound analysis, was far from sound.”

    Not really. The point of a central bank is for it to be a lender of LAST resort – hence the penalty rate. If (as you say) monetary policy ought to aim to reduce the liquidity premium, then there is no reason for a central bank, investment bank, or any commercial bank to exist at all – the Federal Government (under the auspices of any “crisis” that they can make up) simply prints up enough (or more than enough) liquidity.

    “That was Hawtrey’s advice, but not Bagehot’s, whose concern was about banks’ moral hazard and imprudent lending in the expectation of being rescued in a crisis by the Bank of England. Indeed, moral hazard is a problem, but in a crisis it is a secondary problem, when, as Hawtrey explained, alleviating the crisis, not discouraging moral hazard, must be the primary concern of the lender of last resort.”

    What Hawtrey and Bagehot both miss is that banks or any other large financial institution (including the federal government) can offload the risk that they undertake by selling equity shares.

    The problem is that rather than letting equity share holders take the brunt of any downturn by converting debt to equity or selling additional shares, financial institutions (including the federal government) instead lean on monetary policy.

    This is the mistake that was made by Greenspan / Paul O’Neil in 2000-2001, it’s the same mistake made by former Bernanke / Hank Paulson in 2008, and it was the same mistake that Andrew Mellon made during the Great Depression.

    But you keep pointing fingers at everyone other than the individuals that have run the Treasury Department. I sure hope Janet Yellen is a bit smarter than the rest of the folks that have been there.

  2. 2 Frank Restly February 3, 2021 at 9:05 pm

    Investment selection matrix:

    Low————————-Risk——————————-High
    |. | |
    | Government | Missing |
    | Bonds | Market |
    | | |
    Trust————————————————————|
    | | |
    | Corporate | Corporate |
    | Bonds | Equity |
    | | |
    High————————————————————-|

    Suppose there are plenty of people willing to take risk (for instance sky divers), but those sky divers don’t trust total strangers packing their parachutes for them.

    As the pilot of the plane, which do you sell to your group of skydivers:
    1. Prepacked parachutes
    2. Instruction manuals for packing your own chute

  3. 3 Kurt Schuler February 6, 2021 at 6:26 pm

    I believe that Bagehot was implicitly constrasting a policy of lending freely, that is, accepting collateral that the Bank of England did not ordinarily accept for loans, with keeping the Bank rate the same but only accepting the best collateral. Reducing the Bank rate during an external drain of gold would have accelerated the drain and pushed the Bank off the gold standard.

    Under a floating exchange rate a central bank can reduce its policy rate during a crisis, typically at the expense of seeing the currency depreciate and perhaps also generating some inflation. High inflation admittedly has not been a problem for most countries for at least 15 years now.

  4. 4 Mike Sproul February 6, 2021 at 8:17 pm

    Banks can easily protect against runs by issuing their money in exchange for 30-day assets, and then putting a 30-day suspension clause on the money they issue. Such a bank, as long as it is solvent, does not need a LOLR. If it is not solvent, then a LOLR will be no help.

  5. 5 Frank Restly February 7, 2021 at 8:16 am

    Kurt Schuler,

    “Under a floating exchange rate a central bank can reduce its policy rate during a crisis, typically at the expense of seeing the currency depreciate and perhaps also generating some inflation. High inflation admittedly has not been a problem for most countries for at least 15 years now.”

    To say that a central bank exists to “control” inflation is a total misrepresentation of why central banks exist in the first place. Central banks act as a neutral party in any lending arrangement – hence the “lender of last resort” moniker. They exist because they are precluded from passing judgement on a borrower’s race, sexual orientation, religion, or political affiliation when deciding who should get a loan.

    In that way, they are a progressive entity. The U. S. central bank was born out of the progressive movement of the early 1900’s.

    Depending on how the public and private sectors are financed, you may have the sign wrong on the effect that interest rates have on inflation. A higher policy rate may in fact drive inflation higher not lower (and vice versa).

    Higher interest rates in and of themselves do not reward saving over spending. Debt structure and how the debt is held matter in this case. If government bonds offer coupon interest, then the coupon interest is immediately available to spend. How does 10% or 30% or 100% coupon interest reward saving? If the bonds are zero coupon or held in a retirement account then obviously the interest payments are not immediately available to spend.

    Additionally, interest expense may be factored into a company’s cost recovery mechanism if they heavily rely on debt financing (rather than a mix of debt and equity). And so a company may raise prices in response to higher interest costs.

  6. 6 David Glasner February 7, 2021 at 8:52 am

    Kurt, Thanks for your comment. You are certainly correct that the gold standard would be a constraint on reducing the interest rate in a crisis. The point had occurred to me, but I forgot to include it and will make the appropriate revision. But one could also argue that the defectiveness of the collateral offered by banks in a crisis is less a reflection on the bank offering the collateral than on the state of the economy. So, aside from the international considerations, that argument for a penalty rate doesn’t seem very compelling to me, and as you point out in the absence of currency peg, it doesn’t have much traction. Finally, if you believe, that the international gold standard was a pound sterling standard, the Bank of England was not prevented from reducing its lending rate in crisis by the gold standard constraint.

  7. 7 David Glasner February 7, 2021 at 9:00 am

    Mike, Kevin Dowd has written about the option clause which is, I think, what you’re referring to. The argument is I think sound, but the option clause was largely rejected in the gold standard era. I forget now whether it was ever practiced in Scotland. The shadow banking sector got in trouble in 2008-09, because they didn’t adopt such a provision when they promised to redeem all account at $1 per share.

  8. 8 Mike Sproul February 7, 2021 at 11:08 am

    Well, now you’ve sent me scurrying back to my econ history books, because I always thought 30-day suspension clauses were the norm in the gold standard era, and every other era.

    As I remember, when the panic of 1837 hit, every bank in the country suspended within 10 days, even though suspension was illegal. In the 1930’s, most banks were prevented from suspending, and so they failed instead.

    I blame the invention of the telephone. If a bank suspended in the 1830’s, it would be months before bank examiners could shoot down the suspension. If a bank suspended in the 1930’s, it would get an angry phone call from the bank examiner on the same day.

  9. 9 David Glasner February 7, 2021 at 12:53 pm

    Which books did you look at?

  10. 10 Benjamin Cole February 9, 2021 at 1:04 am

    OK, so now bitcoin is near $40k, and smart guys like Elon Musk are buying in. Maybe even Apple. The institutions have decided bitcoin is viable.

    To me, this does not make sense. To David Glasner it makes even less sense.

    But suppose bitcoin holds value for 100 years, 200 years.

    OK, let us work backwards. Let us premise that Bitcoin is viable. What are the reasons?

  11. 11 Frank February 9, 2021 at 1:41 am

    Ben,

    “OK, let us work backwards. Let us premise that Bitcoin is viable. What are the reasons?”

    Let’s begin by defining the properties of most currencies:

    1. Fungibility – Meaning there is no discernible difference in value between one piece of currency and another

    2. Divisibility – Meaning that the currency can be subdivided into smaller amounts of the same currency

    3. Acceptance in the discharge of a liability – that liability can either be a tax or a debt

    4. Relative scarcity – Credit based currencies have this feature in that money / deposits are created through an increase in debt and reduced when the debt is fulfilled. Bitcoins and other digital currencies rely on limited production.

    5. General acceptance as a medium of exchange

    No one has convinced me that bitcoin is a generally accepted medium of exchange other than exchanging dollars for bitcoins and bitcoins for dollars.
    How much in actual real US GDP was contracted with bitcoin last year?

    You and I could prop up the value of anything simply by borrowing money from each other and selling bitcoin back and forth.

    I borrow $100 from you and buy some bitcoin. You borrow $200 from me and buy the same bitcoin. I then borrow $500 from you and buy the bitcoin back. Rinse and repeat until the same bitcoin is worth $40,000 or whatever number you like. It is because the supply of bitcoin is constrained and debt is not that you see things like this.

    Tesla has about $12.3 billion in debt (along with about $22 billion in equity).
    Tell me when bitcoin hits that number.

    If policy makers (US Treasury) were actually interested in productive output (rather than swapping alternative currencies back and forth) they would sell non-transferrable tax breaks which would reduce the federal debt, increase both the natural and monetary rate of interest, and increase the economic growth rate.

    The presumption on Wall Street and in politics is that guys like Elon Musk can always find productive ways to deploy capital. Apparently not.

  12. 12 Frank Restly February 9, 2021 at 1:45 am

    If I were an investor in Tesla and heard Elon Musk talking about using capital to buy bitcoin, I would be selling my shares immediately.

  13. 13 Frank Restly February 9, 2021 at 8:20 am

    Has Tesla’s credit been downgraded yet? I imagine the credit rating for a publicly traded company that deals in speculative assets (like alternative currencies) can’t be that high.

  14. 14 Benjamin Cole February 9, 2021 at 4:53 pm

    Frank and Frank Restly:

    1. No, Bitcoin is not accepted as payment for government taxes. For me, this is a big indicator the digital currency is worthless.

    2. But Bitcoin is becoming more widely accepted in commerce every day, and is fungible.

    3. Bitcoin backers say bitcoin is divisible to eight places past the decimal.

    OK, let me put it this way: For the last 40 years, many very intelligent, highly respected individuals in macroeconomics, such as Paul Volcker and Martin Feldstein, argued consistently, perennially, without respite that higher inflation and interest rates were pending. Instead, inflation and interest rates went lower.

    OK, at some point, people have to say, “You know, something is off with my analysis. Whether I like it or not, the economy, or an investment, or people are not acting as I was sure they would.”

    True, most people just double down until they die, and never admit they were wrong. Probably we all have friends and relatives that fit into this category.

    So, I ask again. Think backwards:

    What caused inflation to go down in the last 40 years?

    What caused Bitcoin to rise in value?

    Are we missing something?

  15. 15 Frank Restly February 9, 2021 at 7:54 pm

    Ben,

    “No, Bitcoin is not accepted as payment for government taxes. For me, this is a big indicator the digital currency is worthless.”

    Is it acceptable is satisfying a debt liability – are debt contracts written in terms of payment in Bitcoin? The only thing written on every federal reserve note is this “This note is legal tender for all debts, public and private”.

    “But Bitcoin is becoming more widely accepted in commerce every day, and is fungible.”

    Based on what evidence other than what bitcoin backers are telling you?
    Has anyone created a “Real / Nominal GDP” tracker for transactions in Bitcoin?

    “OK, let me put it this way: For the last 40 years, many very intelligent, highly respected individuals in macroeconomics, such as Paul Volcker and Martin Feldstein, argued consistently, perennially, without respite that higher inflation and interest rates were pending. Instead, inflation and interest rates went lower. What caused inflation to go down in the last 40 years?”

    One theory is that the directly of causality is reversed – higher interest rates cause higher inflation instead of inflation causing higher interest rates. There is some merit to that way of thinking. See above where I discuss interest rates and the propensity to save.

    Another is that interest rates and inflation are totally uncorrelated. And there is some merit to that as well. If you go back to the 1940’s and 1950’s there were a couple bouts of inflation in the U. S. where interest rates did not move.

    You can add in some others. Obviously inflation in the U. S. during the 1960’s and 1970’s was preceded by two oil embargoes. The U. S. is becoming less reliant on oil for it’s energy needs.

    During the 1960’s and 1970’s union contracts were inflation adjusted, so the cost of production of basically anything rose with oil prices. Today I think less than 20% of U.S. workers are labor union members.

    Finally there is the peace dividend. The 1950’s through the 1980’s were the Cold War era. The end of the Cold War opened a lot of markets and international trade both in goods and in financial contracts (bonds).

    I don’t think there is one particular set in stone answer to your question. I think it is a cumulative answer.

  16. 16 Henry Rech February 9, 2021 at 9:35 pm

    Benjamin,

    “What caused inflation to go down in the last 40 years? ”

    Firstly, globalized Japan, then globalized south east Asia, then globalized China.

    These regions were a source of cheap goods and cheap labour.

    “What caused Bitcoin to rise in value? ”

    A welter of stupid money sloshing around the financial markets, money representing the massive accumulated wealth from mal-distributed income earned in the last 50 years.

    Bitcoin would be more aptly named Bitcon. If that’s not to anybody’s fancy, perhaps Bitchcoin. 🙂

  17. 17 Frank Restly February 9, 2021 at 9:38 pm

    Ben,

    I mention this because it alludes to what I have described above. Interest rates are low because governments rely exclusively on bond sales for their financing needs.

    Given that the interest payments on government bonds are made from tax revenue, bond traders can only bid down bond prices (bid up yields) to the Ponzi limit.

    After that point, they put their own long positions at risk – they would be basically making the interest payments on the bonds that they own with their own investment dollars (rather than taxpayer dollars) – hence the name “Ponzi limit”.

    The Ponzi limit is the point at which total interest payments on government debt are equal to or exceed available tax revenue.

    Today the U. S. federal government has about $27 trillion in outstanding debt and total tax revenue is about $2.06 trillion. The Ponzi limit is an average interest rate on government debt of about 7.6%. Think about that for a moment. Back in the late 1970’s / early 1980’s, interest rates on government bonds were in the high teens / low twenties.

    The closest the U. S. ever came to hitting the Ponzi limit was during the Reagan presidency. Total interest payments hit 51.8% of tax revenue in 1985, dropped slightly and then grew again to 49.6% of tax revenue in 1991.

    This limit becomes particularly noticeable during a recession (for instance the 1990-91 recession).

    The solution created by Bill Clinton and Robert Rubin was to shorten the average duration of the U. S. federal debt.

    That works but creates problems of it’s own. It puts monetary policy focused on short term interest rates in the cross hairs of fiscal policy and it is not a long term answer to government financing concerns. Eventually even the interest payments on short term debt create the same problem.

  18. 18 Benjamin Cole February 10, 2021 at 3:58 am

    Frank and Henry–

    Thanks for your replies.

    On Bitcoin:

    1. Widening acceptance? PayPal recently said they will accept Bitcoin, and some other platforms, and of course Tesla said they will. There is also widening acceptance, in that institutional investors are moving into Bitcoin. So, yes, there seems to widening acceptance of bitcoin as payment, and as store of value. But why? What are we missing?

    2. Whether Bitcoin is worthless or not in theory, in fact the commenters on this board (including me) missed out of gigantic profits to be made in Bitcoin. Again, what are we missing?

    3. On inflation, yes, there seems to be a lot of “small answers” that add up to lower inflation. Still, what did Feldstein and Volcker miss? Did not they miss that larger federal deficits and accommodative monetary policy would not lead to higher inflation? Isn’t that the bottom line?

    A. On government debt, I am beginning to wonder. Central banks have the ability to buy back government debt, evidently without inflationary consequence. See Japan. So, who is over-indebted? The interest payments flow from Uncle Sam to Uncle Fed and back to Uncle Sam.

    B. If interest rates rise to 7%, yes, the national debt burden would rise. On the other hand, inflation at 7% a year cuts the national debt in half (all other things being equal) in 10 years.

    C. Yes, bondholders would squeal if inflation/interest rates went to 7%. They will say they are being robbed. They were not so alarmed when inflation became disinflation and bondholders made big money for owning the safest assets in the world.

    D. So, bondholders lose money if inflation ramps up to 7%. Income-tax payers have their debt burden relieved. In general, both income-tax payers and bondholders are the better-off. In one pocket and out of the other.

    Just my thoughts, to my fellow losers who did not invest in Bitcoin.

  19. 19 Frank Restly February 10, 2021 at 5:16 am

    Ben,

    “Widening acceptance? PayPal recently said they will accept Bitcoin, and some other platforms, and of course Tesla said they will.”

    How much of PayPals business has been conducted in Bitcoin? How many Tesla vehicles have been purchased with Bitcoin? Have Tesla’s creditors said that they will accept Bitcoin? Tesla has about $12.3 billion in outstanding debt.

    “If interest rates rise to 7%, yes, the national debt burden would rise. On the other hand, inflation at 7% a year cuts the national debt in half (all other things being equal) in 10 years.”

    Not really, you are presuming that tax revenue rises commensurately with the inflation rate, you are presuming that new debt isn’t created over those ten years, AND you are presuming that existing debt doesn’t experience an interest rate reset. If inflation is at 7% a year but tax revenue falls at 2% per year and new debt grows by 5% per year, then the debt burden is getting worse not better.

    In the case of stagflation this is exactly what happens. And raising tax rates during such a period only makes things worse.

    “On inflation, yes, there seems to be a lot of small answers that add up to lower inflation. Still, what did Feldstein and Volcker miss? Did not they miss that larger federal deficits and accommodative monetary policy would not lead to higher inflation? Isn’t that the bottom line?”

    Their analysis was based on their own prior experiences – just like anyone else. We are talking about is debt, not deficits – please understand the distinction – it’s important.

    Something else, if you believe in the Phillips Curve (trade off between employment and inflation) and you see something like this (below), the question you should be asking is – why aren’t we seeing outright deflation:

    https://fred.stlouisfed.org/series/EMRATIO

    Year 2000 – Employment to population ratio of 64% (Inflation in the low 2-3% range)

    Year 2021 – Employment to population ratio of 57.5% (Inflation in the low 2-3% range)

    “Just my thoughts, to my fellow losers who did not invest in Bitcoin.”

    I didn’t have $5,000 to piss away when it was at $5,000, I didn’t have $20,000 to piss away when it was at $20,000, and I certainly don’t have $40,000 to piss away now that it’s at $40,000.

  20. 20 Frank Restly February 10, 2021 at 7:33 am

    Ben,

    “On inflation, yes, there seems to be a lot of small answers that add up to lower inflation. Still, what did Feldstein and Volcker miss? Did not they miss that larger federal deficits and accommodative monetary policy would not lead to higher inflation? Isn’t that the bottom line?”

    My Response: Their analysis was based on their own prior experiences – just like anyone else. We are talking about is debt, not deficits – please understand the distinction – it’s important.

    Let me elaborate on that. The whole reason that government debt / bonds came into existence is war and a draft / conscription – that’s it.

    With a draft / conscription, a government expects you to put down your plowshare or hammer or whatever other tools you use to make your living and go serve a greater cause. In return government offers you a pension / bond that pays a guaranteed rate of interest. That pension / bond is transferrable to next of kin / wife / husband in the event you perish during the conflict.

    Volcker / Feldstein and a lot of other economists learned economics while the U. S. went through a period of two world wars and several other smaller conflicts (Korea, Vietnam, etc.) and so to them government bonds were the way of the world.

    What Volcker / Feldstein and others never bothered to figure out is how to do government finance during peacetime (they never figured out how to beat their swords back into plowshares).

    Clinton / Rubin thought they had it figured out with balanced budgets – they were wrong.

    The second reason that government bonds exist is to allow banks to manage credit risk. How do banks manage credit risk when the supplier of “riskless” government securities turns off the spigot?

    Clinton / Rubin thought they had that figured out as well by combining investment banking / commercial banking / and insurance. The thought was that because these various aspects of banking are diversified, a downturn in one type of financial sector would be offset by others.

    They were wrong. Consolidating different types of banking under one roof increases the chances of black swan credit risk events wiping out the whole bank (investment, commercial, and insurance) – see AIG, Lehman Brothers, Merrill Lynch, etc.

  21. 21 Henry Rech February 10, 2021 at 12:17 pm

    Benjamin,

    ” What are we missing? ”

    Is there an anonymity factor that would attract outlaw money and money evading the taxman?

  22. 22 Frank Restly February 10, 2021 at 12:44 pm

    Henry,

    “Is there an anonymity factor that would attract outlaw money and money evading the taxman?”

    Bitcoin and the digital currencies began to take hold in 2015 if memory serves correctly. Take a lot at total US tax revenue from 2015 onward:

    https://fred.stlouisfed.org/series/W006RC1Q027SBEA

    Notice how the growth in total tax receipts leveled off starting in 2015 and then started growing again in 2018 (before the recession began)?

    Now compare that to Bitcoin’s market price – 2015 price of $410.58, 2017 price of $19,650.00, 2018 price of $3,798.00.

    The rise in US tax revenue coincided with a drop in Bitcoin price from it’s high of $19,650.00 to a low of $3,798.00.

    Obviously, correlation is not causation.

    If the two events are connected and if the point of Bitcoin is to avoid the taxman, why did everyone sell in 2017 and incur a tax liability?

    https://fred.stlouisfed.org/series/FEDFUNDS

    For that I think you need to look at the Fed funds rate – 0% at the start of 2015, 2.4% by end of 2018, and now back to 0%.

    There was a shift in investment from Bitcoin to short term government debt and then back to Bitcoin.

  23. 23 David Glasner February 10, 2021 at 4:42 pm

    Frank, Sorry for the delayed response. Not necessarily defending Fed policy in 2001-03. I think in the aftermath of 9/11, there was perhaps heightened concern about uncertainty that made further interest reductions seem prudent at the time. I don’t think the consequences of those reductions were as serious as the post 2007 policy.

    You’re correct that the effective Fed Funds rate fell by about half a point between March and May 2008. But from May through September, the economy was deteriorating and unemployment rising, which the Fed was aware of but decided to ignore because of concern about headline inflation. The Fed was still slow in reducing the Fed Funds rate even after the crisis broke, not going to near zero until December 2008. I don’t know how you calculated that January 2008 (I believe the official start of the recession is December 2007) is 17 months after July 2007.

    I haven’t thought too much about the increase in corporate bond rates starting in September 2007, but I don’t think the cause was rising inflation expectations. More likely I am guessing an extreme uncertainty premium during the height of the crisis, when an even more severe collapse seemed possible.

  24. 24 Frank Restly February 10, 2021 at 6:00 pm

    David,

    You are right, I had the months swapped in my head – July 2008 is 17 months after January 2007 (apologies).

    Nonetheless, the Fed was beginning to cut interest rates before the official start of the recession and so your conclusion that the Fed members were somehow late in their response seems misguided.

    “I haven’t thought too much about the increase in corporate bond rates starting in September 2007, but I don’t think the cause was rising inflation expectations. More likely I am guessing an extreme uncertainty premium during the height of the crisis, when an even more severe collapse seemed possible.”

    You have written about TIPs spreads as an expression of inflation expectations, what do they tell you about inflation expectations starting in September of 2007?

    “Not necessarily defending Fed policy in 2001-03. I think in the aftermath of 9/11, there was perhaps heightened concern about uncertainty that made further interest reductions seem prudent at the time.”

    If there was heightened concern about uncertainty, that should have appeared in corporate bonds – no? Look at corporate bond yields after 9/11 – they fell.

    And so what uncertainty are you specifically referring to here? Housing prices were going gangbusters even at that time, gross domestic product was growing feverishly. Perhaps you need to elaborate on what uncertainty measure you are referring to.

    “I don’t think the consequences of those reductions were as serious as the post 2007 policy.”

    Take a look at employment to population ratio since 2000:

    https://fred.stlouisfed.org/series/EMRATIO

    Do the consequences look serious to you?

    April, 2000 – Labor force participation rate at 64.7%

    Each subsequent business cycle peak has been lower than the previous.

    January, 2007 – Labor force participation rate peaks at 63.3%
    February, 2020 – Labor force participation rate peaks at 61.1%

    Wanna bet that the next peak is lower still?

  25. 25 Henry Rech February 10, 2021 at 7:53 pm

    David,

    “Under those conditions, banks have neither the incentive nor the capacity to cause inflation.”

    Is that your reasoning or Smith’s?

    How can this conclusion be drawn from the immediately previous statement? (“To make enhance the attractiveness …..”)

  26. 26 David Glasner February 10, 2021 at 8:23 pm

    Henry, It’s my reasoning which I am ascribing to Smith by way of inference from his discussion.

    I meant, but failed, to delete “make.” By making their notes or deposits convertible into gold or some other asset not under the control of the banks, banks pin down the value of their liabilities. At least for a small open economy, the behavior of banks cannot affect the value of their liabilities which are locked into the equivalence with the value of gold or whatever asset their liabilities are convertible into.

  27. 27 Henry Rech February 10, 2021 at 8:35 pm

    David,

    “Whether a different strategy for addressing the systemic risks associated with banks’ creation of money by relying solely on deposit insurance and a lender of last resort is a question that still deserves thoughtful attention.”

    It’s one thing to bail out the system. It’s another to effectively reward those that were responsible for the collapse by continuing to retain their services. In crisis after crisis, those that were responsible for the crisis have escaped sanction of some sort. (The savings and loan crisis of the late 1980s, I think, did involve some prosecutions, however.)

    Additionally, equity holders in organizations responsible for crises, have their equity to some degree preserved.

  28. 28 Frank Restly February 10, 2021 at 9:58 pm

    Henry,

    “Additionally, equity holders in organizations responsible for crises, have their equity to some degree preserved.”

    The problem is one of encouraging risk taking without privatizing gains and socializing losses.

    Pointing fingers at the parties “responsible” for crises can be disingenuous. There are obvious cases involving out right fraud where the guilty parties should be punished. There are cases involving incompetence where the parties involved were in over their heads. Then there are cases involving unforeseen circumstances such as naturally occurring events and government policy changes.

    Should government be left to sort out who is the crook, who is the idiot, and who is the victim of circumstance? The problem is the potential for corruption. The low paid government regulator sees everyone as a crook until a check arrives by mail from a firm that he / she is investigating.

    I think that if we are going to continue to socialize losses, then the financing for bailouts must involve the sale of equity. And it doesn’t really matter where in the economy that equity exists as long as it is equity purchased by choice (Libertarian) rather than equity by mandate.

  29. 29 Benjamin Cole February 10, 2021 at 11:41 pm

    https://au.finance.yahoo.com/news/rba-mistakes-jobs-011712466.html

    Fun little story.

    The RBA suggests doubling QE might little effect on inflation or the Aussie job market.

    So?

    So why not double QE and monetize debt, then? Bondholders are paid in full, and taxpayers are relieved.

  30. 30 Henry Rech February 10, 2021 at 11:54 pm

    Frank,

    “Should government be left to sort out who is the crook, who is the idiot, and who is the victim of circumstance? ”

    Yes.

  31. 31 Henry Rech February 10, 2021 at 11:57 pm

    Perhaps not so much the government as the judicial system.

    This what the judicial system does routinely.

  32. 32 Frank Restly February 11, 2021 at 6:05 am

    Ben,

    “The RBA suggests doubling QE might little effect on inflation or the Aussie job market. So? So why not double QE and monetize debt, then? Bondholders are paid in full, and taxpayers are relieved.”

    Because then the currency becomes equity (a risk asset) by mandate of the RBA. We are looking for equity by choice instead of equity by mandate.

  33. 33 Frank Restly February 11, 2021 at 11:23 am

    Henry,

    “Should government be left to sort out who is the crook, who is the idiot, and who is the victim of circumstance? ”

    Your answer: “Yes.”

    Question: At what cost? What I mean is how much should the government (with taxpayer support) pay to our judges, prosecutors, and investigators to weed out the bad from the incompetent and unfortunate?

    That is where corruption becomes dangerous. For the government to financially dissuade judges, prosecutors, etc. from taking bribes, should compensation at the regulator level be commensurate with compensation offered to those that are being investigated?

    Would it not be easier and a lot less costly for the government to simply say okay, as long as someone is willing to buy equity from us (the U. S. Treasury) we (the government) will be ready to use those funds to buy nonperforming debt. Or if all loans are performing, we (the U. S. government / Treasury) will buy back our own debt? And that somebody buying equity could be any U. S. taxpayer located anywhere in the country.

    Yes, there would still be issues with moral hazard, but at least bailouts would not be put on the shoulders of taxpayers as a whole, but rather individuals who freely choose to take risk?

    During the great depression there was a proposed plan (The Chicago Plan) to overcome the inadequacies of the monetary system. This plan was ultimately rejected, but one of it’s key precepts was that banks MUST fund risky investments through either retained earnings or through the sale of equity shares. This plan was ultimately rejected in favor of a central bank acting as lender of last resort and the plan never tells you who MUST buy the equity shares in a bank – for every seller of shares there needs to be a buyer.

    Rather than mandating banks sell equity (socialism) does it make more sense to say U. S. Treasury will sell equity to any tax payer that wants to buy it (libertarianism)?

  34. 34 Henry Rech February 11, 2021 at 2:48 pm

    Frank,

    If bureaucrats, politicians and the judiciary are so easily corruptible then we may as well allow the anarchists to take over.

    And people/organizations must know they will be held responsible for initiating a crisis otherwise we can just blithely wait for the next one.

    When the system is in full crisis mode I doubt you will find sufficient equity to prevent the system failing. In part, a definition of crisis is that the financial system in toto is in the state of epileptic fit.

  35. 35 Frank Restly February 11, 2021 at 3:07 pm

    Henry,

    “If bureaucrats, politicians and the judiciary are so easily corruptible then we may as well allow the anarchists to take over.”

    Please stop trying to be overly dramatic. I am merely suggesting an alternative approach to policy. Yes there are corrupt people and yes there are well meaning honest people. But rather than relying entirely on parsing bad intentions from incompetence and / or bad luck, I think that equity offers a better solution where the evidence one way or another is not clear cut.

    “When the system is in full crisis mode I doubt you will find sufficient equity to prevent the system failing.”

    Again with the drama queen schpiel. We are talking about debt and banks not armageddon. The reason policy makers fail to find sufficient equity is that they can’t see beyond the Manhattan skyline (see Hank Paulson and Paul O’Neil).

    “In part, a definition of crisis is that the financial system in total is in the state of epileptic fit.”

    The definition of a crisis is “Wahhh…..give me some more money Mr. Fed Chairman so I don’t have to actually work for a living.”

  36. 36 Frank Restly February 11, 2021 at 3:16 pm

    Henry,

    The non-discounted present value of all of the tax revenue that a government is ever going to collect can be considered infinite under any tax rate regime.

    And so the amount of equity that any government can sell is infinite as well.

    The problem is that government policy makers have been convinced that they must borrow by a long line of war time economists.

  37. 37 Frank Restly February 11, 2021 at 3:44 pm

    Henry,

    “When the system is in full crisis mode I doubt you will find sufficient equity to prevent the system failing. In part, a definition of crisis is that the financial system in toto is in the state of epileptic fit.”

    The system goes into crisis mode because of collectivist herd behavior. One buffalo in the lead of the pack runs off the top of the cliff and the rest follow him (herd mentality).

    To prevent this from eliminating the entire buffalo population completely you need enough isolationist buffaloes (individualistic libertarians) who trade security in numbers for self sufficiency.

    And that is what government / treasury equity does. Instead of taxpayers as a whole (the herd) making interest payments on government bonds, each taxpayer that buys government equity is ultimately responsible for his / her own returns on investment.

    In the insurance world I believe it is called risk diversification.

  38. 38 Henry Rech February 11, 2021 at 6:13 pm

    Frank,

    I would say it is you who is being overly exaggerating the corruption issue. 🙂

    “We are talking about debt and banks not armageddon.”

    I think you should think back to the crisis of 2008. The problem was that liquidity absolutely disappeared, as it does in every crisis. Uncertainty and fear are rampant. Every that’s got money is hangin’ on to it.

  39. 39 Frank Restly February 11, 2021 at 6:42 pm

    “I think you should think back to the crisis of 2008. The problem was that liquidity absolutely disappeared, as it does in every crisis.”

    No, the only way liquidity disappears is when credit contracts. Otherwise, it goes to some other portion of the economy – like it did after the 2000 stock market “crisis” that sent money from the equity markets into housing.

    I was there for the “crisis” of 2000, the “crisis” of 2008, and I am here for the ongoing “crisis” we are facing now.

    “Uncertainty and fear are rampant.”

    No, distrust is pretty rampant. That doesn’t mean people aren’t willing to take risk.

    “Every that’s got money is hangin’ on to it.”

    Fair enough, demand deposits are elevated.

    So from a government policy perspective you can do one of several things to obtain money and distribute it to people in need – tax people that have money, sell bonds and have the central bank buy them up to obtain money, or sell equity to the people that have money.

    I have no problem with Biden’s / Harris’s rescue package – whether it’s $500 billion or $2 trillion. I have a problem with how it’s going to be paid for.

    If Biden / Harris / Yellen wants to spend $2 trillion on a rescue package and was willing to sell equity claims against future tax revenue to pay for it…I would be jumping in line to buy them.

    And I am quite sure a lot of moderate Republicans would jump on board as well.

  40. 40 Frank Restly February 11, 2021 at 7:05 pm

    Henry,

    There is a saying in politics – “Don’t let a crisis go to waste.” Basically it means a crisis is the perfect opportunity to make fundamental changes in how government operates.

    I hope that Biden / Harris / Yellen don’t waste this opportunity.

  41. 41 David Glasner February 13, 2021 at 6:27 pm

    Frank, My view about the Fed policy in 2007-08 is that they had raised the rate too much in the first place and didn’t cut it sufficiently as the economy lapsed into a recession, and, as the situation became significantly worse in the summer of 2008, still refused to reduce rates until after the crisis started and even in then did not reduce rates enough and then implemented the counterproductive interest on reserves policy.

    I wrote:
    ““I haven’t thought too much about the increase in corporate bond rates starting in September 2007, but I don’t think the cause was rising inflation expectations. More likely I am guessing an extreme uncertainty premium during the height of the crisis, when an even more severe collapse seemed possible.”

    That should have been September 2008.

    Inflation expectations in September 2008 were rapidly falling. Before that they were pretty stable, but the Fed was hyperventilating about possible increases in inflation expectations.

    Uncertainty in 2002-03 after the 9/11 attack, uncertainty was manifested in reduced investment and reduced demand for financing, but there was no shortage of liquidity. The conditions in summer of 2008 were much more dire and there was a demand for financing to cover debt obligations, and the breakdown of the financial system made financing all but impossible to obtain.

    Changes in the employment ratio reflect both long-run demographic and cyclical factors, so they aren’t very relevant to the cyclical issues that I’m discussing in this post

    Henry, I agree with you that there is financial misbehavior that needs to be addressed and that there should be consequences for that misbehavior. However, the time to call that misbehavior to account is not while the crisis is raging. It is after the crisis is over that action should be taken against misconduct.

  42. 42 Frank Restly February 13, 2021 at 7:43 pm

    “Inflation expectations in September 2008 were rapidly falling.”

    And yet they (inflation expectations) were rapidly rising from Feb through May 2008 – while the Fed was cutting interest rates.

    See:
    https://fred.stlouisfed.org/series/MICH
    https://fred.stlouisfed.org/series/BOGZ1FL072052006Q

    If the Fed should raise interest rates in response to increasing inflation expectations, then they should have been raised from Feb through May 2008 Instead the Fed reduced interest rates over that time frame because of collapsing home prices. That’s the point.

    “Uncertainty in 2002-03 after the 9/11 attack, uncertainty was manifested in reduced investment and reduced demand for financing, but there was no shortage of liquidity.”

    Reduced demand for financing – you are kidding right?

    Here is total credit growth:
    https://fred.stlouisfed.org/series/TCMDO

    Show me where this reduced demand for financing appears?

    “Changes in the employment ratio reflect both long-run demographic and cyclical factors, so they aren’t very relevant to the cyclical issues that I’m discussing in this post.”

    You didn’t say cyclical issues in your original post, you said consequences – from your original statement:

    “I don’t think the consequences of those reductions were as serious as the post 2007 policy.”

    The consequences of any decision can be far reaching, not because of the decisions themselves but because of the thought process that led to those decisions. Here is exactly what I am referring to:

    Your statement:

    “But the soundness of Bagehot’s advice to lend freely at a penalty rate is dubious. In a financial crisis, the market rate of interest primarily reflects a liquidity premium not an expected real return on capital, the latter typically being depressed in a crisis. Charging a penalty rate to distressed borrowers in a crisis only raises the liquidity premium. Monetary policy ought to aim to reduce, not to increase, that premium. So Bagehot’s advice, derived from a misplaced sense of what is practical and prudent and financially sound, rather than from sound analysis, was far from sound.”

    My retort to the faulty thought process.

    “Not really. The point of a central bank is for it to be a lender of LAST resort – hence the penalty rate. If (as you say) monetary policy ought to aim to reduce the liquidity premium, then there is no reason for a central bank, investment bank, or any commercial bank to exist at all – the Federal Government (under the auspices of any “crisis” that they can make up) simply prints up enough (or more than enough) liquidity.”

  43. 43 Frank Restly February 13, 2021 at 8:41 pm

    David,

    And you know, none this arguing about Federal Reserve policy really matters anyway. You work for the Treasury Department (not the Fed) in the credentials you list on this site are correct.

    Instead of finger pointing toward the FOMC (or the Bank of France in the case of the Great Depression) for everything that goes wrong, perhaps you should take a closer examination at the failings of Andrew Mellon during the Great Depression, and others that have served as Treasury Secretary including Robert Rubin, Larry Summers, Paul O’Neil, John Snow, Hank Paulson, Timothy Geithner, etc., etc.

  44. 44 David Glasner February 13, 2021 at 8:45 pm

    Frank, Rising inflation expectations is one factor for the Fed to consider in setting interest rates, but it’s not the only or the most important one. Raising interest rates in a recession is a bad idea and the economy went into a recession in December 2007 and the recession was getting worse fast in the summer of 2008.

    Thanks for the link to Fred and total borrowing. Total credit growth seems pretty modest in the early 2000s picking up later in the decade, so it looks to me as if the reduction in interest rates at the time might well have kept credit growth from weakening. Some people might think it’s good if the Fed reduces interest rates and keeps credit growth rising steadily.

    You are certainly right that I didn’t say “cyclical consequences” I only said “consequences.” I don’t think my subsequent clarification that I was referring to “cyclical” consequences is obviously insincere or implausible. Are you trying to suggest that it is?

    You said:

    “The point of a central bank is for it to be a lender of LAST resort – hence the penalty rate. If (as you say) monetary policy ought to aim to reduce the liquidity premium, then there is no reason for a central bank, investment bank, or any commercial bank to exist at all – the Federal Government (under the auspices of any “crisis” that they can make up) simply prints up enough (or more than enough) liquidity.”

    You are right that the Federal Government could simply print up enough money to provide liquidity without the need for a central bank. It could do so, but that is not the monetary system that we have. A different monetary system might be better than a central banking system, but for better or worse, the system we have is a central banking system, and that’s the system most monetary economists have thought about and the one that’s relevant for my discussion. If you want to think and talk about a different system, you are more than welcome to do so, but that’s not what my post was about.

    Frank, I don’t know where you got the idea that I work for the Treasury; I don’t work for the Treasury and I never have. I work for another federal agency that has no responsibility for budget or monetary policy, and my comments on this blog are entirely my own and don’t reflect the views of my agency or any other government agency. You are free to disagree with my views about the Fed or the Bank of France or anything else, but please don’t attribute my views to anyone but myself. If you ever do that again, I’m afraid that I will have to block you. I hope that I won’t have to do that.

  45. 45 Frank Restly February 13, 2021 at 9:20 pm

    David,

    “I don’t know where you got the idea that I work for the Treasury; I don’t work for the Treasury and I never have. I work for another federal agency that has no responsibility for budget or monetary policy, and my comments on this blog are entirely my own and don’t reflect the views of my agency or any other government agency.”

    My apologies. You once had an indication on this website about your position within government, but it no longer shows up in the side bar. If memory serves it is FTC not Treasury – correct?

    But my point remains valid, I don’t think that the actions of Andrew Mellon during the Great Depression have received much attention. Maybe I am wrong. Maybe someone has written a biography about Mr. Mellon describing his economic policy decision making process pre and post Great Depression.

    “Raising interest rates in a recession is a bad idea and the economy went into a recession in December 2007 and the recession was getting worse fast in the summer of 2008.”

    They didn’t raise interest rates during a recession. They had already begun cutting rates in June of 2007 before the recession had officially begun.

  46. 46 David Glasner February 13, 2021 at 9:32 pm

    Apology accepted. I now prefer not to disclose my agency affiliation on social media, to avoid any limitation on my ability to freely express my opinion.

    You are right that the Fed did not raise interest rates during the recession, I was speaking hypothetically in response to a question that you had raised in your earlier comment.

  47. 47 Frank Restly February 13, 2021 at 9:48 pm

    David,

    Here is my case against Andrew Mellon:

    1. Interest is not strictly the cost of borrowing or debt service – it is the cost of time (something not appreciated by Mellon IMHO).

    2. Interest is not limited to lending arrangements – it is the cost associated with any transaction where goods are delivered at different points in time (again something not appreciated by Mellon).

    3. The U. S. federal government was limited in it’s ability to address the Great Depression because it was thought (by Mellon and others) that the only way the government could spend in excess of it’s revenues was by borrowing placing a strain on it’s own gold reserves.

    4. What Mellon and every Treasury Secretary since has not figured out is that the U. S. federal government (or any government for that matter) can sell discounted claims against future tax revenue without actually borrowing.
    All that needs to happen is that the claim sold by Treasury is recognized by government as sufficient to discharge a tax liability at some future date.

    5. With that knowledge in hand, the Treasury can fully offset any private sector interest rate (real or nominal) with a discounted claim against future tax revenue.

    And so even in the event of deflation, credit markets clear because any real interest rate is offset by a corresponding reduction in taxes through the term of the loan.

    Make sense?

  48. 48 Frank Restly February 14, 2021 at 2:47 pm

    David

    “You are right that the Federal Government could simply print up enough money to provide liquidity without the need for a central bank. It could do so, but that is not the monetary system that we have.”

    https://fred.stlouisfed.org/series/FDHBFRBN

    Say that again with a straight face. If the central bank is willing to buy up any amount of federal debt in the name of providing “liquidity”, then why do you need a central bank (or any bank) at all?

  49. 49 David Glasner February 14, 2021 at 3:26 pm

    Frank, I think it’s well understood that a central bank through open market purchases can technically fund government expenditures to any desired extent subject to political constraints and that open market operations are a substitute for lender of last resort functions except in cases where a particular institution is at risk whose failure could have systemic repercussions that are serious enough to warrant intervention to prevent that institution from failing. If such institutions are saved, there should be consequences for the managers and stockholders of the bank (unlike some past interventions) but those consequences need not be administered by charging a penalty rate. I really don’t understand why you making a fuss about this.

  50. 50 Frank Restly February 14, 2021 at 5:18 pm

    David,

    “I think it’s well understood that a central bank through open market purchases can technically fund government expenditures to any desired extent subject to political constraints and that open market operations are a substitute for lender of last resort functions except in cases where a particular institution is at risk whose failure could have systemic repercussions that are serious enough to warrant intervention to prevent that institution from failing. If such institutions are saved, there should be consequences for the managers and stockholders of the bank (unlike some past interventions) but those consequences need not be administered by charging a penalty rate.”

    The key phrases are Subject to Political Constraints and Lender of Last Resort.

    The whole reason the central bank was created in the first place is to NOT place it under political control – that is what an independent central bank is all about – to avoid cronyism. If you don’t understand that, then all of your complaints about central bank policy choices are misguided.

    The notion that a central bank can / should / must buy government debt presumes that the government must borrow in the first place. Read the US Constitution – there is no direction that says a Congress MUST borrow. Again, if you can’t understand this, then your understanding of the Great Depression and the actions taken to escape from it are incomplete.

    “I really don’t understand why you making a fuss about this.”

    The fuss is this – if you are going to assign blame for the Great Depression, then the least you could do is point your in the right direction. I am making a big fuss about this because your repeated attempts to blame the Bank of France for the Great Depression in the United States are not well founded.

  51. 51 David Glasner February 14, 2021 at 5:37 pm

    Frank, Oh really? I’ve been writing about this for almost 10 years on this blog, and now you bring up Andrew Mellon? Sorry, but I’m not gonna engage with you about this now. But if you’re patient, maybe I will at some point in the future. Not gonna get into this discussion now, that’s too much of a distraction for me now.

  52. 52 Frank Restly February 14, 2021 at 5:55 pm

    David,

    That’s fine. I bring up Andrew Mellon now because I am NOT paid to be an economist or economic policy maker – I have a regular job outside of my own interest in economics and policy decisions. My very limited investigations into the actions of Andrew Mellon during the Great Depression were a complete accident.

    “I’ve been writing about this for almost 10 years on this blog, and now you bring up Andrew Mellon?”

    The point isn’t that I am just bringing this up now, the point is that you (writing on this blog for 10 years) haven’t brought it up – or maybe you did and discounted it, I don’t know. It’s entirely possible that you wrote about Andrew Mellon and I missed it – if you did, I would appreciate a link.

  53. 53 David Glasner February 14, 2021 at 6:16 pm

    My knowledge of Andrew Mellon is very limited, he pushed for tax cuts in the Coolidge Administration and is reputed to have favored liquidationism during the Great Depression, a charge leveled at him by Hoover in his memoirs, which I believe Mellon denied after Hoover made the charge. I have no view on that dispute. He did endow the marvelous National Gallery of Art in Washington DC after he left office, which, I hope, will be to his everlasting credit.

  54. 54 Frank Restly February 14, 2021 at 6:52 pm

    David,

    “My knowledge of Andrew Mellon is very limited, he pushed for tax cuts in the Coolidge Administration and is reputed to have favored liquidationism during the Great Depression…”

    Did he push for the Coolidge administration to grant tax cuts and then offset those tax cuts through reduced government spending OR did he push for the Coolidge administration to sell tax cuts through the Treasury department (under his control) and leave government spending unchanged?

    I suspect the former rather than the latter.
    And that is the crux of my argument against his economic policy leanings.

    During or even prior to the Great Depression he could have got his wish for lower taxes while simultaneously allowing government spending to address demand deficiencies and social welfare, all without placing a strain on the U. S. government’s gold reserves.

  55. 55 David Glasner February 14, 2021 at 7:00 pm

    I don’t know much about the budgetary stance of the US in the 1920s. You can find the supply side interpretation of the Mellon tax cuts in Jude Waninski’s The Way the World Works which was a kind of bible for supply siders in the late 1970s and early 1980s and helped bring about the Reagan tax cuts in the 1980s. I don’t vouch for its accuracy, but I don’t say that his statements about the taxes and spending and revenue are incorrect. You can do your own checking if you are interested.

  56. 56 Frank Restly February 14, 2021 at 7:56 pm

    David,

    “You can find the supply side interpretation of the Mellon tax cuts in Jude Waninski’s The Way the World Works which was a kind of bible for supply siders in the late 1970s and early 1980s and helped bring about the Reagan tax cuts in the 1980s.”

    I am familiar with “The Way the World Works”. I also know that Waninski / Reagan / Mellon (as well as Paul Ryan) got things wrong.

    See:
    https://www.ourpursuit.com/ronald-reagan-and-paul-ryan-share-one-common-regret/

    “The outgoing Speaker of the House admitted earlier this week the national debt is one of his biggest regrets.”

    While Paul Ryan was still in office I participated in President Obama’s national Deficit Reduction Committee. I was able to personally meet Alice Rivlin in Philadelphia, PA who has since passed away.

    The supply siders got things wrong because they didn’t understand that supply side economics isn’t about government spending or deficits, it is about the after tax cost of private capital formation.

    When a Treasury sells tax breaks (instead of giving them away) that tax break (as an asset) can be used to offset a private sector liability (debt). In that way the after tax cost of debt service in the private sector can always be whatever you want it to be irregardless of inflation / deflation.

    Meaning that a company or a farm or whatever can continue to produce and sell goods even during a deflation because the real cost of debt service for that company / farm is reduced through tax policy. But instead, Mellon’s suggestion was liquidate everybody.

    When a Treasury sells tax breaks, the Congress can then use that money received in the purchase for whatever purpose they desire – if they want to pay back federal debt or spend money on social programs, that is for them to decide.

    Paul Ryan apparently never heard of Irving Fisher – “The investment decision is separate and distinct from the financing decision.” He, like so many others before him was trying to reconcile two separate decisions into one.

    Decision #1 – What do you want to spend money on?
    Decision #2 – How do you want to pay for it?

  57. 57 Mike Sproul February 22, 2021 at 7:33 pm

    “unless those liabilities are made convertible into an asset whose value is determined independently of the banks, the value of their liabilities is undetermined. Convertibility is how banks anchor the value of their liabilities”

    No, convertibility is window dressing. It’s backing that matters. If a bank issues $100 against assets worth 100 ounces of silver, then any attempt to maintain convertibility at 1.01 oz/$ will fail, and any bank that maintains convertibility at .99 oz/$ will have no customers.

  58. 58 David Glasner February 22, 2021 at 7:51 pm

    Without convertibility, what’s the anchor that pins down the price level. All prices could just double and there would still be enough backing for the currency.

  59. 59 Mike Sproul February 23, 2021 at 10:19 am

    Only a small fraction of the dollars issued by a bank need to be physically convertible into metal. The rest of the bank’s dollars can be nominally convertible into a dollar’s worth of bonds.
    For example, a bank has issued $10 in exchange for 10 oz of silver, and then it issues another $90 in exchange for $90 of bonds. Define E as the exchange value of the dollar (oz/$). Setting assets equal to liabilities yields:

    10+90E=100E

    or E=1 oz/$

    If the bank is then robbed of 4 oz (=4% of its assets) the above becomes

    6+90E=100E

    or E=.6 oz/$

    so a 4% loss of assets causes 40% inflation, due to the large amount of nominal backing held against the bank’s dollars.

  60. 60 David Glasner February 23, 2021 at 11:07 am

    A dollar is a dollar. How does one distinguish between the convertible dollar and the inconvertible dollar?

  61. 61 Frank Restly February 23, 2021 at 12:32 pm

    Mike,

    “Only a small fraction of the dollars issued by a bank need to be physically convertible into metal.”

    Because? How does a bank pick and choose which dollars will be convertible to metal and which won’t?

    From your equation above, the bank has $100 in liabilities but only 10 ounces in assets.

  62. 62 Mike Sproul February 23, 2021 at 4:04 pm

    Customers only have to know that some dollars will be convertible on some days and times, and those days and times don’t need to be especially well-specified.

    Convertibility can be instant or delayed, certain or uncertain, real or nominal. Customers don’t much care. But they definitely do care if a bank has enough assets to buy back all its money. Convertibility at a given rate can only be maintained if a bank has enough assets. That’s why I say that backing is of primary importance, and the rate of convertibility is just window dressing.

  63. 63 Mike Sproul February 23, 2021 at 4:08 pm

    Frank:
    The bank also has $90 worth of bonds, worth E ounces each. This is exactly enough for the bank to buy back all its money at $1=1 oz. For example, the bank could sell its $90 of bonds for $90 of its money, then burn the money. Then the bank sells 10 oz for $10 of its money, which it burns. Thus the bank completely winds down without its customers losing anything.

  64. 64 Frank Restly February 23, 2021 at 5:07 pm

    Mike,

    “The bank also has $90 worth of bonds, worth E ounces each. This is exactly enough for the bank to buy back all its money at $1=1 oz. For example, the bank could sell its $90 of bonds for $90 of its money, then burn the money.”

    When the bonds are first created they may be worth $90. After that, their value is dependent on several factors including the perceived credit risk of the borrower.

    And perceptions matter a lot. The bank holding the bonds may perceive the borrowers as good credit risk and value the bonds at $90. I or you may not agree with the bank and value the bonds at $60.

    So no, though the bank may value the bonds that it holds at $90, they may not be able to recover $90 if and when they try to sell any of the bonds.

  65. 65 Mike Sproul February 23, 2021 at 7:16 pm

    Frank:
    Nobody denies that if a bank loses assets, then money issued by that bank will lose value. In fact, that’s a fundamental claim of the backing theory of money: If a bank maintains its asset backing then that bank’s money will hold its value. If not, its money will lose value.

  66. 66 David Glasner February 23, 2021 at 7:20 pm

    Mike, Under the backing theory, does a reduction in the value of a bank’s assets cause its liabilities to lose value if the bank still has positive equity or do the bank’s liabilities lose value only when the bank’s equity goes to zero?

  67. 67 Mike Sproul February 23, 2021 at 7:41 pm

    David:
    Normally, money issued by a bank is a very senior claim on the bank’s assets, so a loss of assets would reduce the bank’s stock price before it would reduce the value of the bank’s money.

  68. 68 David Glasner February 23, 2021 at 7:45 pm

    Mike, Thanks, that’s what I thought, but I wanted to get your take. We are in substantial, but not total, agreement.

  69. 69 Frank Restly February 23, 2021 at 8:53 pm

    David / Mike,

    A bank could recover the $90 that it originally lent out by selling $90 worth of equity while retaining it’s bonds. Under those circumstances, the market value of the equity can adjust to reflect the performance of the underlying bonds.

    E=1 oz/$
    B=$1 / bond
    S=$1 / share

    The equation becomes:

    10 = 10E : $10 dollars in circulation is fully convertible to 10 ounces of silver
    90B = 90S

    I believe that is what the “Chicago Plan” tried to achieve.
    All bank lending (bond creation) was to be funded through either retained earnings (private equity) or the sale of shares (public equity).


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About Me

David Glasner
Washington, DC

I am an economist in the Washington DC area. My research and writing has been mostly on monetary economics and policy and the history of economics. In my book Free Banking and Monetary Reform, I argued for a non-Monetarist non-Keynesian approach to monetary policy, based on a theory of a competitive supply of money. Over the years, I have become increasingly impressed by the similarities between my approach and that of R. G. Hawtrey and hope to bring Hawtrey's unduly neglected contributions to the attention of a wider audience.

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