Tuesday, October 14, 2008 62 Comments

The Misesian explanation of the bank crisis

I've addressed this subject before at greater length, but I want to put it in one post that people can easily link to and pass around.

Briefly: the fundamental cause of the bank crisis is not evil Republicans, lying Democrats, "deregulation," "affirmative-action lending," or even "ludicrous levels of leverage." A banking system is like a nuclear reactor: a complicated piece of engineering. If it's engineered right, it works 100% of the time. If it's engineered wrong, it works 99.99% of the time, and the other 0.01% it coats the entire tri-state area in radioactive strontium.

The bank crisis is an engineering failure. Its fundamental cause is a humble bug. Once we find the bug, we can start to ask: who is responsible for this bug? Who wrote the code? Who rolled back the fix? That discussion, though fascinating, is out of scope here.

Another analogy is the Space Shuttle disasters. Challenger had a bad booster O-ring; Columbia's wing was hit by falling foam. The level of discourse we're hearing now on the crisis tends to be "the Space Shuttle was Nixon's idea" or, at best, "Columbia's wing melted through and fell off." This is not an engineering analysis. It is point-scoring at best, anti-information at worst.

I believe I know what the bug is. It was first identified by the 20th-century economist Ludwig von Mises, capo of the Austrian School. Mises was an excellent writer, as eloquent as Marx and far more sensible, and it's unsurprising that there is a large Internet cult devoted to his work.

I am going to assume you are not a member of this cult. If there was a video of Mises walking on water, I might be tempted to take his pronouncements for granted. Since no such tape exists, they have to be explained and justified.

But we do need to start with Mises, because he was the first to solve the problem. Almost a hundred years ago, in his Theory of Money and Credit, he wrote:
For the activity of the banks as negotiators of credit the golden rule holds, that an organic connection must be created between the credit transactions and the debit transactions. The credit that the bank grants must correspond quantitatively and qualitatively to the credit that it takes up. More exactly expressed, "The date on which the bank's obligations fall due must not precede the date on which its corresponding claims can be realized." Only thus can the danger of insolvency be avoided.
Let's call the sentence in quotes Mises' rule. A banking system which obeys it is Misesian. We do not have a Misesian banking system - and that's the bug.

Basically, imagine that there were two kinds of nuclear reactors - fission and fusion, perhaps. Fission reactors work 99.99% of the time. Fusion reactors work 100% of the time. The reason our society gets its power from fission reactors is that our reactor experts are fission experts. Therefore, we have resigned ourselves to having fission reactors, plus a large fleet of mobile power-washers to clean up the radioactive strontium every ten or twenty years. If you ask either the reactor engineers or the cleanup crews about the possibility of switching to fusion, the best answer you'll get will be something like "waah?" There are many worse.

Let's consider the sentence again. "The date on which the bank's obligations fall due must not precede the date on which its corresponding claims can be realized." Mises' rule of banking. Let's explain these terms and the reasoning behind them.

A "bank" is a financial middleman. It borrows from you and lends to someone else. When you "deposit" money "in" a bank, you are actually lending money to the bank. The bank does not keep this money in a big cardboard box. (I really hope this is not news to you.) It lends it to someone else - call him Dwight.

The bank's "obligation" is its agreement to repay you your loan. Its "claim" is Dwight's agreement to pay back his loan. (And your claim is the bank's obligation.) So what Mises is saying is that the bank must not agree to return your money (plus interest) before Dwight returns his money (plus interest).

Because, duh, it doesn't have it yet. Sounds obvious, right?

Of course, banks do not match individual claims and obligations in this way. If this is the way it worked, you and Dwight could save time and money by cutting the bank out of the loop. In reality, a bank borrows from and lends to thousands if not millions of people, which allows it to meet its obligation to you even if a few Dwights turn out to be deadbeats. Nonetheless, we can make the same obvious statement: by the time the bank needs to pay you, it needs to have collected from enough Dwights in order to have the money to pay you. Duh.

A more general way to describe Misesian banking is that the bank's plan to fulfill its obligations must not involve any implicit transactions. For example, if the bank promises to give you your money back in a week, and Dwight promises to give the bank its money back in two weeks, the bank has an implicit transaction. At the end of the first week, it needs to borrow money from someone else in order to repay you. That someone else might just be you, in which case you are rolling over - that is, renewing - the loan. But this is your decision, and the bank cannot know that you will roll over. After all, presumably there is a reason you selected a one-week loan.

We observe that in Misesian banking, the duration of a loan is as important as its amount. To balance a one-week obligation with a two-week claim is to balance an apple with an orange. It is just, not, done. Recall Mises' statement: the credit that the bank grants must correspond quantitatively and qualitatively to the credit that it takes up. That means it can't have an apple on the right and an orange on the left. (And what happens if it breaks this rule? Ha. We'll find out.)

A more naive approach to banking might just add up the claims on the left side of the page, add up the obligations on the right side, note that the sum on the left exceeds the sum on the right, and be satisfied. This would be "corresponding quantitatively" - but not "qualitatively." In Misesian banking, the bank makes sure its structure of claims allows it to satisfy its structure of obligations, as is, without implicit transactions. (Another kind of implicit transaction might be a currency conversion.)

Let's look slightly more closely at the loan market. We'll start with the obvious and segue into the not so obvious.

When you lend, you are exchanging present money for a claim to future money. Even if you know that this claim is perfectly good, you have no reason to make the trade unless you are getting more money in future than you give up in present - otherwise, you would just keep the money in your big cardboard box. So, for example, you might trade $100 in 2008 dollars for $110 in 2009 dollars.

The $10, obviously, is your interest rate, or yield - 10%. If you thought the loan had a 10% chance of not being paid back - the default risk - you might add another $10 or so, to get the same expected return. And the year (from 2008 to 2009) is the maturity of the loan.

We are now in a position to ask a very interesting question: in a healthy lending market, assuming Misesian banking, and forgetting about default risk for a moment, how should yield vary by maturity? Should a longer-term loan carry (a) a higher interest rate, (b) a lower interest rate, or (c) the same interest rate?

I suspect that, just intuitively, you said (a). This is indeed the right answer. Let's see why.

The market for loans is set, like everything else, by supply and demand. Every loan has a lender and a borrower. The lender always prefers a higher rate. The borrower always prefers a lower rate. At any maturity, the market rate is that rate at which the number of dollars which lenders are willing to lend is exactly equal to the number of dollars borrowers are willing to borrow.

We can make a little graph of this market, putting maturity on the x-axis and yield on the y. The result is called the yield curve. At least in a free market, the yield curve will always slope upward - higher maturities will command higher interest rates. This is true for any set of lenders and borrowers, anywhere in the known universe. If they have Misesian banks in the Lesser Magellanic Cloud, their yield curves slope upward.

How can we possibly know any such thing? We know only one thing: interest rates are set by supply and demand. But we can make some elementary observations about lenders and borrowers, which are true by definition.

The first is that at the same rate, any lender will prefer a shorter maturity. Consider the choice between one-week and two-week lending. If both transactions had the same rate, you could just lend for one week, get the money back and lend it again. This gives you the option to use the cash at the end of the first week, an option that the two-week maturity does not provide. An option can never have negative value, so why not: you'll pick the one-week maturity.

The second is that at the same rate, any borrower will prefer a longer maturity. For a borrowing transaction to be profitable, some productive process must use the money and generate a return. The set of productive processes that can produce round-trip return at a maturity of one second is empty. Therefore, in Misesian banking, no one should want to borrow at a one-second maturity, because there is no lending at a zero rate and no way to finance a productive enterprise at any nonzero rate - however small.

As the maturity of the loan increases, so does the set of productive processes, and so does the demand to borrow. Without violating Mises' rule, you cannot finance a nine-month pregnancy with a one-month loan. You need a nine-month loan. Nine one-month loans in a row will not suffice, because the last eight are implicit transactions.

Thus, for a higher maturity there is less supply of lending, and more demand for borrowing. Less supply and more demand means higher price, which means a higher yield. Which means the yield curve slopes upward.

This concludes our explanation of Misesian banking. Now let's explain the crisis.

Again, we don't have a Misesian banking system. We have what might be called a Bagehotian banking system - after Walter Bagehot (pronounced "badget"), who wrote Lombard Street, the first description of how this system works.

Here is a nice, concise explanation of the Bagehotian system:
The essence of what banks do in normal times is to borrow short and to lend long. In doing so, they transform short-term assets into long ones, thereby creating credit and liquidity. Put differently, by borrowing short and lending long, banks become less liquid, thereby making it possible for the non-banking sector to become more liquid; that is, have assets that are shorter than their liabilities. This is essential for the non-bank sector to run smoothly.
This appeared in the Financial Times on October 9, 2008. The author is one Professor Paul de Grauwe, who like Professor Mises, and unlike me, got paid to understand this matter.

Note the perfect inversion between the Misesian and Bagehotian theories. Mises, writing almost a hundred years ago, describing a banking system that did not exist in his time any more than it exists in ours, says: "Only thus can the danger of insolvency be avoided." De Grauwe, writing now, says: "This is essential for the non-bank sector to run smoothly."

Hm. We may not be sure whom to trust here, but we do know that neither of these gentlemen is stupid. So what gives?

First, let's decode what Professor de Grauwe is saying. He's saying that banks routinely violate Mises' rule - they borrow "short" (ie, with short-term maturities), and lend "long" (ie, with long-term maturities). In other words, they engage in what we call maturity transformation.

Because we know the shape of the yield curve, we know why MT is profitable. Short interest rates are lower than long interest rates. So if the rest of the world is practicing Misesian banking and you're practicing Bagehotian banking, you make a mint.

In fact, we can say even more than this: we can say that MT lowers long-term interest rates. In our stodgy, Teutonic Misesian bank, if someone wanted to borrow money for 30 years, we had to match him with a lender who wanted to lend money for 30 years. In our fast-paced, Anglo-Saxon Bagehotian bank, we don't care - we balance our balance sheet quantitatively, not qualitatively. We can match the borrower with any lender, and get a better rate.

This is how a classic, Wonderful Life-style deposit bank works. A so-called "deposit" is really a loan of instantaneous maturity, continuously rolled over - by not "withdrawing" the cash, you are really renewing the loan. In the classical Bagehotian model, this might be used to finance, say, a 30-year mortgage.

Bagehotian banking seems like a just plain better idea. Its profits can be distributed to lender and borrower alike, producing higher rates for the former and lower rates for the latter.

Unfortunately, there is a slight downside. As we said earlier: "duh, the bank just doesn't have the money yet." When a bank borrows for a month and lends for a year, how exactly does it complete the transaction? Is there a little time machine inside the vault?

By violating Mises' rule, the Bagehotian bank makes itself dependent on an implicit transaction: viz., finding someone to loan it money for eleven months. Let's look at the ways in which it can implement that transaction.

The easiest way is just by inducing you to roll over your loan. It finds someone, and that someone is you. The reason Bagehotian banks work 99.99% of the time is that lenders, especially individual lenders, tend to roll over their loans a lot. You make a bank deposit rather than buying a six-month CD, even though the CD pays a higher rate, because you are not sure you won't need the money before the six months is up. Often you find you didn't. In retrospect you should have bought the CD, but you had no way of knowing this at the time.

The bank can also sell the 1-year loan. But selling a loan is equivalent to finding a new lender. Again, it cannot be known on what terms this implicit transaction can be executed.

What we've identified here is the wad of duct tape in the nuclear reactor. A Bagehotian bank is not contractually sound, because it does not have a complete plan to carry out its obligations. It relies on implicit transactions. And when these transactions cannot be executed on the terms expected - poof. The duct tape catches fire. The reactor melts down. The bank has a run.

In a bank run, the lenders start to doubt collectively that the bank will not be able to execute on its obligations to all of them. The origin of the doubt could be concern about the bank's quantitative solvency - eg, its 30-year claims are subprime mortgages. Or it could just be a suspicion that the bank will experience a run. If there is a run, you want to be the first out.

What happens as a Bagehotian bank experiences a run? Let's assume that, before the run, the bank was still quantitatively solvent - the current market price of its claims exceeds the sum of its obligations. The only problem is that the claims mature far later than the obligations.

So the bank sells the claims on the open market. If it can sell them all at the market price before the run, it is fine - it can raise enough cash to pay off all its depositors.

But a market price is a market price. It is not magic. Introduce new supply into the market, or withdraw demand - and the price drops like a stone. The bank run changes the price of the claims that are being sold. It has to find a lot of new lenders - but the market price of everyone's claims is dropping. So all banks which hold claims in this market are becoming quantitatively insolvent. The bank run spreads to the entire market. Lenders run in the other direction. And so on.

The idea of the yield curve lets us visualize this in a particularly elegant way. Recall that Bagehotian banking, by transforming maturities, lowers long-term interest rates. It flattens the curve. At least as compared to the Misesian yield curve.

Think of this curve flattening as putting pressure on a spring. A Bagehotian banking system is, at all times, a bank run waiting to happen. And when the run happens, the spring explodes in the other direction - well past where the Misesian yield curve would have been. It will not stop at the Misesian level, because a Misesian banking system would never have made so many long-term loans. It will produce astronomical long-term rates.

(This is exactly what we see now in the mortgage-backed securities market. It is impossible to get a read on exactly what the risk-free interest rate is in this market, because by definition there are no risk-free securities in it. Maturity-transformed demand is (at present) no longer buying mortgage securities, but not all the holdings have been liquidated, and there is no maturity-matched banking system to provide baseline demand. So neither interest rate nor default risk can be computed from asset price - you are trying to solve one equation for two variables.)

This metaphor of the spring lets us understand Professor de Grauwe's perspective. He believes "[maturity transformation] is essential for the non-bank sector to run smoothly" because he is thinking empirically, rather than deductively. He simply notes that every time MT stops, the reactor fails and melts down, and the tri-state area receives its coating of strontium. His thought is not intended as a comment on a Misesian banking system which never initiates MT to begin with, an idea that has probably never come to his attention. He is a fission expert, after all.

The difficulty in transitioning from Bagehotian to Misesian finance is immense, which is probably a big part of why it's never been tried. The Misesian sees an enormous set of financial structures which violate Mises' rule. He sees no way to unwind them. Other than massive liquidation - the bank run as a virtuous purge of "malinvestments" (pretty much any investment is a loss if it has to be financed at 80% interest) - there is no obvious way to get from here to there. The reactor just has to blow, and the strontium has to be swept up. Or so at least is the conventional wisdom, and no one is really working on the problem.

Moreover, there is another way to save a Bagehotian banking system: find a new lender who can print infinite amounts of money. (Or, in a metallic standard, compel the acceptance of paper as equivalent to metal.) This friendly fellow is generally known as "the government," or more formally as a "lender of last resort."

The end result of Bagehotian banking is that, without any government protection, it is incredibly unstable and will melt down at a drop of the hat. With full government protection, it is stable, and it drives down long-term interest rates - just as if the government itself had been making the loans itself. The lender of last resort might as well be a lender of first resort. (There are no modern schools of economics which believe, as far as I know, that governments should print money and lend it.) And with wishy-washy, informal, wink-and-a-nod protection - which is what we had until the other day - these toxic qualities are combined.

And this is how we continually stumble forward with a broken, Victorian-era banking system, suffering the slings and arrows of bad financial engineering. The whole thing needs to be rebooted, if not reinstalled, and we simply don't have a political system - or an intellectual system - which is capable of this. But I digress.


Blogger Publius said...

Let me get this straight. For every $250,000, 30-year mortgage, the bank needs to find a depositor who will own a CD for the same amount and time-frame. Isn't that just creating a logistical nightmare?

October 14, 2008 at 2:23 AM  
Anonymous vlade said...

MM, while you're right that the fixed rate has in it a liquidity option, you're dismissing the premia for fixing the rate for a longer period. Unless, of course, you assume that the rates stay always the same (for a given maturity). So, there's a liquidity option price vs. fixed rate guarantee.
If you'd assume the fixed yield curve, then of course the higher yield can be driven by the re-investment reality (i.e. if you have lower interest rates for a week, then investing for two weeks, assuming away credit risk and constant yield curve, must yield at least as much as two weekly reinvestment (getting a bit of MT there, aren't we?):) ).
The explanation of the rising yield curve is really a simple - the longer the curve, the higher the probability of us not being able to use the money at the end. That doesn't mean just borrower's default, it means things like meteorite striking the earth, me dying etc... If I postpone my consumption, I need reward that is (amongs other things) commesurate with my chances of being to enjoy the postponement.

Also, I wanted to point out that Mises' quote does not preclude MT. It says " corresponding claims can be realized" (emphasis mine). So, for liquid markets, MT markets meet the definition. Here, I want to state that short of fiat-money printing press, there are no "always liquid" markets, as even perfectly maturity matched borrower might be solvent but illiquid for a number of reasons (like failure of the banks IT system, resulting in all the payments being postponed by a day or two, making him technically default on his payment).

I read the quote as "bank's asset must be kept liquid" as opposed to "bank's asset much be maturity matched", which is a much weaker assumption

October 14, 2008 at 4:39 AM  
Blogger G. M. Palmer said...

publius -- if the bank is operating properly under a Misean system, it should be making money -- therefore it can lend its own profit for long-term loans (and make pads of money on them).

But you're also thinking of things incorrectly -- under a Misean system few folks would take out a $250,000, 30-year loan. The interest rate would just be far too high.

It would be an interesting thought experiment to figure out exactly what the Misean system would do to home ownership.

October 14, 2008 at 5:20 AM  
Anonymous Doug_S said...

You left out the concept of fractional reserve banking. Banks wanted to make more loans than they had deposits, and they can to an extent. It works particularly if the bank purchases insurance to cover the 0.01% chance of too many withdrawls. During the house bubble US and european regulators halved the capital requirements (doubled the amount of loans they could make for a given deposit)(oversimplified details different in US and Europe). The banks pressured the govt to do that so the banks could make more profit. The govts went along because regulatory agencies are always captured by the regulated party. Both parties thought it was a good idea because the asset bubble made it seem safe. If banks had to match quality, quanity and maturity, you would have a vastly different financial system. Investment would be shorter term and there would be less of it. There would be less economic growth.

October 14, 2008 at 8:11 AM  
Anonymous Anonymous said...

doug s:

"There would be less economic growth."

That is always the claim. I have yet to see it seriously justified in real terms.

It is a version of the broken window fallacy that discounts the counterfactual economic activity of the people who were involved in questionable endevours that (presumably) wouldn't get funded under a Misean system.

In short, it is quite difficult to separate the dilution of the money supply from real economic growth under the current system. It is not obvious to me that better accounting standards, which would prevent the former, would have a negative impact on the latter.


October 14, 2008 at 8:45 AM  
Anonymous Quercus said...

But you're also thinking of things incorrectly -- under a Misean system few folks would take out a $250,000, 30-year loan. The interest rate would just be far too high.

It would require a computer-assisted loan market and zero-closing-cost loans, but it strikes me house buyers would take a 250 oz. gold loan for the first month, a 249 oz. gold loan for the second month, etc. Provided the buyer put enough money down, he could weather a mild decline in the property's value and still be able to refi every month.

I suspect a MisesBank world would have far lower volatility in real estate prices than does our Lombard Street one.

October 14, 2008 at 9:03 AM  
Blogger G. M. Palmer said...

quercus --

not a bad thought, really -- since you have a real asset, there's less problem with reupping the loan each month/year/etc.


October 14, 2008 at 9:35 AM  
Anonymous sa-rah said...

In a bank run, the lenders start to doubt collectively that the bank will not be able to execute on its obligations to all of them.

Did you mean that they doubt that the bank will be able to execute?

Thank you for the informative post.

October 14, 2008 at 11:57 AM  
Anonymous Curve of Freedom said...

I am sort of stumbling toward an understanding (maybe incorrect) of why Austrian stalwart Moldbug would support both bank nationalization and Obama.

Bank nationalization will end in tears, as do most socialist programs, but with Obama and a thoroughly D Congress in office, it will be clear who to blame. After the financial hits the fan, the Republicans or their successor movement will sweep their house clean of socialism, and when the banks are denationalized the pain will be lost in the general pain of the depression. Then they can be denationalized to whatever system the folks in power advocate.

Moldbug is trying to plant the seeds of advocacy for an Austrian / gold-standard monetary system to be a platform plank of whoever is in power post-depression, post-Obama.

Time to start the drumbeat of "Fractional reserve banking is to blame!" right now, and let the Keynesians and neo-Keynes try to convince everyone (a) there is no depression or (b) bank runs aren't all that big of a deal.

October 14, 2008 at 12:24 PM  
Blogger Leonard said...

For every $250,000, 30-year mortgage, the bank needs to find a depositor who will own a CD for the same amount and time-frame. Isn't that just creating a logistical nightmare?

Not at all.

First off, we have computers. So even if we had to exactly match up specific creditors and borrowers, we could do it. We'd probably end up having to standardize loan amounts some, but that is perfectly reasonable. (We already standardize mortgage lengths -- can one get a 27.3-year mortgage? I don't know; nobody does.) So instead of taking a mortgage of $451000, instead you might get a $400000 and a $50000, and figure out how to get the extra $1000 from your parents instead of paying $40 in extra service charges.

But the thing is, we don't have to exactly match up specific loans. We only need to match up maturities and (total) amounts. So, say that we think that next month, our bank will write 40 mortgages of 30 years each, for $250000 on average. What we do is, we sell 30-year bonds, with a total value of $10m, into the bond market. This raises $10m in cash, which we then lend out.

The bonds might be 100000 of $100 each, or 10 $1m bonds, or one big $10m bond. It doesn't matter. There does not need to be a bond of exactly $451000 to match a particular mortgage. It only has to be the case that the sum of the amounts borrowed at any given maturity X are greater than or equal to the sum of the amounts lent at maturity Y, for Y<=X. Note the two less-than-or-equals in there. That gives a lot of fudging room.

Perhaps we don't manage to lend out all the cash; what then? Well, next month we make loans for 29 years and 11 months -- or, we can do shorter, of course. We can do loans of 25 years, then have extra cash for 4 years at the end -- or the start. So in part the bond money is just our working funds for a while; each month we'll have many small amounts from old bonds which we are not yet due to repay -- these can be lent, but only for short terms.

Another transaction that we might do is buy a piece of a bond from some other bank. Say you've got $10000 left over with 29 years left to go -- rather than trying to do really long-term car loans, you might just sell a fraction of your bond to some other bank, which needs it to round out a 25-year mortgage.

October 14, 2008 at 12:26 PM  
Anonymous Curve of Freedom said...

... of, I suppose, the Keynesians can try to convince everyone that (c) while informal monetary expansion (reducing reserve requirements, etc.) is to blame, old-fashioned formal monetary expansion (free silver, etc.) is A-OK.

October 14, 2008 at 12:26 PM  
Blogger Leonard said...

Let me reiterate the question I asked last time, since nobody answered then.

In Misesian banking, I'm convinced there would be no 30-year CDs, at least not CDs as we currently know them. That being, money locked up in a nonnegotiable investment vehicle. Instead, all long-term borrowing would be what we would call bonds -- the money is locked up (you cannot demand early payment of principle), but the instrument itself is still negotiable. You can sell a bond.

Given that all long term savings are in bonds, the market for such paper would be extremely liquid -- fees for buying and selling could be very low. So, how much does that actually change the interest rates, by comparison to our non-Misesian system? I don't think it does very much -- they might be a bit higher, but not that much.

Think of it this way: maturity transformation is still taking place. Instead of banks doing it, though, using those naughty implicit transactions, individual lenders are doing it explicitly. They do it by buying bonds with maturity dates far beyond their anticipated investment, which they then sell at a later time.

Thus, a series of short-term investment of perhaps 6 months to several years each are serialized and turned into one 30-year investment.

How is this so different than what we have? Would long-term interest rates really be very much higher?

October 14, 2008 at 12:38 PM  
Anonymous Anonymous said...


If there is some sort of regulation preventing banks from doing maturity transformation (MT), then such a regulation would have to be worded expansively enough that anyone selling short-term loans and buying long-term loans would be considered a bank.

If we are simply relying on the market to take care of things, then the situation becomes much easier to analyze.

No one is prevented from doing MT, there simply isn't a lender of last resort. In this case, though, Misesian banks could 'aggressively compete' with their Bagehotian counterparts by collusively failing to roll over short term loans, spreading rumors of bank runs, etc.

In either case, the Bagehotians would (presumably) be unable to compete with their Misesian counterparts.

As far as higher interest rates go, I'm having difficulty with how much MT in the general case is affecting the interest rates. It is quite easy to see how fractional reserve banking (FRB) affects interest rates, though.

One can reformulate the interest rate as the cost of buying present dollars with future dollars. Under the Misesian Banking system, when a bank makes a loan for $10, the bank's supply of present dollars decreases by $10. Under the Bagehotian system, the bank's supply of present dollars decreases by only $1 (the reserve requirement is 10%). Since the cost of anything is intimately linked with its supply, interest rates under the Bagehotian system are, in general, lower.

The reason why the yield curve is steeper for the Misesians is because maturity arbitrage - in other words, MT - is verboten.


October 14, 2008 at 1:27 PM  
Anonymous vlade said...

This is the "realised" part, as I see it. So, your bank (in my world) is still Misesian :).

October 14, 2008 at 1:29 PM  
Anonymous vlade said...

"Under the Bagehotian system, the bank's supply of present dollars decreases by only $1 (the reserve requirement is 10%)."

This cannot be true, given that you have to pay out (physical) $10 at time zero. Or, if you don't pay out the physical cash, the M3 still stays the same (cos your extra 9 dollars most likely came from wholesale market).

Fractional banking doesn't mean that you lend what you don't have, it means that you keep only a fraction of the assets in immediately liquid form (which, in turn, means that when under run you your illiquidity transforms to insolvency automatically).

October 14, 2008 at 1:39 PM  
Blogger Leonard said...

Vlade, I'm afraid fractional reserve does mean you can 'lend what you don't have'. (Although who's to say you "don't have" money? Here's a check for one million dollars! ... What, don't you trust me?)

If you have $10 in the bank, then you can loan out $9, keeping $1 in the vault. Note that in this step alone, assuming that the $10 is a demand deposit, we've violated Misesianism -- we've now got $10 in demand deposits, but only $1 in hand, w/ $9 out as a long-term loan.

Has money been created? You bet! There are now claims to $19, in total, in this system. M1 was $10; M3 is $19!

In a banking system with lots of banks, the $9 loan is likely to end up deposited elsewhere -- but then that bank will take it and lend out $8.10, keeping $.90 in reserve. And so on, and so on. (To be more precise, the $9 is spent into the economy, and then eventually ends up being banked in dribs and drabs all over the place.) Eventually the $10 demand deposit in one specific bank is turned into fully $90 in loans, and $10 in cash on hand, distributed over the banking system as a whole.

October 14, 2008 at 2:09 PM  
Blogger Dan Weber said...

The first is that at the same rate, any lender will prefer a shorter maturity.

What if I think that interest rates next week will be lower? Hence I "lock in" a better rate over the next two weeks.

Yes, this is saying that I'm smarter than the market, which I'm usually not. But FR banking usually works, too.

October 14, 2008 at 3:03 PM  
Blogger TGGP said...

Curve of Freedom, funny I should read your comment shortly after coming across this in my RSS feed.

October 14, 2008 at 5:29 PM  
Blogger George Weinberg said...

I recently made comments on this topic here.

Any time an entity has multiple obligations which must be fulfilled upon demand, something like a bank run is possible.

October 14, 2008 at 7:48 PM  
Anonymous vlade said...

leonardo: yes, but at every step the bank lent money they did have.

How does that differ from a 100% backed MT-free banking where you lend me for 3 months, and I find five people I lend (in aggregate the same sum) for 3M, and they go and invest that (which ends in another bank which lends it out)? As long as we have the same tenor, I can lend indefinitely, and thus create infinite M3.

Assuming away default, the system's perfectly stable and it matters not that I economy might have just $100 in it in total, and that a lot of people end up with 3M papers that add up to much more than $100.

October 15, 2008 at 1:18 AM  
Anonymous vlade said...

MM, thinking some more about it, I believe you cannot get rid of MT, because world is not MT-free. World could be MT free only if we assume that liquidity and solvency are the same, which they are not.
Even the best MT-free instituion could be solvent but illiquid, if one of their cpties is solvent but illiquid - and when I say cpties, I don't mean another financial institution, but a "real user" of the money. For example, assume you're a banker that lent for 2W to an exporter whose ship got delayed by a storm in Atlantic and so instead of 2W (which is, under normal circumstances plenty of time to cross it), it takes 2w+2D. If you equate liquidity with solvency, you're technically insolvent, which doesn't seem right to me.
Of course, you could extend the maturity, but then you're bearing the cost of paying the extra-time insurance and still not getting 100% surety (as say combined with a strike in a port, it can get even longer before the exporter can offload his goods and get paid for them).

October 15, 2008 at 1:24 AM  
Blogger Daniel Newby said...

It is not clear that Misesian banking would prevent panics that are destructive, even apocalyptic. The present collapse is NOT happening because of maturity transformation. Maturity transformation merely determines where the shattered gears come flying out when the Engine of the World throws a rod. The collapse is happening because suicide loans were being opaquely securitized and passed off as money-good.

The proposed Misesian system would simply move the explosion somewhere else. As Leonard says, "Think of it this way: maturity transformation is still taking place. Instead of banks doing it, though, using those naughty implicit transactions, individual lenders are doing it explicitly. They do it by buying bonds with maturity dates far beyond their anticipated investment, which they then sell at a later time."

And that would be done, on a grand scale. Instead of putting money in demand deposit accounts, businesses would buy longer-term bonds in the Quest for Maximum Yield. After all, the bonds are liquid (wait for it), and carefully underwritten. They're practically as good as money. When 85% of them are discovered to have been underwritten by a crack monkey with a broken abacus, the supposed liquidity would collapse. Businesses would miss payroll, massive instant deflation would take place as almost-money turned into no-way-in-hell-money overnight, new securitization would grind to a halt, etc.

Even with good underwriting, a panic could still cause liquidization to grind to a halt.

The main benefit would seem to be that there is no reserve fraction for a corrupt regulator to tamper with.

Credit cards would need attention. Demand credit would have to be backed by pre-arranged lending. Either credit limits would have to become extremely fluid (and digitally published with high frequency) as lending could be arranged, or interest rates would be high to cover a pool of pre-borrowed money that was not being used.

October 15, 2008 at 3:34 AM  
Anonymous Anonymous said...

It seems that the fusion reactor doesn't work as well as the fission reactor 99.9% of the time. Even if you accept every word of MM's post, it's not really clear that we would be better off with the fusion reactor. Does the security of the fusion reactor outweigh the losses?

I look at it this way - if we had a fusion reactor, I would have $120,000 in student loans at, say, 16% instead of 8%. Fission looks pretty good in comparison. Alternatively, I would not have any loans at all, because they would have been too expensive, and I would work at a concession stand instead of at a job where I can hope to pay off a $120,000 loan. Fission look even better. On the third hand, maybe the government would have paid for my education, because there would be no other way to get enough people with my skill set. Maybe fusion is better after all.

October 15, 2008 at 5:47 AM  
Anonymous Mencius Moldbug via email said...

(posted by Leonard; I emailed MM my question above at 12:38pm, and he answered me in email as follows:)


You can sell a bond. But selling a bond is equivalent to finding a new lender. This means you are using the term 'liquid' in precisely the Bagehotian sense - you are assuming the supply of lenders in the market who are willing to buy a bond at the price you consider justified is constant. In a maturity collapse, this supply will diminish rapidly.

The existence of financial intermediaries is not essential to the phenomenon of maturity crises. A liquid bond market, in which the lenders are retail investors, is no different from a liquid loan market, in which the lenders are banks.

In particular, in your example, yes: if individuals invested in bonds in a way that mismatched their maturities, they would suffer a maturity crisis in exactly the same way. Think about what happens when, a year after buying all these 30-year bonds, all your investors decide to sell them.


October 15, 2008 at 7:12 AM  
Blogger Leonard said...

You can sell a bond. But selling a bond is equivalent to finding a new lender.

In a sense, sure. But not in another sense: if I cannot sell a particular bond I own at the price I think it is really worth, then nothing bad happens. I am not bankrupt. No one else is bankrupt. No "liquidity crisis" occurs, other than my own personal one -- that for some reason I want to sell, and cannot at a high price.

In particular, in your example, yes: if individuals invested in bonds in a way that mismatched their maturities, they would suffer a maturity crisis in exactly the same way. Think about what happens when, a year after buying all these 30-year bonds, all your investors decide to sell them.

I don't see any problem. Perhaps they get pennies on the dollar, if they are all really that dumb -- but recall that they are long in bonds. If they cannot sell at price X, then they may not be able to do something they were saving for -- true. So what? So, they economize.

If this is what you're calling a "maturity collapse", it is distinctly unfrightening.

Let me restate what I believe to be the fundamental difference here: the matter of implicit transactions. When I buy a bond thinking to "save" w/ it for a year, you are claiming there is an implicit transaction at the end. In a sense, correct. But not in this sense: I do not have to sell at the end. The implicit transaction there is, in fact, controlled by me. I cause it to happen, if it does happen, and I don't have to. I never have to sell.

By contrast, with maturity transformation there is an implicit transaction that is not under the control of the MTer. Thus, crisis is possible for it. If short-term loaned money is withdrawn, it must find new loans, or do a fire sale. It has no third option, to simply scale back its desires, and wait.

October 15, 2008 at 7:32 AM  
Blogger Leonard said...


at every step the bank lent money they did have.

But they are still creating money, which is the point. $10 went into the system; we agree on that. The balance sheets end up showing $100 in demand deposits owed to various customers, and $90 in loans.

How does that differ from a 100% backed MT-free banking where you lend me for 3 months, and I find five people I lend (in aggregate the same sum) for 3M, and they go and invest that (which ends in another bank which lends it out)? As long as we have the same tenor, I can lend indefinitely, and thus create infinite M3.

It differs in being maturity matched, or not.

For one thing, with maturity matching (and assuming a real world without zero-time loan resolution), you cannot in fact lend for 3 months exactly. Rather you can lend for, say, 2M and 29 days -- something like that. It takes time to wrap up a loan. Then whoever you loaned to, can re-loan for 2M and 28 days, etc. So it is actually finite.

But second, while reloaning for shorter time periods is possible -- and might even a viable business for one level -- you simply cannot expect an infinite tower of maturity matched lending to be viable in economic terms, that is, in terms of paying interest. Because you are going to shorter loan periods with each new loan, not longer. Remember the analysis of the shape of supply and demand. Shorter loans get less interest, not more.

It is one thing make profits by borrowing short at 1%, and lending long at 5%. It's easy to see how that would be profitable -- you've got 4% built in, without even doing anything.

It's another thing to make profits when you are borrowing at 5%, and lending at 1%. The only way to make profit with reloaning money when it is maturity matched, is via nimbler business operations. Perhaps you can run a very lean business, doing small loans, and make up for the lost interest in fees and whatnot.

October 15, 2008 at 7:57 AM  
Blogger Leonard said...

daniel newby:

You are wrong in asserting this crisis is not about MT. It very much is. The mortgage crisis (meaning: a bunch of crap paper based on crap mortgages) is a real problem, but it is finite. The people that own the crap paper deserve to take losses, and some of them deserve bankruptcy.

The larger problem we're looking at, is that is has triggered a "bank run". Not as much by us little people but by banks themselves. This is the engineering problem MM identifies.

And here's the thing about a bank run: the banks are, short term, bankrupt. They do not have the option to just scale back their spending, and wait a while. They must sell right now, or go bankrupt.

By contrast, there is no "must sell now" with maturity matching. There is just the much weaker thing, "I really wanted to sell now". Thus, while "liquidization" might "grind to a halt", that has no particular bad effect. Just a bunch of deferred consumption.

There can be no "bank run" with matched maturities. As I wrote to MM: the worst that happens is that a bunch of people are disappointed, people who bought a bond as savings, thinking it would preserve its value. That's your "explosion", and it's exactly the same as when the stock market goes down -- we all grumble about our 401ks' declines, but that's about it.

What does not happen is a systemic crisis; new lending can and will still take place.

October 15, 2008 at 8:43 AM  
Blogger G. M. Palmer said...

Anonymous College Loan,

In a fusion world inflation would never have risen to the point where you would need three times the average annual salary to pay for college.

October 15, 2008 at 8:52 AM  
Anonymous Anonymous said...

To those who argue that restrictions on MT by banks would stifle growth to the point where we'd all still be growing our own tobacco and guarding it with our newfangled breechloaders had it not been in place lo, these many years:

The recent banking crisis, by some reasonable if not yet (for obvious reasons) confirmed accountings, has lost more money than has been generated by the last few decades of banking. In other words, if you somehow magically were entitled to the entire profit and loss of all banks worldwide for the last twenty years, you would have... nothing. Less than nothing, perhaps.

Admittedly, in the meantime, banks employed many people, some humble tellers who made a decent living and some investment bankers who made a hundred lifetimes' worth of decent living. But perhaps those same people would have been employed just the same as Misesian tellers and lion-tamers, respectively, under a different system. It is impossible to objectively quantify anything of this complexity with precision. But at a basic level, Bagehotian banks are not nearly the mighty engines of economic growth that they appear to be the 99.99% of the time that they are not spewing Strontium-90 into the local milk supply. The cost of cleaning up the messes they periodically make wipes out most if not all of the advantage they generate the rest of the time.

Misesian banks do not have to function as pure middlemen, or loan brokers. They can treat their loans and deposits of equivalent maturity as liquid and fungible pools. The trick is to make sure that the maturities in general match so that, at any time, if the referee blows the whistle and says, "Everybody out of the pool!" you can offset all existing obligations with existing assets. Any responsible Misesian bank, if it had to be suddenly liquidated, should actually return a small profit to the shareholders, since theoretically all loans made should be on slightly better terms than all deposits accepted. This assumes, as does the main post, no factoring in of default risks.


October 15, 2008 at 8:55 AM  
Anonymous anonymous college loan debtor said...

gm palmer, there are schools with programs similar to mine that charge twice as much. I would be getting a better deal going to the school I'm going to now with 16% loans from an Austrian bank than those students are getting now - and those schools still fill every seat and turn over 2/3rds of their applicants away.

I think I would just be paying more to the LvM fusion bank. So would everybody else who did anything requiring long term loans (or they just wouldn't be doing it at all).

The last anonymous said:
if you somehow magically were entitled to the entire profit and loss of all banks worldwide for the last twenty years, you would have... nothing
What's special about the last 20 years? Why not go back to the last fission meltdown? Wouldn't that be more like 70 years or so, at least in the US?

Also, even if the Bagehotian banks really didn't make any money, they enabled people to get long-term loans at lower rates than Misesian banks would have. How much extra wealth did those people generate, compared to what they could have if they had had to borrow at higher interest rates (or not at all)?

Railroads and airlines were notorious money-losers for investors too, but that doesn't mean they didn't assist in the creation of wealth.

I accept that Bagehotian banking leads to bank runs, but there's another side that just hasn't been addressed here. The thesis of this article, as it stands, is sort of like saying that we could avoid The Big One by abandoning Calfornia.

Finally, if we had had stricter regulations, maybe we wouldn't have had so much toxic, bad debt. Bagehotian banking may lend itself to bank runs, but it doesn't require lending trillions of dollars to people with no jobs to buy homes. It didn't have to happen now, or even in our lifetimes (given Murphy's Law I wouldn't go so far as to say it didn't have to happen ever). The length of time between bank runs could be increased by avoiding blatant stupidity like that, and it's already measured in decades. This seems to be mainstream thought these days (except that they don't think of it as Bagehotian banking).

October 15, 2008 at 12:11 PM  
Anonymous Anonymous said...


I picked "twenty years" because I did a very, very sketchy check of sector profits and was confident that my assertion would stand up to scrutiny. It was inspired by a claim I read that as of now in point of fact the banking sector has lost more money than it made since the creation of the Federal Reserve. I could believe that but wouldn't feel comfortable restating it without more research.

If you want credit for all the "wealth creation" that the banks have made possible, you must also accept blame for all the wealth destruction. My assertion, and the assertion which inspired it, aren't even talking about the money lost in the broader stock market, only the losses of the banks themselves. The trillions in "wealth" they have destroyed in dot-com busts, housing busts, ABS busts, et cetera, ad infinitum, must be counted against the wealth they allegedly generated which could not have been generated in a Misesian banking system. I don't think the difference is great enough to justify the disruptions, but I have no math to justify that conclusion. It is my assertion, though, that neither do you, and while your objection to Misesian banking is theoretical my objection to Bagehotian banking is readily available at finance.yahoo.com this afternoon.


October 15, 2008 at 2:02 PM  
Blogger G. M. Palmer said...

acld --

but bagshot banking (and gubmint-backed student loans) helped encourage universities (and hospitals and and and) to skyrocket their costs. When the GI bill was introduced it covered enough to pay for every U in the USofA. About 10 years after the GI Bill you could have a kid in the hospital for the whopping cost of 80 bucks. Both are no longer even kinda the case.


October 15, 2008 at 6:05 PM  
Blogger Daniel Newby said...


"Thus, while "liquidization" might "grind to a halt", that has no particular bad effect. Just a bunch of deferred consumption."

My thesis is that the lust for the short-term profits of maturity transformation is strong. The human mind finds the lure of easy cash irresistable. Someone will inevitably put together a pool of Misesian bonds, link it to auction exchanges, and treat the pool like cash. People will stash their rent and payroll funds in the fund, and congratulate themselves at their wisdom in finding another 1.5% of yield. Then the auction market will experience a panic, the self-styled investors (i.e., speculators) will blow up.

To improve systematic stability, we would have to require that contracting to pay a debt with the auction of a third-party security constitutes fraud unless agreed to in advance by the creditor.

Even that would not suffice to prevent systemic meltdowns. Creditors, particularly in certain keystone industries, would need to be prevented from accepting excessive maturity transformation risk regardless of their wishes. "Pools of pools" would need to be tightly regulated to avoid the hiding of maturity transformation.

And the regulations would have to be enforced. Regulatory capture would have to be avoided. For example, political structures at all levels would need to have joint and equal ability to investigate and enforce maturity transformation limits. We would have to end the practice of ring-fencing regulatory ability into a single national entity, subject to winner-takes-all capture. (I agree with Mencius that a necessary precondition for that in the U.S. in the foreseeable future is the election of Obama, followed by an epic populist backlash.)

October 15, 2008 at 7:32 PM  
Blogger eclipse said...

Hi, Mencius:

I think you are wrong using the term "system" for Bagehotian and Misesian "practices". In my view, without a lender of last resort, the Bagehotian practices would be self limited and too risky. The interest rates would fluctuate until rendering these practices worthless or even lead to ruin.

But, the very existence of the central bank as a LLR and the belief (revealed true) that it would come to the rescue in case of massive iliquidity encourage the "borrowing short and lending long" practice.

October 16, 2008 at 1:43 AM  
Blogger Isegoria said...

As Leonard has pointed out, if banks act a bond funds, the threat of a bank run goes away.

Sure, the loans they make might go bad, but shareholders in a fund have no incentive to pull their money out before everyone else, because their share is their share; it scales up or down with the value of the bonds in the fund.

Further, shareholders who want their money back don't take their money back from the threatened bank. They sell their shares on the market — presumably at a low price, if there's a crisis, but there's no reason for things to spiral out of control.

October 16, 2008 at 6:47 PM  
Anonymous mobile said...

Yield curve inversion is a consequence of a supply shock in credit markets, and it can happen in a Misesian system just as easily as in a Bagehotian system.

When credit is tight but the expectation is that things will ease up in a few months or years, folks with money to lend will be able to choose between lending at a decent interest rate for a decent amount of time or lending at a spectacular rate for a shorter time.

October 17, 2008 at 10:19 PM  
Anonymous Claire said...

Nice article and comments.
Maybe I will link to this page.
thanx for posting.

October 18, 2008 at 5:48 PM  
Anonymous Michael S. said...

I can assure you that banks pay a great deal of attention to the duration both of loans and of deposits and apply sophisticated methods of analysis to balance them. A failure to do so is not the reason for the current financial crisis. There are a great many commercial banks that have not been directly affected by it, and are indirectly affected only because of the financial stresses placed on their customers arising from sources outside the commercial banking system.

The collapse began in the secondary mortgage market, which was for all practical purposes created by Fannie Mae. Fannie Mae (the Federal National Mortgage Association) was created in 1938 as one of FDR's New Deal Agencies. In 1968, during the Johnson administration, it was spun off the Federal government as a "GSE" (government sponsored enterprise) in order to get its debt off the Federal balance sheet. Shortly thereafter, Freddie Mac (the Federal Home Loan Mortgage Corporation) was created by Congress to compete with Fannie Mae, so that Fannie would not have an effective monopoly. Between them, Fannie Mae and Freddie Mac hold or have guaranteed over 50% of the residential mortgages in the United States.

Many of these mortgages were and are badly undercollateralized and were made to borrowers of doubtful creditworthiness. The GSEs accepted loans of up to 97% of appraised value. Loan originators made their money from origination fees and had little incentive to underwrite their mortgages soundly since they stood to lose nothing if the loans went bad. Furthermore, appraisers learned that they had to be generous in their appraisals in order to do business with the store-front mortgage brokers. An appraiser we use at my bank told us that he could not get work from such operations because his appraisals were too cautious. Thus, not only were the loans undercollateralized at 97% of appraised value, but the appraised values were unrealistically high.

Fannie Mae and Freddie Mac did not operate under the same rules regarding their lending practices and capital-to-assets ratios as do commercial banks. In addition, under HUD supervision, the GSEs were told how to allocate loans. In 1992, Congress pushed them to increase their purchases of mortgages going to low-income borrowers. For 1996 they were given an explicit target - 42% of their loans had to go to borrowers with incomes below the median in their geographic area. In 2000 this target was increased to 50% and in 2005 to 52%. But politically mandated credit allocation did not stop there. For 1996, HUD specified that 12% of the GSEs' mortgage purchases be 'special affordable' loans to borrowers having incomes less than 60% of the median in their areas. This target was increased to 20% in 2000, to 22% in 2005, and to 28% in 2008.

Fannie and Freddie obtained the funds for these loans not by soliciting deposits from the public, as commercial banks do, but by selling bonds, backed by the mortgages they bought - mortgages we now know, and which we should have known all along, were largely unsound. Why didn't we? First, because a buyer of such investment securities does not and cannot examine each of the mortgages by which they were backed with the same level of scrutiny that he might investigate an individual borrower applying to him for a loan. He instead relies on bond rating agencies like Moody or Standard & Poor to evaluate the obligation. He further looks to bond insurance companies for guarantees of payment. Second, the bond buyer, like the rating agency and the insurance company acting as guarantor, assumes that- whether or not it be explicitly provided by contract - that a GSE has the implicit backing of the U.S. government. As we now know the U.S. government has been called upon in that role, and has accepted it.

The Federal Reserve's manipulation of interest rates brought about the first wave of defaults, as customers who had borrowed on 5-year adjustable-rate mortgages with balloon payments at the end of their term found they had to re-finance their remaining balances at rates 2 - 3 percentage points higher than they had paid for their first 5 years. It may not seem like a great rise in rates, but when applied to a mortgage on a 25- or 30-year amortization schedule, such an adustment can nearly double the monthly payment. Since it is not the price of the house but the monthly payment that really dictates whether a buyer can afford it, many of these houses went on the market when their owners could no longer meet their monthly payments. As more houses came on the market than had willing buyers, the prices at which they could clear the market fell. Now many of them were worth less than the outstanding mortgages on them, which had been made at excessive loan-to-value ratios to begin with. The result was a cascading fall in the price of housing, akin to the fall in the price of stocks in 1929, when people who had bought them on margin could not meet their margin calls. In both cases, the bubble was inflated by easy money and excessive leverage, and punctured by a reversal of the easy-money policy. As housing prices fell, mortgages began to go into default; as mortgages began to go into default, mortgage-backed securities began to fall in value.

Investment banks were affected more profoundly by the collapse in the secondary mortgage maket than were commercial banks, because investment banks were more highly leveraged. Those commercial banks that were affected were, not so much because they had bad loans on their books, as because they owned securities that had fallen so badly in value that when marked-to-market they devastated their balance sheets. Bad investments or loans are charged first to loan-loss reserves, then to current earnings, and finally to stockholders' equity. It does not take many such charge-offs to burn through most or all of a bank's capital, leaving nothing to support its deposits.

What is most sad and perplexing about this situation is that politicians - not least of them Barack Obama - have presented it to the public as the result of 'deregulation,' and the public has largely swallowed their explanation. Yet it is hard to see how bank deregulation, properly so called, has anything to do with it. The principal bank deregulation that has taken place in the past fifteen years was the relaxation of restrictions on interstate branching in 1993 or '94, and the Gramm-Leach-Bliley act of 1999, which eliminated some of the barriers set up by the Glass-Steagall act between investment and commercial banking. As an owner of an independent community bank neither of these actions was particularly favorable to me, yet I can't find particular fault with their effects under present circumstances. Interstate branching has probably strengthened commercial banking more than it has weakened it; the soundness of Wells Fargo and U.S. Bancorporation provide examples. Gramm-Leach-Bliley has permitted J.P. Morgan Chase to acquire Bear Stearns, and Bank of America to acquire Merrill Lynch. These former investment banks will now be subject to the stricter reserve requirements of their acquirers, which is all to the good.

The collapse of housing and the secondary mortgage market stemmed not from 'deregulation' but from the political allocation of credit through Fannie Mae and Freddie Mac. Now, under the Paulson plan, which has forced the country's largest banks to accept senior capital investment from the Federal government (and all of the conditions attached to it) whether they want or need it or not, we shall see more, rather than less, politicized allocation of credit.

Alexander Hamilton's project of a national Bank of the United States horrified Thomas Jefferson and his followers, because they foresaw that political allocation of credit would lead to favoritism, consolidation, monopoly, special privilege, jobbery, patronage, and theft by taxation. The First and Second Banks - the latter killed by Andrew Jackson - did not last long enough to yield the expected results, but in Fannie Mae and Freddie Mac we have seen the fulfillment of these predictions. Yet do you suppose that the voters of Connecticut will ever call Christopher Dodd to account, or those of Massachusetts do likewise of Barney Frank? I don't. Like beaten dogs they will return to slobber and fawn over the hands that abused them. The worst irony is that these people claim to represent the party of Jefferson and Jackson, while exemplifying everything those historical figures feared and detested.

October 20, 2008 at 1:19 PM  
Anonymous Curve of Freedom said...

Thank you for writing that, Michael S. I've been trying to chew through accounts of the crisis and I never quite bought the line that Mae and Mac were private businesses. I also suspect that the US Postal Service has something to do with the US government, like maybe its governing board being appointed by the President?

Seriously though, it feels odd to be against "public-private partnership" since it sounds like it belongs right there next to apple pie and county fairs, but a lot of public-private stuff strikes me as a little too corporatist. Corporatism seems to work for Scandinavia and Japan, probably because those are high-trust cultures. As trust plummets in the United States I think corporatism will stop working and regular old Cold Hard Capitalism may be the only route.

Anyway, I think I'm going to have to copy your the Michael S. post on the subject, admirably informative and concise (if only Mencius were that concise!) and bounce it off some of my pro-regulation pals. (If you're curious, see a similar post at Volokh on whether this crises discredits libertarians.)

I kind of think what is going on is, some people think "deregulation" means "legalizing fraud". It seems to me like a highly deregulated environment in which fraud is hotly pursued by men with handcuffs and mirror sunglasses is pretty much ideal.

As to how to keep barely-legal quasi-fraud from allowing corporate officers from robbing stockholders, I was really interested in Mencius' post about a million years ago saying something like 'corporate governance has remained unchanged since FDR, and is totally obsolete'. So how to change it?

October 20, 2008 at 5:57 PM  
Anonymous Michael S. said...

A few additional thoughts since my previous post:

I can't speak for other commercial banks, but mine holds no loan at a fixed rate for more than 72 months, which is the same length as our longest-term CD. Mortgage payments may be calculated on a 25- or 30-year amortization schedule, but all of our mortgages so amortized have 5-year terms with a balloon payment at the end, refinanceable at whatever is the then-going rate. Good funds management indeed tries to balance the maturities of loans and of deposits in what MM describes as a Misesian fashion.

The assets of a bank are cash on hand and due from banks (e.g., checks deposited but not cleared are 'due from banks'), loans, investments, the banking house and its furniture and fixtures. Its liabilities are demand deposits, time deposits, other borrowings, and stockholders' equity (comprising capital stock at par value, surplus, and undivided profits).

On the asset side one may hold investments (e.g., bonds) for longer terms than one has deposits. Indeed it is necessary to hold them because some large depositors require securities to be pledged against their deposits. Such investments do not need to be held to maturity, but can normally be liquidated at any time by sale. Hence the Misesian requirement to balance maturities of bank assets against bank liabilities isn't ordinarily called into question by their presence on the balance sheet. The exception, of course, is if the investments have proven to be of less quality than expected, and there is no market for them. I suspect that if we look at the problems of several prominent banks we will find they originate with investments in mortgage-backed securities rather than with loans the banks intended to hold to maturity.

Misesian requirements were not really breached by operations that held long-term fixed rate mortgages, because those operations (e.g., Fannie & Freddie, Countrywide, etc.) obtained funds for them by the issuance of long-term bonds - the infamous mortgage-backed securities. The problem with these, as explained in my earlier post, is that the collateral of the underlying mortgages was inadequate to begin with, and in many cases the borrowers were not creditworthy. Had these circumstances not existed, the securities might have been sound instruments.

What MM's discussion of Misesian vs. Bagehotian banking failed adequately to emphasize - a glaring omission! - was the role of a bank's capital. Stockholders' equity appears on the liability side of the balance sheet, but it is a liability of a very peculiar kind. Unlike a deposit it can neither be withdrawn on demand nor redeemed after a certain term. If its owner wishes to liquidate he must sell it to a willing buyer, at whatever price the market may bear. This has no definite relationship to the amount of money actually paid in as capital at the time of the stock's issuance, nor to its book value at any given time thereafter.

Adequate capital is necessary to provide sufficient liquidity when depositors wish to withdraw their funds. The ratio of capital to a bank's total footings - i.e., how leveraged the bank is - tells whether it can continue to do business or not.

I think it is quite useful to note that the two great market crises of the past thirty years have mainly involved institutions other than normally-organized commercial banks, and that those institutions are distinguished from them by their capital structure.

Remember the savings-and-loan crisis of the 'eighties? In those days there were a great many savings-and-loan associations that were mutually owned - i.e., at least in theory, they were owned by their depositors. They did not have a separate group of stockholders whose equity was at risk standing between the depositors and any losses on loans or investments. If one looked at a mutual S&L's balance sheet, where there would on a commercial bank's have been an entry for stockholders' equity, there was only a single line for what was called 'surplus' - viz., the amount left over after depositors had been paid their fixed 'dividends' and the operating expenses of the S&L had been paid. Things were well and good as long as the S&L had positive earnings after expenses, but these 'surpluses' were typically thin and they were really 'nobody's baby.'

In theory, the surplus could be touched only at the liquidation of the S&L, at which time it would be divided pro-rata amongst current depositors. In practice, control of S&Ls typically fell to boards consisting of their large customers, who were often real-estate developers. These worthies would finance their developments through their captive S&Ls, and as they sold houses would retire their debt as they referred the buyers to the S&L for mortgages. Assuring the capital adequacy of the S&L was far down the list of their priorities.

S&Ls were the fair-haired children of politicians, regulatorily favored over commercial banks, which were subject to more stringent oversight. In the absence of stockholders and boards acting in their interest, the surpluses of mutual S&Ls were swiftly dissipated and at their liquidation there was nothing for the depositors, who had to be bailed out by the (then) FSLIC. Within relatively little time there was a great contraction and consolidation of the thrifts. At the same time commercial banks were largely unaffected, because of their superior capital structures.

The secondary mortgage market collapse, as we have seen, first affected specialists in it such as Countrywide, and the two GSEs, Fannie and Freddie. It then spread to investment banks such as Bear Stearns, Merrill Lynch, and Lehman Bros. A characteristic of all of these institutions was that they were much more highly leveraged than commercial banks - i.e., were less well capitalized.

As far as 'deregulation' of investment banks goes, my recollection of that industry goes back to a day when the stock exchanges had their own rules about who could hold seats. One of them was that member firms had to be proprietorships or partnerships, and could not be corporations. This rule was swept away by the Federal government along with fixed commissions, the requirement that all trades take place on the floor, etc., all being regarded as constituting anti-trust violations. Here is a classic instance of the conflict described by Nock between state power and social power.

There are many differences between corporations on one hand and proprietorships or partnerships on the other. The salient one here is that the liability of corporations is limited to the capital paid into them, whereas the liability of partners and proprietors is unlimited - if the capital they have invested in their business is not sufficient to satisfy their liabilities, their personal assets, down to the clothes on their backs, may be attached for the purpose. For an example of how this works, see Lloyd's of London.

I cannot help but think that the old rule the stock exchanges, exercising Nockian 'social power,' imposed on their members, was right, and that government thoughtlessly discarded this vital baby along with the bathwater of fixed commissions, etc. If one is going to operate with as much leverage as investment banks customarily did, would it not be well to have the caution that potential loss of one's whole net worth would bring to bear? The limited liability of their status as publicly traded corporations enabled the management of Bear Stearns, Lehman, and Merrill to operate on the principle of the auld Scots saying, "dinna fash - it's nae our siller" - and not a penny of (for example) the half a billion dollars taken home from Lehman by Jeffrey Fuld from 1993 to 2007 can be touched.

Genuine deregulation levels the playing field in an industry and destroys the monopolies and other rent-seeking opportunities that are the inevitable concomitants of political interference. Can anyone sincerely argue that deregulation of, say, the telephone or truck freight industries has been anything but a benefit to consumers?

By contrast, what has passed for 'deregulation' in the financial sector has often been the selective relief of regulatory requirements for politically favored constituencies. It has facilitated rent-seeking rather than eliminated it. Dealing in the delivery of such favors is the stock-in-trade of politicians. There is little to distinguish them from gangsters in the 'protection racket,' save that politicians have the great advantage of making the laws.

Curve of Freedom, assuming we can't go back to the requirement that investment banks be unlimited-liability organizations, the next best thing would be to emulate the French bankruptcy law, which at least used to provide for a finding of 'banqueroute frauduleuse.' The corporate officers of a company that collapsed as a result of fraudulent bankruptcy were not only liable to criminal penalty, but were disabled for life from holding positions as corporate officers or directors. Fool us once, shame on you; we won't give you a chance to fool us twice.

October 21, 2008 at 12:25 PM  
Anonymous Curve of Freedom said...

Now how come everyone else can't write as clearly as that?

October 21, 2008 at 12:43 PM  
Anonymous Anonymous said...

I think you nailed it -- and I wish I had (could have) written it myself. So far as a Misesian system curtailing growth: perhaps so, and perhaps that's because any growth faster than the growth possible with a Misesian system introduces risk which, barring an insurer truly able to protect against it, is unacceptable. Unacceptable because the system simply blows up, or it suffers such a growth of disruption that long-term average growth is actually *lower* than the Misesian system average.

October 22, 2008 at 5:13 AM  
Blogger G. M. Palmer said...

"The collapse of housing and the secondary mortgage market stemmed not from 'deregulation' but from the political allocation of credit through Fannie Mae and Freddie Mac. Now, under the Paulson plan, which has forced the country's largest banks to accept senior capital investment from the Federal government (and all of the conditions attached to it) whether they want or need it or not, we shall see more, rather than less, politicized allocation of credit."

Michael S,

Thank you for writing this. It's a clear explanation of why "deregulation" wasn't.

How would one go back to requiring unlimited liability? Or instituting French corporate bankrupcy laws?

October 22, 2008 at 5:14 AM  
Anonymous Curve of Freedom said...

How to make this happen? Aww geez, that's easy. Just make it part of the platform of a mass political movement, along with the abolition of entitlement-based social welfare and most public spending on economic development. Though classical economics isn't nearly as easily explained as economics derived from Marxism, the highly-studious public (all having benefited from 12 years of the most expensive public education system in history - a whole lot more taxpayer-funded education than Frederick Douglass ever got!) will see through the simplistic jabs of the left. Freedom is obviously something no one would ever want to escape from!

Also, DON'T try selling people "old age insurance". Everyone knows when they'll turn 65! No point in taxing people to do what they'll do already.

Sorry, the election has put me in a downright whacky mood.

October 22, 2008 at 11:54 AM  
Anonymous Michael S. said...

I don't know how we could go back to requiring investment banks to be organized on an unlimited-liability basis. Certainly no new ones will be so organized voluntarily, and the existing players would of course complain vehemently of such a change being forced upon them. There is a sort of corollary to Gresham's law at work here: bad and unsound forms of industrial organization chase the sound and good ones out of existence.

It would not be so difficult to require these firms to be better capitalized. In fact this has already happened to some extent. The acquisition of Bear Stearns by J.P. Morgan Chase, and of Merrill by Bank of America, effectively require them to adhere to commercial banking standards for capitalization, which will force them to be less leveraged. As I noted in an earlier post, these serendipitous outcomes would not have been possible without the passage of the Gramm-Leach-Bliley act - part of the 'deregulation' which Obama and Biden (the latter of whom voted for the act in 1999) are now blaming for the crisis!

Years ago commercial banks were subject to 'double liability' - i.e., although they were limited liability corporations, should circumstances require it, the stockholders could be assessed for an amount equal to the par value of the stock they held, in addition to what they had already paid for it. This requirement was eliminated years ago, but with the understanding that banks would henceforth carry a surplus above the total par value of their stock at least equal to the latter.

Surplus in this context is distinguished from undivided profit by being part of a bank's permanent capital, not being able to be paid out to shareholders except upon dissolution (and then only if it is still there!). It is the combined capital and surplus of a commercial bank that set its legal lending limit, a ceiling on the amount of credit it may extend to any single customer, expressed as a fraction of the bank's permanent risk-based capital. Legal lending limits are intended to prevent banks from having "too many eggs in one basket," since the ruin of a given customer cannot thus burn up more than a fixed fraction of the bank's capital.

No comparable limit applies to banks' investment portfolios, although prudent management dictates that securities be laddered in maturities, reasonably diverse in issuers, etc. I have run across a couple of delicious phrases attributed to Pierpont Morgan in this context. He once described a market in the doldrums as being due to the amount of "undigested securities" in circulation. Our problem today is that we do not know whether many securities are merely undigested, or are in fact indigestible. The available information about them is so opaque as to suggest deliberate obfuscation. In another circumstance Morgan described certain market participants as having an "undeveloped sense of trusteeship." I suggest this has become much more common since his day.

Revising the bankruptcy law would be simpler than going back to unlimited-liability partnerships or double liability, but consider the difficulties the last revision of bankruptcy laws faced. All the usual bleeding hearts bled for the poor debtor who was supposedly going to be squeezed harder. It seems to me it would be hard to portray a stiffened provision for fraudulent bankruptcy of corporations as facilitating the eviction of poor widows and orphans from their humble homesteads by greedy financiers, but never underestimate the ingenious venality of politicians. They are almost invariably low fellows who conceal behind their bleatings about the poor the delivery of favors to rich constituencies that have bought them.

Our present problems are deeply rooted in current social and moral attitudes, and politics as much represents these as it serves to exercise influence upon them. When I was a child, two of the greatest disgraces that anyone could possibly face, short of being convicted of a crime, were bankruptcy and divorce. They led to ostracism from respectable society. Now neither is more than a passing inconvenience. The social and economic order under which we live reflects this. It is unclear to me whether efforts to reform behavior by passing laws can succeed if there is not first a transformation in popular moral attitudes. If recent history teaches anything about this, it is that laws can keep the door closed to bad behavior, but once it be opened, it is almost impossible to close again by legislative or judicial means.

October 22, 2008 at 12:17 PM  
Anonymous Randy said...


I've been on the road so I just got around to reading this. Excellent work. One of your best.

October 24, 2008 at 7:43 AM  
Blogger Aaron Davies said...

@michael: so true. thus my vacillating between the objectivist "screw politics, focus on fixing the culture" and mencius' "screw politics, let's have a coup".

October 24, 2008 at 9:04 AM  
Blogger Ignacio said...

The problem in my opinion is not Bagehotian versus Misesian banking, but the fact that banks are inherent multipliers of risk, since they invest on margin (with borrowed money). A Misesian bank has a very ovbious mode of failure, which is bank's borrowers defaulting. If this happens, this is, if the bank's borrowers do not pay their loans, the bank goes bankrupt.
The only way to avoid bank runs is to impose a capital ratio of 100% (this is, bank cannot lend their depositor's money) and change the current accounts with mutual fund (investment) accounts, backed by the bank loans to their customers.
If things go bad, these accounts can decrease their value by, for example, 5%, but this is compensated by yields of 3% most of the time, and by knowing that the alternative to this 5% decrease in value is bank going bankrupt.

October 27, 2008 at 9:17 AM  
Anonymous Anonymous said...

I do not expect that politics will solve anything this late in the day. I do not expect either party to save us. I do not expect either party to do anything about the banking system or anything else.

What do I expect?

I expect nationwide riots regardless of the election results, and hope that I don't return from vacation to find my place of employment burned to the ground. If it isn't "dem honky motherfuckers cheated! kill whitey! burn baby burn!" then it will be "we goan paint de White House black y'all! we'z takin over at last! kill whitey! burn baby burn!" Either way I think we may be about to see interesting times.

I don't believe in politicians any more and haven't for a long, long time. Ali Baba is an empty suit, just another soulless Chicago machine politician, the very definition of the corrupt ward-heeler and sinister wire-puller, and his foaming-at-the-mouth legions of worshippers either don't know that he has no ideas and no plans or lack sufficient functional synapses to grasp that a slogan is not a plan. What miniscule legislative record he has, and you have to get out the magnifying glass even to see his accomplishments, if that is quite the word I want, indicates legislative and political philosophies somewhere between Pol Pot and the planet Neptune.

McCain is only slightly less of an empty suit; he hails from the country-club wing of the GOP and has ever been a wishy-washy, go-along-to-get-along Rockerfeller Republican, with a legislative record barely distinguishable from Ted Kennedy's and no detectable actual principles except whatever he thinks will get him elected for another term.

Neither party has been relevant for a long, long time.

The whole process is aesthetically repugnant to me, and the only thing I would get out of participation is a summons for jury duty. I do not perceive anything I might possibly do as having any possibility of advancing either my own self-interest or the interests of my culture.

And so I am getting as far from the city as I can before the Election Night Bongo Party. A trusted friend not far from here will be taking care of the cats for me for a while, and I hope nothing happens to them in the interim. Mags are loaded, irons are zeroed, and I am as ready as I will ever be. I wonder if we're about to see a civil war. Or, rather, a low-level insurgency has been simmering in this country since 1965 or thereabouts, and I wonder if we're about to see it go from retail to wholesale.

October 29, 2008 at 10:15 AM  
Blogger Jack Reylan said...

The Columbia Financial Engineering program mostly trains programmers who pretend to be quants. It grew out of the Trotskyite degree mill of industial engineering, most of whose graduates were actuaries pretending to be something more.

November 11, 2008 at 11:16 AM  
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