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Archive for the ‘Gold standard’ Category

On March 2nd (Fundación Rafael del Pino, Madrid) I had the pleasure to join a panel on the future of the European Banking Union (EBU) (and on Brexit) with very distinguished colleagues and friends: Jose Manuel Gonzalez Paramo (BBVA and former member of the ECB Executive Committee), David Marsh (OMFIF, London) and Pedro Schwartz (UCJC, Madrid) (see the video of the seminar here). During the  event I also had the opportunity to launch in Madrid the book I co-edited last year on the European Banking Union. Prospects and Challenges (Routledge). The book is a collection of essays on the EBU by central banks’ analysts, academics and practitioners from different jurisdictions. Each of them addresses the topic from a different perspective, either legal or economic, and highlights the pros and cons of the EBU as well as its expected challenges over the next few years.

It is obvious to all now, but also to many experts at the time of the launch of the euro, that the institutional architecture of the euro was, at the very least, weak and incomplete (see some of the articles in the 1990s written by W. Buiter, C. Goodhart, P. Schwartz, T. Congdon or G. Wood, amongst others). No currency union has survived for long without a political union or a supranational Treasury, with enough powers and policies to back the currency. And this is particularly true in the case of an area, such as the Euro area, which is far from being a flexible and fully functioning monetary area. You may want to check out the results of the research report just published by the Institute of International Monetary Research on the measurement of the integration of the euro area or its ‘optimality’ as a single currency.

The reference to the classical gold standard (1870s – 1913) as a comparison with the current euro standard deserves some attention. We should be aware of the differences between both standards: the gold standard was indeed a monetary union, where member economies fixed their currencies against gold; whereas the euro standard is a currency union, where countries get rid completely of their national currencies and adopt a single currency for all. The latter is much more rigid and demanding during a crisis, since member states have no room to alter the parity of the currency (there is no national currency!), nor to abandon the parity on a temporary basis. Under a currency union member countries have effectively no central bank of issue, as this function has been fully delegated to a supranational central bank. We have experienced since 2008 how demanding this monetary system becomes under a crisis, much more a severe financial crisis, as countries have no other option but to cut costs and prices in an effort to regain competitiveness (the so-called ‘internal devaluation’). This is an option to sort out the crisis, but it has proven to be a painful one our economies (and even more, our populations) seem not to be ready to implement or even to accept.

In a nutshell, the EBU implies the following (more details on the presentation here):

  • The establishment of the European Banking Authority (EBA), which overseas the implementation of the new (much higher) Basel III banks’ capital ratio and the new liquidity ratio across the EU.
  • The establishment of a single banking regulator under the ‘Single Supervisory Mechanism‘ (SSM) for big banks or transnational banks in the Eurozone (around 80% of all), in the hands of the European Central Bank in Frankfurt. In addition the new Single Resolution Mechanism (SRM) has been stablished to deal with the recovery or resolution of a bank (see more details below).
  • According to the new EU Recovery and Resolution Directive (RRD), every bank must draft a resolution plan to be approved by the regulator, in order to resolve the bank if needed be in an orderly and timely manner. In addition, should a bank under the SSM need to be resolved, the government will not use taxpayers’ money in the first place. Actually the resolution or recovery process is going to be handled by the SRM. And only when the bank’s shareholders and creditors’ money has been (mostly) exhausted (so they have absorbed losses of at least 8% of the total liabilities), the bank can benefit from other sources of funding to pay its debt or conduct other operations (such as the Resolution Fund, see below). This is what the literature calls a bail-in rather than the bail-outs of the banks with taxpayers’  money we have seen in the recent crisis.
  • In addition, all member states have agreed to guarantee the deposits up to 100,000 euros per person per bank (however there is not yet a pan-EU deposit guarantee scheme but national schemes).
  • Finally, the EBU would not be complete should we not pay attention to the role of the ECB and the National Central Banks as the lenders of last resort in the Euro area. Modern central banks (particularly since the 19th century, but also earlier in the case of the Bank of England) were established to support the banks in case of a liquidity crisis. If a bank is solvent but illiquid, and thus cannot pay its deposits temporarily, the bank can always request extraordinary lending to the central bank (as W. Bagehot put it in his famous 1873’s seminal book: unlimited lending but always against collateral and at a penalty rate). However, this competence is still in the hands of the National Central Banks in the Euro zone which, provided there is no objection of the ECB, can lend money to the national bank in crisis at request. This division of competences between the ECB and the National Central Bank should be better coordinated so no banking crisis is artificially ‘hidden’ or postponed under the provision of liquidity by the national central bank.

The ‘Euro 2.0’

As Jose Manuel Gonzalez Paramo put it, the European Banking Union is a sort of ‘Euro 2.0‘ as it comes to remedy (at least some) of the Euro 1.0 institutional problems and weaknesses. In this regard, I agree it is an improvement as it helps to create a more consistent and credible institutional setting (*); however it does not tackle important aspects I will just briefly mention below:

  • First of all, the EBU and the new Resolution Fund (paid for by the banks, its amount will be no less than 1% of banks’  guaranteed deposits) will not be completed until 2024. So, should a banking crisis occurs in the meantime the banking sector will not have enough funds to pay for the banks’ liabilities on its own or to fund and implement the decisions made by the SRM.
  • Secondly, if a bank needs to be assisted and finally resolved, a complicated coordination between many actors of divorced nature and aims (political, national and supranational) is required in a question of days/hours. Of course the test to this procedure will come when we experience the next banking crisis (see more details on chapter 2 by T. Huertas, see book mentioned above).
  • But finally and most importantly, in my opinion, the EBU does not resolve the fundamental problems of the Euro zone; which are the abysmal internal asymmetries amongst member states in terms of competitiveness, public finances or costs (see some measurements here), as well as the actual lack in internal and cross-border flexibility as regards labour and good and services markets. Just a view of the asymmetries in Target-2 member states’ balances is as striking as self-explanatory.

The EBU adds consistency and predictability to the supervision and resolution of banks. In this sense, it is an improvement. It also makes banks pay for the losses before applying any other funding, even less taxpayers money; but we are yet to see the robustness of the new institutions established as well as the political commitment to the bail-in option in reality. The EBU is in my view another ‘patch’ on the euro’s structural weaknesses.

 

Juan Castañeda

Notes:

(*) However more consistent, I do not think this type of euro currency, very much centralised and linked to an increasingly powerful supranational State, is the best we could have established to preserve the purchasing power of the euro; I will elaborate further on the alternatives in next posts.

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Did you know that central banks have not always been State-owned banks? The vast majority of them were in the hands of the public before the wave of nationalisations that took place right after the end of WWII. And the system did not work bad at all; the record of both price stability and financial stability before 1913 was certainly impressive. True, bank panics also occurred but the different response taken to such crises is the key to understand the pros of a monetary system fully in the hands of the public and market participants. And, a regards price stability, from approx. 1870 to 1913 most developed (and other less developed) economies ran the gold standard as the rule to determine the amount of money in the economy; a standard which very much tied the hands of central banks and governments as regards money creation. The outcome of the running of a system which preserved monetary stability for a 50 year-time period limited was (not surprisingly for any monetary economist!) was true price stability (by true, I mean that the price level in 1870 was roughly similar to that in 1913), and a growing and rather stable financial system on the whole.

Why was such a ‘miracle’ possible? There is no mystery nor secrecy about it at all! It was the establishment of the right institutions and policies to discipline both the Treasury and a highly independent (actually privately-owned!) central bank what explains such a favourable outcome. And, did you know something even more striking? Several central banks are traded in the market in our days in different ways: the Swiss National Bank, Belgium Central Bank, Reserve Bank of South Africa, Greece Central Bank and Bank of Japan. Historically speaking as I said above this is not an anomaly but the norm before the 1940s. Given the poor record of our monetary authorities since then and the miss-management of the recent financial crisis, why not extending private ownership even further and thus mitigate the threats of a politically-exposed (some will say ultimately ‘controlled’) central bank?

In an interview with Standard and Poor’s, ‘New way forward or outdated anomaly? The future of publicly traded central banks’ (S&P Global. Market Intelligence), I advocate for central banks to return to the public and the banking sector, in order to guarantee their independence from governments and thus be able to achieve a more sound and stable monetary system. You will find the arguments in favour of a more independent central banks, owned by market participants in many references. Here I will just mention two of them, one written by Tim Congdon (Chairman of the Institute of International Monetary Research), Central Banking in a Free Society (IEA), and the other by myself with Pedro Schwartz (Visiting Professor, University of Buckingham), Central banks; from politically dependent to market-independent institutions (Journal of Economic Affairs); both pieces written in the midst of the Global Financial Crisis (2008-09) and the observed mismanagement of the lender of last resort function of central banks.

Find below an extract from the interview with my arguments:

‘Those in favor of privately owned central banks say such institutions would be better equipped to preserve market stability and could help prevent future financial crises.

“If publicly traded or owned by the banking sector … the market incumbents will have a genuine interest in setting clear … rules for the central bank to maintain financial stability over the long term,” said Juan Castañeda, director of the Institute of International Monetary Research at the University of Buckingham in England.

In the event of another financial crisis, a central bank would be fully independent to intervene at a bank in need, and any injection of capital would come from the banking or private sector, Castañeda said. Situations like the nationalization of Northern Rock by the Bank of England at the outset of the global financial crisis could be averted were central banks not in public hands, he argued.

“Those are the things that you can avoid if your central bank is publicly traded,” he said, citing the late 19th century example of U.K.-based Barings Bank, which faced bankruptcy but was saved by a consortium of fellow lenders, helping to stave off a larger crisis.

Oversight of a central bank would belong to the bank’s shareholders, although national authorities would also have a say because of the bank’s management of monetary policy and financial stability.’

It is not surprising Tim Congdon and myself advocate for more independent central banks (privately-owned) as a way to protect them from political interference in the development of its functions. I do believe this would contribute to a more sound running of monetary policy and to less financial instability in the future. If publicly-traded or owned by the banking sector (following the US Fed model), market incumbents will have a genuine interest in setting clear mandates/rules for the central bank to maintain financial stability over the long term. Should another financial crisis occur in the future (that it will), the central bank will have free hands to intervene promptly and avoid the contagion of panic in the market (by the application of its lender of last resort function). And if any injections of capital were needed, it would be the banking sector (or the private sector as a whole) which would bail-in the bank in crisis and, most likely, taxpayers’ money will not be needed again.

Of course this alternative arrangement is fully compatible with the central bank be given statutory functions (such as an inflation target for example) and be subject to parliamentary oversee; so the Governor will have to answer not just to the Bank’s shareholders but to Parliament as well in relation to the running of monetary policy and financial stability (find further details on these arrangements in Congdon’s 2009 work mentioned above).

Juan Castañeda

PS. An excellent narrative of the flaws of the current system can be found in Milne and Wood (2008)’s  analysis of Northern Rock bank crisis in the UK.

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The communication of a banking crisis: it’s all about confidence!

During a visit to the National Portrait Gallery in Washington DC (‘The Reynolds Center for American Art and Portraiture’) I visited the Presidents’ gallery and found Franklin Delano Roosevelt‘s portrait accompanied by an interactive panel with some of his very popular at the time ‘fireside (radio) chats’ with the nation. One of them caught my attention; it was his address to the nation on the 13th of March of 1933 on the occasion of a major financial panic which led to the suspension of all banking activities for a week (the proclamation of 5 days of bank holiday). Of course the explanation of it would take us to the Great Depression and the massive fall in banks’ deposits in the country (as calculated by M. Friedman and A. Schwartz in their seminal Monetary History of the US, more than a third of the money supply since 1929). But what this brief post is about today is on just the communication of the suspension of the banking activities by the President himself to the nation: as you will hear in this audio recording, it is a very good explanation, and very easy to follow, of how the financial system in a modern economy operates and how fragile it becomes when confidence is lost and people run suddenly on their banks for liquidity. Even at that time, when the US was still on the gold standard and thus paper notes were ultimately backed by gold, the system relied on the confidence of the depositors on the soundness of the banks. Being very well aware of it, all the President tries to do with in this ‘fireside chat’ on the banking crisis was to restore the confidence lost by reassuring the american  people the monetary authorities were willing (and had already) to lend to sound banks to meet the liquidity needs of their customers. It is a good example of how to educate the people on these complex issues and to communicate how the crisis was being tackled.

Do not miss the opportunity to listen to it; in just a two-minute recording you will easily recognise all the elements involved in a banking panic and in the solutions needed: run on liquidity, fractional reserve, fiat versus backed money, lender of last resort, confidence, … . It is an excellent teaching material for a lecture in macroeconomics or money and banking.

However, involved in a massive fiscal expansionary program, only three months later the President suspended the convertibility of the US$ notes in gold, which left more room for the government and the baking sector as a whole to expand the amount of (fiat) money in circulation.

Juan Castañeda

PS. This audio and others of FDR and other Presidents can be found at ‘The American Presidency Project‘ website (http://www.presidency.ucsb.edu/medialist.php?presid=32).

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(Franklin Delano Roosevelt, picture taken at the National Portrait Gallery, Washington DC)

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Mr. Carney, the Old Lady is not for tying

I found this caricature in The Times last Saturday (see below) and I could not resist the temptation to write a post on it. With a blog like this one, with its name, I had no other choice but to welcome and echo this caricature and its message. As I already explained in more detail here, I do believe that a  course on money and central banking could be taught by using these classical (and contemporary) caricatures as the main material of the course. They provide the political and historical context needed to properly analyse how different constraints/events have affected the policies conducted by the central banks along the modern history.

As J. Gillray masterly did it two centuries ago, here you will find again the (poor) Old Lady screaming and fighting with the authorities; represented this time not by the prime minister but by the next governor of the Bank of England, Mr. Carney. There are some other differences of course. In this new version of Gillray’s “Political-ravishment, or the old lady of Treadneedle-Street in danger!” (1797), the new governor is not taking some gold coins from her pocket but trying to keep the Lady well tied up and under his control. The Lady is obviously protesting and is struggling to free herself from the new ties imposed in the last years; ties which represent the new and extraordinary lending facilities the Bank has had to implement since the outbreak of the recent financial crisis to assist the banking system and the Government. True, many will say that the central banks, wisely acting as the lenders of last resort of the financial system, had no other alternative but to support the banking system and maintain the proper running of the payment system. Fine, I agree to some extent since, in the face of a major financial panic, the central bank must act firmly and timely to avoid the collapse of the financial system. But at some point these extraordinary policies will have to cease and the central banks will return gradually to normality in the coming years; which certainly will mean the adoption of a more orthodox monetary policy, one committed to maintaining the stability of the financial system but also the purchasing power of the currency. Let’s see if the new governor of the Bank of England succeeds and is able to extend the existing “ties” or even adopt new ones: an expansionary nominal income targeting strategy?, the adoption of a new, higher of course, inflation target?

Nothing new at all. Under the gold standard there were clear rules which prevented the central banks from printing too much money. In our days, under a fully fiat monetary system, one in which money is created out of thin air (or ex novo), those rules are even much more needed (though become blurred many times …); so, yes, somebody must tie the hands of the Government and those of its bank (i.e. the national central bank) not to overspend and overissue respectively, in order to maintain monetary stability and the purchasing power of the currency in the medium to the long term. Until relatively recently (in the interwar years), it was in the very nature of the central bank to limit the amount of money in circulation to preserve the value of its own currency in the markets. It was a profit maximising institution for quite a long time and that was the best policy to increase the demand of its money and thus its revenues (the seigniorage). However, as depicted in this caricature, this time it looks like the world is turning upside down, since it is the (next) governor of the Bank of England, the “manager” of the bank, the one who wants to impose his own (new) ties to the Old Lady to keep on running extraordinary policy measures in the UK.

Future will tell which vision prevails in the UK and elsewhere, the classical one which defines the central bank as a bank which provides essential financial services to the banking system (a sound money amongst them) or the modern view of the central bank as a major policy actor committed to a time changing basket of macroeconomic goals, either given by the government or not.

Paraphrasing Mrs. Thatcher’s very famous quote (1980), The Time‘s cartoonist has chosen a very clever title for this satirical caricature: “the Lady is not for tying (see below). Enjoy it.

Juan Castañeda

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Published in The Times, 4th May 2013. Business section p. 51. “The Lady’s not for tying”. By CD, after Gillray.

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 “Los Bancos Centrales deben hacer menos, no más”

Este es el acertado titular con que el periodista especializado en economía, Diego Sánchez de la Cruz, resume nuestra entrevista, que acaba de publicarse en Libre Mercado (10/3/2013). En un tiempo en que parece que todos piden al banco central que haga más, como si fuera una especie de Deus ex Machina  omnipotente capaz de sacarnos de la crisis y parálisis económica actuales, merece la pena recordar que fue precisamente el activismo y excesivo crecimiento monetario desarrollado en la última expansión económica lo que está en la base de los problemas que aún padecemos. Por eso, una vez solventada la crisis financiera (cuando quiera que ésto sea), convendría reflexionar sobre cuál es la mejor política monetaria para la nueva etapa expansiva que, en mi opinión, pasará por una reforma en profundidad de las reglas monetarias vigentes hasta 2007. Una política monetaria que sea menos activa y se centre en la estabilidad monetaria y no en el manejo de la economía, el control del ciclo (del “output gap”) ni tampoco la estabilización de los precios, menos aún si se hace persiguiendo un crecimiento (aunque sea moderado) de la inflación medida mediante el IPC.

Hablamos también de los recientes rescates bancarios, la política de préstamo (más o menos expreso)  de los bancos centrales a sus Estados, así  como de algunas alternativas al sistema actual de monopolio de emisión de moneda de curso legal controlado en última instancia por el Estado. Como siempre, vuestros comentarios serán muy bienvenidos en el blog.

Texto completo de la entrevista aquí:

http://www.libremercado.com/2013-03-10/juan-castaneda-los-bancos-centrales-deben-hacer-menos-no-mas-1276484372/

Juan Castañeda

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(A summary in English)

“Central banks should do less, not more”

This is the headline of my recent interwiew with the economic journalist, Diego Sánchez de la Cruz, just published in Libre Mercado (10/03/2013). In a time when all and sundry ask the central bank to do more, as if it were an omnipotent “Deus ex Machina”  able to overcome the current economic and financial crisis, it is worth remembering that it was central banks’ monetary activism and excessive money creation during the last economic expansion what ultimately caused a massive distortion in financial markets and led to the current crisis. As recessions and crises have its roots in the previous expansion, we should be discussing now which is the best monetary policy to be adopted in the next expansionary phase of the cycle (see here a summary of the debate in the UK). One less active and more focused on maintaining monetary stability and not the management of the economy, the stabilisation of the cycle (the “output gap”) or price stabilisation, let alone the stabilisation of a positive inflation target as measured by CPI.

We also discussed in the interview other “policies” of the central banks, such as the recent banks’ bailouts and the more or less explicit financial assistance to the(ir) States; finally, we also talk about some alternatives to the current monetary system ultimately controlled by the State. As always, your comments are very welcome.

Full access to the interview here:

http://www.libremercado.com/2013-03-10/juan-castaneda-los-bancos-centrales-deben-hacer-menos-no-mas-1276484372/

Juan Castañeda

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A chat on fractional reserve and monetary competition

This video was originally recorded in Spanish and released on the 15th of March 2012 at Vimeo (Spanish version). Then it was very kindly supported by the GoldMoney Foundation, so we could release an English version of the video on July this year, entitled: “The Spanish economic crisis”. I would like to thank GoldMoney very much for their support.

You can also find below a summary of the content of the video, as quoted from the GoldMoney website (research section).

Enjoy it! Comments very much welcome.

Juan Castañeda

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The Spanish economic crisis: ‘Yo Invito – ¿Dónde está mi dinero?’

What caused the Spanish economic crisis, and how safe is your money in banks? Maria Blanco, economist and member of the Instituto Juan de Mariana; Doctor in Economics Juan Castaneda; Marion Mueller, founder of OroyFinanzas.com; and Expansion.com journalist Miquel Roig discuss this and more over coffee at Madrid’s Café Gijón.

Fractional reserve banking, sound money, and the prospects for monetary reform in Spain and the wider world are the broader topics of conversation. Though the quartet are heartened that more and more people in Spain are taking an interest in economics since the country’s debt problems became apparent, they doubt that the kind of radical monetary reforms they favour would win support among many Spaniards. They are heartened though that elsewhere in the world – notably an increasing number of US states – the sound money cause is gaining support, albeit slowly, among citizens and politicians.

This video was recorded on 10 March 2012 in Madrid.

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Article originally published in GoldMoney Research (15th May 2012)

Improving the banking system

Governments grant central banks a monopoly on the creation of hard currency. At the same time, we ordinarily make transactions with other means of payment supplied by commercial banks. This is possible because in our monetary system commercial banks are able to create so-called bank money. These means of payment consist of different banks’ deposits that can be used with cheques, bank transfers, credit or debit cards and direct billings, which make our lives much easier as we do not have to hold or carry bank notes or coins to make ordinary transactions.

However, commercial banks are not free to issue their own currency. Bank money has to be denominated in the currency issued by the national central bank and the banks are legally required to redeem their sight deposits in the currency of the central bank at any time. However, the need to back any single deposit of their clients does not necessarily mean that the bank is keeping all our money in their vaults at all times. According to current regulations, they just have to keep a tiny fraction of it. This is the legal reserve ratio. In the eurozone this is 2% of banks’ total deposits; and for this reason we call it a fractional reserve monetary system. This system allows for easy expansion of the money supply, but it also involves a significant risk: that of bank runs caused when depositors all try to take their money out of banks at once.

Banks started to operate under a fractional reserve system in the early modern era, when it started dawning on them that in ordinary times, few clients actually asked for the money kept on deposit. So they started to lend part of it out. By doing so, new deposits were created and hence new means of payments. Consequently, banks increased their balance sheets as well as their profits quite substantially, as the costs of backing their new deposits were much lower than the earnings coming form the new loans. Since the mid to late 19th century, with the expansion and development of modern banking, banks were able to offer these new means of payment more efficiently – which did not require the use of paper notes or coins. As a result, banks realised that their clients needed less and less physical currency, which resulted again in a reduction in reserve ratios.

But during the 19th century the gold standard regime – championed by the British Empire – was an effective means to limit monetary expansion, both from central banks and commercial banks, as they still had to keep gold in reserve to back their issuance of money and credit. However, with the abandonment of the classical gold standard during the First World War, banks no longer needed to keep valuable assets in their vaults as the new reserve money of the economy was the notes of the central bank; which, in theory, could be expanded overnight with no tangible costs. This new system, in combination with the running of purely discretional monetary rules, resulted in excessive money creation and, finally, in more inflation and output instability in the late 1960s and 1970s.

Consequently, fractional reserve systems based on fiat currency tend to over-issue money unless strictly controlled by the central bank, or by the emergence of free competition in money. With the former, the central bank commits to a sound monetary rule focused on maintaining the purchasing power of money. Under this rule, both the central bank and the commercial banks are able to create means of payments but are subject to restrictions.

As sight deposits are redeemable at very short notice, banks could be required to fully back all their sight deposits with an equivalent amount of notes. Hence, the reserve ratio would amount to 100% of all sight deposits. Under this regulation, banks could only create new means of payment by lending the money kept in their time or savings deposits. It would result in a more stable monetary system but at the cost of having a less developed banking system, and thus a much smaller money supply.

In my view we do not have to go all the way towards a 100% reserve ratio to preserve the stability of the monetary system, while allowing for the development of the banking system. The gold standard seen in Britain and other countries during the 19th century is a good example of a self-correcting monetary system that nonetheless operated on a fractional reserve basis.

However it is achieved though, greater recourse to preserving the purchasing power of money would go a long way to improving our current monetary system.

Juan Castañeda

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