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Banking Systems and Crises from Deposit Insurance to Stablecoins with Charles Calomiris | Hoover Institution · The Capitalism and Freedom in the Twenty-First Century Podcast

0:14
- This is The Capitalism and Freedom in the 21st Century
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Podcast, an official podcast
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of the Hoover Institution Economic Policy Working Group
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where we talk about economics, markets, and public policy.
0:23
I'm Jon Harley, your host Today.
0:24
My guest is Charlie Calomiris, who is an emeritus professor
0:27
of finance at the Columbia Business School,
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and a legendary authority on all things banking.
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His research spans the years of banking, corporate finance,
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financial history, and monetary economics.
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He's also for his 2014 book on global banking history,
0:41
fragile by Design, the Political Origins of Banking Crises
0:45
and Scarce Credit written with Steven Haber.
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Charlie also sits on the Shadow Open Markets committee
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as well, where he often gives his thoughts on monetary
0:56
policy and and finished regulatory policy.
0:58
Welcome, Charlie. Thanks so much for joining.
1:00
- It's great to be with you, John. Very much so.
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By the way, I should mention I'm also now at the Anderson
1:09
Institute for Finance
1:10
and Economics, my new job, which I'm enjoying very much.
1:14
- Well, terrific. That, that's so great to hear.
1:17
And I know a number of your colleagues as well
1:20
who are doing great things there as well.
1:21
I want to start with your personal origins
1:24
and where did you grow up
1:25
and how did you first get interested in economics
1:27
and finance, and when did you sort of realize
1:30
that you would be spending
1:31
and dedicating much of your life to studying banking?
1:37
- That's a great question.
1:41
I grew up in Washington,
1:42
dc My father was a prominent civic leader,
1:46
real estate developer
1:47
and owner of apartment houses in the DC area.
1:53
And so it was part of the family business to be tracking
1:59
banking credit and also interest rates very much so.
2:03
My dad was on the Board of Rigs National Bank in Washington.
2:07
He was also on the board of a savings and loan.
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And so it was just,
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I had a very close relationship with my father.
2:15
I admired him very much
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and he educated me from almost as,
2:22
as, as far as I can remember, age five maybe.
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I don't know, to think about finance and banking
2:29
and monetary policy.
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I remember very well, even as a,
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I guess I must have been about 13
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or 14 at the time when Arthur Burns was creating havoc in
2:40
the Federal Reserve, how much trouble that was creating
2:42
for real estate people.
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So I saw most of these topics originally through the lens
2:48
of a real estate developer.
2:51
- Wow. That, that's what a great introduction to banking.
2:55
And, and no wonder, you know, you're an expert very young,
3:00
no wonder, you know, I suppose it's not surprising at all
3:04
that, you know, you, you grow to become, you know, one
3:07
of the greatest living experts on banking.
3:10
You know, just to really, I guess start, so like,
3:13
I guess tell, tell us a little bit about you, you know,
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I guess becoming an academic, your, your dad was sort
3:19
of a, a practitioner.
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I mean, what, what made you think
3:22
that joining academia would, would be a good way to, I mean,
3:26
explore these sorts of issues?
3:28
And I'm, I'm curious how, how that sort
3:31
of transformation becoming a professor, how that came about.
3:35
- You know, I think John, a lot of times when we tell tell
3:39
answers to questions like that, we sort of make them up.
3:43
That is, I don't really know,
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and I doubt whether anybody really knows how they get
3:51
into the academic business exactly why.
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But at the best I can figure out, I didn't have much choice.
3:58
I just was very curious about things
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and just wanted to study things more and more.
4:06
And it wasn't, you know, something
4:10
that my family was particularly excited about.
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I think my dad was expecting that I would get a law degree
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or do something more useful from his perspective,
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and it took a while for him to warm to the idea that
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I was gonna be an academic.
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So I think I just
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never got enough is, is really what it came down to.
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I just, it was almost a personal, just
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yearning honestly, to just study.
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That's all I can say.
4:43
- That's terrific. Well, I wanna dive deep.
4:46
I, I, I guess just in the banking straight away
4:49
and really want to start with
4:51
deposit insurance theory of bank runs.
4:55
I mean, we could get into sort of banking history,
4:57
but I, I feel like especially given the recent Nobel Prize
5:01
given, you know, toward, you know, Doug Diamond
5:04
and Phil Dibb big, and you know, it's also
5:06
that same prize was also given Ben Bernanke as well.
5:10
You know, the, the, this is a big topic, you know, the
5:12
what causes bank runs in the first place.
5:15
You know, we think, you know,
5:17
these long lines maybe in the late 1920s,
5:21
1929 crash, we think, you know, more recently, you know,
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you could argue that in 2008 was a, you know, run on,
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you know, some people call it the shadow banking system
5:31
or run on the money fund system.
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You know, what causes these is I think a, a a big question.
5:37
And, you know, one justification that they've given,
5:40
you know, the, the, the Diamond Dig big model gives is that,
5:42
you know, that there's a coordination failure
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amongst depositors
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and that there's sort of a, a self-fulfilling prophecy with,
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you know, if, if if there's enough, you know,
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even a small number of depositors are,
5:57
are afraid it can trigger a panic and,
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and can sort of leap this bad equilibrium outcome.
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Now you are, you've been a long sort of time critic of, of
6:06
that framework.
6:08
I'm curious where you, you know, what you think
6:10
that model gets wrong about why banking crises occur and
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and tell us a little bit more about what your theory of,
6:18
sort of the cause of, of bank runs are and,
6:21
and whether deposit insurance is an effective policy tool
6:25
to mitigate bank crisis.
6:27
- Well, let me start off just
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by saying I was a whole wholehearted supporter
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of giving the prize to all three
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of those people the Nobel Prize
6:35
and in fact wrote some things to the Nobel Committee
6:40
suggesting that it was a good idea.
6:43
But the way I would describe my relationship
6:47
with the Diamond Divi model is that it was the things
6:51
that were unsettling about the diamond divi model
6:55
and seemed to me wrong.
6:57
That really were my main motivation in getting into banking
7:01
theory and the theory article that Charles Cann and I wrote.
7:05
And when I met Gary Gorton
7:06
after a conference
7:07
where we had both presented bank theory papers,
7:10
he presented his 1990 paper with George Panke
7:14
and I presented mine with, with Charles Can.
7:17
We met in the airport
7:19
and we found that both of us had to a very large extent,
7:23
been driven to do banking theory, mainly
7:25
because of how much we disliked the diamond DG model.
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But that doesn't mean that the diamond divi model
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didn't contribute.
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I think its main contribution was this coordination failure
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idea that you could have Nash equilibrium where you had runs
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coming just out of the expectation by depositors
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that others might run.
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So I think that's the main contribution of the paper.
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But I do want to emphasize there are no loans
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that banks are making.
7:55
There's no loan risk in the Diamond DI model.
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The claims on the bank are not transactable,
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and since there's no risk runs can't be a response
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to anything that's a problem.
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So all of those are big problems.
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If you want to have a kind of historically
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informed understanding of banking trouble, I would say
8:21
that actual bank failures,
8:26
and I think runs are a little over-emphasized to be honest,
8:30
but bank failures
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and waves of bank failures clearly reflect fundamental
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problems in the economy that hurt banks.
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And the the key things you need
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to have an empirically realistic model of bank runs
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or bank withdrawals
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that is deposit withdrawals is two things.
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First, that there's gotta be an observable shock
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that scares depositors about the value
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of the bank loan portfolio.
8:57
And secondly, depositors don't wait for banks
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to become insolvent.
9:03
Depositors are risk intolerant,
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and as soon as the banks get risky, they start
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to withdraw their money.
9:10
And when depositors usually begin that process,
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it happens in a kind of smooth and continuous way.
9:16
So that what's happening is the depositors are withdrawing
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gradually, not all at once, not suddenly.
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And that, that discipline actually leverages banks
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and in most cases leads the banks to restore their stability
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through a reduction in leverage
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and a kind of forced increase in cash
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assets that the banks have.
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So when banks experience that disciplinary pressure, most
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of the time they respond to it favorably
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reduce their risk and continue.
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And then of course, there's some extreme cases when it
9:50
happens very suddenly, especially if there's some whiff
9:54
of fraud or other kind of very sudden kind of news,
9:59
then you can get very quick responses.
10:02
But the key is any model,
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and by the way, very few models of
10:07
of banking have these features.
10:10
They, a lot of 'em have the feature of, of responding
10:13
to bad news.
10:15
But I would say that one of the kind
10:16
of consistent flaws in a lot of the models is
10:20
that they assume that depositors care about whether the bank
10:23
is insolvent, actually depositors care about whether the
10:26
bank is safe and long
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before it's insolvent, they start
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to withdraw their money if they're concerned about its
10:33
safety deposit is pretty much wanted in the uninsured
10:37
banking days, an investment grade risk or better.
10:42
- Interesting. So I guess, you know, translate for us
10:46
what this I guess means for deposit insurance because,
10:49
because I guess there's, there's a story that's told that,
10:53
you know, essentially FDIC insurance ended bank runs that,
10:58
you know, you had the 1929 crash,
11:00
you had all these people lined up outside the banks.
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We've all seen this in these, you know, famous photos of,
11:05
of Wall Street.
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And during the panic of of 1929, you had deposit insurance
11:10
that FDR created with the FDIC in the 1930s,
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and we hadn't had a traditional systemic set
11:18
of bank runs since then.
11:21
You know, there's obviously the odd,
11:23
you know, rare instance.
11:25
I mean, you think about Silicon Valley Bank in 2023,
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there were a lot of uninsured deposits.
11:30
It's sort of unclear right now
11:31
what exactly the level of deposit insurance is.
11:33
But, but the theory is that the FDIC sort
11:36
of stopped deposit insurance, sorry,
11:39
stopped bank runs from, from happening.
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Do you sort of buy that?
11:43
- No, it's that, that is a popular misconception.
11:47
So the most obvious reason,
11:49
it's a misconception is federal deposit insurance doesn't
11:52
even go effect until the beginning
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of 1934.
11:58
The banking problems were resolved
12:02
with the bank holiday of March, 1933.
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And then what happened was, and partly
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because the FDIC was being created, the supervisory process
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of doing due diligence to see which banks were, were
12:18
well enough to reopen starts at that point.
12:22
Some banks reopened right away in the, the spring
12:26
of 1933, others get some assistance in terms
12:31
of preferred stock purchases by the government
12:33
through the Reconstruction finance corporation later,
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and then they reopened several months later
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and still other banks just were shut down.
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And partly the reason for that was
12:43
to actually resolve the problems prior
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to the creation of deposit insurance.
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So no, there was no connection between bank instability
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and the 19 early 1930s and deposit insurance.
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Certainly not that deposit insurance solved any problems.
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Also, deposit insurance at that time was passed only
13:02
as a temporary measure.
13:04
Of course, it, it became permanent
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and it only applied to its small deposits.
13:09
And that's because it was really lobbied for by small banks
13:13
that were very versified typically in rural areas.
13:17
Henry Stegel from Alabama was the one
13:19
who really pushed for it.
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And so it was really a protection
13:23
that mainly benefited small banks
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because they had small deposit accounts.
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Large banks like the New York City banks were not very much
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affected by a deposit insurance when it was first brought in
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because they had a lot of deposits that weren't insured.
13:39
- Fascinating. So I
13:41
wanna start short talking about your book.
13:42
I mean, some of these issues are, are talked about in your
13:44
book, fragile by Design with Steven Haber.
13:46
And you wanna just talk about, I guess, the history
13:49
of banking crises a little bit
13:50
and how sort of political economy feeds into this?
13:55
So, so one, you know, I think you, you may get a strong case
13:58
that, you know, banking is important for economic growth.
14:03
You know, credit's an important mechanism, you know,
14:06
for economic growth that banks and,
14:08
and banking can't really exist without a state,
14:11
without some level of regulations, some sort
14:14
of property rights that are really set forth and,
14:17
and, you know, to prevent expropriation and so forth.
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But you know what, what's interesting, you know,
14:22
I know the evidence from Reiner Roff is
14:23
that banking crises tend to be recessions
14:26
that are very bad in terms of GDP growth.
14:29
Interestingly, over time,
14:30
and this is something that, you know in your book, is that
14:32
over time this sort of, those who take those
14:35
who bear the losses of banking crises has really shifted
14:38
from those who are taking risk, you know, bankers
14:41
to really the taxpayer explain to us like how that
14:45
that political transition has happened over time.
14:47
And, you know, is deposit insurance maybe part of that,
14:50
or certainly bank bailouts are, are, are part of
14:52
that which have become increasingly common I think in the us
14:55
I, I'm just curious like which, you know,
14:56
how have the political coalitions sort of changed over time?
14:59
You know, give us the sort of full history of how banking,
15:05
the, you know, how the politics of banking have,
15:06
have changed since the founding of the US 250 years ago.
15:11
- Well, I th I think the, the right starting point is to,
15:14
once you realize that when big shocks from the macro economy
15:19
occur, there's gonna have to be some allocation of loss.
15:23
Okay, so somebody is going to experience some loss.
15:27
That could be it when you're looking at the banking sector
15:32
because banks are making loans
15:34
and some of those loans aren't gonna work out.
15:36
Now that is, they're gonna have loan losses.
15:39
That means the stockholders in the banks are gonna be the
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sort of first line of defense
15:44
and they're gonna be the first ones experiencing loss.
15:47
And that continues to happen to today as well.
15:51
The difference is, it used to be that
15:54
because that was true, bankers had a lot
15:58
of incentive to manage their risks.
16:03
By the way, you know, most, most bank closures
16:05
that happened, let's say during the Great Depression were
16:08
actually voluntary liquidations
16:11
because banks had extended liability,
16:13
they had double liability for their paid in capital,
16:15
meaning they could lose more than
16:17
what they had already invested in the bank.
16:19
And so bankers often shut down their banks if they,
16:22
if they thought that things were going
16:24
to get worse for their banks.
16:25
So bank stockholders bore the losses depositors,
16:29
and those voluntary liquidated banks
16:32
didn't suffer any losses typically.
16:34
And, and many banks shut themselves down long
16:39
before depositors were at risk.
16:41
But then some banks didn't do that.
16:43
That's an interesting question why I'm exploring
16:46
that right now in some research.
16:48
But they, the bankers who didn't do
16:50
that despite their extended liability, maybe
16:53
because they didn't have that much wealth
16:55
that they could lose as a result of the extended liability
16:58
that is the extended liability would come ask them
17:00
to give more of their wealth.
17:03
So I think that's a reasonable guess.
17:06
And so those bankers let the depositors be the ones
17:10
who decided what to shut down the bank.
17:12
So some banks were shut down by the bank stockholders,
17:15
typically very wealthy people who didn't wanna lose anymore.
17:18
The ones that weren't shut down that way were shut down
17:21
by the depositors.
17:22
The depositors in the 1930s lost more than they did in
17:26
previous periods,
17:27
but still depositor losses were actually fairly small
17:32
as a percentage of of deposits.
17:35
Now that was one loss allocation,
17:37
but notice that that loss allocation
17:40
created a lot of risk management.
17:43
Banks were under very heavy incentives to manage their risks
17:46
and when things weren't going well, they got hit with a lot
17:48
of withdrawal pressure.
17:49
And part of that withdrawal pressure was designed
17:53
to force banks to manage their risks
17:55
during the recessions too, to limit the losses.
17:59
Now the negative part of that is
18:02
that banks curtail credit supply during these recessions,
18:06
even more so that if you think about
18:09
how the predeep deposit insurance system works, bankers are,
18:14
stockholders are the first line of defense depositors
18:17
because they exercise.
18:18
A lot of discipline tend to lose a little,
18:21
but not very much.
18:23
But the big losers are borrowers
18:27
because borrowers,
18:29
because of the bank's engaging in risk management, tend
18:32
to curtail credit dramatically.
18:35
So I see deposit insurance as an international movement
18:40
and bank bailouts as mainly a government decision
18:45
to subsidize the supply of credit.
18:48
That is to actually try to make sure
18:50
that credit crunches are less severe
18:53
and that this kind of risk management system doesn't go into
18:56
operation that you can certainly see that
18:59
that has a benefit, which is if you have an A negative rece,
19:04
a recession shock, you're gonna have less of a contraction
19:07
of credit to magnify that shock.
19:09
So from a macro standpoint, it sounds like a good idea
19:13
from a micro standpoint, the bad news is that means all
19:17
of the why's credit contraction, that was part
19:22
of a risk management system, the incentives for
19:25
that have been substantially reduced.
19:27
And when that happens,
19:29
when you get less good risk management,
19:31
you get bigger losses eventually,
19:33
only this time they're gonna be losses of banks
19:36
that are now the loss allocation shared with the FDIC
19:41
and with taxpayers because ultimately taxpayers
19:45
and depositors are the ones who fund the, the FDIC
19:49
and who fund the bank bailouts that go beyond the FDIC.
19:52
So to summarize,
19:54
if you think about shocks hitting from a recession
19:57
and then being transferred in terms of loss allocation
20:01
through the banking system, it used
20:03
to be the banks shareholders,
20:05
because they were incentivized to sort of wrap manage risks,
20:09
they tended to cause much
20:12
of the loss coming from the recession to take the form
20:15
of reduced supply of credit for borrowers.
20:19
Whereas with deposit insurance, basically that was mitigated
20:23
to, to some extent,
20:25
and now the losses become the bad incentive structures
20:29
of banks coming from the bailout risks are now leading the
20:33
banks to, to be more lax in their
20:37
risk management
20:39
and now leading to larger losses for society.
20:43
So I, I would say if I, if you look at the balance
20:46
between those and,
20:47
and I think a lot of people agree with me about this,
20:50
Jerry Caprio at the World Bank I know
20:54
was advising countries on deposit insurance in the 1990s
20:58
and trying to prevent the widespread,
21:01
I'm putting words in his mouth,
21:03
but I think I'm accurate that he saw it, I think correctly
21:07
as protection wasn't worth it.
21:10
That his protection tends to create larger social losses
21:13
through this sort of subsidization of risk.
21:17
And I think the lack of discipline has turned out
21:21
to be a bad idea,
21:23
but it's, you could see why it's motivated.
21:26
I think people don't understand this.
21:28
The real motive, I would say for deposit insurance,
21:31
going back to Henry Stegel
21:33
and those bankers, was to protect banks so
21:36
that they could have, they could avoid the costly aspects
21:41
to them of risk management.
21:43
But that means that might sound like a good short term thing
21:47
for the macro economy.
21:49
But longer term for the macro economy, it does tend to mean
21:54
more aggravated risks so that the history
21:59
of deposit insurance has been, has meant
22:02
that banking crises, that used to be situations
22:06
where depositors suffered small losses
22:09
and governments suffered no losses.
22:12
Now we have situations where governments
22:15
that are protecting banks sometimes suffer huge losses.
22:19
You know, if you look at the 1990s
22:23
in the E East Asian economies, I think Indonesia's cost
22:28
to its government from its banking crisis in 19 97, 98
22:32
for something like 60% of GDP.
22:35
And in Mexico it was 25%
22:38
of GDP in 1995 in Chile, a similar number.
22:42
So this is where if you looked at the, the
22:46
depositor losses
22:48
during the Great Depression in the us it's a number,
22:51
like a couple percentage points of GDP, so that
22:55
you got a huge credit crutch happening
22:59
during the Great Depression.
23:00
But the actual experienced losses
23:04
from bank failures
23:08
to depositors were very small as a percentage for GDP.
23:12
But once you have the government protecting banks,
23:14
those losses become much bigger.
23:16
And that's what we've really seen that since the 1970s,
23:21
we've had a pandemic,
23:24
a banking crisis all over the world
23:27
with extremely high losses.
23:30
And I think that basically it's not worth it.
23:32
The protection of banks is not ultimately
23:38
the right answer.
23:39
It's very hard to give it up politically, but
23:43
because you just try to get rid of deposit insurance
23:47
or you know, other kinds of bank bailout policies,
23:50
it's very difficult to do politically.
23:52
Politicians don't want to experience very sharp contractions
23:57
of credit for one thing.
23:58
And secondly, they tend to have a lot of borrowers
24:03
as well as bankers are lobbying them
24:06
for this kind of protection.
24:08
So I think people have the, the politics
24:10
of deposit insurance completely backwards.
24:13
They think that it's all about depositors, actually
24:18
I would say it's all about borrowers and bankers.
24:21
That's why we've really got it.
24:25
And it's, I think, not ultimately a good bark.
24:29
- So I, I would, I guess then just to ask, I, I mean, what,
24:33
what does the optional banking system look like?
24:36
You know, if we could sort of start from scratch, we,
24:39
obviously, it's hard to remove politics from these things,
24:41
but you know, I, I think there's obviously there, there's,
24:47
there are trade-offs that,
24:48
that are inherent in, in all of this.
24:49
And you know, to some degree there's, you know, a desire
24:54
to have what some might call riskless capitalism.
24:58
We, we don't have any any bailouts,
25:03
but at, at, sorry, we, we, we don't have any crises,
25:05
any banking crises,
25:07
but we, we essentially have all these, you know, sort
25:10
of things like fed puts, you know, the almost
25:14
a blanketed sort of insurance, even right now sort
25:18
of post Silicon Valley Bank.
25:20
It's not even clear sort of what the levels
25:22
of deposit insurance really are.
25:25
And so I'm just cu sort of curious, like, you know,
25:27
at some level we, we could have a system where there's
25:31
essentially no banking crises where the government sort
25:34
of backstops the banking system,
25:36
but you know, there's obviously a cost to that as well.
25:40
And I mean, in your mind is an optimal banking system, sort
25:43
of have some crises, you know, the odd banking failure here
25:48
and there, you know, like I think Silicon Valley Bank
25:50
certainly a preventable banking crisis in the sense
25:52
that you had some risk managers that didn't know how
25:54
to manage interest rate risk
25:56
and you know, they had all these uninsured deposits.
25:59
If, if they maybe understood how
26:00
to manage interest rate risk
26:01
that maybe wouldn't have happened.
26:02
But at some level, you know, there's just inherent in
26:06
lending, there's, there's always risk.
26:08
And so, you know, obviously, you know,
26:11
a systemic banking crisis is something I think that's,
26:14
it's more desirable to be able to prevent, given that,
26:16
you know, certainly how bad banking crises
26:18
can be for the economy.
26:19
But I'm curious, like what exactly does an optimal banking
26:23
system look like with regard
26:26
to its role in relationship to the state?
26:29
- Well, that's a a lot
26:30
of difficult questions you're asking me.
26:34
I guess the first thing I would say is you don't ever get
26:37
rid of banking crises.
26:38
You just postpone them So that if, if we decide,
26:43
remember we had deposit insurance,
26:44
pretty much a hundred percent deposit insurance for
26:48
most savings and loans in the 1970s.
26:51
And when interest rates go up, savings
26:55
and loans initially become insolvent
26:57
because of the interest rate increase
26:59
because they had long duration assets.
27:02
So they experienced very large losses on their mortgages
27:04
and other assets, but then they became zombies
27:08
because of deposit insurance.
27:09
They weren't forced to shut down.
27:11
So we had, we were living in a banking system
27:14
of zombie savings and loans through the 1980s,
27:19
and they, so yes, you could say there was no banking crisis,
27:23
or you could say it there,
27:24
the banking crisis had already happened
27:27
and the banks were, those banks were insolvent.
27:30
And then it wasn't until
27:31
after the 1988 election that we got in the beginning
27:36
of 1989, we finally dealt with the problem.
27:39
So we got, we finally caused the savings loans
27:43
to fail when we passed legislation in early 1989
27:47
to kind of, you know, deal with the whole problem.
27:50
So we didn't avoid a banking crisis,
27:52
we just took it from being something that was,
27:55
would've been a kind of sudden thing
27:58
that would've been observed at the time
28:00
that interest rates went up.
28:01
And we made it much worse
28:03
because what did those banks do when they had
28:05
that extra time after they were already insolvent?
28:09
They took new risks to try to get a resurrection sort
28:14
of strategy going, that is, okay, we're currently insolvent,
28:17
the regulators aren't intervening.
28:19
We'll take some risk on oil fields
28:23
and shopping centers, f funding and other kinds of things.
28:27
And then of course, that made the losses
28:29
ultimately much bigger.
28:31
So we, we did f finally end up shutting down a huge number
28:35
of savings loans.
28:37
We, so we did have a banking crisis that was revealed
28:41
with lots of failures,
28:42
but it happened, you know, a decade
28:45
beyond when it should have,
28:47
and the losses were much bigger as a result.
28:49
So my first answer would be, you never get rid
28:53
of these banking crises.
28:54
What people find is that
28:55
that phy pattern is actually quite typical.
28:58
Din wrote some papers where he showed that
29:03
after elections,
29:04
that's when these unresolved overhang
29:08
of failed zombie banks tend to be dealt with.
29:10
And I want to emphasize the politicians are watching those
29:13
banks doing continuing risk behavior, opting
29:17
for resurrection, risk taking, taking on new risks.
29:20
And ultimately they, they have to discipline them.
29:23
By the way, I found that this pattern is true throughout the
29:27
world, that when you increase the generosity
29:31
of deposit insurance, it causes banks
29:33
to take on more risk on their asset side
29:36
and also to lever up as much
29:38
as they can on their liability side.
29:41
And that combination, of course tends
29:44
to make the banking system much riskier.
29:46
So actually you get more banking crises as a result
29:49
of more generous deposit insurance.
29:52
So what's the ideal banking system look like?
29:57
Well, I, let me start with democracies
30:00
because it's, you know, talking about autocracies, it's hard
30:04
to have an ideal banking system in an autocracy
30:07
because everything's kind of distorted
30:11
and perverse in an autocracy.
30:13
And the banking system is all part of that same
30:17
perverse power allocation in, in the democracy.
30:22
I think we could look at a country like Canada,
30:26
certainly prior to Canada's decision
30:29
to have some deposit insurance.
30:33
It was an extremely stable banking system,
30:36
very diversified portfolios of nationwide branch banks.
30:41
They never had a banking crisis.
30:42
They did have a few bank failures in their history,
30:46
but Canada still has never had a banking crisis.
30:49
That's quite interesting.
30:52
I would say that they made a mistake in going
30:54
for deposit insurance in the 1960s, I believe it was,
31:00
but I don't think that it has undermined their overall
31:03
stability, which I think is a testimony to the,
31:07
the regulatory structure in Canada.
31:10
But I would say that nationwide branch banking
31:14
in a competitive model where there's a sufficient number
31:16
of banks to compete with one another is really
31:20
an ideal kind of banking system.
31:22
You have to have good protections for the property rights of
31:28
bank stockholders that allow bank to
31:32
get their money back when they lend it.
31:35
Those kinds of things really are very helpful,
31:38
but free entry as much as possible.
31:41
Competition and discipline.
31:46
- Just, I guess one, one quick question on,
31:47
I guess on just Ken in the us so I guess your diagnosis,
31:52
and I think this is, I think pretty,
31:54
I think SAB well established,
31:56
but the difference between why Canada had
31:58
virtually no banking crises.
32:00
There were a few bank failures, I think in the 18, early
32:03
to mid 18 hundreds or something like that, before Canada was
32:08
before Canada Federation in the 1860s.
32:11
But the US had many banking crises throughout this time.
32:15
And the argument there is
32:17
that the US had very severe branching restrictions
32:22
nationwide branch banking basically didn't exist,
32:24
and so banks couldn't diversify risk across regions.
32:28
And because of this, there were just more banking crises
32:31
that were, were likely to happen.
32:32
So you're that's you, you're on board with that?
32:36
- Oh yes. Well, if it wasn't just
32:40
that you couldn't branch across state lines, which is true,
32:43
you couldn't, but also in most states you couldn't branch
32:46
even within states, which meant that banks had very local,
32:50
single office banks
32:52
with very local concentration of risk.
32:55
So if you were in a place like Champagne
32:57
or Bann Illinois, where if you go there today,
33:00
you'll see pretty much two things, corn
33:02
and soybeans as well as the university,
33:05
but mainly corn and soybeans.
33:07
And if you were in business in Champaign-Urbana,
33:10
even if you were, let's say a mechanic
33:12
or a plumber, you were basically still in the corn
33:15
and soybean business because if corn
33:18
and soybeans tanked,
33:19
that meant the whole local economy tanked
33:21
and the banks were lending effectively against corn
33:24
and soybeans, even if they were lending to a merchant
33:27
or whoever.
33:29
And so what that means is
33:30
that the bank portfolio was very versified,
33:34
and of course the US was primarily an agricultural economy
33:37
in the 19th century and early 20th century.
33:40
So if you're looking at, you know, what,
33:44
what is the riskiness of a banking system that has that kind
33:47
of lack of diversification?
33:50
It's, it's quite, quite great.
33:52
But it wasn't just the lack of diversification, you know,
33:56
we had tens of thousands sometimes at, at its peak
34:00
of banks in the US
34:02
and it was very hard for them to coordinate their behavior.
34:06
That's another element of the Canadian system.
34:08
So if you have just, let's say a dozen
34:11
nationwide branching banks, then when a a, a problem arises
34:16
where sometimes it's advantageous
34:18
for the banks to coordinate.
34:19
That happened in the early part of the 20th century.
34:22
Twice the banks got together
34:25
and said, well, here we are.
34:28
We're all operating coincidentally
34:30
through the whole country.
34:32
What are we gonna do about the fact
34:33
that there's been a market scare that's leading
34:36
to the failure of one of our brother banks?
34:39
And so in both of those cases, the Bank of Montreal led,
34:44
believe it or not, a takeover of the failing bank
34:47
with the costs being shared proportionally among the,
34:50
the surviving banks.
34:52
And the idea of this was by taking on the costs
34:55
and sharing them, they basically made it clear that none
34:58
of them would be insolvent as a result.
35:01
So this was a great systemic risk resolution.
35:06
So when the Canadian banks experienced some systemic risk,
35:09
they were able to coordinate
35:10
because there were only a dozen of them
35:12
or less they could operate.
35:14
They operated in the same territory,
35:16
they watched each other,
35:17
they knew each other's business practices,
35:19
and they were willing to work together to solve problems.
35:23
It's worth remembering,
35:25
Canada didn't even get a central bank till 1935.
35:28
So a lot of economists would say, well,
35:30
you can't have a stable banking system without a central
35:34
bank and deposit insurance and lots of other things.
35:37
Canada, you know, it was very late to the game
35:40
of those kinds of government interventions
35:41
in the banking system.
35:44
But the Bank of Montreal in coordinating
35:46
with the other banks, was able
35:47
to solve problems when they arose pretty well.
35:50
Now, of course, that doesn't mean there weren't credit
35:52
crunches in Canada.
35:53
There were big credit crunches
35:55
because when a recession shock at can Canada was even more
35:59
of an agricultural economy than the us.
36:01
So when, when macro shocks happened, that meant that
36:05
there were contractions of credit precisely
36:08
because the banks were managing their risks.
36:11
So the Canadian banking system was very successful
36:14
as a banking system,
36:17
but it did it, that doesn't mean
36:19
that it could avoid macroeconomic shocks affecting the
36:24
supply of loans.
36:25
So I think that this is something people really don't,
36:28
don't get that a properly managed risk managing banking
36:33
system is going
36:34
to necessarily aggravate macroeconomic downturns.
36:38
And if you try to prevent that,
36:40
you'll make the losses bigger.
36:44
- So, so, okay, so, so I'm I'm with you.
36:48
So like Bank Montreal sort
36:50
of played this like def facto central banking role for a lot
36:53
of Canada's history
36:55
before the Bank of Canada was created in the 1930s.
36:58
I, I guess similar to what jp, the role
37:00
that JP Morgan played, I guess is sort of a
37:03
private lender last resort, like it did in 1907,
37:06
the 1907 crash, but it
37:08
- Was much more limited, John,
37:09
because, you know, really what Morgan was able
37:12
to do was mainly to prevent the,
37:16
the failure of the New York Stock Exchange
37:19
to coordinate bank behavior
37:21
to keep the New York Stock Exchange running
37:24
New York City banks.
37:25
But New York City banks were small potatoes compared
37:28
to the size of the overall banking system.
37:31
They, they had to suspend convertibility in 1907.
37:34
They couldn't coordinate to deal with a nationwide shock.
37:39
They just were too small.
37:41
But what they could do, what JP Morgan did manage to do was
37:45
to help work together the New York City banks to,
37:50
to keep the New York Stock Exchange going.
37:53
But I think a lot of people think that, you know,
37:56
have a misconception about
37:57
how far reaching JP Morgan's influence was.
38:00
He certainly was, you know,
38:02
a very influential person in many, many ways.
38:05
However, the US banking system at
38:09
that time consisted of, gosh, I can't remember the amount,
38:11
but there's more than 10,000 banks all located in a
38:15
different location.
38:17
You know, JP Morgan's one guy at the tip of the point
38:21
of the pyramid of reserves in New York City,
38:25
but he, he couldn't, through force of nature
38:29
or great coordinating abilities, he couldn't prevent the
38:34
nationwide suspension of convertibility.
38:38
- I, I guess even, even more recently, I guess you have,
38:40
you know, the, the banks in 1997 got together and,
38:43
and basically, you know, bailed out LTCM,
38:47
long-term capital management.
38:48
I mean, they met in the New York Fed headquarters,
38:50
but I don't think there was any government
38:52
assistance in involved in that.
38:54
So I guess it's a, a bit similar sort of banks acting to,
38:58
you know, promote stability in in the system.
39:01
I, I just so you know, in the US Canada distinction,
39:04
before we jump off that, you know, in 2008,
39:07
the king banking system sort of did fair, I think,
39:09
much better than the us What features there,
39:13
institutional features do you think
39:15
put Canada in better stead?
39:16
Is it really more just this arc of history?
39:18
The US still has tons of smaller banks
39:20
because of this history of severe sort
39:22
of branching restrictions that,
39:24
- But by, I mean, I think the difference was that the US
39:29
of course, the US created the crisis
39:32
through the subsidizing risk in real estate,
39:35
in housing risk.
39:37
And that was a politically driven subsidy
39:40
where you just had a lot of mortgages that were just crappy
39:44
and were crappy on purpose.
39:46
If you tell people that you're not going
39:49
to investigate the veracity of their mortgage application,
39:53
you're gonna attract some fairly dodgy people
39:56
to the mortgage market.
39:57
And then you tell them they don't have to put down much
39:59
of a down payment, if at all, some some zero down payment.
40:03
So imagine if I told you, John,
40:04
you look like a handsome young man.
40:06
I'm gonna give you a mortgage wherever you'd like
40:08
with zero down payment,
40:09
and I'm not gonna check up on your income.
40:14
That doesn't happen as a result of spontaneous greed
40:18
that happens as a result
40:20
of government interventions into the mortgage market
40:23
that are driven by politics.
40:25
And again, notice a common denominator, the politics
40:28
of borrowers, the political influence of borrowers,
40:32
in this case, housing borrowers,
40:35
and this has now happened all over the world.
40:38
Housing finance is extremely politically powerful all over
40:42
the world, and we're getting a lot more risk taking,
40:45
coming from the subsidization
40:46
of housing finance all over the world.
40:49
So I think the, you know, the US was in a different position
40:54
because we were the source of the problem.
40:57
Canada managed to avoid the worst of it
41:00
because they weren't taking on these huge risks.
41:04
So I think, you know, certainly two of our largest banks,
41:08
bank of American, Citi Bank were insolvent, or,
41:13
or in case of Citi, clearly it was insolvent, bank
41:16
of America borderline insolvent,
41:18
but this was related to fundamentals.
41:20
There was no like panic, you know, out
41:23
of the blue we get back to the diamond dimo, there was no,
41:26
you know, like random co co coordination problem.
41:30
No, it was that things were getting very bad
41:33
and the banks were exposed to that risk.
41:34
And if you had looked, if you just tracked the equity value
41:39
of the banks for the year
41:40
and a half prior to the crisis,
41:42
you would've seen Citibank declining from about a 13% equity
41:46
to asset ratio in market value terms to about a 2%
41:50
by the time you get to 2%, which includes the value
41:53
of the deposit insurance.
41:54
By the way, that means the bank's effectively in solvent,
41:57
even though on a book value of tangible asset basis,
42:01
Citibank was showing almost a 12% capital ratio.
42:06
So, so it, you know, again, you know,
42:08
these aren't the mystical things.
42:10
I mean, Canada was in a better position.
42:13
It wasn't making all these mistakes.
42:15
It wasn't the,
42:16
the political bargain in Canada wasn't driving its largest
42:19
banks to this, to the brink of disaster.
42:23
Now, not all the US banks did it.
42:25
JP Morgan Chase managed to avoid it.
42:27
Wells managed to avoid it.
42:31
So I think that's a also a really interesting question,
42:35
and I think that what you're looking at there is also
42:38
quality of management differences.
42:41
So there's a lot
42:43
to be said about why the US experienced this problem in
42:46
Canada, didn't, but I I would come down to a combination
42:49
of government incentives for extreme risk-taking,
42:52
and in the worst cases, also bad managers.
42:57
And what bad management means is they love
42:59
to go on onto the sort of risk-taking bid
43:02
because they, they don't have a,
43:04
a inherently valuable franchise.
43:09
- So I wanna talk about, so, so I think we've covered sort
43:11
of the cause of the 2008 financial crisis.
43:14
I wanna talk, I guess just for a few minutes here about sort
43:17
of the post 2008 aftermath,
43:20
and what do you think about the financial reforms, St.
43:23
Dodd-Frank and around the world, sort of Basel three
43:27
tighter capital standards, you know, banks have
43:29
to hold more equity on their balance sheet.
43:32
Would you say that that's a good reform, something
43:34
that you, you think is good?
43:35
I mean, I'm curious what you think about some
43:37
of the other pieces, like, you know, that sort
43:40
of other balance sheet features, you know, the,
43:44
I guess you could think about things like, for instance,
43:48
central clearing of, of swaps, derivatives.
43:52
Any thoughts on sort of SLR
43:53
or some, some of the specifics of some
43:55
of these capital standards that, that are now sort
43:58
of being changed a little bit?
44:00
Any, any thoughts, any thoughts on things
44:02
that should have been done that, that weren't achieved?
44:05
You know, I know John Taylor for a long time talked about
44:07
reforming the bankruptcy act
44:10
or the, the bankruptcy code in introducing sort
44:12
of a chapter 14, a special sort of bankruptcy,
44:16
chapter four bank, specifically,
44:19
there's early liquidation authority,
44:20
which is something introduced through Dodd-Frank.
44:22
I'm curious, what do you think about the whole suite
44:24
of financial regulatory reforms that came in after,
44:28
after Dodd-Frank and, and
44:29
after the gold financial crisis, the us
44:32
- Well, I, I wrote a, a small, a short book, sir, going
44:35
through all of those reforms
44:37
and pointing out why they were so bad
44:39
and what would've been a, a serious alternative.
44:43
So I, I guess what I would say is I was very much in
44:46
favor of some reform.
44:48
Let, let's start by just putting some things aside,
44:50
like the Volker Act or a lot of the discussion about swaps.
44:55
Some of those reforms might've made sense,
44:57
but they had nothing to do with the crisis,
44:59
and I didn't think most of them made sense
45:02
on the Prudential side, really trying to bolster
45:05
banks' condition by increasing capital
45:07
and increasing cash assets.
45:10
Now that made sense, but it wasn't done effectively.
45:15
And again, as we point out in fragile by design,
45:18
it was ineffective on purpose.
45:20
So you have to kind of understand that
45:22
what the political bargain
45:23
of Dodd-Frank was all about was pretending
45:26
to do something while doing exactly
45:30
what you had done before.
45:32
So it, it, it was a very ineffective set of reforms,
45:36
as we've seen since then.
45:38
I mean, imagine that we had Silicon Valley Bank
45:43
that was borderline in solvent on, on a,
45:46
if you just looked at their 10 K report,
45:49
their public public document,
45:51
you knew they were borderline insolvent,
45:53
and yet the regulators were pretending
45:55
that they were very well capitalized.
45:58
So that just doesn't make any sense, right?
46:01
If you wouldn't,
46:02
if you're serious about bank prudential stability,
46:06
you wouldn't act that way.
46:08
So we know that our whole regulatory
46:10
and supervisory system is unserious.
46:14
So I, I could go through a lot of reforms that
46:16
that would be much more effective.
46:18
But what they would do is they would
46:20
be more rules-based in using objective
46:23
information about banks.
46:26
So for example, banks wouldn't be able to have
46:30
a market value of their equity that's close to zero
46:33
and pretend that they had a very high ratio of equity
46:37
to assets so
46:38
that you'd use market information also
46:41
about the loan portfolio.
46:42
If the loan portfolio is charging huge high interest rates,
46:46
let's just agree that that's probably
46:48
because it, they're making a lot of risky loans,
46:51
but we don't want to use the interest rates on loans
46:55
as a measure of their riskiness.
46:57
How crazy is that, right?
46:58
We don't want to use the actual financial position
47:01
of the bank in terms of its equity to asset ratio
47:04
as information in the supervisory process.
47:07
So these are not random mistakes.
47:11
These are done on purpose to achieve the protection of banks
47:16
and their borrowers
47:18
and depends on the circumstances,
47:20
which borrowers are being protected,
47:22
which bankers are being protected.
47:23
But, and I say that also, I had a year at the
47:29
OCC as chief economist, by the way,
47:31
I'm the last chief economist of the OCC, because
47:34
after i, the experience of having me as chief economist,
47:37
they abolished the position of chief economist
47:40
because I guess they decided that having someone around
47:43
who was constantly pointing out
47:45
that the emperor has no clothes
47:47
and you know, you guys are pretending this bank is
47:50
fine, but you know, it isn't.
47:51
And by the way, that's the truth. They know it isn't.
47:56
And then behind closed doors, you'll, I'll say to them,
47:59
you know, that bank's in trouble.
48:01
Yes, but that bank's very politically powerful.
48:04
That's the fact. Nobody likes to talk about it.
48:08
The supervisors hate it.
48:09
When I, when I speak the truth about it, by the way,
48:12
I was on the, an advisory committee
48:15
of the systemic risk board for the eu,
48:19
probably even worse, right?
48:21
The amount of political haggling
48:23
and compromising, that's part of the supervisory process.
48:28
So what we really need to do is figure out how to make
48:32
the market kinds of information that's,
48:35
that's really dependable
48:37
and has proven itself to be dependable.
48:39
How to bring that into the regulatory
48:41
and supervisory process.
48:43
And the reason the politicians don't wanna do it,
48:45
and the supervisors and regulators don't wanna do it, is
48:48
because they would lose control of the process.
48:52
That is, the process might actually work.
48:55
That's the last thing the politicians want.
48:57
They wanna control the process.
48:59
Why do we pretend that the book value
49:02
of tangible capital is the measure of the health of a bank?
49:06
Why do we pretend that?
49:08
Because that's something we can control.
49:11
So when we get that, we, we, we can control that
49:14
and feel good about the fact that
49:18
market pricing or perceptions
49:21
or it gonna disturb our equilibrium.
49:24
And I think this is, so
49:25
whenever you, you hear someone like me,
49:28
or like most financial economists actually
49:31
who work on banking saying that we need
49:34
to get market discipline back into the regulatory
49:36
and supervisory process.
49:38
Bankers are horrified, regulators are horrified,
49:40
politicians are horrified because it might actually work.
49:44
And so I'll be honest,
49:45
and I'm sorry to depress everyone,
49:47
I don't think there's much chance that this is gonna happen.
49:51
The reason is because you'd need voters to be conscious
49:56
of this and to care about it enough to push for it.
50:00
If they actually created accountability
50:02
for politicians, then it could happen.
50:05
But voters are not that informed about this
50:08
and they have other priorities.
50:09
And so that is of course why special interests can
50:14
get away with murder.
50:15
And they do.
50:17
- So we've talked a bit about, you know, Dodd-Frank,
50:20
fin reg on, you know, post gold financial crisis.
50:24
I think it's hard not to talk about post financial crisis
50:27
banking without talking about
50:28
quantitative easing in some way.
50:30
'cause quantitative easing, you know,
50:32
fundamentally changed the banking system in that, you know,
50:36
we've shifted from a scarce reserve system
50:39
to an ample reserve system.
50:41
So much of the bank's assets now are no longer in things
50:44
like, you know, treasury bills are now are reserves at,
50:47
you know, the central bank or at the Fed, you know,
50:50
certainly post COVID, many other central banks in the Bank
50:52
of Canada sort of made that leap
50:54
to expanded their balance sheets a lot
50:56
with long-term asset SS some people, you know,
50:59
and obviously the goal is, you know,
51:02
and it makes sense, you know, certainly when you're at maybe
51:04
the, the zero lower bound on short-term interest rates
51:07
that you wanna lower long-term interest rates.
51:08
And so central banks are,
51:10
are you buying up long-term assets?
51:12
Now, we're no longer at the zero lower bound and,
51:14
and, you know, short-term interest rates have been above 0%
51:18
for, for a good number of years now.
51:21
Now I, I'm curious what you think about, you know,
51:23
this ample reserve system that, that we're in.
51:25
Certainly, you know, the Fed chair
51:27
and nominee Ken Warsh has spoken quite a bit over the past
51:30
15 years about ending the ample reserve system
51:33
and going back to, you know, pre 2008 scar system.
51:38
What do you think about that idea? And
51:40
- I'm in support of it.
51:41
I, I think it would be a very good idea
51:44
and I wish we would do it,
51:45
but I'm very skeptical that we're going to do it.
51:47
So why aren't we gonna do it?
51:50
First of all, the main, so, so
51:52
what would it look take to make it happen?
51:55
Basically announce that you're going
51:56
to reduce the interest paid on reserves
51:59
to zero over let's say a two or three year period.
52:02
So you, you just take
52:04
that interest rate down from its current market rate down
52:07
to a zero rate forecastable slow, nice
52:10
and gradual over three years, that will get you back
52:13
to a scarce reserve system
52:17
and a much smaller Fed balance sheet
52:19
because banks will start laying off all of these
52:23
excess reserves once they're not being remunerated, right?
52:27
So it's not hard. What's the problem?
52:30
Well, the problem is once banks start laying off all these
52:33
treasuries, that that is not holding them at the Fed,
52:38
not only the Fed balance sheet shrinks,
52:40
but bank holdings of treasuries are going to go down
52:45
as those bank
52:46
and fed holdings of treasuries go down,
52:48
that's gonna force up the yields on treasuries
52:51
and the mortgage market will be the first place
52:54
where you'll see higher interest rates.
52:57
So the, the main political reason why this won't happen is
53:00
the mortgage market, and it's pretty simple.
53:03
So I would predict very, very boldly
53:05
that Kevin Walsh will do very little, despite the fact
53:08
that I like Kevin very much and I wish him well.
53:11
And I know he's sincere.
53:12
I think he'll end up doing little,
53:14
because the political costs will be too great for the Fed
53:17
to really push very hard.
53:19
There. There's another point that makes it not,
53:22
it's not a coincidence that we're standing at the precipice
53:26
of a US fiscal crisis
53:29
and our central bank is holding huge amounts
53:31
of long-term government debt.
53:33
That is, nobody wants to start seeing
53:38
how the market, if the market non fed
53:41
and non-banks who are kind of being pushed into it have
53:45
to actually start buying government debt on a massive scale
53:50
at a time when the US is at the, the precipice
53:53
of a fiscal crisis.
53:55
What's that gonna look like?
53:57
So I, I don't think it's a coincidence either,
54:00
that this is happening at a time when,
54:03
if you look at the last 15
54:04
or 20 years, it's a time when the US government debt is B
54:08
is, is is ballooning as a fraction of GDP.
54:12
And we're on a binge, by the way, so is France,
54:15
so are several other countries.
54:19
We are looking at some very serious consequences
54:24
of deficit spending that have accumulated over decades now.
54:29
So I think the possibility that the Fed is going
54:32
to shrink its balance sheet,
54:35
driving up mortgage rates, forcing the private sector
54:39
to have to evaluate whether it really wants to hold
54:43
so much government debt at this particular moment, almost,
54:47
IM impossible I think for the Fed to pull this off.
54:51
And then of course, within five years,
54:53
I'd say we'll be in a new equilibrium,
54:55
the so-called fiscal dominance equilibrium, where
55:00
as a result of the arithmetic, the Fed will, will be forced
55:03
to monetize government deficits simply
55:06
to avoid a government default on debt.
55:09
And that will lead to a high inflation.
55:11
So unless we curtail entitlement expenditures
55:14
and defense expenditures
55:16
or some combination of them, which are the elements
55:18
that are growing Medicare, most importantly
55:23
also social security and defense spending,
55:25
unless we find a way to pull some
55:28
or all of those back, we're looking at inflation rates
55:32
that I would say will be at least 10% a year starting,
55:36
let's say about five years from now.
55:38
So for people your age, not my age,
55:42
you guys are paying the bills,
55:44
you're gonna pay the bills in terms of smaller benefits
55:47
and hi and or higher inflation,
55:51
people my age have been taking advantage of the entitlements
55:55
and postponing the day of reckoning.
55:58
And it's, it's really unconscionable.
56:00
So I I'm, I'm sorry to be so pessimistic,
56:03
but I, so far, I'm, I'm,
56:05
I'm batting a thousand on pessimism.
56:07
You're not gonna get any reforms
56:08
of prudential bank regulation.
56:11
You're gonna have a fiscal crisis,
56:12
you're gonna have high inflation.
56:14
You poor young people are gonna get fewer benefits
56:16
and likely some inflation.
56:20
- Well, you know, it's, I I'm, I share your view.
56:23
I think it's gonna, it's extremely difficult, I think
56:26
to move back to a system of obs scarce reserves
56:29
to move away from ample reserves.
56:30
I mean, even when the fed's balance sheet was, you know,
56:34
being decreased in 2019, we had the repo crisis, you know,
56:36
the, the banking system is just dependent,
56:39
heavily dependent on a system of, of,
56:42
of interest paying reserves.
56:44
That, and, and the whole sort of financial plumbing,
56:46
the repo system and so forth is, is is dependent on it.
56:50
I, I'm curious like, because this word gets thrown out a a
56:52
lot and it's a term that's coined
56:55
by Ron McKinnon in the late international economist who's a
56:59
professor at Stanford.
57:00
This is the, the term of financial repression,
57:02
I think it gets thrown around a lot.
57:04
I don't think there's actually a very good definition,
57:06
but I think in general it's used to refer to when the sort
57:10
of government represses interest rates for some reason.
57:14
And certainly, you know, there are I think
57:17
very clear instances of it in history, you know,
57:19
regulation q you know, where that the
57:22
governments have basically, you know,
57:24
said the interest rates, the positive pay are gonna be zero.
57:27
And and in part I think this is a subsidy of banks.
57:29
Some people have called quantitative easing
57:31
and I guess central bank, the existence
57:33
of central bank intervention in the, you know,
57:35
true term interest rate market.
57:36
I in general, I guess you could maybe think of as,
57:39
as financial repression, you know,
57:41
yield curve control on the long end the Bank
57:43
of Japan has been doing in recent years.
57:45
I mean, what, what do you think, I mean you've studied,
57:48
you know, global banking history over centuries.
57:50
What do you think about financial repression?
57:52
It's a term that comes up a lot now
57:54
and is it important, is it something
57:56
that we should still pay attention to?
57:57
I mean, they ended req a long time ago,
57:59
but are these things like QE
58:00
and you know, maybe excessive central bank intervention
58:03
in short term rates?
58:05
Certainly, I guess if, if it's the case that we're in a new
58:08
fiscally dominant equilibrium are is in your mind,
58:12
is financial repression newly relevant in some way?
58:15
- Yes, it is. It is. So actually Ron McKinnon was a mentor
58:18
of mine when I got my PhD at Stanford.
58:20
And I think one of the great
58:23
and maybe underappreciated economists of the 20th century
58:28
and his focus on financial repression, I think was
58:32
not just useful then, but useful now.
58:35
So you raised one aspect of it having to do
58:39
with the distorting interest rates.
58:41
Often the in, in the interest of some political objective.
58:44
I wanna mention another aspect of it.
58:48
And that is requiring banks
58:51
to maintain very high reserve ratios at zero interest
58:55
against their deposits.
58:57
So currently the, in the US we have a zero reserve
59:00
requirement, but
59:02
as I pointed out in a paper I wrote three years ago,
59:04
which was published in the St.
59:05
Louis Fed Review, once we hit the fiscal dominance
59:11
point where the Fed has to monetize
59:15
if we, if we don't get rid of do we have to do two things,
59:20
both of which are in the power of the Federal Reserve Board,
59:23
we need to get rid of all interest paid on reserves
59:26
and we need to require banks to hold a lot of reserves.
59:31
Now that means we're taxing the banking system
59:34
because we're gonna require them to hold maybe 20%,
59:38
let's say, of their deposits as reserves.
59:40
That's not that unusual throughout the world.
59:42
That would be unusual in the US though.
59:44
But so what's the, why is that financial repression,
59:48
because you're taxing the banks by telling them that 20%
59:52
of the deposit funds are taking in they can't
59:55
get any interest on.
59:56
But the reason that will be irresistible
59:59
to the Federal Reserve Board is simple arithmetic.
1:00:04
If you don't do that,
1:00:06
if you don't raise reserve requirements
1:00:09
and get rid of interest payments on reserves,
1:00:12
the implied inflation rate, if you don't change entitlements
1:00:17
or defense spending at all the implied inflation rate in the
1:00:20
us I know you're gonna think I'm smoking something is
1:00:25
greater than 30% a year.
1:00:28
If you tax the banking system
1:00:31
and require the banks to hold something like 20%
1:00:34
of their deposits as reserves, you, you cut
1:00:38
that inflation rate by more than half.
1:00:40
So you get the inflation rate down around 10 to 15%.
1:00:45
Now that may sound horrible,
1:00:47
but the point is the American public's gonna be very angry
1:00:50
about inflation,
1:00:52
but they'd be a lot angrier if the inflation rate were 30%
1:00:55
than if it were 10%.
1:00:57
So that the, where financial repression is McKinnon
1:01:00
realized, where it always comes from is fiscal
1:01:02
dominance always.
1:01:05
It comes from the fact that governments who are looking
1:01:09
for money look to the banking system
1:01:13
because it's one of the easiest things to tax often
1:01:16
because people don't even realize they're paying the tax,
1:01:19
the depositors are paying the tax,
1:01:21
but they don't realize it.
1:01:23
So it'll, it'll trash our banking system to do it,
1:01:27
but it's the political sort of path of least resistance.
1:01:31
So I'm also worried that we're gonna have this kind
1:01:34
of a shock to the banking system
1:01:36
of financial repression once we hit the fiscal wall.
1:01:40
And then we're going to have a, you know,
1:01:42
an interesting moment where we have to figure out,
1:01:46
do we want to have a chartered banking system that delivers
1:01:50
for our economy, all the good features of,
1:01:53
of financial intermediaries do, do we wanna do that?
1:01:57
Do we wanna push everything into shadow banks
1:02:01
that if you do, then
1:02:03
that reduces even the reserve tax, right?
1:02:05
It reserve reduces the tax base you get from repression.
1:02:08
So it's gonna be a really tricky moment there
1:02:13
because the path of least resistance is doing a little bit
1:02:15
of back of the envelope arithmetic.
1:02:18
You're looking at really high steady state inflation rates
1:02:22
and combined with financial repression, combined with a sort
1:02:26
of debilitating banking system,
1:02:31
debilitating the banking system.
1:02:34
So I wish I could be more positive,
1:02:37
but I, I can't be,
1:02:39
because this is what happens when a democracy
1:02:42
loses its intergenerational balance
1:02:46
where instead of planning on a balanced basis for current
1:02:50
and future generations, the myopia
1:02:53
of our political system has focused just on getting through
1:02:57
to the next election.
1:02:59
And it, it's, it's,
1:03:01
I never would've guessed if you had asked me in the 1990s
1:03:04
would the US go this far to basically, you know,
1:03:08
a Ron McKinnon kind
1:03:09
of remember Ron McKinnon's financial repression.
1:03:12
Well, that was intended for Banana Republics as an analysis
1:03:15
of Banana Republics.
1:03:16
It's turning out that we're a Banana Republic.
1:03:19
We can't plan for future generations.
1:03:24
- Well, I, and I'm, I'm with you.
1:03:27
I mean, I, I sell you a lot of physical issues and,
1:03:30
and a lot of my work is, is, and,
1:03:32
and a lot of the work of many scholars at Ubers is very,
1:03:34
very much focused on, on fiscal right now.
1:03:38
I, before just, I guess one last question for you, and,
1:03:41
and this is just on a very big topic right now in finra,
1:03:45
and that's the issue of stable coins
1:03:47
and whether they can offer yield or not.
1:03:50
I mean, I guess you could in part see this
1:03:52
as a fi repression sort of issue as well.
1:03:55
You know, right now there's stable coin legislation
1:03:58
that's going through Congress.
1:03:59
There's the Genius Act that has passed last year.
1:04:01
Basically the, the big point of contention right now
1:04:03
that's being fought between the crypto firms
1:04:05
and the banks are whether
1:04:08
or not stable coins can offer yield or not.
1:04:11
And the banks argue
1:04:13
that stable coins will disintermediate the banking system.
1:04:18
Stable coins argue that, you know, this is not a level
1:04:20
of playing field or the firms argue it's not
1:04:22
a level of playing field.
1:04:24
What's your take on all this?
1:04:25
I mean, at some level, I mean, do the banks sort of
1:04:28
similarly like launch the same complaints when money market
1:04:32
funds came around in the eighties and nineties and
1:04:34
- Exactly.
1:04:35
- Questions about whether they, they clearly didn't
1:04:37
dis the banks. They're so round
1:04:39
- The incumbent banks will be disintermediated
1:04:43
because they're, they're buggy whips, right?
1:04:45
I mean they're, they're, they're
1:04:48
a business model based on rent seeking
1:04:51
and rent sharing of a regulated entity.
1:04:55
That's part of a political bargain.
1:04:57
And what's interesting about stable coins is
1:05:00
that they are coming in
1:05:02
and from the payment system standpoint,
1:05:04
skimming the cream off off the incumbent banks
1:05:06
and say, we can provide a better payment system,
1:05:10
pay higher interest, clear, faster, clear
1:05:14
and more interesting ways like combined messaging with,
1:05:17
with clearing, we can do all this without any need
1:05:21
for a systemic risk problem.
1:05:23
There's a lot of, you know, what,
1:05:24
what do the politicians say?
1:05:25
Oh, this sounds so risky, risky, risky.
1:05:28
It's risky to them
1:05:29
because it could undermine their political bargain.
1:05:32
And of course it's gonna disintermediate the banks.
1:05:35
But what that might lead to, if,
1:05:37
if we were doing this the right way,
1:05:39
is modernizing bank charters
1:05:42
to allow these narrow banks focusing just on payments
1:05:45
without deposits using stable coins,
1:05:48
focusing on bank lending funded mainly by market sources
1:05:52
and starting to think about the unbundling
1:05:54
of the banking system, which it's, there's no longer a need
1:05:57
for these archaic structures that we're used to
1:06:01
and the centralized clearing through fed wire and all that.
1:06:05
This is not really needed anymore.
1:06:08
It's not where we should be going.
1:06:11
Of course, the political resistance is great,
1:06:16
whether we can do it,
1:06:18
and of course we should pay interest on stable coins.
1:06:20
It was a, a ridiculous thing
1:06:22
that the Genius Act prohibited it.
1:06:25
And of course, even at the time they passed it,
1:06:28
they already had designed this get around
1:06:31
by paying the interest on the platforms instead,
1:06:34
which I hope they'll continue.
1:06:36
And yes, that will disintermediate the banks,
1:06:38
but the solution is to get stable coins, to be banks,
1:06:42
to get other kinds of banks to come into existence
1:06:46
that will be part of a modern efficient consumer
1:06:49
serving financial system.
1:06:52
Now, of course, that's not very likely
1:06:53
because you can't just re rescind the laws of politics.
1:06:58
And these people are meeting in Washington.
1:07:00
These bankers are meeting with your elected officials
1:07:03
and other people's elected officials
1:07:05
and trying to strike bargains every day.
1:07:07
And the consumers whose, whose have
1:07:10
so much at stake in this, are not sitting at that table.
1:07:15
And that's the problem.
1:07:17
So I hope that, you know,
1:07:18
in the future we can solve all these problems somehow.
1:07:21
You know, there, there was so much hope in the 1990s
1:07:24
that the information age would make democracy smarter,
1:07:28
would make voters smarter and more effective.
1:07:31
Hasn't worked out that way.
1:07:33
- It's interesting. Yeah, just how, I guess I've long argued
1:07:37
that I, I think stable coins should be treated like banks.
1:07:38
So I I agree with you. I mean, it's interesting, I guess,
1:07:40
you know, at some level, stable coins, narrow banks, which,
1:07:43
you know, regulators have in, you know, in,
1:07:46
in the banking industry have, have wanted to outlaw for and,
1:07:50
and ban for quite some time.
1:07:51
You know, I think Jimmy Macres tried
1:07:54
to start the narrow bank a few years ago,
1:07:55
and he's the former research director of the New York Fed,
1:07:58
and he was sort of, you know,
1:08:01
there was a massive regulatory barrier there.
1:08:03
I mean, you also think back to like the, you know,
1:08:05
the Chicago plan ideas, you know, of fully backed banks
1:08:09
and, and narrow banks.
1:08:10
I think the, the concept of it maybe comes out of
1:08:13
that the Chicago plan or the idea
1:08:14
that the banks should maybe hold, you know,
1:08:17
a hundred percent treasuries or,
1:08:18
or should only issue equity.
1:08:20
I'm curious, I mean, if you have any other thoughts on,
1:08:22
I guess reinventing.
1:08:24
- So in the, in the old days, you know, I I I have argued
1:08:27
that this was a bad idea for a,
1:08:31
for a traditional banking system
1:08:33
because there really are synergies from bundling
1:08:36
deposit taking and lending.
1:08:38
But I don't think that's true anymore,
1:08:40
or at least it's much, much reduced
1:08:42
because of changes in technology.
1:08:45
And I think that's why you're seeing FinTech firms
1:08:49
are taking the form either of payment systems,
1:08:52
stable coins especially, or new ideas and lending
1:08:57
and those le and, and have very skinny balance
1:08:59
sheets if they're lenders.
1:09:01
They're not trying to, they can't, as non-banks,
1:09:04
they can't fund themselves with deposits,
1:09:06
but they can still operate, you know, so I think this is
1:09:09
where we're heading, we're heading toward, yes, this
1:09:14
stable coins will be basically narrow banks
1:09:17
and then lenders are going to be entities
1:09:20
that fund themselves with market debt
1:09:23
primarily, and some equity.
1:09:26
I think that's the system of the future.
1:09:28
It's not what the banks want to hear.
1:09:32
- So it'll be just stable coins
1:09:33
and non-bank lenders out there.
1:09:38
- No banks, I would say banks.
1:09:40
No banks because, yeah, so I don't think you can get a,
1:09:42
get rid of the idea that these need to be chartered banks,
1:09:47
partly because even if a bank is operating
1:09:52
without deposit accounts, it still will,
1:09:57
there's going to be some advantage from being able
1:10:00
to manage its risks by having access to the Fed.
1:10:06
And so I think you're gonna see chartered lenders
1:10:10
and chartered stablecoin providers
1:10:13
who will both be new kinds of bank charters and,
1:10:17
and especially on the lender side as they have to.
1:10:21
So how, how are they gonna manage their business?
1:10:23
They're gonna have working capital and securitization maybe.
1:10:26
So the working capital needs to be funded
1:10:29
with short-term debts, like commercial paper kind of things.
1:10:32
And that means it's subject to rollover risks
1:10:36
that can be very disruptive.
1:10:38
So just like we had,
1:10:39
remember we had a commercial paper crisis in 1970,
1:10:44
the Penn Central Crisis, which the Fed intervened in.
1:10:48
So the, the important thing to kind
1:10:50
of realize is deposits aren't the only kind
1:10:53
of short-term debt.
1:10:55
And as we move to banks
1:10:58
that are doing lending based on working capital
1:11:01
to fund securitization, let's say, if that's the model,
1:11:04
they'll pick that working capital will still create some
1:11:08
systemic liquidity risk.
1:11:09
And in fact, what we're seeing is the shadow banks right now
1:11:13
are still relying hugely on the banks for lines of credit.
1:11:18
Why? Because the banks have access to the Fed.
1:11:22
So actually, you know, in terms
1:11:24
of managing systemic liquidity risk, we're, we're still,
1:11:28
I think, going to need chartered banks
1:11:30
where the charter is basically making sure
1:11:34
that the examination of what's going on is consistent
1:11:37
with having access to
1:11:39
ultimately a taxpayer funded discount window.
1:11:43
So I think this is where it gets really interesting is the
1:11:46
whole future of, of the charting
1:11:48
of banks should change moving away from the incumbent
1:11:52
bundled banks to allowing banks to be much more specialized.
1:11:56
- This has really been a fascinating conversation, Charlie,
1:11:59
a real honor to have you on.
1:12:01
Really fantastic talking about all things banking
1:12:04
and your amazing career in contributions
1:12:06
and finance and economics.
1:12:07
Really wanna thank you for coming on.
1:12:09
- Thanks so much, John.
1:12:10
Thanks for your great questions and for your patience.
1:12:12
- This is the Capital and Freedom the Train First Century
1:12:14
podcast, an official podcast
1:12:16
with the Hoover Institution Economic Policy working group
1:12:18
where we talk about economics, markets, and public policy.
1:12:21
I'm John Trevor, your host. Thanks so much for joining us.