Sunday, May 11, 2014

Plus ça change

Corresponding on the "Run Free Financial System," François Velde at the Chicago Fed sends me an interesting paper, "Early Public Banks" with William Roberds.  François and William document nicely just how long bank runs have been going on, just how long we've been struggling with money-like bank liabilities, and just how long narrow-banking proposals have been around.

The focus of the paper is on "Public banks," predecessors of central banks.

Abstract: Public banks were created to "create a liquid and reliable monetary asset," but "even well-run banks could become unstable over time as their success made them susceptible to fiscal exploitation." "A prominent exception was the Bank of England, whose adept management of a fiscally backed money provided a foundation for the development of central banks as they exist today." I think we have about a thousand years of experience well distilled in those few sentences.

Runs go back a long way. Here is a lovely description (p. 16):
When advocating the creation of a public bank in 1584, Tommaso Contarini... emphasized the inherent fragility of the banking business (Lattes 1869, 124):
A suspicion born, a voice heard, that there is no cash or that the banker has suffered some loss, a person seen at that time withdrawing money, is enough to incite everyone to take his money and the bank, unable to meet the demand, is condemned to fail. The failure of a debtor, a disaster in some venture, the fear of war is enough to destroy this enterprise, because all creditors, fearing the loss of their money, will want to insure themselves by withdrawing it and will bring about its complete destruction. It is too difficult, indeed impossible that in the space of a few years one of these events fails to occur that bring about the ruin of the bank. 
Bank-created money goes back a long way:
That banks did not maintain 100% reserves is apparent from a law of 1322; indeed, it appears that by then the main elements of the payments system were in place: payment in bank money (that is, by transfer on the books of a bank) was considered final payment, that bankers kept fractional reserves, and that they kept accounts with each other.
 1322.  Bank regulation goes back a long way:
The [1322] law also indicates that legislators felt the need to intervene, since it required bankers to redeem deposits on demand within three days, and in cash rather than with claims on other bankers (Mueller 1997, 16).  This was but one of many legislative attempts to remedy the fragility of banks, which more often relied either on some primitive form of capital requirements or else restricted allowable activities.
If you will recall, the central innovations of the Dodd-Frank act are.. to impose capital requirements and to restrict allowable activities.
Venice did not have limited liability as Siena and Florence did, so a banker’s patrimony provided security in addition to the bond...
Clawbacks, skin-in-the-game rules, and so on go back a long way.
The first proposal for a public bank was made in 1356, following the failure of a major bank and a resulting liquidity crunch marked by high interest rates (Mueller 1997, 112,142). The Senator Giovanni Delfin proposed that a bank be set up alongside existing private banks, headed by three noblemen appointed by the city. It would be prohibited from lending or investing money and paying interest: its sole function was to receive deposits for the purpose of making payments by transfer. 
Narrow banking proposals go back a long way. In the 21st century, we allow noblewomen too to run our central banks. Progress.

François chides me gently, that if bank debt and bank runs have been with us for nearly a thousand years, and if narrow banking based on government debt has not succeeded in all that time, surely there must be a reason. I gave two answers, expanding a bit on the arguments in "run-free." First, technology has really changed. We don't need fixed-value claims for transactions or liquidity. Electronic transactions, index funds, instant communications make a difference. Second, not all that is, is good. The Venetians also poured sewage into the lagoon for centuries. Short term runnable debt really is an externality, so its existence is not proof of its optimality.

But I appreciate François' insistence on this point. There is merit in the Chicago philosophy: if you see something durable that you don't understand, work harder to figure out why it lasts so long. It's the opposite of the Cambridge philosophy: if you see something durable that you don't understand, get on a plane to Washington and tell them to pass a law making the world in to the way you think it should be. (I use "Chicago" and "Cambridge" just as humorous ways to describe a philosophy, as plenty of interventionists live here, and there is lots of humility there.) Somewhere in the middle is the optimum.

Blog readers who don't know François, take the aftenoon off and read "Macroeconomic Features of the French Revolution" with Tom Sargent. All of modern monetary and macroeconomics unfolds, pretty well understood by the actors of the time.  Proceed to a Chronicle of a Deflation Unforetold. 18th century France had a fascinating dual currency system, with a unit of account "Livres" separate from the medium of exchange "ecus." Find out what happens when the exchange rate changes. Proceed to The Big Problem of Small Change also with Tom. It reads as a thousand-year discovery of MV=PY, though I read it as a thousand-year discovery of the fiscal theory of the price level. I've been plotting blog posts on all three at some point. (And plenty more, but that's a good start.)

In any case, you will be humbled by how well our ancestors understood monetary issues, and how hard they struggled with the same issues we do. (And, like me, you'll wish you could write papers like these.) It makes you wonder if we're really making progress. In the end I think that being able to write down the equations and quantify the results of old ideas really is progress after all. Diamond and Dybvig really are better than Contarini, no matter how poetic the latter, in part because it's much harder to come up with contrary equations than it is to come up with even more poetic prose that describes fallacies. But most economists don't appreciate that these issues go back quite so far, or that our forebears understood things as well as they did.

PS:  François sent along the original of the above quote in 16th century Venetian (see bottom of p. 124 on the link) which fellow italophiles will appreciate for its poetry. It also raises my appreciation for the kind of original source material François plods through to find these gems.
Un suspetto che nasca, una voce, che si senta, che non vi sia danaro, ò che il banchier habba patido qualche perdita; una persona, che si veda in tal occasion à estraher contadi, è bastante à eccitar tutti, che vadano à cavar i suoi danari; à che non potendo supplir in banco, è astretto à ruinar senza remedio. Un fallimento di qualche suo debitor, un sinistro di qualche suo negotio, il timor di una guerra, è causa potente à destrugger questa fabrica ; poiche tutti i cerditori insuspettidi di non perder il suo danaro, per assicurarsene vanno à estraherlo, e gli apportano la total iattura.
Più cambia, più è la stessa cosa.


  1. If 100% equity banking were optimal, it would have spontaneously arisen somewhere in the world in the last thousand years and come to dominate global banking. Indeed, banking will have started as 100% equity with money lenders just lending out their own capital.

    1. If pollution controls were optimal, they would have spontaneously arisen somewhere in the world in the 2000 years before 1970, and come to dominate global industry.

    2. Banking will have started when farmers took their grains to third party granaries for safe keeping and were issued storage notes... well, actually we can't know where and when the first "bank" came about and if were grains or precious metals that were being deposited. But we can be pretty sure that the bank's function as a haven was the impetus for its birth and that interest/loans/insurance/exchanges/equity were subsequent inventions...

      It is the conflation of these two (probably mutually exclusive) purposes, safe-keeping and money-making, that causes the financial carnage.

    3. Absalon,

      Large scale banking (central banking) began as governments realized the benefits of a country operating with a single unified medium of exchange. Indeed, Alexander Hamilton (U. S. Treasury Secretary) is often referred to as the first central banker of the U. S and was a leading proponent for the creation of the First Bank of the United States:

      "According to the plan put before the first session of the First Congress, Hamilton proposed establishing the initial funding for the Bank of the United States through the sale of $10 million in stock of which the United States government would purchase the first $2 million in shares. Hamilton, foreseeing the objection that this could not be done since the U.S. government did not have $2 million, proposed that the government make the stock purchase using money lent to it by the Bank; the loan to be paid back in ten equal annual installments."

      Notice how Hamilton proposes a borrow the money to buy the stock scheme? There is a bit of chicken and egg problem here:

      1. Start an economy with no money whatsoever
      2. Insist that banks must sell equity before they can make their first loan
      3. Where does the money come from to buy the equity?

      Which is your answer why 100% equity banking never took hold. I might also add that the first publicly traded shares were for the Dutch East India Company (founded circa 1602). Debt has been around seemingly forever, publicly traded equity is a relatively new invention.

    4. "declines in values of existing assets are mostly redistributional: if home values fall by half, those planning to sell large houses and downsize lose"

      If we want to discuss bank runs, surely we must consider the exposure of banks to home values. You suggest that if banks are financed purely with equity, then they can endure the collapse of a housing bubble, without failing. In a technical sense, that is true. But why would home prices suddenly drop so quickly? And is that not equivalent to a bank run in some sense? Some economists argue that housing bubbles indicate inadequate liquidity provision. Does narrow banking solve that problem, or worsen it?

      If we also consider the serious misallocation of resources towards construction, then the prevention of housing bubbles should be an important consideration in financial regulation. We want people to stop using houses as money, because the pecuniary externality affects us all - even if banks are protected from insolvency. Let's give them more, and better, money than what they are using now.

    5. Absalon,

      The reason 100% equity banking has never appeared is that there is a fraudulent activity that undercuts it: fractional reserve banking.

      Fractional reserve is fraudulent because it involves promising depositors $X back for every $X deposited, while that money is loaned on or invested, and loans and investments are certain to go wrong sooner or later. At which point the $X can’t be returned. And if you want proof, witness the fact that fractional reserve banks have gone bust regular as clockwork for centuries (except when they’re offered trillion dollar bailouts gratis the taxpayer).

      Of course if depositors ACCEPTED that loss, then OK. But they don’t: they demand deposit insurance (funded by taxpayers in most countries). But if they DID ACCEPT the loss, then their stake in the bank becomes very near to being a shareholding, not a deposit: which makes the bank pretty much a 100% equity bank!!!!!

      As to whether those share type deposits should be converted to full blown shares, the answer is “yes” in the case of all but the smallest banks because that helps avoid systemically damaging runs.

    6. Ralph,

      "As to whether those share type deposits should be converted to full blown shares, the answer is yes in the case of all but the smallest banks because that helps avoid systemically damaging runs."

      Why should the smallest banks be excluded?

    7. "The reason 100% equity banking has never appeared is that there is a fraudulent activity that undercuts it: fractional reserve banking."

      Yes!! Thank you! (I finally understand the phrase "bad money chases away good".)

    8. Ralph,

      "Fractional reserve is fraudulent because it involves promising depositors $X back for every $X deposited, while that money is loaned on or invested, and loans and investments are certain to go wrong sooner or later."

      First, you and I have different definitions of fraud - in a legal construct, fractional reserve banking is perfectly legal and thus not fraudulent.

      Second, depositor flight can occur even if all of the loans held by a bank are current and in good standing. For example, a bank can hold a bunch of 30 year home loans at 5-6% interest, but depositors leave for better returns elsewhere (see certificate of deposit brokers during the S&L failings of the 1980's).

      "Of course if depositors ACCEPTED that loss, then OK."

      Which loss are you talking about? The loss that occurs when loans / investments held by a bank go sour or the loss that occurs when other depositors in the bank leave for greener pastures?

      Simple example:

      Bank A has $1 million is deposits and $1 million in 30 loans at 5% interest. Bank B comes along and starts making loans at 10% interest. Bank B then hires a brokerage to sell CD's at 8% interest (brokerage keeps the other 2%). $250,000 of deposits leave Bank A to buy Bank B's CDs.

      Suddenly Bank A has only $750,000 in deposits and $1 million in loans even though all of those loans are performing. How should those $750,000 in deposits bear a loss? Should the value of the loans be written down even though they are all performing?

  2. "Public banks were created to 'create a liquid and reliable monetary asset'" - it looks like earlier generations understood the need to reduce friction, while we propose retrograde steps that would reduce the money supply. I think that Gary Gorton best embodies the Chicago philosophy by updating our concept of money, while narrow bankers follow the Cambridge way by trying to throw sand in the gears - instead of more oil.

    If monetary theory is too difficult for asset-pricing experts to understand, then let's eliminate the need for it - by creating so much money that we no longer need to worry about bubbles, and runs on the banks that invested in them.

  3. "Short term runnable debt really is an externality"

    Shaky ground here. This is a pecuniary externality (one that acts through prices, and does not justify government intervention) as opposed to a physical externality (one that acts through the production function and does justify government intervention). Uber and Lyft are imposing pecuniary externalities on the taxi industry, and even causing taxi drivers to lose their jobs, but that does not justify government intervention in the taxi industry.

    1. So the run on shadow banks and some larger investment banks like Lehmans five years ago which caused the biggest economic collapse since 1929 and five years of excess unemployment wasn’t an “externality”?

    2. Ralph:
      As I said, it was a pecuniary externality, not a physical externality.

    3. Mike,

      So you're saying there was no “physical externality” involved in the credit crunch? Strikes me that large scale home re-posessions, big rises in unemployment and GDP falling will below trend growth is an enormous “physical externality”.

    4. Ralph:
      No, it's an enormous pecuniary externality. If someone had done something to physically damage those houses, that would have been a physical externality.

    5. Mike,


  4. Bravo se possa capire il dialetto veneziano del 16 secolo! Secondo me è un po' difficile.

  5. John

    I think your reading of "The Big Problem of Small Change" should be supplemented with this review by Neil Wallace As Wallace notes, their model (such as it is) leaves a lot to be desired, and largely ignores the important monetary models of the last 25 years.


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