Capital market freedom

I gave a presentation on "capital markets" at the Hoover Centennial series on Tuesday.  Caroline Hoxby gave a clear  presentation on human capital, and George Shultz told  some great  stories  from his time in government. Judging from the questions, Caroline was the star and  I put them to sleep. Finance always does that. The  video:

Here is the text of my  presentation

Hoover  stands for freedom: ideas defining a free society is our motto.  And economic is a central freedom: You can’t guarantee political freedom, social and lifestyle freedom, freedom of speech and expression, without economic freedom.

Economic freedom applies to capital; to financial  freedom, as much as to goods, services, and labor.  Freedom to buy and sell, without a government  watching every transaction. Freedom to save, and invest your capital with the most promising venture, at home or abroad, or to receive investment from and sell assets to anyone you choose — whether the investments conforms to a government’s plans or not.

But freedom is not anarchy. Economic and financial freedom depend on a public economic infrastructure. They need functioning markets, property rights, an efficient court system, rule of law; They need a stable and efficient money, and a government with sound fiscal affairs  that will not inflate, expropriate, or repress finance to its benefit, and freedom from confiscatory taxation.

Here lies our conundrum. The government that can set up and maintain this public architecture can restrict trade and finance. Businesses, workers and other groups can demand protection. The government can control finance for political ends and to steer resources its way. And that ever-present temptation is stronger for finance. Willie Sutton, asked why  he  robbed banks,  responded   “that’s where the money is.” Governments have noticed as well.

Ideas matter. People care about prosperity, too. Citizens and voters must understand that their own freedom, and that of their neighbors, is the best guarantor of their and the common prosperity. 250 years after  Adam Smith, most of US still really does not trust that fervent competition is their best protection, not extensive regulation. See our rent control and labor laws. That necessary understanding remains even more tenuous in financial affairs

Can a more free financial, payments, monetary, and capital market system work? How? It is our job — ours, the ideas-defining-a free-society people  —  to put logic and experience together on this question. And the answer is not obvious. Finance paid for our astonishing prosperity. But the history of finance is also full of crashes, panics, and imbroglios. Government finance won wars, but also impoverished nations.  Economic freedom does  not mean freedom to  dump garbage in neighbor’s back yard. Just where this parable applies to financial markets is an important question.

The last 100 years have been a great  ebb and flow of freedom in financial and monetary affairs. The immediate future is cloudy, suggesting more ebb, but offering some hope for flow

Hoover scholars have been and are in the midst of it. Milton Friedman spent a quarter century here, advancing free exchange rates, free trade, open capital markets, sound money, and sound fiscal policy. John Taylor took up that baton. Allan Meltzer, author of the magisterial history of the Federal Reserve, was a  frequent visiting fellow here.  George Shultz spearheaded the transition to floating exchange rates and free capital movement, fought valiantly against price controls, and anchored the Reagan Administration’s effort to eliminate inflation and fix  the tax code. Many others contributed, and Hoover is just  as alive  today.

We  could  spend  an afternoon on the financial history of the last 100 years. I’ll just focus  on three pivotal stories.

Bank and financial panics have been central to the ebb and flow of financial freedom for all of the last hundred years. The banking  panic of 1933 was surely the single event that made the great depression great. It was centrally a failure of regulators and regulation. The Federal Reserve was set up in 1914, to prevent another panic of 1907.  And it promptly failed its first big test.  Micro-regulation failed too. Interstate banking and branch banking were illegal. So, when the first bank of Lincoln, Nebraska failed, it could not sell assets to JP Morgan, who could have  reopened the bank the next day. The bank could not recapitalize by selling shares.  So the people who knew how to make loans were out selling apples.

As usual, the response to a great failure of regulation was... more regulation. Deposit insurance protected depositors. But offering insured deposits to bankers is like sending your brother-in-law to Las Vegas with your credit card. So the government started extensively regulating how banks invested, and forbade banks to compete for deposits. But people in Las Vegas with  your credit card, for 20 years, get creative. From Continental Illinois to the savings and loan Crisis, to the Latin American and Southeast Asian crises, to LTCM, and Bear Stearns, and finally the great crisis of 2008, we repeated the same story: bailout larger classes of creditors, add regulations to try to stop more creative risk taking, add power to regulators who really really will see the next one ahead of time, promise it won’t happen again. Dodd Frank, and today’s “macroprudential” policy are not new, they are just the last logical patch on the same leaky ship.

An alternative idea has been around since the  1930s. Financial crises are runs, period. Runs are caused by a certain class of contract, like deposits, which promise a fixed value,  first-come first-served payment, and the bank fails if it cannot pay immediately. Then, if I hear of trouble at the bank, I run  down to get my money before you do, and the bank  fails. The solution is simple —  let  banks get their money largely by issuing equity and long term debt.  Such banks need no asset regulation, and no protection  from competition, as  they simply  cannot fail. Run prone short term debt financing is the garbage in the neighbor’s back yard, and eliminating it is the key to financial freedom — and innovation.

Many of us at  Hoover have been advancing this idea, adapted to modern technology, along with reform of the bankruptcy code so that large banks can fail painlessly, a lesson we should have learned from the 1930s. It is slowly gaining traction in the  world  of ideas, though not  yet in the world of policy. A lot of vested interests will lose money in this free world, not the least of which the vast regulatory bureaucracy and economists who serve them more welcome ideas.

Second, let’s talk about international trade and capital flows.  Financial freedom includes the right to buy and sell abroad as you see fit, and to invest your money or receive investment from wherever you wish, even if that crosses political boundaries. As always that freedom leads to prosperity.

The world learned a good lesson from the disastrous Smoot-Hawley tariffs of the 1930s. So, the  postwar order built an international system aiming for free trade and free capital markets.  Now  free trade and capital should be easy. They take one-sentence bills, ideally that start “Congress shall make no law…” But each government faces strong pressure and temptations to protect its weak industries, and their employees, and to redirect its citizens’ savings to pet projects, favored sectors, and to government coffers, mixed with frankly xeonophobic fears of “foreign ownership.” So the postwar order was a long hard slog, with international institutions, long international agreements that are more managed mercantilism than free trade, and consistent US leadership.  Capital  freedom took even  longer than trade freedom. As recently as the 1960s, US citizens were not allowed to take money abroad. Many people around the world still fact such restrictions.

This time, a crisis helped. The Bretton Woods system of 1945 envisioned free trade but little net trade, so it wanted fixed exchange rates and allowed capital controls to continue. The US deficits and inflation of the early 1970s blew that apart, leading to floating exchange rates and open capital markets.

By the 1990s, the world entered an era of vastly expanded trade and international investment, strong economic  growth. The last 30 years  have seen the greatest decline  in poverty around the globe in all human history. Now much-maligned “globalization” and “neo-liberalism” was a big  part of it.  I think we shall remember it nostalgically alongside the free-trade and free-capital pax Britannica of the late 19th century.

But crises often lead to bad policy in international finance as  well. The Latin American and Southeast Asian crises of the 1990s, even before the great financial crisis of 2008 unsettled many nerves. To me the stories look  familiar: Latin American governments borrowed too much money, again, and US banks found a way to leverage their  too-big-to-fail guarantees around the supposedly wise oversight of  risk regulators, again. East Asian governments were on the hook for their banks' short term borrowing and big American banks were lending again.

But the policy community, and countries wanting cover for bailouts and expropriations, convinced themselves that dark forces were at work, “hot money” “sudden stops,” and that all foreign capital — not just short-term foreign-currency debt — is dangerous and must be controlled. Now even the IMF, formerly the bastion of free exchange rates, free capital flows, and fiscal probity, advances capital controls, exchange-rate intervention, and government spending on solar cells and consumer subsides, in the name of climate and inequality, even in times of crisis.

Moreover, I think the world of ideas failed really to understand what it had created. For a generation economists scratched their heads that countries seemed to invest mostly out of their own savings rather than borrow from abroad, and called this a puzzle. When the world started to look like our models, and huge trade and capital surpluses and deficits emerged, economists pronounced “savings gluts” and “excessive volatility” needing “policy-makers” to “manage flows,” and lots of  clever economists  to  advise them.  Time-tested verities do not get you famous in economics.

Let me close by speculating a bit about the future. It will be an… well an exiting time for those of us who value ideas in defense of a free society and who think about money, finance, and capital.

Sooner or later, if  our path does not change, the western world will confront a sovereign debt crisis. Our governments have  made  promises they cannot keep, buttressed  by economists bearing the singularly bad idea  that  debts do not have to be repaid.  Since government debt is the core of the financial system, most of which counts on a bailout of borrowed money, the subsequent financial crisis will be unimaginably awful.

Payments,  technology and financial  innovation will force some fundamental  choices.

We are headed to a world of  electronic rather than cash transactions.  But cash has one great freedom-enhancing virtue: anonymity. If the government  can watch everything you buy and sell, or exclude people from the ability to transact, all sorts of freedoms vanish.  Now Governments have good reasons to monitor transactions  to better collect  taxes, and to make life difficult for criminals, drug smugglers, and terrorists. But governments have many bad reasons: to impose capital controls and trade barriers, to prop up onerous domestic regulations, and to punish political enemies, foreign and domestic.

So a great battle of financial freedom will play out. Will the emerging electronic payments  system work on the Chinese social credit model? Or  will innovation undermine leviathan — and  undermine even basic law enforcement efforts? Can we reestablish a balance between anonymity, freedom, and optimally imperfect enforcement of often ill-conceived financial laws and regulations?

In a larger sense, Silicon Valley is trying  to do to finance what Uber did to taxis. Will the Fed and Congress  allow narrow banks, electronic  banks, payments networks like Libra, and internet lenders to compete and serve us better? Or  will they continue to defend by regulation the oligopoly of banks and credit card companies?

Larger questions hang over us. On one political side seems to lie business as usual — unreformed, highly regulated banks, the usual subsidies  such as Fannie and Freddy, student loans, and so on, with increasing restrictions on international trade and investment. On the other side lies a large increase in bank regulation, direction of credit to green new deal projects and favored constituencies, and extreme levels of capital taxation. From the Fed, central banks, IMF, OECD, BIS, CFPB, and so on, I hear  only projects for ever larger expansion  of their role in directing finance.

I do not hear many voices for patient liberalization. Ideas defining a free society will be sorely needed.

********


The Q&A was interesting. John Raisian wisely preempted  the usual "what about inequality?"  question. My main regret was not answering cogently enough the questioner who asked (paraphrase) "Now that unions are gone, who will speak for the little guy (or gal)?" What I should have said, in addition to what I did say:

The little guy or gal voluntarily dropped out of unions, and voted against pro-union politicians, because they felt unions did not speak for them. If you're a Republican, a Libertarian, a fan of school  choice, concerned about pension debt, unions do not speak for you. A lot of formerly union people voted for Trump. Unions became government-supported advocates  for  one wing of one political party, and their members left in droves. Political  parties "speak for" you if you  wish someone to do that.  Not unions.