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in money and banking, and their impact
on the world's leading economies

Are Well Capitalised banks the safest?

 

16th March 2017  - Professors Tim Congdon and Steve Hanke jointly authored an Op-Ed in the Wall Street on the subject of bank capitalisation.

Professor Congdon summarised the piece as follows:-

Dear  fellow macroeconomists and monetary analysts,

Steve Hanke of Johns Hopkins University and I have contributed an article to The Wall Street Journal on 'More bank capital could kill the economy'. It appears in yesterday's edition. It is covered by copyright protections and I cannot reproduce it, but please go to https://www.wsj.com/articles/more-bank-capital-could-kill-the-economy-1489446254 if you are interested.

The piece is a response to a proposal from Neel Kashkari, president of the Federal Reserve Bank of Minneapolis, that banks should double their capital/asset ratios. Kashkari is far from alone in believing that well-capitalized banks are safe, and when banks are safe, they cannot threaten the cyclical instability that was recently exemplified, in traumatic circumstances, by the Great Recession of late 2008 and 2009.

Always implicit, and sometimes explicit, in the analyses that come from Kashkari and similar figures is an allegation. This is that banks and bankers were to blame for the Great Recession. There is something rather odd about these allegations, as banks themselves are a fairly small part of the economy (usually accounting, in most countries, for under 5% of gross value added) and their losses are a trivial fraction of the capital stock. How can they be so important? In truth, Kashkari & Co. do not appeal to an organized, widely-recognized theory of the determination of national income and wealth. Someone may have put forward a theory that losses in the banking industry are by themselves a major determinant of economic activity, but I have never seen it in an established textbook or a much-cited academic article.

Of course, economics does have organized, widely-recognized theories of the determination of national income and wealth. The favourite in classroom instruction is the Keynesian income-expenditure model, in which national income is a multiple of autonomous expenditure (i.e., of investment and government spending). For various reasons I don't rate this theory and instead prefer the quantity theory of money, and the related monetary theories of the determination of national income and wealth.

The key point of the Hanke-Congdon article in yesterday's WSJ is that official action to boost banks' capital/asset ratios since 2008 has had perverse and counter-productive results. When banks are forced by regulation to have higher capital/asset ratios, they can either raise more capital or reduce their risk assets. (I trust this is obvious.) If banks raise more capital, subscribers to the new capital have to pay for it from their deposits, which disappear from the economy. As deposits are nowadays the main form of money, the consequence is a destruction of money balances. If banks reduce their risk assets, they can sell off assets to non-banks, when - again - a payment is made from deposits, which disappear from the economy etc. Alternatively, they can halt new lending or try to secure the early repayment of loans from existing customers. When a company pays off a loan, it does so from a deposit. The deposit is paid over to the bank and drops to nothing, and so disappears from the economy etc.

In other words, an important effect of moving to a higher capital/asset ratio in the banking industry is to destroy money balances. At the least the macroeconomic data are likely to see a reduction in the rate of money growth or even a fall in the quantity of money. If one believes (as Hanke and I do) that the quantity of money and nominal national income are related, an official push for extra bank capital is deflationary. That is why 'more bank capital could kill the economy', just as the (crazily mistimed) demands for extra bank capital from October 2008 caused the Great Recession.



The argument here will not be new to those who have followed my work over the last few years, but it is a breakthrough to have it appear in the op-ed pages of The Wall Street Journal. (I am very grateful to Steve Hanke for obtaining this opportunity.) Over time the argument will - I expect - receive more attention and start to influence the public debate, on this side of the Atlantic as well as in the USA. More generally, the Great Recession was not caused by the inherent instability of free-market capitalism. Instead it was caused by an almost impossibly stupid blunder in official regulation and was avoidable. (Some cyclical reverse was inevitable after the excessive money growth and asset price excesses of 2005 - 07, as I said during late 2006 and early 2007. But the very severe downturn of late 2008 and early 2009 was not necessary. The notion is sometimes circulated that the Lehman bankruptcy was responsible for the Great Recession. That is baloney. It led to losses of about $150b. mostly for such organizations as Goldman Sachs, Bank of America and JP Morgan. $150b. is a number which - absorbed over a few years - would hardly bother them all that much; it certainly ought not to cause sudden falls in global demand and output more than 30 times as large.)

I attach an initial draft of the article, which was written by me. Only some of this survives in the WSJ version. I also add to the draft a couple of slides on the International Monetary Fund's estimate in April 2009 that US banks would suffer asset write-offs of $1,600b. on their 2007-2010 business. It was this estimate that was fed into the policy-making process and was one input for the demands (from the G20, the Bank for International Settlements, etc.) for extra bank capital. (The IMF's work provoked assertions that the entire American banking system was bust. I am not joking.) As I show (using date from the Federal Deposit Insurance Corporation), the IMF's estimate was wildly wrong.

Officialdom's mania for bank recapitalization, and ever-higher levels of bank capital, has done great damage to Western advanced economies since 2008. It continues to pose a major challenge to free-market capitalism - and must be resisted.