Equity financed banking is inefficient

I see that Tyler Cowen and John Cochrane are having an exchange about banking. First, Cowen expresses a nuanced view of banking, then Cochrane takes the opportunity to promote his narrow (aka equity-financed) banking proposal, and Cowen questions how successful equity-financed is likely to be in practice.

With my latest paper, I have something different to contribute to the discussion: a model of how banking — and the leverage of banks — promotes efficiency. From a macro perspective the argument is really very simple: we all know from the intertemporal Euler equation that it is optimal for everyone to short a non-interest bearing safe asset. (The Friedman Rule is just an expression of this fact.) The point of my paper is that we should understand banking as the institutionalization of a naked short of the unit of account.

How is this efficiency-enhancing? A naked short position requires you to sell something that you do not have. It is a means of creating a temporary “phantom” supply of what is sold, until such time as the short position is closed out. The Euler equation tells us that a “phantom” supply that supports short positions is exactly what the economy needs to achieve intertemporal allocative efficiency.

Of course, the problem with a naked short position is that if a short squeeze (aka bank run) forces the closure of the positions too early, bankruptcy will be the result. The paper is a careful study of what is necessary to make this role of the banking system incentive feasible, and finds (alongside many other studies) that competitive banking is inherently unstable. Two means of stabilizing banking in the context of the model are (i) the natural monopoly approach: permit a non-competitive industry structure, but regulate what banks can charge; or (ii) the central bank approach: set a lower bound on the interest rate banks can charge.

So I don’t think that Cowen really captures what banks do when he presents “transforming otherwise somewhat illiquid activities into liquid deposits” as the primary liquidity function of banks. In my model banks promote allocative efficiency by creating “phantom” units of account. But I think Cowen does capture a lot of the regulatory complexity that is created by the liquidity function of banks.

Cochrane is the one, whom I really think is working from the wrong model. I’ll go through his points one by one.

1) We’re awash in government debt.

So what. Unless the government is going to start guaranteeing private sector naked short positions in government debt, it doesn’t matter how government debt we have, because it will do nothing to solve the monetary problem. We need banks because they do make possible for the private sector in aggregate to support a naked short position in the unit of account (that’s what bank deposits are) and this is necessary for intertemporal allocative efficiency.

2) Liquidity no longer requires run-prone assets. Floating value assets are now perfectly liquid

This view fundamentally misunderstands the settlement process in securities transactions. I responded to this view in a previous post and will simply quote it here:

Cochrane, because his theoretic framework is devoid of liquidity frictions, does not understand that the traditional settlement process whether for equity or for credit card purchases necessarily requires someone to hold unsecured short-term debt or in other words runnable securities. This is a simple consequence of the fact that the demand for balances cannot be netted instantaneously so that temporary imbalances must necessarily build up somewhere. The alternative is for each member to carry liquidity balances to meet gross, not net, demands. Thus, when you go to real-time gross settlement (RTGS) you increase the liquidity demands on each member of the system. RTGS in the US only functions because the Fed provides an expansive intraday liquidity line to banks (see Fed Funds p. 18). In short RTGS without abundant unsecured central bank support drains liquidity instead of providing it. (See Kaminska 2016 for liquidity problems related to collateralized central bank support.) In fact, arguably the banking system developed precisely in order to address the problem of providing unsecured credit to support netting as part of the settlement of payments.

Just as RTGS systems can inadvertently create liquidity droughts, so the system Cochrane envisions is more likely to be beset by liquidity problems, than “awash in liquidity” (p. 200) – unless of course the Fed is willing to take on significant intraday credit exposure to everybody participating in the RTGS system. (Here is an example of a liquidity frictions model that tackles these questions, Mills and Nesmith JME 2008). Overall the most important lesson to draw from Cochrane’s proposal is that we desperately need better models of banking and money, so we can do a better job of evaluating what it is that banks do.

3) Leverage of the banking system need not be leverage in the banking system.

Because the purpose of banking is to promote economic efficiency by providing society with “phantom” units of account, we need leverage in the banking system. What Cochrane calls “banking” cannot play the role of banks as I model them.

4) Inadequate funds for investment

My model of banking does not provide funds for investment — as least as a first order effect. My model of banking only provides funds for transactions. On the other hand, as a second order effect by promoting allocative efficiency, it seems likely that banks make investing more profitable than in an environment without banks. So an extension of the model that shows that banking promotes investment should not be difficult.

In short, both Tyler Cowen and John Cochrane are in desperate need of a better model relating the macroeconomy to banking. It’s right here.

 

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In Defense of Banking II

Proposals for reform of the monetary system based either on public access to accounts with the central bank or on banking systems that are 100% backed by central bank reserves and government debt have proliferated since the financial crisis. A few have crossed my path in the past few days (e.g. here and here).

I have been making the point in a variety of posts on this blog that these proposals are based on the Monetarist misconception of the nature of money in the modern economy and likely to prove disastrous. While much of my time lately is being spent working up a formal “greek” presentation of these ideas, explaining them in layman’s terms is equally important. Thanks to comments from an attentive reader, here is a more transparent explanation. Let me start by quoting from an earlier post that draw a schematic outline of Goodhart’s “private money” model :

The simplest model of money is a game with three people, each of whom produces something another seeks to consume: person 2 produces for person 1, person 3 produces for person 2, person 1 produces for person 3. Trade takes place over the course of three sequential pairwise matches: (1,2), (2,3), (3,1). Thus, in each match there is never a double coincidence of wants, but always a single coincidence of wants. We abstract from price by assuming that our three market participants can coordinate on an equilibrium price vector (cf. the Walrasian auctioneer). Thus, all these agents need is liquidity.

Let the liquidity be supplied by bank credit lines that are sufficiently large and are both drawn down by our participants on an “as needed” basis, and repaid at the earliest possible moment. Assume that these credit lines – like credit card balances that are promptly repaid – bear no interest. Then we observe, first, that after three periods trade has taken place and every participant’s bank balance is zero; and, second, that if the game is repeated foerever, the aggregate money supply is zero at the end of every three periods.

In this model the money supply expands only to meet the needs the trade, and automatically contracts in every third round because the buyer holds bank liabilities sufficient to meet his demand.

Consider the alternative of using a fiat money “token” to solve the infinitely repeated version of the game. Observe that in order for the allocation to be efficient, if there is only one token to allocate, we must know ex ante who to give that token to. If we give it to person 3, no trade will take place in the first two rounds, and if we give it to person 2 no trade will take place in the first round. While this might seem a minor loss, consider the possibility that people who don’t consume in the first stage of their life may have their productivity impaired for the rest of time. This indicates that the use of fiat money may require particularized knowledge about the nature of the economy that is not necessary if we solve the problem using credit lines.

Why don’t we just allocate one token to everybody so that we can be sure that the right person isn’t cash constrained in early life? This creates another problem. Person 2 and person 3 will both have 2 units of cash whenever they are making their purchases, but in order to reach the equilibrium allocation we need them to choose to spend only one unit of this cash in each period. In short, this solution would require people to hold onto money for eternity without ever intending to spend it. That clearly doesn’t make sense.

This simple discussion explains that there is a fundamental problem with fiat money that ensures that an incentive compatible credit system is never worse and in many environments is strictly better than fiat money. This is one of the most robust results to come out of the formal study of economic environments with liquidity frictions (see e.g. Kocherlakota 1998).

In response to this I received the following question by email:

In your 3 person model, [why not allocate] a token to everybody? – I don’t understand how you reached the conclusion that “this solution would require people to hold onto money for eternity without ever intending to spend it”. If people have more units of cash than they need for consumption, the excess would be saved and potentially lent to others who need credit?

This question arises, because I failed in the excerpt from my post above to explain what the implications of “allocating a token to everybody” are when translated into a real world economy. In order for an efficient outcome to be achieved, you need to make sure that everybody has enough money at the start of the monetary system so that it is not possible that they will ever be cash-constrained at any point in time. In my simple model this just implies that everybody is given one token at the start of time. In the real world this means that every newborn child is endowed at birth with more than enough cash to pay the full cost of U.S. college tuition at an elite institution (for example).

Turning back to the context of the model, if the two people with excess currency save and lend it, we have the problem that the one person who consumes at the given date already has enough money to make her purchases. In short there is three times as much currency in the economy as is needed for purchases. What this implies is that we do not have an equilibrium because the market for debt can’t clear at the prices we have assumed in our model. In short, if we add lending to the model then the equilibrium price will have to rise — with the result that nobody is endowed with enough money to make the purchases they want to make. Whether or not an efficient allocation can be obtained by this means will depend on the details of how the lending process is modeled. (The alternative that I considered was that there was no system of lending, so they had to hold the token. Then when they had an opportunity to buy, choose to spend only one token, even though they were holding two tokens. This is the sense in which the token must be held “for eternity” without being spent.)

Tying this discussion back into the college tuition example. If, in fact, you tried to implement a policy where every child is endowed at birth with enough cash to pay elite U.S. college tuition, what we would expect to happen is that by the time these children were going to college the cost would have increased so that they no longer had enough to pay tuition. But then of course you have failed to implement the policy. In short, it is impossible to “allocate a token to everybody”, because as soon as you do, you affect prices in a way that ensures that the token’s value has fallen below the value that you intended to allocate. There’s no way to square this circle.

Connecting this up with bitcoin or deposit accounts at the central bank: the currently rich have a huge advantage in a transition to such a system, because they get to start out with more bitcoins or larger deposit accounts. By contrast in a credit-based monetary system everybody has the opportunity to borrow against their future income.

The problem with the credit-based monetary system that we have is that guaranteeing the fairness of the mechanisms by which credit is allocated is an extremely important aspect of the efficiency of the system. That is, in a credit-based monetary system fairness-based considerations are not in conflict with efficiency-based considerations, but instead essential in order to make efficiency an achievable goal.

Because of the failure to model our monetary system properly, we have failed to understand the importance of regulation that protects and supports the fair allocation of credit in the system and have failed to maintain the efficiency of the monetary system. In my view appropriate reforms will target the mechanisms by which credit is allocated, because there’s no question that in the current system it is allocated very unfairly.

The problem with proposals to eliminate the debt-based system is that as far as I can tell, doing so is likely to just make the unfairness worse by giving the currently rich a huge advantage that they would not have in a reformed and well-designed credit-based monetary system.

On the Value of an “Aggressive” Academic Culture [Updated]

This morning’s procrastination included a few tweets and blogposts on the “women in economics” debate, and the twist the discussion is taking concerns me. Claudia Sahm writes about ” the toll that our profession’s aggressive, status-obsessed culture can take” and references specific dismissive criticism that is particularly content-free and therefore non-constructive. Matthew Kahn follows up with some ideas about improving mutual respect noting that “researchers are very tough on each other in public seminars (the “Chicago seminar” style).” This is followed up by prominent economists’ tweets about economics’ hyper-aggressiveness and rudeness.

I think it’s important to distinguish between the consequences of “status-obsession,” dismissiveness of women’s work and an “aggressive” seminar-style.

First, a properly run “Chicago-style” seminar requires senior economists who set the right tone. The most harshly criticized economists are senior colleagues and the point is that the resultant debate about the nature of economic knowledge is instructive and constructive for all. Yes, everyone is criticized, but students have been shown many techniques for responding to criticism by the time they are presenting. Crucial is the focus on advancing economic knowledge and an emphasis on argument rather than “status-obsession”.

The simple fact is that “Chicago-style” seminars when they are conducted by “status-obsessed” economists are likely to go catastrophically wrong. One cannot mix a kiss up-kick down culture with a “Chicago-style” seminar. They are like oil and water.

An important point to keep in mind is that a “status-obsessed” academic environment with a more gentle seminar style quickly degenerates into a love-fest for influential academics, whose skills frequently and noticeably degrade. In short, there’s a lot to be said for a tell-it-like-it-is culture, as long as the focus of that culture is on advancing knowledge and not on one-upsmanship.

One of the best descriptions I have heard of the “Chicago-style” seminar is that it’s a contact sport. Getting knocked to the ground is part of the game. You just pick yourself up and pay your opponent back in kind. And then you both head out to the pub afterwards to discuss the game, the sport, and solve the world’s problems.

Will some people be uncomfortable in such an environment? Of course. But some of us are uncomfortable in an environment where aggressively advocating a position is seen as rude or unscholarly. In any environment there will always be some people who are uncomfortable.

Do women tend to feel more uncomfortable than men in such an environment? Maybe. I have my doubts because I’m the kind of woman who’s often asking herself whether I’ve been too assertive, so I feel like I can finally relax when I’m around assertive people. I suspect that it’s patronizing to assume that women are more uncomfortable then men in such an environment — but I may be biased.

In short, “status-obsession” and the acceptability of denigrating behavior towards women and towards junior scholars without adequate patronage may well be a problem for the economics profession, but “Chicago-style” seminars are unlikely to be a major source of the profession’s problems.

Update: I should probably add that I have no direct familiarity at all with “Chicago” seminars, but only with those run by Prescott’s descendants. So maybe what I’m referring to is a “Minnesota-style” seminar. In any event, the rough and tumble of economic discourse seems to me essential to its progress.

 

Reasons to reform macro by rejecting “M” #2: To End the Mission-Creep of Central Banks

New monetarist theory tells us that monetary frictions can only be fully addressed by unsecured private sector debt — and thus can only be solved by designing incentive structures that make unsecured private sector debt enforceable, or in other words by a carefully designed banking system.

Prior to the 1930s, the central bank played two main roles: it supported the private sector money supply through panics and monitored the growth of credit, taking action to prevent credit-boom-driven inflation. (The latter was the real bills approach to bank regulation, which the Fed unfortunately was not well-equipped to address — explained here.)

Monetarism introduced a new era in which it was believed that government “control” of the money supply played an important role in economic activity. The financial system has evolved to match the theory. There has been a steady increase in the role of the central bank over the past few decades, and this evolution culminated in the vast expanse of the central bank role subsequent to the crisis of 2007-08.

With the collapse of interbank lending markets, the growth of central bank reserves, and the shift to secured lending backed by government debt, the role of unsecured private sector debt in the money supply has declined dramatically. In short, the better part of a century after it was first set forth the monetarist agenda of putting in place government control over the money supply and of minimizing the role of the private sector in the money supply is finally being achieved.

And just as new monetarist theory would predict, the decline in the use of unsecured, private sector instruments as money is associated with sluggish economic activity — because “M” is a poor substitute for the money that a well-structured banking system can provide.

 

Reasons to Reform Macro by Rejecting “M” #1: Banking is no longer a mystery

In my previous post, I explained that when one actually models monetary frictions (as new monetarist models do), it becomes immediately clear that the only full solution to these frictions is a debt-based form of money. The intuition behind this fact is simple: some people need to buy before they receive payment for what they have sold. For example, consider the case of the employee who won’t be paid until two weeks after he starts work, but who needs to eat in the meanwhile. Or alternatively, consider the case of his employer who needs to pay her employee but won’t actually receive payment for the good the employee produced until two weeks after the paycheck is due. The earliest banking systems existed to turn these claims to future payment (i.e. those which are already “earned” or receivable in accounting terms) into immediate cash at a slight discount.

In many of these cases there is virtually no uncertainty that payment will be forthcoming, so it is inefficient for employee or his employer to be unable to draw on his or her expected earnings. Observe in these examples how important debt is not just to the flow of money through the economy, but also to the flow of economic activity through the economy. Thus, banking institutionalizes and stabilizes the system of monetary debt which makes possible the flow of economic activity to which we are accustomed. The stabilization that is provided by banking includes both monitoring to minimize the degree to which cheaters are able to take advantage of the system of debt, and controls on the growth of monetary debt to make sure that it is commensurate with economic activity — and to limit the likelihood of inflation. (This stabilizing anti-inflation policy was known by the term “real bills,” but is a matter of profound confusion for modern scholars particularly in the U.S. as is explained here.)

Given the conclusions that can be drawn from the formal models that make up the new monetarist literature, from a logical point of view it is remarkable that most of modern macroeconomics studies “M” or a form of money that is not based on private sector debt. (As noted in my previous post, this phenomenon can, however, be explained by taking a sociological view of the economics profession.) It is important to be clear that it is not just monetarists, and their intellectual heirs, who make this error. James Tobin was equally confused about this issue, writing that “the linking of deposit money and commercial banking is an accident of history.” (h/t Matthew Klein).

These entirely misguided beliefs about the nature of money and the nature of banking can almost certainly be attributed to the fact that the models that were being used in the mid-20th century when the field of macroeconomics was being developed did not include monetary frictions. Thus, Friedman and Tobin and the vast majority of their colleagues failed to comprehend the simple truth that in the absence of loans to the individuals who seek to trade in an economy, there is no reason to believe that the monetary friction will be solved at all.

In short, theory tells us that that the linking of what circulates as money and commercial loans is necessary in order for an efficient economic outcome to be attainable. Under these circumstances, it seems extremely unlikely that the well-established link between the two in modern economies is an “accident of history.” It is much more plausible that, because in the presence of monetary frictions an efficient outcome is only possible when money is based on the debt of the traders in the economy, banks developed to institutionalize this efficiency-enhancing phenomenon.

Rebutting the “It Takes a Model …” Defense of Modern Macroeconomics

Steve Williamson writes “It takes a model to beat a model. You can say that you don’t like [modern macroeconomics], but what’s your model? Show me how it works.” Well, I’m going to take up that challenge, because I wrote that model.

In my view, the challenge is not to write a model that works, but to write a model that the macroeconomic establishment will find “convincing.” And that generally requires writing a model that comes to conclusions that are closely related to the existing literature and therefore “make sense” to the establishment. The problem, however, is that many of the implications of the existing literature are batshit insane. (My personal pet peeve is explained in detail below, but there are others … ) The choice faced by a young economist is often to join the insanity or leave the profession. (This is actually a conversation that a lot of graduate students have with each other. Many compromise “temporarily” — with the goal of doing real research when they are established.)

Williamson’s own area of macro, new monetarism, which is the area that I was working in a decade ago too, illustrates the gravitational pull of conformity that characterizes the macroeconomics profession, and that interferes with the development of a genuine understanding by economists of the models they work with.

Williamson acknowledges, as every theorist does, that the models are wrong. The problem with macro (and micro and finance) is that even as economists acknowledge that formally there is a lot to criticize in the market clearing assumptions that underlie far too much of economic theory, they often dismiss the practical importance of these critiques — and this dismissal is not based on anything akin to science, but instead brings to mind a certain Upton Sinclair quote. (Note that there are sub-fields of economics devoted to these critiques — but the whole point is that these researchers are separated into sub-fields — in order to allow a “mainstream” segment of the profession to collectively agree to ignore the true implications of their models.)

Let’s, however, get to the meat of this post: Williamson wants a model to beat a model. I have one right here. For non-economists let me, however, give the blog version of the model and its implications.

(i) The model fixes the basic error of the neo-classical framework that prevents it from having a meaningful role for money. I divide each period into two sub periods and randomly assign (the continuum of) agents to “buy first, sell second” or to “sell first, buy second” with equal probability.

Note that because the model is designed to fix a well-recognized flaw in the neo-classical framework, it’s just silly to ask me to provide micro-foundations for my fix. The whole point is that the existing “market clearing” assumptions are not just microunfounded, but they interfere with the neo-classical model having any relationship whatsoever to the reality of the world we live in. Thus, when I adjust the market clearing process by inserting into it my intra-period friction, I am improving the market-clearing mechanism by making it more micro-founded than it was before.

Unsurprisingly, I wasn’t comfortable voicing this view to my referees, and so you will see in the paper that I was required to provide micro-foundations to my micro-foundations. The resulting structural assumptions on endowments and preferences make the model appear much less relevant as a critique of the neo-classical model, since suddenly it “only applies” to environment with odd assumptions on endowments and preferences. Thus, does the macroeconomics profession trivialize efforts to improve it.

(ii) An implication of this model in an environment with heterogeneous agents is that (a) money in the form of Milton Friedman’s “M” cannot solve the monetary problem, but that instead (b) a monetary form of short-term credit is needed to solve the monetary friction. To be more precise, in order to support a good outcome using “M” in an environment with heterogeneous agents the monetary authority needs to impose different lump-sum taxes for every type of agent (otherwise either some agents face a binding cash-constraint or the transversality condition that keeps agents from forever holding and never spending increasing amounts of money is violated). Thus, technically “M” can solve the monetary problem but only if an all-knowing monetary authority is constantly tweaking the amount of money that each member of the economy holds — that is, only if “M” does not have the anonymous properties that we associate with money.

In short, when the neo-classical model is corrected for its obvious flaws, we learn that the basic premise of monetarism, that there is some “M” which is clearly distinguishable from credit and which can solve the monetary problem, has no logical foundations. This whole approach to money is a pure artifact of the neo-classical model’s fatally flawed market-clearing assumptions.

These issues with “M” are actually well-established in the new monetarist literature. (See, e.g. here or here.) The problem is that this motivated changes in the literature, discussed below, that protect the concept of “M.” (Moral: if you want to get published be careful to rock the boat with a gentle lulling motion that preserves the comfort of senior members of the profession — they don’t like swimming in unfamiliar waters.)

(iii) I interpret (ii)(b) as a wholesale rejection of the concept of “M.” The fact that the fundamental monetary problem can only be fully addressed by credit points directly to the importance of the banking system. We need the transactional credit that banking systems have long provided — not incidentally starting at the dawn of modern growth trends — in order to solve the monetary problem.

This is where, in terms of modern macroeconomics, I go completely off the rails. Correctly viewed, however, this is where modern macroeconomics goes completely off the rails. Every modern macroeconomist, whether of the salt- or of the fresh-water school was trained to ignore the banking system. They are persuaded that it doesn’t matter, because if banking is a fundamental determinant of economic performance, then the whole of their understanding of how the economy works is fundamentally flawed. (See Upton Sinclair above.)

So we have the development of a sub-field of macroeconomics, new monetarism, and the implications of this literature should be understood as a direct challenge to the concept of “M.” What, in fact, happened to this literature? The basic model was tweaked, so the workhorse model in this area is now the Lagos-Wright model. What does this model do? After every trading period with frictions it introduces a frictionless stage in which money balances, “M,” can be reallocated using standard neo-classical market clearing assumptions. (To make this work the axioms of preference are also relaxed with respect to one good, but that’s another issue.) That is, it guts the basic intuition that economists should derive from the older new monetarist literature. Why does it do this? Because it turns the model into something that simply tweaks the traditional understanding of “M” and makes it easier for economists to continue to ignore the fundamental monetary role of the banking system — carefully lulling the macroeconomic boat.

To conclude, the models Williamson has been working with for years should tell him to reject the monetarist view of money. While he and other researchers in this area have explored bank money and its benefits, they do so in a tentative manner without in fact directly challenging the conceptual foundations of “M.” In short, the problem with macroeconomics today is not the models we have, but the illogical, emotionally-tied manner in which economists choose to interpret them.

Comparing bankers past and present

Even after verifying that banking was indeed an unlimited liability enterprise in the 19th century, TED appears to struggle with the idea that anybody with wealth would be willing to take on such risks — especially for a measly return of 5% or less on assets.  TED writes:

My intuition about unlimited liability is that capital providers subject to it have a natural limit to the amount of credit they are willing to extend regardless of price. Each lender sets her individual limit based on her estimation of the likelihood of loss beyond initial capital invested. Beyond that there is no price at which she would be willing to lend. This certainly would be my preference: if I faced the loss of my home and possessions, penury, and utter ruination, you can damn well be sure I would not extend just one more loan to capture an extra fifty, hundred, or even thousand basis points of yield. I do not think I am alone among heartless, flinty-eyed rentiers in this regard.

What this sounds like to me is that the employees of our financial institutions are so habituated to making outrageously large risk-free (i.e. government guaranteed) returns, that the idea of risking one’s own assets in order to make a profit seems patently ridiculous — which of course it is — if you happen to be one of the few privileged enough to be able to spend your life sucking at the government’s teat.

(My apologies to TED, Alea, Sonic Charmer and all the other financiers looking for a better system, but this bit of hyperbole seems close enough to the truth to me that I couldn’t bring myself to edit it out of existence.)

Given the growth of unlimited liability banking in the past and the plethora of Americans living lives of quiet desperation in the present, I suspect that the risks of unlimited liability banking could in fact attract many, many small lenders whose initial capital may be little more than significant equity in their own home — if it were not the case that the whole industry is overshadowed by government sponsored mega-lenders.  After all, how many small businessmen and women in this country have already signed up to be personally liable for their business debts?  Putting all of one’s assets at risk to start a business is hardly an unknown or rare phenomenon in this country.

To support the view that unlimited liability banking operates as a constraint on the economy, TED writes:

The historical evidence Andrew Haldane cites from early 19th century Britain is entirely consistent with this: compared to the situation today, banks were massively overequitized and highly liquid, and bank assets and hence lending were a very low proportion of the economy. If my intuition is correct, it may well be that prevailing market rates of interest during that period evidence less that capital was plentiful and demand fully satisfied and more that supply and demand were balanced in a regime of artificially limited supply. Certainly Mr. Haldane contends—based upon what, I do not know—that the system of unlimited liability was not capable of supplying the growing need for capital during the rapid industrialization of the mid 19th century.

Given that Britain spent the 19th c. growing economically into its role as a premier world power (“the sun never sets …” etc.) and by the late 19th c. was exporting capital around the world, it’s hard to understand the foundation for TED’s argument that the supply of capital must have been “artificially limited,” since banks were lending at 5%.  If banks in Britain were “overequitized,” there’s little or no evidence that this had an adverse effect on the economy.  As long as banks could be operated profitably, to the degree that existing lenders were at the limit of their ability/willingness to lend, new entrants into the industry — or new partners — could probably be found to expand the business and take advantage of good lending opportunities.

The data on the United States indicates that banks subject to double liability were not “overequitized.”  In 1919 the ratio of the aggregate total capital account for all Federal Reserve member banks to total assets was 11%. (See column 1 of Chart No. 57 here.  This ratio rose to 15% at the depths of the Depression and then dropped with the advent of deposit insurance.)  At the start of the recent financial crisis the Fred database indicates that this ratio was hovering around 10%.  Thus, it’s far from clear that double liability in the US resulted in “overequitized” banks.

I believe that the claim that “the system of unlimited liability was not capable of supplying the growing need for capital during the rapid industrialization of the mid 19th century,” is just an explanation for the growth of stock markets and limited liability non-financial companies.  It is widely recognized – and I do not dispute this claim – that certain industries with extremely high fixed costs but significant risks in the form of aggressive competition to take advantage of recent technological developments, like railroads or fiber optic cables, can, more or less, only be financed via a limited liability shareholder structure.  Since banking developed as a successful industry before the rise of stock markets, and as Andrew Haldane notes the banking industry was very slow to embrace limited liability, it is far from clear that limited liability is an essential element of a efficient banking system.

Mr. Haldane appears to argue that because systems of extended liability did not protect depositors in the Depression, such systems were rejected.  While this may be a historical explanation for the growth of limited liability banking, it is far from clear that Depression-era problems should be taken as conclusive evidence against extended liability.  It’s doubtful that any banking system could have survived Depression-like events, marked most notably by the world’s reserve currency delinking itself from gold and setting off a reserve currency transition, without significant losses.

In short, while unlimited or extended liability banking would almost certainly mean that the economy was populated with a greater number of smaller banks, it’s far from clear that credit itself would be constrained.  Nor should one assume that interest rates would rise.  After all the risk premium portion of interest rates depends as much on the quality of bank underwriting and social enforcement mechanisms as on the characteristics of the borrower, so incentivizing banks to screen borrowers and lend carefully may actually reduce the interest rates available to most borrowers.

Related posts:
What banks do
The problem of collateral
What is capital?