In his
new lecture series, Federal Reserve chairman Ben
Bernanke is going out of his way to discuss the
"problems with the gold standard". To a central
banker, the gold standard may be considered
"competition", as their power would likely be
greatly diminished if the US were on a gold
standard.
The Fed, Bernanke argues, is the
answer to the problems of the gold standard. We
respectfully disagree. We disagree because the Fed
ought to look at a different problem.
Bernanke lists price stability and
financial stability as key objectives of the Fed.
Focusing on the latter one first, the Fed was
established to reduce the risk of financial
panics. Bernanke
points out:
A financial panic is possible in any
situation where longer-term, illiquid assets are
financed by short-term, liquid liabilities; and
in which short-term lenders or depositors may
lose confidence in the institution(s) they are
financing or become worried that others may lose
confidence.
Bernanke goes on to blame
the gold standard for the panics. While he is
certainly not alone in his view - indeed, his very
lecture to students at George Washington
University is promoting that view to a new
generation of economists - we beg to differ.
Banks - by definition - have a maturity
mismatch, making long-term loans, taking
short-term deposits. As such, banks are prone to
financial panics as described by Bernanke. To
mitigate the risk of financial panics, central
banks can do what the Fed is doing, namely to be a
lender of last resort. Alternatively, central
banks can focus on the core issue, the structural
"problem of banking".
Following the Fed's
approach, there are inherent moral hazard issues -
incentives for financial institutions to increase
leverage, to become too-big-to-fail. To address a
panic that might happen anyway, the Fed would
double down (provide more liquidity), potentially
exacerbating future banking panics. After yet
another crisis, new rules are introduced to
regulate banks.
The resulting financial
system may not be safer, but it will increase
barriers to entry, further bolstering the
leadership position of existing, too-big-to-fail
banks. With all the government guarantees and
too-big-to-fail concerns, banks might then be
regulated in an attempt to have them act more like
utilities.
Ultimately, that might make the
financial system more stable, but will stifle
economic growth. Financial institutions, as much
as we have mixed feelings about their conduct, are
vital to finance economic growth, as they
facilitate risk taking and investment.
The
problem of all financial panics is not the gold
standard - otherwise, the panic of 2008 would not
have happened. The problem of financial panics is
- again - that "longer-term, illiquid assets are
financed by short-term, liquid liabilities".
Missing from Bernanke's definition is a
key additional attribute, leverage. A maturity
mismatch without leverage might cause a lender to
go bust, but - in our interpretation - does not
qualify as a panic when a limited number of
depositors are affected. The "panic" and the
"contagion" may occur when leverage is employed,
as it creates a disproportionate number of
creditors (including consumers with cash
deposits).
There's a better way. To avoid
having financial institutions serve as "panic"
incubators, regulation should address the core of
the issue. Bernanke shouldn't use gold, as a
scapegoat for all that was wrong with the US.
economy previously, to justify a license to print
money.
First, failure must be an option;
individuals and businesses must be allowed to make
mistakes and suffer the consequences. The role of
the regulator, in our opinion, is to avoid an
event where someone's mistake wrecks the entire
system.
The easiest way to achieve a more
stable financial system is to reduce incentives
for leverage. A straightforward method is through
mark-to-market accounting and a requirement to
post collateral for leveraged transactions. The
financial industry lobbies against this, arguing
that holding a position to maturity renders
mark-to-market accounting redundant.
Consider the following example, which
highlights the implication: assume a speculator
before the financial crisis took a leveraged bet
that oil prices - at the time trading at $80 a
barrel - would go down to $40 a barrel. In the
"ideal world" according to the banks, this
speculator would not have been required to post
collateral and would have been proven right when
oil (briefly) dropped to $40 a barrel after the
financial crisis.
In reality, however, as
oil prices soared to $140 a barrel before
declining, the typical speculator would have been
forced to post an ever larger amount of
collateral; likely, the speculator's brokerage
firm would have closed out the position, as the
speculator ran out of money. The speculator lost
money because he was unable to meet a margin call;
importantly, though, the system remained intact.
The speculator might complain: the price
ultimately fell to $40! But such whining is futile
because the rules of engagement were known ahead
of time. As such, the speculator had an incentive
to use less (or no) leverage. The bank's attitude,
in contrast, incubates panics. In this example,
regulated exchanges exist. But even without
regulated exchanges or easily priced securities,
similar concepts can be developed.
Another
way to make financial firms more panic prone is to
require them to issue staggered subordinated debt.
Rather than relying heavily on short-term funding
(retail deposits or inter-bank funding markets),
banks should be required to stagger the maturities
of their own funding over years.
If, say,
each year 10% of their loan portfolio needs to be
refinanced, then - in times of financial turmoil -
it might become exorbitantly expensive for a bank
to finance that 10% of their loan portfolio. A
bank should be able to shrink its loan portfolio
by 10% in a year in an orderly fashion, without
jeopardizing the survival of the firm or spreading
excessive risks throughout the financial system.
Note that this is a market-based mechanism to
police the financial system.
These
concepts reduce leverage in the system. And that's
the point, as leverage is the mother of all
panics. The concepts presented above will not
solve all the challenges of banking, but blaming
"the problem of the gold standard" for financial
panics is - in our analysis - premature.
Modern central banking is not the answer
to mitigate the risk of financial panics because
the cost for this perceived safety is enormous. As
a result of responding to each potential panic
with ever more "liquidity", entire governments are
now put at risk when a crisis flares up.
Beyond that, central banks have done a
horrible job in containing inflation. The wisdom
of central banking is that 2% inflation is
considered an environment of stable prices. At 2%,
a level often touted as a "price stable
environment", the purchasing power of $100 is
reduced to $55 over a 30-year period. It's a cruel
tax on the public. What's more, in practice,
countries with a fiat currency system have
generally been unable to keep long-term inflation
below 2%.
Bernanke warns of deflation. To
the saver, deflation is a gift. Not to the debtor.
In a debt-driven world, deflation strangles the
economy. Governments don't like deflation as
income taxes and capital gains taxes are eroded.
In a deflationary world, governments would need to
rely more on sales taxes (or value added taxes):
gradually reduced revenue in a deflationary
environment would be okay as the purchasing power
of those tax revenues would increase.
That
assumes, of course, that the government carries a
low debt burden - deflation would be a good
incentive to limit spending. Get the picture why
governments don't like deflation?
Axel Merk is manager of the Merk
Hard, Asian and Absolute Currency Funds,
www.merkfunds.com. To learn more about the Funds,
visit www.merkfunds.com.
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