Models, Damn Models and Statistics, or Math Gone Mad

Parliamentary committees are not especially noted for entertainment, but the November Treasury Select Committee hearing on the Bank of England’s Inflation Report is a refreshing exception. The fun starts on p. 30 of the transcript of the hearings with Steve Baker MP and Bank of England Governor Mark Carney light-heartedly jousting with each other.

Steve begins by asking Dr. Carney if the Bank is all model-driven. To quote from the transcript:

Dr Carney: No. If we were all model driven, then you would not need an MPC.

Q81 Steve Baker: All right. But we do have plenty of models floating around.

Dr Carney: I presume you feel we do need an MPC, Mr Baker?

Steve Baker: I think you know I think we don’t.

Dr Carney: I just thought we would get that read into the record.

[KD: First goal to Dr. Carney, but looks to me like it went into the wrong net.]

Steve Baker: I want to turn to a criticism by Chris Giles in The Financial Times of the model for labour market slack, which called it a nonsense. If I may I will just share a couple of quotes with you. He said that, according to a chart in the inflation report, the average-hours gap hit a standard deviation of -6, and this is something we would expect to happen once in 254 million years. He also said that the Bank of England is again implying the recent recession, as far as labour market participation is concerned, was worse than any moment in 800 times the period in which homo sapiens have walked on the earth. How will the Bank reply to a criticism as strident as this one?

[KD: The article referred to is Chris Giles, “Money Supply: Why the BoE is talking nonsense”, Nov 17 2014:]

Dr Carney: Since you asked, let me reply objectively. Calculations such as that presume that there is a normal distribution around the equilibrium rate. Let me make it clear. First off, what is the point of the chart? The chart is to show a deviation relative to historic averages. It is an illustrative chart that serves the purpose of showing where the slack is relative to average equilibrium rates, just to give a sense of relative degrees of slack. That is the first point. The second point is that the calculation erroneously, perhaps on purpose to make the point but erroneously, assumes that there is a normal distribution around that equilibrium rate. So in other words to say that there is a normal distribution of unemployment outcomes around a medium-term equilibrium rate of 5.5%. So it is just as likely that something would be down in the twos as it would be up in the eights. Well, who really believes that? Certainly not the MPC and I suspect not the author of that article. It also ignores that the period of time was during the great moderation for all of these variables as well, so it is a relatively short period. These are not normal distributions. You would not expect them. You would expect a skew with quite a fat tail. So using normal calculations to extrapolate from a chart that is there for illustrative purposes is—I will not apply an adjective to it—misleading and I am not sure it is a productive use of our time.

Q82 Steve Baker: That is a fantastic answer. I am much encouraged by it, because it does seem to me it has been known for a long time that it is not reasonable to use normal distributions to model market events and yet so much mathematical economics is based on it.

[KD: Carney’s is an excellent answer: one should not “read in” a normal distribution to this chart, and the Bank explicitly rejects normality in this context.

Slight issue, however: didn’t the Bank’s economists use the normality assumption to represent the noise processes in the models they used to generate the chart? I am sure they did. One wonders how the charts would look if they used more suitable noise processes instead? And just how robust is the chart to the modelling assumptions on which it is based?]

Dr Carney: People do it because it is simple—it is the one thing they understand—and then they apply it without thinking, which is not what the MPC does.

Steve Baker: That is great. I can move on quickly. But I will just say congratulations to the Bank on deciding to commission anti-orthodox research because I think this is going to be critical to drilling into some of these problems.

Dr Carney: Thank you.

[KD: Incredulous chair then intervenes.]

Q83 Chair: To be clear, the conclusion that we should draw from this is that we should look at all economic models with a very high degree of scepticism indeed.

Dr Carney: Absolutely.

[KD: So you heard it from the horse’s mouth: don’t trust those any of those damn models. Still incredulous, the chair then intervenes again to seek confirmation of what he has just heard.]

Chair: Can I just add that it is an astonishing conclusion? I do not want to cut into Steve Baker’s questions, but is that the right conclusion?

Dr Carney: Absolutely. Models are tools. You should use multiple ones. You have to have judgment, you have to understand how the models work and particularly, if I may underscore, dynamic stochastic general equilibrium forecasting models, which are the workhorse models of central banks. What they are useful for is looking at the dynamics around shocks in the short term. What they are not useful for is the dynamics further out where—

[KD: Dr. Carney reiterates the point so there can be no confusion about it. So let me pull his points together: (1) He “absolutely” agrees that “we should look at all economic models with a very high degree of scepticism.” (2) He suggests “You should use multiple [models]”, presumably to safeguard against model risk, i.e., the risks that any individual model might be wrong. (3) He endorses one particular – and controversial – class of models, Dynamic Stochastic General Equilibrium (DSGE) models as the “workhorse models” of central banks, whilst acknowledging that they are of no use for longer-term forecasting or policy projections.

I certainly agree that none of the models is of any longer-term term use, but what I don’t understand is how (1), (2) and (3) fit together. In particular, if we are to be skeptical of all models, then why should we rely on one particular and highly controversial, if fashionable, class of models, never mind – and perhaps I should say, especially – when that class of models is regarded as the central banks’ workhorse. After all, the models’ forecast performance hasn’t been very good, has it?

The discussion then goes from the ridiculous to the sublime:]

Chair: I am just thinking about all those economists out there whose jobs have been put at risk.

Dr Carney: No, we have enhanced their jobs to further improve DSG models.

Steve Baker: We are all Austrians now.


[A little later, Steve asks Sir Jon Cunliffe about the risk models used by banks.]

Q84 Steve Baker: Sir Jon, before I move too much further down this path, can I ask you what would be the implications for financial stability and bank capital if risk modelling moved away from using normal distributions?

Sir Jon Cunliffe: Maybe I will answer the question another way. It is because of some of the risks around modelling, the risk-weighted approach within bank capital, that we brought forward our proposals on the leverage ratio. So you have to look at bank capital through a number of lenses. One way of doing is to have a standardised risk model for everyone and there is a standardised approach and it works on, if you like, data for everybody that does not suit any particular institution and the bigger institutions run their own models, which tend to have these risks in them. Then you have a leverage ratio that is not risk-weighted, and therefore takes no account of these models, and that forms a check. So with banks, the best way to look at their capital is through a number of different lenses.

[KD: Sir Humphrey is clearly a very good civil servant: he responds to the question by offering to answer it in a different way, but does not actually answer it. The answer is that we do not use a non-normal distribution because doing so would lead to higher capital requirements but that would never do as the banks would not be happy with it: they would then lobby like crazy and we can’t have that. Instead, he evades the question and says that there are different approaches with pros and cons etc. etc. – straight out of “Yes, Minister”.

However, notwithstanding that Sir Jon didn’t answer the question on the dangers of the normal distribution, I would also ask him a number of other (im)pertinent questions relating to bad practices in bank risk management and bank risk regulation:

1. Why does the Bank continue to allow banks to use the discredited Value-at-Risk (or VaR) risk measure to help determine their regulatory capital requirements, a measure which is known to grossly under-estimate banks true risk exposures?

The answer, of course, is obvious: the banks are allowed to use the VaR risk measure because it grossly under-estimates their exposures and no-one in the regulatory system is willing to stand up to the banks on this issue.

2. Given the abundant evidence – much of it published by the Bank itself – that complex risk-models have much worse forecast performance than simple models (such as those based on leverage ratios), then why does the Bank continue to allow banks to use complex and effectively useless risk models to determine their regulatory capital requirements?

I would put it to him that the answer is the same as the answer to the previous question.

3. Why does the Bank continue to rely on regulatory stress tests in view of their record of repeated failure to identify the build-up of subsequently important stress events? Or, put it differently, can the Bank identify even a single instance where a regulatory stress test correctly identified a subsequent major problem?

Answer: The Northern Rock ‘war game’. But even that stress test turned out to be of no use at all, because none of the UK regulatory authorities did anything to act on it.

In the meantime, perhaps I can interest readers in my Cato Institute Policy Analysis “Math Gone Mad”, which provides a deeper – if not exactly exhaustive but certainly exhausting – analysis of these issues:



The Truth Behind The Swiss Gold Referendum

A recent column in US News & World Report, The Swiss Gold Rush by Pat Garofalo, its assistant managing editor for opinion, is subtitled “A push for the gold standard in Switzerland is symbolic of Europe’s rising right wing.” US News & World Report hereby descends from commentary to propaganda. Who edits its editors?

To begin with, the Swiss referendum, decisively and sensibly rejected by the Swiss electorate, was not about “the gold standard.” It was a vote on a proposition requiring its central bank to increase its gold reserves from around 8% to 20% — implying the acquisition, over five years, of 1,500 tons (“costing at about $56.3 billion at current prices,” reports Bloomberg), never to sell gold, and to hold that federation’s gold within Switzerland.  That had nothing to do with the gold standard.

The Swiss voted 77% – 23% to reject this proposition. The Swiss National Council had rejected the initiative by 156 votes to 20 with 22 abstentions, and the Council of States by 43 votes to 2 abstentions. And the referendum may well have been a bad, or at least silly, idea.

With a Swiss GDP of around $650 billion (USD) per year the requirement to acquire $10B/year of this iconic shiny-and-ductile commodity while not insignificant, at less than 2% of annual GDP, hardly would have been crippling.  That said, the gold standard was not on the ballot.

As for the gold markets themselves, according to a 2011 report by the FT, reporting on a study by the London Bullion Market Association, there was a $240bn average daily turnover in the London bullion market. The annual mandated Swiss acquisition, then, apparently would have amounted to about … half an hour’s trading volume on one of the world’s major gold marketplaces.  Commodity investment, however, has nothing to do with the gold standard.

Demonetized (as at present), gold merely is a commodity. The gold standard is a quality standard, not a quantity standard, and is about maintaining the integrity of the currency, not limiting its supply. This Swiss referendum substantively was irrelevant to monetary policy. As’s own Nathan Lewis perceptively has pointed out the amount of gold held, under the gold standard, as reserves by banks of issue fluctuated dramatically and immaterially.

The Swiss referendum generated a modicum of international attention and considerable criticism. The referendum presented, in fact, as misguided. It did not, however, even imply a restoration of the gold standard much less prove itself, as Garofalo presented it, as a symptom of “Europe’s rising right wing.”

Garofalo stated that “the gold standard is the idea that a nation’s money supply should be tied to gold, rather than being fully controlled by its central bank.”  This is not even a crude approximation of the gold standard. The gold standard simply holds that the value of a currency shall be defined by, and legally convertible into, a fixed weight of gold.

Garofalo implies, and cites other writers who claim, that the gold standard constrains the money supply.  Not so.  As Nathan Lewis has pointed out, for instance, from 1775 to 1900 the amount of gold in the U.S. monetary system increased by 3.4x while the currency increased by 163x without causing a depreciation in value of the currency.

The gold standard is a qualitative, not quantitative, standard. It does not constrain growth of the money supply, merely calibrating it reasonably well (albeit imperfectly, perfection having never been attained by any monetary system) to the real economy’s money demand. Lewis:

between 1880 and 1900, the monetary base in Italy actually shrank by 4.8%.  However, the monetary base in the U.S. grew by 81% over those same years. Both used gold standard systems. So, the “money supply” not only has no relation to gold mining production, but two countries can have wildly different outcomes during the same time period.

As for whether the gold standard is superior to fiduciary management there is abundant evidence that the organic nature of the gold standard consistently outperforms the synthetic nature of central bank discretion.  Garofalo references a poll of 40 academic economists who dismiss the (admittedly unfashionable) gold standard.

In criticizing the performance of the gold standard Garofalo relies on The Atlantic’s Matt O’Brien.

Indeed, when it was in force, the gold standard brought with it a whole host of negative effects, and as Matt O’Brien wrote in The Atlantic, “was a devilish device for turning recessions into depressions.” It ensures that a central bank can’t respond to a crisis by putting more money into the financial system, greasing the wheels of the economy, since the money supply is restricted by an outside factor.

As for another celebrity on whom Garofalo relies, Nouriel Roubini, his ill-founded hysteria on the gold standard has been critiqued here and here. O’Brien and Roubini are entitled to their own opinions but not to their own facts.

As economic historian Professor Brian Domitrovic, also at, relates, The Gold Standard Had Nothing To Do With Panics and Busts,

Looking at the 19th century, before the gold standard became a ghost, a dead-letter in the early era of the Federal Reserve from 1913-33, there is no evidence that the good old thing was implicated in any panic or bust.

Rather than relying on commentators and academics, pro or anti gold, it might be pertinent to turn to the thoughts of central bankers. Herr Dr. Jens Weidmann, president of the Bundesbank, in a 2012 speech referred to gold as “in a sense, a timeless classic.”

And Garofalo makes no reference to the 2011 Bank of England Financial Stability Paper No. 13, summarized and hyperlinked by contributor Charles Kadlec here. This study by the prudential Bank of England — not for nothing called “the Old Lady of Threadneedle Street” — provides an empirical assessment of the fiduciary management approach ushered in by Presidents Johnson and Nixon and, at the time of the study, in effect for 40 years.

Financial Stability Paper No. 13 contrasts the world economy’s real performance under the Johnson/Nixon protocols relative to the Bretton Woods gold-exchange standard and the classical gold standard. The Bank of England analysis, based on the empirical data, concludes that fiduciary management greatly underperformed (for economic growth, financial stability, inflation, recession, and all other categories assessed) its predecessor systems.

Garofalo legitimately cites the weight of elite academic economic opinion against the out-of-fashion gold standard. That said, this august collection of economists, few if any of whom foresaw the panic of 2007 and ensuing Great Recession, seem to be guided by former U.S. Treasurer Ivy Baker Priest’s motto, “Often wrong, never in doubt.” Readers deserve to be provided with the weight of the evidence to, at least, supplement the weight of elite opinion.

More troubling are Garofalo’s innuendos tying gold standard proponents to sinister “right-wing” politics. There is no meaningful correlation between advocacy for the gold standard and, for example, anti-immigrant sentiment. I, a gold standard proponent, am very much on record for a generous, inclusive, immigration policy (including a path to citizenship for undocumented aliens). So is American Principles In Action, the gold standard’s most prominent advocacy group in Washington, DC (which I professionally advise).

The figure most synonymous with right-wing totalitarianism, Adolf Hitler, virulently opposed the gold standard.  The gold standard then was, as it now is, intrinsic to a liberal republican order. Hitler is recorded as saying:

I had no interest in gold— either natural or synthetic.Our opponents have not yet understood our system. We can be easy in our minds on that subject; they’ll have terrible crises once the war is over. During that time, we’ll be building a solid State, proof against crises, and without an ounce of gold behind it. Anyone who sells above the set prices, let him be marched off into a concentration camp ! That’s the bastion of money. There’s no other way.

Garofalo states that “In 2012, Republicans kowtowed to their more extreme members by including a call to return to the gold standard in their party platform.”   This, flatly, is wrong.  The 2012 GOP platform did not call to return to the gold standard.  It simply called for a ““commission to investigate possible ways to set a fixed value for the dollar.”  (Nor did it represent a “kowtow” to “more extreme members.”)

Instead of reciting the platform language Garofalo relied on a distorted description of it by commentator Bruce Bartlett, to which he links.  (Bartlett’s reference, in his New York Times Economix blog, to a “metallic basis” was to platform language referencing a commission established by Reagan, not the call to action in the 2012 platform.)

Garofalo states that “Kentucky Sen. Rand Paul – has mentioned the possibility of a return to the gold standard.”  The source to which he links states shows the Senator entirely noncommittal:  “Paul wouldn’t comment on whether a gold standard is needed or not….”  Sen. Paul, pressed by a questioner, simply called for a commission to study the matter, which has a subtle yet materially different connotation from having “mentioned the possibility.”

Garofalo’s misrepresentations are, at best, sloppy, giving readers good cause to wonder about the integrity of this writer’s work. His collected writings are a compilation of progressive nostrums: complaining that gas prices are too low, opposing corporate tax reform, criticizing President Obama for refusing to propose a gas tax, supporting the mandated minimum wage, throwing bouquets to the IRS, and so forth.

Garofalo is a propagandist rather than a commentator. Good on him: the discourse is made spicier by propaganda.

That said, the readers of US News & World Report deserve much better quality propaganda than this. The Swiss referendum may have been silly but it was not about the gold standard. The gold standard neither is “ugly” nor evidence of a “rightward lurch.” And, in the words of its foremost living proponent, Lewis E. Lehrman (whose eponymous Institute I professionally advise), “By the test of centuries, the true gold standard, without reserve currencies, is the least imperfect monetary system of history.”

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The Gold Standard Did Not Cause The Great Depression, Part 1

AEI’s James Pethokoukis and National Review’s Ramesh Ponnuru — among many others — appear to have fallen victim to what I have called “the Eichengreen Fallacy,” the demonstrably incorrect proposition that the gold standard caused the Great Depression.  This fallacy is at the root of much confusion in the discourse.

Both these conservatives find themselves, most incongruously, in the company of Professors Paul Krugman, Brad Delong, and Charles Postel; Nouriel Roubini; Thomas Frank; Think Progress’s Marie Diamond; the Roosevelt Institute’s Mike Konczal and other leading thinkers of the left pouring ridicule on the gold standard.  Most recently, Matt O’Brien, of the Washington Post, hyperbolically described the gold standard as “the worst possible case for the worst possible idea,” echoing a previous headline of a blog by Pethokoukis “The case for the gold standard is really pretty awful.”

Mssrs. Pethokoukis and Ponnuru appear to have been misled by an ambient fallacy (reprised recently by Bloomberg View‘s Barry Ritholtz) that there is an inherent deflationary/recessionary propensity of the gold standard. Thus they are being lured into opposition to such respected center-right thought leaders as Lewis E. Lehrman (whose Institute’s monetary policy website I professionally edit); Steve Forbes, Chairman of Forbes Media; Sean Fieler, chairman of American Principles in Action (for which I serve as senior advisor, economics) and the Honorable Steve Lonegan, APIA’s monetary policy director.

They also put themselves sideways with Cato Institute president John Allison; Professors Richard Timberlake, Lawrence White, George Selgin and Brian Domitrovic; Atlas Economic Research Foundation’s Dr. Judy Shelton; Ethics and Public Policy Center’s John Mueller; public figures such as Dr. Ben Carson and, perhaps, Peter Thiel; journalists such as George Melloan and James Grant; and commentators John Tamny, Nathan Lewis, Peter Ferrara, and Jerry Bowyer, among others.

At odds, too, with such esteemed international figures as former Indian RBI deputy governor S.S. Tarapore; former El Salvadoran finance minister Manuel Hinds; and Mexican business titan Hugo Salinas Price. And, at least by way of open-mindedness and perhaps even outright sympathy, The Weekly Standard editor-in-chief William Kristol; Cato’s Dr. James Dorn; Heritage Foundation’s Dr. Norbert Michel; the UK’s Honorable Kwasi Kwarteng and Steve Baker … among many other respected contemporary figures.   Not to mention libertarian lions such as the Honorable Ron Paul.

Gold advocates and sympathizers from the deep past include Copernicus and Newton, George Washington, Alexander Hamilton, Thomas Jefferson, John Witherspoon, John Marshall and Tom Paine, among many other American founders; and, from the less distant past, such important thinkers as Carl Menger, Ludwig von Mises and Jacques Rueff, as well as revered political leaders such as Ronald Reagan and Jack Kemp.

Alan Greenspan recently, in Foreign Affairs, while not discerning gold on the horizon, recently celebrated the “universal acceptability of gold” while raising a quizzical avuncular eyebrow, or two, at what he describes as “fiat” currency.

Let not pass unnoticed the recent statement by Herr Jens Wiedmann, president of the Bundesbank,

Concrete objects have served as money for most of human history; we may therefore speak of commodity money. A great deal of trust was placed in particular in precious and rare metals – gold first and foremost – due to their assumed intrinsic value. In its function as a medium of exchange, medium of payment and store of value, gold is thus, in a sense, a timeless classic.

Nor let pass unnoticed the Bank of England’s 2011 Financial Stability Paper No. 13 assessing the long term performance of the Federal Reserve Note standard and assessing its real outcomes — in every category reviewed, including job creation, economic growth, and inflation — to have proven itself, over 40 years, as deeply inferior in practice to the gold and even gold-exchange standards.

Seems a puzzling mésalliance on the part of Mssrs. Pethokoukis and Ponnuru.The Eichengreen Fallacy — that the gold standard caused and protracted the Great Depression — has led the discourse severely astray. It is imperative to set matters straight.  As I previously have written:

Prof. Eichengreen, author of Golden Fetters, was and remains non-cognizant of a subtle but crucial aspect of world monetary history — and, apparently, of the works of Profs. Jacques Rueff and Robert Triffin elucidating the implications.  Eichengreen blundered by attributing the Great Depression to the gold standard.  This, demonstrably, is untrue.

As Lehrman puts it, the true gold standard repeatedly has proven, in practice, the least imperfect of monetary regimes tried. Robust data actually recommend the gold standard as a powerful force for equitable prosperity.

Just perhaps it can be bettered.  So let the games begin. That said, proposing alternatives to the gold standard is very different from denigrating it.

Pethokoukis (whose writings I regularly follow and with appreciation) recently presented, at AEIdeas, The gold standard is fool’s gold for Republicans. This was a riposte to my here calling him to task for insinuating a connection between the gold standard and the rise of the Nazis and Hitler.  And to task for making statements in another of his AEIdea blogs taking Professors Beckworth and Tyler Cowen out of context.  He also therein conflated the “weight of the evidence” with “weight of opinion.”  It appears that he has fallen prey to the Eichengreen Fallacy.

In self-defense Pethokoukis cites scholarly materials which tend to prove the innocence of the gold standard rather than his insinuation.  For example: he cites Prof. Beckworth’s statement that “the flawed interwar gold standard … probably … led to the Great Depression which, in turn, guaranteed the rise of the Nazis….”

Prof. Beckworth’s characterization “flawed” is entirely consistent with the characterization by the great French monetary official and savant Jacques Rueff, whose work informs my own, of the gold-exchange standard as “a grotesque caricature” of the gold standard.

Similarly, his reference to Prof. Sumner overlooks the obvious fact that Prof. Sumner would appear fully to grasp the key distinction.  Sumner, as quoted by Pethokoukis:

The gold standard got a bad reputation after the Great Depression, when it was seen as contributing to worldwide deflation.  Kurt Schuler points out that the interwar gold standard didn’t follow the rules of the game, which is true.

Pethokoukis speculates,

Perhaps advocates are so sensitive to charges that the gold standard played a key role in the Great Depression, that nuance gets lost in their knee-jerk counterattacks. After all, many gold bugs think their moment is approaching once again. As Ron Paul wrote in his 2009 book “End the Fed”: ” … we should be prepared for hyperinflation and a great deal of poverty with a depression and possibly street violence as well.”  And when the stuff hits the fan, nations will again return to the gold standard for stability. Or so goes the theory over at Forbes.

Notwithstanding my high regard for Dr. Ron Paul I have not shared in prognostications of hyperinflation, poverty, and possible street violence.  If such sentiments have occurred at, whose columnists trend to the classical liberal rather than Austrian model preferred by Dr. Paul, they are vanishingly rare.  To indict by imputing Dr. Paul’s views here suggests a lack of familiarity with these publications.  There are some crucial distinctions to which his attention hereby is invited.

There are some civil disputes amongst various camps of gold standard proponents.  They are far less material than the demonstrably incorrect fallacy that the authentic gold standard has deflationary tendencies which precipitated the Great Depression.  Once this fallacy is dispelled, James Pethokoukis and Ramesh Ponnuru may find it congenial to adopt a different posture in the — steadily rising — debate over the gold standard.  They, as do Profs. Beckworth and Sumner, might find themselves arguing for their version of a better policy rather than denigrating the case for gold standard as, in Pethokoukis’s words, “pretty awful.”

To be continued.

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Markets and reality disconnected

The behaviour of financial markets these days is frankly divorced from reality, with value-investing banished.

Markets have become distorted by Rumsfeld-knowns such as interest rate policy and “market guidance”, and Rumsfeld-unknowns such as undeclared market intervention by the authorities. On top of these distortions there is remote investing by computers programmed with algorithms and high-frequency traders, unable to make human value-assessments.

Take just one instance of possible “market guidance” that occurred this week. On Thursday 16th October, James Dullard of the St Louis Fed hinted that QE might be extended. In the ensuing four trading sessions the Dow rallied over 5%. Was this comment sparked by signs of slowing economic growth, or by a desire to buoy up sliding equity markets? Then there is the vested interest of keeping government funding costs low, which raises the question whether or not exceptionally low bond yields, particularly in the Eurozone, are by design or accidental.

Those who support the theory that it is all an evil plot will also note that governments and their central banks through exchange stability funds (set up with the explicit purpose of market intervention), wealth funds and state pension funds have some $30 trillion to direct as they see fit. The reality is that there is intervention across a range of markets; but most of the mispricing is in the hands of private, not government investors. For evidence look no further than the record level of brokers’ loans to buyers of equities, who with greed worthy of a latter-day South-Sea Bubble seek to gear up their speculative profits.

These are not markets with widespread public participation, buying dot-coms and the like. Instead ordinary people have given their savings and pension funds to professionals who speculate on their behalf. It is the professionals who talk about the Yellen put, meaning the Fed simply won’t let prices fall significantly. We can fret about who is actually responsible for market distortions, instead we should ask who benefits.

Governments: in the past they have covered their debts through a process dubbed financial repression, when artificially low interest rates and bond yields were the principal mechanism whereby wealth is transferred from savers to the government. This process still goes on today. Forget government inflation figures: when did a bank deposit net of taxes last give a positive return after your cost of living increases?

Zero interest rate policy lays the process bare, and turns savers into borrowers. Mr Average has replaced savings with mortgages and car loans. And while the elderly and other passive savers are still defenceless against financial repression, the process has taken on a new twist. The transfer of wealth to governments now targets investment managers.

Investment and hedge funds we invest with together with the banks which take our deposits speculate on our behalf. They think that with a Yellen or Draghi put underwriting markets a ten-year government bond with a two per cent yield is an attractive investment. In doing so they are transferring financial resources to governments in a variation on old-fashioned financial repression.

Our dysfunctional markets have become little more than the essential prerequisite, as Louis XIV’s finance minister Colbert might have said, to plucking the goose for the largest amount of feathers with the minimum of hissing.


A market reset due

Recent evidence points increasingly towards global economic contraction.

Parts of the Eurozone are in great difficulty, and only last weekend S&P the rating agency warned that Greece will default on its debts “at some point in the next fifteen months”. Japan is collapsing under the wealth-destruction of Abenomics. China is juggling with a debt bubble that threatens to implode. The US tells us through government statistics that their outlook is promising, but the reality is very different with one-third of employable adults not working; furthermore the GDP deflator is significantly greater than officially admitted. And the UK is financially over-geared and over-dependent on a failing Eurozone.

This is hardly surprising, because the monetary inflation of recent years has transferred wealth from the majority of the saving and working population to a financial minority. A stealth tax through monetary inflation has been imposed on the majority of people trying to earn an honest living on a fixed salary. It has been under-recorded in consumer price statistics but has occurred nonetheless. Six years of this wealth transfer may have enriched Wall Street, but it has also impoverished Main Street.

The developed world is now in deep financial trouble. This is a situation which may be coming to a debt-laden conclusion. Those in charge of our money know that monetary expansion has failed to stimulate recovery. They also know that their management of financial markets, always with the objective of fostering confidence, has left them with market distortions that now threaten to derail bonds, equities and derivatives.

Today, central banking’s greatest worry is falling prices. The early signs are now upon us, reflected in dollar strength, as well as falling commodity and energy prices. In an economic contraction exposure to foreign currencies is the primary risk faced by international businesses and investors. The world’s financial system is based on the dollar as reserve currency for all the others: it is the back-to-base option for international exposure. The trouble is that leverage between foreign currencies and the US dollar has grown to highly dangerous levels, as shown below.

Total World Money 2013

Plainly, there is great potential for currency instability, compounded by over-priced bond markets. Greece, facing another default, borrows ten-year money in euros at about 6.5%, while Spain and Italy at 2.1% and 2.3% respectively. Investors accepting these low returns should be asking themselves what will be the marginal cost of financing a large increase in government deficits brought on by an economic slump.

A slump will obviously escalate risk for owners of government bonds. The principal holders are banks whose asset-to-equity ratios can be as much as 40-50 times excluding goodwill, particularly when derivative exposure is taken into account. The stark reality is that banks risk failure not because of Irving Fisher’s debt-deflation theory, but because they are exposed to a government debt bubble that will inevitably burst: only a two per cent rise in Eurozone bond yields may be sufficient to trigger a global banking crisis. Fisher’s nightmare of bad debts from failing businesses and falling loan collateral values will merely be an additional burden.


Macro-economists refer to a slump as deflation, but we face something far more complex worth taking the trouble to understand.

The weakness of modern macro-economics is it is not based on a credible theory of prices. Instead of a mechanical relationship between changes in the quantity of money and prices, the purchasing power of a fiat currency is mainly dependent on the confidence its users have in it. This is expressed in preferences for money compared with goods, and these preferences can change for any number of reasons.

When an indebted individual is unable to access further credit, he may be forced to raise cash by selling marketable assets and by reducing consumption. In a normal economy, there are always some people doing this, but when they are outnumbered by others in a happier position, overall the economy progresses. A slump occurs when those that need or want to reduce their financial commitments outnumber those that don’t. There arises an overall shift in preferences in favour of cash, so all other things being equal prices fall.

Shifts in these preferences are almost always the result of past and anticipated state intervention, which replaces the randomness of a free market with a behavioural bias. But this is just one factor that sets price relationships: confidence in the purchasing power of government-issued currency must also be considered and will be uppermost in the minds of those not facing financial difficulties. This is reflected by markets reacting, among other things, to the changing outlook for the issuing government’s finances. If it appears to enough people that the issuing government’s finances are likely to deteriorate significantly, there will be a run against the currency, usually in favour of the dollar upon which all currencies are based. And those holding dollars and aware of the increasing risk to the dollar’s own future purchasing power can only turn to gold and subsequently those goods that represent the necessities of life. And when that happens we have a crack-up boom and the final destruction of the dollar as money.

So the idea that the outlook is for either deflation or inflation is incorrect, and betrays a superficial analysis founded on the misconceptions of macro-economics. Nor does one lead to the other: what really happens is the overall preference between money and goods shifts, influenced not only by current events but by anticipated ones as well.


Recently a rising dollar has led to a falling gold price. This raises the question as to whether further dollar strength against other currencies will continue to undermine the gold price.

Let us assume that the central banks will at some time in the future try to prevent a financial crisis triggered by an economic slump. Their natural response is to expand money and credit. However, this policy-route will be closed off for non-dollar currencies already weakened by a flight into the dollar, leaving us with the bulk of the world’s monetary reflation the responsibility of the Fed.

With this background to the gold price, Asians in their domestic markets are likely to continue to accumulate physical gold, perhaps accelerating their purchases to reflect a renewed bout of scepticism over the local currency. Wealthy investors in Europe will also buy gold, partly through bullion banks, but on the margin demand for delivered physical seems likely to increase. Investment managers and hedge funds in North America will likely close their paper-gold shorts and go long when their computers (which do most of the trading) detect a change in trend.

It seems likely that a change in trend for the gold price in western capital markets will be a component part of a wider reset for all financial markets, because it will signal a change in perceptions of risk for bonds and currencies. With a growing realisation that the great welfare economies are all sliding into a slump, the moment for this reset has moved an important step closer.


Math Gone Mad: Regulatory Risk Modeling by the Federal Reserve

The U.S. financial system faces a major, growing, and much under-appreciated threat from the Federal Reserve’s risk modeling agenda—the “Fed stress tests.” These were intended to make the financial system safe but instead create the potential for a new systemic financial crisis.

The principal purpose of these models is to determine banks’ regulatory capital requirements—the capital “buffers” to be set aside so banks can withstand adverse events and remain solvent.

Risk models are subject to a number of major weaknesses. They are usually based on poor assumptions and inadequate data, are vulnerable to gaming and often blind to major risks. They have difficulty handling market instability and tend to generate risk forecasts that fall as true risks build up. Most of all, they are based on the naïve belief that markets are mathematizable. The Fed’s regulatory stress tests are subject to all these problems and more. They:

  • ignore well-established weaknesses in risk modeling and violate the core principles of good stress testing;
  • are overly prescriptive and suppress innovation and diversity in bank risk management; in so doing, they expose the whole financial system to the weaknesses in the Fed’s models and greatly increase systemic risk;
  • impose a huge and growing regulatory burden;
  • are undermined by political factors;
  • fail to address major risks identified by independent experts; and
  • fail to embody lessons to be learned from the failures of other regulatory stress tests.

The solution to these problems is legislation to prohibit risk modeling by financial regulators and establish a simple, conservative capital standard for banks based on reliable capital ratios instead of unreliable models. The idea that the Fed, with no credible track record at forecasting, can be entrusted with the task of telling banks how to forecast their own financial risks, displacing banks’ own risk systems in the process, is the ultimate in fatal conceits. Unless Congress intervenes, the United States is heading for a new systemic banking crisis.

[Editor’s Note: the full document published by the Cato Institute can be found here]


A black mark for benchmarks

“Sir, So Ed Miliband “forgot” to mention the deficit. This from a man who was a key member of the team that ran up a massive structural debt pile when the UK should have been enjoying a cyclical surplus. He was part of a Labour administration that took the UK economy to the brink of effective bankruptcy. Yet less than five years on, as we still struggle to deal with the toxic mess that he and his colleagues left behind, he “forgot” to mention it. This surely ranks alongside “the dog ate my homework” for feeble and unbelievable excuses for non-performance of basic required tasks.”

  • Letter to the FT from Mr Max Irwin of Kew, Surrey, UK.

Politicians and diapers have one thing in common. They should both be changed regularly, and for the same reason.”

  • Anonymous.

It should be striking that government bonds, in nominal terms, have never been this expensive in history, even as there have never been so many of them. The laws of supply and demand would seem to have been repealed. How could this state of affairs have come about ? We think the answer is three-fold:

  1. The bond market is clearly not perfectly efficient.

  2. Bond yields are being manipulated by central banks through a deliberate policy of financial repression (and QE, of course).

  3. Many bond fund managers may be unaware, or unconcerned, that the benchmarks against which they choose to be assessed are illogical and irrational.

What might substantiate our third claim ? It would be the festering intellectual plague that bedevils the fund management world known as indexation. Bond indices allocate their largest weights to the most indebted issuers. This is the precise opposite of what any rational bond investor would do – namely, to overweight their portfolio according to those issuers with the highest credit quality (or perhaps, all things being equal, with the highest yields). But bond indices do exactly the opposite. They force any manager witless enough to have fallen victim to them to load up on the most heavily indebted issuers, which currently also happen to offer amongst the puniest nominal yields. As evidence for the prosecution we cite the US Treasury bond market, the world’s largest. The US national debt currently stands at $17.7 trillion. With a ‘T’. Benchmark 10 year Treasuries currently offer a yield to maturity of 2.5%. US consumer price inflation currently stands at 1.7%. (We offer no opinion as to whether US CPI is a fair reflection of US inflation.) On the basis that US “inflation” doesn’t change meaningfully over the next 10 years, US bond investors are going to earn an annualised return just a smidgen above zero percent.

How do US Treasury yields stack up against the longer term trend in interest rates ? The following data are from @Macro_Tourist:

10 year US Treasury yields since 1791

10 Year US Treasury Yields Since 1971

The chart shows the direction of travel for US market rates since independence, given that the Continental Congress defaulted on its debts.

Now it may well be that US Treasury yields have further to fall. As SocGen’s Albert Edwards puts it,

“Our ‘Ice Age’ thesis has long called for sub-1% bond yields and I see this extending to the US and UK in due course.”

As things stand, the trend is with the polar bears. The German bond market has already broken down through the 1% level (10 year Bunds at the time of writing currently trade at 0.98%).

Deutsche Bank Research – specifically Jim Reid, Nick Burns and Seb Barker – recently published an extensive examination of global debt markets (“Bonds: the final bubble frontier ?” – hat tip to Arnaud Gandon of Heptagon Capital). Deutsche’s strategists ask whether bonds constitute the culminating financial bubble after almost two decades of them:

“After the Asian / Russian / LTCM crises of the late 1990s we entered a supercycle of very aggressive policy responses to major global problems. In turn this helped encourage the 2000 equity bubble, the 2007 housing / financial / debt bubble, the 2010-2012 Euro Sovereign crisis and arguably some recent signs of a China credit bubble (a theme we discussed in our 2014 Default Study). At no point have the imbalances been allowed a full free market conclusion. Aggressive intervention has merely pushed the bubble elsewhere. With no obvious areas left to inflate in the private sector, these bubbles have now arguably moved into government and central bank balance sheets with unparalleled intervention and low growth allowing it to coincide with ultra-low bond yields.” [Emphasis ours.]

The French statesman George Clemenceau once commented that war is too important to be left to generals. At this stage in the game one might be tempted to add that monetary policy is far too important to be left to politicians and central bankers. We get by with free markets in all other walks of economic and financial life – why let the price of money itself be dictated by a handful of State-appointed bureaucrats ? We were once told by a fund manager (a Japanese equity manager, to be precise – rare breed that that is now), around the turn of the millennium, that Japan would be the dress rehearsal, and that the rest of the world would be the main event. Again, the volume of the mood music is rising in SocGen’s favour.

We nurse no particular view in relation to how the government bond bubble (for it surely is) plays out – whether yields grind relentlessly lower for some time yet, or whether they burst spectacularly on the back of the overdue return of bond market vigilantes or some other mystical manifestation of long-delayed economic common sense. But Warren Buffett himself once said that,

“If you’ve been playing poker for half an hour and you still don’t know who the patsy is, you’re the patsy.”

The central bank bond market poker game has been in train for a good deal longer than half an hour, and the stakes have never been higher. Sometimes, if you simply can’t fathom the new rules of the game, it’s surely better not to play. So we’re not in the business of chasing US Treasury yields, or Gilt yields, or Bund yields, ever lower – we’ll keep our bond exposure limited to only the highest quality credits yielding the highest possible return. Even then, if Fed tapering does finally dissipate in favour of Fed hiking – stranger things have happened, though we can’t think of any off the top of our head – it will make sense at the appropriate time to eliminate conventional debt instruments from client portfolios almost entirely.

But indexation madness is not limited to the world of bonds. Its malign, unthinking mental slavery has fixed itself upon the equity markets, too. Equity indices, as is widely acknowledged, allocate their largest weights to the largest and most expensive stocks. What’s extraordinary is that even as stock markets have powered ahead, index trackers have enjoyed their highest ever inflows. The latest IMA data show that more UK retail money was put into tracker funds in July than in any other month since records began. We accept the ‘low cost’ aspect of tracker funds and ETFs; we take serious issue with the idea of buying stock markets close to or at their all-time high and being in for any downside ride on a 1:1 basis.

But there is a middle way between the Scylla of bonds at all-time low yields and the Charybdis of stocks at all-time high prices. Value. Seth Klarman of the Baupost Group once wrote as follows:

“Stock market efficiency is an elegant hypothesis that bears quite limited resemblance to the real world. For over half a century, disciples of Benjamin Graham, the intellectual father of value investing, have prospered buying bargains that efficient market theory says should not exist. They take advantage of the short-term, relative performance orientation of other investors. They employ an absolute (not relative) valuation compass, patiently exploiting mispricings while avoiding overpaying for what is popular and trendy. Many are willing to concentrate their exposures, knowing that their few best ideas are better than their hundredth best, and confident in their ability to tell which is which.

“Value investors thrive not by incurring high risk (as financial theory would suggest), but by deliberately avoiding or hedging the risks they identify. While efficient market theorists tell you to calculate the beta of a stock to determine its riskiness, most value investors have never calculated a beta. Efficient market theory advocates moving a portfolio of holdings closer to the efficient frontier. Most value investors have no idea what this is or how they might accomplish such a move. This is because financial market theory may be elegant, but it is not particularly useful in formulating a successful investment strategy.

“If academics espousing the efficient market theory had no influence, their flawed views would make little difference. But, in fact, their thinking is mainstream and millions of investors make their decisions based on the supposition that owning stocks, regardless of valuation and analysis, is safe and reasonable. Academics train hundreds of thousands of students each year, many of whom go to Wall Street and corporate suites espousing these beliefs. Because so many have been taught that outperforming the market is impossible and that stocks are always fairly and efficiently priced, investors have increasingly adopted strategies that eventually will prove both riskier and far less rewarding than they are currently able to comprehend.”

That sounds about right to us. Conventional investing, both in stocks and bonds on an indexed or benchmarked basis, “will prove both riskier and far less rewarding” than many investors are currently able to comprehend.


Does low US price inflation provide room for a more aggressive Fed?

The US Federal Reserve can keep stimulating the US economy because inflation is posing little threat, Federal Reserve Bank of Minneapolis President Kocherlakota said. “I am expecting an inflation rate to run below 2% for the next four years, through 2018”, he said. “That means there is more room for monetary policy to be helpful in terms of … boosting demand without running up against generating too much inflation”.

The yearly rate of growth of the consumer price index (CPI) stood at 1.7% in August against 2% in July and the official target of 2%. According to our estimate the yearly rate of growth of the CPI could close at 1.4% by December. By December next year we forecast the yearly rate of growth of 0.6%.

Shostak CPI

It seems that the Minneapolis Fed President holds that by boosting the demand for goods and services by means of an additional monetary pumping it is possible to strengthen the economic growth. He believes that by means of strengthening the demand for goods and services the production of goods and services will follow suit. But why should it be so?

If by means of monetary pumping one could strengthen the economic growth then it would imply that by means of monetary pumping it is possible to create real wealth and generate an everlasting economic prosperity.

This would also mean that world wide poverty should have been erased a long time ago, after all most countries today have central banks that possess the skills of how to pump money. Yet world poverty remains intact.

Despite the massive monetary pumping since 2008 and the policy interest rate of around zero Fed policy makers seem to be unhappy with the so-called economic recovery. Note that the Fed’s balance sheet, which stood at $0.86 trillion in January 2007 jumped to $4.4 trillion by September this year – a monetary pumping of almost $4 trillion.

Shostak Fed Balance Sheet

We suggest that there is no such thing as an independent category called demand. Before an individual can exercise demand for goods and services he/she must produce some other useful goods and services. Once these goods and services are produced individuals can exercise their demand for the goods they desire. This is achieved by exchanging things that were produced for money, which in turn can be exchanged for goods that are desired. Note that money serves here as the medium of the exchange – it produces absolutely nothing. It permits the exchange of something for something. Any policy that results in monetary pumping leads to an exchange of nothing for something. This amounts to a weakening of the pool of real wealth – and hence to reduced prospects for the expansion of this pool.

What is required to boost the economic growth – the production of real wealth – is to remove all the factors that undermine the wealth generation process. One of the major negative factors that undermine the real wealth generation is loose monetary policy of the central bank, which boosts demand without the prior production of wealth. (Once the loopholes for the money creation out of “thin air” are closed off the diversion of wealth from wealth generators towards non-productive bubble activities is arrested. This leaves more real funding in the hands of wealth generators – permitting them to strengthen the process of wealth generation i.e. permitting them to grow the economy).

Now, the artificial boosting of the demand by means of monetary pumping leads to the depletion of the pool of real wealth. It amounts to adding more individuals that take from the pool of real wealth without adding anything in return –an economic impoverishment.

The longer the reckless loose policy of the Fed stays in force the harder it gets for wealth generators to generate real wealth and prevent the pool of real wealth from shrinking.

Finally, the fact that the yearly rate of growth of the CPI is declining doesn’t mean that the Fed’s monetary pumping is going to be harmless. Regardless of price inflation monetary pumping results in an exchange of nothing for something i.e. an economic impoverishment.


The Taylor Rule Won’t Save Us

[Editor’s Note: This article, by Mateusz Machaj, first appeared at]


Various criticisms have been raised against the Fed, not only from the side favoring the abolition of central banking, but also from the side of those who argue that the Federal Reserve is indispensable for stability. One of those arguments came from respected economist John Taylor, who is the author of the often mentioned “Taylor Rule” on how to conduct monetary policy, with two House Republicans recently proposing to impose this “rule” on the Fed .

Like Taylor, politicians who advocate for such a rule blame huge credit expansion for the Great Recession. Unfortunately such policymakers are usually not convinced by the Austrian arguments in favor of abolition of the Federal Reserve. Instead they are convinced by John Taylor’s statistical demonstrations. According to Taylor, the Fed set the interest rates too low in the beginning of this century, which led to an unsustainable real estate boom. He adds nonetheless: if only the central bank followed his rule of proper interest rate levels, then monetary policy would work very well.

For Taylor, the Federal Funds rate in recent years should have looked something like this:

The first thing to note about the Taylor Rule is that, strictly speaking, there is no such thing as one universal Taylor Rule. There are many possible Taylor Rules, depending on a variety of factors, on which there is no agreement. Any version of the rule crucially depends on the usage of mathematical variables and their coefficients in the used equation, which is used for calculating the “right” level of interest rates set by the central bank. Those main variables are price inflation and the so called “output gap,” a difference between “actual output” and “potential output.”

Depending on which variables we exactly pick and how we use them, we can have different rules, and therefore different interest rate policy recommendations. It is all well documented in the mainstream literature. Economists disagree how to measure “potential output” (should we use trends, econometric models, or “production function models”?) and there is no agreement how much importance should be assigned to it. There are discussions about the nature of the data that is being used — should it be the one registered currently, or real-time data, or should it be somehow adjusted, since every data set will sooner or later become revised data? Or perhaps since monetary policy takes time we should focus more on the predicted data, rather than just look at the immediate past? We can add to this the Austrian flavor: there are problems with proper price inflation measurements (various indices can differ significantly), and even the actual output measurements can be questioned as proper indicators of economic activity.

It is in fact the case that one can come up with several versions of the Taylor Rule. For example, we could come up with one that would recommend lower interest rates than what we had at the beginning of this century or we could come up with a version of the rule that would recommendhigher interest rates. Or we could come up with one that suggests no change. Research does not give us any clear answer which version of the rule should be chosen.

One particular version which John Taylor is using for his criticism of Alan Greenspan, for example, serves as an ex post demonstration that interest rates should have been higher. Yet there is nothing really that special about this inference. After the fact, anyone can come up with an alternate version of any rule to demonstrate that interest rates should have been higher.

The crucial question to be answered is the following: can reliance on one particular version of the Taylor Rule pave the way for a bubble-proof economy? As described above, a Taylor Rule in any of its versions can at best target the balance between a chosen index for “price inflation” and a chosen way of measuring the invented concept of aggregate “potential output.”

The problem is that targeting either of those macroeconomic variables is not a recipe forintertemporal coordination understood in the Hayekian sense: as coordination between successive stages of production. In his major works Hayek proved that targeting one selected variable, such as price inflation, is not a proper formula for macroeconomic stability. Actually, stabilizing the index may ultimately cause macroeconomic destabilization. It is the same case with Taylor Rules, although in the rule the concept of “potential output” is hidden. Yet this potential output describes production in the aggregate, so it cannot capture the notion of intertemporal coordination among many acting individuals in countless industries.

Malinvestment bubbles are still possible when the central bank follows Taylor Rules, because by targeting potential output and price inflation the central bank triggers artificial credit expansions. For an example, we need only look to the dot-com bubble which happened even though the federal funds rates were actually significantly higher in the nineties than the most-used version of the Taylor Rule would recommend at that time.

The answer to the Taylor Rule is the Hayek Rule, which is the rule of balancing savings with investments in truly free financial markets. Meanwhile, we must endure the current situation of a market stimulated by the central bank with its pretense of knowledge about the “right” price for money and credit.


Understanding Deposit Insurance (I): Deposit Insurance is a Creature of the State

Deposit insurance is one of the most misunderstood – and also most dangerous – forms of government intervention into the financial system.


Let’s start with the common misconception that deposit insurance is an industry-operated affair independent of the government.


In the UK, deposit insurance is provided by the Financial Services Compensation Scheme (FSCS). To quote from its website:


“The FSCS is the UK’s statutory fund of last resort for customers of financial services firms. This means that FSCS can pay compensation to consumers if a financial services firm is unable, or likely to be unable, to pay claims against it. The FSCS is an independent body, set up under the Financial Services & Markets Act 2000 (FSMA).”


It also explains that the FSCS is funded by levies on firms authorised to operate by either of the Prudential Regulation Authority or the Financial Conduct Authority.


So the FSCS is notionally independent and the guarantees are financed by levies on participating firms.


However, this does not mean that deposit insurance is in any way a free-market phenomenon: it is explicitly the creature of legislation and participating firms are compelled not just to join, but to join on dictated terms. This is rather like having a system of compulsory car insurance and, moreover, a compulsory system that mandates the exact terms (including the pricing) of the car insurance itself – compulsory one-size-fits-all.


This should set off alarm bells that there might be something wrong with it.


And how do we know that its designers designed it properly? We don’t.


In fact, we know that they couldn’t possibly have designed it properly, as any rational insurance system would tailor the charges to the riskiness of clients, include co-insurance features and other incentives to moderate risk-taking, have charges that would evolve over time in response to changing market conditions, and so forth. This is insurance 101.


This is not how deposit insurance works, however.


Most of all, any rational system would have the product delivered by the market, not by some jerry-built contraption dreamt up by committees of legislators and regulators who have neither the knowledge nor the incentive to get it right. One also might add few if any of these people have any experience in or understanding of the industry they are meddling with, but let’s move on.


It then occurred to me that perhaps my kids are right and I am too cynical – maybe Father Christmas and the fairies do exist: one should keep an open mind – so I checked out the FSCS website to have a closer look at their system. What I found was a masterpiece of gobbledegook that I highly recommend to other connoisseurs of regulatory gibberish:


Backward ran sentences until reeled the mind. My favourite bit is the explanation of the levy calculation that does not explain how the levy is actually calculated.


All this said, the banks rather like deposit insurance because it gives them a great marketing tool: bank with us and your money is safe because we are members of the deposit guarantee scheme, and you will get your money back even if we happen to fail.


They also like it because they can game the system – taking extra risks and offering higher deposit rates than they would otherwise be able to get away with – in effect, exploiting the risk-taking subsidy created by deposit insurance and passing the extra risks to the fund itself.


But surely, if the banks like the system, they would create one themselves if the government didn’t create it for them? No. Were this true, the banks would have done exactly that many years ago, and there would have been no ‘need’ for the state to have intervened to do it for them. The fact is that they didn’t.


The reason they didn’t is because the service that deposit insurance provides to the retail customer – reassurance or confidence – is better provided in other ways, most notably, by pursuing conservative lending policies and maintaining high levels of capital. And the reason for this is simply that deposit insurance introduces an additional layer of moral hazard and governance headaches that can be avoided if the banks self-insure via moderate risk-taking and high levels of capital.


This should come as no surprise. True confidence does not come from “you can trust us if we screw up because someone else will bail you out” but from “you can trust us because it is demonstrably in our interest to make sure we don’t screw up”. Deposit insurance is an inferior confidence product – one might even say, a confidence trick.


We can also look at this another way. Suppose that a group of banks attempted to set up a scheme similar to the current one, of their own free will and with no government intervention. They would soon realise that the scheme was not viable – no bank would want to be liable for the risks the others were taking, with no means of controlling those risks. So it would never get off the ground – and the current system only got off the ground because the state imposed it.


In short, deposit insurance is not a creature of the market but a creature of the state, and a decidedly inferior one at that. It is, indeed, a classic instance of that regulatory Gresham’s Law by which state intervention causes the bad to drive out the good. Where have we seen that before?