Book Reviews

‘The system has spun out of control’

Book Review: The Death of Money: The Coming Collapse of the International Monetary System by James Rickards

The_Death_of_Money_Cover_ArtThe title will no doubt give Cobden Centre readers a feeling of déjà vu, but James Rickards’ new book (The Death of Money: The Coming Collapse of the International Monetary System) deals with more than just the fate of paper money – and in particular, the US dollar. Terrorism, financial warfare and world government are discussed, as is the future of the European Union.

Though he quotes F.A. Hayek a few times, the Austrian School gets only one mildly disparaging mention in the entire book. This seems odd for an author who devotes a whole chapter to the benefits of the gold standard. His first bestselling book, Currency Wars, argues that currency wars are not just an economic or monetary concern, but a national security concern for the USA.

Rickards relies on emerging Chaos theories of economics and markets (1) to buttress his arguments in favour of sound money and prudent – limited – government. He uses the same insights, twinned with years of Wall Street experience, to explain why the “coming collapse of the dollar and the international monetary system is entirely foreseeable.”

One of Rickards’ key arguments is that exponential increases in the total size of credit markets mean exponential increases in risk. The gross size of derivative markets is the problem, irrespective of false assurances about netting, he claims. Politicians and central bankers have by and large learnt nothing from recent crises, and are still “in thrall to bank political contributions.”

He makes the case for the US federal government to reinstate Depression-era restrictions on banking activities and for most derivatives to be banned. As a former Federal Reserve Chairman, Paul Volcker, said in 2009, “the only useful thing banks have invented in 20 years is the ATM” – a sentiment Rickards would probably be sympathetic to.

The chapter dealing with the Fed’s hubris and what investment writer James Grant calls our “PhD Standard” of macroeconomic management will be familiar territory for readers of this site. The Fed is trapped between the rock of natural deflationary forces of excessive debt, an ageing population and cheap imports frustrating its efforts to generate a self-sustaining economic recovery and the hard place of annualised inflation of 2%. Rickards quotes extensively from eminent economist and Ben Bernanke mentor Frederic Mishkin, who noted in a 2013 paper titled Crunch Time: Fiscal Crises and the Role of Monetary Policy that “ultimately, the central bank is without power to avoid the consequences of an unsustainable fiscal policy.”

More interesting is the author’s attempt to map out what-happens-next scenarios. The chapter about the on-going transformation of the International Monetary Fund into the world’s central bank, and Special Drawing Rights (SDRs) into a global currency, is particularly insightful. Though Rickards doesn’t say it, Barack Obama’s former chief of staff (and current Mayor of Chicago) Rahm Emanuel’s dictum about never letting a crisis go to waste seems to apply here: hostile acts of financial warfare would lead to calls for more international regulation, and to more government intervention and monitoring of markets. Observers of the EU’s crab-like advance over the last half century will be familiar with the process.

Indeed, my only quibble with this book is Rickards’ starry-eyed take on the EU – soon to be “the world’s economic superpower” in his view. Though he makes a good argument – similar to Jesús Huerta de Soto’s – that relatively-tight European Central Bank monetary policy is forcing effective structural adjustments in the eurozone periphery, as well as in eastern states that wish to join the euro, his endorsement of other aspects of the EU seem too sweeping.

The author talks of the benefits of “efficiencies for the greater good” in supranational government, and how subsidiarity makes allowances for “local custom and practice”. But, as the regulatory débacle surrounding the Somerset floods has shown recently, EU rule frequently licenses bureaucratic idiocies that destroy effective, established national laws. Regulatory central planning for an entire continent is, I’d say, just as suspect as monetary central planning for one country.

The continent’s demographic problems are probably containable in the short-term, as Rickards says. But mass immigration is driving increasing numbers of white Europeans to far-right parties. And while there is consistently strong public support for the euro in the PIIGS (Portugal, Ireland, Italy, Greece and Spain), he’s silent on the broader question of the EU’s democratic legitimacy. No mention of those pesky ‘No’ votes in European Constitution, Maastricht and Lisbon Treaty referendums – or of the Commission’s own Eurobarometer polls, which show more and more Europeans losing faith in “the project”.

No matter I suppose: the eurocrats will rumble on regardless. But what was that quote about democracy being the worst form of government apart from all the others?

All in all though, this is a great book – even for someone like me who’s not exactly new to the economic doom ‘n’ gloom genre. As Rickards says at the end of his intro: “The system has spun out of control.”

(1) For example Juárez, Fernando (2011). “Applying the theory of chaos and a complex model of health to establish relations among financial indicators”. Procedia Computer Science 3: 982–986.


Fed tightens control over banks activities

On Tuesday July 2, US central bank policy makers voted in favour of the US version of the global bank rules known as the Basel 3 accord. The cornerstone of the new rules is a requirement that banks maintain high quality capital, such as stock or retained earnings, equal to 7% of their loans and assets.

The bigger banks may be required to hold more than 9%. The Fed was also drafting new rules to limit how much banks can borrow to fund their business known as the leverage ratio.

We suggest that the introduction of new regulations by the Fed cannot make the current monetary system stable and prevent financial upheavals.

The main factor of instability in the modern banking system is the present paper standard which is supported by the existence of the central bank and fractional reserve lending.

Now in a true free market economy without the existence of the central bank, banks will have difficulties practicing fractional reserve banking.

Any attempt to do so will lead to bankruptcies, which will restrain any bank from attempting to lend out of “thin air”.

Fractional reserve banking can, however, be supported by the central bank. Note that through ongoing monetary management, i.e., monetary pumping, the central bank makes sure that all the banks can engage jointly in the expansion of credit out of “thin air” via the practice of fractional reserve banking.

The joint expansion in turn guarantees that checks presented for redemption by banks to each other are netted out, because the redemption of each will cancel the other redemption out.

By means of monetary injections, the central bank makes sure that the banking system is “liquid enough” so that banks will not bankrupt each other.

The consequences of the monetary management of the Fed as a rule are manifested in terms of boom-bust cycles.

As times goes by this type of management runs the risk of severely weakening the wealth generation process and runs the risk of severely curtailing so called real economic growth.

We maintain that as long as the present monetary system stays intact it is not possible to prevent a financial crisis similar to the one we had in 2007-9. The introduction of new tighter capital requirements by banks cannot make them more solvent in the present monetary system.

Meanwhile, banks have decided to restrain their activity irrespective of the Fed’s new rules. Note that they are sitting on close to $2cg trillion in excess cash reserves.  The yearly rate of growth of banks inflationary lending has fallen to 4.1% in June from 4.2% in May and 22.4% in June last year.

Once the economy enters a new economic bust banks are likely to run the risk of experiencing a new financial crisis, the reason being that so called current good quality loans could turn out to be bad assets once the bust unfolds.

A visible decline in the yearly rate of growth of banks inflationary lending is exerting a further downward pressure on the growth momentum of our monetary measure AMS.

Year-on-year the rate of growth in AMS stood at 7.7% in June against 8.3% in May and 11.8% in June last year.

We suggest that a visible decline in the growth momentum of AMS is expected to bust various bubble activities, which sprang up on the back of the previous increase in the growth momentum of money supply.

Remember that economic bust is about busting bubble activities. Beforehand it is not always clear which activity is a bubble and which is not.

Note that once a bust emerges seemingly good companies go belly up. Given that since 2008 the Fed has been pursuing extremely loose monetary policy this raises the likelihood that we have had a large increase in bubble activities as a percentage of overall activity.

Once the bust emerges this will affect a large percentage of bubble activities and hence banks that provided loans to these activities will discover that they hold a large amount of non-performing assets.

A likely further decline in lending is going to curtail lending out of “thin air” further and this will put a further pressure on the growth momentum of money supply.

In fractional reserve banking, when money is repaid and the bank doesn’t renew the loan, money evaporates. Because the loan was originated out of nothing, it obviously couldn’t have had an owner.

In a free market, in contrast, when money i.e. gold is repaid, it is passed back to the original lender; the money stock stays intact.

Since the present monetary system is fundamentally unstable it is not possible to fix it. The central bank can keep the present paper standard going as long as the pool of real wealth is still expanding.

Once the pool begins to stagnate – or worse, shrinks – then no monetary pumping will be able to prevent the plunge of the system.

A better solution is of course to have a true free market and allow the gold to assert its monetary role. As opposed to the present monetary system in the framework of a gold standard money cannot disappear and set in motion the menace of the boom-bust cycles.

Summary and conclusion

Last week US central bank policy makers voted in favour of tighter rules on banks’ activities. The essence of the new rules is that banks maintain high quality capital equal to 7% of their assets. The new rules are aimed at making banks more solvent and to prevent repetitions of the 2008-2009 financial upheavals. We suggest that in the present monetary system which involves the existence of the central bank and fractional reserve banking it is not possible to make the monetary system more stable and immune to financial upheavals. As long as the Fed continues to tamper with interest rates and money supply we are going to have boom-bust cycles and financial upheavals.


The problem with regulation

It is seems to be universally agreed that regulation is a good thing, ensuring that people are treated fairly by unscrupulous businesses. Regulation is a vindication of state intervention and control. The alternative is seen as a free-market jungle full of hidden dangers and traps for the unwary and innocent.

It is less universally known that regulation was the method that the pre-war fascists used to pursue their political ends, contrasting with communism which sought instead to own the means of production. Post-war, regulation re-emerged in the 1980s when it was used to control newly-privatised state monopolies to make privatisation politically acceptable. And every country that followed the UK in their own privatisation programmes adopted regulation as the means of maintaining state control.

These privatised industries are still regulated today, with the addition of financial services and less obviously perhaps most other aspects of economic life. European socialists reinvented themselves by dropping their commitment to ownership of the means of production in favour of the fascist model. Thus, the policies of the right and left became joined at the hip.

The objective of regulation may be to protect the consumer but the weaknesses are multiple. In framing and operating the rules, Government gets to decide what people should have. Businesses use the seal of regulatory approval as a replacement for stand-alone reputation, and regulation eliminates both competition and innovation from unregulated businesses. It ensures that big business has a basis for partnership with government, and that government does big business’s bidding.

At its heart regulation is therefore anti-competitive. It is not based on consumer choice and the subjective values of goods and services that go with it. Instead it allows businesses to act as monopoly providers, where their costs determine prices. But fixing prices to the cost of production is only a first step: a regulated business can find many ways of placing regulation above the interests of the consumer by gaming the system.

This is most obvious in financial services. Under the cloak of regulation, the general public has become a source of profits not through being provided a benefit, but by simply acquiring its wealth. If the reader doubts this statement, he needs to explain how and why all large investment banks are able to declare trading profits every business day, when an independent professional trader reckons to do well with a 55-60% success rate.

There is nothing wrong with any business having conflicts of interest as such: after all, it is up to the consumer to judge whether or not to deal with it. The wrong is for the state to give business respectability through licencing and regulation, replacing genuine commercial reputation.

Defenders of regulation do not realise that it is primarily a means of state control. This is why all political parties with very few exceptions endorse it. And that is the insidious part of it: in an effort to correct the many wrongs of regulation, more and more regulations, always amounting to greater state control, are subsequently introduced.

Instead of protecting the unwary and innocent, regulation encourages businesses to manipulate the system with a view to enhancing their own protection and profit. As is so often the case with government interference in social and economic matters, regulation achieves the exact opposite of the stated objective.

This article was previously published at


Collateral transformation: the latest, greatest financial weapon of mass destruction

Back in 2006, as the debate was raging whether or not the US had a mortgage credit and housing bubble, I had an ongoing, related exchange with the Chief US Economist of a large US investment bank. It had to do with what is now commonly referred to as the ‘shadow banking system’.

While the debate was somewhat arcane in its specifics, it boiled down to whether the additional financial market liquidity created through the use of securities repo and other forms of collateralised lending were destabilising the financial system.

The Chief US Economist had argued that, because US monetary aggregates were not growing at a historically elevated rate, the Fed was not adding liquidity fuel to the house price inflation fire and that monetary policy was, therefore, appropriate. (Indeed, he denied that the rapid house price inflation at the time was cause for serious concern in the first place.) I countered by arguing that these other forms of liquidity (eg. securities repo) should be included and that, if they were, then in fact the growth of broad liquidity was dangerously high and almost certainly was contributing to the credit+housing bubble.

We never resolved the debate. My parting shot was something along the lines of, “If the financial markets treat something as a money substitute—that is, if the incremental credit spread for the collateral providing the marginal liquidity approaches zero— then we should treat it as a form of de facto money.”

He dismissed this argument although I’m not sure he really understood it; at least not until there was a run on money-market funds in the wake of the Lehman Brothers bankruptcy in November 2008. It was at that point that economic officials at the Fed and elsewhere finally came to realise how the shadow banking system had grown so large that it was impossible to contain the incipient run on money-market funds and, by extension, the financial system generally without providing explicit government guarantees, which the authorities subsequently did.

This particular Chief US Economist had previously worked at the Fed. This was and remains true, in fact, of a majority of senior US bank economists. Indeed, in addition to a PhD from one of the premiere US economics departments, a tour of duty at the Fed, as it were, has traditionally been the most important qualification for this role.

Trained as most of them were, in the same economics departments and at the same institution, the Fed, it should perhaps be no surprise that neither the Fed, nor senior economists at the bulge-bracket banks, nor the US economic academic and policy mainstream generally predicted the global financial crisis. As the discussion above illuminates, this is because they failed to recognise the importance of the shadow banking system. But how could they? As neo-Keynesian economists, they didn’t—and still don’t—have a coherent theory of money and credit.[1]


Time marches on and with lessons learned harshly comes a fresh resolve to somehow get ahead of whatever might cause the next financial crisis. For all the complacent talk about how the “recovery is on track” and “there has been much economic deleveraging” and “the banks are again well-capitalised,” the truth behind the scenes is that central bankers and other economic officials the world over remain, in a word, terrified. Of what, you ask? Of the shadow banking system that, I believe, they still fail to properly understand.

Two examples are provided by a recent speech given by Fed Governor Jeremy Stein and a report produced by the Bank of International Settlements (BIS), the ‘central bank of central banks’ that plays an important role in determining and harmonising bank regulatory practices internationally.
The BIS report, “Asset encumberance, financial reform and the demand for collateral assets,” was prepared by a “Working Group established by the Committee on the Global Financial System,” which happens to be chaired by none other than NYFed President William Dudley, former Chief US Economist for Goldman Sachs. (No, he is not the Chief US Economist referred to earlier in this report, although as explained above these guys are all substitutes for one another in any case.) [2]

In the preface, Mr Dudley presents the report’s key findings, in particular “evidence of increased reliance by banks on collaterised funding markets,” and that we should expect “[t]emporary supply-demand imbalances,” which is central banker code for liquidity crises requiring action by central banks.

He also makes specific reference to ‘collateral transformation’: when banks swap collateral with each other. This practice, he notes, “will mitigate collateral scarcity.” But it will also “likely come at the cost of increased interconnectedness, procyclicality and financial system opacity as well as higher operational, funding and rollover risks.”

Why should this be so? Well, if interbank lending is increasingly collateralised by banks’ highest quality assets, then unsecured creditors, including depositors, are being de facto subordinated in the capital structure and are highly likely to ‘run’ at the first signs of trouble. And if banks are holding similar types of collateral that suddenly fall in value, then they can all become subject to a run at the same time, for the same reason.

Collateral transformation is thus a potentially powerful FWMD. But don’t worry, the BIS and other regulators are on the case and doing the worrying. As a belated response to the financial crisis that they all failed to foresee, the latest, greatest trend in financial system oversight is ‘liquidity regulation’. Fed Governor Jeremy Stein explains the need for it thus:

[A]s the financial crisis made painfully clear, the business of liquidity provision inevitably exposes financial intermediaries to various forms of run risk. That is, in response to adverse events, their fragile funding structures, together with the binding liquidity commitments they have made, can result in rapid outflows that, absent central bank intervention, lead banks to fire-sell illiquid assets or, in a more severe case, to fail altogether. And fire sales and bank failures–and the accompanying contractions in credit availability–can have spillover effects to other financial institutions and to the economy as a whole. Thus, while banks will naturally hold buffer stocks of liquid assets to handle unanticipated outflows, they may not hold enough because, although they bear all the costs of this buffer stocking, they do not capture all of the social benefits, in terms of enhanced financial stability and lower costs to taxpayers in the event of failure. It is this externality that creates a role for policy. [3]

Ah yes, wouldn’t you know it, that ubiquitous, iniquitous enigma: market failure. Regulators have never found a market that doesn’t fail in some way, hence the crucial need for regulators to prevent the next failure or, at a minimum, to sort out the subsequent mess. In the present instance, so the thinking behind liquidity regulation goes, prior to 2008 the regulators were overly focused on capital adequacy rather than liquidity and, therefore, missed the vastly expanded role played by securitised collateral in the international shadow banking system. In other words, the regulators now realise, as I was arguing back in the mid-2000s, that the vast growth in shadow banking liquidity placed the stability of the financial system at risk in the event that there was a drop in securitised collateral values.

In 2007, house prices began to decline, taking collateral values with them and sucking much of the additional, collateral-based liquidity right back out of the financial system, unleashing a de facto wave of monetary+credit deflation, resulting in the subsequent financial crisis. But none of this was caused by ‘market failure’, as Governor Stein contends. Rather, there is another, simpler explanation for why banks were insufficiently provisioned against the risk of declining collateral values, yet it is not one that the regulators much like to hear, namely, that their own policies were at fault.

In one of my first Amphora Reports back in 2010 I discussed in detail the modern history of financial crises, beginning with the 1980s and concluding with 2008. A pattern rapidly becomes apparent:

[Newton’s] third law of universal motion was that for each and every action there is an equal and opposite reaction. While applicable to the natural world, it does not hold with respect to the actions of financial markets and the subsequent reactions of central banks and other regulators. Indeed, the reactions of regulators are consistently disproportionate to the actions of financial markets. In sinister dialectical fashion, the powers assumed and mistakes made by policymakers tend to grow with each crisis, thereby ensuring that future crises become progressively more severe…

[W]as the Fed’s policy reaction to the 1987 crash proportionate or even appropriate? Was it “an equal but opposite reaction” which merely temporarily stabilised financial markets or did it, in fact, implicitly expand the Fed’s regulatory role to managing equity prices? Indeed, one could argue that this was merely the first of a series of progressively larger “Greenspan Puts” which the Fed would provide to the financial markets during the 18 years that the so-called “Maestro” was in charge of monetary policy and, let’s not forget, bank regulation…

By the late 1980s, a huge portion of the S&L industry was insolvent. The recession of 1990-91, made a bad situation worse. FSLIC funds were rapidly depleted. But a federal guarantee is supposed to be just that, a guarantee, so Congress put together a bailout package for the industry. A new federal agency, the Resolution Trust Corporation (RTC), issued bonds fully backed by the US Treasury and used the proceeds to make insolvent S&L depositors whole…

In retrospect, the entire S&L debacle, from its origins in regulatory changes and government guarantees, through the risky lending boom, bust, credit crunch and fiscal and monetary bailout can be seen as a precursor to the far larger global credit bubble and bust of 2003-2008: Just replace the S&Ls with Fannie/Freddie and the international shadow banking system. But there is no need to change the massive moral hazard perpetrated by incompetent government regulators, including of course the Fed, and the reckless financial firms who played essentially the same role in both episodes.[4]

Notwithstanding this prominent pattern of market-distorting interest-rate manipulation, guarantees, subsidies and occasional bailouts, fostering the growth of reckless lending and other forms of moral hazard, the regulators continue their self-serving search for the ‘silver bullet’ to defend against the next ‘market failure’ which, if diagnosed correctly as I do so above is, in fact, regulatory failure.

Were there no moral hazard of guarantees, explicit or implicit, in the system all these years, the shadow banking system could never have grown into the regulatory nightmare it has now become and liquidity regulation would be a non-issue. Poorly capitalised banks would have failed from time to time but, absent the massive systemic linkages that such guarantees have enabled—encouraged even—these failures would have been contained within a more dispersed and better capitalised system.

As it stands, however, the regulators’ modus operandi remains unchanged. They continue to deal with the unintended consequences of ‘misregulation’ with more misregulation, thereby ensuring that yet more unintended consequences lurk in the future.


In his speech, Governor Stein also briefly mentions collateral transformation, when poor quality collateral is asset-swapped for high quality collateral. Naturally this is not done 1:1 but rather the low quality collateral must be valued commersurately higher. In certain respects these transactions are similar to traditional asset swaps that trade fixed for floating coupons and allow financial and non-financial businesses alike to manage interest rate and credit risk with greater flexibility. But in the case of collateral transformation, what is being swapped is the principal and the credit rating it represents, and one purpose of these swaps is to meet financial regulatory requirements for capital and, in future, liquidity.

An obvious consequence of such collateral transformation is that it increases rather than decreases the linkages in the financial system and thus in effect replaces firm-specific, idiosyncratic risk with systemic risk, exactly the opposite of what the regulators claim they are trying to do by increasing bank regulatory capital ratios. Liquidity regulation is an attempt to address this accelerating trend and the growing systemic risks it implies.

Those financial institutions engaging in the practice probably don’t see things this way. From the perspective of any one instution swapping collateral in order to meet changing regulatory requirements, they see it as necessary and prudent risk management. But within a closed system, if most actors are behaving in the same way, then the net risk is not, in fact, reduced. The perception that it is, however, can be dangerous and can also contribute to banks unwittingly underprovisioning liquidity and undercapitalising against risk.

Viewed system-wide, therefore, collateral transformation really just represents a form of financial alchemy rather than financial engineering. It adds no value in aggregate. It might even detract from such value by rendering opaque risks that would otherwise be more immediately apparent. So I do understand the regulators’ concerns with the practice. I don’t, however, subscribe to their proposed self-serving remedies for what they perceive as just another form of market failure.


Already plagued by the ‘Too Big to Fail’ (TBTF) problem back in 2008, the regulators have now succeeded in creating a new, even more dangerous situation I characterise as MAFID, or ‘Mutual Assured FInancial Destruction.’ Because all banks are swapping and therefore holding essentially the same collateral, there is now zero diversification or dispersion of financial system risk. It is as if there is one massive global bank with thousands of branches around the world, with one capital base, one liquidity ratio and one risk-management department. If any one branch of this bank fails, the resulting margin call will cascade via collateral transformation through the other branches and into the holding company at the centre, taking down the entire global financial system.

Am I exaggerating here? Well, if Governor Stein and his central banking colleagues in the US, at the BIS and around the world are to be believed, we shouldn’t really worry because, while capital regulation didn’t prevent 2008, liquidity regulation will prevent the scenario described above. All that needs to happen is for the regulators to set the liquidity requirements at the right level and, voila, financial crises will be a thing of the past: never mind that setting interest rates and setting capital requirements didn’t work out so well. Setting liquidity requirements is the silver bullet that will do the trick.

Sarcasm aside, it should be clear that all that is happening here is that the regulators are expanding their role yet again, thereby further shrinking the role that the markets can play in allocating savings, capital and liquidity from where they are relatively inefficiently utilised to where they are relatively more so. This concept of free market allocation of capital is a key characteristic of a theoretical economic system known as ‘capitalism’. But capitalism cannot function properly where capital flows are severely distorted by regulators. Resources will be chronically misallocated, resulting in a low or possibly even negative potential rate of economic growth.

The regulators don’t see it that way of course. Everywhere they look they see market failure. And because Governor Stein and his fellow regulators take this market failure as a given, rather than seeking to understand properly how past regulatory actions have severely distorted perceptions of risk and encouraged moral hazard, they are naturally drawn to regulatory ‘solutions’ that are really just plagiarised copies of an old playbook. What is that definition of insanity again, about doing the same thing over and over but expecting different results?

[1] Neo-Keynesians will deny this, claiming that their models take money and credit into account. But they do so only to a very limited extent, with financial crises relegated to mere aberrations in the data. The Austrian economic school of Menger, Mises, Hayek, etc, by contrast, has a comprehensive and consistent theory of money and credit that can explain and even predict financial crises.
[2] The entire paper can be found at the link here (PDF).
[3] This entire speech can be found at the link here.
[4] FINANCIAL CRISES AND NEWTON’S THIRD LAW, Amphora Report Vol. 1 (April 2010). The link is here.


This article was previously published in The Amphora Report, Vol 4, 10 June 2013.


Regulating banks the Austrian way

Most people — from young to old and from all ends of the political spectrum — are united by a common bond. The idea that banks are deserving of taxpayer support is viewed as morally repugnant to them. Business owners see bank bailouts as an unfair advantage that is not extended to all businesses. Those typically on the political left see it as support for the establishment, and a slap in the faces of the little people. Those more at home on the political right see it as just another form of welfare: a wealth redistribution from the hard working segment of the population to the reckless gambling class of banksters.

Despite this common disdain for bankers, there is considerable disagreement on how to deal with them. One group sees less regulation as the solution — letting market forces work will allow the virtues of prudence and industry to prevail. This formulation sees these same market forces as limiting firm size naturally to evade the “too big to fail” issue, through many of the same incentives that foment competitive economic advancement.

Another group sees the solution as more regulation. The natural tendency in business, according to this group, is for large monopolies to form. As companies grow in size, they gain political influence as well as an aura of indispensability. The consequence is that not only will a company come to be seen as too big to fail, but it will also be politically influential enough to seek such recourse if troubles surface.

Like most answers, the truth lies somewhere in the middle.

The first group correctly notes that there are two specific drawbacks of increasing regulation. On the one hand, “one size fits all” regulatory policies (such as is commonly the case on the Federal level) are rarely capable of handling the intricacies and dynamics of business. They also have the effect of relaxing the attention individuals and businesses afford to their own behavior. Under the pretense that the state has enacted wise regulations, individuals see little need to actively monitor companies to make sure they behave in a responsible manner. Businesses too succumb to this mentality. By abiding by the existing regulatory regime, they take solace in knowing that any attack on their integrity can be brushed aside as an attack placed more appropriately on the failures of the regulating body.

On the other hand, increased regulation breeds the problem of what economists call “moral hazard.” An activity is morally hazardous when a party can reap the benefits of an action without incurring the costs. The financial industry is very obviously afflicted with moral hazard today.

Banks and other financial companies have largely abided by the law. I would venture a guess that there is no industry more heavily regulated than the financial services industry, and no industry that spends more time and resources making sure that it complies with this complex regulatory maze. Capital levels must be maintained, reporting must be prompt and transparent, and certain types of assets must be bought or not bought. Banks following these regulations get a sense that they will survive, if not flourish, provided they work within the confines of the law.

However, it is increasingly evident that the financial regulations put in place over the past decades are woefully inept at maintaining a healthy financial industry. In spite of (or perhaps because of) all these regulations, a great many companies are, shall we say, less than solvent. So, who is to blame? It would be easy to blame the companies themselves, except that they did everything that the regulators told them to do.

Why not at least consider relaxing regulations? Doing so would have a two-fold advantage.

On the one hand, businesses would be more obviously responsible for the instability they have now created. On the other hand, without regulations, more reckless or clumsily managed companies would have gone out of business already, lacking the benefit of a regulatory “parent” scolding them for their mistakes. The result would be fewer unstable businesses, and more attention to the dangers of one’s own actions.

I previously mentioned that both sides are correct to some degree, implying that those calling for more regulation had some merit to their arguments. And this is indeed true. However, to paraphrase Inigo Montoya, when they use the word “regulation,” I do not think it means what they think it means.

It is true that not all companies play on a level field. In the financial services industry, and particularly in the banking sector, this is especially apparent. Banks are granted a legal privilege of “fractional reserves.” The result is that banks behave in a way which is fundamentally different from any other type of business, and which is easy to misdiagnose as “inadequate regulation.”

A depositor places money in his bank. The result is a deposit, and the depositor has a claim to this sum of money at any moment. One would think that the bank would be obliged to keep the money on hand, much in the same way that other deposited goods — like grain in an elevator — must be kept on hand. The law begs to differ. Banks are obliged to keep only a portion, or fraction, of that deposit in their vaults and are free to use the remaining sum as they please. Canada and the United Kingdom are examples of countries where there is no legal requirement for a bank to hold any percentage of that original deposit in its vault. In the United States, if a bank has net transactions accounts (deposits and accounts receivable) of less than $12.4 million, the reserve ratio is also set at zero. This differs greatly from grain elevators, where the law strictly states that the elevator owner must keep 100 percent of the deposited grain in the silo.

There are two results of the practice of fractional reserve banking, neither of them positive for the average person.

First, banks grow larger because they have access to a funding source that would otherwise not be available if they conducted themselves by the same laws as other businesses. When commentators say “banks are different,” there is truth in the statement. They have a legal privilege that enables them to grow in scope beyond that which they could naturally. This also explains why many banks, and financial services companies, come to be viewed as too big to fail.

Second, banks become riskier. Every time a deposit is not backed 100 percent, the depositor is exposed to the possibility of not getting his deposit back in full. If a bank uses his deposit to fund a mortgage, and the borrower defaults and cannot repay the bank, there is a risk that the original depositor will lose some of his money. A more common case is a bank run, in which many depositors try to withdraw money at the same time. The result will be insufficient funds to simultaneously honor all redemption demands. This occurred with various banks in Iceland, Ireland, Britain, and Cyprus over the last four years.

Few people worry about this latter problem, however, because of the former one. Since banks have become too big to fail, we are assured that if one goes bankrupt, we as depositors do not stand to lose personally. The government has pledged implicitly, or even explicitly through deposit insurance, that it will step in and bail out the irresponsible actors.

The result is the confusing state of affairs that we have today with two sides both arguing for the same thing — banking stability — via two diametrically opposed means. The “more regulation” camp is pitted against the “less regulation” camp. 

A solution

These two camps are not mutually exclusive. We can solve the problems of moral hazard and “too big to fail” in one fell swoop by ending fractional reserve banking.

By ending this legal privilege, we eliminate the ability for banks to grow to such inordinate sizes. By abiding by the same legal principles (or “regulations,” if you will) as any other deposit-taking firm, banks are not unduly advantaged. If banks shrink in size, the “too big to fail” doctrine is eliminated, or at least greatly reduced. This means that depositors and bankers will realize that if a loss occurs to their bank, they personally stand to lose.

The risk of loss is a great force in removing moral hazard. Remember that it only arises when one person’s ability to gain is not constrained by the threat of a loss. Cognizant of ensuing losses, depositors will demand that their banks adhere to more prudent operating principles, and bankers will be forced to meet these demands.

The critics worried about “too big to fail” are right. We do need more “regulations,” in a sense. We need banks to be regulated by the same legal principles regarding fraud as every other business. The critics worried about moral hazard are also right. We need fewer of every other kind of regulation.

Repairing a broken financial system does not have to be hampered by irreconcilable political differences. Recognizing the true issues at stake — legal privilege and unconstrained risk taking — allows one to bring together advocates of widely differing solutions into one coherent group. Getting bankers to agree to all this is another story.

This article was previously published at


A central banker worth hearing?

I’m not aware of any unconditional support for central banking as such around The Cobden Centre but, nevertheless, occasionally a central banker says something worth hearing. Today, that central banker is often Andy Haldane, Executive Director, Financial Stability at the Bank of England.

The Wall Street Journal and the FT (£) report his speech at Jackson Hole, which may be found here. For example,

So what is the secret of the watchdogs’ failure? The answer is simple. Or rather, it is complexity. For what this paper explores is why the type of complex regulation developed over recent decades might not just be costly and cumbersome but sub-optimal for crisis control. In financial regulation, less may be more.

Mr Haldane is a way from Greenspan’s famous defence of gold and free banking but the contemporary debate is also far from that point. Haldane’s speech is an intellectual tour de force which concerns some of the epistemological problems which will be so familiar to Austrians.

In my time-limited speech on the Bill which hands vast discretionary power to the Bank of England, I criticised it, saying, “I sincerely hope that it represents the absolute zenith of contemporary thinking on interventionist bank reform”. Perhaps it may yet: Haldane concludes,

Modern finance is complex, perhaps too complex. Regulation of modern finance is complex, almost certainly too complex. That configuration spells trouble. As you do not fight fire with fire, you do not fight complexity with complexity. Because complexity generates uncertainty, not risk, it requires a regulatory response grounded in simplicity, not complexity.

Delivering that would require an about-turn from the regulatory community from the path followed for the better part of the past 50 years. If a once-in-a-lifetime crisis is not able to deliver that change, it is not clear what will. To ask today’s regulators to save us from tomorrow’s crisis using yesterday’s toolbox is to ask a border collie to catch a frisbee by first applying Newton’s Law of Gravity.

It does not yet seem likely that a central banker will produce a speech with which Austrian-School liberals will agree whole-heartedly but Andy Haldane’s recent contribution was a courageous step in the right direction.


How to fix financial services regulation

As I was reading of yet another spectacular mismatch between bank managers’ competence and their remuneration, and this time at JP Morgan no less, I realized there is a simple solution which really could be implemented.

Make the cost of regulation zero – or very nearly – for unlimited liability partnerships. Then let judicious self-interest, exercised by the partners themselves, do the rest.

My father was what they now call an ‘investment banker’. His firm got it wrong by expanding business into the 1970s’ slump, and when it went wrong the Official Assignee took everything he owned. That was in the days when partners had joint and several liability, which meant that all the top management of a firm were personally liable for the entire debts of their business.

Joint and several liability quickly weeded out the incompetents, the gamblers and the unlucky (my poor old Dad, I like to think). It made managers look very carefully at their colleagues’ strategies, and concentrated everyone’s efforts on controlling risks, rather than seeking bonus-building nominal profits.

The approach was discarded in 1986 after 150 years of pretty effective operation. It wasn’t perfect (what is?) but we were all very stupid to think we could do better by replacing the natural damper of direct personal liability with a combination of salaried and bonused managers, and sixty thousand pages of regulations.

I realised this morning that official regulation of financial services has become so onerous and so unsuccessful at loss prevention that joint and several liability could easily be re-introduced. All it would need would be a subsidiary arm of the regulator, set up exclusively for the regulation of investment businesses run by unlimited liability partnerships.

Lots of reputable financial professionals do not get big bonuses, because they work competently in the low-risk, low-return areas of the industry. Yet within the regulated sphere of financial services, there are so many complex rules that even these firms have to employ more compliance officers than accountants, while at the same time funding the wretchedly unfair Financial Services Compensation Scheme in the UK, or Federal Deposit Insurance Corp. in the US – which is a bit like being forced to pay for the car insurance of your drunken neighbour.

They should be given the choice of submitting to financial services, or choosing a simpler system, where they put up as collateral their house, their car, their holidays and their children’s school fees, and – within reason – are left to get on with managing their business risks as they see fit.

Making management collectively liable for their mistakes has lots of benefits.

  1. Size – Because partners all want to be able to understand their whole business it encourages smaller and less systemically dangerous organisations – ones which are not ‘too big to fail’
  2. Growth and competition – It encourages business formation, something which has ground to a halt now because of the huge cost of setting up a compliant organisation;
  3. Attention to detail – It forces revenue generators to be more critical about risks, rather than leaving it to formulae which pass the rules and get boxes ticked, but do not work in practice;
  4. Liability – It encourages senior management stability and accountability, and suppresses the job merry-go-round whereby careers advance by sweeping problems temporarily out of sight and quickly changing jobs;
  5. Rewards – It directly links remuneration to risk, as well as to performance;
  6. Clawback – It keeps all prior remuneration still in the compensation pot, to be reclaimed in the event of future investor losses.

Our experiment with rulebooks, regulators and salaried managers has been a bit of a disaster. Maybe a partial return to the old ways is not such a bad idea.

A version of this article was previously published at on the 14th of May.


The canary in the gold mine

In 2007 there appeared the first signs of serious trouble in the US subprime mortgage market. While US Treasury Secretary Paulson assured investors that the problems were ‘contained’, by mid-2008, financial markets were pricing in trouble ahead. Sure enough, by fall 2008, it was clear that not only the US but also much of the global banking system was in need of a general bailout. As concerns mounted, equities and other risky asset prices fell and high-quality government bond prices rose. Investors were seeking safety. Yet a fabled safe-haven asset, gold, was also falling in price. Why?

In 2008, banks were scrambling to raise capital, accumulating so-called ‘Tier1’ assets, primarily highly-rated government bonds. In order to do so, they sold liquid, non-Tier1 assets, including gold, notwithstanding its historical safe-haven status. (However much banks would have liked to have sold illiquid non-Tier1 assets, it was impossible to do so, unless the central bank obliged, as the Fed did with Bear Stearns, AIG and other distressed entities.)

Regulatory capital is just that, regulatory. In 2008, distressed banks had no choice but to maintain adequate Tier1 ratios or risk being shut down or taken over by the regulators. As shown in the previous chart, from a peak of nearly $1,000 reached in March that year, notwithstanding its fundamental safe-haven status, gold plummeted 30%, to nearly $700 by November.

However, once it became clear that policymakers were going to ease capital and mark-to-market requirements for banks and, in certain cases, explicitly guarantee their liabilities, the forced selling of gold and other liquid non-Tier1 assets came to an abrupt halt. The gold price rose to over $850 by year end. However, because risk aversion remained high, due to concerns about the broader economic fallout of what had occurred in the financial system, there was no general recovery in the equity markets until the following spring.

Viewed in this way, the gold price can be understood as a deflation or reflation ‘canary’, appearing to buck the trend from time to time but, in fact, giving critical prior warning of deflationary trouble on the one hand or reflationary relief on the other. Gold is unique in this important sense: It is arguably the only non-Tier1 asset to be universally regarded by investors the world over as a safe-haven asset. As such, it is a more reliable indicator of financial system distress or relief than government bond markets, in particular when central banks are actively manipulating the latter via QE, ‘Twist’, etc.

Recent gold price action vis-a-vis Tier1 assets is thus not only a clear indication of rising banking system distress, it is also an opportunity for those who believe that policymakers stand ready to provide some reflationary, palliative medicine to the financial system in the event that things continue to deteriorate. Although reflationary policies are highly likely to put a floor under equities and other risky assets, the primary, first beneficiary should be the safe-haven of gold, artificially depressed as it now is by being excluded from the Tier1 regulatory basket.


A recent study by Fitch ratings calculated that banks need to raise $566bn of Tier1 capital, a 23% increase. That implies much potential selling of liquid, non-Tier1 assets. At first glance, this would appear to be negative for gold. But in fact it is not that simple.

As it happens, given that so many banks are desperate to raise their capital ratios, there is in fact a discussion underway regarding whether or not gold should, in fact, be designated as Tier1 capital. In a recent article in the Financial Times, it was reported that, “The Basel Committee for Bank Supervision, the maker of global capital requirements is studying making gold a bank capital Tier 1 asset.”

This is a hugely under-appreciated development. For if it happens, it will be an important step toward the re-monetisation of gold. Gold would be able to compete on a level playing field with government bonds. While the playing field could be levelled in this way, there would be a gross mismatch on the pitch. On the one hand, you have unbacked government bonds, issued by overindebted governments, yielding less than zero in inflation-adjusted terms. On the other, you have gold, the historical preserver of purchasing power par excellence. In my opinion, if gold becomes eligible as Tier1 collateral, the price is likely to soar to a new, all-time high.

Now while the gold price might seem elevated in a historical comparison, notwithstanding the recent correction, most prices are. This is what inflation does. It raises prices over time as the base currency depreciates in value. Yes, the stock market may be roughly where it was a decade ago. But this reflects lower valuations, something entirely appropriate for a world awash in unserviceable debt; with profligate, in some cases essentially bankrupt national, state and local governments; complex, inefficient regulatory burdens; challenging demographics; and political instability in some parts of the world. Sorry but this is not the mid-1990s, folks.

As P/E ratios have declined for these compelling, fundamental reasons, equity prices have struggled to rise. Not so the price of gold, for which there is no P/E. Warren Buffet and his sidekick Charlie Munger may disparage this lack of ‘E’, due to gold being an ‘unproductive asset’, but as these guys happen to own a major insurance company, you would think that they would know better. What, exactly, is the P/E of an insurance policy? Doesn’t it have one? No? Well that’s because insurance, by its very nature, is ‘unproductive’. It doesn’t generate an income. (In fact, in normal circumstances, it has a negative carry cost, or ‘premium’.) But importantly, critically, it protects that which does produce an income against extreme or unforeseen negative outcomes.

Now if you’ve got wealth, and you want to protect it from, say, some combination of inflation, deflation, tax and regulatory uncertainty, excessive debt, poor demographics, geopolitical concerns, what have you, well then do you buy into the Facebook IPO? Or do you take out insurance and buy gold instead? After all, with real interest rates negative in developed countries, gold insurance, at present, does not even have a negative carry cost, or ‘premium’! With uncertainty rising and the cost of carry positive in real terms, the fundamental case for accumulating gold is unusually strong at present, quite possibly the strongest it has been since late 2008.


Based on the 2008 experience, investors who agree that gold remains a safe-haven asset, the current lack of regulatory recognition thereof notwithstanding, and who also belive that policymakers stand ready to step in the rescue the financial system if so required, now is an excellent time to acquire or add to positions in gold. This is not a technical trading or momentum argument. This is a qualitative judgement call on my part, based on my fundamental understanding of what factors drive the price of gold in the medium-term and what I believe is a critical lesson from 2008 specifically.

While I would not rule anything out, given just how arbitrary economic policy-making has become in recent years, I would be surprised were major central banks not to come to the rescue if the euro-area debt crisis escalates further or if another major global crisis emerges in the coming months. By how much might the price of gold fall in the meantime, as the Tier1 scramble continues? Recent and some past price action suggests a floor around $1,500, but it could fall to the $1,200-50 area. Were that to happen, and were other factors to remain essentially unchanged, I would recommend for investors to increase their exposure to gold to the maximum that their portfolio allocation guidelines permit.

Given depressed valuations, investors could also consider increasing their allocation to gold mining shares. That said there are good reasons why gold share P/Es are depressed at present, the subject of a future Amphora Report.

This article was previously published in The Amphora Report, Vol 3, 18 May 2012.


Financial regulators and the free market

Adam Smith’s great insight was that in a commercial transaction both parties benefit. Before his time, it was generally believed that in an exchange of goods, one party usually gained what the other lost. The mistake was to misunderstand value: it is different to different people. A seller places greater value in the money than the product he sells for it, and the buyer places a greater value on the product than its cost, otherwise the deal would not happen.

Lovers of regulation do not seem to understand Adam Smith’s perception of enlightened self-interest. They believe unprincipled capitalists steal the widow’s mite. The prevalence of regulation, particularly in Europe, where everything must be regulated, is in this sense a complete denial of all economic progress since the days of mercantilism.

Regulation often defeats its objectives, a point which was made clear to me many years ago. I met the managing director of a spread-betting business at the time when there was a debate about whether or not spread-betting should be regulated as an investment activity. He welcomed regulation, because it would give his business added credibility, despite by definition being gambling. He was right: that is why everyone in the financial services business dealing with the public wants regulation. It enhances their credibility.

Unregulated, a business’s reputation is its most valuable asset. A regulated business does not have the same problem, so long as it obeys the regulations. Regulations replace the overriding need for a business to protect its reputation, and it is no longer solely concerned for its customers: the rule book has precedence. And the more regulation replaces reputation, the less important customers become. Nowhere is this more obvious than in financial services.

Back in the Eighties when single capacity was scrapped in London, and securities businesses were allowed to act as both brokers and market-makers, the conflict of interest was meant to be resolved by the interposition of a Chinese wall. We hardly ever hear the term nowadays, but this sham separation of broking from market-making demotes customers’ interests. Predictably, they have become cannon-fodder for the trading book, where the real profitability lies. And then there is the egregious example of MF Global, which it appears, has been permitted by the regulator to gamble and lose its customers segregated money.

The regulators assume the public are innocents in need of protection. They have set themselves up to be gamed by all manner of businesses intent on using and adapting the rules for their own benefits at the expense of their customers. These businesses lobby to change the rules over time to their own advantage and hide behind regulatory respectability, as clients of both MF Global and Bernie Madoff have found to their cost.

Where is the protection? Adam Smith must be turning in his grave.

This article was previously published at


Regulating towards depression

There have been many books attempting to find and explain the causes of the ongoing financial crisis.  Authors have approached the issue from all sorts of ideological perspectives and with different sets of evidence.  Most of these works are lacking, incomplete, or even flat-out wrong.  Many of them do not even care for the facts, instead using vague generalizations to justify the application of broad economic theories.  There has not, until recently, really been a meticulous analysis of the mechanics of the causes of the Great Recession, despite the enormous interest displayed by the economics profession in the subject.

This lacuna has been filled by Jeffrey Friedman, editor of Critical Review, and Wladimir Kraus, in their recently published book: Engineering the Financial Crisis.   The authors make the purpose of their study evident from the very beginning.  They shed themselves of any ideological priors which may have otherwise impaired their analysis, even going as far as to disprove a number of general theories from either side of the spectrum (insufficient regulation versus insufficient economic freedom), and task themselves simply with accumulating, analyzing, and interpreting the evidence.  The data they look at has to do with the regulations which governed the financial institutions that presided over the network of financial instruments which suddenly lost the bulk of their value.  The question they ask is a simple one: based on the facts, was the recession caused by under-regulation or was it something in the regulation itself which may have influenced the ways banks invested?

Friedman and Kraus give reason to believe that it was the latter — perverse regulations — which gave way to the great contraction which took place between 2007 and 2009.  Looking through the relevant legislature which dictates the laws governing the banking industry, the authors find that it was this regulatory web which led banks to invest in the specific financial assets that would soon after be deemed nearly worthless.

Friedman and Kraus emphasize the importance of the fact that the banking industry had no idea — what they call “radical ignorance” — about just what kind of quagmire they were investing themselves into.  They use evidence to illustrate the fact that, predominately speaking, the bankers, regulators, politicians, and other major actors in this crisis had absolutely no idea of the relevant potential for a recession to occur, let alone that the highly rated assets they invested into would soon become relatively valueless.

We can see now the broad thesis of Engineering the Financial Crisis.  Bankers did not buy large amounts of soon-to-be “toxics assets” because the risk had been externalized to the taxpayer. [1] Neither is their any evidence suggesting that bankers purposefully ignored high risk in favor of pursuing high profits.  The majority of assets purchased were actually AAA rated, and because of this the risk-load they carried, as perceived at the time of purchase, was relatively low.  What manipulated the relevant price signals which funneled investment into the housing market were regulations which rewarded these type of investments. To a lesser extent, the authors also point at government programmes which pushed for house ownership and the relatively low rates of interest on new loans which made borrowing seemingly more affordable.

Leading up to the crisis, bankers were generally very risk sensitive, preferring assets with lower revenue returns.  Roughly 93 percent of mortgage bonds held by U.S. Commercial banks were AAA-rated mortgage backed securities (both private label [PLMBS] and agency rated [MBS]), and almost another 7 percent were AAA-rated collectivized debt obligations (CDO). [2] Missing from this collection of assets were any mortgage bonds rated less than AAA, which were usually the bonds which the highest rate of return.

Most commercial banks in the United States were also above their legal capital reserve minimum on the eve of the financial crisis — the twenty largest banks held capital levels averaging 11.7 percent, where the legal minimum was 10 percent of a bank’s total assets (as dictated by the Federal law, whereas the Basel I accords had set it at 8 percent).  More specifically, if one only accounts for “Tier 1” capital [3] banks retained a capital cushion of 50 percent, even while federal law required a minimum of 5%.  In other words, most banks opted to retain a substantial capital cushion, where one would expect a bank interested in maximizing profit (while ignoring risk) to push the boundaries of its legal requirements. [4]

The issue, then, was not about bankers with low risk aversion, seeking high profits by investing mostly in high-risk assets.  The evidence suggests quite the contrary.  U.S. commercial banks invested in what were perceived as low-risk, low-return assets, and on top of this held higher than required capital cushions.  Also going out the window is the “too big to fail” theory, or any other case that argues that it was risk externalization which created an incentive for an over-concentration of investment into the mortgage market.  Simply put, there was a high aversion to risk during the years leading up to the crisis.

Friedman’s and Kraus’ explanation of what caused the crisis can be divided into two parts: what caused the over-concentration of investment into mortgage-backed securities and why these securities, which by 2008 had lost the majority of their value, had been rated so highly by the major rating agencies.  The strength of their book is found in its accounting of the first — what led to the pattern of investment that characterized U.S. commercial bank assets prior to the recession.

Because different types of investments generally have different degrees of risk, a capital requirement minimum that encompasses all assets is illogical.  Rather, it makes more sense to create different capital reserve requirements for different sorts of investments, based on the general perceived riskiness of the different types.  The Basel I accord was an attempt to correct the issues of a homogenous treatment of assets by creating different categories and attaching a capital reserve minimum to each category.  Higher risk assets, therefore, were categorized into higher “risk buckets” and required a greater capital cushion.  In other words, the greater the risk the asset carried, the more it cost the banks to protect against, by reducing the amount of capital available to invest.

The issue, as explained by Friedman and Kraus, is that these regulations led to “regulatory arbitrage”.  For example, a bank could invest into mortgage bonds with a risk-weight of 50 percent, then re-sell these bonds to a government sponsored enterprise (such as Freddie Mac and Fannie Mae), and buy them back as an agency bond.  These agency bonds were risk-weighted at 20 percent, effectively reducing the capital cushion necessary to back the asset, even though the composition of the asset remained exactly the same.  The Basel regulations made it more expensive to issue business loans than home loans, creating a financial incentive to issue more home loans.  Basel I created incentives for banks to make certain types of loans and then securitize them.

A further boon to securitization came with the adoption of the Recourse Rule, which borrowed the Basel II accord’s method of rating privately issued securitized assets by risk.  This system caused banks to increase investment in AAA-rated securitized mortgage bonds, especially since the risk-weight of unsecuritized mortgages remained at 50 percent (as dictated by Basel I).  It remained cheaper to invest in mortgages, rather than other types of loans to consumers and businessmen, and then banks could further increase profitability by securitizing these mortgages and releasing part of their capital reserves for further investments.  This explains the concentration of investment in mortgage backed securities.

We see a pattern between 2001 and 2007 of an increase in housing loans and investment into mortgage backed securities.  We know that at the time these types of investments being made were being pooled into buckets which were considered generally less risky than other forms of investment.  It was not an issue, therefore, of carrying on more risk.  In fact, this pattern of investment was created out of the fact that the regulations incentivized purchase of less risky assets.  The problem which led to the financial collapse, therefore, deals exclusively with the fact that these assets carried more risk than was originally perceived by the regulators (and banks).  In fact, the collapse of the subprime mortgage market came as a total surprise, both for the bankers and the regulators.

It was not just the architecture of the impending financial collapse that the regulatory web was responsible for, but also the magnification of the disaster.  Thanks to the capital reserve minima, many banks faced insolvency even though the circumstances did not really call for it.  In order to remain legally solvent, U.S. banks are forced to maintain a certain capital reserve minimum.  As the crisis unfolded, bonds which had been previously rated at AAA were suddenly downgraded, raising the necessary capital reserve minima for each risk-bucket.  In other words, as ratings fell for different types of bonds, banks were suddenly forced to raise new capital to cover their loss.

Furthermore, regulations forced banks to mark-to-market their assets to reveal their “true value”.  This process was not done on an individual basis; rather, different bonds were lumped together and them marked-to-market as a group.  So, even individual bonds which may have not actually lost  value were readjusted on a bank’s balance sheet as assets that were suddenly worth less than had been perceived prior to the crisis.  It was on the basis of these new market values that a bank’s solvency was judged.  The issue is that by late 2009 many of these same bonds had recuperated much of their value, and so a bank that had been legally insolvent in early 2008 may not have been two years later.  In other words, many banks were forced into insolvency that could have survived the crisis, and other banks had to radically contract outstanding liabilities in order to remain solvent.

The consequence of these regulatory restrictions was a giant credit contraction — much larger than was actually necessary.  And, of course, the monetary contraction only worsened the situation, as it reduced the financial viability of the various investments that depended on this credit.

Friedman and Kraus blame the inadequate rating of mortgage bonds on the cartelization of the major rating agencies — Moody’s, Standard & Poor’s (S&P), and Fitch.  Basel II and the Recourse Rule had effectively tied their capital reserve requirements to the ratings provided by these three agencies.  It was these three rating agencies that had been classified as Nationally Recognized Statistical Rating Organizations by the Securities and Exchange Commission (SEC) in 1975, and the various regulations that relied on risk ratings depended exclusively on this cartel.  None of the three “nationally recognized” rating agencies, furthermore, had accounted for the possibility of a nationwide hosing crisis leading up to 2008.

There were private rating agencies, though, that had recognized the potential for crisis.  According to Friedman and Kraus one such company was First Pacific Advisors, which sold its $1.85 billion investment in mortgage-backed bonds in late 2005.

Friedman’s and Kraus’ analysis hinges on the notion that what was ultimately at fault were these rating agencies.  Had they been more accurate in their risk assessments then banks would not have malinvested in so many mortgage-backed bonds.  But, why had the banks relied exclusively on the risk-assessment provided by the three “nationally recognized” agencies?  Were these banks not aware of the risk assessments being made by private investment companies?

Perhaps the authors put too much weight on the notion that it was this cartelization of the rating agencies which made possible the crisis, and that had there been more competition in this industry the recession may have been less destructive than it turned out to be.  But, Friedman and Kraus do not make clear exactly how many private agencies had foreseen the crisis.  Few investors sold off their mortgage-backed bonds in anticipation of a market crash.  Indeed, the majority of investors were still fairly confident in the strength of the housing market.

Here is where the explanation of the crisis becomes more detached from the data.  Friedman and Kraus leave room for further interpretation, since their explanation for why the different bonds were assessed as they were comes off as inadequate (or, at least, incomplete).  Understandably, they are looking to separate themselves from ideology — even though the book’s conclusions are extremely pro-market — and thus avoid applying far-reaching theories to the evidence they were able to collect

However, that there is still room for further interpretation is not necessarily a bad thing.  As far as their analysis on the impact of regulations on the housing boom and the consequent financial crisis goes, it is difficult to refute.  That there is still room for the application of theory means that their empirical findings can easily be assimilated into grander explanations of the financial crisis.

For the task it sets out to accomplish, Engineering the Financial Crisis is undoubtedly one of the best books written yet on the causes of the Great Recession.  Jeffrey Friedman and Wladimir Kraus painstakingly dig through the data to provide a solid picture of why there was such an overconcentration of investment in the mortgage market.  The evidence clearly shows that it was the web of regulation on the banking industry that shaped the structure of banking investment by favoring certain investments over others.  The entire system collapsed when it turned out that these regulations had depended on agency assessments that had totally miscalculated the risk these favoured assets carried.  Thus, banks had loaded themselves up with mortgage backed bonds, completely unaware of the fact that these bonds would soon be relatively valueless.  It was not the market which caused the crisis, rather the distortions to the market that were created by government intervention.

[1] That banks did not buy mortgage-backed securities and other similar assets because the bankers knew that there was no risk for them is a very specific claim, and it does not include many banking practices which are undertaken because of risk externalization (such as the extent of fiduciary expansion, which in our present banking system is a product of its cartelization under the Federal Reserve System).

[2] Friedman and Kraus 2011, p. 42 (table 1.3).

[3] Basel I divides bank capital by the type of asset, Type I being the safest pool.  Type I is composed of “funds received from sales of common equity shares and from retained earnings.” Ibid., p. 40.

[4] A capital reserve basically allows banks to take losses, since it gives it a cushion of assets it can capitalize on to make up for net losses (before liabilities exceed assets).