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By Tom Clougherty, on 21 April 10
The BBC reports that the IMF has unveiled its interim proposals on a new international tax on the financial sector, ahead of a meeting of finance ministers this weekend.
In fact, the IMF’s paper suggests two new taxes. The first, a ‘financial stability contribution’ would be levied on all financial institutions, initially at a flat rate, to help cover the ‘fiscal cost of any future government support to the sector’. The second, is a ‘financial activities tax’, which would be levied ‘on the sum of the profits and remuneration of financial institutions’.
The first point to be made is that justifying these taxes on the grounds that the proceeds will help governments deal with future crises is a straightforward con. The proceeds of the first tax could either ‘accumulate in a fund to facilitate the resolution of weak institutions or be paid into general revenue’ say the IMF, but you don’t need to be psychic to work out which of those is more likely – governments will just spend the money on current expenditure, as they always do. The second tax doesn’t even come with an either/or fig leaf – proceeds will go into general revenue, for governments to spend as they see fit.
So it is pretty clear that what we have here isn’t so much a policy to ensure financial stability, but rather to bail out profligate governments. Moreover, this could in itself worsen financial instability by making fiscal policy even more pro-cyclical (revenues would be highest during financial booms), and exacerbating boom and bust cycles.
There are other problems too. For example, the idea of compulsory ‘insurance’ against failure for banks (this is the direction the ‘financial stability contribution’ moves us in) is likely to make moral hazard – already a major issue – an even more severe problem. Even now, government guarantees to banks are largely implicit, but the IMF’s tax proposal would make them explicit. Indeed, the ‘financial stability contribution’ is not just an overt indication that irresponsible banks will be bailed out – it could easily be read as creating an obligation that they must be bailed out. And that’s hardly a way to encourage less risk-taking.
It is also problematic that these taxes will be applied to all financial institutions (including insurers, hedge funds and so on), most of which had little to do with the financial crisis. They are thus likely to damage the wider financial economy, without actually doing anything much to deal with the real offenders.
Which brings me neatly to the most depressing aspect of these proposals: the complete lack of understanding they exhibit about the actual causes of the financial crisis – loose monetary policy, ramped up by unrestrained fractional reserve banking, and amplified by fiscal incontinence. The saddest thing is that the world’s financial system desperately does need reform. Without a radically new approach to controlling the money supply and taming the credit cycle, history is doomed to repeat itself. But the IMF’s proposals do not even qualify as a step in the right direction.
By Steven Baker MP, on 15 February 10
 Dowd, Alchemists of Loss We are delighted to announce a forthcoming book by Cobden Centre Senior Fellow Professor Kevin Dowd and US-based journalist and former investment banker Martin Hutchinson: The Alchemists of Loss: How Modern Finance and Government Intervention Crashed the Financial System. The book contains some delightfully simple insights into a complex subject. For example:
The credit default swap sneaked up on everybody, becoming a $62 trillion market, without anyone outside the business knowing much about it. As the Bear Stearns, Lehman and AIG debacles revealed, these instruments also involved highly non-transparent credit risks of their own. As a holder of a CDS you don’t know whether your counterparty has issued only a few of your CDS, in which case you’ll probably get paid in a bankruptcy, or whether he has issued fifty times the outstanding debt you’re trying to hedge, in which case you’re unlikely to get paid.
And moreover:
Financial engineering’s benefit to the global economy is highly questionable and the proliferation of financially-engineered products of recent years has brought few benefits and led to huge losses for society at large. As we have seen, one quarter’s bad losses in late 2008 wiped out all the accumulated financial engineering profits of the last quarter century and saddled taxpayers with a bill for hundreds of billions, if not more.
Prof. Dowd has kindly agreed to pre-release two chapters through The Cobden Centre:
From Chapter 16:
Alert readers will have already picked up some of the advice we would give investors and clients of financial institutions:
- take a longer-term perspective and return to investment rather than speculation;
- do not seek to ‘enhance’ yields, because this always exposes investors to hidden costs and risks, whilst firms seeking finance should resist cutting corners on their financing costs, for the same reason; thus, both parties should be realistic in their expectations;
- avoid frequent trading, focus on static over dynamic strategies, buy and hold over activist portfolio management;
- pay more attention to costs and hidden charges, and work on the assumption that higher charges are usually a good signal of a bad deal;
- distrust commission-based salespeople;
- if you use derivatives, be clear why and use them only for risk management and not speculation;
- avoid complicated opaque products; and
- do not take liquidity for granted and ensure that your liquidity is protected in a crisis.
Besides this motherhood and apple pie stuff, investors should also be careful of correlation-based investment and risk management strategies, which work well when not needed but are apt to break down when they are. This is not to suggest that they should give up on diversification. People understood diversification long before Modern Portfolio Theory, but they tended to practice it differently and more wisely. Diversification was assessed by committees of experienced practitioners, who took a long-term view and relied on their judgment rather than unreliable correlation estimates – a far cry from modern practices of modern fund management, with its obsession with short-term performance assessment
Investors should demand transparency. Perhaps the most sobering lesson we have learned since the subprime crisis broke is the benefit of transparency in business dealings. Time after time, when a fiasco has occurred, a key contributing factors has lack of transparency. Subprime mortgages, CDOs and credit default swaps were all financial innovations that relied crucially on nobody asking too many questions. So too with the vast Madoff Ponzi scheme, involving some of the most sophisticated investors in the world, which rested on the same fatal human omission.
Download Chapter 16 to read on.
From Chapter 17:
The restoration of a rational and stable financial system inevitably requires major reform on a number of fronts. History gives much guidance here and also a role model: the period we should seek to emulate is the nineteenth century. Then money was sound, the dominant currency of the time, the pound, was literally as good as gold, while financial institutions were conservative and generally stable, and an altogether healthier financial ethos reigned.
It is very common these days to sneer at the gold standard: after all, it was Keynes who once dismissed it as “a relic from a barbarous age”. We would suggest, on the contrary, that a gold standard or some suitably 21st Century commodity equivalent would be highly desirable, and put an end to the disastrous century-long experiment with fiat money and its attendant miseries of inflation and monetary instability. The fact that Keynes opposed the gold standard is a further reason to support it.
The nineteenth century model would also entail major reforms to financial institutions and the regulatory system: greater liability and greater responsibility, the repeal of deposit insurance and investor protection legislation and the abolition of the big financial regulatory bodies such as the SEC and FSA. And by nineteenth century standards, we really mean early nineteenth century standards, those that pertained to the period before the Bank Charter Act of 1844 and the Companies Act of 1862, when liability was very real.
As for the banking system, we would suggest that the role model is Scotland pre-1845, when the Scottish banking system was virtually free of state control, unhindered by a central bank, and equally admired and envied across the world – and copied by countries such as Canada and Australia. In all three countries, free banking systems operated highly successful for very long periods of time. Indeed, the Canadian system was widely admired in the United States – and many US reformers in the late nineteenth century saw it as their ideal. The Canadian system was highly stable – apart from the failures of two small Alberta banks in 1985, its last notable bank failure was that of the Home Bank of Canada back in 1923. There were no Canadian bank failures in the 1930s and, even after the establishment of the Bank of Canada in 1934, many still regard the Canadian banking system as the best in the world.
Our first choice environment would be one with a commodity standard, free banking (no central bank) and financial laissez-faire, restrictions on the use of the “limited liability” corporate form and the most limited government. Even if we don’t return all the way to these early nineteenth century standards (and we can imagine the opposition!), we should still move as much as possible in that direction, though we would not advocate the reintroduction of the notorious debtors’ prisons immortalized in the fiction of Charles Dickens! However, our proposed reforms herein are adapted to the “second best world” (if it’s actually that; it may be about thousandth best of all the ‘parallel universe’ possibilities) in which we live, with relatively large government, a fiat currency and a central bank.
The most important institutional policy that must be solved is that of an excessively expansionary monetary policy. Simply making the monetary authority “independent” does not achieve this if the monetary authority retains its interactions with politicians and the financial community, both of which want loose money. The ideal to aim at is a hard money Fed, a Paul Volcker Fed.
Download Chapter 17 to read on.
You can also pre-order Alchemists of Loss at Amazon.
Further Reading
- Huerta de Soto, Money, Bank Credit and Economic Cycles
- Baxendale, A day of reckoning: how to end the banking crisis now
- What is wrong with banking, part 1: the legal nature of banking contracts
- Frank Whitson Fetter, Development of British Monetary Orthodoxy 1797 – 1875
- F. A. Hayek, Denationalisation of Money: The Argument Refined
- Gordon Kerr, How To Destroy the British Banking System and Bailing out the Banks – Glaring Evidence of Moral Hazard
- James Tyler, My Journey to Austrianism via the City, Money is not working and How to avoid future encounters with financial meltdown
- Irving Fisher, 100% Money, 1935
By Jamie Whyte, on 10 February 10
Last year two police women (WPCs) were discovered to have a reciprocal child-minding arrangement. It was initially declared unlawful. Child minders who receive payment for their services must be registered with Ofsted. And receiving payment is not restricted to receiving money. Anything of value counts, including “free” minding of your own child. These unregistered WPCs were wrongdoers.
Public outrage at the absurdity of preventing friends from looking after each other’s children caused Ed Balls, the Secretary of State for Children, Schools and Families, to intervene. He declared that reciprocal childminding was not a kind of payment after all. The WPCs congratulated him on this small victory for common sense.
Which just goes to show that the common sense of WPCs cannot be relied upon. For, despite Mr Balls’ great powers, he cannot by mere proclamation stop reciprocal childminding from being a kind of payment. His decision simply exempts this barter payment from the tax that Ofsted’s rules and registration fees impose on childminding when other forms of payment are used.
If one of those WPCs quit her police job but offered to continue minding her friend’s child for £50 a day, Ofsted’s requirements would reimpose themselves. The child may be cared for by the same person in the same place, but the introduction of money to the deal would bring with it the state’s administrative and financial burdens. Mr Balls’ “common sense” intervention thus encourages a barter economy in childcare.
This is a silly thing to do. Because money is a better method of payment than barter. While the WPCs barter, they can consume the value of the childminding work they do only in the form of childminding for themselves. This means that they will restrict the amount of childminding they supply to the amount they want to consume. If they paid each other in cash, this restriction would disappear.
As all economists know, money increases the opportunities for trade. Limit its use and many potential transactions will not take place; valuable goods and services will not be produced. And, when they are, they will often be produced by the wrong people.
For where money-based exchange is restricted, people must produce a wider range of goods, either for their own consumption or to increase the chance of having something they can swap for something they want. This is unfortunate, because the more things you do, the worse you will be at them.
In short, discouraging the use of money constrains trade, which limits the division of labour, which leads to inefficiency. Politicians ought not do it. Yet they do it all the time. They impose burdens on activities when done in exchange for money that they otherwise leave alone.
Consider the minimum wage. I am not allowed to pay someone £4 to spend an hour shopping for me. According to our government, that would be unfair, even if my employee agreed to it. Yet I am free to add an hour to my own shopping by walking to a distant supermarket in search of a £4 saving.
I am also allowed to spend an hour cooking my dinner, even if I would be unwilling to pay someone more than £3 to do it for me. Contrary to what you may have read on the Directgov website, working for less than £5.80 an hour is not illegal in Britain. It is illegal only if the payment is made in money.
Taxes have the same effect. Since most are levied on money-based transactions (with the notable exceptions of poll and property taxes), they inhibit trade and, hence, the division of labour. And the greater the rate of tax, the greater this malign effect.
Suppose, for example, that you are willing to pay up to £10 an hour to have some work done, and that the cheapest qualified labourers are willing to work for anything over £9 an hour. Then you should find someone to do the job. But if incomes are taxed at 20 per cent, the most the labourers can earn from you is £8 an hour and they will be unwilling to take on your job. You will have to do it yourself or go without.
Britain’s enormous regulatory and tax burdens on trade lead to an excess of do-it-yourself. People with neither talent nor inclination cook, garden, teach, drive and shop, to name but a few of the more common amateur activities. They are thereby drawn away from doing things they are better at and enjoy more.
What is the cost of such restrictions on the division of labour? Terry Arthur of the Institute of Economic Affairs has estimated that, at current tax levels, the cost is two thirds of every pound of tax collected. In other words, the marginal cost of transferring a pound from private hands into the coffers of Her Majesty’s Revenue is 67 pence.
Mr Arthur may be wrong, of course; estimating such “invisible”, deadweight costs is notoriously difficult. But even if his estimate is three times the real cost, the implications are profound. Taxes, minimum wages and the other regulatory burdens the government places on money-based commerce are far more costly than politicians and voters seem to realise.
Indeed, most do not recognise this cost at all. Some lament the futility of a system in which people are taxed only to receive their money back in the form of government provided services, such as education and healthcare. But they fail to see that the spinning of this money-go-round creates a terrible economic drag.
Alas, there is no prospect of an end to this waste, even if politicians understood it. When invisible costs are incurred for the sake of visible benefits, a politician will never consider them too great.
By Toby Baxendale, on 4 February 10
Drawing on the work of Nobel Laureates in economics from three traditions, plus numerous other distinguished scholars, Cobden Centre Chairman, economist and successful entrepreneur Toby Baxendale presents an informal introduction to our proposal for honest money and the benefits consequent on the reform. See also our precis of Irving Fisher’s 100% Money.
Fact
- The average overhang of credit to money of all banks in the United Kingdom is 34 x to its reserves i.e. its actual money base.
- If more than one person in 34 walks into all banks simultaneously to withdraw their deposits, there will be a system wide bank run and a mass liquidity event with systematic default and insolvency.
- We saw the start of this with Northern Rock in the summer of 2007.
- We attempt to paper over the cracks and restore confidence in the banking system still today – with little success.
 Sterling Liquid Assets (BoE FSR, Jun 2009) A practical, politically-acceptable proposal
Our proposal is, as Irving Fisher wrote, “The opposite of radical”:
- Require 100% cash reserves to be held against all demand deposits; there can never be a crisis if a bank always holds 100% cash against all its demand deposits.
- Parliament can do this with one Act.
A similar Act took place in 1844. The Bank Charter Act or “Peel’s Act” established a 100% reserve requirement for bank notes that were issued claiming to be redeemable in gold. The reality was that there were 23 notes in issue for every one unit of gold at the time, creating instability, “panic” and general economic chaos. Not a too dissimilar situation from today where we have 34 claims on money to one unit of money. Politicians in the 19th century did not see the creation of unbacked credit through accounting entries as a problem, since it was only done on a very small scale. The problem then was rampant note issue (claims to real money) well over and above the monetary base, as this was the preferred method the bankers used at the time.
It is often forgotten but when you place £1m in a savings account (in cash) in say the Royal Bank of Scotland, which has no legal reserve requirement, they then lend £970k (in credit) , keeping on average 3% of cash back in reserves, to an entrepreneur in say HSBC, who then deposits that money in HSBC. We now have one claim to the original £1m and one claim to the £970k. The money supply has moved from £1m to £1.97m – just like magic! This is credit expansion.
The reality is that across all the banks in the United Kingdom licensed by the Bank of England, we have for every £1 of money (in cash), £34 in claims to money (credit)!
Peel’s problem was the over issue of notes to gold: our problem is the over issue of credit to money.
Continue reading “A day of reckoning: how to end the banking crisis now”
By Steven Baker MP, on 25 January 10
Via The Guardian, City minister campaigns to protect taxpayer from bank failures:
City minister Lord Myners today stepped up the government’s campaign to ensure taxpayers will never again need to bail out banks by urging delegates to a Downing Street seminar to hammer out ways to transfer the risk of bank failures away from the public sector.
At the start of the meeting with academics, country officials from the G7, international and UK policymakers, Myners said: “There is clearly a strong rationale to charge for the externality caused by the financial sector and financial institutions should shoulder the responsibilities for losses they may face”.
“Numerous innovative ideas including contingent capital and systemic risk levies have recently emerged to increase the resilience of the financial system globally and to ensure that the costs of any future failures primarily fall to banks and bank investors rather than taxpayers,” Myners said.
Well, yes indeed: businesses should certainly shoulder their own risks.
However, rather than raising a levy on the systemic risk, the law should remove it: bank deposits should be subject to sound property rights and contract law.
Further reading
By Steven Baker MP, on 25 January 10
 Should banks be permitted to operate with a fractional reserve on demand deposits or should 100% reserves be a legal requirement? Should there be a central bank with a monopoly on note issue? What are the consequences of these choices? These were mainstream questions in the 19th century and they demand attention today. Here, following the ESCP Europe/Cobden Centre “Colloquium on Honest Money”, Steve Baker frames the debate to be had about money and banking.
Today, people are well aware that we have a banking crisis, a “credit crunch“. That is, there is a problem in the financial system, a system which is centrally planned — see Economic Interventionism, Banks and the Crisis – and an approach which necessarily works badly – see Strip the Bank of England of its power. So, what are the features of the present system and what are the alternatives?
The two important features of the present, orthodox system are:
- The banks are not required to keep money in reserve to the value of demand deposits. That is, they operate with a fractional reserve. As Toby Baxendale has pointed out, today if more than one person in 34 asks their bank for their money back in notes and coins, which is a reasonable, contractually-sound request, we will have a systemic banking crisis — a run on all banks — because there is simply not as much cash as people’s bank statements say there is.
- There are, across the world, central banks in which committees of experts set “monetary policy” — see The kindness of geniuses – a rate of interest which, through various mechanisms, affects the entire economy. And the economy is, of course, what people choose to do, since the economy is nothing more or less than the cooperation of thinking, acting individuals and of corporations run by thinking, acting individuals; therefore, manipulating the interest rate necessarily distorts the actions of people and the productive structure. Central banks also act as “lenders of last resort” in the event of a run on a particular bank — which is possible because of their fractional reserve — but in the case of Northern Rock, the Bank of England did not ultimately fulfill that role.
Stepping back from today’s monetary orthodoxy — a fractional reserve and a central bank — the options are plain: we can have a 100% reserve on demand deposits, or not, and separately, we can have central banks with a monopoly on the supply of currency, or not. Hence, Jesús Huerta de Soto models (PDF) the banking debate as follows:
 The shape of the debate (click to enlarge) As Irving Fisher, one of the founders of Monetarism, pointed out in the sub-title and content of his book 100% Money, there are potential benefits to be gained from moving to another system. For example, Fisher identified the following as the headline benefits of moving to a 100% reserve requirement:
- keeping chequing banks 100% liquid so that there can be no more runs on banks,
- preventing inflation and deflation,
- largely curing or preventing depressions,
- and wiping out much of the National Debt.
Since we have had a run on a bank, since the money supply has deflated, since attempts to reflate the money supply risk price inflation and distort the economy, since the boom-bust cycle is evidently still in progress and since we are doubling our national debt, it is perhaps worth taking seriously the question of how our system of money and banking is organized.
Furthering that discussion was the purpose of the recent ESCP Europe/Cobden Centre Colloquium on Honest Money directed by Founding Fellow Dr Anthony J. Evans, Chaired by Corporate Affairs Director Steve Baker and attended by Chairman Toby Baxendale amongst 9 other academics and practitioners in the field of money and banking.
We will continue to develop and promote a range of ideas to open up and further the debate on money and banking.
Further Reading
- Baxendale, A day of reckoning: how to end the banking crisis now
- Frank Whitson Fetter, Development of British Monetary Orthodoxy 1797 – 1875
- F. A. Hayek, Denationalisation of Money: The Argument Refined
- Huerta de Soto, Money, Bank Credit and Economic Cycles
- Gordon Kerr, How To Destroy the British Banking System and Bailing out the Banks – Glaring Evidence of Moral Hazard
- James Tyler, My Journey to Austrianism via the City, Money is not working and How to avoid future encounters with financial meltdown
- Irving Fisher, 100% Money, 1935
By Steven Baker MP, on 22 January 10
Today, we publish our brief guide to money and banking.
The Guide comprises:
- Four charts showing how Baxendale and Evans’ measure of the money supply correlates to economic activity whereas the Bank of England’s measures do not,
- How wealth is created,
- What is and is not money,
- What is wrong with the mechanistic Quantity Theory of Money,
- The role of the interest rate in the business cycle,
- How banking has become socialised through legal privilege and taxpayer guarantee,
- The shape of the debate on money and banking.
By Gordon Kerr, on 21 January 10
Financial engineer Gordon Kerr explains how to destroy the British banking system through the use of derivatives which take advantage of the regulatory system, then sets out four measures to solve the problem.
Nine years ago I worked as a structuring engineer in a three-man team within the investment banking unit of a major British bank. One of us was very bright. He stunned me one day with an idea as to how we could:
- Produce immediate (but illusory) substantial profits for our bank, thus ensuring that we would enjoy generous personal remuneration;
- Generate ‘virtual’ share capital to boost our bank’s capital reserves;
- Leave the actual investment risk exposure and profit expectation of our bank almost exactly the same after the transaction as before it.
Was this idea the kind of rocket science derivative engineering that justifies master of the universe labels for the three of us who designed and implemented it? No: it was extremely simple. Here’s how it worked. We transmuted some loan assets into a derivative transaction for regulatory purposes, whilst leaving the actual loan arrangements unaltered.
Continue reading “How To Destroy the British Banking System –- Regulatory Arbitrage via ‘Pig on Pork’ Derivatives.”
By Jamie Whyte, on 14 January 10
I once saw an advertisement for a book that would apparently reveal the secret of making a profit in the foreign exchange markets. I did not buy it. Someone who knew such a secret could use it to make billions for himself. He would not sell his secret, and thereby render it worthless (currency trading is a zero-sum game), for £9.99.
You should be sceptical of those who claim to be giving away something very valuable, including their extraordinary knowledge or skills. Yet that is precisely what our political leaders are now asking us to believe of financial regulators.
The big new idea in banking regulation is that regulators should force banks to hold more capital when their lending is causing the price of assets (such as houses) to get too high: that is, to reach levels from which they must crash. The Obama administration now has a similar idea concerning commodities, such as oil. They want regulators to intervene in commodity markets to counteract speculation that they believe is making prices too high or too low.
Let us not argue about whether it makes sense to say that a price can be too high when people are willing to pay it, nor whether any human, even computer-assisted, could possibly know that it is. Suppose that some people really do know such things. Why would they work for the government on a salary of less than £50 million?
Knowing that the market has over-priced oil, for example, is extraordinarily valuable. You could take a massive short position and make a killing when the price falls from the heights it wrongly occupies. Or, if you knew that house prices are too low, you could buy shares in real estate investment trusts and soon be rolling in money. For someone who knows whether tradable assets are over- or under-valued, massive wealth is assured.
Perhaps I underestimate the benevolence of those blessed with such amazing skills, but it is hard to believe that they would forgo great wealth for the sake of working in a government department. My guess is that the people who will end up occupying the envisaged regulatory roles will be ordinary human beings. They will know no more about the proper value of things than any other well informed market participant, such as an investment banker guided by his economic research team.
Intelligent, informed people disagree about the value of things. Market prices reflect the balance of disagreement between those willing to put their money where their mouths are. If you think a panel of government employees with no “skin in the game” can do a better job … well, I wonder if you would like to buy this sensational new book …
By Steven Baker MP, on 25 November 09
Cobden Centre Advisory Board member Chris Neal writes on ConservativeHome’s Platform:
We have endured a torrid time of late and appear to be in the process of throwing the baby out with the bath water. For years now we have benefited from a robust and thriving financial services sector. City firms contributed £67.8billion to tax coffers in 2007 but this had already dropped to £32.5billion to the end of March 2009. Arguably this is the most transportable global business; consequently droves of hedge funds and private equity firms are relocating to jurisdictions with tax friendly regimes.
Well chaps, let me make this clear: we are losing these tax revenues and the high earning individuals that spend lavishly on smart homes and consumer lifestyle – which benefits society as a whole. These guys have had enough. They are not all responsible for what happened, yet the knock-on effect of their departure is plain to see but you are all ignoring it: choosing to kill the golden goose with higher taxes and by handing over regulation to an unelected Brussels elite.
Read more.
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