Topic: Finance, Banking & Monetary Policy

Does Drug Prohibition Inhibit Economic Development?

Even the most dedicated opponent of drug prohibition might not guess that this policy harms economic development.

Yet claims in a recent WSJ story, combined with research on the relation between banking and development, suggests just such an impact.

The reason is that drug prohibition fosters anti-money laundering laws; which then discourage U.S. banks from doing business in Mexico; which then impedes Mexican banking; which then negatively impacts development.

The WSJ story says,

U.S. banks are cutting off a growing number of customers in Mexico, deciding that business south of the border might not be worth the risks in the wake of mounting regulatory warnings.

At issue are correspondent-banking relationships that allow Mexican banks to facilitate cross-border transactions and meet their clients’ needs for dealing in dollars—in effect, giving them access to the U.S. financial system. The global firms that provide those services are increasingly wary of dealing with Mexican banks as well as their customers, according to U.S. bankers and people familiar with the matter.

And why are U.S. banks worried about regulation?  Because 

U.S. financial regulators have long warned about the risks in Mexico of money laundering tied to the drug trade. The urgency spiked more than a year ago, when the Financial Crimes Enforcement Network, a unit of the Treasury Department, sent notices warning banks of the risk that drug cartels were laundering money through correspondent accounts … Earlier, the Office of the Comptroller of the Currency sent a cautionary note to some big U.S. banks about their Mexico banking activities.

As for evidence that banking is important for economic development, see this paper by Scott Fulford of Boston College (featured soon in a Cato Research Brief).  Fulford writes:

Do banks matter for growth and how? This paper examines the effects of national banks in the United States from 1870–1900. I use the discontinuity in entry caused by a large minimum size requirement to identify the effects of banking. For the counties on the margin between getting a bank and not, gaining a bank increased production per person by 10%. National banks in rural areas improved agriculture over manufacturing, moving counties towards geographic comparative advantage. Since these banks made few long-term loans, the evidence suggests that the provision of working capital and liquidity matter for growth.

Bad policies (drug prohibition) breed more bad policies (anti-money-laundering laws), which have additional adverse consequences that few could plausibly have forseen.  This is one reason why any government interference with liberty, no matter how well intentioned or seemingly well justified, should face extreme skepticism.

One Sentence, or, Unpacking the Truth about the Founding of the Bank of France

When, in my days as a professor, I occasionally assigned term papers, I used to smile when students wondered out loud how they could possibly come up with enough to say to fill a whole 20 (or 15, or 5, or whatever) pages.  After all, the problem, once you got to be where I was, wasn’t having too much space: it was not having space enough to say what needed saying.  It was all I could do sometimes to squeeze my ideas into the 25 double-spaced typescript page-limit that prevailed among scholarly economics journals.

These days I’m no longer compelled to wrestle with academic journal editors, thank goodness.  But I still face strict length limits now and then, like the one I’m confronting as I finally get around to writing my long-overdue review of Roger Lowenstein’s America’s Bank: The Epic Struggle to Create the Federal Reserve. I’m supposed to limit the review to 1000 words.  Yet I could easily write 20,000 words about that book.  In fact I have written 20,000, and then some, in the shape of a Cato Policy Analysis called “New York’s Bank: the National Monetary Commission and the Founding of the Fed.” Our respective titles give you some idea of where Lowenstein and I differ.  Anyway, the PA isn’t ready yet.  When it is, probably about a month from now, I will let you know.

Despite that PAs length, it also leaves much unsaid.  It says nothing at all, for example, about the seemingly innocuous sentence in chapter five of America’s Bank that reads: “The Bank of France was chartered in 1800 as an antidote to the financial turmoil of the French Revolution.”

Portugal-Style Bail-ins: The New Norm under Dodd-Frank?

As 2015 came to an end, so perhaps did a central tenet of resolving failed companies, the notion that “similarly situated” creditors ought to be treated equally, or, as the lawyers like to say “pari passu” (Latin for “on the same footing”).*  The turning point was Portugal’s treatment of creditors of Novo Banco SA.

Until its failure in August of 2014, Banco Espirito Santo SA had been Portugal’s second largest bank.  When it failed, the Banco de Portugal, acting as receiver, divided the failed bank into  “good” and “bad” components, as the FDIC commonly does in the event of a large U.S. bank failure.  Banco Espirito Santo SA continued as the “bad bank,” which was to be liquidated in an orderly process.  The “good bank” became Novo Banco SA, which would stay in business.

In such “good bank-bad bank” resolutions, all equity holders usually remain with the bad bank, while more senior creditors are transferred to the good bank.  In any event all creditors of the same class are treated alike.  Creditors assigned to the good bank are much more likely to recover some part of their investment.

Venezuela’s Lying Statistics

Surprise! Venezuela, the world’s most miserable country (according to my misery index) has just released an annualized inflation estimate for the quarter that ended September 2015. This is late on two counts. First, it has been nine months since the last estimate was released. Second, September 2015 is not January 2016. So, the newly released inflation estimate of 141.5% is out of date.

I estimate that the current implied annual inflation rate in Venezuela is 392%. That’s almost three times higher than the latest official estimate.

Venezuela’s notoriously incompetent central bank is producing lying statistics – just like the Soviets used to fabricate. In the Soviet days, we approximated reality by developing lie coefficients. We would apply these coefficients to the official data in an attempt to reach reality. The formula is: (official data) X (lie coefficient) = reality estimate. At present, the lie coefficient for the Central Bank of Venezuela’s official inflation estimate is 3.0.

The Bank of England Fails Its Stress Test, Again

On December 1, 2015, the Bank of England released the results of its second round of annual stress tests, which aim to measure the capital adequacy of the UK banking system. This exercise is intended to function as a financial health check for the major UK banks, and purports to test their ability to withstand a severe adverse shock and still come out in good financial shape.

The stress tests were billed as severe. Here are some of the headlines:

“Bank of England stress tests to include feared global crash”
“Bank of England puts global recession at heart of doomsday scenario”
“Banks brace for new doomsday tests”

This all sounds pretty scary. Yet the stress tests appeared to produce a comforting result: despite one or two small problems, the UK banking system as a whole came out of the process rather well. As the next batch of headlines put it:

“UK banks pass stress tests as Britain’s ‘post-crisis period’ ends”
“Bank shares rise after Bank of England stress tests”
“Bank of England’s Carney says UK banks’ job almost done on capital”

At the press conference announcing the stress test results, Bank of England Governor Mark Carney struck an even more reassuring note:

The key point to take is that this [UK banking] system has built capital steadily since the crisis. It’s within sight of [its] resting point, of what the judgement of the FPC is, how much capital the system needs. And that resting point — we’re on a transition path to 2019, and we would really like to underscore the point that a lot has been done, this is a resilient system, you see it through the stress tests.[1] [italics added]

But is this really the case? Let’s consider the Bank’s headline stress test results for the seven financial institutions involved: Barclays, HSBC, Lloyds, the Nationwide Building Society, the Royal Bank of Scotland, Santander UK and Standard Chartered.

Some Blessings of Cheap Oil and Low Inflation

1. Cheaper oil lowers the cost of transporting people and products (including exports), and also the cost of producing energy-intensive goods and services.  

2. Every upward spike in oil prices has been followed by recession, while sustained periods of low oil prices have been associated with relatively brisk growth of the U.S. economy (real GDP).


3. Far from being a grave danger (as news reports have frequently speculated), lower inflation since 2013 has significantly increased real wages and real consumer spending.


4. Cheaper energy helps explain why the domestic U.S. economy (less trade & inventories) has lately been growing faster than 3% despite the unsettling Obama tax shock of 2013.


Interest On Reserves, Part III

Why do I keep harping on interest on reserves? Because, IMHO, the Fed’s decision to start paying interest on reserves contributed at least as much as the failure of Lehman Brothers or any previous event did to the liquidity crunch of 2008:Q4, which led to a deepening of the recession that had begun in December 2007.

That the liquidity crunch marked a turning point in the crisis is itself generally accepted. Bernanke himself (The Courage to Act, pp. 399ff.) thinks so, comparing the crunch to the monetary collapse of the early 1930s, while stating that the chief difference between them is that the more recent one involved, not a withdrawal of retail funding by panicking depositors, but the “freezing up” of short-term, wholesale bank funding. Between late 2006 and late 2008, Bernanke observes, such funding fell from $5.6 trillion to $4.5 trillion (p. 403). That banks altogether ceased lending to one another was, he notes, especially significant (p. 405). The decline in lending on the federal funds market alone accounted for about one-eighth of the overall decline in wholesale funding.

For Bernanke, the collapse of interbank lending was proof of a general loss of confidence in the banking system following Lehman Bothers’ failure. That same loss of confidence was still more apparent in the pronounced post-Lehman increase in the TED spread:

The skyrocketing cost of unsecured bank-to-bank loans mirrored the course of the crisis. Usually, a bank borrowing from another bank will pay only a little more (between a fifth and a half of a percentage point) than the U.S. government, the safest of all borrowers, has to pay on short-term Treasury securities. The spread between the interest rate on short-term bank-to-bank lending and the interest rate on comparable Treasury securities (known as the TED spread) remained in the normal range until the summer of 2007, showing that general confidence in banks remained strong despite the bad news about subprime mortgages. However, the spread jumped to nearly 2-1/2 percentage points in mid-August 2007 as the first signs of panic roiled financial markets. It soared again in March (corresponding to the Bear Stearns rescue), declined modestly over the summer, then showed up when Lehman failed, topping out at more than 4-1/2 percentage points in mid-October 2008 (pp. 404-5).

These developments, Bernanke continues, “had direct consequences for Main Street America. … During the last four months of 2008, 2.4 million jobs disappeared, and, during the first half of 2009, an additional 3.8 million were lost.” (406-7)

There you have it, straight from the horse’s mouth: the fourth-quarter, 2008 contraction in wholesale funding, as reflected in the collapse of interbank lending, led to the loss of at least 6.2 million jobs.