Topic: Finance, Banking & Monetary Policy

Hayek v. Krugman – Cyprus’ Capital Controls

Nobelist Paul Krugman has a propensity to spin and conceal. This allows for deception – the type of thing that hoodwinks some readers of his New York Times column. While deception doesn’t qualify as lying, it also fails to qualify as truth-telling.

Prof. Krugman’s New York Times column, “Hot Money Blues” (25 March 2013) is a case in point. Prof. Krugman sprinkles holy water on the capital controls that will be imposed in Cyprus. He further praises to the sky the post-1980 capital controls that were introduced in a number of other countries.

Prof. Krugman then takes a characteristic whack at all those “ideologues” who might dare to question the desirability of capital controls:

But the truth, hard as it may be for ideologues to accept, is that unrestricted movement of capital is looking more and more like a failed experiment.

Fine. But, not once did Prof. Krugman mention that there just might be a significant cost associated with the imposition of capital controls – a cost with which Prof. Krugman is surely familiar.

Before more politicians fall under the spell of capital controls, they should take note of what another Nobelist, Friedrich Hayek, had to say in his 1944 classic, The Road to Serfdom:

The extent of the control over all life that economic control confers is nowhere better illustrated than in the field of foreign exchanges. Nothing would at first seem to affect private life less than a state control of the dealings in foreign exchange, and most people will regard its introduction with complete indifference. Yet the experience of most Continental countries has taught thoughtful people to regard this step as the decisive advance on the path to totalitarianism and the suppression of individual liberty. It is, in fact, the complete delivery of the individual to the tyranny of the state, the final suppression of all means of escape—not merely for the rich but for everybody.

When it comes to capital controls, I think the Cypriots – even the non-ideologues – might be inclined to agree with Hayek over Krugman.

Cyprus: Follow the Money

While the Cypriot Parliament may be dragging its feet on a proposed rescue plan for Cyprus’ banks, the country ultimately faces a choice between Brussels’ bitter pill…and bankruptcy. Cyprus’ newly-elected President, Nicos Anastasiades, has quite accurately summed up the situation:

“A disorderly bankruptcy would have forced us to leave the euro and forced a devaluation.”

 Yes, Brussels and the IMF have finally decided to come to the aid of the tiny island, which accounts for just 0.2% of European output – to the tune of roughly $13 Billion. But, this bailout is different. Indeed, the term “bail-in” has emerged, a reference to the fact that EU-IMF aid is conditional upon Cyprus imposing a hefty tax on its depositors. Not surprisingly, the Cypriots, among others, are less than pleased about this so-called “haircut”.

Still, the question lingers: Why now? The sorry state of Cyprus’ banking system is certainly no secret. What’s more, the IMF has supported a “bail-in” solution for some time. So, why has the EU only recently decided to pull the trigger on a Cyprus rescue plan?

One reason can be found by taking a look at the composition of Cyprus’ bank deposits (see the accompanying chart).

 

There are two main take-aways from this chart:

  1. European depositors’ money began to flow out of Cyprus’ banks back in 2010. Indeed, most European depositors have already found the exit door.
  2. Over that same period, non-Europeans (read: Russians) have increased their Cypriot exposure. If the proposed haircut goes through, Russian depositors could lose up to $3 billion. No wonder Valdimir Putin is up in arms about the bail-in.

Perhaps a different “red telephone” from Moscow will be ringing in Brussels soon.

Lessons from Cyprus

It doesn’t create a lot of confidence in Europe that tiny little Cyprus, with a GDP less than Vermont, is now causing immense turmoil.

Though to be more accurate, events in Cyprus aren’t causing turmoil as much as they’re causing people to examine both government finances and bank soundness in other nations. And that’s causing anxiety because folks have taken their heads out of the sand and looked at the reality of poor balance sheets.

Looking closer at the specific mess in Cyprus, an insolvent financial sector is the cause of the current crisis, though the problem is exacerbated by the fact that the government has dramatically increased the burden of government spending in recent years and therefore isn’t in a position to finance a bailout.

But that then raises the question of why Cyprus is bailing out its banks? Why not just let the banks fail?

Well, here’s where things get messy, particularly since we don’t have a lot of details. There are basically three options for dealing with financial sector insolvency.

  1. In a free market, it’s easy to understand what happens when a financial institution becomes insolvent. It goes into bankruptcy, wiping out shareholders. The institution is then liquidated and the recovered money is used to partially pay of depositors, bondholders, and other creditors based on the underlying contracts and laws.
  2. In a system with government-imposed deposit insurance, taxpayers are on the hook to compensate depositors when the liquidation occurs. This is what is called the “FDIC resolution” approach in the United States.
  3. And in a system of cronyism, the government gives taxpayer money directly to the banks, which protects depositors but also bails out the shareholders and bondholders and allows the institutions to continue operating.

As far as I can determine, Cyprus wants to pick the third option, sort of akin to the corrupt TARP regime in the United States. But that approach can only work if the government has the ability to come up with the cash when banks go under.

I’m assuming, based on less-than-thorough news reports, that this is the real issue for Cyprus. It needs taxpayers elsewhere to pick up the tab so it can bail out not only depositors, but also to keep zombie banks operating and thus give some degree of aid to shareholders and bondholders as well.

But other taxpayers don’t want to give Cyprus a blank check, so they’re insisting that depositors have to take a haircut. In other words, the traditional government-imposed deposit insurance regime is being modified in an ad hoc fashion.Cyprus Bank Bailour

And this is why events in tiny Cyprus are echoing all over Europe. Folks in other nations with dodgy banks and unsound finances are realizing that their bank accounts might be vulnerable to haircuts as well.

So what should be done?

I definitely think the insolvent institution should be liquidated. The big-money people should suffer when they mismanage a bank. Shareholders should lose all their money. Then bondholders should lose their money.

Then, if a bailout is necessary, it should go only to depositors (though I’m not against the concept of giving them a “haircut” to save money for taxpayers).

But Cyprus apparently can’t afford even that option. And the same is probably true of other European nations. 

In other words, there isn’t a good solution. The only potential silver lining to this dark cloud is that people are sobering up and acknowledging that the problem is widespread.

Whether that recognition leads to good policies to address the long-run imbalances – such as reductions in the burden of government spending and the implementation of pro-market reforms – remains to be seen.

Chavez: The Death of A Populist … and His Currency?

Although Hugo Chávez, the socialist presidente of Venezuela, has finally met his maker, the grim reaper is still lingering in Caracas. As it turns out, Chávez was not the only important Venezuelan whose health began to fail in recent weeks: the country’s currency, the Venezuelan bolivar fuerte (VEF) may soon need to be put on life support.

In the past month the bolivar has lost 21.72% percent of its value against the greenback on the black market (read: free market). As the accompanying chart shows, the bolivar has entered what could be a death spiral, which has only accelerated with news of Chávez’s death.

 

Shortly before his death, Chávez’s administration acknowledged that the bolivar was in trouble and devalued the currency by 32%, bringing the official VEF/USD rate to 6.29 (up from 4.29). But, at the official exchange rate, the bolivar is still “overvalued” by 74% versus the free-market exchange rate.

Gabelli v. SEC: Fairness Wins, 9-0

Congress has provided that most federal agencies filing civil enforcement actions for penalties, fines or forfeitures must act within five years of the accrual of the government’s “claim,” which generally means within five years of the challenged conduct. In Gabelli et al. v. Securities and Exchange Commission, the Supreme Court considered the issue of whether the SEC could file claims of fraud against an investment adviser after this deadline had passed on the argument that it had not discovered the violation until more recently. Courts sometimes apply a “discovery rule” of this sort to keep alive otherwise-lapsed securities claims by investors and other private parties alleging fraud.  

The Cato Institute weighed in with a November amicus brief in support of the petitioner-defendants. As we noted then: 

Statutes of limitations exist for good reason: Over time, evidence can be corrupted or disappear, memories fade, and companies dispose of records. Moreover, people want to get on with their lives and not have legal battles from their past come up unexpectedly. Plaintiffs thus have a responsibility to bring charges within a reasonable time of injury so that the justice system can operate efficiently and effectively — and that is doubly so when the would-be plaintiff is the government, with all its tools for investigation and enforcement. …

[After noting strong historical reasons to read the statute as excluding a discovery rule] …even if courts could alter rather than merely interpret the meaning of statutes, there’s no basis for creating a discovery rule for government enforcement actions. Government agencies with broad investigatory powers — indeed, whose purpose is to monitor regulatory compliance — don’t face the same difficulty as private plaintiffs in identifying causes of action which give rise to the discovery rule. Adding a discovery rule to § 2462 would create an indefinite threat of government lawsuits and invite agencies to review decades of past conduct of selectively disfavored companies and individuals — inevitably chilling innocent and valuable economic activity. To preserve individual liberty in the face of an ever-burgeoning regulatory state and ensure constitutional separation of powers, we urge the Court to reverse the Second Circuit’s decision and hold that no discovery rule applies in Gabelli v. SEC.

I’m happy to report that yesterday by a unanimous 9-0 vote the Supreme Court agreed with this view. Chief Justice John Roberts’s reasoning, as summarized by Robert Anello at Forbes, takes note that the rationale for the “discovery rule” exception is to aid private fraud victims who are often unsophisticated, without means of investigating fraud, and seek simply to be made whole as opposed to punishing an opponent.  

This is not true of government agencies like the SEC, however.  Indeed, the agency’s “central ‘mission’” is to investigate and root out violations of the securities laws and it “has many legal tools at hand to aid in that pursuit.”  Because it is always on the lookout for fraud, the agency does not need the benefit of the doubt afforded by the discovery rule.

Further, unlike a private party who is seeking money to compensate them for injuries sustained as a result of the fraud, the SEC seeks to inflict penalties on a defendant.  As stated by the Court, the outcome of an SEC action is “intended to punish, and label defendants wrongdoers.”  Allowing the SEC to rely on the discovery rule would “leave defendants exposed” to such punishment “not only for five years after their misdeeds, but for an additional uncertain period in the future.”  The Court concluded by noting that the types of changes proposed by the SEC could only be made with congressional approval.

Because the five year limitation period also applies to other government agencies in other contexts, the Court’s decision is tremendously important. 

A federal agency armed with the power to seek quasi-criminal penalties over stale claims – perhaps even claims from decades earlier – is an agency with too much discretionary power.

Defending Cato from Paul Krugman’s Inaccurate Assertions

Writing for the New York Times, Paul Krugman has a new column promoting more government spending and additional government regulation. That’s a dog-bites-man revelation and hardly noteworthy, of course, but in this case he takes a swipe at the Cato Institute.

The financial crisis of 2008 and its painful aftermath…were a huge slap in the face for free-market fundamentalists. …analysts at right-wing think tanks like…the Cato Institute…insisted that deregulated financial markets were doing just fine, and dismissed warnings about a housing bubble as liberal whining. Then the nonexistent bubble burst, and the financial system proved dangerously fragile; only huge government bailouts prevented a total collapse.

Upon reading this, my first reaction was a perverse form of admiration. After all, Krugman explicitly advocated for a housing bubble back in 2002, so it takes a lot of chutzpah to attack other people for the consequences of that bubble.

But let’s set that aside and examine the accusation that folks at Cato had a Pollyanna view of monetary and regulatory policy. In other words, did Cato think that “deregulated markets were doing just fine”?

Hardly. If Krugman had bothered to spend even five minutes perusing the Cato website, he would have found hundreds of items by scholars such as Steve Hanke, Gerald O’Driscoll, Bert Ely, and others about misguided government regulatory and monetary policy. He could have perused the remarks of speakers at Cato’s annual monetary conferences. He could have looked at issues of the Cato Journal. Or our biennial Handbooks on Policy.

The tiniest bit of due diligence would have revealed that Cato was not a fan of Federal Reserve policy and we did not think that financial markets were deregulated. Indeed, Cato scholars last decade were relentlessly critical of monetary policy, Fannie Mae, Freddie Mac, Community Reinvestment Act, and other forms of government intervention.

Heck, I imagine that Krugman would have accused Cato of relentless and foolish pessimism had he reviewed our work  in 2006 or 2007.

I will confess that Cato people didn’t predict when the bubble would peak and when it would burst. If we had that type of knowledge, we’d all be billionaires. But since Krugman is still generating income by writing columns and doing appearances, I think it’s safe to assume that he didn’t have any special ability to time the market either.

Krugman also implies that Cato is guilty of historical revisionism.

…many on the right have chosen to rewrite history. Back then, they thought things were great, and their only complaint was that the government was getting in the way of even more mortgage lending; now they claim that government policies, somehow dictated by liberals even though the G.O.P. controlled both Congress and the White House, were promoting excessive borrowing and causing all the problems.

I’ve already pointed out that Cato was critical of government intervention before and during the bubble, so we obviously did not want government tilting the playing field in favor of home mortgages.

It’s also worth nothing that Cato has been dogmatically in favor of tax reform that would eliminate preferences for owner-occupied housing. That was our position 20 years ago. That was our position 10 years ago. And it’s our position today.

I also can’t help but comment on Krugman’s assertion that GOP control of government last decade somehow was inconsistent with statist government policy. One obvious example would be the 2004 Bush Administration regulations that dramatically boosted the affordable lending requirements for Fannie Mae and Freddie Mac, which surely played a role in driving the orgy of subprime lending.

And that’s just the tip of the iceberg. The burden of government spending almost doubled during the Bush years, the federal government accumulated more power, and the regulatory state expanded. No wonder economic freedom contracted under Bush after expanding under Clinton.

But I’m digressing. Let’s return to Krugman’s screed. He doesn’t single out Cato, but presumably he has us in mind when he criticizes those who reject Keynesian stimulus theory.

…right-wing economic analysts insisted that deficit spending would destroy jobs, because government borrowing would divert funds that would otherwise have gone into business investment, and also insisted that this borrowing would send interest rates soaring. The right thing, they claimed, was to balance the budget, even in a depressed economy.

Actually, I hope he’s not thinking about us. We argue for a smaller burden of government spending, not a balanced budget. And we haven’t made any assertions about higher interest rates. We instead point out that excessive government spending undermines growth by undermining incentives for productive behavior and misallocating labor and capital.

But we are critics of Keynesianism for reasons I explain in this video. And if you look at current economic performance, it’s certainly difficult to make the argument that Obama’s so-called stimulus was a success.

But Krugman will argue that the government should have squandered even more money. Heck, he even asserted that the 9-11 attacks were a form of stimulus and has argued that it would be pro-growth if we faced the threat of an alien invasion.

In closing, I will agree with Krugman that there’s too much “zombie” economics in Washington. But I’ll let readers decide who’s guilty of mindlessly staggering in the wrong direction.

Osborne Risks a Triple-Dip for the UK

U.K. Chancellor of the Exchequer George Osborne has resumed his saber-rattling over raising capital requirements for British banks. Most recently, Osborne has fixated on alleged problems with banks’ risk-weighting metrics that, according to him, have left banks undercapitalized. Regardless of Osborne’s rationale, this is just the latest wave in a five-year assault on the U.K. banking system – one which has had disastrous effects on the country’s money supply. The initial rounds of capital hikes took their toll on the British economy – in the form of a double-dip recession. Now, Osborne appears poised to light the fuse on a triple-dip recession.

Even before the Conservative, Osborne, took the reins of Her Majesty’s Treasury, hiking capital requirements on banks was in vogue among British regulators. Indeed, it was under Gordon Brown’s Labour government, in late 2007, that this wrong-headed idea took off.

In the aftermath of his government’s bungling of the Northern Rock crisis, Gordon Brown – along with his fellow members of the political chattering classes in the U.K. – turned his crosshairs on the banks, touting “recapitalization” as the only way to make banks “safer” and prevent future bailouts.

It turns out that Mr. Brown attracted many like-minded souls, including the central bankers who endorsed Basel III, which mandates higher capital-asset ratios for banks. In response to Basel III, banks have shrunk their loan books and dramatically increased their cash and government securities positions, which are viewed under Basel as “risk-free,” requiring no capital backing. By contrast, loans, mortgages, etc. are “risk-weighted” – meaning banks are required by law to back them with capital. This makes risk-weighted assets more “expensive” for a bank to hold on its balance sheet, giving banks an incentive to lend less as capital requirements are increased. 

Five years later, Osborne is attempting to ratchet up the weights on these assets. Indeed, he is taking another whack at banks’ balance sheets – and the result will be the same as when the U.K. Financial Services Authority first took aim at the banking system (under Gordon Brown). As the accompanying chart shows, the first round of capital requirement hikes (in 2008) dealt a devastating blow to the U.K. money supply. Indeed, it tightened the noose on the supply of bank money – the portion of the total money supply produced by the banking system, through deposit creation.

Not surprisingly, this sent the British economy spiraling into its first recessionary dip. The second hit to the money supply came shortly after the Bank for International Settlements announced the imposition of capital hikes under the Basel III accords, in October 2010. Despite numerous infusions of state money (reserve money) via the Bank of England’s quantitative easing schemes, these first two squeezes on bank money have put the squeeze on the U.K.’s total money supply.

This is the case because state money makes up only 16.3% of the U.K.’s total money supply. The remaining 83.7% of the money supply is made up of bank money. In consequence, the Bank of England would have to undertake a massive expansion of state money, via quantitative easing, to offset the U.K.’s bank money squeeze.

It is doubtful, however, that the British pound sterling would be able to withstand such a move. Indeed, there are more storm clouds brewing over Threadneedle Street. The sterling recently touched a 15-month low against the euro, and it has fallen 8% against the euro since late July. For the time being, at least, the pound’s tenuous position will likely put a constraint on any further significant expansion of state money, through quantitative easing. It appears markets simply wouldn’t tolerate it.

Accordingly, the only viable option to jumpstart the faltering U.K. economy is to release the banking system from the grips of the government-imposed bank-money squeeze. Alas, Osborne’s most recent initiative on bank recapitalization goes in exactly the wrong direction.