Where Brexit negotiations are concerned, we have reached (as they say in Britain) “squeaky bum time.” The triggering of Article 50 on March 29^th 2017 started a 2‑year countdown for the UK and EU to negotiate a withdrawal agreement for a binding international treaty. Yet just 5 months from deadline, the EU’s position on Northern Ireland and a lack of domestic support for Prime Minister Theresa May’s desired long-term trading relationship mean a no deal Brexit in March remains a real possibility (the tweet linked here quotes Britain’s trade minister Liam Fox). True, much of the withdrawal agreement has been long agreed. A transition period through to 31 December 2020 is planned to essentially keep the UK within the EU’s economic institutions (the single market and customs union), though reports suggest both sides might be willing to extend this for an extra year. Free movement of people would continue for this period, and the UK would pay £39 billion into the EU budget. Importantly, though Article 50 states that a withdrawal agreement must take account of the longer term post-exit relationship, this is not going to be achieved in time: the agreement would merely be accompanied with a joint, loose-languaged political declaration on the future framework. But it’s here where difficulties have arisen, and most center around the Northern Irish border. Both sides have said from the start that, post-Brexit, they want to keep the border between the Republic of Ireland (an EU state) and Northern Ireland (part of the UK) free of physical infrastructure and associated interventions at politically-sensitive crossings. But making that commitment self-evidently necessitates a trade relationship. Given long-term trade arrangements will not be agreed in the withdrawal agreement, the EU has therefore insisted that the withdrawal deal itself contain backstop provisions to ensure the border remained open should another arrangement or trade deal incorporating not be agreed. This is what led last December to the UK and EU agreeing in principle to a fudged “backstop” position on Northern Ireland. In vintage legalese, the text stated: “In the absence of agreed solutions, the United Kingdom will maintain full alignment with those rules of the Internal Market and the Customs Union which, now or in the future, support North-South cooperation, the all-island economy and the protection of the 1998 Agreement.” Given the UK government has said repeatedly that the UK would be leaving the EU customs union and single market, this text raised Brexiteer eyebrows. Yes, the UK government agreed this to kick forward future trade relationship talks, and in the hope it would not be ultimately necessary. But talk of full alignment left ambiguity, and the potential for the backstop itself to keep the UK locked into Brussels’ regulatory and customs orbit. However much the UK government insisted that this language did not mean regulatory harmonization, but instead merely achieving shared regulatory goals via detailed sanitary rules, customs procedures, and the Single Energy Market, the backstop left an uncomfortable feeling that the UK had fallen into a trap. This was not helped when the EU then rejected proposed “technological solutions” and “away from the border checks” that the UK insisted could have avoided the backstop. The unease intensified when, from February, the EU and Ireland began proposing a backstop arrangement where Northern Ireland alone would remain within the EU single market and customs union to ensure a soft border. This was something out of kilter not only with the text but with the wishes of the Northern Irish Democratic Unionist party which props up the Conservative minority government. This is all significant because Brexiteers fear now that the Northern Irish border has become the tail wagging the dog not just on the backstop, but on the potential future long-term trade relationship between the EU and UK. They fear the UK is being hoodwinked into a Brexit-in-name-only by threats of breaking up the UK through saying that only a soft Brexit can keep the Northern Irish border without physical infrastructure. The Prime Minister Theresa May’s proposals for a longer-term trade relationship (known as the Chequers Plan) is Exhibit A. Rather than aiming for the best trade arrangements and then seeking to minimize disruption at the Irish border, the plan seems explicitly designed to keep the border as frictionless as possible, at the cost of an extraordinary loss of policy freedom. Chequers proposes a common rulebook between the UK and the EU on goods and agri-goods trade but not services, where fears of Brussels regulating the City of London alone without a UK vote were reason enough alone for exclusion. Non-regression-like clauses on environmental and labor laws would be included. A complex facilitated customs arrangement would see the UK collect the EU’s tariffs on its behalf. This deal has proven anathema to most Conservative Brexiteers, binding as it does the UK to EU goods regulation without voting power over it and stripping away the bargaining chip of goods regulation in making liberalising trade deals with third parties. They see Chequers as an unnecessary loss of sovereignty, and want Theresa May to “Chuck Chequers” and instead negotiate with the aim of a whole of UK FTA and practical solutions at the border. Incidentally, the EU doesn’t like Chequers either. They rightly see it as cherry-picking parts of the single market, are suspicious of a foreign government collecting its duties and would prefer even tighter integration of lots of regulations (including commitments for full harmonization on labor and environmental laws), such that the UK cannot secure a competitive advantage. Political commentators in the know say Chequers is dead as far as the EU is concerned. In the EU’s eyes, the preferred long-term options have always been a Canada-style free trade agreement, or maintained UK membership of the single market and a customs union (in essence, a political Brexit but not an economic Brexit). Most Brexiteers very much prefer the former, which comes with more regulatory and trade policy freedoms. This brings us to the crux of the current political crisis. May’s government have thus far lined up with the EU (and against Brexiteer insistence otherwise) in stating that it’s impossible to solve the border problem satisfactorily through an ordinary UK-EU free trade deal and other practical solutions. They imply that with a Canada-style FTA, Northern Ireland alone would have to remain tied to EU economic institutions to avoid a hard border, effectively creating an economic border down the Irish Sea. Conveniently, May claims that only something like her Chequers plan can avoid this. But with Chequers seemingly without much support at home or in the EU, the future relationship talks have effectively stalled. With so much uncertainty about it, the backstop agreement has taken center-stage, because de facto that could become the default relationship. And here Brexiteer fears have heightened. Since May insists no UK government would countenance Northern Ireland having different customs arrangements from Britain, she has proposed the whole of the UK remaining in a customs union-like arrangement as a backstop. Earlier this year she suggested this would last for an extra year beyond transition (to December 2021) and Brexiteers are still keen on this kind of time limit. But the EU says that a backstop cannot be time-limited, because otherwise it’s not a backstop. Brexiteers winced this week when the PM’s position seemingly “evolved” in the EU’s direction, with her suggesting remaining in a customs arrangement as a backstop on a “temporary” but indefinite basis. These fears heightened with news that the EU believed there was not enough time to discuss a UK-wide backstop proposal, and insisting that the withdrawal agreement incorporate a “backstop to a backstop,” with a Northern Ireland-only customs arrangement should a full UK-wide agreement fail to be agreed. For many Brexiteers, the major economic benefit of Brexit is the ability to conduct independent trade policy, cutting deals and setting tariffs. An indefinite customs arrangement threatens this. Given the EU would seemingly prefer the whole of the UK to remain within its economic institutions, a non-time-limited customs backstop provides little incentive for the EU to agree to a future comprehensive free trade deal the Brexiteers desire. Combined with Chequers then, Brexiteers fear a huge sell out is on the cards. The UK government’s official position has always been that the country will leave the EU single market and customs union. But now both Chequers and the backstop risk are seen to keep the UK within these arrangements to varying degrees. The result is a political crisis. The PM this week updated the house on the negotiations but could not provide assurances any customs arrangement backstop would be time-limited. She has since floated and then rowed back on extending the transition period, something that would see UK taxpayers pay for at least another year of EU funding, without settling the backstop issue. As a result, everyone is unhappy. There is talk of Brexiteers dethroning May as a last gasp attempt to push for the Canada FTA-type deal the EU has offered. The DUP are threatening to derail the government’s domestic legislative agenda should the PM allow Northern Ireland to be treated differently. The hardline Remainers, meanwhile, are pressing for a second referendum on any withdrawal agreement May brings back. With the clock ticking, and stakes rising, the prospect of no deal is therefore heightening. The EU has engineered a situation where in the long-term it insists either the UK must sign up to a backstop where Northern Ireland must be effectively economically annexed, or the UK must remain locked in the EU’s regulatory and customs embrace itself. The Brexiteers (to my mind rightly) consider this unacceptable. Ignoring whether a change of Prime Minister or strategy is perceived as bad faith negotiating by the UK, it does not seem an extreme position to say that the EU should not have the right to dictate the economic breakup of a sovereign country, nor determine its domestic economic regulations. But at such a late stage and in such a febrile political environment, who knows where this multi-actor game of chicken ends?

Management practices in firms differ widely between countries according to research summarized by economists Nicholas Bloom and John Van Reenen. The differences between well-managed firms and those that are poorly managed are significant and could help explain differences in Total Factor Productivity (TFP) between countries. In the field of economic history, economists Louis Putterman and David N. Weil (henceforth P&W) found that the length of time that a population of a country has lived with a centralized state and with settled agriculture (henceforth, Deep Roots) are powerful predictors of their GDP per capita today. Perhaps there is a relationship between firm management practices by country and that country’s Deep Roots?

P&W tested their Deep Root’s hypothesis by creating a matrix of contemporary populations of each country based on their population’s ancestral origin in the year 1500. They use a variable called state history that measures how long a country has lived under a supra-tribal government, the geographic scope of that government, and whether that government was controlled by locals or by a foreign power. Their second variable is agricultural history and it measures the number of millennia that have passed since a country transitioned from hunting and gathering to agriculture. P&W then combined the matrices of ancestry with the Deep Roots variables to show how long each national origin group was governed by a centralized state and how long they had settled agriculture. The Deep Roots score varies dramatically between peoples and locations. P&W’s findings stand in contrast to those that explain economic development and GDP per capita as the ultimate result of geography, institutions, or other conventional explanations.

Ryan Murphy and Alex Nowrasteh tested whether the Deep Roots variables can explain differing GDP per capita by U.S. state in a paper published in the Journal of Bioeconomics (working paper available here). They found that P&W’s core result of a statistically significant and positive relationship between Deep Roots variables and GDP per capita does not hold at the subnational level in the United States. This argument is related to immigration because new immigrants bring different state history and agricultural history scores with them, eventually affecting the Deep Roots of their new country. Whether that matters for economic growth is up for debate. 

Since Deep Roots are correlated with GDP per capita globally and some economists think that they can explain economic development, firm management practices should probably also be correlated with Deep Roots. To test this, we ran simple linear OLS regressions testing the relationship between firm management practices and a country’s state and agricultural history. Our standard errors are robust to heteroskedasticity. We controlled for the same variables that P&W did as well as the economic freedom score. We downloaded the firm management practices dataset for 34 countries here. 

We found precisely nothing interesting related to the Deep Roots (Table 1). Neither state history nor agricultural history is correlated with better management practices. However, economic freedom and absolute latitude are positively correlated with state history and agricultural history. On the positive side, our R‑squared is 0.72, so the variables that we included can explain 72 percent of the variation. 

There are a lot of reasons why this could be. We only had management score data for 34 countries, collinearity was rampant, cross sections are limited, or other explanations that we haven’t considered. Regardless, there is no evidence here that there is a link between Deep Roots and firm management practices. 

 

Table 1

Firm Management Practices, State History, and Agricultural History

Millions of Americans move between states each year. These migration flows are influenced by numerous factors including job opportunities, climate, and housing costs. Interstate migration is also influenced by state and local taxes, as discussed in this recent study.

Internal Revenue Service data show that 2.8 percent of households moved to another state in 2016. The map below shows the net patterns of movement. People are leaving the red and purple states for the blue states.

The ratio of domestic gross in-migration to gross out-migration is shown for each state. In 2016, New York gained 142,722 households and lost 218,937 for a ratio of 0.65. Florida gained 307,022 households and lost 211,950 for a ratio of 1.45.

States losing population to other states have ratios of less than 1.0 and states gaining population have ratios of more than 1.0. People are generally moving out of the Northeast and Midwest to the South and West, but they are also leaving California, on net.

Here are some of the regional patterns:

• The Northeast. New Hampshire enjoys net in-migration. It is a low-tax state with no individual income tax. Higher-tax Connecticut, Massachusetts, Rhode Island, and Vermont suffer net out-migration.
• The Midwest. South Dakota enjoys modest net in-migration, while its higher-tax neighbors Iowa, Minnesota, and Nebraska suffer net out-migration. South Dakota is a low-tax state with no income tax. Neighbor Wyoming has net out-migration overall but has substantial net in-migration among high-earning households. Wyoming has no income tax.
• The Southeast. Kentucky has suffered net out-migration for years, while its neighbor Tennessee has enjoyed net in-migration. Kentucky is a relatively high-tax state, while Tennessee is a low-tax state with no individual income tax.
• The West. The largest destinations for out-migration from high-tax California are Texas, Washington, and Nevada—all low-tax states with no income taxes.

In this study, I divide the states between the 25 highest tax and 25 lowest tax, with taxes measured as state and local individual income, sales, and property taxes as a percent of personal income. In 2016, 286,431 households (with almost 600,000 people) moved, on net, from the 25 highest-tax states to the 25 lowest-tax states. Of the 25 highest-tax states, 24 of them had net out-migration in 2016. (Maine was the exception).

The 2017 federal tax reform law will likely intensify the patterns shown in the map of people moving from high-tax states to low-tax states. The law doubled standard deductions and capped state and local tax deductions. Those changes will reduce the number of households deducting state and local taxes from 42 million in 2017 to about 17 million in 2018. Those households will feel a larger bite from state and local taxes and become more sensitive to tax differences between the states.

Welcome to the Defense Download! This new round-up is intended to highlight what we at the Cato Institute are keeping tabs on in the world of defense politics every week. The three-to-five trending stories will vary depending on the news cycle, what policymakers are talking about, and will pull from all sides of the political spectrum. If you would like to recieve more frequent updates on what I’m reading, writing, and listening to—you can follow me on Twitter via @CDDorminey. 

1. “Trump appears to call for defense spending cut,” Aaron Mehta. This week’s Cabinet meeting went a bit differently than most. The President, apparently due to worry about the country’s rising debts and deficits, issued a call for every federal department to cut it’s spending by five percent in Fiscal Year 2019 (FY19). Reporters understandably rushed to ask President Trump if this initiative would include defense spending; while he doesn’t seem to want the full five percent, Trump commented that the budget next year would be “around $700 billion” (a 2.3 percent cut). 
2. “Air Force B‑21 Raider Long Range Strike Bomber,” Jeremiah Gertler. The Congressional Research survey released an update on the still-classified B‑21 program. While many details remain unavailable to the public, this report discusses the status of the program and includes useful information on projected research and development funding. 
3. “Air and Missile Defense at a Crossroads,” Mark Gunzinger and Carl Rehburg. The Center for Strategic and Budgetary Alternative released a new report today on adapting missile defense for protecting overseas bases, and recommendations to move the portfolio in that direction. 
4. “Senior defense committee Democrat wants to stop U.S. weapon sales to Saudi Arabia,” Tony Bertuca. Senator Jack Reed, the ranking Democrat on the Senate Armed Services Committee (SASC), said publicly that all sales of offensive weapons to Saudi Arabia should be blocked until a thorough investigation into the death of journalist Jamal Khashoggi can be undertaken. 

The U.S. Treasury reports that the federal budget deficit was $779 billion in fiscal 2018. The deficit is caused by spending in excess of tax revenues and is financed by borrowing from foreign and domestic creditors.

Federal spending in 2018 was $4,108 billion and tax revenues were $3,329 billion, so Congress financed 19 percent of its spending with borrowing. Did taxpayers—who will ultimately bear the burden—really consent to that extra debt-financed spending? It is like Dad leaving the kids some cash to buy pizza, and then coming home to find that they also used his credit card to rack up charges on the Internet.

Unless the politicians grow up and start making reforms, the deficit will likely grow from $1 trillion in 2019 to more than $2 trillion a year a decade from now.

Annual deficits are piling onto accumulated federal debt held by the public of $16 trillion. That is $127,000 for every household in the nation. Compared to the size of the economy, today’s federal debt is, by far, the highest in our peacetime history.

Why is soaring government debt so worrying?

1. Spending Induced. Most federal spending is for subsidy and benefit programs, not for activities that increase productivity. Subsidy and benefit programs distort the economy and generally reduce overall output and incomes. Those distortions occur whether spending is financed by debt or current taxes. But the availability of debt financing induces policymakers to increase overall spending, which at the margin goes toward lower-valued activities.
2. Tax Damage Compounded. When taxes are extracted to pay for government spending, it induces people to change their working and investing activities, which distorts the economy and reduces growth. When spending is financed by borrowing, the tax damage is pushed to the future and compounded with interest costs.
3. Investment Reduced. Government borrowing may “crowd out” private investment, and thus reduce future output and incomes. Economist James Buchanan said, “By financing current public outlay by debt, we are, in effect, chopping up the apple trees for firewood, thereby reducing the yield of the orchard forever.” The crowd out will be reduced if private saving rises to offset government deficits. But the CBO says, “the rise in private saving is generally a good deal smaller than the increase in federal borrowing.” Government debt may also deter investment through expectations—businesses will hesitate to invest if rising debt creates fears of tax increases down the road.
4. Borrowing from Abroad. A decline in private investment due to government borrowing may be avoided if capital is attracted from abroad. Indeed, huge federal borrowing has been facilitated by global capital markets, and today more than 40 percent of federal debt is held by foreigners. Borrowing from abroad may prevent a fall in domestic investment but does not prevent the shifting of costs to future taxpayers. As government debt rises, more of our future earnings will be taxed to pay interest and principal on the government’s debt to foreigners.
5. Macroeconomic Instability. CBO warns that a “large and continuously growing federal debt would … increase the likelihood of a fiscal crisis in the United States.” Experience shows that high levels of government debt tend to reduce growth and increase financial fragility. In their study of financial crises through history, Carmen Reinhart and Ken Rogoff concluded, “again and again, countries, banks, individuals, and firms take on excessive debt in good times without enough awareness of the risks that will follow when the inevitable recession hits.” Government debt, they found, “is certainly the most problematic, for it can accumulate massively and for long periods without being put in check by markets.”

Sadly, with regard to the federal budget, policymakers seem to be in la-la land, a “euphoric dreamlike mental state detached from the harsher realities of life.” They dream about spending on their favorite programs and act as if there won’t be harsh consequences to their profligacy. But there will be. Future living standards are being eroded as huge costs are being pushed forward, and the rising debt will eventually spark a damaging financial and economic crisis.

Last week, I had the pleasure of addressing the Michigan Credit Union Economic Summit on the future of financial services. I discussed emergent themes in financial regulation as a result of new technologies, and their implications for the industry. Here are my remarks -- I hope you find them informative.

*****

It is an interesting time to work in financial services. This month, we are celebrating ten years since the financial crisis, which in its impact was comparable to the Great Depression. While the macroeconomic picture today is much different, with strong growth and record low unemployment, the impact of the crisis on the financial sector was long-standing and continues to make itself felt.

Additionally, the rapid expansion of data analysis, mobile applications, and machine learning among financial institutions over the last decade is transforming not just lending, but asset management, too. Allied with the demands from post-crisis regulation, these developments present a challenge to established depository institutions.

Making predictions without a crystal ball

My talk is about disintermediation and decentralization. These are big words, but they are ubiquitous in today’s discussion of the future of financial services.

According to Investopedia, disintermediation is “the withdrawal of funds from intermediary financial institutions [...] to invest them directly.” The same source defines financial decentralization as “a market structure that consists of a network of various technical devices that enable investors to create a marketplace without a centralized location.”

Behind the big words, therefore, lurks a simple yet momentous question: Will financial technology - Big Data, machine learning, blockchains - render incumbent financial institutions - banks, fund managers, stock exchanges - obsolete?

Pretending to predict with any certainty what the banking and broader financial services landscape will look like in 25 years’ time seems like a fool’s errand. Even the best-informed observers in 1993, on the eve of branching liberalization, would have struggled to foresee the scope and speed of consolidation in subsequent years, let alone the contemporary boom in stock investing, mortgage lending and, ultimately, the financial crisis.

I do not presume to have a crystal ball. Nevertheless, there are a number of signs of the long-term direction of travel. They do suggest that depository institutions will face renewed competitive pressure from outsiders. But this may lead to more, not less, intermediation - just like Uber added a layer of intermediation to passenger transport in order to make the market more efficient.

As for decentralization, time will tell if technology can make a fully peer-to-peer economy cost-effective. Right now, it looks like only some degree of centralization of financial transactions can overcome the barriers to cheap and reliable market exchange.

Structural trends in the financial sector

Let me begin with some important secular trends in finance which preceded, but we're deepened by, the Great Recession, and which have carried on in its wake.

The first is a marked reduction in the number of banks, which dropped to 4,918 in 2017 from 7,077 in 2008, and as many as 10,453 when the Riegle Neal Act (which liberalized branching) was passed in 1994. Credit unions, as you know, have witnessed a similar trend: As of June 2018, there were 5,594 chartered credit unions, compared to 12,333 in 1994.

The decline is in stark contrast to credit union membership, which grew from 67 million to 115 million during that time. Indeed, despite average assets of only $225 million compared to $3 billion for banks, credit unions have managed not only to retain market share but to grow it, from 5.6 percent to 7.4 percent, over the last 25 years.

The disappearance of many smaller credit institutions over the last quarter-century has led to the emergence of so-called “banking deserts”: areas without a single bank or credit union branch within a 10-mile radius. Around four million Americans lived in banking deserts as of 2016, with the number set to rise as many small institutions who are the sole physical branches in some communities face closure in coming years. Still, there is reason to believe that community organizations are less prone to branch closures during downturns than are large banks, as they have fewer alternative uses for available capital given the limited geographic scope of their operations.

The extent to which this structural decline in institution numbers is driven by economic as opposed to political factors is in dispute. America for a long time had a high ratio of credit institutions per capita. After 25 years of consolidation, that ratio is closer to other Western markets such as Germany and Spain. The UK, on the other hand, which in its level of financial depth and breadth is most similar to the U.S., has a more concentrated banking market, with the four largest banks holding 60 percent of personal deposit accounts.

Technological advances have probably also contributed to consolidation, since IT systems have high fixed costs but low marginal costs. Furthermore, as firms grow and expand, and as individuals become more mobile, a large branch network gives credit institutions more of a competitive edge.

But it's likely that non-economic factors have also played a significant role, since the second structural trend is a steady growth in the scale and scope of financial regulation. Between 1970 and 2008, regulatory restrictions on credit intermediaries grew fourfold, from around 10,000 to 40,000 on the eve of the crash. The Dodd-Frank post-crisis regulatory package, on its own, piled another 27,000 regulations on the financial sector as a whole - in what has been called “one of the biggest regulatory events ever.”

You might think that most of the new rules have prudential motives - higher capital and liquidity requirements; stricter mortgage origination standards; and so on. In fact, a lot of the regulatory growth has to do with increased reporting of suspicious transactions under the Bank Secrecy and USA PATRIOT Acts. While these obligations are justified on grounds of crime prevention, tax collection and national security, there is evidence to believe they are not very effective.

For example, estimates put the cost of enforcing anti-money laundering regulations at between $4.8 and $8 billion annually for the financial system as a whole. Yet, despite a sharp rise in suspicious activity reports by depository institutions, from 670,000 in 2013 to 920,000 in 2017, investigations, prosecutions, and convictions for money laundering have been in steady decline for years.

It is plausible that this drop is due to the fact that copious reporting has discouraged potential felons. A more cynical view, however, is that regulation is simply casting its net too widely - collecting information on perfectly legitimate transactions and pushing up bank compliance costs in the process. That the thresholds for transaction reporting by banks and other financial institutions have not been adjusted for inflation since the 1970s supports the latter interpretation.

The third trend is a shift from deposit-taking to non-depository financial institutions. Quicken Loans recently overtook Wells Fargo as the country’s largest mortgage originator. Marketplace lenders are growing providers of consumer and auto loans. The federal government has taken over the bulk of student lending. Even private equity is replacing banks in their bread-and-butter corporate loan sector.

The extent to which more efficient technology is behind this trend, rather than especially onerous regulation of deposit-taking institutions, is a matter of debate. A 2017 paper for the National Bureau of Economic Research found that regulation explained 60 percent of the growth of so-called “shadow banks,” while better technology accounted for 30 percent. The paper focused on U.S. mortgage markets, which were a chief target of post-crisis regulation. Depositories have retreated from this market, while the role of non-depository lenders and government-sponsored entities has increased.

Small business lending was another victim of the crash. While it has recovered somewhat over the last three years, research has shown that the decline of community financial institutions affected local small business lending. Big banks have not fully replaced them and have themselves restricted small business credit, with measurable impacts on local economic growth and local wages. Even after the economy recovered, these effects persisted where large banks had a large market share.

The challenge of financial technology

Post-crisis supervision has become a burden, especially on smaller institutions. Yet, the trends of consolidation and growth in average asset sizes are unlikely to reverse. Economies of scale are a glaring reality in finance, particularly as more financial activity moves online, lowering the variable costs of operations. On the regulatory front, it will be more difficult to justify relaxing prudential rules on deposit-taking institutions, which enjoy comprehensive government-sponsored insurance, than on “shadow banks,” which do not.

As regulation increases, the “optimum size” of a credit institution will grow. That is because larger banks and credit unions can better bear the fixed compliance burden of much regulation. Entry requirements are another regulatory barrier, and with new bank charters hard to come by and applications becoming ever more cumbersome, increasing demand for financial services can be more cheaply met by an expansion of incumbent institutions than by the establishment of new ones.

Finally, the role of technology in driving a wedge between incumbents and disruptors (plus those who ally with them) is likely to only increase as data collection becomes ubiquitous and machine learning improves. A recent Fed paper found that FICO, the workhorse credit score used for credit decisions in the United States, performed poorly in comparison with Lending Club’s proprietary credit model, which uses FICO but also other variables such as utility payments, internet usage data, and insurance claims. Notably, Lending Club’s predictive advantage has improved as its score diverged from FICO.

The promise of technology

The findings of this paper are interesting for two reasons.

First, making credit decisions from a richer set of data can lead to more accurate estimation of repayment probabilities, resulting in more and better-priced loans. Indeed, the increase in loan volumes and improvement in pricing can especially benefit marginal borrowers who currently face rejection or, alternatively, interest rates high enough to place them in dire straits if anything goes wrong.

Second, and more transformationally, increased use of alternative data can make financial services available to people who would otherwise remain unbanked or underbanked. There are 126 million households in the United States. 29 percent of them are unbanked or underbanked, according to the Federal Deposit Insurance Corporation: 9 percent, or 11.3 million, are altogether outside the mainstream banking system, while another 19.9 percent (25 million) have only a basic bank account.

That’s more than 36 million American families whom the banking system is not adequately serving at present.

However, of the 126 million households in America today, 110 million have a broadband connection. 95 percent of Americans have a cell phone. As credit-scoring models incorporate this information, financial institutions will be able to offer affordable products to a larger set of consumers who are now on the margins of the financial system. Better risk assessment technology could halve the number of unbanked and underbanked - and then some.

It’s not just about credit

Fintech is disrupting financial services beyond credit risk. Many of you probably have come across, and use, financial apps on your smartphones. Not only have platforms such as Robinhood, Stash, and Motif made retail investment more accessible and user-friendly, but in the process they are contributing to the downward push on brokerage and management fees that has forced cost discipline on money managers. Minimum investment amounts have also fallen, all the way to zero in some cases, lowering barriers to entry for cash-strapped Millennials.

The impact of app-based entrants has forced incumbents to respond. This summer, Fidelity announced the launch of zero-fee index funds available to customers of all sizes. JP Morgan followed suit with You Invest, an app which (like Robinhood) will allow its customers to trade stocks for free. Vanguard has also expanded its offer of fee-free exchange-traded funds. For 20 years, the battle for investor cash was between active and passive managers. As many underperforming stock-pickers have fallen by the wayside, competition among passive funds has become fiercer.

At a time of historically low interest rates - the lowest since Babylonian times, that is, around 1500 BCE, according to financial historian Richard Sylla - retail investors have snapped up these increased opportunities for cheap capital deployment. Furthermore, the cost savings from moving to zero fees from the 0.25 percent which still prevails across much of the fund management industry can make a 20 percentage-point difference in returns over a lifetime of investing.

Crypto

There is another decennial that we are commemorating in October of 2018. Ten years ago, an enigmatic programmer (or group of programmers) by the name of Satoshi Nakamoto published a paper entitled “Bitcoin: A Peer-to-Peer Electronic Cash System.” Nakamoto proposed to have solved a long-standing challenge of decentralized - that is, disintermediated - payment systems: the so-called “double-spend problem.”

Before Bitcoin, any peer-to-peer system of fund transfers could not easily prevent a user from spending the same funds more than once. Because there was no authority overseeing transactions - making sure that A had the funds that it claimed to have sent to B, that B had received those funds, and insuring A against the possible non-delivery of the good or service promised by B in exchange - peer-to-peer networks inevitably failed under pressure from fraudsters.

Nakamoto’s solution was to use cryptography to make it difficult to steal one’s funds, but easy to verify ownership; an open ledger held by all network participants to log transactions in real time; and a system of rewards that encouraged users to spend time and effort confirming true transactions, while making fraud prohibitively expensive.

I like to compare cryptocurrency networks to market economies. For a market economy to succeed - and history shows that only market-based societies really do flourish - the institutions that govern interactions between people must promote trust and mutually beneficial exchange. In the United States, strong property rights protections give people the incentive to guard and develop economic resources. Contracts make the planning of long-term business and other relationships possible. A reliable court system facilitates dispute resolution. Fraud is punished, both financially and criminally.

This is the atmosphere which cryptocurrencies like Bitcoin seek to replicate, only virtually. Hence the use of cryptography, transparent ledgers, and a sophisticated rewards system for those helping to complete transactions. Whether crypto will manage to one-up established payments and other financial institutions is a question that competition will solve. But those who suggest cryptocurrencies are purely a scam are probably wide of the mark.

Here to stay?

Bitcoin’s birth has spawned thousands of other cryptocurrencies in the ensuing decade. To be sure, the market gyrations of this new asset class can be vertiginous. Just a year ago, bitcoin sold for $4,800. It went on to rise all the way to $19,000 by the end of 2017, only to drop back to around $6,200 as of Thursday [October 11]. I do not purport to give financial advice, but it is safe to say that cryptocurrencies should probably not form a large portion of the portfolio of the typical long-term-oriented, risk-averse investor.

Indeed, cryptocurrencies as a whole still only represent around $200 billion of market value - tiny when compared to the $32 trillion market capitalization of U.S. listed companies.

Furthermore, since the IRS treats Bitcoin and others as property subject to capital gains tax, rather than currency, cryptocurrencies do not make for very efficient exchange media - unless you enjoy accounting for your tax liability each time you use your bitcoin to buy groceries and clothes.

However, the technology has proved to have staying power, despite booms and crashes along the way. Businesses from software giant IBM to shipping conglomerate Maersk to Amazon are exploring internal applications of blockchains, the decentralized ledger technology made famous by Bitcoin. Ripple, the third-largest cryptocurrency in circulation, has set up trials with established financial institutions for international payments, which at present are notoriously slow and expensive. New cryptocurrencies continue to launch despite the bearish cycle: EOS, based in the Cayman Islands, raised $4.2 billion at the end of June.

Regulators rule

The market is pretty good at picking winners and losers. Those who provide a valuable service to customers at a good price make a profit and can continue to serve them. Those who underperform have to choose between swift change or demise. The result is excellence and higher living standards, which have risen 30-fold in the West since open markets started to become the norm in the late 1700s.

Yet, laboring under tens of thousands of rules, the financial services industry is far from a free market. So, regulators will play a salient role in determining the future of financial technologies. The novelty, inscrutability, and volatility of cryptocurrency markets means that regulators are wary to let them grow. That fraudsters have taken the opportunity with this New Big Thing to scam unwitting speculators out of their funds has not helped, either. However, and while condemning fraud, it is difficult to have much sympathy for people who - against every public warning - still bought into crypto, lured by rates of return in excess of 200 percent, without performing the requisite due diligence.

Nevertheless, it would be a mistake to make cryptocurrencies synonymous with financial technology. Not only are Bitcoin and its brethren a tiny portion of financial innovation so far, but many of the policy issues that preoccupy lawmakers in the crypto space - crime, anonymity, fraud, and (not least) who on earth is responsible for regulating this stuff - have no parallel for much new lending and investment technology.

Looking at the impact of regulation

Instead, what may stand in the way of the large-scale consumer gains promised by financial technology are long-standing regulations that, while well-intentioned, can hobble innovation and end up harming the people they were written to help.

ECOA, the Equal Credit Opportunity Act, is an example. When this statute was written in 1974, lending discrimination was a major concern. Minority communities consistently faced a tougher borrowing environment for reasons unrelated to the credit quality of individual borrowers. ECOA sought to eliminate this unjust state of affairs by banning discrimination on the basis of race, religion, and sex. At the time, it was a forceful piece of legislation that aimed to end, once and for all, a long-standing inequality in the U.S. financial system.

Yet, as the years have passed, not only has racial discrimination in lending declined by leaps and bounds, but the interpretation of ECOA by the courts has expanded. A major disagreement among legal scholars involves whether the statute bans explicit discriminatory practices only - known as disparate treatment - or whether seemingly above-board practices that result in measurably different outcomes for different groups - so-called disparate impact - should also be prosecuted.

As an economist, it is not my place to offer an interpretation of the law. However, I will point out that language that encompasses disparate impact in subsequent financial regulation is absent from ECOA, casting doubt on the contention that a broad interpretation of its provisions is the right one.

Disparate impact - unintended consequences?

Being an economist, however, I am concerned about the consequences of the law, quite apart from the intended meaning of the law. One concern is that a broad interpretation could easily lead to perfectly legitimate practices coming under the spotlight, leading financial providers to exit markets where they currently provide a valuable service. The Bureau of Consumer Financial Protection’s recent investigation of auto lending, which alleged discrimination in loan markups on the basis of what later proved to be shoddy statistical models that would not have impressed my undergraduate econometrics teachers, is an example.

Congress earlier this year voted to repeal the Bureau’s guidance. It has subsequently become clear that its officers were perfectly aware of the weaknesses in their analysis, but proceeded nonetheless under political orders from the top. Given this sort of arbitrary behavior, it cannot come as a surprise that the Bureau’s efforts to promote innovation - dubbed Project Catalyst - have so far received short shrift from lenders.

More concerning even than the consequences of the disparate impact doctrine on existing practices, however, are its effects on future innovation. I mentioned earlier the potential for better credit scoring to increase credit provision at lower interest rates. But such improvements depend crucially on the freedom to test risk measurement models, inserting new variables and taking out old ones to examine their predictive power. If a model can be deemed unlawful on the basis of its short-term differential impact on certain communities, however, the incentive to innovate is diminished.

Furthermore, what’s the point of coming up with new ideas if the regulator will, following a political script, shut them down as soon they are in place?

A disparate impact claim must show that the practice in question has no business justification. In other words, if Asian Americans have higher median incomes than whites, and median income is a useful predictor of ability to repay, then systematically pricing loans to Asian Americans lower than to whites is not discriminatory, since whites are a worse credit risk. Yet, the Bureau conspicuously ignored borrower income and other characteristics relevant to credit risk when it looked at auto lending. Who’s to say that other regulators, and courts, will not behave the same way?

Machine learning is especially vulnerable to regulatory action, since it consists of evolving algorithms that make credit decisions on the basis of reams of data, much of it seemingly unrelated to creditworthiness. When the machine spits out its verdict, it often cannot point exactly to the factor that drove the decision. But watchdogs concerned about disparate impact may not allow technologies that cannot explain their lending policies with minute detail. It would not be the first time that beneficial innovations die from good intentions.

Opening up banking services

Regulators are risk-averse, we can all agree. Because they get little credit for allowing successful new products and much blame for failing to identify trouble spots and potentially fraudulent practices, the people in charge of bank supervision tend to be conservative in their judgements. This is individually rational but can harm the economy as a whole, if it causes promising but uncertain innovations to fall by the wayside due to regulatory overkill.

Sometimes, though, regulation can help innovation and competition in financial markets. Some people believe that will be the case with ‘Open Banking,’ a new regulatory structure for retail financial services provision pioneered in the United Kingdom.

The basic idea of Open Banking is that consumers are trapped with their incumbent providers because competitors cannot access their data to offer better and more suitable alternatives. As a result, consumers remain oblivious to options that would make them better off. The consequence is that retail banking markets are less competitive, and less likely to yield optimal outcomes, than other services sectors - such as groceries and e-commerce - where suppliers do have ready access to customer data.

Open Banking forces providers to make available their customer data in an interoperable way. With clients’ consent, third-party vendors and data aggregators - notably, mobile apps - get secure access to customer information, which they can scrape and use to offer suitable products. In the same way that Google and Facebook can use your browsing data to place more relevant ads in front of your eyeballs, Open Banking would allow for more targeted credit, savings, and investment product offerings.

The key, as you may have gleaned from the comparison to internet platforms, is how to promote such open access without compromising the security of customer data. Financial accounts contain much sensitive information, which in the wrong hands could facilitate surveillance, blackmail, and - in some cases - even fraud and extortion. Thus, enabling authorized providers to access customer data, but only if they are authorized, is imperative to make the system work.

The UK and other European countries have attempted to resolve this conflict by ramping up privacy regulations - through an enormous legislative package known as the General Data Protection Regulation. Even the largest tech firms have struggled to comply, but the most onerous burden falls on smaller services and apps who now must ask for user consent for the most mundane forms of data collection.

It remains to be seen whether the benefits from greater competition will outweigh greater compliance costs from the new privacy rules. Privacy is not the only challenge to Open Banking: If there is a data breach in the dealings between financial institutions and third-party vendors, who will be to blame? Who is liable for compensation? Will users know with whom the fault lies? This is important, because without adequate customer awareness, the reputational damage from data breaches may fall on perfectly innocent shoulders.

This is what disintermediation looks like

Despite the implementation challenges, something akin to Open Banking is bound to arrive on these shores in the near future. The recent Treasury report on nonbank financials and fintech praised the British model, while noting the differences to laws and practices in the United States. The report encouraged increased data-sharing by financial institutions with customers and authorized third parties. It also stressed the need to define liability. Crucially, it expressed a need for standards that facilitate data-sharing and left the door open to standard-setting by federal authorities if the private sector does not deliver them.

With or without the intervention of public authorities, a growing partnership between fintech firms and data aggregators, on one hand, and financial institutions, on the other hand, looms on the horizon. It will mean that traditional banking relationships, in which retail customers held their deposit account, money market account, retirement account, mortgage and auto loan, and other financial products, with the same firm will gradually cease to be the norm. Instead, switching and arbitrage by consumers, enabled by better information and easier access to competing platforms, will grow.

The upshot is that depository institutions, not least credit unions whose business model is predicated on direct relationships, common bonds, and a lifetime link with customers, will face the challenge of outside firms with lower costs, able to lure customers away with customized offerings at low prices. That does not mean the days of established financial institutions are numbered, nor that the impact of financial technology will be uniform across all banks and other depositories. Already there are important differences in the technological readiness of some institutions compared to others. The coming years will only underscore that contrast.

Pioneers of disintermediation

Should credit unions be afraid of disintermediation? History offers grounds for optimism. Not only have credit unions, as we saw earlier, managed to grow their market share of banking assets even as small financial institutions as a whole lost ground; but they were pioneers of financial disintermediation over 100 years ago.

Originating in England, Germany, and Austria as cooperative banks during the 19th century, credit unions came to America via Canada at the start of the 1900s. Alphonse Desjardins, who had set up one such credit institution in Quebec, helped to establish the first American credit union in New Hampshire in 1909.

That is all well-known to you. What may perhaps be less obvious is that credit unions championed a form of disintermediation of their own. By pooling the savings of communities and groups who shared a common bond, credit unions dispensed with the middleman and were able to offer more competitive rates to borrowers and better returns to their members. Peer-to-peer lending has a modern ring to it, but it would not have seemed an alien concept to Desjardins if it had been explained to him more than a century ago.

The upshot is that the future of financial services is likely to give consumers more power, in the form of data and information. It will not spell doom for intermediaries, but will instead create space for new intermediaries who collect, sift through, and disseminate information, adding value in the process. Decentralization will be a feature of the process, as consumers bank, borrow, and invest with a larger and more diverse set of providers than ever before. But financial institutions are unlikely to become redundant anytime soon.

Regulatory trends will shape these developments. As we have seen, zealous regulation can slow down and even halt financial innovation. Regulatory accumulation can also have an impact on the structure of the financial industry and its costs. The credit union sector has, in aggregate, withstood the onslaught of financial regulation since the 1970s rather well, but within the sector, a secular trend of consolidation akin to that of banks has taken place.

Financial institutions anticipate the advent of new financial technologies with a mixture of excitement and apprehension. To the extent that innovation is likely to give some firms a competitive edge over others, such ambivalence in the face of uncertainty is understandable. The industry as a whole, however, may be more adversely affected by regulatory developments. It behooves us all to ensure financial regulation evolves with technological change, and that policymakers focus on the consequences, and not just the intent, of the rules they write.

Thank you.

The focus of the Trump administration’s trade policy to date has been on renegotiating existing trade deals (with a mix of minor liberalization and modest new protectionism), putting tariffs on a wide range of imports using flimsy justifications, and engaging in a high-profile trade war with China. By contrast, it has put very little effort into pushing for significant new trade liberalization.

That may be about to change. The U.S. Trade Representative’s Office has just sent letters to Congress formally notifying the administration’s intent to enter into trade negotiations with the EU, Japan, and the UK. Cato scholars have called for exactly these negotiations (see here, here, and here, and much more detail here).

There is a lot of work ahead, as these negotiations won’t be easy. They would have been easier if the administration had not imposed “national security” tariffs on imports of steel and aluminum from these very same trading partners. Nevertheless, almost two years into the Trump administration, there is finally a glimmer of hope that there could be some trade liberalization coming.