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Charles Calomiris joins the weekly commentary – CLICK HERE to buy Charle’s book – Fragile by Design: The Political Origins of Banking Crises and Scarce Credit (The Princeton Economic History of the Western World)

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The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick

CHARLES CALOMIRIS: ALL BANKING IS POLITICALLY DRIVEN
January 30, 2019

“It’s not inconceivable to me that within 20 years central banks will be much less important – the Federal Reserve, the European Central Bank, the Bank of Japan, the Bank of England – much less important. And governments will still be finding ways through regulation, because they still will have those powers, to achieve their objectives. I think that financial technology is just the next wave of the chartering of banking.”

– Charles Calomiris

Kevin:We have a guest today, Charles Calomiris. Before we get to the guest, Dave, tell our listeners a little bit about the man we are going to be talking to.

David:Charles Calomiris is the Henry Kaufman Professor of Financial Institutions at Columbia University Graduate School of Business, and is also a professor at Columbia’s School of International and Public Affairs. He is someone who has explored the ideas of moral hazard and currency devaluations, and certainly in an era where the tendency is to blame the bankers for what has happened post global financial crisis, he gives us some perspective on just how integral politicians are to what actually occurs in the midst and the formation of banking policy, and ultimately, the crises that we see emerge from that.

Looking at four, five, six centuries, it is helpful to have in perspective what those contributing factors are. Looking at conflicts of interest, looking at politics, looking at the origins of banking crisis, this is what he has done. Fragile by Designis the book that I am familiar with, and as we mentioned last week, came from the footnotes of Mr. Pollock’s book, Finance and Philosophy, and I am grateful for bibliographies, as always. You will be probably not surprised as a listener to know that there are dozens of books from the references and bibliography in Fragile by Designwhich will be coming from Amazon shortly, and I’m grateful for the research that Charles and Stephen Haber put into this book.

Kevin:I think what we talked about last week, Dave, in preparation for this interview, is that sometimes we look to the wrong source of a problem or a solution, and oftentimes we look at banking and say banking needs to be changed. But actually, the skeletal structure behind what we see in banking, finance, mortgages, what have you, is always political, and unless we understand that, the voter blocks and the politics behind it, we probably really can’t understand the next financial crisis.

David:And that becomes very clear when you look at the history of U.S. banking, where even though Hamilton was the architect for the banking system that we have, he did not get all that he wanted, and as much as he modeled things after the Bank of England, there was less centralization in what we ended up with, in terms of our banking system. Let’s just say, we are not the enviably dull, like our Canadian bankers, and that might have been what we would have been had Hamilton gotten his way.

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Charles, thank you for joining us on the Commentary today. As I went through your book, Fragile by Design: The Political Origins of Banking Crisis and Scarce Credit, there was obviously some discovery, a learning experience, and a few misconceptions that I had that you created an argument and documented a case that took me in a different direction. So I’m grateful for the education going through the book, and I’m grateful for the time that you put into writing it.

I want to dive right into what the content is. One of your main arguments is that banks’ strengths and shortcomings are the predictable consequences of political bargains, and that those bargains are structured by a society’s political institutions. Maybe you could frame today’s discussion for us with that idea in mind.

Charles:First of all, thanks very much for the opportunity, and thanks for reading the book. All authors are pleased, and almost shocked sometimes, when people read their book so carefully, and your description of the main theme of the book is exactly accurate. So thanks again.

I think that it is a common experience I have that most people who are looking at the recent banking crisis in the U.S., or the whole plague of banking crises that we have had throughout the world for the past 30 years, which is really unprecedented, are asking themselves, what is the random shock that happened? What mountain lion climbed out of the rock next to them and decided to eat them at this particular moment?

Just as you say, we’re trying to get people to understand that when you look at banking crises, and the current wave of them, and why they happen in some places and not in others, it is pretty clear that banking crises are coming from risk, that is, not just something that happened because there is a bad mountain lion attack, but because you were taking risks in the first place.

And then the question is, why would people in some places decide to take these kinds of risks? And in the case of the U.S., why would we decide to take them perpetually, over and over again, and never seem to learn that we are the riskiest of all the developed countries’ banking systems in the world, that we keep purposefully doing this? And the point, of course, is people take risks because the banking system is controlled by the government. The government charters commercial banks, and it regulates them. It decides whether to protect them, and how to protect them. It decides when losses happen, who is going to bear those losses, whether the taxpayers will, or the shareholders, or the depositors.

So it is all those government decisions about chartering, regulating, protecting banks, that makes banks decide, or not decide, to take risk. Those are political decisions, and so it’s really not a very controversial thing to say, if you have a country that is deciding to take risk through its politically engineered decisions about banks, over and over and over again, that must be a political outcome. And it’s obviously a conscious political outcome.

Now, of course, politicians never like to frame it that way. They don’t like to say, “We’ve decided to have a risky banking system.” What they want to say is something different. “We’ve decided to make the American Dream happen. We’ve decided to make sure that our economy grows. We’ve decided to make sure credit is abundant – all those positive things. But the way that they decide those, the way that they make those happens, entails, and purposely, it reflects, the decisions about risk. It’s not that the politicians want risk, it’s just that they want the things that are stapled to risk (laughs) and those things are going to happen, and continue to happen in the U.S. We just experienced one of the worst real estate crises in our history, but most of our banking crises are real estate crises of one kind or another, and by the way, we are probably going to have another one, maybe not quite as severe, but we are already in the middle of a very high-risk real estate situation once again.

This isn’t a coincidence, it’s because politicians get a lot of benefits from subsidizing the risk inherent in real estate borrowing. People will vote for them, or not vote for them…. In [unclear] work I’ve done since the book, people will vote for a politician or not vote for them based on their own personal mortgage credit experience. So if you want to know who is to blame for all of this crisis stuff, and I’m very unpopular when I say this, I tell people, if you are an American voter, look in the mirror (laughs). You’re the one who is rewarding politicians, on both sides of the aisle. This is a bipartisan thing. You’re the one who is instigating politicians to want to create a fragile banking system. They don’t do it because they are pathologically drawn to risk. They do it because they’re pathologically drawn to getting elected.

David:Right. And that may be a pathology. Well, talk to us about the co-evolution of the modern state with banking, because originally you had banking, which was there to finance trade and war, and now we have the iteration that benefits the consumer. So take us on a quick tour from the 16thto the 21stcentury (laughs).

Charles:I’m happy to do that. I don’t usually get people asking me to give them a quick tour of 500 years all over the world, but actually, it’s not that hard to do a quick one. So as you said correctly, the first chartered banks are the creation of government which is really there to finance trade and war. Actually trade and war in the 16thcentury were really part of the same thing, which was expansion of empire. You had some of the most important ones in the 17thcentury. The early 17thcentury was the Dutch Wisselbank, and toward the end of the 17thcentury the British Bank of England.

These were extremely important. The Wisselbank was basically a trade finance clearing house. It wasn’t a big, risky lender, it was really trying to make sure that what was then the most important means of financing trade, which is bills of exchange, could be liquid and could be traded to a central clearing house. And that is what the bank did. It wasn’t really interested in lending.

Similarly, the Bank of England wasn’t very interested in lending either. The Bank of England was actually created as an equity-for-debt swap mechanism to create liquidity and increase the value of British sovereign debt for the government, as part of the struggle between Britain and France that went for more than a century. And those were really the purposes of those banks, that they were extremely successful for promoting trade in the case of the Wisselbank and promoting sovereign debt restructuring and increased war finance capability for the Bank of England, and therefore, for the British crown.

And over time, let’s say by the 19thcentury, banks started getting chartered more for financing business. In Scotland, I guess you would say, by the middle of the 18thcentury, all of the important inventions of banks in creating money and creating credit as what we are used to as the mature modern bank, including clearing houses for exchanging notes, including letters of credit, including branch banking, all of those things that we think of as the obvious credit and money functions of banks, really were perfected, I would say, by the middle of the 18thcentury in Scotland.

And then, as it became clear that this was a very important tool of state for developing further prosperity, growth, countries that were more interested in jump-starting their growth, again, partly as a national priority, for military or other purposes – I’m thinking now of Germany and Japan around the end of the 19thcentury – they saw banking as absolutely necessary for that jump-starting of their own industrialization. So what you see happening in countries like Germany and Japan is charter banks getting more aggressively involved in longer-term industrial finance.

That really then brings us to the final phase, almost, which is banks learning to do securities markets underwriting alongside their other existing functions, which were credit and money creation, and that is really, I would say, roughly speaking, the 20thcentury and where we are today. Of course, there have been a lot of changes. Banks got much more protected in the middle to end of the 20thcentury. Banks didn’t used to be protected by governments very much. For example, by the 1960s, the U.S. was still the only country that had any deposit insurance for banks. So that grew and became very pronounced.

The notion of government bailouts and insurance of deposits was really the final phase, and that is really the last 50 years or so, and especially the last 30 years or so, which, not coincidentally, is also the era of the worst banking crises in history, because if you protect banks more – guess what? They take on a lot more risk.

So that is pretty much where we are with the modern universal bank that does all those functions and how they were taken on. And the key point is that those decisions about what banks do, why they are chartered, what their powers are, and how they are protected, were all political decisions that came about at certain times for perfectly understandable political reasons.

David:I think most people, when they think of banks, they don’t think of statecraft, and yet because of these bank bargains we have had the evolution which you just described which brings us into the modern era. Preservation of political order, in many instances, is through using the mechanisms of finance and credit as tools. So maybe you could just expand on that a little bit – banks as a tool in statecraft.

Charles:Absolutely. The way I would like to start that conversation is by pointing out that there are some countries in the world that don’t have standing armies – Costa Rica. There are some countries in the world where the government doesn’t tax – Kuwait. But there are no countries in the world where the government does not charter, that is license, specifically, the creation of banks. That is, you might say, in that sense, the defining function of government, to figure out how to set up a financial system.

Of course, in the U.S., Alexander Hamilton is our great national architect of our financial system. But if you just sit for a minute and think, how could a government function without a financial system, without an ability to collect taxes, which is a financial transaction, or to spend money, which is a financial transaction, to borrow, and how can the government be prosperous if its economy isn’t prosperous? And if people can’t transact and borrow at some minimum level, of course, the government is going to suffer, too.

So a perfectly selfish government, because remember, a lot of these governments are not democracies, historically they weren’t run, necessarily, for the interest of the common man – but governments have always seen the importance of making sure that their economies function and that their own public finances could be executed properly. So banking is just essential.

And the governments then have to decide, what kinds of things they can achieve with banks more easily than they could achieve through other means. And this varies a little bit by country and by time. So for example, in the U.S. we really depend on banking, through many means, to subsidize real estate credit, particularly housing credit.

Now, you could say the government could just do that directly, but the government decided in the 1960s, when it was already full-blown with using banks for this purpose as government functions, that it didn’t want to have that on its own balance sheet anymore, and that was because we were in the middle of the Great Society and the Vietnam War, so why create housing subsidies on the government’s balance sheet? That requires the government to actually recognize its own costs.

How about this? Let’s do something different. Let’s regulate to make a private entity – Fannie Mae, Freddie Mac, and the commercial banks, the federal home loan banks, I could go on and on, the FHA, the Veterans Administration – all of these are banking vehicles that are part of the government apparatus. None of them is part of the government accounts. The government achieves all of those subsidies without having to actually show the cost on its own balance sheet.

Of course, every once in a while when things blow up, the government has to come in and clean up. But then, that’s just something that they claim as some sort of crisis cleanup. They don’t ever have to recognize the high cost of the subsidies that they are providing at the time they are actually providing them.

So that is a political decision. Not all countries do it that way. Not all countries prioritize, let’s say, housing finance. So the point is, the function of the banking system, the role of the government’s use of the banking system, varies by country, but it always reflects a political calculation. In the U.S. we have decided that we want to do a lot of risky housing subsidization through finance, but we don’t want to do it through our own government’s direct balance sheet.

We want to do it – I don’t want to way non-candidly or invisibly – but we want to do it in a way that absolves the government of direct involvement, but politicians still get to claim the credit for all the programs for housing that they actually are creating. So it’s a strange outcome in the U.S. and it is actually fairly unusual. But that is an example of how the government decides, and always has decided, that it wants to use this power to create finance, to regulate finance, to protect finance, to achieve particular objectives.

David:So banking systems, as you say, are made vulnerable by construction, as a result of these political choices. What are the choices which have tended to make the U.S. banking system one of the most crisis-prone in the world?

Charles:They have changed over time, as the power of different coalitions have changed. So one of the funny things I think a lot of people believe about the politics of banking is they think it is all about bankers. Bankers are always powerful players, politically, of course, but it’s really mainly about borrowers. And especially borrower groups that are able to organize themselves to lobby for these special favors. And this shifted because initially in the U.S. it was an agricultural economy for the most part. Most people were initially engaged in agriculture.

And the important coalition of borrowers was rural borrowers, that is, land-owning farmers. And they decided that they wanted a banking system with a particular set of attributes. And that was unique. The U.S. was, for example, the only country in the world to decide to have what is called unit banking, which is, each bank operates one office, one branch, one physical location. It wasn’t until the mid-1990s that we had universal branch banking throughout the United States. I think many young people would be surprised to hear that. The banking system that they are used to is actually quite new.

So why did farmers want to have unit banking? That’s a long story, but I can go back to it if you’re interested. They wanted unit banking, but unit banking is very risky because we have tens of thousands of banks all over the U.S. They weren’t able to coordinate their actions during bad times very well. They weren’t able to diversify their risks because they lent very locally. And our banking system, therefore, was extremely unstable.

So then, instead of changing it to be a more stable banking system like, let’s say, our northern neighbor, Canada, which never has had a major banking crisis, by the way, we decided we don’t want to change it so we’re going to try to protect it. So the first country to have deposit insurance was driven by that same motivation coming from that same coalition of agricultural borrowers who wanted a particular kind of banking system and didn’t want to just live with the instability that their choice entailed, they wanted to then pile on top of that bad choice another bad choice, which was to try to protect the banks so that they would be less unstable.

Of course, that backfired, and what we learned in the U.S. is that when you protect them, they get even more unstable and so then you have even bigger losses. And so we experienced that in the U.S. as early as the 1820s, 1830s. And then instead of learning that lesson we just kept doing it. We did it again in the early 20thcentury. We’re still doing it. So you could ask, “Why are we doing that?” Well, it’s because the protection is something that the borrowers want and the taxpayers pay for. So that is, from the standpoint of the borrowers, a pretty good deal.

What shifted about 1930 to 1980 is, instead of mainly agricultural borrowers being the coalition that was successful in getting what they wanted in the bank, it became urban borrowers, especially homeowners. This partly reflected demographic shifts toward the cities but there were other influences. So then, from after the 1960s, in particular, it all became about trying to subsidize urban housing acquisition, the American Dream, and doing that in a very risky way.

Most Americans probably aren’t familiar with the fact that our mortgage system is a complete international outlier, something that we don’t see anywhere else, in many respects, but the most obvious one is that Americans put down very low down payments. Their mortgages are extremely risky. Many Americans have down payments currently in their house of 3% or less, or 5%, and many would regard 10% as a large number. In most of the world 10% would be regarded as cuckoo – cuckoo low, not high.

So how did we get that? How is it possible to set up a financial system that spends so much of its resources on risky mortgages? The answer is, when you create a lot of government-sponsored enterprises and a lot of regulations of other financial institutions like banks, it ensures that risky mortgages are going to be there, and very cheaply supplied.

So I would say that the answer to your question is, over time things have shifted from a coalition of unit bankers and agricultural borrowers to what is now the case where we have a coalition of urban mortgage borrowers with government-sponsored enterprises like Fannie Mae and Freddie Mac, but also all of the large, now-nationwide branching commercial banks. So even though the structure has changed and the identities of the influential coalition have changed, the basic logic is the same.

David:The shift from rural to urban, and the demographic shift, as well, was accompanied by the vote. How has the right to vote impacted the credit markets and development banking? Maybe you can look at the electorate and the penchant toward voting self-interest. You might even call it wealth redistribution. A lot of that, overlapping that timeframe where you are talking 1930-1980, we saw universal suffrage more popular after World War II.

Charles:There are two ways in a democracy that you can influence banks, and they are both important, but they are important in different ways. One way you can influence banks is not with voting, but with organizing as a political action committee and lobbying, and you can have a lot of power because you can influence other people’s votes. You can also give large campaign contributions which influence other peoples’ votes. And so there is something called, believe it or not – and it is a complete irony because they are anything but – the Coalition for Sensible Housing Policy.

The Coalition for Sensible Housing Policy should be called, “The Coalition for Ripping Off Taxpayers to Create Subsidies for Risky Mortgages.” That coalition spent a lot of efforts on lobbying and other kinds of activities, and politicians pay attention to them. There are, of course, other organized groups and members of that same organization, the groups that participate in that, that also do campaign funding.

So that’s one way to do it, but of course that is important because you are influencing voting through the lobbying efforts that you are doing, creating good publicity or bad publicity for politicians, by the way, attending the ribbon-cutting ceremonies for some new subsidized activity or housing project. So there are a lot of ways that in a democracy you can participate.

What about voting? In voting, I found in a recent study I did, that people, when they go to the polls, if they have been rejected from a mortgage application, they take it out on the incumbent party. We don’t find the reverse. When things are good and you get your mortgage, you don’t actually reward the incumbent party by being more likely to vote for them. So the way that I understand this psychologically is, when my mortgage gets approved, that is obviously something that reflects well on me. “I did that.” When my mortgage gets denied – “David, you must have done that. Somebody did it. It wasn’t me.” So I think we have a tendency in the voting to not really reward on the upside, but to penalize on the downside.

So the way I look at it is, those are the two different mechanisms. The organized groups are much more important in getting this thing started, and then when the crisis hits, it’s the voters’ potential penalty if the subsidy isn’t continuing through the crisis, then the politicians get penalized that way. So the incentives in a democracy are kind of complicated. There are different ways that people operate on the politicians. But the important thing to recognize in the U.S. is, they are very successful in doing so.

There hasn’t been a president elected who hasn’t been part of this coalition in recent years. Whether you are a Republican or a Democrat, you are all in for subsidizing risky mortgages. George W. Bush was. Bill Clinton was maybe the worst of them all. Of course, Barack Obama was. Of course, Donald Trump is. Even George H. W. Bush, God rest him, was the one who signed the GSE [Government Sponsored Enterprises, meaning Fannie Mae and Freddie Mac, the legislation was the Housing and Community Development Act] act in 1992 during the election year when he was trying to win over some big cities, because, of course, Ohio and Florida, for example, which are important states – hard to win the presidency without them – have lots of cities in them.

So whether you are a Republican or a Democrat running for president, you’re all in. The Democrat party, which is mainly an urban party, is all in. And the Republicans who are running for election from urban areas, like Newt Gingrich, for example, from suburban Atlanta, are also all in. So the current dividing line is between the Democrats and the urban Republicans and anyone running for president, on the one hand, and then local Republicans in rural areas who tend to be opposed to it, and you can see that they are in a dwindling minority. So the political coalition is pretty strong. And that is why, even though we just had a major crisis, we have also just rebuilt over the past decade, a huge, fragile structure of mortgages where now more than a third of the mortgages being originated in the U.S. are extremely risky.

So once we get another downturn in the mortgage market you are going to see another wave of foreclosures. And then people are going to be scratching their heads, “How come we didn’t learn? Why didn’t we learn?” And the answer is, because we all voted for and supported politicians who thought it was their job to create exactly that risky situation. And they’re doing it right now, and they have been doing it very aggressively over the past decade.

David:To some degree, the history of banking and the history of money are in a parallel track. We were talking about the Great Society a few minutes ago, and Vietnam, and the Johnson administration and their guns and butter policies set up for an interesting set of events. And I’m curious because we left the last vestige of the gold standard in Bretton Woods, in that time frame, 1971. In your opinion, is the gold standard untenable in a world where fiscal and monetary policies support the welfare state, prioritize full employment, or choose some other social or political objective, but clearly these are objectives that are prioritized above price stability?

Charles:Yes. I think the simple answer to your question is yes. My friend, Barry Eichengreen, at Berkeley, has written about this extensively. It is almost exactly the same logic parallel to what I have been saying about banking charters, that basically, again, this is one of the defining powers of government, to create a medium of exchange, a unit of account. Our government creates the U.S. dollar. In fact, that is in our Constitution. And it used to be that when short-term political pressures weren’t so great through all the mechanisms you describe, it used to be that longer-term perspectives about the importance of price stability and that maintaining the stability of the currency could allow for what I would say is wiser decision-making about long-run growth, everyone’s long-run economic interest.

Well, as that shifted, it became clear that central banks really wouldn’t be able to prioritize that, and as you have pointed out, the guns and butter policies of the 1960s were a great example of this. The U.S. destroyed the Bretton Woods system of fixed exchange rates precisely because of that guns and butter system. The U.S. decided to spend a lot of money, to print a lot of money at the Federal Reserve in support of that, and that actually made the dollar no longer supportable at a fixed value relative to gold.

And that was when the French came into the gold window and demanded that the U.S. maintain parity. And then that is what caused the system to explode. But the reason it exploded, and the reason the French saw the writing on the wall, was that the U.S. was minting dollars like crazy, but then pretending that the dollar’s value wasn’t falling. Well, of course, that’s not sustainable.

But I think you are right in pointing to a deeper political point, which is, it was a political decision, and a very understandable one, to prefer inflation to giving up those other priorities that the Johnson administration was pushing through at that time. I think we’ve learned from that, and I think currently there is less of a taste for inflationary policy than there was in the 1960s.

However, notice how much our debt has grown, notice currently that when you have a divided government in Washington, what can they agree on? “Well, I’ll spend more money for my things, if you’ll spend more money for your things.” So ironically, the more divided the government, it seems to me, the more they are willing to make deals that have the form [unclear] both spend more. And we don’t worry about the fact that we’re borrowing and borrowing until at some point, and we are not that far away from it, the only choice will be inflating that debt away. I think we are not very far away from that point.

But I think on a more optimistic note, Americans did learn from the inflation of the 1970s, that they didn’t want to have inflation. Of course, they are not seeing the inflation right now, and many politicians are saying, “Oh, don’t worry about spending more. We’re not going to get inflation.” But it’s one of those things that happens through a cumulative effect, and ultimately, when the debt gets high enough, there is no choice. And that is what I’m worried about right now.

David:There are a lot of questions that I would love to ask on the inflation issue, and I want to make sure that we spend a little bit of time hanging out on that. But I’m also interested in your view of the impact of technology on the financial markets because you look at the bank bargains which have been in place, today we have technology which allows something of a workaround, allowing the markets to evolve around the traditional flows of credit and banking, and around the current regulatory regimes, how do you see policy responses to that?

Charles:It’s a great question, and I have a pretty radical answer to your question, which is I actually think that it is conceivable that the new political deal – and I want to emphasize that you’re not going to get any financial technology to evolve without it being part of a political deal, so let’s start there. Many people look at cryptocurrency, for example, and they say, “Cryptocurrency will replace the dollar.” And so, all these political deals that have to do with central banks and all the regulation of banks, because central banks and commercial banks are married organizations. They’re connected at the hip.

So if you can unravel the government’s control over central banks, we can have cryptocurrencies and we can have new kinds of banks that exist out in the ether. That means the governments won’t be in charge anymore. That is, unfortunately, not true. I say unfortunately, because I think if it weren’t for the government’s involvement, we would have a more stable banking system and maybe even a more stable unit of account in the future.

But what is going to happen is, the cryptocurrencies will threaten the central bank control, and I think what that means is, you will eventually have some choice, politically, that the nation state is going to have to make about whether to throw away this technology of the central bank. It sounds strange, and it sounds a little radical, but this is how I see it evolving. Central banks are just one of the tools that nation states created. They don’t have to last forever. The nation state could decide to achieve the same objectives it wants to achieve with central banks using other mechanisms.

One possibility would be to create a new set of cryptocurrency providers that would be licensed and allowed to operate by the government if the government saw an interest in allowing them to operate. But again, you can’t have a cryptocurrency if it is operating outside of what the state wants because we all have to use the cryptocurrency, and the state, through its laws, can make cryptocurrencies legal or illegal, and it can enforce those because we have to use those cryptocurrencies in our daily transactions. And even though cryptocurrency providers may exist in the ether, you and I who are doing transactions do not exist in the ether. So people who believe that somehow the government won’t be able to reach its hand in and control and regulate those transactions are kidding themselves.

But I’m optimistic, though, that the government is going to see an advantage in a new form of cryptocurrency that hasn’t really come into existence yet, so I shouldn’t talk about it too much at length, but it is going to be a cryptocurrency that solves security problems for individuals and their transactions in a new way. We are starting to see some competition and invention in that direction, and I think that once that technology exists, we are also going to see cryptocurrencies used, and used in banking systems also to fund lending and other things in the future. It is going to be used in a way that the government will benefit from. Why? Well, because this new cryptocurrency technology, instead of being a vehicle for criminal activity, and tax avoidance, is actually going to help facilitate less use of the cryptocurrencies for criminal activities or tax evasion.

So it’s a very long story, but the way I see the future evolving, actually, is central banks becoming less powerful and nation states deciding that they want to jump onto the bandwagon of the financial technology changes that are happening in the crypto world and seeing banks really start to evolve more licensed banks operating with a cryptocurrency platform. I know that is very futuristic, but it’s not inconceivable to me that within 20 years central banks will be much less important – the Federal Reserve, the European Central Bank, the Bank of Japan, the Bank of England – much less important. And governments, though, will still be finding ways through regulation, because they still will have those powers, to achieve their objectives.

I think that financial technology is just the next wave of the chartering of banking. It is a get-around in many ways but let’s not exaggerate. The government can still use the fact that we are physically located here, and we have to physically transact at a particular store, or online. We have to transact physically, and the way that transaction structure works will inevitably lead to regulation. If you look in China, it is one of the most technologically progressive countries in terms of the way its medium of exchange is heading through these universal and interesting types of transacting platforms. However, that is all heavily regulated and controlled and monitored by the government, and it will continue to be so.

David:It reminds me of Ken Rogoff’s comment that the long history of currency tells us that what the private sector innovates, the state eventually regulates and appropriates. And with that idea of the government playing a greater role in the digital ether there is a comment that you make in a footnote in your book, that “depositors and minority shareholders do not have to receive the same compensation for risk. Depositors are trapped because they need the banks as a means of payment. They may be forced to accept negative real returns. In this case, they limit their exposure by limiting their deposits to the bare minimum necessary to meet current payments.”

This brings to mind the trends in many parts of the world toward financial inclusion, which Modi in India has really gone after through the move toward a cashless banking system. So what you were suggesting with the cryptocurrencies certainly would enable that. I know Rogoff has championed the idea of moving toward a cashless society. In the event of a crisis, this is the real issue for me. Is it easier to apportion losses if the financial system is gated, if depositors are corralled, which in a digital world we don’t have the options that you might otherwise.

Charles:Well, that’s true, yes. I want to clarify one thing, which is, while I did write exactly as you said, that depositors, in some sense, because they are stuck with having to do transacting, they are stuck with the regulatory system. They don’t have as much choice as someone who has decided to buy stock in a bank. However, you can decide not to be a depositor.

For example, in Mexico, at the height of the worst part of the regulation of the Mexican system in the 1990s, if you were a middle class Mexican family, you had your deposits largely offshore in, let’s say, a Texas bank, or another American bank. But if you were a Mexican business that was transacting, you didn’t have any choice. Some depositors moved their money out of the country and held it elsewhere, and found different ways to do their transacting, but businesses were kind of stuck. So not all depositors are stuck, I want to clarify that.

But I do think you are right that the depositor is, in some sense, if you do want to maintain deposits, you’re stuck. So what that means, of course, is that these liberalizing financial innovations could be a very promising vehicle for “unstucking” depositors. A great example of this is money that you can hold in a cell phone-activated account somewhere, so that instead of having to have your money held in a bank, you could imagine many different platforms, not just banks, where you could have money, let’s say, in a money market mutual fund on a platform somewhere, which you could then spend with your cell phone.

Now, that may sound like a futuristic idea because Americans do some of it, but what’s really funny is, in countries like India and in some countries in Africa, this can be the primary way that a poor person can actually use a cell phone to do banking transactions. So you might be able to make a $20 transaction with a fee of about 20 cents by cell phone. And so, your point about financial inclusion is exactly right. And in many of these countries where bank charters are particularly problematic because of government involvement that has made the banking system very small, having this new option is extremely important.

In East Africa, for example, in Kenya, Tanzania, Uganda, and spreading pretty rapidly there is a bank called Equity Bank that has been extremely successful and important. It is a chartered bank, but what they figured out how to do is to really solve some of these financial inclusion problems, both on the lending side and on the transacting side at the same time. That is just one of many examples. So yes, I think you are onto something there. I think that the depositor has the potential to hugely benefit from this new financial technology as a way to leapfrog some of the older, more backward banking technologies.

David:Well, I will introduce you offline to something that we innovated in recent years through the Royal Canadian Mint, a digital interface that allows for you to actually store kilo bars, or some fraction of a kilo gold bar, through them. That is our Vaulted program. And this gets to the point of why. What is the difference between – this goes to the inflation issue we were talking about earlier – what is the difference between the inflation tax that you describe where bankers and politicians benefit, to some degree, at the expense of the general public, and of course, in society, in the growing popularity of monetary policy inflation targeting?

Charles:In the case of, let’s say, where we discuss in detail in our book, the Brazilian hyperinflation of the 1970s and 1980s, it was definitely the case that the governments and the banks, just as you said, were splitting the inflation tax. It was the main source of profit to the banks, and it was a major source of revenue for the government. And the public got sick of it, and that was part of the reason you finally had regime change in Brazil in the mid 1990s. And Brazil’s inflation has been very low since then.

Now, when I say very low I mean, typically, less than 10% a year. So Brazil, now, is an inflation-targeting country, as the U.S. is. They are targeting a higher rate of inflation. I think that they would probably claim 5%, roughly, targeting. We’re targeting 2%. But inflation targeting is when the government decides what is its desirable rate of inflation, and of course, that does reflect the fiscal use of the inflation tax. That is why a country like Brazil has an inflation rate that is higher than the U.S. still, although compared to its past history, the current rates that we have experienced in Brazil for the last 20 years are extremely low.

So I would say inflation targeting reflects the unpopularity of inflation. During the period from the 1960s through the 1990s worldwide, the public in all these countries was very upset about the high rates of inflation that they were bearing. So we have seen movement toward inflation targeting as a way of trying to commit to lower inflation. Now, that doesn’t mean zero inflation, so there is still an inflation tax whenever inflation is positive.

In the case of the U.S., we tend to think that there is also a measurement error there so that a 1% measured inflation is probably a 0% true inflation. So the target of 2% inflation is probably something like 1% true inflation per year, which is probably very, very politically acceptable, not important. I don’t think people are going to object to it. In Brazil it is a little bit higher, of course, as I said, but for those fiscal purposes, however, I don’t think that it is a hugely unpopular policy, either, compared to what they experience.

So I see inflation targeting, actually, as an attempt by government to set up ways to limit inflation because inflation is so unpopular. Whether it will work depends on whether those same democracies will be able to limit the amount of unlimited borrowing that governments engage in, because eventually, if the government there gets large enough, inflation is unavoidable. So that is, really, I think, one of the key questions of the 21stcentury, and I think we will know the answer within 20 years or so.

Will these democracies that instituted inflation targeting as a way to try to credibly limit inflation, which has been working pretty well in the short run, will they also do what needs to be done in the long run to make that feasible, to make that policy work, which is limiting their borrowing? I’m skeptical. I’m skeptical in the U.S., I’m skeptical in Europe, I’m skeptical in China. These are all places where debt is very large – Japan, too, and where governments seem to, although they give lip service to fiscal discipline, debt-to-GDP ratios just keep growing.

We know that can’t go on forever. So that is the real question. What does inflation targeting mean? Does it mean that governments also will eventually decide to turn back from unlimited debt finance? Because if they don’t, then the commitment to inflation targeting can’t be sustained.

David:It sounds to me like that inflation tax, the target, you have to find what, as you said, is politically acceptable. Is there a reactive threshold that you can stay just underneath, and, I don’t know, over time is there the possibility of experimenting with that threshold to see if it can be pushed to a politically acceptable level?

Charles:Well, you know, economists really don’t know the answer to that, and are disagreeing about it. One group, and I would put myself in that group, says you know it in the following way. If people are not thinking about inflation when they are making all their decisions, if it’s just not something that is in their minds, then you probably have a successful inflation targeting policy. So I think that is true in the U.S. today, that the 2% inflation target, these people don’t really think about it much, and therefore, you are satisfying the political herd.

Some economists say, yes, and so why don’t we raise it to 4%? Olivier Blanchard, formerly chief economist at the IMF, has made that argument because he sees some advantages to having higher inflation. I won’t go into his arguments, but he sees some potential advantages, and he says, “People will accept 3-4% just as much as they would accept 2%. Of course, it’s a slippery slope. We don’t know. How would you feel about 10%. I think most Americans, when inflation was 10%, were very unhappy with it.

So we don’t really know, as economists, what the political threshold is. My own belief is, we’re better off with a 2% target, or it may be even a little lower, 1.5%, but 2% is certainly acceptable as far as I am concerned. But it depends on what country you are in. As I said, in Brazil it is politically acceptable to have several percentage points higher because, of course, what they were used to within the last 20-some years ago, they were used to hundreds of thousands of percent a year, at its worst, and we are seeing that, of course, in countries like Venezuela today, and not so long ago in some African countries.

So it’s not like hyperinflation or very bad inflation experiences are not something we should discount as a possibility once again in the U.S. It mathematically, arithmetically, will be necessary, must happen, if we don’t contain our borrowing. That is just arithmetic.

David:Back to the problem of inflation relating to borrowing, I am very interested in your opinion on the expanse of trends toward shadow banking. At one point, before they closed this down, the shadow financial regulatory committee was something that you were contributing to, a member of, and is this issue of shadow banking transforming the traditional bank bargains. We have borrowing that we know of, and then there is the off-book borrowing. How does this change the political calculus, whether it is in a democracy like the U.S., or in an autocracy like China where obviously there has been tremendous growth, off balance sheet and on balance sheet?

Charles:The Chinese case and the U.S. case are interesting, and similar in some respects. First of all, shadow banking means anything but the most narrowly defined chartered commercial banks. For example, let’s look in China. The Chinese government wanted to regulate or restrict certain things that were happening in the commercial banks, but it didn’t want to cut off all the credit growth. So it tolerated, and even encouraged, the shadow financial institutions, trusts and municipalities that were setting up their own kind of financial structures.

And it basically allowed that to happen because it wanted to see the credit growth even though it wanted to maintain certain restrictions on commercial banks. That was a political outcome, and I would say it was part of the intendedpolitical outcome. It wasn’t a surprise. Everybody saw it happening. And in the U.S. it is the same.

Now, we have something in the U.S. called the FSOC, the Financial Stability Oversight Council, and it hasn’t really done too much since it was created about eight years ago, but one of the things it did was limit this thing called leveraged lending. That meant that it told banks that it didn’t want them to be involved in certain kinds of higher risk corporate lending. A recent study by a couple of people at the New York Federal Reserve Bank found that it was a successful regulation in limiting the commercial banks’ leveraged lending, but that for every dollar of lending that the commercial banks did less of, the shadow bank did that dollar.

In other words, the intent of the FSOC was to limit total leveraged lending. They weren’t trying to limit what the banks were doing only. They wanted to limit the outstanding leveraged lending because they thought it was a systemically bad idea. But they had zero effect on it because the shadow banks completely undid what they had done. I could give you many examples where shadow intermediaries undo the regulatory effects.

So you might say they are undoing everything so the regulation has no consequence. That is true for some of the regulations, but there are still political consequences for these regulations. For example, the Credit Card Act of 2009 was a very politically populist kind of initiative to try to limit the pricing of risk in credit cards. Well, guess what happened? A lot of people weren’t getting credit cards anymore so those people migrated to shadow banks called installment credit finance, which is consumer credit outside of the chartered banks, and those have grown dramatically as the credit card business has shrunk, particularly in the high-risk end.

But the politicians got a lot of rewards from their constituents for cracking down on what was considered by some to be excessive interest rates on credit cards. Well, of course, the consumers in some states have suffered a lot from that, but in many cases those consumers just migrated to shadow banks in the states where that was allowed. Where the states have usury laws that prohibit the finance companies from being able to substitute for the high-interest credit cards, those consumers have neither choice. They can neither borrow with the credit cards, nor can they borrow from the shadow banks.

So it depends. There are some effects. Politicians sometimes get political rewards for doing things even if they are not effective. First of all. That is very important. That is the benefit to them of regulating. Secondly, in some states where the state usury laws effectively have prohibited the competition by the shadow institutions, we haven’t seen the replacement of the high-risk credit card lending. So shadow banks do often do as you are saying, but that doesn’t mean that they can completely offset it. We don’t want to, I think, exaggerate the ability of institutions to get around regulations. The government can decide a lot of different dimensions to regulate that can make it hard for shadow lenders or shadow money creators to actually arise.

But I still accept the point. And in both China, as you pointed to, and in the U.S., we have seen dramatic growth of shadow institutions precisely because of that regulatory arbitrage. The long-term consequence, of course, is that it makes good regulations much harder, because if you actually wanted to establish regulations to try to do things that make sense from the standpoint of systemic stability, it is much harder to do because half of your financial system isn’t even being regulated by you anymore. It is operating outside your control. And I think that is a real challenge in both China and the United States going forward.

David:Charles, I know we are out of time and you have a plane to catch. I am heartened to know that when you are not at Columbia University you are this year at Stanford, or visiting with the National Bureau of Economic Research, that you do spend a little bit of time in Colorado, because I would love to sit down, whether it is a microbrew on the front range, or a cup of coffee somewhere else, continue the conversation. There are things that I still want to ask you about, the 1825 England crisis, and there are points of curiosity that haven’t been satisfied yet, and hopefully we can get together.

Charles:You are very welcome to do that. I am in Colorado quite a bit. And I think when you raise things like that, the 1825 crisis, what it really, I hope, shows your listeners is, really, in a sense, everything is one conversation. It is not like we do history off in the corners while we are wearing our frumpy clothes and smoking our pipes. No, this is all part of one conversation. This subject has been uniform in the sense of its politics and banking connections. We learn from all the examples, and history doesn’t quite repeat itself but it rhymes with what is going on now. And so any time you want to talk about 1825, I’m very happy.

David:I look forward to it. Safe travels and I look forward to that next conversation.

Charles:Thanks so much, David. This was a pleasure.

*     *     *

Kevin:What a fascinating interview. You know, I hadn’t thought of that, Dave, but people voting by their experience of the last mortgage that they tried to get or got, if they don’t get a mortgage they seem to take it out on an incumbent. I had never heard that before but it makes perfect sense.

David:And if we are to the point where we are in a shaky environment for real estate again, with a third of existing mortgages being high-risk, it would suggest that there are quite a few people who are happy with the state of affairs that we have, and may not be taking out so much on the current administration. But again, we’re back to that issue of moral hazard. The more you please the people, the more you are taking care of the populist request, the greater the risk. But that’s the nature of politics and banking, as we have been discussing.

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