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Bernanke's Fairy Tale

by Vern McKinley April 12th, 2012 8:44 am

Taking a cue from Dr. Selgin who made a convincing case on this blog regarding the entertainment value of the first installment of Chairman Bernanke’s GW lectures; and after spending an hour and a half of my free time while recently working in the Caribbean listening to Peter Schiff’s critique of the same lectures in an event on Reason TV, I felt the need to watch one of them in its entirety. What a maddening experience indeed. These two gentlemen picked apart the Chairman’s indoctrination with their usual skill and grace, especially with regard to creation of bubbles and discretionary monetary policy. As I am wont to do, my focus was on the Fed’s bailout policy and I happened to catch the third installment of the Bernanke series which involved a discourse on the AIG bailout (about the 45:50 mark):

It's an oldie but a goodie for our Federal Reserve chairman. In one of his recent lectures at George Washington University (GWU), Ben S. Bernanke made the self-congratulatory assertion that the "forceful policy response" led by the Federal Reserve in 2008 helped avoid a more serious economic downturn.

This rhetoric is nothing new. Mr. Bernanke has made similar remarks in the past. As he confided in one interview, "I was not going to be the Federal Reserve chairman who presided over the second Great Depression." It is clear that like Treasury Secretary Timothy F. Geithner, who recently trumpeted the fourth anniversary of his role in the Bear Stearns bailout, Mr. Bernanke is aggressively using the GWU lectures to shape his legacy before he steps down.

During the chairman's one-hour-plus lecture, he dedicated five full minutes (and four PowerPoint slides) to a case study on AIG. In the classic dour assessments reminiscent of 2008, Mr. Bernanke used Chicken Little hyperbole, noting that the "failure of AIG, in our estimation, would have been basically the end." The chairman did not elaborate for the benefit of the students in attendance what he meant by "the end" or the precise connection between the failure of AIG and the end of financial life as we know it, but it certainly made for a dramatic moment during the lecture.

Interestingly enough, one of the GWU students pressed the chairman for more details on the decision-making process underlying interventions like what occurred with AIG. The student, identified by Mr. Bernanke as "Max," boldly questioned the chairman's methods: "Where do you draw the line between bailing out a bank and allowing it to fail? Is it arbitrary or is there some sort of methodology?" Mr. Bernanke meandered a bit in responding to Max and eventually admitted that the process was somewhere in between arbitrary and a set methodology, noting that it was a "case-by-case process" and "somewhat ad hoc."

For the full article, please see today’s Washington Times.


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Penny Lame

by George Selgin April 9th, 2012 5:48 pm

As Congress prepares once again to decide the fate of the penny, with deliberations to take place next week concerning whether to revive the WWII-era practice of striking pennies of steel, so as to at least avoid wasting more than a penny's worth of resources on each penny struck, penny (read: zinc) lobbyists--henceforth "pennysniffs"--have been busy making the case that messing around with the penny, especially by doing away with it but even by altering its metal (read: zinc) content, will hurt American consumers.

Of various bad arguments for keeping the penny--and all of them are bad to some degree--perhaps the worst is the one first promulgated by Zinc Lobby Penn State economics professor Raymond Lombra, and recently repeated by Eric Wen in The New Republic. It is that, if pennies are abolished, retailers will respond by rounding up to the nearest nickel, making everything cost more. Lombra calls it, ominously, a "rounding tax," presumably to win gullible conservatives over to his cause.

I'm tempted to stop typing now, and make this into a pop-econ quiz, the quiz question being: Why would any economist, or even any intelligent journalist, say anything so stupid? No, sorry, that's the second quiz question. The first is, Is this argument consistent with the most elementary principles of economics?

If you answered "no," congratulations! You have at least some grasp of how competitive market forces work, especially by recognizing how they would force rival retailers to come up with some alternative to merely "rounding up" prices in every instance, probably by rounding up some and lowering others, because under competition something called a "zero profit" condition holds, which is a fancy way of saying that if any firm in a competitive industry raises prices more than it has to to earn a normal return it will see its customers blazing a trail to some rival firm or firms smart enough to resist doing the same.

If you answered "yes," on the other hand, you too may have a future as a professional pennysniff, perhaps for Americans for Common Cents; alternatively you may qualify as a staff-writer for a neo-liberal monthly. But please have some consideration for others in choosing your vocation, and don't go 'round pretending to be an economist.


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Robust Convertibility

by George Selgin April 6th, 2012 3:06 pm

What determines the extent to which a bank can be trusted to honor its fixed-rate redemption commitments?

The answer that's at least implicit on most writings is that what matters is the nature of the assets backing a bank's IOUs, and especially the extent to which those assets consist of cash reserves. As a bank's reserves approach 100 percent of its outstanding demand liabilities, its ability to meet redemption requests improves, other things remaining equal; and if it actually maintains 100-percent reserves even a systemic run cannot force it to suspend. The case for currency boards, as more robust alternatives to central banks for preserving fixed exchange rates, rests entirely on this simple truth, which is also one of the arguments (but by no means the most important argument) offered by those who favor 100-percent reserve commercial banking over a fractional-reserve alternative.

But while the argument in question is valid so far as it goes, it overlooks a far more important determinant of the robustness of a bank's commitment to convertibility. For if history is any guide a bank's ability to fulfill its contractual obligations matters far less than its willingness to do so. And that willingness depends less upon the state of a bank's cash holdings than on its legal and economic status. Specifically it depends on whether the bank is so privileged as to be able to default on its promises without running the risk of being forced into liquidation, or that of being taken over by its creditors, or even that of losing much business.

A competitive and privately-owned bank, lacking any special privileges, can't default with impunity. It's outstanding liabilities are just that--liabilities--which means that it has to honor them or face legal consequences, including either its liquidation or a transfer of ownership. In earlier times a bank's owners might also have been liable to an extent exceeding the nominal value of there shares, and perhaps to the full extent of their personal wealth, with imprisonment the normal penalty for non-payment.

Moreover even if the owners of a competitive bank might somehow have escaped legal penalties for nonpayment of the bank's debts, they could hardly have avoided the market penalty consisting of the utter ruin of the bank's reputation, and the corresponding, wholesale loss of business to more reputable banks. There would still be no question of the bank's continuing to be a going concern.

For these reasons it is, of course, impossible to imagine a competitive bank "devaluing" its currency. The concept of "devaluation" is strictly applicable to banks having monopoly privileges, and particularly to monopoly banks of issue. By the same token, it is incorrect to equate a competitive issuer's commitment to redeem its notes at an unalterable rate as an instance of "price fixing": a competitive bank is no more free to "adjust" the rate at which it exchanges reserve money for its IOUs than a restaurant cloakroom is free to adjust the rate at which it exchanges coats and hats for claim tickets. It was only once governments awarded monopoly privileges to favored bankers, and then allowed those bankers to devalue their promises, or stop paying them altogether, and to do so with impunity, that what had once been solemn obligations to repay debts devolved into mere "price fixing."

It is, moreover, precisely owing to this devolution of former promises to pay that fixed-rate convertibility schemes are now notoriously subject to "speculative attacks," that is, to runs based upon (sometimes self-fulfilling) fear of an impending devaluation. Notwithstanding the fantasies of Diamond and Dybvig, commercial-bank note redemption agreements were historically far less vulnerable to speculative attacks than modern pegged-exchange rate schemes overseen by central bankers, for the simple reason that commercial note-issuers who failed to keep their promises had a lot more to lose than their modern central-bank counterparts.

A particularly remarkable illustration of a private issuer's tenacity in this regard took place in Scotland during the 'Forty-Five, when, as Prince Charles was marching his way toward Edinburgh, both the Bank of Scotland and its rival, the Royal Bank, took the precaution of placing their cash reserves beyond trouble's reach in the city's relatively impregnable Castle. After the city itself was occupied, the Castle remained in the hands of Royalists, who harassed the enemy (and innocent civilians alike) by raking the streets below with round after round of grapeshot. Still that didn't prevent a white-flagged band from courting death to make its way to the Castle drawbridge one morning. The band consisted of the Royal Bank's cashier, three of its directors, its accountant, and a teller. They had come to get cash to pay notes returned to them from Glasgow the evening before.

Of course, despite the penalty of failure, commercial issuers did sometimes fail to keep their promises. But unlike central banks, which have often resorted to suspension or devaluation or both while still well-stocked with reserves, they never did so if they could help it; in any event the monetary standard survived individual issuers' misfortunes and misconduct. When, in contrast, a central bank is obliged, for any reason, to break its promises, it is necessarily obliged to alter its nation's monetary standard as well.

Considerations such as these explain why the proliferation of central banks would have doomed the gold standard even if wars and depression hadn't taken their distinct toll on it. For central banking tended to reduce that standard to a mere set of official gold price-fixing schemes, with their corresponding vulnerability to speculative attacks. By the same token, they also explain why persons wishing for a revival of the gold standard had better also wish for competitive rather than centralized paper currency.