The Era of Free Banking Ended when the neo-Hamiltonians (Republicans) Established Their “Unqualified Government Monopoly”

The era of free banking was abruptly ended when the neo-Hamiltonian Republicans passed three Legal Tender Acts, beginning in February 1862. These acts of legislation permitted the treasury secretary to issue paper currency (greenbacks) that was not immediately redeemable in gold or silver. Then they passed the National Currency Acts of 1863 and 1864, which created a system of nationally chartered (and regulated) banks that could issue currency. A punitive 10 percent tax was placed on state-chartered banks in order to drive them into bankruptcy. The neo-Hamiltonians were candid about their intention to create an “unqualified government monopoly,” though they rather absurdly claimed that this would allow “all Americans to share in the advantages of the monopoly.” In reality, monopoly is bad for consumers, whether it is a monopoly in steel production, computers, petroleum, or currency. There is no such thing as a “good” monopoly from the consumers’ perspective.

—Thomas J. DiLorenzo, Hamilton’s Curse: How Jefferson’s Archenemy Betrayed the American Revolution—and What It Means for America Today (New York: Crown Forum, 2008), 127.

According to Hummel and Timberlake, the “Free Banking Era” Was the Most Stable Banking System in American History

Despite all the Hamiltonians’ efforts, the Jeffersonians more or less prevailed for decades. The government remained relatively small and decentralized. By the mid-1850s tariff rates were as low as they would be for the entire nineteenth century, and federal subsidies for “internal improvements” were all but nonexistent. The Bank of the United States was dismantled in the 1830s. The American banking system was dominated by state-chartered banks that issued currency backed by gold and silver on demand and that therefore did not inflate their currency beyond what their specie reserves justified. It was not a perfect system, of course, but two highly reputable economic historians, Jeffrey Hummel and Richard Timberlake, have made compelling cases that it was the most stable banking system the United States has ever had. . . .

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A nationalized banking system was one key element of Alexander Hamilton’s agenda that the Lincoln regime resurrected. It did not seem to matter that such a system had been tried twice, with the First and Second Banks of the United States, and each time had created economic instability and corruption. Nor did it matter that during what economists call the “free banking era,” which began when the Second Bank of the United States was dissolved in the 1830s, the purchasing power of American currency remained stable. This stability resulted precisely because the money supply was denationalized. State governments took a more or less laissez-faire attitude toward banking; about half did not even require a state government charter for individuals who wanted to start a bank, accept deposits, and issue banknotes. Banks, then, were “regulated” mainly by competition in the marketplace: a bank that printed too much currency and did not hold sufficient specie reserves would eventually fail. Such failures did occur, but they remained localized and never caused a national bank panic or depression, as has been the case with nationalized banking systems. Panics and depressions are what economists refer to as “contagion effects” of centralized or nationalized banking.

—Thomas J. DiLorenzo, Hamilton’s Curse: How Jefferson’s Archenemy Betrayed the American Revolution—and What It Means for America Today (New York: Crown Forum, 2008), 124, 126-127.

Canada's First Bank, the Bank of Montreal, Was Modeled After the Second Bank of the United States

Canadian bank charters, if not other aspects of the banking system, were modelled explicitly on American examples, a fact that is emphasized by W.T. Easterbrook and Hugh G.J. Aitken in Canadian Economic History. The first Bank of the United States, based on principles enunciated by Alexander Hamilton, served as the model for the stillborn Bank of Lower Canada in 1808. The articles of association that led to the charter of the Bank of Montreal also followed American examples, particularly that of the second Bank of the United States, which began operation only six months before the Bank of Montreal. The latter bank sent its officers to New York to study banking procedures in effect there, and it employed experienced American bankers during its early years. Easterbrook and Aitken saw strong parallels between the centralist organization, branch systems, and uniform stable currency of Hamiltonian principles, and the legislative framework of Canadian banking. Some nineteenth century opinion supports this view. In 1877 Sir Francis Hincks offered the generalization that the Canadian banking system was modelled on the one that formerly prevailed in the United States. He was referring to the first and second Banks of the United States and their branch systems.

—Stephen Edward Thorning, “Hayseed Capitalists: Private Bankers in Ontario” (PhD diss., McMaster University, 1994), 25. 

In Pre-Antitrust U.S. Banking, Networks (Clearinghouses) Arose; Collusion Was Checked by the Threat of Network Withdrawal

In the pre-antitrust U.S. banking industry, then, networks known as clearinghouses arose to reduce transactions costs and bolster reputations. “An essential feature of the banking industry was the endogenous development of the clearinghouse, a governing association of banks to which individual banks voluntarily abrogated certain rights and powers normally held by firms.” Membership requirements and monitoring enhanced the public’s trust in the redeemability of members’ bank notes and the overall soundness of their business practices. As Gorton and Mullineaux (1987) explain:

The clearinghouse required, for example, that member institutions satisfy an admissions test (based on certification of adequate capital), pay an admissions fee, and submit to periodic exams (audits) by the clearinghouse. Members who failed to satisfy [commercial-bank clearinghouse] regulations were subject to disciplinary actions (fines) and, for extreme violations, could be expelled. Expulsion from the clearinghouse was a clear negative signal concerning the quality of the bank’s liabilities. . . . 

An additional check against collusion was banks’ credible threat to withdraw from the network or refuse to join. As Dowd recounts:

A good example of banks “voting with their feet” even when the market could only support one clearinghouse is provided by the demise of the Suffolk system. The Suffolk system was a club managed by the Suffolk Bank of Boston, but some members found the club rules too constraining and there were complaints about the Suffolk’s highhanded attitude toward members. Discontent led to the founding of a rival, the Bank of Mutual Redemption (BMR), and when the latter opened in 1858 many of the Suffolk’s clients defected to it.

—Bryan Caplan and Edward P. Stringham, “Networks, Law, and the Paradox of Cooperation,” in Anarchy and the Law: The Political Economy of Choice, ed. Edward P. Stringham (New Brunswick, NJ: Transaction Publishers, 2007), 305-306.

Cowen Maintains that the Historical Evidence on Collusion under Laissez-Faire Cannot Be Extended to Network Industries

Cowen’s case is almost wholly theoretical. The usual historical evidence on collusion under laissez-faire, he maintains, cannot be credibly extended to network industries: “Although private cartels usually collapse of their own accord, most historical examples of cartel instability do not involve the benefits of joining a common network.” But Cowen provides little in the way of empirical counter-examples to support his belief that networks industries are different.

This section takes a preliminary look at modern and historical network industries. While they definitely standardize products in beneficial ways, there is little evidence that network industries are more prone to collusion than non-network industries. Instances of attempted and temporarily successful collusion do surface. But collusive efforts in network industries appear neither more common nor more successful than in other sectors of the economy. A full-blown comparative history of collusion in network and non-network industries is beyond the scope of this paper. On Cowen’s account, however, the contrast should be too large to miss. . . .

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The market for credit cards has all the defining characteristics of a network industry. The value of a credit card increases with the number of participating consumers, merchants, and banks. As Evans and Schmalensee (1999) observe, “[P]ayment cards are provided through a network industry in which participants are linked economically in unusual ways. Payment cards are useless to consumers unless merchants accept them, but merchants have no reason to accept cards unless consumers carry them and want to use them.” Consumers value widely accepted payment cards more, so issuers typically belong to large networks. But competition persists. The market sustains inter-network competition between networks owned by member banks, such as Visa and MasterCard, proprietary networks like Discover and American Express,and store-specific cards. What is more striking is the scope of intra-network competition. Visa and MasterCard, the two leading networks, are non-profit membership corporations with thousands of member firms. They provide infrastructure and a large network of users, and finance their services with membership fees. Despite strong network features, there is vigorous intra-network competition.

—Bryan Caplan and Edward P. Stringham, “Networks, Law, and the Paradox of Cooperation,” in Anarchy and the Law: The Political Economy of Choice, ed. Edward P. Stringham (New Brunswick, NJ: Transaction Publishers, 2007), 303-304.

In Banking, Scale Is Crucial for Success Because You Can Spread Your Technology and Network Costs over a Broader Base

In 2000, Baillie told me in an interview for a documentary called Titans, based on Peter C. Newman’s book of the same name, that he had wanted to run a large corporation ever since he was a young boy. He got his chance in 1995, becoming president of TD when Robin Korthals left, adding the CEO title in 1997 and the chairman’s title a year later, which he kept into 2003.

Baillie’s analytical mind had come to the conclusion that scale was crucial for success in banking. If you got bigger, you could spread your technology and network costs over a broader base. In Canada, that meant mergers of the big banks made sense. Beyond that, it meant planting the TD flag around the United States.

It had been decades since the last significant bank combinations in Canada. In the early 1960s, there was the marriage of the Imperial Bank and the Commerce Bank that created CIBC. Before that, there was the merger of the Bank of Toronto and the Dominion Bank in 1955 that had given birth to TD. Now, in the late 1990s, the Big Five banks were huge, with their tentacles reaching into all aspects of the economy. By and large, even though Canadians invested in them and liked their boring, stable ways, the banks were unpopular. No one liked the big fees they charged and people fumed when they saw how much money they made. They were also big employers. Mergers would mean closing branches and firing people. The banks were political dynamite.

—Howard Green, Banking on America: How TD Bank Rose to the Top and Took on the U.S.A. (Toronto: HarperCollins Publishers, 2013), 99-100.

Toronto-Dominion Bank’s CEO, Ed Clark, Prudently Distanced Himself from Subprime-Related Structured Products

It’s said the mark of a truly smart person is not being afraid to say he or she doesn’t understand something. That’s what Ed Clark said about subprime mortgage-related structured products in 2005. This was Clark’s epiphany and perhaps his most important decision as CEO. It was his view that these products were far too complicated for anyone to understand, and if he didn’t understand them, TD was clearing out any exposure and not buying them. He no doubt resisted pressure from within saying he was being too conservative. But by being a prudent banker and distancing himself from subprime-related structured products, Clark would position TD as one of the strongest banks on the planet.

Purdy Crawford, Clark’s old boss at Canada Trust, pinpoints Clark’s best quality: “He’s smart as hell, of course. I think it’s judgment—plus getting good people around him.”

Crawford says he knows a lot of people tried to talk Clark into buying what turned out to be toxic asset-backed commercial paper. Third-party asset-backed commercial paper, or ABCP, as it became known, was Canada’s own brush with subprime chaos. Commercial paper is a financial product that allows issuers to borrow money and lenders to park money for a set number of days—for periods less than a year. Government-issue treasury bills provide a similar function, but are backed by governments. Commercial paper is not. It’s backed by creditworthy corporations that need to borrow. In the case of ABCP, assets such as consumer loans and credit card receivables were pooled together like mortgages to create a stream of cash that could be paid out to an investor. The paper was also backed by synthetic assets, or derivatives, making it highly complex. Most importantly, assets and liabilities were not properly matched. Once again, however, a credit rating agency, this time Canada’s DBRS [Dominion Bond Rating Service], gave the ABCP a top rating.

Unfortunately for those in Canada who had invested $32 billion in ABCP, the market for it froze up along with the credit crunch. Commercial paper that matured could not be rolled over into a new investment. Holders were stuck and couldn’t get their money. Ironically, it was Purdy Crawford who was recruited, in his late seventies, to help solve the ABCP crisis and restructure the market, a daunting task.

—Howard Green, Banking on America: How TD Bank Rose to the Top and Took on the U.S.A. (Toronto: HarperCollins Publishers, 2013), 145-146.

The Reich’s Finances Had Been Spiraling Towards Disaster Because the Reichsbank Engaged in an “Inflationary Creation of Money”

Within days of the Munich agreement, the Reichsbank economics department drafted a memorandum, which, though it was never circulated outside the offices of the central bank, nevertheless deserves to stand as the final monument to Hjalmar Schacht’s career in the Third Reich: ‘With the incorporation of the Sudetenland into the Reich,’ the Reichsbank declared, ‘the Fuehrer has completed a task that is without parallel in history. In barely five years of National Socialist rule, Germany has achieved military freedom, sovereign control of its territory and the incorporation of the Saarland, Austria and the Sudetenland. It has thereby turned itself from a political non-valeur into the pre-eminent power in continental Europe.’ Hitler had achieved the ultimate goal of German nationalism, the establishment of Grossdeutschland, something which had eluded even Bismarck, and he had done so without provoking war. This extraordinary national resurrection was above all based on a gigantic armaments effort, which had been managed in such a way as to give full employment to the German people whilst avoiding the curse of inflation. This too was a unique historical accomplishment.

But, in the autumn of 1938, at the moment of Hitler’s greatest triumph, the economic foundations of his success were in question. The Reichsbank was forced to acknowledge that despite its best efforts, there was ‘no longer . . . complete stability of the German currency’. ‘An inflation of the Reichsmark’ had begun, even if this was ‘not yet fully apparent’. This was an admission that Schacht repeated a few weeks later in a report to the Capital Market Committee (Kapitalmarktauschuss) — the committee of the RFM [Reichsfinanzministerium (Finance Ministry)], RWM [Reichswirtschaftsministerium (Ministry of Economic Affairs)] and Reichsbank which oversaw the raising of funds on the German financial markets. In front of his colleagues, Schacht openly stated: ‘It cannot be denied . . . that we are already on the threshold of inflation.’ To restore the Reichsmark to a state worthy of a great power, Germany needed a restoration of monetary and fiscal stability. Since the spring of 1938, the Reich’s finances had been spiralling towards disaster. For months the Finance Ministry had been living ‘from hand to mouth’ and the Reichsbank had been forced into an ‘inflationary creation of money’.

—Adam Tooze, The Wages of Destruction: The Making and Breaking of the Nazi Economy (London: Penguin Books, 2007), 285-286.

Rent Controls, One of the Key Elements of the Weimar Welfare State, Hindered New Apartment Construction

The most common way of describing the housing situation in Germany in the inter-war period was one of ‘housing shortage’. Rival interest groups competed to define this deficit, with estimates varying between 1 and 2 million apartments depending on the author of the estimate. The concept of shortage, however, is a problematic one. In a ‘free’, self-equilibrating market there are no shortages. An excess of demand over supply would tend to drive up the price, resulting in a reduction in effective demand and an increase in supply, eliminating the deficit. The symptoms of shortage in the housing market of inter-war Germany were, therefore, first and foremost a reflection of the ‘distortions’ introduced by the imposition of rent controls after the end of World War I. . . .

The Depression fatally undercut Weimar’s system of publicly subsidized construction. As tax revenue plunged and expenditure on welfare increased, the flow of public funds towards new construction collapsed. From a peak of 1.34 billion in 1928 the public subsidy to housing fell to as little as 150 million Reichsmarks in 1932 with devastating consequences for the building trades. In Berlin, a city of more than 4 million people, construction was begun in the last six months of 1931 on only 2,606 new apartments. In this extreme situation, the Reich took the extraordinary step of announcing a subsidy for the self-built settlements of the unemployed and their families on the margins of Germany’s cities. Each settlement was to be provided with enough land for the families to secure a high degree of self-sufficiency in their food supply. The Reich would provide a subsidized loan of 2,500 Reichsmarks towards construction, the rest would come from the self-help of the settlers themselves.

—Adam Tooze, The Wages of Destruction: The Making and Breaking of the Nazi Economy (London: Penguin Books, 2007), 157-159.

The Main Nazi Newspaper, the Völkischer Beobachter, Praised Roosevelt’s “New Deal” for Its Affinity with National Socialist Philosophy

The National Socialists hailed the emergency relief measures undertaken during Roosevelt’s first hundred days in office as fully consistent with their own revolutionary program. On May 11, 1933, the main Nazi newspaper, the Völkischer Beobachter, offered its commentary in an article with the headline “Roosevelt’s Dictatorial Recovery Measures.” The author wrote, “What has transpired in the United States since President Roosevelt’s inauguration is a clear signal of the start of a new era in the United States as well.” The tone on January 17, 1934, was much the same: “We, too, as German National Socialists are looking toward America. . . . Roosevelt is carrying out experiments and they are bold. We, too, fear only the possibility that they might fail.” And on June 21, 1934, the paper drew its initial conclusion about the success of the New Deal: “Roosevelt has achieved everything humanly possible in light of his narrow, insufficient basis.”

Just as National Socialism superseded the decadent “bureaucratic age” of the Weimar Republic, the Völkischer Beobachter opined, so the New Deal had replaced “the uninhibited frenzy of market speculation” of the American 1920s. The paper stressed “Roosevelt’s adoption of National Socialist strains of thought in his economic and social policies,” praising the president’s style of leadership as being comparable to Hitler’s own dictatorial Führerprinzip. “If not always in the same words,” the paper wrote, “[Roosevelt], too, demands that collective good be put before individual self-interest. Many passages in his book Looking Forward could have been written by a National Socialist. In any case, one can assume that he feels considerable affinity with the National Socialist philosophy.” The newspaper admitted that Roosevelt maintained what it called “the fictional appearance of democracy,” but it also proclaimed that in the United States “the development toward an authoritarian state is under way.” The author added, “The president’s fundamental political course still contains democratic tendencies but is thoroughly inflected by a strong national socialism.”

—Wolfgang Schivelbusch, Three New Deals: Reflections on Roosevelt’s America, Mussolini’s Italy, and Hitler’s Germany, 1933-1939, trans. Jefferson Chase (New York: Metropolitan Books, 2006), e-book.

Hjalmar Horace Greeley Schacht Accepted Hitler’s Offer of the Position of President of the Reichsbank on March 17, 1933

Hitler also showed his pragmatic side when Hjalmar Schacht was called into his first meeting with the new chancellor. After all, Schacht was not a party member, and although he had more than demonstrated his willingness to be helpful, he was distrusted by most of the party establishment, who still saw Schacht as a collaborator of the Jewish bankers.

It was middle of March 1933.

Herr Schacht, I am sure we are agreed that the most urgent task for the new government is to end unemployment. That will need a lot of money. Do you think it can be obtained without the Reichsbank?

Schacht agreed with the immediate need to end unemployment but told Hitler it could not be done without the Reichsbank. When pressed for the amount of money needed, Schacht hedged.

Herr Chancellor, all I can tell you is that the Reichsbank should be ready to lend all assistance until the last unemployed citizen is back at work. 

 Then came Hitler’s pivotal question.

Would you be willing to resume leadership of the Reichsbank? 

 Later, Schacht remembered his reaction. Could he accept the offer from a leader “whose political methods and individual acts he found difficult to accept”? Or should he overcome his scruples “for the sake of the six and a half million unemployed”? Besides, he was quite aware that Luther, who had held the Reichsbank presidency since Schacht had resigned, had already met with Hitler and had given an unsatisfactory answer to Hitler’s question. Schacht told Hitler that he would not find it “fair” — he used the English term — to fire Reichsbank president Luther, but Hitler reassured him that Luther had already been slated for another position. Schacht then decided on the spot.

“If that is so, then I am ready, once again, to take the presidency of the Reichsbank;” and “on March 17, almost exactly three years after I had left it, I went back to work at the Reichsbank.”

He insisted that it was not out of personal ambition or agreement with the National Socialist Party or personal greed. It was for the “welfare of the broad masses of our people.”

—John Weitz, Hitler’s Banker: Hjalmar Horace Greeley Schacht (Boston: Little, Brown and Company, 1997), 142-143.

As a Sure Indication of the Disintegration of the State, Tax Revenues in Greece Covered Less Than 6% of Government Spending

Relatively mild in the Protectorate and Slovakia, inflation was a far more serious problem in Belgium, and worse still in Serbia, Croatia and Greece. Hyper-inflation was caused by the government’s inability to raise more than a small fraction of its needs from taxation and the huge increase in the money supply caused by the central bank’s printing of banknotes. By the end of the war, tax revenues in Greece covered less than 6 per cent of government spending, a far smaller proportion than anywhere else, and a sure indication of the disintegration of the state. Gold sovereign prices rose fifteen-fold in the first two years of the occupation and soared again as it neared its end.

Greece stood as a warning of what could happen when occupation economics went badly wrong and when German demands could only be met by printing money. In July 1942 Finance Minister von Krosigk warned Göring that ‘in Greece … a legal market no longer exists, nor a price mechanism which could act as a basis for stabilization and reorganization … If the war drags on, it will be necessary to prevent the countries whose potential we are exploiting, from premature economic ruin.’ A few months later, when the German commissar at the Belgian central bank wrote of dangerous inflationary pressures because of the difficulty of controlling the black market, he highlighted the risk of making ‘a monetary “Greece” out of Belgium’. German administrators did not care too much one way or the other about Greece itself, which they had not really wanted to invade, and whose value to the war effort was minimal, but they knew that the costs for the German war effort of allowing Belgium or France go the same way would be much higher.

—Mark Mazower, Hitler’s Empire: How the Nazis Ruled Europe (New York: Penguin Books, 2009), 272-273.

A Major Element of Exploiting Occupied Countries Is the Manipulation and Devaluation of the Official Exchange Rates

From the very beginning, a major element in Germany’s successful exploitation of occupied countries was the manipulation of official exchange rates. In France, German occupiers lowered the exchange rate for 100 francs from 6.6 to 5 reichsmarks—a devaluation of just under 25 percent. This automatically raised soldiers’ salaries, which were paid in francs but calculated in reichsmarks. (The franc would, of course, have inevitably become softer under German occupation, but even in late 1942 the exchange rate in Zurich was 16 percent higher than the one set by German occupiers.) Similar action was taken with the establishment of the Protectorate of Bohemia and Moravia. The Czech crown remained the official currency but was devalued by a third. In 1939 the Reich also intervened in Poland and in 1943 in Nazi-occupied northern Italy, where the exchange rate between the lira and the mark was lowered from 100 to 13.1 to 100 to 10. But even that is dwarfed by the 470 percent devaluation of the Russian ruble in 1941. Those responsible for the new exchange rates knew exactly what they were doing. Privately, they acknowledged that the reichsmark was “greatly overvalued in comparison with [other] European currencies.”

—Götz Aly, Hitler’s Beneficiaries: Plunder, Racial War, and the Nazi Welfare State, trans. Jefferson Chase (New York: Metropolitan Books, 2006), 81.

To Ensure “Economically Just Prices,” The Reich’s Commissar for Price Formation Suspended the Operations of the Price Mechanism

In 1933 the government issued the “Law on Compulsory Cartels,” by virtue of which it assumed the right to consolidate enterprises as a means of regulating the market for their products and reducing competition. In time, Berlin forged hundreds of such compulsory cartels, which determined, under state guidance, what their member firms could produce and what prices they could charge: the normal practice until the end of 1941 was for enterprises to operate on a cost-plus basis, presenting government agencies with evidence of costs and then being allowed to add 3-6 percent profit. In 1936, the office of the Reich’s Commissar for Price Formation was created to ensure “economically just prices.” The operations of the price mechanism of the open market were thus suspended. The cartel law made new investment conditional on state approval. State authorities also regulated dividend payments: a law issued in 1934 decreed that the profits to be distributed to stockholders were not to exceed 6 percent of the paid-in capital; another law of that year provided that any excess was to be invested in state bonds for future distribution. Holders of municipal and other bonds were compelled to convert them into new issues carrying lower interest rates. Private enterprise was constantly whipped into shape by complaints of “economic egoism” and tireless reminders that the interests of the community took precedence over those of the individual.

—Richard Pipes, Property and Freedom (New York: Alfred A. Knopf, 1999), Vintage e-book.

Brüning's “Rolling Deflation” Is Used to Argue in Favor of an International Lender of Last Resort and World Currency

It is understandable that economic and political elites fear deflation, but it is not so clear why almost all economists have developed a deflation phobia. It was this fear of deflation that has ensured that we are still stuck in the monetary system which was about to melt down in 2008. Unfortunately, at the time In Defense of Deflation was not out there to help combat the myths about price deflation.

There are all kinds of myths about price deflation that inhibit the surge of free market institutions, because these myths are used to justify interventions. The fear of a deflationary spiral is only one, albeit probably the most important of them. An almost equally harmful myth is that the rate of the growth of the money supply must be at least as high as the rate of economic growth, because otherwise there would be a harmful price deflation. This is an argument that even well-trained economists bring forward against the introduction of a gold standard or against the chances of bitcoins to become money.

Another myth that has become very relevant recently is that policies aiming at lowering costs, especially wages, and reducing public budget deficits would drive an economy into recession. Indeed, in the European sovereign debt crisis, austerity is branded as a harmful deflationary policy. Commentators recall the supposedly fateful deflationary policies of German Chancellor Heinrich Brüning in the early 1930s as a deterrent example of austerity. Moreover, the “rolling deflation” of 1931 is even used to argue in favor of an international lender of last resort, a step close to the introduction of a world currency. In this book all these myths are rebutted. There is even an historical analysis of Brüning’s policies, showing that they helped to speed up recovery.

—Philipp Bagus, preface to In Defense of Deflation, Financial and Monetary Policy Studies 41 (Cham, CH: Springer International Publishing, 2015), viii.

As Europe “Reinterpreted” the Maastricht Treaty to Avoid Catastrophe, Ben Bernanke Launched His “QE-Infinity” Policy

Towards avoiding the feared 2nd Lehman crisis, which incidentally would sink the re-election prospects of their commander-in-chief, President Obama, Treasury Secretary Geithner and Federal Reserve Chair Bernanke were prepared to put US taxpayer funds on the line by way of swaps with the ECB even though under some scenarios the ECB might itself become insolvent. As part of the deal Chancellor Merkel was persuaded to put at stake a much larger amount of German taxpayer funds, either directly via the new EU bail-out entities, the European Stability Mechanism (ESM) or European Financial Stability Facility (EFSF), or indirectly by standing (albeit to an unknown extent) behind the ECB’s vast loan programs. The LTROs [Long-Term Refinancing Operations] were highly dubious in terms of constitutionality — with critics arguing that the Maastricht Treaty specifically banned such bail-out operations. What followed was even more dubious, and to such a degree that we describe it here as a coup against the monetary constitution in the Treaty.

This coup played itself out in Summer and Autumn 2012 as the Spanish government debt market plunged and another crisis of survival erupted in EMU, this time with the centre of the storm in Spanish banking collapse. ECB Chief Mario Draghi, buttressed by the US Treasury Secretary, persuaded German Chancellor Merkel that the only way to avoid ‘catastrophe’ in Europe would be to ‘re-interpret’ the Maastricht Treaty so as to allow direct monetary financing of weak sovereigns, albeit subject to certain conditions. Simultaneously Chairman Bernanke launched his QE-infinity policy setting no time or quantity limit to massive monetary base expansion.

—Brendan Brown, Euro Crash: How Asset Price Inflation Destroys the Wealth of Nations, 3rd ed. (Houndmills, UK: Palgrave Macmillan, 2014), 217-218.

How the TARGET2 Balances of the European Central Bank Worked BEFORE the European Financial and Debt Crisis

With the national central banks being part of the Eurosystem, the intra-euro area rescue measures became reflected in the TARGET2 balances of the European Central Bank. TARGET2 (Trans-European Automated Real-time Gross Settlement Express Transfer System) is a real-time gross settlement system for payments within the euro zone, which is used to clear cross-border transfers in the euro area. Before the European financial and debt crisis, the national central banks’ positions in the TARGET2 system were widely balanced, because private capital flows were matched by respective payment flows resulting from goods markets transactions. For instance, German (Greek) capital exports (capital imports) corresponded to payments receipts (payments) for German goods sales (Greek goods purchases).

—Gunther Schnabl, “The Failure of ECB Monetary Policy from a Mises-Hayek Perspective,” in Banking and Monetary Policy from the Perspective of Austrian Economics, ed. Annette Godart-van der Kroon and Patrik Vonlanthen (Cham, CH: Springer International Publishing, 2018), 140.

On the Two Major Risks with the Euro: Sovereign Default and Redenomination or Intra-Euro Currency Risk

Currently there remains a strong strand of belief (particularly in euro zone countries) that exit is impossible. As we have already seen in 2010–12, markets are constantly probing and re-evaluating the probabilities and scale of alternative outcomes, and managing their investment and derivative positions accordingly. To date, most of the market pricing of euro stress has been concentrated in the sovereign debt markets. But this represents just one of two risks within the euro — the risk of sovereign default. The other risk — the risk of redenomination (or ‘intra-euro currency risk’) — has so far found little direct expression in the markets.

With a euro exit, this belief would be shattered and, once that happened, almost all of the advantages that a single currency had over an exchange rate mechanism would evaporate. It is likely, if there are any exits from the euro zone, that markets will begin to discriminate in favour of ‘strong’ (predominantly northern) debtors and against weak (predominantly southern) debtors on the basis of perceived exit risk. This could lead to a rapid emasculation of southern countries’ banking systems as southern depositors moved their deposits north for little or no cost or loss of interest.

—Neil Record, “Managing the Transition: A Practical Exit Strategy,” in The Euro: The Beginning, the Middle . . . and the End? ed. Philip Booth (London: Institute of Economic Affairs, 2013), 148-149.

Germany Broke Free from the Worldwide Dollar Standard (Bretton Woods System) By Floating the Deutsche Mark in May 1971

US monetary chaos has been both a hugely creative and a destructive force in the history of EMU [European Monetary Union].

If monetary stability had reigned throughout in the US there would have been no impetus to monetary union in Europe at least in its modern gargantuan form. Each country there might well have adhered individually to an international US dollar standard. . . . 

Instead the inflationary path taken by the Martin and Burns Federal Reserves fanned direct US monetary conflict with Germany where monetarist titans had assumed power in the Deutsche Bundesbank. Eventually Germany ‘broke free’ from the deeply flawed worldwide dollar standard often described as ‘the Bretton Woods system’, floating the Deutsche mark in May 1971. The calculation in Frankfurt and Bonn was that that the gains for the German economy from domestic monetary stability now possible would more than match the losses from exchange rate instability. Even so there was considerable concern about those possible losses.

—Brendan Brown, Euro Crash: How Asset Price Inflation Destroys the Wealth of Nations, 3rd ed. (Houndmills, UK: Palgrave Macmillan, 2014), 210.

The Axis Joining the Berlin Chancellery to the ECB Would No Longer Be Able to Support German Export Companies with a Cheap Euro

Hence the big German export companies would face a Day of Reckoning. The axis which joins the Berlin Chancellery to the ECB [European Central Bank] (at present the Merkel-Draghi axis) would no longer be able to support them (via a cheap euro). Under these changed circumstances, the euro falling apart may be their most promising road to future success. Yes, a re-incarnated DM [Deutsche Mark] would press down on export profit margins; but the menace of US-German or US-EU trade war would recede.

The CDU [Christian Democrat Union] could have new scope to move towards the right and away from the prevailing euro-centrism of the Merkel era, so winning back voters from the parties on the far right while also gaining some middle-class support from savers long disgruntled with the soft euro and negative interest rate euro. The feared descent of Germany into Weimar-style political chaos as could occur if the CDU remains frozen in euro-centrism (eventually joining up with the Greens in coalition and thereby fanning support for the extreme parties) could be aborted.

Yes, Italy would fall out of the euro-zone. The potential for sound money renaissance in Europe, possibly with France, Holland and Germany getting together in a new monetary union, would be real. Europe’s monetary future would no longer hang on a US thread. This possible window of opportunity might be short, given the potential danger of a US inflation storm further ahead as stemming from devastatingly weak public finances.

—Brendan Brown, “How a Fragile Euro May Not Survive the Next Crisis,” in Anatomy of the Crash: The Financial Crisis of 2020, ed. Tho Bishop (Auburn, AL: Mises Institute, 2020), 84-85.

The Death of the Euro Will Occur in Response to the Sudden Emergence of a “Deflationary Interlude”

A big US monetary inflation bang brought the euro into existence. Here’s a prediction: Its death will occur in response to a different type of US monetary bang—the sudden emergence of a “deflationary interlude.” And this could come sooner than many expect. . . . 

We find the existential vulnerability of the euro and the next US monetary shock will present the severest test yet. The shock is most likely to take the form of a sudden arrival of a “deflationary interlude” in a long and likely intensifying monetary inflation over the long-run beyond.

Specifically, as the virulent asset inflation stoked up in the present global monetary cycle (as always led by the Federal Reserve) proceeds into the final stage of unwind (asset deflation) and recession, there will be a period of overall credit contraction. This will be reflected most likely in the broad money aggregates. Prices and wages could come under some downward pressure, though this is not in itself evidence of monetary deflation.

In this asset deflation phase, accompanied by global slowdown or recession, Europe would be in a particularly dangerous situation. The vastly over-extended export sectors of Northern Europe are vulnerable, not least to the emerging market credit bubble turning to bust. Weak banks and sovereigns across Europe would descend into an insolvency zone. The weak euro and market share boosting measures of the big northern European exporters are likely to attract Trumpian ire.

There would be zero tolerance in Washington for continued or new-style monetary radicalism in Europe. If this is what holding the euro together requires, meaning that currency’s perpetual weakness, then it should not be held together.

—Brendan Brown, “How a Fragile Euro May Not Survive the Next Crisis,” in Anatomy of the Crash: The Financial Crisis of 2020, ed. Tho Bishop (Auburn, AL: Mises Institute, 2020), 81, 83-84.

Conditions Today Were Last Seen in 1929 When Smoot-Hawley Tariffs Coincided with the End of a Long Phase of Credit Expansion

Germany, whose fastest growing market was China, has been driven into recession, with last Monday’s purchasing managers’ index headlined as “simply awful”. With Germany being the locomotive pulling along all the other Eurozone members, this is already leading to deepening concerns for the Eurozone’s outlook and a resumption of asset purchases by the ECB (quantitative easing) is now due in November. It is also very bad news for Germany’s hard-pressed banking community, represented in New York by Deutsche Bank. . . . 

Clearly, the conflict between America and China has escalated well beyond just tariffs, making it difficult to visualize how the damage to global trade can be corrected. The economic outlook is therefore set to deteriorate further, with no end to it in sight. From a banker’s viewpoint, a global recession is the greatest threat to his business as a financial intermediary between failing borrowers and nervous depositors. He can only survive by taking anticipatory action to avoid potential losses.

Some bankers will have been clinging to the hope that the Fed, by reducing interest rates and if necessary, reintroducing quantitative easing, will rescue the US economy from outright recession and that economic growth will resume. Without doubt, this is the advice being given to management by in-house economists, unfamiliar with today’s destructive dynamics of tariffs combining with a failing late-stage credit cycle. These conditions were last seen in 1929, when Smoot-Hawley tariffs coincided with the end of a long phase of credit expansion. However, there is little statistical evidence so far that the US economy faces anything more than a pause in economic growth, which is why stock prices and other collateralized assets have held their values.

The reality is that a credit crisis cannot be avoided, only deferred. It is also hard to see how zero interest rates reduced from current levels can be enough to rescue markets that, on the evidence from the repo market, are beginning to price growing counterparty risk into interbank loans. Recent experience and central banking models suggest that dollar interest rates should be reduced by at least four or five per cent to stabilize the situation, putting them deep into negative territory. And as for negative rates, there is no development more likely to drive depositors into gold, silver and other media to escape from the taxation of negative rates on deposits.

—Alasdair Macleod, “The Ghosts of Failed Banks Have Returned,” in Anatomy of the Crash: The Financial Crisis of 2020, ed. Tho Bishop (Auburn, AL: Mises Institute, 2020), 63-65.

A More Worrying Comparison between Deutsche Bank and Northern Rock Is with the Credit-Anstalt Crisis of May 1931

Returning to the subject of bank relationships, a more worrying comparison between Deutsche Bank and the Northern Rock episode could be with the Credit-Anstalt crisis of May 1931. It was the largest bank in Austria, just as Deutsche is the largest in Germany, a far larger country with a more important economy. Then in Austria and today in Germany, European economies were tipping into recession, forcing large losses onto their banks. Following the 1931 crisis, within months not only Austria but other European countries endured financial distress, the gold exchange standard began to disintegrate, and the international flow of goods was disrupted by growing protectionism as governments tried to batten down the hatches.

The flight of foreign creditors triggered by these events rapidly turned a major crisis in a minor country into a major crisis for all Europe and beyond. Today, if the same fate were to happen to Deutsche Bank, not only would it be on a far larger scale, but there is the additional question of the gross notional value of its derivatives book of nearly $50 trillion and the future of the euro itself. Is it any wonder, if Deutsche is indeed at the centre of last week’s repo crisis, that other major banks,  have decided to step back and refused to accept its collateral in a repo?

—Alasdair Macleod, “The Ghosts of Failed Banks Have Returned,” in Anatomy of the Crash: The Financial Crisis of 2020, ed. Tho Bishop (Auburn, AL: Mises Institute, 2020), 58-59.

We Are Seeing (October 2019) the Ghosts of Past Bank Failures, Most Recently in the UK (2007) with Northern Rock

I have a strong suspicion we are seeing the ghosts of past bank failures, most recently in the UK, the sorry tale of Northern Rock which I closely observed. For non-British readers, a short reminder: as a licensed bank, Northern Rock was a mortgage lender which got into difficulties in September 2007, before being nationalized the following February. An old-fashioned run with customers queuing outside its branches seeking to withdraw their deposits had alerted the general public to Northern Rock’s problems. It was unable to tap wholesale money markets, because other banks were unwilling to lend to it on an uncollateralized basis.

The establishment missed the point. As Gillian Tett wrote in the Financial Times at the time, there were increasing concerns over how Libor [London Interbank Offered Rate] was operating. There was a growing divergence in the rates that different banks were quoting in the various currencies priced in Libor, discriminating against the smaller borrowers (actually, an indication of growing counterparty risk, not a supposed failure of Libor). Furthermore, larger banks were reducing their exposure to Libor by sourcing funds from the treasury operations of large companies and using the developing repo market (which is collateralized, unlike Libor — a further indication of increasing systemic concerns) to maintain their overnight balances instead.

—Alasdair Macleod, “The Ghosts of Failed Banks Have Returned,” in Anatomy of the Crash: The Financial Crisis of 2020, ed. Tho Bishop (Auburn, AL: Mises Institute, 2020), 55.

On a Key Difference between How the ECB and the BoJ Plus the SNB Have Administered Negative Interest Rate Policy

The subject: a key difference between how the ECB on the one hand and the Bank of Japan (BoJ) plus the Swiss National Bank (SNB) on the other have been administering negative interest rate policy in this cycle.

The powerful bank lobby in Germany has been asking why the ECB does not copy the SNB and BoJ in only charging banks negative rates on a marginal slice of their deposits with the central bank rather than the entirety.

Chief Draghi has not provided a direct or frank answer but admits that the issue is “under review.” His reticence hints at some of the disturbing motives behind negative rate policies.

In puzzling out why the ECB is administering negative rate policy in harsh fashion as regards the banks which are plush with reserves let’s start by identifying what common purpose it could achieve with the BoJ and SNB by keeping to a lighter touch (imposing negative rates on only a small marginal slice of deposits placed with the central bank by its member banks).

This common aim is currency manipulation.

The national money (or union money in the case of the euro) depreciates as a flight of capital occurs out of negative rate assets. All are not equal in this flight. Banks seek to shelter their regular domestic clients from negative rates. They pass on the cost of the negative rate fee on their reserves only to wholesale and foreign depositors, also taking account of the squeezed rates of return obtainable on their other assets including loans and short-maturity government bonds.

In effect the negative rate regime operates partly like a system of exchange restrictions which imposes penalties on foreign inflows into the domestic money market.

German banks are more stressed in sheltering their depositors from negative rates than their Swiss and Japanese counterparts given the harsh treatment of the ECB. In consequence the shelter they offer is less broad and deep and bank shareholders have to pay more heavily for its provision via diminished profits.

Why doesn’t Chief Draghi relent? Because that would mean less subsidy to Italian banks, stupid! The ECB takes advantage of the negative rate fee it charges on deposits (and German banks are the main net creditor of the euro-system reflecting the huge German savings surplus) to make subsidized loans most of all to Italian banks.

If ECB Chief Draghi were just pursuing currency manipulation, yes, he could please the German bank lobby (and the Bundesbank which pleads on their behalf). But he has this second purpose in mind. Hence the prevarication.

Ultimately these transfer consequences of negative rates within Europe (mainly from Germany to Italy) are not a matter for anyone else, including the Trump Administration. German voters should have their say. The aspect of concern for the US is currency manipulation.

—Brendan Brown, “The Menace of Sub-Zero Interest-Rate Policy,” in Anatomy of the Crash: The Financial Crisis of 2020, ed. Tho Bishop (Auburn, AL: Mises Institute, 2020), 41-42.