“As finance becomes more innovative, money becomes less substantial. It would be nice if a few of Mr. Palmer’s intellectual pioneers could spare some time to improve the quality of the currency – and, while they’re at it, to beat back the depredations of the regulatory state…

…As for the relationship between a bank and the state, it’s been downhill for more than a century. Under the long-ago doctrine of double liability, the stockholders of a nationally chartered bank got a capital call—a dunning notice—if the institution in which they held a fractional interest became impaired or insolvent. It seemed only fair that the owners of a bank should be held responsible for its safety and soundness. Double liability went out the window in the 1930s at about the time that federal deposit insurance came in. The passing decades have moved us ever further away from the ideal of individual responsibility in finance and ever closer to the dubious netherworld of collective responsibility….. Mr. Palmer finds nothing to fear in financial derivatives, though he seems to overlook the most problematical kind of all. You’ll recall that a derivative is a financial instrument that owes its value to some underlying asset—interest rates, say, or the level of the S&P 500 index. The dollar bill is a ubiquitous derivative—actually, a former one. It derived its value from the gold or silver into which it was freely convertible. All that ended during the Nixon administration. In 1971, the Treasury stopped exchanging dollars for gold at the fixed rate of $35 to the ounce (one might call it a default). At that moment, the Federal Reserve “note”—an obligation to pay—became, in the words of the economist John Exter, an “IOU nothing.”…..The dollar’s transformation into pure paper scrip has given the world’s central bankers enormous discretion. They have availed themselves of that power to redefine “price stability” to mean inflation—2% a year would suit, they judge. They have materialized $10 trillion since the financial crisis just as easily as you might send an email. They have caused bank-deposit rates to fall to zero even as they’ve talked up the stock market. The financial inventions that Mr. Palmer extols ultimately owe their utility to free markets. Manipulate those markets and the value of the inventions, whatever they are, becomes problematical…. If American banking regulation peaked in 1842 and the individual responsibility for solvent banking topped out in the early 1930s, the rhetoric of central banking made its high on April 13, 1953. On that day, the chairman of the Federal Reserve, William McChesney Martin Jr., in a speech before the Economic Club of Detroit, celebrated the liberation of interest rates from central-bank control. (The Fed had been holding down the cost of the Treasury’s wartime borrowing.) “Dictated money rates breed dictated prices all across the board,” Martin declared. “This is characteristic of dictatorships. It is regimentation. It is not compatible with our institutions.””, James Grant, “Forging Ahead”, The Wall Street Journal

Bookshelf

Forging Ahead

As finance becomes more innovative and banking more complex, money becomes less substantial.

Big Change

A souvenir from the 1900 presidential campaign.

A souvenir from the 1900 presidential campaign. Photo: Granger, NYC / The Granger Collection

By James Grant

Progress in science is cumulative—we stand on the shoulders of giants. Progress in finance is a little different—here, frequently, we stand on the shoulders of pygmies. Then, too, we seem to keep falling off. It’s up and down, boom and bust—or is it?

Not entirely, according to Andrew Palmer, a London-based editor at the Economist and the author of “Smart Money,” a scintillating brief for financial invention. The long-lingering disaster of 2008, he contends, blinds us to constructive new developments in business credit, public finance, pension management, payday lending and charitable giving. It’s a cheerful and lucid Cook’s tour that Mr. Palmer conducts. You begin to think that there’s hope for the financial trades after all.

If mankind falls short in the quotidian business of buying low and selling high, Mr. Palmer observes, it can’t be for want of practice. Investing, lending at interest and dealing in the rudimentary forms of structured finance are as old as the hills. “Whether providing a way of storing wealth, of connecting capital with investments, of bridging the gap between the present and the future,” he says, finance has played a role in helping people “meet their objectives since the very earliest civilizations.”

Smart Money

By Andrew Palmer
Basic, 285 pages, $27.99

Better living through finance is Mr. Palmer’s optimistic theme. It’s not just the corner ATM that’s making life easier, he relates. Good people—idealists in their way—are adapting the once-toxic mortgage-backed security in the hunt for a cure for cancer. To back a single cancer-research study is by definition a long shot. To invest in a diversified pool of such efforts is a less speculative undertaking. To hold a senior claim against the potential future cash flows of a host of cancer-research projects (getting first crack at the income that they might one day produce) might even be construed as a conservative investment. Someday, by Mr. Palmer’s telling, cancer bonds—looking more than a little like the combustible mortgage securities of yesteryear—may raise life-saving billions.

In the same progressive vein, the author says, keepers of “big data” are weighing our creditworthiness more accurately than bankers used to do. Brainiacs are dreaming up new ways to finance higher education—not through conventional student debt but by a kind of equity investment in a student’s future earning power. Public-spirited inventors are creating “social impact bonds” that pay off when, for example, a prison succeeds in rehabilitating its inmates.

Mr. Palmer is a far from uncritical booster of all things new. He is quick to acknowledge how frequently a seemingly useful idea becomes destructive through misapplication or overuse. One thinks in this context of 1987-vintage “portfolio insurance,” the gimmick that led to concentrated selling of equity-futures contracts when the market started to fall (and wound up crashing). One thinks, too, of the May 2010 “flash crash,” in which equity-futures contracts collided with computer-directed common stocks to send the Dow Jones Industrial Average skittering like a billiard ball. “Beyond a certain scale and beyond a certain point of development,” the author observes, “good ideas have a tendency to run wild.”

As an example of benign adaptation, Mr. Palmer notes that new kinds of lenders—lightly regulated and digitally empowered—have sprung up to fill the business vacuum that Washington’s suffocating rules have made. Lending Club, a so-called peer-to-peer lender, and OnDeck Capital, a non-bank lender to speculative-grade small business, are among the author’s favorite creations. What he seems most to admire about OnDeck, which was founded in 2007 and went public early this year, is the speed with which it tells its customers, “Yes!” No need to eyeball the applicant when all the facts you need are online. Speed, accuracy and flexibility are the advertised virtues of the digital method. At last report, OnDeck was borrowing at 5.1% and lending at 36.7%. Oddly enough, the company does not turn a profit even at that shocking interest differential. Credit losses and competitive pressures take a large and growing bite out of revenue even today, a time of ostensible prosperity. Stay tuned for the next recession.

Money—smart or otherwise—is at the center of Mr. Palmer’s narrative, though the raw material itself gets short shrift. As finance becomes more innovative, money becomes less substantial. It would be nice if a few of Mr. Palmer’s intellectual pioneers could spare some time to improve the quality of the currency—and, while they’re at it, to beat back the depredations of the regulatory state.

The centerpiece of post-crisis banking regulation, the asphyxiating Dodd-Frank law, runs to thousands of pages. The substance of the landmark Louisiana Banking Act of 1842 occupies a single page. Edmond J. Forstall, the author of that 19th-century regulatory masterpiece, drew a sharp distinction between what a bank owed and what it owned. A regulated New Orleans institution, for instance, was obliged to hold back the equivalent of one-third of its deposits in hard cash, gold and silver, while placing the rest in high-quality, short-dated, self-liquidating commercial bills. After all, there was no telling when the depositors might want their money back. Bray Hammond, the author of “Banks and Politics in America From the Revolution to the Civil War” (1957), judged the Forstall law to be the acme of enlightened banking legislation. The 21st century seems unlikely to topple it from its pinnacle.

As for the relationship between a bank and the state, it’s been downhill for more than a century. Under the long-ago doctrine of double liability, the stockholders of a nationally chartered bank got a capital call—a dunning notice—if the institution in which they held a fractional interest became impaired or insolvent. It seemed only fair that the owners of a bank should be held responsible for its safety and soundness. Double liability went out the window in the 1930s at about the time that federal deposit insurance came in. The passing decades have moved us ever further away from the ideal of individual responsibility in finance and ever closer to the dubious netherworld of collective responsibility.

Mr. Palmer finds nothing to fear in financial derivatives, though he seems to overlook the most problematical kind of all. You’ll recall that a derivative is a financial instrument that owes its value to some underlying asset—interest rates, say, or the level of the S&P 500 index. The dollar bill is a ubiquitous derivative—actually, a former one. It derived its value from the gold or silver into which it was freely convertible. All that ended during the Nixon administration. In 1971, the Treasury stopped exchanging dollars for gold at the fixed rate of $35 to the ounce (one might call it a default). At that moment, the Federal Reserve “note”—an obligation to pay—became, in the words of the economist John Exter, an “IOU nothing.”

The dollar’s transformation into pure paper scrip has given the world’s central bankers enormous discretion. They have availed themselves of that power to redefine “price stability” to mean inflation—2% a year would suit, they judge. They have materialized $10 trillion since the financial crisis just as easily as you might send an email. They have caused bank-deposit rates to fall to zero even as they’ve talked up the stock market. The financial inventions that Mr. Palmer extols ultimately owe their utility to free markets. Manipulate those markets and the value of the inventions, whatever they are, becomes problematical.

If American banking regulation peaked in 1842 and the individual responsibility for solvent banking topped out in the early 1930s, the rhetoric of central banking made its high on April 13, 1953. On that day, the chairman of the Federal Reserve, William McChesney Martin Jr., in a speech before the Economic Club of Detroit, celebrated the liberation of interest rates from central-bank control. (The Fed had been holding down the cost of the Treasury’s wartime borrowing.) “Dictated money rates breed dictated prices all across the board,” Martin declared. “This is characteristic of dictatorships. It is regimentation. It is not compatible with our institutions.”

Mr. Palmer may be right about the improving uses of financial ingenuity. A dollop of the wisdom of Edmond Forstall and William McChesney Martin Jr. would improve matters all the more. A curious thing is financial progress. Now you see it—and now you don’t.

—Mr. Grant’s latest book, “The Forgotten Depression: 1921, the Crash That Cured Itself,” won the 2015 Hayek Prize.

Posted on May 12, 2015, in Postings. Bookmark the permalink. Leave a comment.

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