new lecture series, Federal
Reserve (Fed) Chairman Ben Bernanke is going out of his way to discuss
the "problems with
the gold standard." To a central banker, the
gold standard may be considered "competition,"
as their power would likely be greatly
diminished if the U.S. were on a gold standard. The Fed, Bernanke
argues, is the answer to
the problems of the gold standard. We respectfully disagree. We disagree because the Fed ought to look at a different problem.
Bernanke lists price stability
and financial stability
as key objectives of the Fed. Focusing on the
latter one first, the Fed was established
to reduce the risk of financial panics. Bernanke
panic is possible in any
situation where longer-term,
illiquid assets are financed by short-term, liquid liabilities; and in which short-term lenders or depositors may lose confidence in the
institution(s) they are financing
or become worried that others may
Bernanke goes on to blame the gold
standard for the panics. While he
is certainly not alone in his view – indeed, his very lecture to students at George Washington University is promoting that view to a new generation of economists -, we beg to differ.
Banks - by definition
- have a maturity mismatch, making long-term loans, taking
short-term deposits. As such, banks are prone to financial panics as described by Bernanke. To mitigate the risk of financial panics, central banks
can do what the Fed is doing, namely
to be a lender of last resort. Alternatively, central banks can focus on the core issue, the structural "problem
of banking." Following
the Fed's approach, there are inherent moral hazard issues – incentives
for financial institutions to increase
leverage, to become too-big-to-fail.
To address a panic that might happen anyway, the Fed would double
down (provide more liquidity),
future banking panics. After
yet another crisis, new rules are introduced to regulate banks. The resulting financial system may not be safer, but it will increase
barriers to entry, further
bolstering the leadership position of existing, too-big-to-fail banks.
With all the government guarantees and too-big-to-fail concerns,
banks might then be regulated
in an attempt to have them
act more like utilities. Ultimately, that might make the financial system more stable, but will
stifle economic growth. Financial institutions, as much
as we have mixed feelings about their
conduct, are vital to finance economic
growth, as they facilitate risk taking and investment.
The problem of all financial panics is not the
gold standard - otherwise, the panic of 2008 would not have happened. The problem of financial panics is - again - that "longer-term, illiquid assets are financed by short-term, liquid liabilities."
Missing from Bernanke's definition is a key additional attribute, leverage.
A maturity mismatch without leverage might cause a lender to go bust, but - in our interpretation - does not qualify as a panic when a limited number of depositors are affected. The
"panic" and the "contagion" may
occur when leverage is employed,
as it creates a disproportionate number of creditors (including consumers with cash deposits).
There's a better way. To avoid having financial institutions serve as “panic” incubators, regulation should address the core of the issue. Bernanke shouldn’t use gold, as a scapegoat
for all that was wrong with the U.S. economy previously, to justify a license to print money. First, failure
must be an option; individuals
and businesses must be allowed
to make mistakes and suffer the consequences. The role of the regulator, in our opinion, is to avoid an event where someone's mistake wrecks the entire system.
The easiest way to achieve a more stable financial system is to reduce incentives for leverage. A straightforward method is through
and a requirement to post collateral
for leveraged transactions. The financial
industry lobbies against this, arguing that holding a position to maturity
renders mark-to-market accounting redundant. Consider the following example, which highlights the implication: assume a
speculator before the financial crisis took a leveraged bet that oil
prices - at the time trading at $80 a barrel - would go down to $40 a barrel. In the “ideal world” according to
the banks, this speculator would not have been required to post collateral and
would have been proven
right when oil (briefly) dropped to $40 a
barrel after the financial
crisis. In reality however,
as oil prices soared to $140 a barrel before declining, the typical speculator would have been forced to post an ever larger amount of collateral; likely, the speculator's brokerage firm would have closed out the position, as the speculator
ran out of money. The speculator
lost money because he was unable
to meet a margin call; importantly, though, the system
remained intact. The speculator
might complain: the price ultimately fell to $40! But such whining is futile because the rules of engagement
were known ahead of time. As such, the speculator had an incentive to use less (or no) leverage. The bank's attitude,
in contrast, incubates
panics. In this example, regulated exchanges exist. But even without regulated exchanges or easily priced securities, similar concepts can be developed.
Another way to make financial
firms more panic prone is to require them to issue staggered subordinated debt. Rather than relying
heavily on short-term funding (retail deposits or inter-bank funding markets), banks should be required to stagger the maturities of their own funding
over years. If, say, each year 10% of their loan portfolio needs to be refinanced,
then - in times of financial
turmoil - it might become exorbitantly expensive for a bank to finance that 10% of their loan portfolio. A bank should be
able to shrink its loan portfolio by 10% in a year
in an orderly fashion, without jeopardizing the survival of the firm or spreading excessive risks throughout the financial
system. Note that this is a market-based mechanism to police the financial
concepts reduce leverage
in the system. And that's the point, as leverage is the mother of all panics. The concepts presented above will not solve all the
challenges of banking, but blaming
"the problem of the gold standard" for financial panics is - in our analysis - premature.
Modern central banking
is not the answer to mitigate the risk of financial panics because the cost for this perceived safety is enormous. As a result of responding to each potential panic with ever more "liquidity", entire governments are now put at risk when
a crisis flares up.
Beyond that, central banks have done a horrible job in containing inflation. The wisdom
of central banking is that 2% inflation is considered an environment of
stable prices. At 2%, a level often touted
as a “price stable environment”,
the purchasing power of $100 is
reduced to $55 over a 30-year period.
It's a cruel tax on the
public. What’s more, in practice, countries with a fiat currency system
have generally been unable
to keep long-term
inflation below 2%.
Bernanke warns of deflation. To the saver, deflation is a gift. Not to the debtor.
In a debt driven world, deflation strangles the economy. Governments don't like deflation as income taxes and capital gains taxes are eroded. In a deflationary
world, governments would need to rely more on sales taxes (or value added
taxes): gradually reduced
revenue in a deflationary environment
would be okay as the purchasing power of
those tax revenues would increase. That assumes,
of course, that the government
carries a low debt burden -- deflation would be a good incentive to limit spending. Get the picture why governments
don't like deflation?
inflation, people have an "incentive" to work harder, to take on risks, just to retain their purchasing power, the status
quo. What about the pursuit
of happiness? The idea that if you earn
money and save, you can retire and live off your savings? We consider
it quite an imposition that unelected officials have such sway over our standard of
Bernanke also attacks the gold standard
for causing havoc in the currency markets. Please subscribe to our newsletter to be informed as we provide food for thought about the relationship between gold and currencies. We will also
discuss what investors may want to do in a world that has moved further and further away from the gold standard. Subscribe
to Merk Insights by clicking here. Also,
please click here to register for the Merk Webinar: Quarter 1 Update
on the Economy and Currencies
which will take place on Thursday, April 19th at
4:15pm EF / 1:15pm PT. We manage the Merk Funds, including
the Merk Hard Currency Fund. To learn more about the Funds, please visit www.merkfunds.com.