Author: Warren Coats

I specialize in advising central banks on monetary policy and the development of the capacity to formulate and implement monetary policy.  I joined the International Monetary Fund in 1975 from which I retired in 2003 as Assistant Director of the Monetary and Financial Systems Department. While at the IMF I led or participated in missions to the central banks of over twenty countries (including Afghanistan, Bosnia, Croatia, Egypt, Iraq, Israel, Kazakhstan, Kenya, Kosovo, Kyrgystan, Moldova, Serbia, Turkey, West Bank and Gaza Strip, and Zimbabwe) and was seconded as a visiting economist to the Board of Governors of the Federal Reserve System (1979-80), and to the World Bank's World Development Report team in 1989.  After retirement from the IMF I was a member of the Board of the Cayman Islands Monetary Authority from 2003-10 and of the editorial board of the Cayman Financial Review from 2010-2017.  Prior to joining the IMF I was Assistant Prof of Economics at UVa from 1970-75.  I am currently a fellow of Johns Hopkins Krieger School of Arts and Sciences, Institute for Applied Economics, Global Health, and the Study of Business Enterprise.  In March 2019 Central Banking Journal awarded me for my “Outstanding Contribution for Capacity Building.”  My recent books are One Currency for Bosnia: Creating the Central Bank of Bosnia and Herzegovina; My Travels in the Former Soviet Union; My Travels to Afghanistan; My Travels to Jerusalem; and My Travels to Baghdad. I have a BA in Economics from the UC Berkeley and a PhD in Economics from the University of Chicago. My dissertation committee was chaired by Milton Friedman and included Robert J. Gordon.

Protecting bank deposits

Following the collapse of Silicon Valley Bank last week there has been considerable discussion about whether and how the regulatory regime might be strengthened (or actually more effectively implemented) to prevent such collapses (yet again) in the future. Raising deposit insurance coverage to 100% of all deposits is being suggested (and was provided ad hoc to SVB and Signature Bank this week). Econ 101: SVB and bank runs – Warren’s space (wcoats.blog)

Insuring all deposits and adopting the Chicago Plan represent two very different approaches to removing all risk of loss to depositors and thus any incentive to run from a bank. In the search for regulatory or market checks on excessive bank risk taking or poor management, the expectation that depositors would carefully monitor the behavior and condition of their banks was never realistic. Thus, removing any financial incentive for such due diligence by raising deposit insurance to cover all deposits would have little to no impact on bank behavior. Such scrutiny by bank shareholders and managers is much more realist and thus important. US bank bankruptcy procedures do not spare shareholders, who in the case of SVB have lost everything. However, more might be done to impose losses on managers of insolvent banks.

Following the bankruptcy of SVB considerable attention has rightly focused on the speed with which facts or rumors of a bank’s weakening financial condition can spread over the Internet. What might have taken weeks as depositors began to line up outside their banks to withdraw their deposits while the funds lasted, now takes minutes, dramatically accelerating the speed with which a bank must try to liquidate enough of its assets to fund the withdrawals.

Full deposit insurance and the Chicago Plan of 100% reserve banking (deposits at the central bank, which are always safe and instantly available) eliminate any incentive for bank runs. But the difference between them deserves more attention. The full deposit insurance approach puts the cost of bailing out the depositors of a failed bank on the rest of the banking system (on the “good” banks) who finance the insurance fund.  The cost of the Chicago Plan, if indeed it is a cost at all rather than a benefit, is the need for banks to fund their credit operations with equity or long-term debt, rather than with potentially volatile deposits. We should move to the Chicago Plan and fully separate money from credit.

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Econ 101: SVB and bank runs

What is a bank run and how can we prevent them? A bank run, as I am sure you all know, is a rush by depositors to withdraw their deposits for fear that the bank will not have the money to give them. But there is a lot to unpack there in order to understand what is going on and how runs might be prevented.

It is important to understand the difference between debt and equity—between lending a specific amount of money with specific terms and investing an amount of money in exchange for a share of the earnings (or losses) of the recipient. When you buy shares in a company, it has no obligation to return your money. If you no longer want to invest in that company, you can sell your shares to someone else or the company might, at its discretion, buy them back. Its failure to “return” your money cannot be the cause of a company’s bankruptcy (take over by creditors to collect what the company is no longer able to return).

The deposits that we make in our banks are a special case of debt finance of whatever the banks do with our money. As we know, they lend much of it to people and companies for one thing or another and invest some in hopefully safe assets like Treasury bills and keep a tiny bit on hand for when you need cash. But the deposit contract says that you have the right to withdraw (or pay to someone else) any or all of it whenever you want to. Thus, banks must keep sufficient liquid assets in order to satisfy such withdrawals by selling them in the market when you demand your money back. The Federal Reserve, our lender of last resort, also has facilities for lending to banks needing cash against the collateral of bank assets.

The difference between illiquidity and insolvency is critical as well. A bank is solvent when the value of its assets match or exceed the value of its liabilities (such as your deposits). But having sufficient good assets doesn’t mean that that bank can always honor your deposit withdrawal demand. That is a question of liquidity. Does the bank have enough of its assets backing your deposit in forms that it can pay out immediately (cash in its vault, deposits at the Federal Reserve that it can transfer to another bank or use to buy cash, or assets it can quickly sell such as t-bills, or credit lines with other banks or the Fed, etc.)?  “The difference between bank liquidity and capital” Thus, even a solvent bank (positive capital) might fail to honor your withdrawal demand if it doesn’t have sufficient liquid assets. “The big bailout-what next?”

Usually, a bank becomes insolvent when more of its loan assets default than the bank has capital to cover such losses. But as we will see in the case of Silicon Valley Bank, insolvency can also result from a decline in the current market value of a “good” asset.  When depositors suspect that their bank might be insolvent, they will withdraw their money while they still can. This tends to use up the bank’s liquid assets compounding the risk of default. As the word spreads the classical bank run takes off (electronically these days rather than long lines outside the bank as in the old days).

The SVB, which specialized in financial services to start-ups and technology companies, enjoyed a huge increase in its deposits over the last four years, increasing from $49 billion in 2018 to $189.2 billion in 2021 dropping back to $175.4 billion at the end of 2022. It invested most of those deposits in “safe” long term government and similar debt. While the default risk for these assets was negligible, the risk of a loss in current market value if market interest rates increased was high. No one will pay the face value of a 3% ten-year bond while current market rates for the same maturity are 4%. The rapid increase in interest rates as the Federal Reserve reversed money growth to fight inflation tanked the current market value of a large share of SVB’s assets making it impossible for it to come up with the cash depositors might demand if they “ran”. That is how runs work. On March 10 SVB was put into receivership.

The original sin of modern banking is financing long term loans/investments with money (demand and savings deposits). Islamic banking, what uses equity investing, is wiser in this regard. During the Savings and Loan crisis in the U.S. in the 1980s and early 90s (financing mortgages with deposits) more than 1000 S&Ls failed when interest rates increased. But in fact, the U.S. bank regulation regime has some good features. While bank risk taking is subject to many, often costly, regulations, the ultimate check on risk taking comes from the knowledge of bank owners that they will lose their entire stake if their bank becomes insolvent. The Federal Deposit Insurance Corporation (FDIC), which oversees America’s deposit insurance scheme, has developed effective bank bankruptcy and resolution procedures that allow it to take over and resolve insolvent banks with barely a ripple. A favorite tool is the so-called purchase and assumption transaction by which a healthy bank buys the assess of the insolvent one and assumes its liabilities (deposits), usually over a weekend. Thousands of insolvent banks have been resolved by the FDIC in the last fifty years.  See “Institutional and Legal Impediments to Efficient Insolvent Bank Resolution and Ways to Overcome Them” by Warren Coats and Arno Liuksilo “Warren Coats-17”

Most bank depositors pay no attention to the financial condition of their bank because their deposits are insured against losses, which until last week had been raised to $250,000. But the government has now implicitly extended such insurance to all deposits via accounting and other tricks, thus removing any remaining check on bank risk taking from all depositors. On Monday, President Biden announced that no depositors in SVB (and Signature Bank of New York) would lose any of their deposits.  Following the banking crisis of 2008, the Dodd-Frank law further strengthened financial sector regulations. The most important and helpful provisions of this 2,300 page law provided for significant increases and strengthening of bank capital requirements.  

The overuse of debt rather than equity financing is a more general weakness in our economy. The IRS should stop subsidizing it. Interest on borrowing is deductible from taxable income while dividends on equity financing are not. While increasing bank capital makes them less run prone, a simpler and easer to regulate approach is to remove the cause of runs all together by eliminating any risk that your bank can’t honor its obligation to return your money on demand. Another few thousand pages of laws and regulations might catch the last mistakes (though it is hard to see why regulators didn’t address the obvious duration risks taken by SVB), but there is an easier, less costly solution. Bank failures result from the mistakes of banks (their owners and managers) and the failure of depositors to more carefully evaluate the soundness of the bank in which they deposit their money. But depositors have little competence to evaluate bank soundness, and why should they be expected to?

Money (bank deposits) should be fully separated from credit. Deposits should not finance loans. Those financing investments should share in its risks (and rewards) via equity financing. “More than decade ago Professor Kotlikoff and [John Goodman] proposed “limited purpose banking” in The New Republic and in Investment News. The idea is that credit market institutions should be intermediaries between savers and investors and should not themselves use depositors’ money to make risky investments.”

When we deposit money in banks for safekeeping and making payments there should never be any doubt about the bank’s ability to return it on demand and thus no reason to “run” on the bank to protect our deposits. This is the essence of the Chicago Plan which would replace so call fractional reserve banking with 100% reserves (deposits at the central bank). When my bank deposit is backed totally by my bank’s deposits at the Fed, I would know with certainty that they were 100% safe and instantly available.  The “Chicago Plan” and New Deal Banking Reform | Levy Economics Institute (levyinstitute.org) Narrow banking schemes have a similar motivation. “A proposal for the feds balance sheet”

The District of Columbia

A foreigner dropping into “The District” from wherever, would be flabbergasted by the local debate over Statehood, home rule, etc. for the District.

The powers of Congress enumerated in Article 1, Section 8, of the U.S. Constitution include the power to govern a federal district:

  • “Clause 17: To exercise exclusive Legislation in all Cases whatsoever, over such District (not exceeding ten Miles square) as may, by Cession of particular States, and the Acceptance of Congress, become the Seat of the Government of the United States, and to exercise like Authority over all Places purchased by the Consent of the Legislature of the State in which the Same shall be, for the Erection of Forts, Magazines, Arsenals, dock-Yards, and other needful Buildings;”

The Residence Act passed by Congress on July 17, 1790, established what is now called the District of Columbia, or Washington D.C., as the capital of the United States. Maryland and Virginia ceded between them 100 square miles of their territory for this purpose.  Congress moved from its first capital in Philadelphia to Washington in December 1800. On February 27, 1801, 212 years ago today, the so-called Organic Act was approved giving control of the District to Congress “and took away the right of residents to vote in federal elections.” District of Columbia retrocession – Wikipedia

And in 1812 our British friends burned down the White House forcing James Madison to live in what is now the Arts Club of Washington (of which Ito and I are members).

In March 1847, Congress and Virginia’s General Assembly approved the return (“retrocession”) of Virginia’s contribution to the District of Columbia but the retrocession of Maryland’s contribution failed to pass Congress. Turning Maryland’s part of the district into a new state makes no sense to me at all. But neither does Congress’s continued control over all of Maryland’s portion of the District.

The provisions of the Constitution giving Congress legislative power over the lands needed for and occupied by its facilities would be fully met by returning most of the District to Maryland (thus restoring full voting and other citizen rights to its residents). Virginia did it and so can (and should) Maryland.

Saving Social Security

I recently received a petition for my signature to save social security from an expected Republican attack. To save it we must understand what it was meant to be and what it now is and what problems it faces.

Initially the Social Security program was meant to be a savings financed retirement fund to which employers would be required to contribute half of what was deducted from worker paycheck and put in the Social Security Trust Fund (a fully funded life insurance program). This is (or was supposed to be) like our personal IRAs but with the employer contribution (though many employers offer retirement programs for their employees to which they also contribute in addition to Social Security contributions). But from the beginning, current worker/employer contributions to the Trust Fund were used to finance current retiree benefits rather than being saved for the contributor’s future retirement, i.e., it was pay-as-you-go.

Three factors undermined this pay-as-you-go model. First, benefits were indexed to wages rather than inflation and as real wages have raise over time so have benefits. Second, the average life expectance of retirees has increased dramatically. When the Social Security scheme was launched in 1935, life expectancy in the US was a bit under 60 years (the average retiree received SS benefits for only a year or two). It is now 77.3, down a bit from 78.8 in 1919. Third, population growth has slowed and the number of workers taxes for this growing number of retirees has been and will continue to fall fast.  “Saving Social Security”

The simplest, and in my view most sensible, solution to this financing problem is to: a) increase the retirement age at which SS starts paying; b) increase the number of working age immigrates to help pay for the retired; and c) continue to encourage private pensions and IRAs. Unless you are French most of us continued working beyond normal retirement ages because we wanted to continue using our skills longer. We enjoyed what we did for more than just the money.

Adopting the above reforms would not reduce what a retiree SS beneficiary receives each month.  But it would reduce what she receives over her life time because would be retired for fewer years. Some people are calling this increase in the retirement age cutting Social Security.  What ever.

As I have argued elsewhere, I would replace Social Security with a Universal Basic Income.  “Our social safety net”

Trade once again

Everyone understands that without trade they would be dirt poor. If everyone had to be self-sufficient, they would be lucky to survive. It’s almost as obvious that the wider we can trade the more we can specialize in our comparative advantage raising the incomes of everyone. Where many stumble is at their national borders (though within national borders of large countries some regions restrict trade with other national regions to protect otherwise less efficient enterprises thus lowering incomes in general).

Why should trade be restricted across national borders? Three reasons stand out: two legitimate and one not. A potentially legitimate reason concerns national security. Requiring that products necessary for defense be domestically produced, even at greater cost, reduces the risk of supply chain disruptions. The risk is that this excuse is easily abused to the extent that such protection can turn illegitimate or corrupt.

A second legitimate reason also concerns resilience. The most efficient allocation of productive resources must take account of the risks of disruption to supply chains. We buy insurance for many assets and activities, thus incurring a certain cost, to protect our incomes from risks (large or small) of interruption and potentially larger losses. When buying goods or inputs from cheaper producers located far away, we are exposed to larger risks of supply interruptions. American manufacturers, for example, take these risks into account in deciding where to produce and purchase inputs to their products sold in the U.S.

A government bestowed financial favor on a firm or industry (trade protection, industrial policy) is always part of a quid pro quo. The firm delivers favors to the politicians who favor it.  Government protection of otherwise uncompetitive firms increases their viability and profits but at the expense of lower income for the rest of us. Countries that heavily indulge in such protection have suffered lower levels of income. “Trade protection and corruption”

Following World War II, and the establishment of what became the World Trade Organization, barriers to trade (domestic protectionism) were gradually reduced via bilateral and multilateral trade agreements. In the 62 years from 1959 to2021, real United States’ per capita personal income, when measured in constant 2012 dollars to adjust for inflation, increased 297.1%, from $13,971 in 1959 to $55,477 in 2021. This huge increase is the result of increased productivity per worker. But such productivity gains are only possible because of trade (within or across national borders).  “The case for trade”

Weaknesses in government programs to facilitate worker adjustments that are a necessary part of a dynamic, growing economy and other geopolitical factors are undermining the freest and most efficient trade (domestic and global) that our prosperity has depended on. “Geo Economic Fragmentation and the Future of Multilateralism”  “End globalization?”

The Economist magazine has argued that: “One problem [with protectionism and industrial policies] is their extra economic costs. The Economist estimates that replicating the cumulative investments of firms in the global tech-hardware, green-energy and battery industries would cost $3.1trn-4.6trn (3.2-4.8% of global gdp). Reindustrialisation will raise prices, hurting the poor most. Duplicating green supply chains will make it costlier for America and the world to wean themselves off carbon. History suggests that vast amounts of public money could go to waste…. Yet rescuing the global order will require bolder American leadership that once again rejects the false promise of zero-sum thinking. ”  “The destructive new logic that threatens globalisation”

Misinformation and corruption are undermining the basis of our incredible prosperity just when we need to pull together to deal with global warming. We must resist and fight back to restore and preserve our efficient market economies.  They would not exist without trade.

Diversity Training

America was founded on the principle that every person deserves respect and equal treatment. While our constitution incorporated an unfortunate compromise by permitting slave ownership in the South, which was fixed after our civil war, many scars remain. Each generation needs to be taught our proper principles and we should do our best to reflect them in our dealings with our fellow citizens of all races and creeds.

As Tom Palmer put it some years ago: “The recognition of individuality, of the uniqueness of each individual, is commonplace in all cultures…. Each human person is unique…. What is less commonly grasped is that we all share something morally significant and that therefore all human beings have legitimate claims to rightful treatment by each other, that is, to respect for their human rights.”  “Freedom is the birthright of all humanity”

I assume that diversity training is an attempt to provide such understanding and to endeavor to remove the remaining scars of historical prejudices. That is certainly an important and laudable goal. But perhaps the new generation would benefit more from a forward-looking, positive approach rather than stressing atonement for an unchangeable past. Diversity is a fun and enriching phenomenon.

Let’s learn more about the cultural and historical backgrounds of our fellow citizens and how and why they or their ancestors came here. Let’s sample their food and music. Let’s rejoice in the diversity around us. Most cab drivers in the DC area are immigrants or immigrants once removed. I enjoy asking them where they or their parents are from. Most of them enjoy sharing such information. Every now and then one of them will reply with sarcasm that they are from Arlington or some such place. And I reply, “Yes, yes, but where did your ancestors come from? We all came from somewhere else” (overlooking our natives).

Diversity is more than a moral duty. It is a unique blessing of the American experience.

Fair Tax Act of 2023

While I will not hold my breath, I am thrilled to see the introduction of H.R.25 – FairTax Act of 2023 in the House of Representatives by Rep. Carter Earl L. “Buddy” (R-GA-1) on January 9.

“This bill imposes a national sales tax on the use or consumption in the United States of taxable property or services in lieu of the current income taxes, payroll taxes, and estate and gift taxes. The rate of the sales tax will be 23% in 2025, with adjustments to the rate in subsequent years. There are exemptions from the tax for used and intangible property; for property or services purchased for business, export, or investment purposes; and for state government functions.

Under the bill, family members who are lawful U.S. residents receive a monthly sales tax rebate (Family Consumption Allowance) based upon criteria related to family size and poverty guidelines.” “Fair Tax Act of 2023”

I have written a great deal about taxation, a necessary feature of government spending, and how to make it fair and economically neutral (minimal distortion of the allocation of resources in our economy). Income taxation—especially corporate income taxation—fail these tests. A universal consumption tax passes them. It is especially suitable for our globalized world where companies produce and sell in many countries. “Tax reform and the press”   “The corporate income tax”

But the issue of fairness is somewhat in the eyes of the beholder. I have also supported a Universal Basic Income (UBI), in place of our many safety net transfers including Social Security. “Our social safety net”  Not only does a UBI better fit American’s strong commitment to individual liberty and choice, but when combined with a flat consumption tax it produces a progressive impact on income that satisfies my notion of fairness. “Replacing social security with a universal basic income”

As I understand the new (actually a return to the old) and improved House rules, after consideration by the House Ways and Means Committee, the bill will be debated on the floor of the full House. This is a giant step in a very good direction.  

Restoring Regular Order to Congress

In my “Hopes for the New Year” blog last week I listed among my hopes: “Restore Congressional Leadership. Enforce the War Powers Act. Restore regular order and cross aisle cooperation to address real problems. “Our dysfunctional Congress”

The promises made by Kevin McCarthy to gain the required majority support for his Speakership of the House, largely deliver my wish. They weaken the power of the overly powerful Speaker and increased the power of your and my Congressman or Congresswoman. Each appropriation will be properly and separately considered (first by the relevant committee) rather than the all in one rush package no one has time to read in the final minutes before the government must shut down. The issues and proposed remedies were presented a few days ago by Bruce Fein “Deliverance from the Republican House”

OK guys, please get on with addressing the issues and needs of the country that depend on law. The term “guys” here is a standard reference to both men and women. It reminds me of the many meetings we had in 2000 in Istanbul with the new head of the new Turkish Banking Supervision body created to manage Turkey’s exchange rate and banking crises. We (our IMF team) met with him and his team daily and often well into the night and he often referred to us as “girls” or in his better moods “ladies.”

Russian culture

Article 2 of the Constitution of the Russian Federation states: “Man, his rights and freedoms are the supreme value. The recognition, observance and protection of the rights and freedoms of man and citizen shall be the obligation of the State.”

Chapter two goes on to spell out these rights, which are those observed in most democratic country in the world. “Article 17 1. In the Russian Federation recognition and guarantees shall be provided for the rights and freedoms of man and citizen according to the universally recognized principles and norms of international law and according to the present Constitution.” These include free speech, privacy, “the right to the inviolability of private life, personal and family secrets,” etc. It seemed a bit odd, then, when the deputy from the party “New People”, the well-known Russian actor of theater and cinema, Dmitry Pevtsov, recently stated that Article 2 should be replaced a declaration of the supreme Russian values as faith, family and the fatherland.

These are very different values than in Russia’s existing constitution and those found more widely around the world. That brought to my mind an email conversation I had with a young Russian living in London almost fifteen years ago but it sounds like it was just yesterday. It was rather shocking to me then, but it is important and educational to hear how others think about their own culture and think about ours. Here it is: “Dialog with Denis-a young Russian living in Europe”

Hopes for the New Year

We each have our own beliefs, customs, and preferred lifestyles. But we live together in communities and nations with others who have their own beliefs, customs, and preferred lifestyles. Generally, each of us doing our own things does not interfere with others doing theirs. But sometimes it does, raising issues of the rules governing those interaction. Our personal freedom and peaceful coexistence with others depend on how wisely we define those rules. Finding and observing an optimal balance of personal freedoms with community restraints and obligations enhances the wellbeing of everyone. The U.S. has a bigger space for personal freedom than most countries and has flourished because of it.

Generally, my freedom of behavior stops where my fist meets your face. What I do with my fist otherwise should not be your concern. But some people (or countries) seem to go out of their way to find behavior by others to object to.  We had no national interest or need to attack Iraq, Syria, Kuwait, Libya, Liberia, Somalia, or Kosovo, to name a few of the countries we attacked in the last twenty years. Two men suing a baker for refusing to bake their wedding cake when another baker across the street would be happy to do it are looking for fights rather than harmony. With the same reasoning: should a website designer be required to design a website for the Ku-Klux-Klan when she disagrees with their message and activities?

Nor is it credible, nor a contribution to the rule based international order meant to keep the peace among nations with divergent political systems, to ignore the rules you expect other nations to follow. “The rule of law-China and the U.S.” The U.S. attack on Iraq violated international law as much as does Russia’s attack on Ukraine. Rather than press China to abide by international trade rules, the U.S. is ignoring them itself.  “WTO ruling-Trump tariffs violate rules” Our bullyish hypocrisy is more than embarrassing. It undermines our international standing and influence and is contrary to our national interest.

With that background, what are my most important wishes/hopes for 2023?

–Stop pushing us into WWIII. Remove the neocons from our government. “Ukraine war-how does it end?”

–End the Russian war on Ukraine. Yes we can (push Ukraine and Russia to the negotiating table) “End the war in Ukraine”

–Fix our immigration laws/policies. https://wcoats.blog/2022/09/23/a-land-of-immigrants/

–Join the Trans Pacific Partnership (now called the Comprehensive and Progressive Agreement for Trans-Pacific Partnership)   “Tony Judt on trade”

–End our Industrial policies. “Industrial policy sounds good but is unsound”

–End our trade protectionism  “Trade protection and corruption”

–Compete with China fairly  “Competing with China”

–Return to our principles re-Israel/Palestine “Dear Congressman Kevin McCarthy”

–Restore Congressional Leadership. Enforce the War Powers Act. Restore regular order and cross aisle cooperation to address real problems. “Our dysfunctional Congress”

–Restore fiscal sanity—balance the Federal budget via spending cuts (especially so-called defense). https://wcoats.blog/2011/04/23/thinking-about-the-public-debt/

–Restore the domestic rule of law (even on Trump): “A reflex U turn from the January 6 Committee”

–Restore the Republican Party to the principals I have always supported—get rid of Trump. “More on Trump acquittal”

–Protect our free speech but restore civility to public debate. “Sacred tension-uncanceling ourselves – Jonathan Rauch”

The above would be a good start in restoring America to the principles and scope of government that made us the Land of the Free – Home of the Brave.

Happy New Year