Followup: Dr. Warren Coats offers some ideas on how to restore public trust
In this earlier article, Dr. Warren Coats answered some direct questions I asked related to the loss of public trust in public officials and the banking system we see today. In his answers, he provided a link to an article he wrote in April 2015 in which he offered some ideas on how to restore public trust in the monetary and banking systems.
"The growth in the financial services industry has dramatically outstripped the services it actually performs: payments and allocating saving to investment. While experiences have varied around the world, the dramatic growth in bank risk-taking, especially in the U.S., has its origins in President Nixon’s termination in the early 1970s of the global monetary system – the Bretton Woods system – that anchored most currencies to gold and thus to each other, and dysfunctional and distorting tax systems that favor debt over equity.
Regulatory efforts to limit such risk-taking and thus avoid the severe damage to the world economy experienced from the Great Recession of 2008-09 have proliferated the costs of providing financial services and are likely to fail in their objective.
The growth of regulations along with the growth of the size and economic role of governments more generally are propelling the United States and others into the clutches of crony capitalism. Below I will offer some radical suggestions for changing directions.
Floating fiat currencies. The abandonment of the gold standard not only removed an important pillar of stability in international trade and payments, but also freed individual governments, and especially the U.S. government, from the restraining discipline of sound money on deficit financed spending. Financial markets responded to the new world of floating exchange rates by developing instruments to hedge the new exchange rate and interest rate risks."
. . . . . .
"Efforts to counter recessions with monetary policy, something made possible by the abandonment of the gold standard or any other hard anchor to money’s value, have produced serious distortions in the U.S. and other economies as the result of prolonged periods of abnormally low interest rates. In the U.S. the dot.com and the subsequent real estate bubbles combined with the Greenspan put, then the Bernanke put, have encouraged highly leveraged financial risk-taking unimaginable even in the roaring 20s."
. . . . .
The American government’s expansion into many other areas of the economy, including the financial sector, has extended the government’s capture by industry to areas not imagined by Eisenhower.
"It is difficult for the government to objectively serve the public interest while dealing with and regulating industry. The relationship that develops in such a situation often serves the interests of the regulated industry more than the general public. The larger government becomes and the more involved it becomes in the economy, the larger the risks of regulatory capture. The resulting crony capitalism is the enemy of true capitalism as much as its variants socialism and fascism."
. . . . .
"We need a shift in the balance between market and government regulation of financial services toward more market regulation. To achieve this we need a change in the legal and policy foundations on which these markets operate.
Tax system: The least radical but still politically challenging reform of the tax system “would be to abolish corporation tax and to attribute all corporate income to shareholders.” (Martin Wolf, page 336) A more radical tax reform would be the elimination of all income taxes, personal and corporate, in favor of a value added tax as I have proposed in an earlier issue.
In addition to being simple and economically efficient, it would make special interest carve outs much more difficult.
Monetary system: A critical reform is to return to the monetary discipline of a hard anchor to the money supply. The gold standard was such a system but had weaknesses that could be overcome with a broader and more stable anchor (a small valuation basket of goods). The logical starting place is to reform the International Monetary Fund’s reserve asset, the Special Drawing Right (SDR).
The IMF should replace the SDR’s valuation basket of key currencies with a basket of goods and replace the allocation of SDRs with their issue according to currency board rules (see note below). In addition to replacing the U.S. dollar as the international reserve currency this Real SDR would become an ideal anchor to which to peg national currencies, thus restoring a global currency that contributed so much to the expansion of world trade during the classical gold standard era.
Banking system: Modest reforms of the banking system that may be underway are to significantly increase bank capital requirements and to rigorously adhere to a policy of imposing losses from insolvent banks on their owners, creditors and depositors (no bailouts). The combination of these two should greatly increase the safety of banks and the incentive for their investors and customers to monitor their risk-taking and thus to reduce the need for micromanaged supervision from regulators.
A more fundamental reform would be to separate the payment system from financial intermediation services by adopting the Chicago Plan of 100 percent reserves against monetary deposits at banks as proposed by Milton Friedman, Martin Wolf, Laurence Kotlikoff and others. If all monetary deposits were fully backed by deposits of the same amount with the central bank, no further regulations (beyond normal accounting and reporting requirements) would be needed for the payment subsidiaries of banks.
There would be no reason for bank runs and they would do no harm if they occurred. The lending and financial services subsidiary of a bank, or other financial institutions, would be funded with equity, as are equity mutual funds, as is required by Islamic banking, and would thus only require minimal regulation (fit and proper owners and transparency).
These admittedly radical reforms would provide a foundation for the development and operation of the financial sector that could rely very heavily on the regulation of its activities by its owners, investors, and customers with minimal government oversight." . . . . .
Added notes: For some people, a currency board may be a new concept they are not familiar with. I asked Dr. Coats for some help in explaining a currency board as he envisions it and he gave me this reply by email:
"See my book on One Currency for Bosnia. Your link is basically correct (here is the link I sent him) for existing currency boards. My Real SDR currency board would not be backed with the actual goods in the valuation basket, but with government securities of comparable value as a result of critically important "indirect" redeemability. The currency board rule means that the currency issuer is totally passive responding at the price fixed of the valuation basket to supply or redeem its currency in response to public demand for assets of equivalent current market value."
A key point is that "the currency issuer is totally passive" meaning they are not allowed to create currency based on their own desires or as this link explains -- "there can be no fiduciary issuing of money." Also, under a currency board "the central bank will no longer act as a lender-of-last-resort and monetary policy will be strictly limited to that allowed by the banking rules of the currency board arrangement." For more on the concept of "indirect redeemability", go here.
Robert Pringle(former Group of 30)offered these relevant comments by email which I am including here for readers benefit (underline for emphasis is mine):
"The Ikon would work in the same way as Warren's Real SDR except it would not need indirect convertibility. A critical issue all our proposals have to confront was expressed by Martin Wolf in the FT last week (Sept 14). To rebut calls for a hard anchor, or people who say central banks must follow a mechanical rule, such as the gold standard, MW writes:
"The lesson of history seems absolutely clear: a democracy will not accept that money is outside purposeful control. For now and the foreseeable future, we will remain in a world of monetary policy".
We believe on the contrary that central banks have given discretionary policy, inflation targeting with floating rates, etc their best shot and that it has failed. Confusing monetary and price signals caused by activist monetary policies are undermining the prosperity and stability on which confidence in democracy depends.
The challenge is to persuade economists/policy makers of this. With a few exceptions central bankers are a lost cause; the financial sector does well out of the current volatility so there is no powerful constituency for reform." --- Robert Pringle
In addition, Mr. Pringle has two recent blog articles that expand on these issues: