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"Little else is requisite to carry a state to the highest degree of opulence from the lowest barbarism, but peace, easy taxes, and a tolerable administration of justice" - Adam Smith

Apparently HFT is going to bring on the next crash or something

Written by Tim Worstall | Monday 31 March 2014

I confess, I do find myself a little puzzled by the coverage of finance and banking over at The Guardian at times. Are their writers actually inhabiting this same universe that we are or are they phoning it in from some parallel one? Tke this example, worrying about the perils of high frequency trading (HFT):

Cynics may conclude that Goldman's damascene conversion is a PR exercise designed to counter some of the more incendiary material that Lewis is expected to disclose. But they would be wrong. After playing a heroic role in the sub-prime mortgage scandal and Greece's economic ruin, Goldman, like all the big banks, is surely now turning over a new leaf. This is just as well. The consequences of a repeat of the 2008 financial crash, conducted at warp speed, are too terrifying for us mortals to get our heads around. History repeats itself first as tragedy, second as farce, Marx observed. But then he didn't have fibreoptic broadband.

My first confusion is that of course it wasn't trading, at high frequencies or not, that actually caused the crash. The markets that do have high turnovers, at high speed, are things like foreign currency, options, derivatives, and now moving into equities. None of these causwed the slightest problem during the crash. That was all about housing finance, the securitisation of mortgages into bonds that were then sliced and diced. Abnd, notably, very rarely traded after they have been placed with investors.Almost all of these bonds were nearly entirely illiquid, no one trading in them at all a month after issuance. And that's what caused the problems given that some banks had held onto healthy slices of these issues. How we can comare the perils of HFT with something that was hardly traded at all I'm really not sure.

As to why Goldman Sachs might not like HFT, can we at least start with the idea that GS is a greedy, profits hungry, capitalistic firm? Good, thought we could get agreement there. So, what's the effect of HFT? It reduces trading margins: reduces the difference between the buy and sell price of any particular security. Who would be unhappy if this happened? The people who make markets, the people making those buy and sell prices of course. A large part of GS's business is in making markets in things. And if margins collapse as a result of more trading and greater liquidity then GS isn't going to be happy, is it?

But over in Guardian world things seem to be different....

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Think piece: Bitcoin and the English legal system, Part II

Written by Blog Editor | Monday 17 March 2014

Commercial lawyer and ASI Fellow Preston J. Byrne continues to explain why, despite the cries of his inner libertarian, more government involvement in Bitcoin would be a step forward for the cryptocurrency-cum-payment-system, rather than its end.

I should begin by thanking the numerous individuals who privately provided feedback on my proposition that cryptoledgers need law, and therefore the state.

I am pleased to report that the proposition was overwhelmingly opposed, with a few exceptions.

My position, however, remains unchanged. To set the scene for later discussions, I will provide the primary objections and my responses in outline.

Read the whole thing here.

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Regulation seems to cause bank crises, not prevent them

Written by Sam Bowman | Wednesday 12 March 2014

City AM's Pete Spence (formerly of this parish) reminded me of Mark Carney's claims in January that free banking systems are more unstable than regulated ones. I'm not so sure. Take a look at these two charts from George Selgin's Are Banking Crises Free-Market Phenomena?, which mark an x for every instance of a banking panic. The first chart is for unfree systems, the second for free systems:

In this case at least, it looks like the evidence is against Mark Carney.

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Think piece: Bitcoin and the English legal system

Written by Blog Editor | Wednesday 05 March 2014

Commercial lawyer and ASI Fellow Preston J. Byrne explains why, despite the cries of his inner libertarian, more government involvement in Bitcoin would be a step forward for the cryptocurrency-cum-payment-system, rather than its end.

When Mt. Gox went offline last week, taking half a billion dollars’ worth of bitcoin with it, many of the cryptocurrency’s public advocates – some of whom lost “life-changing” sums –  moved swiftly to its defence. Erik Voorhees’ rallying cry, in particular, was a standout piece of Austrian rhetoric, warning against the near-universal social-democratic impulse to “cry out for Leviathan’s intercession” to remedy every petty inequity and misfortune.

This reaction should not be a surprise. Many early adopters, and practically all bitcoin users I know personally, are libertarians (Roger Ver, in his video-recorded post-Gox appeal for calm, can even be seen wearing a voluntaryist lapel pin). Many are mathematicians; few are lawyers. From this outside perspective, I’ve therefore arrived at a conclusion with which most of them will disagree.

To achieve its full potential, cryptocurrency needs a legal system in the traditional sense. It therefore needs a state.*

Read the whole thing.

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Of course the Fed knew about the manipulation of LIBOR

Written by Tim Worstall | Sunday 23 February 2014

Some seem surprised that the Fed knew about the manipulation of LIBOR way back. To which I would respond that of course they did. Everyone knew about it.

Or perhaps I should point out that everyone knew about one set of that manipulation, for there were (allegedly) two.

The first was where trading desks would try to get the rate submitters to edge the rate to benefit their positions. This is illegal, people are being and rightly should be punished for having done this. The second was rather different:

The US Federal Reserve knew about Libor rigging three years before the financial scandal exploded but did not take any firm action, documents have revealed. According to newly published transcripts of the central bank’s meetings in the run-up to and immediate aftermath of the collapse of Lehman Brothers, a senior Fed official first flagged the issue at a policy meeting in April 2008. William Dudley expressed fears that banks were being dishonest in the way they were calculating the London interbank offered rate – a global benchmark interest rate used as the basis for trillions of pounds of loans and financial contracts. “There is considerable evidence that the official Libor fixing understates the rates paid by many banks for funding,” he said.

This is where the banks themselves were not reporting the correct rates. To understand this the details of what is going on here. Each bank reports what rate it can borrow at (please note, what would it cost to borrow, not the rate at which it would lend) in a currency for a term. Top and bottom quotes are taken off and the average is then LIBOR for that currency and term. And what was happening in the depth of those dark days in 2008?

Well, if we look at Northern Rock the rate at which they could borrow was infinite: no one would lend to them. Happily, NR wasn't a reporting LIBOR bank, but HBOS might have been, Llloyds definitely was when it ran into trouble and so was RBS. And that first sign of the coming trouble is that people refuse to lend, short term and unsecured, to those troubled banks. So we've two things going on here. If a bank reports the true, troubled, rate at which it can borrow it is then admitting that it is troubled. In itself this causes further trouble of course.

The second thing is that in those dark days the interbank market essentially froze solid. No one could borrow in size at all: that's why all such borrowings were routed through the BoE.

All of which means that if the banks had been reporting LIBOR properly then rates would have been somewhere between 20% or so and infinity. Which really isn't somehting that any central banker would want to have reported. And the fact that they weren't being so reported was also known to every central banker. Yes, even to the Fed.


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Why is Oxfam lying to us about the Financial Transactions Tax?

Written by Tim Worstall | Thursday 20 February 2014

It's a sad thing to have to say but, sadly, every single word in that video above is a lie. And this is not just to say that of course all acting is a lie: it is to say that the entire basis upon which Oxfam is operating here is incorrect and also that they know that they are incorrect.

Here is their briefing paper which accompanies that video.

A tiny tax could raise as much as €37bn and would be a heroic victory for people and planet above the special interests of the financial sector.

The lie is in there, in that one single sentence.

The Financial Transactions Tax, as proposed, will raise no revenue at all. Indeed, it will lead to a reduction in revenue collected.

Leave aside all the wittering about the evils of HFT (that did not, in any manner, cause the financial crisis). Leave aside their seeming hatred of derivatives trading (none of which had anything at all to do with the financial crisis). Leave aside their ignorance of the fact that it was mortgages which did cause the crisis: and mortgages tend, even when packaged into bonds, not to get traded very much so a transactions tax is going to have no effect on this market. We can even leave aside the views of this year's Nobel Laureate, Robert Shiller, who insists that it was the absence of trade in derivatives on mortgages that aided the bubble in expanding to the point of collapse. And we can even leave aside the views of Diamond and Mirrlees, Laureates both for their studies of taxation, who point out that transactions taxes are a very bad form of taxation indeed.

We can, instead, simply turn to the European Union itself and its own study of the effects of such a financial transactions tax. As I've pointed out before:

No net revenue will be raised by the specific proposals that have been put forward. This will sound strange to those who can see that there will indeed be revenue coming from the tax, but that is because while there will indeed be revenue from the tax itself there will also be falls in revenue from other taxes. The net effect of this is that there will be less revenue in total as a result of an FTT. But of course, do not just take our word for it. That of the European Commission should be sufficient1:

‘With a tax rate of 0.1% the model shows drops in GDP (-1.76%) in the long-run. It should be noted that these strong results are related to the fact that the tax is cumulative and cascading which leads to rather strong economic reactions in the model.’ (Vol. 1 (Summary), p. 50)

Revenue estimates are as follows: ‘[A] stylised transaction tax on securities (STT), where it is assumed that all investment in the economy are financed with the help of securities (shares and bonds) at 0.1% is simulated to cause output losses (i.e. deviation of GDP from its long-run baseline level) of up to 1.76% in the long run, while yielding annual revenues of less than 0.1% of GDP.’ (Vol. 1 (Summary), p. 33)

A reasonable estimate of the marginal rate of taxation for EU countries is 40-50% of any increase in GDP. That is, that from all of the various taxes levied, 40-50% of any increase in GDP ends up as tax revenues to the respective governments. Thus if we have a fall of 1.76% in GDP we have a fall in tax revenues of 0.7-0.9% of GDP. The proposed FTT is a tax which collects 0.1% of GDP while other tax collections fall by 0.7-0.9% of GDP. It is very difficult indeed to describe this as an increase in tax revenue.

There are, however, bureaucratic reasons why the European Commission might still suggest such a tax move. The revenues from the FTT would be designated as the EU’s ‘own resources’, that is, money which comes to the centre to be spent as of right; not, as with the current system, money begrudgingly handed over by national governments. The EU bureaucracy therefore has a strong interest in promoting such a change. What’s in it for the rest of society is harder to spot.

This result is not unexpected. When the Institute for Fiscal Studies looked at the impacts of the UK’s own FTT, Stamp Duty upon shares2, they found much the same result – from the same cause too. Such a transactions tax upon securities lowers securities prices. This then makes the issuance of new securities more expensive for those wishing to raise capital. More expensive capital leads, inexorably, to less of it being used and thus less growth in the economy.

Please note that this is not some strange application of the Laffer Curve argument. It is not to say that lowering all taxes, or any tax, leads to such extra growth that revenues increase. Rather, it is derived from Diamond and Mirrlees (1971)3 that transactions taxes multiply then cascade through the economy. They are therefore best avoided if another method of achieving the same end is available. Indeed, they point out that taxation of intermediate inputs is to be avoided if possible – better by far to tax final consumption or some other final result of the economy. This very point is acknowledged in the way VAT is structured. Rather than a series of sales taxes which accumulate as one company sells to another along the production chain, there is a value added tax which amounts to one single rate at the point of final consumption. That this point is recognised in a major part of our taxation system suggests that it might be wise to recognise it with regard to the FTT.



3 Diamond, P. A. and J. A. Mirrlees (1971) ‘Optimal Taxation and Public Production II: Tax Rules’, American Economic Review, 61, 3, 261-78.

And yes, I do know that Oxfam are aware of this paper and of the basic truth contained within it. For I have discussed it with them. And their response is, well, umm........*crickets*.

An FTT would raise no net revenue: therefore all tales about how lovely things have been done with the revenue it will not raise are, well, what do you want to call it? Untruths? Misleading? Something stronger?

I would point out that that paper of mine above has been peer reviewed: something I doubt has happened to Oxfam's press release or video. Perhaps that's why the House of Lords Sub-Committee that looked at this proposal believed me not them.

Just as an interesting little update to this story I posted from this same paper in the comments section of The Guardian. On a Bill Nighy piece commending the FTT. Indeed, I used exactly the same quote. And of course the moderators deleted it near immediately.

Comment is free indeed.

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The annuities market

Written by Tim Ambler | Saturday 15 February 2014

The Financial Confusion Authority (FCA) has just spent a year, and a massive amount of our money, discovering that some annuities are better value for money than others. Fancy that!  Some brands of corn flakes are better value than others too.  Some brands of corn flakes are more trustworthy than others and the same applies to annuity providers.  Consumers consider it good use of their money to pay a premium for security.  And who is the FCA to tell them that they shouldn’t?  According to the FCA, differing annuity payments means the market is “disorderly”.

They now intend to spend a further year considering what to do about it, i.e. interfere further in the market and thereby raise the total costs for all buyers of annuities.  Yes, of course financial markets need regulation, as do all markets, but the excessively detailed interventions we have witnessed since Gordon Brown gave us the Financial Standards Authority have eroded the very value for money these regulators were set up to achieve.

Regulators were created to bring about fair, competitive markets and then step away leaving choice to consumers.  Of course this means that the necessary information should be provided, be it the weight of a packet of potatoes or the amount of the annual annuity. The consumer is not helped by information being excessive or over-complex.  The regulator should be able to specify the key facts to be provided by annuity sellers in two days, not 12 months.

The primary mission of any organisation is to survive and, better, to grow.  The FCA is no exception.  The reality, as has been shown before (“I dreamed a dream of the FCA” 29 April 2013 and other ASI blogs and publications) is that the FCA is unnecessary.  The little it achieves could be handled by the Financial Ombudsman Service and Office of Fair Trading.

They key lesson from these two years of FCA self-promotion is that it is struggling to justify its existence.

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How Scotland could flourish by unilaterally keeping the pound

Written by Sam Bowman | Friday 14 February 2014

Between 1716 and 1844, Scotland had one of the world’s most stable and robust banking systems. It had no central bank, no lender of last resort, and no bank bailouts. When banks did fail, it was shareholders who were liable for paying back depositors, not taxpayers. Scottish GDP per capita was less than half of England’s in 1750; by the end of the era in 1845 it was nearly the same. Now that George Osborne has ruled out a currency union if Scotland votes for independence, the Scots have an opportunity to return to this system more seamlessly than any other place in the world could.

As I said to the press this week, there’s nothing really stopping Scotland from continuing to use the pound unilaterally. (Unless the remaining UK introduced strict foreign exchange controls, which would be absolutely crazy.)

What the Chancellor's announcement actually means is that the Bank of England (BoE) would no longer consider Scottish interests when it determines monetary policy and that illiquid Scottish banks would no longer be able to use the BoE as a Lender of Last Resort.

I’m not sure that the first point really matters at all. Scotland’s five million people can’t have much of an influence over the BoE’s policy for the UK’s 63 million people as it is. And, frankly, I’m not sure the BoE knows what it’s doing well enough for it to matter whether it cares about you or not.

The second point is the interesting bit. George Selgin has pointed to research by the Federal Reserve Bank of Atlanta about the Latin American countries that unilaterally use the dollar. Because these countries – Panama, Ecuador and El Salvador – lack a Lender of Last Resort, their banking systems have had to be far more prudent and cautious than most of their neighbours.

Panama, which has used the US Dollar for one hundred years, is the most useful example because it is a relatively rich and stable country. A recent IMF report said that:

“By not having a central bank, Panama lacks both a traditional lender of last resort and a mechanism to mitigate systemic liquidity shortages. The authorities emphasized that these features had contributed to the strength and resilience of the system, which relies on banks holding high levels of liquidity beyond the prudential requirement of 30 percent of short-term deposits.”

Panama also lacks any bank reserve requirement rules or deposit insurance. Despite or, more likely, because of these factors, the World Economic Forum’s Global Competitiveness Report ranks Panama seventh in the world for the soundness of its banks.

I suspect that there would also be another upside. Following Walter Bagehot, central banks are only supposed to lend to illiquid banks, not insolvent ones. Yet since the start of the Eurozone crisis the ECB has clearly made significant bond purchases to prop up both insolvent banks and insolvent governments. This may have been a lesser evil than letting them collapse altogether, but it’s hard to say that this kind of moral hazard is not present.

So, given that some countries do survive and even flourish without a central bank, how would Scotland do it?

The basic mechanics, I think, would be this: in a hangover from the old free banking period, Scottish banks currently issue their own banknotes. After independence, they could continue issuing their own notes that entitle the bearer to GBP on demand. BoE pounds, in other words, would be the 'base money' that Scottish banks use to back their own private currencies, in the same way gold was used during the last Scottish free banking era.

A banknote from a Scottish bank would be, in effect, a promissory note redeemable on demand in BoE-issued pound sterling. (Scottish notes are already promissory notes, but issuance is closely regulated by the BoE.) Of course, there should be nothing stopping banks from issuing notes redeemable in something else, like US Dollars, gold, Bitcoins, or Tesco Clubcard points. Scottish banks would have to arrange private clearing houses, as they did in the last free banking era, to provide loans to illiquid banks, or they could follow Panama in simply maintaining very high reserves.

No bank would have monopoly privileges: any ‘bank’ could issue notes and it would be up to the market to decide whether to accept them as money or not. As Selgin explains here, banks free to issue their own notes will set their reserve ratios according to people's demand for money, stabilising nominal spending.

With respect to other regulations, I quote Selgin again:

"It is, in any event, desirable that there be no Scottish public authority capable of bailing out insolvent banks and of thereby introducing a moral hazard. Deposit insurance should be resisted for the same reason. Foreign banks should be admitted, by way of branches rather than subsidiaries, and should enjoy the same rights as Scottish banks. (Of course the major "Scottish" banks are themselves no longer really Scottish anyway.) Finally, re-establishing some form of extended liability (though not necessarily unlimited liability) wouldn't be a bad idea."

We take no position on Scottish independence — it is up to Scottish voters to decide. And while a return to free banking in Scotland may seem fanciful, this week’s announcement makes it much more likely. Keeping the pound and treating it as the ‘specie’ on which banks can base their notes would make the transition virtually seamless for the average Scot, while giving them a banking system that is unrivalled anywhere in the world for being stable, open, and free.

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Why financial regulation fails

Written by James Hamilton | Monday 10 February 2014

The supposed prime objective of banking rules and regulation is to protect and reduce risk. As the credit crisis has clearly demonstrated regulation has failed to do so. Despite this the proposed solution is more regulation.

Rules and regulations are focused on mechanically risk weighting loans and allocating capital against that perception of risk in a prescribed formula that sounds complicated and is complicated. The capital charade and secrecy with government backing for large banks and almost all deposits means market scrutiny is all but removed from the banks. Detailed P&L and balance sheet data only goes to a few regulators opposed to the many that deposit, invest and research the banks thus limiting market review, risk assessment and analysis.

There is also a major skill set asymmetry with the many PhD brains of the banks easily able to outwit a few £60,000 a year PRA and BoE staff. Consequently the SIV CDO3, inverse IO and many other regulatory compliant but circumventing structures and strategies are created. The fixed formula driven official capital ratios all look to be unchanged at a level we are told is strong. The risk weighting of a loan to a business that is 1000% geared with no sales is the same as a loan to a 1% geared business that has a 50% operating margin from 50 year government contracts. The market would never be so simplistic and will always look forwards opposed to regulators that tend to look backwards. The market would allow much more leverage for genuinely low risk lenders and require much less for high risk lenders.

Today all banks essentially work to a very similar core capital ratio. The regulation based system allows banks to disclose as little as possible to as few as possible, complicating obscuring and circumventing. A market based system would encourage transparency, simplicity and full disclosure to as many as possible. Without regulation there would be little restriction on new banks being created and consequently there would be more specialists and more competition.

The abolition of regulation would make banks less risky. With banks that are too big to fail and deposit protection all banks can borrow cheaply regardless of the risks they take. Removing this will require banks who want cheap deposits to prove they are worthy of them. A market based pricing structure will be created with each bank having to fight for its funding. With very low real deposit returns the demand for disclosure, balance sheet transparency, simplicity and capital strength will be high. Where this is not the case real returns for depositors will be high.

With depositors now determining how much capital is required for any given deposit cost the subordinated debt now, now not ranking in line with the depositors will be priced based on the preference and equity capital structure. Today return on equity is maximised by reducing equity as much as the rules will allow with there being no correlation between capital strength and funding cost. In a market driven world the key funding cost will fall as equity increases. The correlation analysis below shows not only that pre-crisis capital and risk were inversely correlated, but also that risk and return were even more strongly inversely correlated. The strongest inverse correlation is, however, between Growth and Risk.

With rules based regulation that evolves slowly and usually only changes after a major problem banks can easily manipulate their balance sheets to comply with the letter if often not the spirit of the regulation. With the market/depositors setting a bank’s funding cost, the risk perception and analysis of anything new, complicated, or unclear should immediately impact the bank. Consequently the banks focus will shift to genuine economic profit based risk and reward analysis opposed to regulatory arbitrage.

Over time better banks will secure more funding at better terms rewarding appropriate risk assessment with those who operate inappropriately way failing. Evolution will be returned to the banking sector by the removal or regulation. Largely unregulated sectors such as retail have evolved rapidly providing customers with the Amazon service they desire replacing the Woolworths service they do not.

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The positive money idea refuses to die

Written by Tim Worstall | Saturday 08 February 2014

This idea is being given another run around in The G today.

But the 1844 law was never updated to apply to electronic money and still only applies to paper notes. Metal coins and paper notes now make up just 3% of all the money in the UK. The remaining 97% of money consists of essentially numbers in high street banks' computer systems. Banks create this electronic money through a simple accounting process whenever someone takes out a loan.

Yup, same ol' same ol'.

If the Bank of England created all that electronic money instead of the private banking system creating it then we'd be in the clover. And as ever, the idea just doesn't work. Consider just this one point:

Government finances would receive a boost, as the Treasury would earn the profit on creating electronic money, instead of only on the creation of bank notes. The profit on the creation of bank notes has raised £16.7bn for the Treasury over the past decade. But by allowing banks to create electronic money, it has lost hundreds of billions of potential revenue – and taxpayers have ended up making up the difference.

OK, that number for seigniorage is roughly correct on the physical money. But what's wrong with the number for electronic money? Hundreds of billions? Well, the contention is that this value has been created by those private banks: that's how, if the BoE creates it instead then the BoE gets that hundreds of billions in revenue. Excellent: so, if the private banks have been creating all this money then those private banks must have been making those hundreds of billions. Or someone, somewhere, has been.

And the thing is, there just isn't anyone out there who has that hundreds of billions. There just ain't. Therefore, somehow, the creation of that credit (to give it its proper name, not money) doesn't carry a seigniorage profit of hundreds of billions. And thus the BoE cannot appropriate that non-existent seigniorage by doing the credit creation directly.

I agree entirely that it is indeed the banking system (but not an individual bank) that creates credit. But there isn't some hundreds of billions of profit to be made out of doing so: for no one is in fact making that hundreds of billions. Thus it's not possible to the Bank of England to appropriate that hundreds of billions.

It's interesting to note that this idea is backed by Andrew Simms of Not Economics Frankly fame. Sigh.

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