Free vs Regulated Banking: Did Canada's Glass-Steagall Safeguard its Banks in 2008?

(Spoiler: Canada didn't have a Glass-Steagall)

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The Cautious Optimism Correspondent for Economic Affairs and Other Egghead Stuff explores Glass-Steagall regulations as they relate to the Canadian banking industry and the 2008 financial crisis.

Sen. Carter Glass and Rep. Henry Steagall

During the 2008 Great Financial Crisis it became stylish in some circles to blame the upheaval on the repeal of a single provision from the 1933 Glass-Steagall Act: the separation of commercial banking from investment banking. In the fifteen years since Senator Elizabeth Warren has been one of the loudest and most consistent voices blaming the 1999 partial repeal, known also as the Gramm-Leach-Bliley Act, for the crisis.

Aside from the fact Glass-Steagall never existed in European countries like France, Germany, and the UK, all of which avoided systemic financial crises for 75 years, there are several problems with the “bring back Glass-Steagall” theory:

Due to the Johnny-come-lately nature of Gramm-Leach-Bliley, virtually no integration of commercial and investment banking had even taken place in the United States before 2008. Critics blame the crisis on a massive union of business lines that didn’t yet exist.

And an even bigger problem is that Canada has had integrated commercial and investment banking operations at its major banks for a much longer time than the USA. In stark contrast to the USA, by the 2000’s decade all of Canada’s “Big Five” commercial banks had long-since integrated investment banking into their operations.

According to the Glass-Steagall lobby Canadian banking should have suffered an even larger crisis than the United States in 2008, yet it experienced no crisis whatsoever.

GLASS-STEAGALL DURING THE GREAT DEPRESSION

First let’s quickly review what Glass-Steagall was: a Great Depression-era series of banking reforms cosponsored by Representative Henry Steagall (D-AL) and Senator Carter Glass (D-VA) who chaired their respective House Banking and Senate Appropriations committees.

Also known as the Banking Act of 1933, Glass-Steagall contained four major provisions:

1. The introduction of federal deposit insurance through the establishment of the FDIC

2. The creation of the Federal Open Market Committee (FOMC) to conduct monetary policy

3. Regulation Q: Prohibiting banks from paying interest on demand deposits and strict limits on interest paid for other forms of deposits (repealed in 1980)

4. The separation of commercial banking and investment banking activities within the same institution (repealed in 1999)

Ironically, only one of the four provisions did anything to help avert future banking panics (deposit insurance) and two of the provisions were actually anti-competition measures designed to protect politically favored banks (deposit insurance and Regulation Q).

Both anti-competitive provisions were championed by Henry Steagall who represented an unstable unit banking state. Regulation Q was meant to stop monopoly unit banks from losing customers to other monopoly unit banks in neighboring counties, and deposit insurance was designed to protect unit banks from their own unstable structure: undiversified loan portfolios and undiversified depositors stemming from state laws limiting them to a single office in small, rural towns.

The creation of the FOMC can be argued to have actually made the banking system more unstable as monetary policy, the Fed’s buying and selling of assets to manipulate interest rates and the quantity of reserves in the banking system, has produced larger and more destructive credit boom-bust cycles.

And lastly the separation of commercial and investment banking was written at the insistence of one man: Carter Glass—who was convinced in his strange belief that a crossover between lending deposits and underwriting securities caused the great banking crises of the early 1930’s.

However even mainstream economists have recognized for decades that the depression-era crises were due to unit bank laws and the multiple failures of the Federal Reserve. Of the over 9,000 banks that failed between 1929 and 1933 the vast majority were small unit banks in rural areas, hardly active in underwriting new Wall Street stock offerings or corporate bonds.

Nevertheless, Glass’ powerful Appropriations Committee chair provided the clout to successfully push the investment banking provision into law.

AMERICAN INVESTMENT BANKS IN THE 2000’s

The legal barriers separating commercial and investment banking were repealed in November of 1999 meaning financial institutions only began working on merger/acquisition prospects in 2000 and 2001. 

Most did not.

And a key fact many proponents of Glass-Steagall are unaware of is by early 2008 all of America’s leading five investment banks:

-Goldman Sachs
-Morgan Stanley
-Merrill Lynch
-Lehman Brothers
-Bear Stearns

…and top five commercial banks:

-Citigroup
-Bank of America
-JP Morgan Chase
-Wachovia
-Wells Fargo

…were still standalone entities with little to no crossover activity. 

The Big Five investment banks had not merged with any major commercial bank, and the Big Five commercial banks had not merged with any major investment bank.

Despite actively seeking to combine their commercial and investment banking operations, there simply hadn’t been enough time for suitable market conditions to produce attractive merger propositions. And attempts to grow crossover divisions organically were miniscule and slow with Citi and JP Morgan being the closest to having any meaningful investment banking activity at all.

In fact far from having combined in the early 2000’s, it was the financial crisis itself and near-failure of several investment banks that finally gave America’s commercial banks the golden opportunity they had been waiting for: the chance to acquire a major investment bank and finally enter the securities underwriting, M&A, wealth and asset management, and sales and trading businesses writ large. 

In early 2008 J.P. Morgan rescued Bear Steans from collapse through an eleventh-hour government-brokered acquisition. Regulators hoped the buyout would avert a wider financial crisis (they were proven wrong within a few months).

And in a notorious government-pressed shotgun wedding Bank of America bought Merrill Lynch during the depths of the 2008 fall crisis.

Incidentally, the J.P. Morgan/Bear Stearns and Bank of America/Merrill Lynch rescues would have been illegal under Glass-Steagall’s original restrictions. Had the rules not been repealed in 1999, the number of major investment bank failures would have grown from one of the Big Five (Lehman Brothers) to three (Lehman + Bear + Merrill), deepening the crisis and subsequent Great Recession.

Today only two of the original five investment banks remain independent entities: Goldman Sachs and Morgan Stanley.

RESILIENT CANADIAN INVESTMENT BANKS

Canada once had its own version of Glass-Steagall: the so-called “Four Pillars” that separated commercial banking, investment banking, securities trading, and insurance.

In 1987 the conservative Mulroney government freed the first three pillars to be integrated (leaving insurance separated out). The so-called financial “Little Bang” allowed commercial and investment banks to merge a dozen years before U.S. Congress passed the Gramm-Leach-Bliley Act.

Right away Canada’s “Big Five” commercial banks began acquiring securities trading and underwriting firms. Each of their first forays were:

-1987: Toronto Dominion Bank acquires TD Securities*
-1987: Bank of Montreal acquires Nesbitt Thompson
-1987: CIBC acquires CIBC Securities*
-1988: Royal Bank of Canada acquires Dominion Securities
-1988: Scotiabank acquires ScotiaMcLeod*

(* indicates rebranded name)

By the early 2000’s all of Canada’s Big Five had fully integrated investment and securities divisions into their business models, following the so-called “financial supermarket” strategy that had already taken hold in Europe and Asia. By 2008 a few Canadian superbanks were also major players on the global investment banking stage—RBC/Royal Bank of Canada, Toronto-Dominion Bank, and arguably BMO Bank of Montreal and CIBC.

Today each of the Big Five’s comprehensive investment bank divisions are:

-RBC Capital Markets
-TD Securities
-Scotia Global Banking and Markets
-BMO Capital Markets
-CIBC World Markets

According to Glass-Steagall proponents Canada’s megabanks should have gone down in flames. Yet they all sailed through the 2008 financial crisis, remaining profitable throughout with none taking even a penny of government money.

American Enterprise Institute scholar Alex Pollock summarizes this obvious dilemma for Glass-Steagall proponents when he writes…

“Our neighbors to the north in Canada have a banking system that is generally viewed as one of the most stable, if not the most stable, in the world. The Canadian banking system certainly has a far better historical record than does that of the United States.”

“There is no Glass-Steagall in Canada: all the large Canadian banks combine commercial banking and investment banking, as well as other financial businesses, and the Canadian banking system has done very well. Canada thus represents a great counterexample for Glass-Steagall enthusiasts to ponder.”

-from “Glass-Steagall never saved our financial system, so why revive it?” 

Pollock's article can be read at:

https://thehill.com/blogs/pundits-blog/finance/337289-glass-steagall-never-saved-our-financial-system-so-why-revive-it/

A FAMILIAR STORY

So why, if Canada’s combined commercial and investment banks didn’t experience crisis in 2008, did so many of America’s standalone commercial banks and investment banks fail or need government bailouts to survive?

The answer, once again, is bad regulations.

The American mortgage lenders, commercial banks, and investment banks that came under strain in 2008 got that way not because of nonexistent commercial and investment bank mergers but rather due to old-fashioned bad loans.

Federal government regulations forced U.S. lending standards down, particularly on residential mortgages, while GSE’s Fannie Mae and Freddie Mac offered to buy up lousy loans, package them with better loans, and sell the bundled securities to investors to the tune of trillions of dollars.

Bear Steans, Merrill Lynch, and Lehman Brothers joined the securitization party and found themselves holding toxic mortgage paper when the music stopped.

Combined with a historic housing bubble inflated by Federal Reserve cheap money policies, U.S. lenders suffered huge losses when the bubble burst, housing prices plummeted, and uncreditworthy borrowers stopped paying their mortgages.

The culprits were simple and familiar: a central bank-induced bubble and bad loans on the traditional mortgage side.

And as we reviewed in a previous column the Canadian government—particularly the Canadian Senate--has been far less amenable to accommodating populist political movements seeking to transform banks into tools of social justice. 

Hence when the financial crisis struck, Canadian banks held up—because they hadn’t made nearly as many bad loans, or more precisely hadn’t been required to make as many bad loans via regulation.

Far from the partial repeal of Glass-Steagall being the cause of the U.S. system’s problems, the full integration of commercial and investment banking in Canada proves precisely the opposite: Canada’s financial supermarket model held up in 2008 while in the United States, where no major commercial and investment banks had combined in the 2000’s, the financial sector fell into disarray.

CNN Crew Robbed in San Francisco While Reporting on City Crime Wave

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The Cautious Optimism Correspondent for Left Coast Affairs and Other Inexplicable Phenomena hopes CNN called the police, except CNN's reporting has routinely promoted defunding the police.

Oh well then, good luck catching the perps on your own!

Read "CNN reporter reveals her crew was robbed in San Francisco while covering city's rampant crime" at:

https://www.foxnews.com/media/cnn-reporter-reveals-her-crew-robbed-san-francisco-while-covering-citys-rampant-crime-ridiculous

Quotes on SVB: A Regulatory or Supervisory Failure?

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TV guest comments overheard by the Cautious Optimism Correspondent for Economic Affairs:

Reporter: "Is it a foregone conclusion that we are now going to see more regulations? Maybe an expansion of the concept of SIFI to some of these larger regional banks?"

Answer: "Can I make a statement? There is nothing, absolutely nothing that the Federal Reserve, the FDIC, and the California Department of Financial Institutions could not have done to manage SVB. This is so simple to see what was in that company."

"You don't need anything from Congress to tell these people how to do their job. They failed to do a very simple job of insuring that there was diversification, particularly in this case, with interest rates [rising rapidly], to make sure this is a safe and sound bank."

-Richard Kovacevich, former CEO Wells Fargo 

(incidentally Kovacevich refused to take federal money during the 2008 financial crisis but was threatened by the Treasury Department to take it or else)

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“Let’s be honest. Banking supervisors are nearly omnipotent when it comes to the banks they supervise. There’s no mystery. They can see everything. They can force banks to do whatever they want."

"They didn’t see this problem. I mean it was hiding in plain sight. It wasn’t like this duration mismatch was hiding under a barrel somewhere in the bowels of the bank. It’s very, very public, very open. It didn’t occur to the regulators that this is something we should be watching.”

-Pat Toomey, former US Senator (R-PA) and member of the Senate Banking Committee

When You’re a Regulation Hammer Every Problem Looks Like a Nail

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"I don’t think that [2018 rule changes] had any effect. I don’t think there was any laxity on the part of regulators in regulating the banks in that category, from $50 billion to $250 billion.”

-Barney Frank, co-author of the 2010 Dodd-Frank Act

7 MIN READ - The Cautious Optimism Correspondent for Economic Affairs and Other Egghead Stuff finds himself in the predictable position of warding off zombies already blaming “Trump” and “deregulation” for SVB’s collapse.

Chris Dodd and Barney Frank

So with all the news about SVB’s failure the Left and the press (sorry, I repeat myself) have once again become overnight banking virtuosos and are already blaming Trump and deregulation for the bank’s collapse.

In the nation’s capital Senator Elizabeth Warren has complained SVB would never have failed were it not for Trump’s 2018 partial rule changes to some aspects of the 2010 Dodd-Frank Act, even as she’s been trying yet again to expand the Community Reinvestment Act to force a whole new set of institutions beyond just banks to grant large mortgage loans to low-and-moderate income borrowers. (Anyone remember 2008?)

Meanwhile one of Forbes’ token pro-climate change, pro-more regulation columnists was hair-trigger quick to jump on the SVB failure as an opportunity to blame “Trump’s deregulations” too. 

SVB failed on Friday and by Sunday morning Maya Rodriquez Valladares’ article was already pointing fingers.

You can read “How Trump’s Deregulation Sowed The Seeds For Silicon Valley Bank’s Demise” at:

https://www.forbes.com/sites/mayrarodriguezvalladares/2023/03/12/how-trumps-deregulation-sowed-the-seeds-for-silicon-valley-banks-demise/

However after reading over the specific deregulations Valladares blames (I’ll refer to her as Valladares, not Rodriguez), it appears she was in such a hurry to blame Trump that she didn’t even check if the changes in bank supervision rules she cites had anything to do with SVB to begin with.

In fact, nearly every change she cites—many of which are being repeated all over the Internet and in the press—never applied to SVB, and the one change that did apply didn’t matter since SVB was already voluntarily complying with even higher standards at the time (more on that in a moment).

FIVE COMPLAINTS

Nearly all of Valladares’ complaints have to do with Trump signing a 2018 law that raised the asset limits that subjected larger banks to stricter reporting or stress test rules.

Keep in mind as you read these grievances that in its last SEC-filed financial report—the December 2022 10-K—SVB Financial Group held $211.8 billion in assets.

From Valladares:

“Thanks to Trump and his supporters this all changed. Some of the key changes that EGRRCPA [Economic Growth, Regulatory Relief, and Consumer Protection Act] made were:”

1) “Immediately exempting bank holding companies with less than $100 billion in assets from enhanced prudential standards imposed on SIFIs under Section 165 of the Dodd-Frank Act.”

This rule was irrelevant because SVB had more than $100 billion in assets, not less, and not only when it failed but also going back to late 2020.

Non-sequitur #1.

But not to worry, Valladares also points out that other changes included:

2) “Exempting bank holding companies with between $100 billion and $250 billion in assets from the enhanced prudential standards.”

OK, between $100 and $250 billion. That includes SVB. She must be onto something here, right? Well, just what are those “enhanced prudential standards?” Read on.

“This would then allow national bank regulators like the Federal Reserve to impose what are called enhanced prudential standards. These include rules about:”

“-capital, which purpose is to sustain unexpected losses,”

“-liquidity, including calculating the liquidity coverage ratio (LCR) and liquidity stress tests, and”

“-bank resolution plans, referred to as living wills.”

So without those enhanced standards SVB must have let their capital and liquidity ratios slide into dangerous territory, right?

Not if you actually bothered finding the numbers in SVB’s 10-K.

Starting with capital ratios, the bank’s ability to cover losses, regulators required SVB to maintain what are called CET1 (Common Equity Tier) and Tier 1 risk capital ratios that exceed 7.0% and 8.5% respectively.

In December 2022 SVB’s CET1 and Tier 1 risk capital ratios were 12.05% and 15.40%.

But wait, Valladares says the requirement was lowered by Trump's rule changes. SVB should have been treated like a bigger bank and subjected to higher capital ratio requirements.

Well fortunately for us we can compare SVB’s capital ratios against those of America’s very largest, and according to Valladares most strictly regulated, “Big Four” money center banks at the end of 2022.

(URL links to SVB’s 10-K and the Big Four banks in the comments section)

CET1 and Tier 1 capital ratios:

-SVB: 12.05% and 15.40%

-Wells Fargo: 10.60% and 12.11%

-Bank of America: 11.2% and 13.0%

-Citigroup: 13.03% and 14.80%

-JP Morgan Chase: 13.2% and 14.9%

Unfortunately for Valladares SVB’s CET1 capital ratio was already higher than two of America’s “Big Four” national banks that comply with those stricter standards, and its Tier 1 capital ratio was higher than all four.

Non-sequitur #2.

3) How about the liquidity coverage ratio?

It’s true that being under the new $250 billion limit SVB wasn’t subject to as strict rules about liquidity as banks over $250 billion.

But let’s look again at their 10-K. 

It states SVB was not required to publish its official liquidity cover ratio (LCR) which upsets Valladares.

OK, LCR calculations are complicated, but the definition of the LCR is "the requirement whereby banks must hold an amount of high-quality liquid assets that's enough to fund cash outflows for 30 days."

SVB lost one-quarter of all its deposits ($42 billion) in a single day. For Valladares to suggest regulators setting a slightly higher LCR would have allowed SVB to hold up to that kind of mass exodus for a month—without government or Fed help—is simply fantasy.

And we can measure SVB against larger banks using common liquidity metrics and compare their liquid assets (cash, repurchase agreements, and liquid securities) against their most liquid liabilities (deposits).

Liquid assets/deposits ratio (with liquid assets, deposits):

-SVB: 75.8% ($131.2B and $173.1B)

-Wells Fargo: 52.5% ($724.0B and $1.383T)

-JP Morgan Chase: 68.9% ($1.613T and $2.340T)

-Bank of America: 85.8% ($1.657T and $1.930T)

-Citigroup: 92.0% ($1.257T and $1.366)

So at least by a liquid assets-to-deposits measure, SVB was more liquid than two of America’s “Big Four” money center banks whose liquidity rules Valladares bemoans would have averted SVB’s collapse.

Non-sequitur #3.

4) “Limiting stress testing conducted by the Federal Reserve to banks and bank holding companies with $100 billion or more in assets.”

This is the only complaint of Valladares that actually has a bit of grey area, and she proceeds to omit lots of details unfavorable to her case. 

They won't be suppressed here.

SVB had assets of $212 billion, and its assets were greater than $100 billion going back to late 2020.

The legislation signed by Trump gave the Federal Reserve the power to conduct stress tests for institutions above $100 billion but the regulators themselves—the Federal Reserve consulting with the FDIC and OCC—decided to conduct stress tests on banks between $100 and $250 billion every two years and not require them to meet the more stringent liquidity rules for giant banks.

Valladares leaves out regulators at three different agencies making that decision because it had to be Orange Man.

SVB crossed the $100 billion asset threshold in late 2020 and would have been subject to a stress test in late 2022 but that happened just after the last 2022 testing date, pushing their first test into 2023. 

Meanwhile in between 2020 and 2022 the Fed inflated the money supply by a spectacular $7 trillion, swelling the U.S. banking system’s deposits and assets at a record pace including SVB’s which surged to $212 billion or doubling by the end of 2022.

The Correspondent highly recommends viewing the Fed’s own chart of banking system demand deposits after 2020.

Which really narrows down Valladares’ long list of non-sequiturs to just one argument: “If only there had been a stress test, SVB wouldn’t have failed.”

Of course what’s also implied in her only argument, but which she won’t come out and say is: “And the stress test would have foreseen its special niche Silicon Valley tech startup customers substituting deposits for evaporating VC capital, and also predicted Peter Thiel and other VC moguls telling everyone across social media to pull one quarter of the bank's deposits in a single day before it could even raise capital.”

Sure. 

Not a non-sequitur but a strikeout nevertheless.

5) Valladares repeats herself somewhat complaining that another change was:

“Increasing the asset threshold for ‘systemically important financial institutions’ or, ‘SIFIs,’ from $50 billion to $250 billion.

Designating a bank as a SIFI—defined as a bank whose failure could directly lead to a systemic crisis due to its failure to meet obligations to other banks—would have triggered those stricter capital and liquidity ratio rules. But we've already covered that SVB was already meeting or exceeding those stricter rules anyway.

Also, there are nearly 50 U.S. banks with more than $50 billion in assets—including regionals Frost Bank of Texas, Zions Bancorp of Utah, and Asian clientele East West Bancorp of California. To call them all “systemically important” would be ridiculous which is one reason the rule changes raised the threshold for SIFI designation to $250 billion to begin with.

Even Valladares admits that “While a failing or failed bank may not destabilize the entire national banking system, it sure can destabilize a region. Just ask California how things are going now with the SVB management-caused chaos.”

Well, important to California is not the same as important to the entire U.S. financial system. Perhaps she should suggest a new designation for “regionally important,” but California is not the entire system no matter what some Californians think.

Quite frankly, to apply the word “chaos” to describe California—other than its pre-existing crime, drug, and homelessness problems—due to SVB’s failure is hyperbole. Sure, there were some tech firms temporarily struggling with paying employees and wondering what other institutions to look to for future capital—at least before SVB reopened with Federal Reserve deposit backstops—but the state's financial industry was not thrown into “chaos" by SVB's failure.

Non-sequitur #4.

(Note: the Federal Reserve did redesignate SVB as “systemically important” over the weekend, not because its failure was creating another 2008 financial crisis, but rather because the status change gave the central bank legal authority to free up more resources to facilitate the SVB’s reopening and protect depositors)

OK that’s it for the list. Keep in mind despite her incessant writing about rule changes, SVB and other U.S. banks are still subject to a multitude of Dodd-Frank regulations which collectively are more stringent and far more onerous than those before 2010. Despite her attempt to convey an image of Trump removing every regulation in the book, he in fact was effectively applying Dodd-Frank rules to all banks with more stringent Dodd-Frank rules to America’s largest (systemically important) banks.

Of course Valladares might have hit closer to the mark had she bothered checking SVB’s financial statements first. The Economics Correspondent is no Forbes columnist but knows how to Google SEC filings for publicly traded banks.

But there’s always that audience out there in half of America that only needs to hear the words “Trump” and “deregulation” to go into a woke stupor and foam at the mouth. 

It’s like saying “animal cruelty.” You don’t have to give them specifics. Just say the words and watch them melt down.
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SEC-filed 10-K reports containing capital ratios and liquidity metrics such as cash, repurchase agreements, securities, and deposits.

SVB (pages 13 and 95)

https://d18rn0p25nwr6d.cloudfront.net/CIK-0000719739/f36fc4d7-9459-41d7-9e3d-2c468971b386.pdf

BofA (pages 51 and 30)

https://app.quotemedia.com/data/downloadFiling?webmasterId=90423&ref=117273850&type=PDF&symbol=BAC&companyName=Bank+of+America+Corporation&formType=10-K&formDescription=Annual+report+pursuant+to+Section+13+or+15%28d%29&dateFiled=2023-02-22&CK=70858

Wells Fargo (pages 6 and 87)

https://www08.wellsfargomedia.com/assets/pdf/about/investor-relations/sec-filings/2022/exhibit-13.pdf

Citigroup (pages 9, 140, 141)

https://www.citigroup.com/rcs/citigpa/storage/public/10k20221231.pdf

JP Morgan Chase (pages 91 and 55)

https://jpmorganchaseco.gcs-web.com/static-files/57c2ed73-8a15-47c2-94f0-e9e29ca87e2c

Free vs Regulated Banking: What Does SVB's Collapse Tell Us About Depositor Losses During Canadian Free Banking?

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7 MIN READ - The Cautious Optimism Correspondent for Economic Affairs and Other Egghead Stuff has a few words to write about the warp speed collapse of Silicon Valley Bank (SVB), deposit insurance, and even a connection to his ongoing series on free banking in Canada.

The Economics Correspondent just read today that 87% of failed Silicon Valley Bank’s deposits are uninsured, even though it’s an FDIC member. 

87% of deposits are at risk because the FDIC only insures accounts up to $250,000 per depositor. And SVB, the 16th largest U.S. bank by assets, has many wealthy customers including individuals and businesses who draw on deposit accounts to make payroll.

DEPOSIT INSURANCE

The Economics Correspondent had originally decided not to write in detail on the subject of deposit insurance and depositor losses during Canadian free banking, but SVB’s sudden collapse has provided a timely segue to comment.

Canada had no deposit insurance until Parliament established the Canadian Deposit Insurance Corporation (CDIC) in 1967. 

Although there was never a financial crisis during Canada’s earlier free banking era (1817-1935), isolated banks did fail from time to time since banking is, after all, a profit/loss business just like any other.

Critics of free banking argue that absent deposit insurance customers can become nervous, withdraw their funds en masse, and set off a run which could spread to other banks and spawn systemic crisis (oddly, there has never been a financial crisis in Canada). 

Deposit insurance, they say, assuages such fears and makes the banking system more resilient to runs while protecting customers from losses.

Critics of deposit insurance argue it introduces moral hazard both to bankers and their customers since both sides, aware that government guarantees will cover their losses, become less interested in managing risk.

The moral hazard story, they argue, was evident during the 1980’s S&L Crisis. 

During the late eighties thrifts that had gotten in trouble offered absurdly high deposit interest rates, attracting new funds to make extremely speculative all-or-nothing loans in a desperate attempt to avert failure.

But depositors handed their money to institutions they knew were on the brink anyway, indifferent to anything but high yields since they knew the government would cover their losses if the thrift failed.

Instead of prudence S&L depositors cared only if there was an FDIC or FSLIC sticker in the bank’s window.

Subsequently the final cost of the S&L depositor bailout swelled by tens of billions of dollars, a substantial sum back in the 1980’s and a prima facie example of deposit insurance enlarging both a financial crisis and its bailout price tag.

But critics of uninsured deposits have one more, undeniable piece of evidence to support their case: the empirical history of Canada. During free banking some depositors did lose money in the isolated bank failures that occurred from time to time.

Using historical records economists have estimated that in the latter third of the 19th century total Canadian depositor losses totaled less than 1% of failed bank liabilities across the entire period (Selgin, 2021).

Losses were so small in part precisely because there was no deposit insurance in Canada at the time. Instead bank owners and directors were liable for depositor losses up to double their paid-in-capital stake (ie. double liability). 

Having their personal assets at stake focused Canadian bank owners and directors like a laser on sound lending and credit quality.

(Note: During the same period the United States endured several banking panics where estimated depositor losses totaled 57% of failed bank liabilities)

A Federal Reserve report confirmed the trend all the way until 1931 using assets, which are a rough analog to liabilities, bringing the trend total to about 65 years:

"For the period 1901 to 1920 the assets of suspended banks in Canada amounted to about one-half of one percent of the average yearly banking assets of the country... ...For the eleven year period 1921-1931 the assets of suspended banks in Canada were again equal to about one-half of one per cent of the average yearly banking assets of the country while the corresponding figure in the United States was about twenty times as high, or 10.7 per cent."

-"Branch Banking in Canada," Federal Reserve Committee on Branch, Group, and Chain Banking (1932)

Nevertheless, proponents of deposit insurance maintain that even losses of less than 1% are unacceptable. Depositors, they say, should enjoy guarantees they will lose nothing in the event their bank fails. And the FDIC has made good on that promise, with no one losing a penny in insured deposits since its inception in 1933.

INSURED VS UNINSURED

The key phrase the Correspondent would like to stress here is “insured deposits.” Because deposit balances over the FDIC limit ($250,000 per depositor since 2008) are uninsured and therefore ineligible for compensation.

The Economics Correspondent hasn't been able to find total U.S. *uninsured* deposit losses for the 90 years the FDIC has been in business, and the FDIC understandably isn’t keen on announcing such numbers loudly.

However the recent SVB story is quite informative. SVB’s recent annual report documents that in December of 2022 at least 87% of its deposits were above the FDIC limit and therefore ineligible.

Out of curiosity the Economics Correspondent checked JP Morgan Chase's most recent annual report and found over $1 trillion in uninsured deposits.

Given the sheer amount of money wealthy and business clients have in U.S. banks the Economics Correspondent would venture that depositor losses in America’s two post-1933 crises—the S&L Crisis and the Great Financial Crisis—have far exceeded 1% of liabilities.

In fact we already know something about S&L Crisis losses.

Depositor losses were so great in the late 1980’s that the Federal Savings and Loan Insurance Corporation (FSLIC) itself went bankrupt and had to be absorbed into the FDIC. S&L depositors were stuck holding the bag and the U.S. taxpayer had to make up the difference. 

The S&L bailout ultimately cost taxpayers $132 billion or roughly 15% of the entire industry's liabilities (not just failed institutions as measured in Canada).

Cautious Rockers may also remember the taxpayer was on the hook for over $400 billion in capital injections during the 2008 financial crisis to prevent losses that would have easily bankrupted the FDIC.

Ultimately the $400+ billion was repaid with interest, so unlike 1990 taxpayers weren't forced to permanently subsidize depositors, but the point is without putting a huge amount of taxpayer money at risk the FDIC itself would have become insolvent and uninsured depositor losses would have been enormous.

And this doesn’t even include the smaller waves of bank failures that occurred in the mid/late 1930’s plus the decades worth of intermittent bank failures that have occurred since then.

Hence, even though the Economics Correspondent is having trouble finding uninsured depositor losses for the 1933-2023 period, he’ll still bet a steak dinner with anyone that depositors fared better under Canadian free banking (< 1% losses) than they have in the USA even with the FDIC and FSLIC.

SVB

As for SVB itself, the Economics Correspondent is confident that not all of its 87% in (uninsured) deposits will go unpaid. But there is a reasonable chance that there will be *some* losses.

It all depends on the final disposition of the bank. 

If the FDIC is able to find a buyer for SVB, a large firm that’s willing to take over its assets and liabilities and enter into a loss-sharing agreement with the FDIC, all in exchange for SVB's branch network footprint and customer base, then even uninsured deposits might be made whole.

But if the bank has to be wound down—its assets sold and its liabilities paid off—uninsured depositor losses become much more likely. 

SVB’s balance sheet claims assets in excess of liabilities, but in the rapidly rising interest rate environment of late 2022/early 2023—which is rumored to have triggered the bank’s difficulties to begin with—the mark-to-market value of those assets comes into question.

SVB is a bit different from your average bank in that over half of its assets are securities—not loans—such as Treasuries and mortgage backed securities.

As interest rates have risen rapidly the value of those securities has fallen, and if SVB were to wind down and sell all its securities at depressed rates there might not be enough cash to pay off all depositors.

Of course the FDIC will make up the difference for every depositor up to $250,000 apiece, but anyone with more at stake will be out of luck.

And the FDIC won’t mention those losses… at least not very loudly. And neither will critics of free banking.

====

Postscript: For anyone wondering if the Economics Correspondent is advocating the abolishment of deposit insurance in the United States, the answer is a qualified no. 

The pros and cons of deposit insurance can be complicated, but in a single phrase the Correspondent’s opinion is this: So long as a monopoly central bank, politicians, and all their destabilizing regulations exist, then deposit insurance serves as an imperfect, liability-laden, but nevertheless effective remedy for quelling the panics created by Washington, DC.

However history clearly demonstrates that when politicians haven't interfered with banking systems the industry has functioned extremely well on its own, and that deposit insurance has not only been unnecessary, it has actually introduced moral hazard and greater risk into the system.

In fact the moral hazard problem is precisely why U.S. Congress rejected 150 separate bills attempting to establish federal deposit insurance legislation from 1880 to 1933. It's also why most developed countries didn't introduce deposit insurance until the late 20th century—the United States being one of the first in 1933 only after Czechoslovakia—and Australia and New Zealand had no deposit insurance until 2008.

Free vs Regulated Banking: Canada’s Post-1935 Success and the USA’s Failures

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8 MIN READ - The Cautious Optimism Correspondent for Economic Affairs and Other Egghead Stuff explains Canadian banking’s modern day success and stability with a brief summary of how subprime mortgages played out both in the USA and north of the border.

Some 1990's and 2000's U.S. regulations
 that never existed in Canada

Before 1935 Canada possessed the industrialized world’s least regulated banking system yet never experienced a financial crisis. 

By then the United States, with the industrialized world’s most regulated banking system, had already endured fifteen banking panics going back to 1792.

However since 1935 the Canadian government has caught up with the rest of the world and imposed a great deal more control over its banking industry.

The Bank of Canada is now monopoly issuer of the currency, has unilateral control over the banking system’s level of reserves and interbank lending rates, and provides a lender of last resort to member banks.

Federal deposit insurance was introduced in 1967, and today Canadian regulators impose legal capital ratio requirements on banks, inspect merger requests for antitrust violations, and dictate what types of bank investments are too risky.

Yet even as the Canadian banking system increasingly resembles the USA’s Canada has still managed to avoid a financial crisis—ever.

Meanwhile the United States, even with the imperfect but reasonably effective remedy of federal deposit insurance since 1933, has still managed to suffer through the S&L Crisis of the late 1980’s and the Great Financial Crisis of 2008. 

And while American banks received over $400 billion in bailout loans from the U.S. Treasury in 2008 and 2009, Canadian banks remained profitable during the global GFC and didn’t take a penny from the Canadian government.

WHY STILL DIFFERENT OUTCOMES?

What’s the difference between these two seemingly similar regulatory regimes? Why has Canadian banking continued to enjoy such stability and served as a model to the world while over 80 countries, the USA included, have suffered 140 financial crises—defined as aggregate failed bank losses greater than 1% of GDP—since 1978 (Calomiris, 2010)?

The answer again lies in good versus bad regulation.

First we’ll concede that a monopoly central bank is generally an example of bad regulation, and Canada has one. The Bank of Canada has even recently done the country the disservice of inflating a huge housing bubble, the final outcome of which remains to be seen.

But although central bank-induced asset bubbles are major contributing factors to financial crises, they usually aren’t enough to induce panic on their own. Most monetary economists know it takes more than just the central bank.

The other critical element, notably absent in Canada, is a lowering of lending standards.

And historically the United States has had a lot of that, imposing lower lending standards on its banks via regulation. 

For America’s first 170 years state-level unit banking laws restricted bank branching making it difficult to impossible for banks to diversify their loan portfolios.

Unlike the USA, Canada has never told its banks they can’t branch. 

Also unlike Gilded Age America, the Canadian government never restricted the national supply of currency based on the level of federal debt its banks held. And also unlike the United States, in recent decades the Canadian government hasn’t imposed regulations to openly force banks to lower lending standards in the name of social justice.

MORE RECENTLY: CRA

During the years leading up to the 2008 financial crisis U.S. Congress was able to force American banks to either lend $1 trillion directly to uncreditworthy borrowers or to finance lots of subprime mortgages that were originated by mortgage lenders like Countrywide and GMAC.

All of this was mandated by the 1995 Community Reinvestment Act (CRA), a law that was originally passed in the name of anti-racial discrimination.

Supporters of CRA argue Countrywide and other mortgage lenders were never CRA-regulated, only commercial banks. Therefore, they say, the public should blame the free market for the bad loans of the 2000’s.

But it was the regulatory mandate that forced commercial banks to seek out poor-credit borrowers—not the banking industry’s usual clientele—from mortgage companies to begin with. Regulators imposed the mandates, mortgage lenders provided the shaky borrowers, and CRA-regulated banks had to supply the money.

Hence pardoning CRA for bad loans originated by mortgage lenders is tantamount to exonerating the tax code for tens of millions of annual TurboTax and H&R Block tax returns. “After all, the IRS never forced TurboTax and H&R Block to file all those returns” is the twisted logic. 

But of course it’s the complex tax code that drives taxpayers into the arms of tax preparers every year just as CRA drove commercial bank money towards mortgage lenders.

The CRA-regulated bank/mortgage lender relationship has all but disappeared from online marketing websites since the 2008 debacle, but the Economics Correspondent saved one particularly large marketing pitch from the many he saw in that era from large mortgage lenders offering to help banks satisfy CRA regulatory mandates.

From 2004:

"Countrywide's goal is to meet the Six Hundred Billion Dollar challenge, funding $600 billion in home loans to minorities and lower-income borrowers, and to borrowers in lower-income communities, between 2001 and 2010. As of July 31, 2004, the company had funded nearly $301 billion [!] toward this goal."

"The result of these efforts is an enormous pipeline of mortgages to low-and moderate-income buyers. With this pipeline, Countrywide Securities Corporation (CSC) can potentially help you meet your Community Reinvestment Act (CRA) goals by offering both whole loan and mortgage-backed securities that are eligible for CRA credit."

-Countrywide marketing website (now defunct)

MORE RECENTLY: GSE’S

The Clinton and George W. Bush White Houses ordered Fannie Mae and Freddie Mac, via Department of Housing and Urban Development directive, to purchase more and more low quality mortgages from U.S. banks including CRA loans, bundle them into securities, and sell them off with an implied taxpayer guarantee—all in the name of “affordable housing.”

From the 2000 American Bankers Association Conference:

"We will take CRA loans off your hands–we will buy them from your portfolios, or package them into securities–so you have fresh cash to make more CRA loans. Some people have assumed we don’t buy tough loans. Let me correct that misimpression right now. We want your CRA loans because they help us meet our housing goals.”

-Jamie Gorelick, Fannie Mae Vice Chairman

By the dawn of the financial crisis a minimum of 56% of Fannie and Freddie’s annual mortgage purchases were mandatory “below median income” via HUD directive, and 24% of all mortgages were mandated “special affordable” which was defined as “very low income.” 

(see top chart for visual and note mandate increases in 1996 and 2001)

CANADIAN MORTGAGE LENDING

True to the historical pattern, Canada avoided the 2008 crisis by never having any such laws let alone on such immense scale. 

There is a smaller version of Fannie Mae in Canada –the Canada Mortgage and Housing Corporation or CMHC—but it guarantees less than half the mortgages of Fannie Mae and Freddie Mac as a share of the market. To compare…

By December 2007 Fannie and Freddie held or guaranteed $5.4 trillion in mortgage assets, about half the $11 trillion U.S. mortgage market at the time, and were holding or guaranteeing $3.5 trillion in mortgage backed securities, most of which they had packaged themselves from their low-to-moderate and very-low income purchases (see regulator OPHEO's 2007 chart).

While CMHC is not in the business of holding lots of mortgages, in December of 2007 it did guarantee CA$165 billion or 20.8% of Canada’s then CA$792 billion of mortgage debt (source: CMHC and Statistics Canada).

The United States GSE’s and the Canadian CMHC: Half vs 20.8%. Big difference.

But the biggest difference of all is CMHC’s role. Unlike the 2000’s Fannie and Freddie, CMHC more resembles the pre-Clinton administration Fannie: guaranteeing quality mortgages instead of encouraging unsound lending by buying up huge quotas of junk mortgages in a political social engineering scheme.

All throughout the housing bubble years and beyond, Canadian credit quality was and remains high. Just ask any Canadian homeowner about mortgage lending standards.

Canadian homeowners have to reapply and requalify for their mortgages every five years, effectively making all mortgages adjustable-rate.

There’s no such thing as a 30-year fixed mortgage in Canada which is an almost uniquely American invention—created by FDR with government mortgage guarantees during the Great Depression.

2% down, 1% down, and zero-down mortgages are unheard of in Canada, and the absolute minimum down payment in Canada has only recently been lowered to 5% for balances under $500,000 (10% above $500,000 and 20% above $1 million).

(Note to Cautious Optimism’s Canadian readers: Never having bought a house in Canada, if the Correspondent has slipped up anywhere please post your thoughts in the comments section.)

CANADIAN PARLIAMENT

So how have Canadian banks managed to keep lending standards so high while the U.S. government has beaten American lending standards down? 

Simple. Even though for decades there have been many populist bills floated in the Canadian House of Commons to force banks to lower lending standards, they have consistently been blocked by the more level-headed Canadian Senate.

Now before Canadian readers roll their eyes at the idea of their senators being “level headed,” I only ask them to compare their banking legislative edicts and public demeanor of their senators to that of U.S. senators past and present like Bernie Sanders, Elizabeth Warren, Corey Booker, John Fetterman (may his health improve), Al Franken, or even Senator Barack Obama.

Over many decades the U.S. Senate has passed countless laws that forced or rewarded American banks for lowering lending standards including the creation of the GSE’s, Federal Housing Administration, and the CRA.

But the Canadian Senate, which like the U.S. Senate prior to the U.S. Constitution's 17th Amendment (1913) is not directly elected by Canadian voters, has been far less populist when it comes to tinkering with bank regulation. 

Which is why it was possible for American loan applicants with no job and no income to access vast pools of mortgage credit in the 2000’s while Canadian banks were still allowed to tell such borrowers “no”—and did.

The Economics Correspondent doesn’t know if Canada’s winning streak will last forever. The Bank of Canada has inflated a housing bubble of its own, and should it deflate the banking industry will incur higher loan losses. But the size of such losses is less likely to be catastrophic when lending to more creditworthy borrowers – something Parliament has so far allowed the industry to keep doing.

In our last installment we’ll discuss the question of Glass-Steagall restrictions and Canadian financial stability.

Stubborn PCE: What is "Sticky Inflation?"

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3 MIN READ - The Cautious Optimism Correspondent for Economic Affairs and Other Egghead Stuff offers some color analysis explaining what most news stories reporting “sticky inflation” won’t.

So despite the Federal Reserve’s recent campaign of rapid interest rate hikes, and a great degree of success stopping growth of the money supply in its tracks, the January PCE inflation numbers were still elevated. Month to month headline and core were both up 0.6%.

Although inflation numbers vary greatly from one month to the next, a core month-to-month of +0.6%, compounded over twelve months, translates to an annual inflation rate of 7.4%.

Both are still far higher than the Fed’s 2% inflation target.

(1.006^12 = 1.0744 = +7.44% inflation)

Read more on the PCE report at Bloomberg:

https://www.bloomberg.com/news/articles/2023-02-24/fed-officials-flag-risk-of-sticky-inflation-as-pce-comes-in-hot

So if the money supply is no longer growing, and in fact has actually contracted by 2.2% over the last three quarters, why are prices still rising at a 7.4% clip?

Many business news articles are now blaming “sticky” inflation, but few really explain what’s causing price increases to be sticky in the first place.

Well the Economics Correspondent fingered the potential culprit two months ago, and new data show it’s still to blame: rising monetary velocity.

As we prove it using junior high math, the Correspondent can’t stress enough how valuable the Equation of Exchange is for understanding what causes inflation.

mv = py

Where m = the money supply, v = monetary velocity, or how many times each dollar of the money supply is spent each year, p = the price level, and y = real GDP or the dollar value of all economic transactions in the economy.

If we isolate (p) to understand what makes prices move we get:

p = mv/y.

So if the money supply falls, prices fall. If the quantity of goods and services in the economy grows, prices also fall.

Both have happened the last three quarters (St. Louis Federal Reserve source links are below). From 22Q1 to 22Q4:

-The money supply measured by M2 contracted from $21.846 trillion to $21.363 trillion or -2.2%

-GDP has grown—barely. From 22Q1 to 22Q4 real GDP rose from $19.924 trillion to $20.198 trillion or +1.4%.

Therefore if velocity were constant prices should have fallen the last three quarters by 4.3% (0.978/1.022 = 0.957 or -4.3%).

But they haven’t fallen. They’re still rising.

Two months ago the Economics Correspondent wrote he was concerned about the last variable, M2 velocity, which had risen Q1 to Q3 from 1.14 to 1.19, an increase of 4.39% in half a year.

Compounded over a full year such an increase would equate to a 9% annual increase in prices, and the Correspondent argued the Fed sees this, is probably concerned about it, and is still raising rates because of it.

Well, we have a new quarter of velocity data and the trend is confirmed. In Q4 M2 velocity reached 1.226.

So from Q1 to Q4 velocity increased from 1.14 to 1.226 or up 7.5% which, when annualized, translates to an even worse yearly inflation rate of 10.1%.

Of course velocity is being partially offset by falling money and barely rising GDP, so when we plug all three variables into the equation we get our final nine-month inflation rate:

(0.978 x 1.075)/1.022 = +3.7% inflation.

Extrapolate that out one more quarter for a full year and the Fed is looking at an annualized inflation rate of +5%. That’s lower than the implied January number, but consistent with the Fed’s worries about inflation persisting despite its success slowing and even slightly reversing money supply growth.

And what’s causing velocity to rise? Monetary economists blame “inflation expectations.” That is, inflation itself changes consumer and business behavior, both of whom start moving their purchases forward to buy stuff before it gets more expensive. When consumers and businesses move purchases up the rising velocity itself pushes prices up even higher, leading other consumers and businesses to spend even faster and a vicious cycle can ensue.

The Fed wants to squash those inflation expectations and stop the growth in velocity.

And that’s why it’s still tightening even as the money supply has been falling.
======

Source data:

1) Q1 to Q4 M2: $21.846T to $21.363T

https://fred.stlouisfed.org/graph/?g=10qVq

2) Q1 to Q4 real GDP: $19.924T to $20.198T

https://fred.stlouisfed.org/graph/?g=10qVg

3) Q1 to Q4 M2 velocity: 1.14 to 1.226

https://fred.stlouisfed.org/graph/?g=10qVc

Larry Summers Predicts $2.2 Trillion Average Deficits For The Next Decade

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2 MIN READ - The Cautious Optimism Correspondent for Economic Affairs and Other Egghead Stuff heard former Assistant Treasury Secretary and Harvard President Larry Summers on the radio night before last discussing inflation and the federal government’s fiscal outlook.

Summers cited a Congressional Budget Office Report that forecasts a federal debt-to-GDP ratio of 140% within a decade, up from the current 120.7%.

This ties in to the Economics Correspondent’s depressing article last week outlining how growth and inflation will allow the Treasury to easily run $1 trillion deficits every year forever without raising the debt-to-GDP ratio, and calculations that even $1.8 trillion deficits for the next decade would result in no change to the debt-to-GDP ratio remaining at 120.7%.

Well it’s even worse than that. A hike to 140% of GDP means even bigger forecasted deficits.

The Correspondent hasn’t read the CBO report but let’s go with some conservative assumptions: an average of 2% annualized real GDP growth and 2% inflation over the next decade.

Compounding 2% real GDP growth plus a 2% increase in prices over ten years means current GDP of $26.1 trillion will grow to a nominal $38.8 trillion.

(1.02^10)x(1.02^10)x$26.1 trillion = $38.8 trillion

Since the CBO predicts the debt-to-GDP ratio will rise to 140%, that means the national debt will be $54.3 trillion by 2033.

Today the debt is $31.5 trillion.

Therefore the CBO predicts the debt will grow by $22.8 trillion over ten years.

That’s an average of $2.28 trillion annual deficits we can look forward to, much higher than the $1 trillion the Correspondent argued was easily sustainable.

Right now the projection for 2023 is a $1.4 trillion deficit. But of course as GDP grows over time future Congresses and presidents will run much higher than $1.4 trillion shortfalls to reflect higher nominal GDP—probably well north of $2 trillion by the time 2033 arrives.

And of course if there’s a recession or two in between, falling tax revenues and higher government spending—much higher if Washington is controlled by Democrats who believe in Keynesian economic theories and massive deficit spending to “promote recovery”—will raise the thin years deficits well above $2 trillion.

And the best part is Summers predicts 140% of GDP is too low and that America is on course for a debt-to-GDP ratio of 150% by 2033.

That's a national debt of $58.2 trillion by 2033 and average annual deficits of $2.67 trillion.

Enjoy folks. Inflation, the loss of your money’s purchasing power, finances a great deal of Uncle Sam’s ability to borrow and spend like this, and they’re still not happy leaving the debt alone at 120% of GDP. They’re on course to raise it to 140% or 150%.

Yes, Uncle Sam Can Now Run $1+ Trillion Deficits Forever

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5 MIN READ - The Cautious Optimism Correspondent for Economic Affairs and Other Egghead Stuff regrets to inform CO Nation that $1+ trillion federal deficits are now sustainable—forever.

The Economics Correspondent by no means endorses this trickery method of financing the federal government and is only demonstrating the sinister power of economic growth plus a little inflation for maintaining the national debt.

Yes, the U.S. economy has reached a point where even $1+ trillion deficits are sustainable indefinitely. And policymakers know it.

CRUEL MATH

To explain, here are a few facts and assumptions.

Facts:

-The current federal debt is $31.5 trillion

-US nominal GDP is $26.1 trillion

-Therefore, the current debt-to-GDP ratio is 120.7%

Assumptions:

-Going forward the Federal Reserve System produces an average annual inflation rate of 2.5%

-Going forward the U. S. economy averages 2.5% real GDP growth, except…

-Every eight years a recession interrupts that growth. We’ll assume after two or three quarters of negative growth and another five or six quarters of subpar growth the two-year interruption averages GDP growth of just 0.5%. Meaning…

-Over the 10-year cycle real GDP growth is lowered to an average of just 2.1%.

(anyone who wants to double-check the math can verify at the end of the article)

Therefore, if the federal government runs a $1 trillion deficit every year for the next decade the federal debt will grow from $31.5 trillion to $41.5 trillion.

Unthinkable. Right? A disaster. Right?

But over the next decade real GDP will grow at an annualized compounded rate of 2.1% per year. Therefore real GDP will grow from $26.1 trillion to $32.12 trillion.

And most importantly, atop real GDP growth the Federal Reserve will drive up prices with an average inflation rate of 2.5%. Therefore GDP will grow from a real $32.12 trillion to a nominal $41.1 trillion.

Hence in ten years, with a national debt of $41.5 trillion and nominal GDP of $41.1 trillion, the debt-to-GDP ratio will be just 101% or a decline of 19 percentage points.

Yes, running ten straight years of $1 trillion deficits and never balancing the budget the debt-to-GDP ratio will actually fall.

The math is unrelenting. The federal government can actually run even higher deficits - $1.81 trillion for the next decade - and the debt-to-GDP ratio will remain unchanged at 120.7%.

And if the official inflation numbers are understated and prices are actually rising faster than the government says, well... that's better for the politicians because nominal GDP (and by extension the IRS's tax collections) rise even faster.

That’s the dark magic of growth plus inflation. Governments, particularly central banks, treasury departments, and finance ministries, are well aware of how the math works and have been playing this game for nearly a century.

NO FREE LUNCH

Actually the growth part is not so bad. It’s honest, it’s hard work, and everyone benefits from more stuff.

The inflation part? Not so much.

Yes, the sleight of hand is successful because holders of U.S. dollars are silently drained of 2.5% of their money’s value year after year—the proceeds being a gift quietly transferred to the federal government by watering down the real value of its past debts.

As if direct taxation wasn’t tribute enough to Washington, DC.

If we stretch our horizon out to twenty years, maintaining the same assumptions, the federal deficit will increase to $51.5 trillion, but thanks to growth and inflation nominal GDP will be $64.8 trillion.

The debt-to-GDP ratio will have fallen yet again, this time to 79.5%.

Which is why Congress and future presidents won’t stop at $1 trillion deficits. They know that over time they can borrow more and more. Soon it will be $1.5 trillion deficits. Within some of our lifetimes the Treasury will be consistently borrowing $2 trillion a year or more, never balancing a budget and never running a surplus, yet maintaining a manageable debt-to-GDP ratio.

And if their appetites grow too large and they borrow so much that the debt-to GDP ratio starts to get worrisomely high? No problem, the Fed can have a few “accident” years where inflation hits 6% or 7%--like 2022—and the debt-to-GDP ratio will be cut back down to size.

Just the inflation of the 1970’s alone watered the dollar down to 38 cents from 1971 to 1983. The Federal Reserve said “Oh we’re sorry, but we’ve learned our lesson” while the federal government’s debt-to-GDP ratio was reduced by 62%--from 35% of GDP to 11% (not including new deficits).

And holders of U.S. dollars got to foot the bill.

AN OLD TRICK

This sleight of hand has been practiced by western governments going back to at least World War II. They all went off their domestic gold standards during the Great Depression, giving their central banks a great deal more room to inflate the money supply.

America’s national debt in 1945 was $260 billion or 120% of GDP, both astronomical figures at the time, the result of massive borrowing for World War II.

Not to worry. By 1980 it was reduced to 30%.

But not by paying down debt. The federal debt had actually grown by 1980 to $860 billion, over triple its size in 1945.

But through the magic of growth and especially inflation the original $260 billion was no longer so much money anymore. Thank you holders of devalued dollars!

And boy were they devalued. The Federal Reserve went off the last vestiges of the gold standard in 1971—gold redemption for international central banks—and there was no longer any limit as to how much inflation the Fed could create.

It’s no surprise that in the 51 years since 1971 prices have risen 623% (if you trust government statistics) and the dollar’s purchasing power has declined to 13.8 cents.

Even in Ronald Reagan’s day, when the federal debt reached $2 trillion, the number was unimaginable. People said “$2 trillion? We’ll NEVER pay that off!”

They were more right than they knew. The federal government already knew that with growth and inflation there was no need to pay it off. Because today a $2 trillion debt is also nothing—a mere 7.7% of GDP—thanks to growth plus inflation.

Presidents who enter office determined to balance the budget and do something about the national debt are quickly educated by the Treasury Secretary that growth and inflation will always be there to bail out the government, so there’s no need to tighten any belts.

And the moment the first budget standoff with Congress happens, the first time partisan fingerpointing begins, the moment a government shutdown looms, all sides agree: “Hey, why are we fighting? Let’s just borrow another trillion dollars and future generations will pay it off with growth and inflation. And the best part is most of them won’t even realize they’re paying.”
====

For those who want to check the compounded percentage math

1) $1 trillion deficits

-2.1% real GDP growth over ten years = 1.021^10 = 1.231 = 23.1% growth
-Eight years of 2.5% GDP growth + two years of 0.5% GDP growth = 1.025^8 x 1.005^2 = 1.231
-(1.231^(1/10) = 1.021 = 2.1% annualized GDP growth)
-2.5% inflation growth over ten years = 1.025^10 = 1.280 = 28.0% price increase
-$31.5 trillion debt + ten years of $1 trillion deficits = $41.5 trillion
-$26.1 trillion nominal GDP plus ten years 2.1 % GDP growth and ten years 2.5% inflation = 26.1 x 1.231 x 1.280 = $41.1 trillion
-New debt-to-GDP ratio = $41.5 trillion/$41.1 trillion = 101%

2) $1.8 trillion deficits

-Current debt-to-GDP ratio = 120.7%
-$31.5 trillion debt + ten years of $1.81 trillion = $49.6 trillion
-$26.1 trillion nominal GDP plus ten years 2.1 % GDP growth and ten years 2.5% inflation = 26.1 x 1.231 x 1.280 = $41.1 trillion
-New debt-to-GDP ratio = $49.6 trillion/$41.1 trillion = 120.7% (unchanged from today)

Gavin Newsom Demands Federal Investigation Into California Power Prices

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The Cautious Optimism Correspondent for Economic Affairs and Other Egghead Stuff suggests Gavin Newsom starts by investigating himself and the years of bans on California natural gas drilling/fracking he has championed.

Next he might want to focus investigating members of his own party who have blocked pipelines and oil/gas production projects all across the United States.

Read more details at:

https://www.sfexaminer.com/news/gavin-newsom-wants-us-probe-into-california-utility-prices/article_1bca66fc-a72f-11ed-922f-a36fe2719771.html

Free vs Regulated Banking: Canada's Free Banking Era - Why Was the Bank of Canada Established?

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5 MIN READ - Cautious Rockers who’ve even glanced at the Cautious Economics Correspondent for Economic Affairs and Other Egghead Stuff’s articles on Canadian free banking would be justified in asking a logical question: 

“Given how well free banking worked for a century and even withstood the Great Depression without a single bank failure, why on earth did the Canadian government feel it necessary to authorize a central bank in 1935?”

The answer lies in 1930's politics. Curious Rockers feel free to read on to learn more.

Bank of Canada building, circa 1938

As we’ve covered in multiple past entries, Canada’s banking system was the industrialized world’s second least regulated from 1817 to 1844, and least regulated from 1845 to 1935. 

All throughout its entire 118-year “free banking” era the Canadian banking system was crisis-free in contrast to the heavily regulated United States which bore fifteen crises before 1935.

However the free banking era is universally considered as having abruptly ended in 1935 when Canada’s first central bank, the Bank of Canada, opened for business by order of the 1934 Bank of Canada Act.

Why then, if Canada’s free banking system was performing so well, did Canadian Parliament elect to establish a central bank?

As one might expect the answer is rooted in politics.

STEMMING RADICAL PARTIES

There were two primary political catalysts for Ottawa’s embrace of a new central bank.

The greatest, by far, was domestic Great Depression politics. 

In the depths of Canada’s economic hardship an eccentric upstart party named the Social Credit Party (interesting name given China’s modern Social Credit System) won a large bloc of parliamentary seats, mostly in Alberta where the party won 46% of the popular vote.

The Social Credit Party’s platform, based in the theory of social credit, was considered radical in its day.

Social Credit called for redistribution of wealth and mass printing of government “prosperity certificates” which would be doled out to the public plus any business that sold below cost to consumers. Furthermore the party platform was presented in agrarian Christian populist packaging, marketed with slogans hailing the national construction of “A Utopia of Our Own.”

Compounding problems was the surging “Cooperative Commonwealth Federation” (CCF), a socialist party founded in 1932 on a platform that included nationalization of financial institutions. Capitalizing on widespread public discontent with the depression, the CCF rose in just two years to official opposition status within the provincial governments of Ontario and Saskatchewan.

The rapid ascent of these fringe movements so alarmed the establishment Liberal and Conservative parties that they sought some form of political compromise to curb the most extreme elements of the Social Credit and CCF platforms.

A linchpin of that compromise was the Bank of Canada.

Although the Canadian banking sector held up extremely well during the Great Depression and weathered the slump without a crisis, the public nevertheless largely blamed banks—a historically unpopular and easy target—for the depression itself. 

Hence the Liberal and Conservative parties believed the creation of a central bank to conduct monetary policy would appease all disgruntled parties: not only the Social Credit Party and Cooperative Commonwealth Federation but restless Canadian voters as well.

GLOBAL PRESTIGE

A secondary impetus for the decision to establish a central bank was national prestige.

By the mid 1930’s most developed countries were attending regular international monetary conferences, and the post-1933 period saw a particularly rapid flurry of meetings where governments regularly sought to quell competitive “beggar thy neighbor” monetary policies—effectively a cycle of national currency devaluations to boost exports and dig their way out of their problems at the expensive of other trading partners.

However only countries with central banks were invited.

Canadian officials felt they were being left off the world stage, so the two major political parties supported the Bank of Canada Act in order to bring Canada the worldly prestige they thought it was due.

According to Bordo and Redish (1986)…

“The World Monetary and Economic Conference in 1933 had stated that all developed countries without a central bank should create them to facilitate monetary cooperation and recovery. In an article analyzing the need for a central bank, Queen's University economists had stressed the need for a central bank to send representatives to world monetary conferences; ‘There are few countries… …more vitally interested in international cooperation in the monetary and economic fields than Canada and yet we lack any institution which would permit effective participation in such cooperation.”

Shortly after a government commission headed by pro-central bank parliamentarian Hugh MacMillan handed down its central bank endorsement, Prime Minister R. B. Bennett…

“…announced that he would introduce a Bill to establish a central bank, ‘to regulate credit and currency in the best interests of the economic life of the nation, to control and protect the external value of the national monetary unit and to mitigate by its influence fluctuations in the general level of production, trade, prices and employment.’”

Canada’s banking sector had navigated the challenging depression economy just fine without a central bank, but Parliament created one anyway to satisfy politicians of all stripes: populist, socialist, international, and establishment.

RAPID GOVERNMENT SUPERVISION

Once opened the Bank of Canada rapidly took control of monetary functions previously performed by private competitive banks and the historic 118-year era of very light regulation abruptly ended.

-In 1935 the Bank of Canada became the official arbiter of banking system reserves and official lender of last resort.

-By 1936 the Bank of Canada was government-majority owned.

-In 1938 the Bank of Canada was completely nationalized by the federal government.

-By World War II private banknote issuance was effectively monopolized by the Bank of Canada, the last-ever private banknote issued in 1943 by the Royal Bank of Canada.

After World War II Canadian Parliament itself took a more active role in bank regulation. 

Federal deposit insurance was introduced in 1967.

Canada went off gold completely after Richard Nixon effectively ended the Bretton-Woods international gold-exchange standard.

Today Canadian regulators dictate capital ratio requirements to banks, monitor market shares for antitrust violations, and restrict Canadian banks from investing in risky assets.

And just like the Bank of England, Federal Reserve System, and every other modern day central bank, the Bank of Canada has embarked on a campaign of deliberate long-term monetary inflation to serve the central government's fiscal interests. Since 1935 prices in Canada have risen nearly 2,100% or an annualized inflation rate of 3.57%.

Put another way, the Loonie has lost 95.4% of its value, much as the US dollar has lost 95.6% of its value in the same period.

However even with such a dramatic departure from free banking since the Great Depression, Canada’s banking sector has still managed to avoid any systemic crises – unlike the United States which has still braved crises in 1990 and 2008.

What has Canada done differently even in the modern era to outperform the United States? We’ll discuss that subject in our final two chapters.