In her two-year tenure at the Securities and Exchange Commission, Hester Peirce has earned a reputation as a crypto-friendly financial regulator. In speeches around the country, she has warned of the risk that overly zealous application of the securities laws to good-faith crypto projects could smother entrepreneurship and reduce the investment opportunities available to U.S. households.

But Commissioner Peirce is not just a positive voice for innovation sitting at the top of a congenitally risk-averse institution. She’s also one of the most literate public officials on the topic of digital tokens and the decentralized platforms on which one can use them. Although Peirce sometimes finds herself in the minority on the SEC board, her fellow Commissioners must surely rate her views on crypto highly.

I was therefore very encouraged by Peirce’s proposal, in a speech she gave last week, to create a three-year safe harbor that would exempt digital token projects from many provisions of the securities laws. The proposal is both realistic and potentially transformative. If Peirce can muster support from her SEC colleagues, this safe harbor may decisively clear the cloud of uncertainty that has surrounded U.S.-focused crypto projects for several years.

To understand the proposal’s significance, one must recognize that, at present, U.S. crypto projects operate in a regulatory no man’s land. That uncertainty persists despite growing interest in the possibilities of crypto technology. Since the launch of Ethereum in 2014 and particularly from mid-2016, entrepreneurs have attracted a growing amount of startup funding through initial coin offerings (ICOs), in which individuals exchange funds for the promise of a future digital token. According to Coindesk, ICOs had raised a cumulative $22.5 billion as of the end of 2018.

But ICO activity had started to slow down by the middle of that year, after the SEC’s chairman Jay Clayton declared "every ICO I’ve seen" to be a securities offering. The Commission also began launching selective enforcement actions against crypto projects, although many of these involved outright fraud rather than just allegations of an unregistered securities offering. It remains unclear whether the SEC will pursue all ICOs as unregistered offerings, as Clayton’s remark suggested, or only the most egregious cases that may have knowingly flouted the securities laws and attempted to fleece consumers.

Chairman Clayton seems to fear that failing to clamp down on ICOs could enable issuers of securities to evade the law. This is because, following Supreme Court precedent from the 1946 Howey case, a security in the United States is "an investment of money in a common enterprise with the expectation of profits from the efforts of others." Buying in a token offering clearly meets two of these conditions ("investment of money" and "expectation of profits"). The other two criteria ("common enterprise" and "efforts of others") are less clearly applicable. Indeed, legal experts have argued over this question since token offerings started to become popular.

But the 74-year-old Howey test to which the SEC has clung in its evaluation of digital tokens has ushered in what Commissioner Peirce rightly described in her recent speech as "a regulatory Catch 22." She continued:

Would-be networks cannot get their tokens out into people’s hands because their tokens are potentially subject to the securities laws.  However, would-be networks cannot mature into a functional or decentralized network that is not dependent upon a single person or group to carry out the essential managerial or entrepreneurial efforts unless the tokens are distributed to and freely transferable among potential users, developers, and participants of the network.

Peirce’s proposal is not the first attempt at partial regulatory relief for digital token projects. In June 2018, the SEC’s Director of Corporation Finance, William Hinman, stated that decentralized ownership of tokens, what Peirce refers to as "getting tokens . . . into people’s hands," would mean they were not securities, even if the tokens had met the Howey test before the network became "truly decentralized."

Hinman’s standard never became SEC guidance or rulemaking. Indeed, a subsequent SEC guidance document on digital assets, which market participants criticized for muddling rather than clarifying matters, features the term “decentralized” only once. Still, Hinman’s standard was widely interpreted as leaving Bitcoin and Ethereum off the hook, simply because those networks had been around for nine and five years, respectively, at the time of his speech. Other crypto projects, in contrast, were caught if not gutted.

A three-year safe harbor such as Peirce proposes would, instead, reassure many smaller and newer initiatives. This is because the Howey criteria of "common enterprise" and "efforts of others" are most likely to apply to crypto projects in their infancy. Entrepreneurs will raise money from interested participants to develop the network. During that time, the success of the network hinges critically on the founders’ entrepreneurial efforts. But once the network becomes functional or decentralized, as many may after three years, it will no longer be a common enterprise and its success won’t depend mainly on the efforts of its creators.

Peirce’s safe harbor would offer a limited but highly valuable bridge for crypto networks to get their tokens into people’s hands, achieving the decentralization that, according to the Hinman standard, causes them not to be securities. The proposed rule would not exempt crypto projects from all regulation, as they would still be liable for violating the anti-fraud provisions of the securities laws. Furthermore, to be able to rely on the safe harbor, entrepreneurs---or the Initial Development Team (IDT), as the proposal calls them---would need to release substantial information about themselves, the network’s design, transaction history, and the timeline for its development on a public website.

While one always worries about prescriptive disclosures, the proposed rule’s requirements are succinct and relevant, and similar to the information that the more successful crypto projects have divulged in their white papers. The information required is of a technical and factual, rather than legal, nature, which may make it possible for developers to provide it without needing to resort to expensive outside counsel. The proposal also requires the IDT to undertake "good faith and reasonable efforts" to create liquidity for users by allowing secondary trading on an appropriately licensed platform. Finally, IDT members would have to make public the details of any sale of five percent or more of their token holdings during the three-year safe harbor period.

Apart from establishing that digital tokens distributed in the development of a decentralized network are not securities, Commissioner Peirce’s proposal would also exempt entities dealing in such tokens from regulation as exchanges, brokers, and dealers, as those activities are defined in the securities laws. This matters to developers, who might otherwise be alleged to operate as unregistered intermediaries. It would also facilitate the growth of platforms specializing in the secondary trading of safe-harbor tokens, thus helping to fulfill the proposal’s liquidity mandate.

I have some concerns regarding specific parts of the proposal. First, I wonder if the text of the rule should refer to the contracts for digital tokens, rather than the tokens themselves. The definition of “token” in the proposed rule includes a transaction history and other network features that may not be available at the time of fundraising and will not become so until later in the network’s development. Referring specifically to the contracts for tokens might avoid subsequent confusion as to whether individual tokens always met the rule’s definition.

Second, I believe the rule should explicitly state that the IDT’s commitment to return money to token buyers-–-on demand or with some delay, fully or partially-–-counts as good-faith liquidity provision. Some networks may be too small to find it worthwhile to list their tokens on outside exchanges. Moreover, the SEC should provide for alternative avenues to meet its liquidity requirement in case secondary venues do not develop as quickly as it anticipates. Enabling unilateral liquidity provision through a money-back guarantee would achieve that.

The proposed rule’s interaction with other federal and state-level statutes will affect its chances of success. By definition, the regulations promulgated and enforced by other agencies lie outside the SEC’s purview, so it is important to ponder where conflicts might arise. For example, in its most recent guidance, the Financial Crimes Enforcement Network (FinCEN) at the U.S. Treasury noted that developers and sellers of software for token platforms-–-the equivalent of the proposed rule’s IBT-–-are not money services businesses (MSBs) and are therefore exempt from the Bank Secrecy Act’s licensing and reporting requirements, which FinCEN monitors.

However, token issuers may be MSBs if they are "the only person authorized to issue and redeem" tokens. On the other hand, FinCEN’s guidance states that token issuers "registered with, and functionally regulated or examined by the SEC . . . will not be an MSB under [its] regulations." Instead, they are subject to FinCEN rules for SEC-regulated institutions, notably broker-dealers. But Commissioner Peirce’s safe harbor explicitly exempts token issuers from broker-dealer regulation! FinCEN should explain how the SEC’s safe harbor would fit into its MSB regulatory regime.

Things could get even more complicated at the state level. For instance, New York, which as a financial services hub holds much sway among state regulators, requires businesses engaged in "controlling, administering or issuing a Virtual Currency" to obtain a BitLicense from its Department of Financial Services. California has not had a clear policy on crypto projects, although a bill currently under consideration would make “virtual currency business activities” subject to licensing, albeit with broader exemptions than New York’s regime. IBTs relying on the SEC safe harbor might also run afoul of the money licensing laws of 53 other states and territories.

Uncertainty about the application of the securities laws has been an important concern, and a barrier to growth, for many crypto projects in the last five years. Commissioner Peirce’s safe harbor would go a long way toward addressing that uncertainty. She deserves applause and praise for her leadership on a fraught subject. The next step is to explain, to the greatest possible extent, the safe harbor’s implications for regulations that agencies other than the SEC enforce and for which new crypto initiatives might be liable. But this proposal is welcome news to all who believe new technologies deserve a fighting chance.

When Bitcoin’s price spiked in 2017, so did public mentions of the cryptocurrency, as measured by a Google n‑gram plot. When William Jennings Bryan promoted bimetallism during his run for President in 1896, mentions of bimetallism similarly spiked. Noting this parallel, economist Robert Shiller compares the two monetary systems more generally in chapter 12 of his 2019 book Narrative Economics, “The Gold Standard versus Bimetallism.”[1] Shiller was the 2013 Economics Nobel Prize co-recipient. He recently appeared to discuss the book on Russ Roberts’ EconTalk podcast.

Shiller observes (p. 161) that “the enthusiasm for bimetallism in the nineteenth century seems similar to the excitement for Bitcoin we have seen in recent years.” Later he goes a bit further to propose that “narratives about gold and money have a peculiar emotional tone, analogous to the emotions we see in cryptocurrency narratives today.”

“Analogous to”? I would say antithetical to. Shiller overlooks a critical contrast between bimetallists of Bryan’s sort and Bitcoin advocates: bimetallists wanted inflation, whereas Bitcoin maximalists support its deflationary tendency. They praise the hardness of the gold standard as a precursor to Bitcoin. Bryan embraced the softness of bimetallism, and famously cursed the gold standard. Shiller (p. 158) rightly observes that Bryan’s plan—resuming free coinage of silver at 16:1 when the market ratio was 30:1—would have been deliberately inflationary: “Thus the bimetallism proposal would have allowed debtors to cut their debts roughly in half by choosing to repay them in silver rather than gold. In effect, the result would have been a default on about half the value of all debts denominated in US dollars.” But Shiller does not mention that Bitcoin supporters embrace its deliberately deflationary design whereby the stock of Bitcoins grows increasingly slowly and eventually stops growing altogether.

And there is a second important contrast: the 1896 peak discussion of bimetallism came in the context of a political campaign. Bryan sought to impose bimetallism on all American money-users, while the majority of voters rejected the policy. Bitcoin, by contrast, is a payment system whose advocates seek voluntary joiners, one at a time. Theirs is not a political winner-rules-all campaign.

At times Shiller seems implicitly to adopt the attitude that the facts shouldn’t get in the way of a good story. He relates popular narratives about bimetallism and the gold standard but does not fact-check them. Most problematically, he comments (p. 157) that “in history the gold standard has long been associated with prolonged deflation and other economic problems.” Doubtless, there is such an association in many minds. But he might have noted that the association is erroneous in several ways:

• The history of the gold standard shows periods of (mild) deflation alternating with periods of (mild) inflation, making the secular record one of near-zero inflation, not one dominated by deflation. Over the entire “classical gold standard” period, 1880–1914, the average inflation rate in the United States was 0.1 percent per year, as Michael Bordo’s readily accessible encyclopedia entry points out. This mean-reversion of the price level was not a lucky accident, but inherent in the economics of commodity money: any downward price-level movement increases the purchasing power of gold and thereby stimulates more gold production (except when due to a permanent increase in the cost of gold mining).
• Most deflations under the gold standard were not troublesome in themselves, nor symptomatic of problems elsewhere. Bordo, Landon-Lane, and Redish (2010, p. 544) find that “deflation in the late nineteenth century was primarily benign,” the result of rapid growth in the output of goods rather than negative monetary shocks. The negative monetary shocks associated with late-nineteenth-century financial panics in the US were not due to the gold standard (hence Canada didn’t have them), but to banking instability stemming from bank-weakening legal restrictions. Nominal prices fell in gold-standard countries mostly when the world’s real income grew faster than the world stock of gold. Relatively rapid real income growth is of course not a problem. Falling nominal prices with flat nominal wages were how workers enjoyed higher levels of real income.
• Deflation (a decline in overall nominal prices) under the classical gold standard was not normally associated with other economic problems like depression (normally defined as a decline in overall real income). Shiller casually identifies “the 1890s” as a depression based on several years’ high unemployment numbers, but a closer look finds that only 3 years (1893, 1894, 1896) saw a decline in real GDP from the previous year. (He also cites the International Bimetallism Conference in London in 1894 for having “noted that a long slow deflation caused by the gold standard had produced depression in agriculture across much of the world,” but surely relative input and output price movements, rather than monetary forces, must be responsible for a decade-long “depression” in one industry only.) US real GDP in 1900 was 32.5 percent higher than in 1890, for a healthy annualized compound growth rate of 2.86 percent. Deflation characterized half the decade, 1893–88, with the GDP deflator of 1898 almost 3 percent below that of 1893 (for an annualized compound inflation rate of negative 0.57 percent over those five years). Thus, only three years of the 1890s exhibited both deflation and declining real income.[2]

Deflation did coincide with depression during 1920–21 and 1929–34. These sharp deflations were not due to the uninterrupted working of the gold standard, which operates gradually, but followed from the high inflations that the Federal Reserve (and European central banks off the gold standard) had created during the First World War, given their refusal to devalue afterward, as persuasively argued by Mazumdar and Wood (2013).

More importantly, the coincidence of depression with deflation was not typical of the classical gold standard. Shiller (p. 158) counsels that “Because the gold standard was talked about very much during those depressions [the 1890s and the Great Depression], we ought to consider how the gold standard narratives relate to the potential for severe depression.” Surely we should also fact-check those narratives. Atkeson and Kehoe (2004) considered the facts of the matter in a panel of 17 nations over 100 years. They found that “nearly 90% of the episodes with deflation did not have depression.” (A measured “episode” was a five-year period in a nation.) They summarized the overall pattern as follows: “A broad historical look finds many more periods of deflation with reasonable growth than with depression, and many more periods of depression with inflation than with deflation. Overall, the data show virtually no link between deflation and depression.” Shiller appears to be innocent of these and similar findings.

Shiller blurs some other details that would undermine his story of a parallelism between the bimetallic and Bitcoin eras. He likens (p. 162) “the Silverites of the 1890s” to “the supporters of Donald J. Trump in the 2016 US presidential election, both in their sympathies and in the contempt that many intellectuals held for them.” But the Silverites were left-wing or progressive populists, more like some supporters of Bernie Sanders, not right-wing or reactionary populists like some supporters of Trump.

Bimetallism sought to re-establish the unlimited coinage of full-bodied silver dollars and fractional denominations. But with the development of the monometallic gold “standard model,” full-bodied silver coins had become obsolete as a way of solving “the big problem of small change,” that is, keeping small currency in circulation at par value. Shiller characterizes the standard model, which “first came about during the eighteenth century in the United Kingdom,” as consisting of “a single gold coin representing legal tender, subsidiary coinage of base metal, and paper money with value based on the government’s unqualified willingness to exchange it for legal tender.” That characterization is nearly correct, except that the value of British paper money in the 18^th and 19^th centuries—issued by the then-private Bank of England and other private banks—did not rest on any “unqualified willingness” of the UK government to exchange that paper money for legal tender (gold coins). Redeeming notes was the obligation only of the issuing banks. (To be fair, although Parliament did not exchange Bank of England notes for gold coins, it did pass a law to make the notes themselves legal tender during the suspension period of 1797–1819.) The standard model came about from gold monometallism plus the development of trustworthy commercial banknotes that displaced subsidiary coins. In the United States as well, both before and after the Civil War, most currency notes were privately issued and the government did not exchange them for legal tender.

Finally, when Shiller (p. 167) quotes the notorious concluding line from William Jennings Bryan’s speech at the 1896 Democratic Party convention (“we will answer their demand for a gold standard by saying to them: ‘You shall not press down upon the brow of labor this crown of thorns; you shall not crucify mankind upon a cross of gold’”), he fails to consider that its crucifixion trope was anti-Semitic. He comments (p. 168): “Likely the working classes connected their economic suffering with the imagery of Jesus’s suffering a brutal execution at the hands of the powerful Romans.” But as writer Chad Weisman has put it, Bryan was implying “that the religious group responsible for the death of Christ was also the source of the United States’ economic woes.” Bryan and other bimetallists like “Coin” Harvey saw international Jewish bankers, not the Romans, conspiring to impose the gold standard. Bryan had denounced the Rothschild family in earlier speeches. A caricatured Rothschild repeatedly appeared as an object of scorn in the political cartoons of the bimetallist periodical Sound Money. One such cartoon made the subtext of Bryan’s “Cross of Gold” speech explicit by showing Republican Party leader Mark Hanna pressing a crown of thorns down onto a worker, who is nailed to a cross labeled “GOLD,” while Hanna stands on the shoulders of a bearded man labeled “Rothschild, owner of most of the gold in the world.”

In conclusion, while we can applaud Shiller’s attention to the influence of popular economic narratives, we should not take the veracity of those narratives for granted. Some narratives are myths. To study them seriously requires a careful evaluation of their factual basis.

---

[1] See James Grant’s review of the book here.

[2] All percentage calculations are mine, from the real GDP and GDP deflator data at Mea​sur​ing​Worth​.com.

[Cross-posted from Alt‑M.org]

On Feb. 5, I had the pleasure of addressing the annual conference of the Receivables Management Association International in Las Vegas. Below is a transcript of my speech.

*****

Thank you for the opportunity to address you this morning. It has become so easy to borrow in America---to compare options, apply for, receive, and repay loans---that many people aren’t aware of the complex infrastructure that enables the large variety of financial services available to most Americans. But this conference, and the size and diversity of RMAI’s membership, are testimony to the importance of that infrastructure, which decades of innovation and market competition have helped to build.

The purpose of my talk is threefold. First, I’d like to go over the evolution of the credit cycle since the financial crisis. Second, I will discuss the impact of some notable recent regulations on access to consumer credit and other financial services, focusing on the patterns of access by different socioeconomic and demographic groups. Third, I will present two distinct (and often opposed) approaches to consumer protection in financial services, and I will discuss their respective policy implications.

The State of the Credit Cycle

America’s economic recovery from the 2007-09 recession is the longest on record, and ongoing.[1] Unemployment has dropped to lows last registered in the late 1960s, and the S&P 500 stock market index is at more than double the level it had reached before the financial crisis. The longevity of the post-crisis expansion and the unusual performance of key economic gauges has caused some to forecast that the cycle will soon turn.[2]

I’m not paid enough to risk my reputation offering economic predictions, but other analysts have questioned that we’re soon "due a recession." For one thing, growth in the immediate aftermath of the last downturn was weaker than in previous recoveries. Research suggests that it takes longer to come back from recessions triggered by financial crises, perhaps because healing the wounds from major credit misallocation---writing off bad loans, recapitalizing financial institutions, and so on---is a difficult and protracted process.[3]

Contrary to popular wisdom, recessions don’t seem to die of old age. An economist at the Federal Reserve Bank of San Francisco went through all U.S. post-WWII recessions and found that an 80-month-long recovery was no more likely to end than a 40-month-long one.[4] The length of an expansion alone tells us nothing about the probability of a downturn. That, of course, doesn’t mean that a recession at this particular moment is necessarily unlikely.

But, rather than engage in dubious forecasting exercises, let’s consider the position in which a hypothetical recession would catch U.S. consumer credit.

The incautious observer might take it for an ominous sign that outstanding mortgage debt surpassed its 2008 peak in the second quarter of 2019.[5] Other consumer debt, notably student loans and car loans, has also increased substantially since the last recession. But the dollar amount of debt outstanding gives a misleading picture, because U.S. national income has also increased---by around 22 percent---since the last peak. Increasing income gives households more borrowing power, so it’s right to measure credit in terms of income. And as a share of income, household debt is well below pre-crisis levels. This is not the case with business credit, which is close to but still below the high it reached in early 2009.

U.S. Household and Business Credit as a Share of U.S. GDP

There are some areas of concern: Student loan delinquencies rose before and during the financial crisis. After reaching nearly 12 percent of outstanding balances in late 2012, they have stayed around that level, despite a strengthening economy and rising employment. In dollar terms, delinquent balances are around $123 billion higher than at the end of the last recession.[6] Car loan delinquencies have also increased in the last five years, albeit more moderately and to much lower levels. But, for other classes of consumer credit, and notably for mortgages, the single-largest credit category, delinquencies are at pre-crisis lows.

As many of you know, student loans are a special form of consumer credit, because the federal government owns virtually all new loans and issues them without underwriting prospective borrowers. There are also several forgiveness programs that write off unpaid balances after a period. The lax controls on student lending explain not only rising delinquencies, but also the real-terms doubling of outstanding balances over the last decade, and---according to the New York Fed---as much as 60 percent of tuition increases.[7] To repeat: Research suggests that every additional dollar of federal student aid pushes up tuition by as much as 60 cents. Not an impressive outcome for a policy that is often justified on grounds of college affordability.

But these dysfunctions, concerning as they clearly are, present more of a problem for taxpayers than borrowers or private creditors. It’s unfortunate that some policymakers have focused on allegedly improper practices on the part of student loan servicers, who are government contractors and play no role in origination and underwriting policy.[8] The evidence suggests it would be more beneficial to students and taxpayers if the government recognized its involvement in this market is pushing up costs and imperiling the financial well-being of borrowers.

The growth in car loan delinquencies, for its part, seems to be concentrated among subprime borrowers.[9] Analysts point out that the bulk of the more recent increase in auto lending went to the most creditworthy borrowers.[10] They also argue that easier repossession and the size of the auto lending market---7.5 times smaller than the market for home credit---make comparisons with the 2006-2008 subprime mortgage meltdown seem hyperbolic. To that I would add that there is no equivalent in U.S. auto lending to the political drive for homeownership that loomed so large in the growth of subprime mortgage credit before the financial crisis.

The aggregate data for consumer credit therefore give a broadly healthy picture, despite the length of the recovery and the dollar-terms growth of household debt.

Consumer Credit Policy and the Credit Cycle

The evidence above notwithstanding, policy changes since the financial crisis have affected access to, and the composition of, consumer credit. While the spirit behind such policies was often to protect consumers and to make credit more widely available, they haven’t always achieved those goals. Access by many borrowers to certain forms of consumer credit has in fact worsened in the past decade. Meanwhile, in other areas, portfolio risk has increased in a way that may end up harming borrowers.

Let’s start with housing credit, which at $9.83 trillion outstanding as of the end of September 2019 is by far the single-largest consumer credit item. The prevailing interpretation following the financial crisis was that inadvisable lending policies (sometimes misguided, other times predatory) caused a proliferation of high-risk mortgages that eventually went sour.[11] This interpretation informed the Dodd-Frank Act of 2010, which made important changes to financial laws and added several new laws to the books.

Among the key policy changes were the creation of minimum standards for mortgage lending, including a creditor’s obligation to evaluate a prospective borrower’s ability to repay the loan.[12] Dodd-Frank also provided for a safe harbor, called a "qualified mortgage" (QM), which exempted creditors from liability in the event of debtor default. While these provisions may all appear sensible and were no doubt well-intentioned, ten years on, U.S. housing finance has some features that should trouble anyone familiar with the last crisis.

First, Fannie Mae and Freddie Mac, the two government-sponsored enterprises (GSEs) that purchased two-fifths of single-family mortgages in the run-up to the crisis and which the federal government rescued in September 2008, have not stepped back from their dominant role in the eleven years of conservatorship. As of 2019, the GSEs guaranteed 44 percent of single-family mortgage debt outstanding. Among mortgages eligible for GSE acquisition, Fannie and Freddie’s market share is at an all-time high of 71 percent.

There are many reasons for the GSEs’ continued preeminence, but an important one is their exemption from the Consumer Financial Protection Bureau’s QM standards. Since 2014, the CFPB has set a limit of 43 percent on borrower debt-to-income (DTI) ratios for the mortgage to be a QM. GSE-eligible loans, however, are exempt from this requirement. Not surprisingly, this GSE “patch” has caused lenders to favor loan originations that meet the GSEs’ underwriting requirements rather than the general conditions of the CFPB’s QM rule. Yet the CFPB’s own data suggest GSE-eligible high-DTI mortgage loans have higher default rates than non-GSE-eligible loans of similar characteristics.[13]

Another potential trouble spot in housing finance are Federal Housing Administration (FHA) loans. Originally intended as a government-supported program for underserved borrowers, FHA loans have historically been used by the federal government to boost homeownership, often at the cost of increasing future foreclosures.[14] With the decline of private subprime lending from 2006 onward, the FHA has taken an increasing share of the mortgage market, accounting for 19 percent of outstanding loans as of 2019. The FHA portfolio is riskier than average, although in March of last year the agency vowed to tighten its underwriting standards.[15]

FHA Single-Family Housing Mortgage Insurance Portfolio Growth

Not all of the problems with consumer credit policy involve greater risks to the financial system and, potentially, taxpayers. Indeed, opponents of the CFPB’s hard DTI threshold contend that it may prevent sound borrowers from getting mortgages.[16] Indeed, in creating both the QM standard and the GSE “patch,” the CFPB may have spawned a mortgage underwriting regime that both constrains lending to creditworthy borrowers and encourages lending to unsound borrowers. Quite a feat!

Another area where regulation seems to have constrained access to credit and other financial services is payment cards. Two key post-crisis measures---the 2009 CARD Act and the so-called Durbin Amendment to the Dodd-Frank legislative package---fundamentally changed the regulatory landscape for credit and debit cards, respectively. The CARD Act significantly limited credit card issuers’ ability to raise interest rates on existing balances and to change other terms of the original contract. The Durbin Amendment capped interchange fees on debit transactions for banks with over $10 billion in assets.

Both laws were advocated as benign consumer protection measures. Proponents argued that large banks and payment networks were using their market power to impose unfavorable terms and fees on consumers. Regulation could therefore redistribute income from financial institutions to households without causing changes to other features of the payment card market that consumers liked.

A decade on, the evidence suggests otherwise. A recent paper by researchers at the Federal Reserve Board in Washington finds that credit card issuers---banks---became less responsive to reductions in interest rates by their competitors after the CARD Act came into force.[17] Worryingly, issuers seem to be more reluctant to react to offers of lower, but not higher, interest rates by their competitors. The authors’ finding is especially strong for subprime borrowers, consistent with the theory that issuers’ behavior sought to offset revenue losses from the inability to reprice existing balances and to adjust interest dynamically according to repayment performance.[18]

Americans with at Least One Credit Card, by Credit Score Range

Indeed, from 2009, there was a substantial decline in the share of subprime borrowers with credit cards, which the economic recovery hadn’t fully reversed even six years later. Not only that, but according to the CFPB, as of the end of 2018, only two-thirds of subprime and one-third of deep subprime consumers held at least one credit card. Both rates of credit card ownership were below their pre-crisis high.[19]

Large U.S. Banks Offering Free Checking Accounts

The Durbin Amendment also appears to have had adverse consequences for access to financial services. With income from interchange fees capped from 2011 onward, banks cut down on consumer benefits such as free checking accounts, which have dropped by 40 percentage points.[20] Banks only partially recovered the revenue losses from Durbin in this way. But that doesn’t mean consumers are better off thanks to it, as merchants only partially passed through the savings from lower interchange fees.[21]

Two Different Approaches to Consumer Protection

The interventions I have highlighted in mortgage underwriting, revolving credit, and consumer payments reflect one popular approach to financial regulation. This approach has dominated consumer credit policy since the financial crisis, and it consists of restricting the range of products and terms from which consumers may choose. The underlying economic theory is that incomplete information, firms’ market power, and behavioral biases place consumers in a vulnerable position with respect to providers of financial services. Regulation must step in, this approach recommends, to level the playing field.

Without a doubt, regulatory interventions that constrain one party to a transaction can sometimes make the other party better off. According to some, that was the effect of the 1977 Fair Debt Collection Practices Act, although economic studies conducted soon after the FDCPA’s passage found an inverse correlation between access to creditor remedies and loan interest rates.[22] Subsequent research found that consumers are willing to pay far less for restrictions on creditor remedies than the “price” of those restrictions in terms of higher interest and other fees.[23] Comparing state regimes, a 2017 paper by researchers at the New York Fed reported significant decreases in credit availability in the states that increased collection restrictions.[24]

Consumer disclosures that synthesize the most financially significant terms of a credit contract can also help consumers make better decisions, if indeed the information required is such as to improve consumer understanding. But that isn’t always the case. For example, most consumers don’t understand what an annual percentage rate (APR) stands for, yet APR has become the chief measure of cost disclosure in consumer credit.[25]

Yet, often, the impact of restrictive regulation is not straightforward. To take a blunt and headline-grabbing recent proposal, capping APR on consumer credit at 15 or 36 percent nationwide will clearly achieve its first-order aim: to eliminate the legal provision of credit at a price above the cap. But, if we are to properly evaluate the impact of regulation on consumers, it’s not enough to consider its direct effects. For providers of credit will surely respond by limiting the flow of credit to riskier borrowers, since they cannot profitably be served under the rate cap.

As second-order (unintended) consequences go, this one seems easy enough to anticipate. Yet it’s one that policymakers usually discount if not altogether neglect. The CFPB’s October 2017 Payday Rule drew what to many of us seemed the fantastical conclusion that, despite a two-thirds volume reduction as a result of the Rule, only six percent of borrowers would lose access to payday loans.[26] The CFPB is not alone among regulators in its heroic optimism: One of my first empirical assignments in consumer credit policy was to investigate why, after a daily interest cap on short-term loans was introduced in the UK, loan volume dropped by 56 percent, rather than the 11 percent reduction the British regulator had expected.[27]

Politicians are also liable to ignore the potential adverse effects on access from the credit-restrictive legislation they promote. Congresswoman Alexandria Ocasio-Cortez, the House sponsor of the 15-percent national rate cap legislation I cited, has not once---to my knowledge---responded to or even countenanced that her admittedly well-meaning proposal may reduce access to credit.

That’s a pity because the people most likely to lose partial or total access to credit as a result of statutory restrictions are low-income and minority households---communities that Rep. Ocasio-Cortez strives to represent. We saw earlier that consumers with subprime credit scores experienced the steepest drop in credit card access following passage of the CARD Act. The Durbin Amendment one year later caused the share of fee-paying accountholders to double, but low-income consumers, who have a harder time meeting banks’ minimum-balance requirements, were disproportionately---15 times---more likely to be affected.[28]

Despite its status as a global hub of financial innovation and a country where consumer credit options are more diverse and plentiful than elsewhere, America’s consumer financial system remains bifurcated into two groups: the well-served and the underserved. There are different ways of defining the two categories.

For example, the Federal Deposit Insurance Corporation (FDIC) reports that 8.4 million households were “unbanked” in 2017, with another 24.2 million “underbanked.” I’m torn about the FDIC study, because it seems to rule out the possibility that some people might choose to forego a bank account. Indeed, in the survey accompanying the FDIC’s biennial report, the top five reasons for not having a bank account all involve cost and trust. In other words, unbanked households are choosing to remain so because a bank account is not worth the costs to them.

Still, because a bank account is often necessary for essential activities and acts as a gateway to other financial products, making ownership of bank accounts (or their modern equivalents, mobile money accounts and digital wallets) more accessible is an important policy goal. Furthermore, those more likely to face limited access to financial services---minorities and the young---are also disproportionately represented among the ranks of the unbanked.

Unbanked Rates by Household Race and Ethnicity, 2013-2017

There are other measures of financial inclusion that give a sense of the scale of the underserved consumer population. In 2015, the CFPB estimated (using mainly 2010 data) that 45 million Americans were "credit invisible," meaning they lacked a credit history sufficient to give them a credit score.[29] Again, African Americans and Hispanics were nearly double as likely as Asians and whites to be credit invisible.[30] Almost 50 percent of consumers living in low-income neighborhoods were credit invisible, compared with 20 percent of those in middle-income neighborhoods and ten percent for upper-income ones.[31]

While the buoyancy of the economy will have allowed many credit invisibles to build credit, just as it has lifted credit scores across the board,[32] between a quarter and a third of Americans, depending on the source consulted, are subprime even in the current economic environment.[33]

The problem with restrictive regulation is that it often makes it less attractive to serve the underserved. Under restrictive regulations, the underserved are themselves discouraged from using financial services. It’s an approach that I’ve described elsewhere as financial inclusion without finance[34]---the paradoxical belief that a systematic reduction in the options available to consumers can improve their access to financial services. My colleague Todd Zywicki has in the past referred to this approach as “market-replacing regulation.”[35] Market-replacing regulation involves substituting the preferences of the policymakers for those of the consumer. But in most circumstances, the policymaker has neither the knowledge nor the economic incentive to choose better than the consumer could for herself.

Another problem with the restrictive approach is that it acts as a hurdle to competitive innovation. If a specific part of the market for financial services is expensive, unpleasant, unreliable, or otherwise subpar, an open environment is the likeliest to improve it, as challengers vie to take custom away from incumbents. This happened to banking with the removal of branching restrictions in the 1980s and 1990s, and to revolving credit after the 1978 Marquette Supreme Court decision preempted national bank-issued credit cards from state usury caps. More recently, a combination of fintech installment lenders, earned-income access providers, and nonprofit organizations have started to offer alternatives to payday loans, which some people regard as needlessly costly. The market will show whether they’re right.

Some of you may have seen the announcement by the CFPB in October of a task force that will review the 18 enumerated consumer financial laws and their associated regulations.[36] Last month, they released the membership of this task force, which Todd Zywicki will chair. I am not only pleased at the impressive membership roster but also regard it as a timely---and exceptional, considering it’s nearly 50 years since a similar national commission was established---initiative that will allow the CFPB to ponder longer-term questions than its day-to-day operations and even than the Director’s statutory five-year term.

In that spirit, I recently suggested three areas that the CFPB task force should prioritize: consumer financial data, cost-benefit analysis, and financial inclusion.[37] The first is transforming all stages of the consumer credit process, from product recommendations and selection, to applications and underwriting, to payment, collections, and dispute resolution. But the absence of full clarity regarding provider liability, in the context of the CFPB’s extensive powers, has curbed financial institutions’ enthusiasm for the many promising uses of customer data.

Cost-benefit analysis is supposed to feature in every rulemaking, but often it is used to support whatever conclusion the regulator wishes to reach. However, specific forms of cost-benefit analysis---such as evaluating who among the distribution of consumers bears the costs and benefits of prospective rules---can be especially illuminating for America’s bifurcated consumer financial services market. The foremost priority should be to expand access for those overwhelmingly low-income, minority, and asset-poor households who currently face the most limited options.

Many financial regulators see their job as designing or restructuring markets through regulation. Too few, in my view, see their role as mainly that of enabling markets to provide for consumers the financial products they want and need from suppliers eager to compete for their business. But I think recent history suggests that this latter approach, a focus on enabling access and choice, holds greater promise for promoting financial well-being and inclusion than any available alternative.

___________________________

[1] National Bureau of Economic Research, “U.S. Business Cycle Expansions and Contractions,” https://www.nber.org/cycles.html.

[2] Nouriel Roubini and Brunello Rosa, “We Are Due a Recession in 2020 – and We Will Lack the Tools to Fight It,” The Guardian, September 13, 2018. https://www.theguardian.com/business/2018/sep/13/recession-2020-financial-crisis-nouriel-roubini

[3] Arvind Krishnamurthy and Tyler Muir, “How Credit Cycles across a Financial Crisis,” Stanford Graduate School of Business Working Paper No. 3579 (August 2017). https://www.gsb.stanford.edu/faculty-research/working-papers/how-credit-cycles-across-financial-crisis

[4] Glenn D. Rudebusch, “Will the Economic Recovery Die of Old Age?,” Federal Reserve Bank of San Francisco Economic Letter 2016-03. https://www.frbsf.org/economic-research/publications/economic-letter/2016/february/will-economic-recovery-die-of-old-age/

[5] Harriet Torry, “U.S. Mortgage Debt Hits Record, Eclipsing 2008 Peak,” Wall Street Journal, Aug. 13, 2019. https://www.wsj.com/articles/u-s-mortgage-debt-hits-record-eclipsing-2008-peak-11565708431

[6] At the end of Q1 2009, when the recession ended, the delinquency rate on student loans was 7.9 percent on outstanding balances of $707 billion, yielding a delinquent balance of $55.9 billion. As of Q3 2019, 10.9 percent of the $1.64 trillion of outstanding student loans was delinquent, that is, $178.8 billion.

[7] David O. Lucca, Taylor Nadauld, and Karen Shen, “Credit Supply and the Rise in College Tuition: Evidence from the Expansion in Federal Student Aid Programs,” Federal Reserve Bank of New York Staff Report 733 (July 2015). https://www.newyorkfed.org/research/staff_reports/sr733.html

[8] The Consumer Financial Protection Bureau’s three-year-old (and ongoing) lawsuit against Navient, a large student-loan servicer, is one example. See Editorial Board, “Cleaning Up after Richard Cordray,” Wall Street Journal, May 1, 2018. https://www.wsj.com/articles/cleaning-up-after-richard-cordray-1525216332

[9] Jason P. Brown and Colton Tousey, “Auto Loan Delinquency Rates Are Rising, but Mostly among Subprime Borrowers,” Federal Reserve Bank of Kansas City Macro Bulletin, August 15, 2018. https://www.kansascityfed.org/en/publications/research/mb/articles/2018/auto-loan-delinquency-rates-rising

[10] Andrew F. Haughwout, Donghoon Lee, Joelle Scally, and Wilbert van der Klaauw, “Just Released: Auto Loans in High Gear,” Liberty Street Economics, Federal Reserve Bank of New York, February 12, 2019. https://libertystreeteconomics.newyorkfed.org/2019/02/just-released-auto-loans-in-high-gear.html

[11] The majority report of the Financial Crisis Inquiry Commission exemplifies this prevailing view. See FCIC, “The Financial Crisis Inquiry Report: Final Report of the National Commission on the Causes of the Financial and Economic Crisis in the United States,” Government Publishing Office, February 2011, xvii. https://www.govinfo.gov/content/pkg/GPO-FCIC/pdf/GPO-FCIC.pdf

[12] See Dodd-Frank Wall Street Reform and Consumer Protection Act, Public Law 111-203 (July 21, 2010) 124 Stat. 2142 ff. https://www.govinfo.gov/content/pkg/PLAW-111publ203/pdf/PLAW-111publ203.pdf

[13] Bureau of Consumer Financial Protection, “Ability-to-Repay and Qualified Mortgage Rule Assessment Report,” January 2019, 114. https://files.consumerfinance.gov/f/documents/cfpb_ability-to-repay-qualified-mortgage_assessment-report.pdf

[14] Peter J. Wallison, Hidden in Plain Sight: What Really Caused the World’s Worst Financial Crisis and Why It Could Happen Again (New York: Encounter, 2015), 101-103.

[15] Ben Eisen, “FHA Clamps Down on Risky Government-Backed Mortgages,” Wall Street Journal, March 25, 2019. https://www.wsj.com/articles/fha-clamps-down-on-risky-government-backed-mortgages-11553511601

[16] Karan Kaul, Laurie Goodman, and Jun Zhu, “Comment Letter to the Consumer Financial Protection Bureau on the Qualified Mortgage Rule,” Urban Institute, September 2019. https://www.urban.org/sites/default/files/publication/101048/comment_letter_to_the_consumer_financial_protection_bureau_0.pdf

[17] Yiwei Dou, Geng Li, and Joshua Ronen, “Does Price Regulation Affect Competition? Evidence from Credit Card Solicitations,” Finance and Economics Discussion Series 2019-018. Board of Governors of the Federal Reserve System, 4. https://www.federalreserve.gov/econres/feds/files/2019018pap.pdf

[18] Ibid., 5.

[19] Bureau of Consumer Financial Protection Bureau, “The Consumer Credit Card Market,” August 2019, 24. https://files.consumerfinance.gov/f/documents/cfpb_consumer-credit-card-market-report_2019.pdf

[20] Vladimir Mukharlyamov and Natasha Sarin, “The Impact of the Durbin Amendment on Banks, Merchants, and Consumers,” University of Pennsylvania Law School (January 2019), 21. https://scholarship.law.upenn.edu/cgi/viewcontent.cgi?article=3048&context=faculty_scholarship

[21] Ibid., 31-32.

[22] Todd J. Zywicki, “The Law and Economics of Consumer Debt Collection and Its Regulation,” Mercatus Working Paper, Mercatus Center at George Mason University, 24. https://www.mercatus.org/system/files/Zywicki-Debt-Collection.pdf

[23] James R. Barth, Joseph J. Cordes, and Anthony M. J. Yezer, "Benefits and Costs of Legal Restrictions on Personal Loan Markets," Journal of Law and Economics 29, no. 2 (Oct. 1986): 357-380. https://www.journals.uchicago.edu/doi/pdfplus/10.1086/467123

[24] Julia Fonseca, Katherine Strair, and Basit Zafar, “Access to Credit and Financial Health: Evaluating the Impact of Debt Collection,” Federal Reserve Bank of New York Staff Report no. 814 (May 2017), 2. https://www.newyorkfed.org/medialibrary/media/research/staff_reports/sr814.pdf?la=en.%2525205

[25] See Craig Clark, “Does the CFPB Realize the APR May Be Misleading?,” LinkedIn, July 4, 2016. https://www.linkedin.com/pulse/does-cfpb-realize-apr-may-misleading-craig-clark-1/

[26] Todd J. Zywicki and Diego Zuluaga, “Comment on the CFPB’s Notice of Proposed Rulemaking on “Payday, Vehicle Title, and Certain High-Cost Installment Loans” Docket No. CFPB-2019-0006,” Cato Institute, May 15, 2019, 16. https://www.cato.org/sites/cato.org/files/pubs/pdf/zywicki-zuluaga-public-comment-5-15-19.pdf

[27] Financial Conduct Authority, “High‐​Cost Credit: Including Review of the High‐​Cost Short‐​Term Credit Price Cap,” Feedback Statement FS 17/2, July 2017, 11, https://​www​.fca​.org​.uk/​p​u​b​l​i​c​a​t​i​o​n​/​f​e​e​d​b​a​c​k​/​f​s​1​7​-​0​2.pdf; FCA, “Proposals for a price cap on high‐​cost short‐​term credit,” Consultation Paper CP14/10, July 2014, 6, https://​www​.fca​.org​.uk/​p​u​b​l​i​c​a​t​i​o​n​/​c​o​n​s​u​l​t​a​t​i​o​n​/​c​p​1​4​-​1​0.pdf.

[28] Mukharlyamov and Sarin, “The Impact of the Durbin Amendment,” 33.

[29] Bureau of Consumer Financial Protection, “Data Point: Credit Invisibiles,” May 2015, 6. https://files.consumerfinance.gov/f/201505_cfpb_data-point-credit-invisibles.pdf

[30] Ibid., 17.

[31] Ibid., 15.

[32] Matt Tatham, “Consumer Credit Review,” Experian, January 13, 2020. https://www.experian.com/blogs/ask-experian/consumer-credit-review/

[33] Ibid. and Bureau of Consumer Financial Protection, “The Consumer Credit Card Market,” 21.

[34] Diego Zuluaga, “Financial Inclusion without Finance? The Misguided Quest to Limit Choice in Consumer Credit,” Speech at the Financial Services Centers of America (FiSCA) Annual Conference, October 21, 2019. https://www.cato.org/blog/financial-inclusion-without-finance-misguided-quest-limit-choice-consumer-credit

[35] Todd J. Zywicki, “Market-Reinforcing versus Market-Replacing Consumer Finance Regulation,” 320-321, in Reframing Financial Regulation: Enhancing Stability and Protecting Consumers, eds. Hester Peirce and Benjamin Klutsey. Mercatus Center at George Mason University, 2016. https://www.mercatus.org/system/files/peirce_reframing_ch12.pdf

[36] Consumer Financial Protection Bureau, “CFPB Announces Taskforce on Federal Consumer Financial Law,” October 11, 2019. https://www.consumerfinance.gov/about-us/newsroom/cfpb-announces-taskforce-federal-consumer-financial-law/

[37] Diego Zuluaga, “A Plan to Give CFPB’s New Task Force Some Teeth,” American Banker, January 22, 2020. https://www.americanbanker.com/opinion/a-plan-to-give-cfpbs-new-task-force-some-teeth

[Author’s note: as I composed this essay, unbeknownst to me, some clever devil in the Trump administration thought it wise to change the geographic designations of President Trump’s current nominees to the Fed’s Board of Governors. Thus Judy Shelton, who in the January 16th nomination announcement was designated “of Virginia,” is now described as being “of California,” while Chris Waller, listed then as “of Missouri,” is now “of Minnesota.” Because Shelton was in fact born in California, her nomination now appears in conformity with long-standing practice as described in my article. The only basis I’m aware of for Chris Waller’s Minnesota designation is that he earned his B.S. at Bemidji State U.]

Although one might suppose that, to be eligible to serve as a Federal Reserve governor, a candidate should know something about monetary policy or banking or both, so far as the law is concerned, only two things clearly matter: a candidate cannot serve more than once, and he or she can’t be from just anywhere.

Few Americans will know that that second requirement exists, why it does, and how it has come to be routinely ignored. Yet the question of geographic eligibility is likely to be raised during upcoming Senate confirmation hearings for two current Fed Board nominees, Judy Shelton and Chris Waller. Hence this brief “Fed Geography Lesson,” written for the sake of those who, should a fuss be raised about where a nominee comes from, wonder what it’s all about.

Checking Eastern Influence

Unlike other central banking arrangements, the Federal Reserve System consists, not of a single central bank, but of a dozen banks each responsible for a separate territory or district. The system is overseen by a Board of Governors headquartered in Washington, D.C., whose seven members are appointed by the President for terms lasting up to 14 years.

When, in 1913, the Federal Reserve Act was being hammered-out in Congress, certain influential Democratic Congressmen, fearing that the Federal Reserve Board (as the present Board of Governors was then known) might come to be dominated by persons (and Wall Street bankers and their cronies especially) from the East Coast, took preventative action: they had the Act’s 10th Section stipulate, first, that no more than one member of the Board should be from any one Federal Reserve district; and second, that in nominating Board members the President “shall have due regard to a fair representation of the financial, agricultural, industrial, and commercial interests, and geographical divisions, of the country.”

From Obscurity to Controversy: The Case of Peter Diamond

For most of the Fed’s existence, the Federal Reserve Act’s geographical diversity provisions drew little public attention. But in 2011 they became front-page news when Richard Shelby (R‑AL), then ranking member of the Senate Banking Committee, appealed to them, and to the first provision especially, in successfully opposing Nobel Laureate Peter Diamond’s appointment to the Board. Although Diamond was supposed to represent the Chicago Fed district, he had only tenuous ties to it, whereas he’d long resided in Boston, a district that was already being represented at the time by Daniel Tarullo.

Some commentators, including the CMFA’s own Mark Calabria, defended Shelby’s stand, holding it to mark a needed return to strict adherence to the law and to the intentions of the Federal Reserve’s founders. Others, however, including Diamond himself, saw it as mere cover for a strictly partisan act, namely, Republican retaliation for Democrat Senators’ having blocked Randall Kroszner’s Board reappointment several years before.

In truth, both interpretations were valid.

Today, Judy Shelton’s nomination has raised the geographic diversity question again. According to some of Shelton’s critics, including Sam Bell of Employ America, being “of Virginia” (according to the official nomination papers), Shelton is only qualified to represent the Richmond Fed district. But that district is already represented by Governor Lael Brainard. Like Shelby, Shelton’s critics have the law on their side; and, like him, they are, one strongly suspects, only inclined to insist upon it because they hope it might disqualify a nominee they oppose for other, including partisan, reasons.

A Sea Change

When, and how, did the Fed’s geographic diversity requirement devolve into a weapon of party politics? Clark Hildabrand, a lawyer who was then completing his J.D. at Yale, where he studied with Cato adjunct scholar Jonathan Macey, answered that question very thoroughly in a 2016 note for the Yale Law & Policy Review. I draw heavily upon that work here.

Early in his note, Hildabrand observes that, of the Federal Reserve Act’s two provisions aimed at achieving a geographically-diverse Board, only the first, providing that no two of the Board’s members be from the same Federal Reserve district, is specific enough to have real teeth. Yet, even it allowed for more than one interpretation of what being “from” a particular Fed district meant. The deliberations that gave shape to the Act’s final draft suggest that “from” was originally understood to refer to where a prospective appointee lived at the time of his or (eventually) her nomination. Still, it was not long before

Presidents, intent on nominating individuals with similar political values, close personal ties, or recognized expertise, began to bend the requirements… away from the focus on residency… and toward inclusion of where the nominee was born.

Allowing for this particular bending of the rule, the diversity provision was abided by until 1978. In that year, what Hildabrand calls a “sea change” came about with President Carter’s nomination of G. William Miller to represent the Fed’s 12th (San Francisco) District. Although Miller got his law degree from Berkeley, he was born in Kansas City and had been living in Boston for two decades. But both the Boston and Kansas City Fed districts were already represented on the Board, while the San Francisco spot was open. Carter therefore asked the Justice Department’s Office of Legal Counsel (OLC) whether his choice of Miller was consistent with the statute. In its response, the OLC opined only that Miller did not have to be born in and reside in the Fed District he was appointed to represent. He was qualified, in other words, to represent either the Kansas City or the Boston district.

That finding did not, of course, mean that Miller could legally represent the 12th (San Francisco) District! Still, his nomination went forward. When questioned about his West-Coast ties, Miller said he understood “that an opinion has been given by the Attorney General’s Office that an adequate relationship exists in order for me to be a representative of that district.” Miller had either been misled himself or was misleading his interrogators. Still, the Senate took him at his word, paving the way, Hildabrand says, “to even lesser Senate enforcement of the geographic diversity requirements.”

Miller’s case was soon followed by others like it. In 1979, for example, Emmett Rice was appointed to represent the 2nd (New York) Fed district despite being a long-time resident of Washington, D.C. who was born in South Carolina; and in 1980 Lyle Gramley, who also lived in Washington and was born in Illinois, was chosen to represent the Kansas City district. Gramley’s case provoked objections by several Senators, including Jake Garn (R‑Utah), the Senate Banking Committee’s ranking minority member. According to that Committee’s report on Gramley’s nomination, the Senators complained

that in recent years strict attention has not been given to the representation requirements in the Federal Reserve Act. …In several cases individual Governors represented regions in which they have not lived for some time or in which they have spent only a small portion of their lives.

The committee nonetheless overwhelmingly recommended that Gramley be confirmed, with only two Senators dissenting. Senator Garn was among those who supported him, but only because he thought “it would be unfair to penalize Dr. Gramley” after he’d supported others concerning whom the same objections might have been raised. Garn nonetheless made it clear nevertheless that in future he’d “oppose otherwise qualified nominees unless they honestly met the Federal Reserve Act’s geographical and other diversity requirements”; and the committee as a whole resolved “that in the future full consideration will be given to the regional and economic interest requirements specified… in the Federal Reserve Act” and that “regional representation should reflect to the maximum extent possible, a genuine relationship with the Federal Reserve district from which the individual has been nominated.”

Alas, if it was kept at all, the Senate’s resolution wasn’t kept for long. Instead, the Senate was eventually to pay less heed than ever to the Federal Reserve Act’s diversity requirements.

The Floodgate Opens

If in confirming Miller the Senate not only bent but severely twisted the law calling for geographic diversity at the Fed, when it confirmed Susan Bies’s 2001 nomination by President Bush, it went from twisting the law to thumbing its nose at it. Bies was born in New York and resided in Memphis. But because those places were in already-represented Fed districts, President Bush nominated her to represent the 7th (Chicago) Fed District, where she’d earned her graduate degree and worked briefly at the Chicago Fed. So far, the case resembles Miller’s. But Bies’s case differed in that Bies was generally recognized, in official documents and throughout the hearings, as being “of Tennessee.” That is, the Senate did not consider her to be “of” the district she was nominated to represent. Yet no Senator objected to her appointment on that score.

From this point until Peter Diamond’s 2010 nomination, the Fed’s geographic diversity requirement appeared to be a dead letter. According to Hildabrand, out of sixteen Fed Board members confirmed by the Senate between 2001 and 2016, nine were officially held to be “of” Fed districts other than those they were meant to represent. These were:

• Susan Bies, 2001: “of Tennessee,” but to represent the Chicago Fed district;
• Ben Bernanke, 2002: “of New Jersey,” but to represent the Atlanta Fed district;
• Donald Kohn, 2002: “of Virginia,” but to represent the Chicago Fed district;
• Ben Bernanke, 2006: “of New Jersey,” but to represent the Atlanta Fed district;
• Randall Kroszner, 2006: “of New Jersey,” but to represent the Richmond Fed district;
• Frederic Mishkin, 2006: “of New York,” but to represent the Boston Fed district;
• Elizabeth Duke, 2008: “of Virginia,” but to represent the Philadelphia Fed district;
• Jerome Powell, 2012: “of Maryland,” but to represent the Philadelphia Fed district; and
• Jeremy Stein, 2012: “of Massachusetts,” but to represent the Chicago Fed district.

Hildabrand notes that, in three of these instances (Bernanke 2002 and 2006 and Stein 2012), the nominees were in fact born in the Fed districts they were slated to represent. So they might have met the diversity requirement by being considered “of” their birth states. Still, the fact that the Senate didn’t bother to consider them so, yet did not hesitate to confirm them, speaks to the degree to which the diversity requirement had ceased to matter: even when a relatively easy way to meet it was at hand, no one bothered to use it.

The Charade Continues

Since Hildabrand wrote, and notwithstanding Shelby’s highly-publicized appeal to the diversity requirement in opposing Peter Diamond’s confirmation, the Senate has continued to do little more than pay lip service to that requirement. Although Randy Quarles was born in San Francisco and lived in Utah (which is also part of the San Francisco Fed district) when he was being considered in 2017 for the post of Fed vice chair of bank supervision, when it came to being nominated he allowed himself to be represented as being “of Colorado,” which is in the Kansas City Fed district, thus avoiding a clash with Janet Yellen, who already represented the San Francisco district.

And consider the case of Fed Vice Chairman Richard Clarida, who was appointed in 2018. Clarida was born in Illinois and lived in New York, but was designated “of Connecticut,” to qualify him for the 1st (Boston) Federal Reserve district, which unlike Illinois and New York was as yet unrepresented. But Clarida’s only substantial connection to Connecticut consisted of his having been a managing director at PIMCO, which is located in Southport, CT, in Fairfield County. And it happens that, although most of Connecticut falls within the Boston Fed district, Fairfield County belongs to the New York Fed, which Powell already represented. Never mind: so far as the record reveals, no Senator bothered to ask Mr. Clarida which part of Connecticut he was “of.”

In short, although they did not do so for most of the Fed’s existence, for the last two decades, Senators have routinely turned a blind eye to the Federal Reserve Act’s geographic diversity requirement. The Peter Diamond case was exceptional. And, should any Senator oppose Judy Shelton’s on geographic grounds, that, too, will be exceptional.

It may also prove awkward, for Christopher Waller, President Trump’s other nominee. Waller is a far less controversial candidate than Shelton. But he was born in Nebraska and both lives in and has been designated as being “of” Missouri—two states already represented by sitting Fed governors. In short, geographically speaking, he and Shelton are in precisely the same boat. That should make it awkward for anyone to oppose one on geographic diversity grounds without opposing both. But, partisan politics being what they are, no one should be surprised to see the attempt made.

Ties That Bind

If the Fed’s geographic diversity requirements have ceased to be meaningful except as a (very blunt) weapon of partisan politics, perhaps we’d be better off without them.

Perhaps. But the requirements’ original purpose—making sure the Fed didn’t become a plaything of East Coast banking interests—shouldn’t be forgotten. In fact, as Hildabrand documents, the requirements’ neglect has gone hand-in-hand with a dramatic change in the actual geographic composition of Fed appointees. For example, while only 30 percent of Fed Board members appointed between 1914 and 1996 were born on the East Coast, 80 percent of those appointed between 1996 and 2015 were born there, and that despite a considerable, concurrent decline in the East Coast’s share of total U.S. population. This bias, it bears noting, is only compounded by Wall Street’s outsize influence upon the regional Fed banks. In an age that prizes diversity while worrying about Wall Street’s capturing of those meant to regulate it, this makes for very bad optics, if nothing worse; and one very much suspects that, were the matter to be put to a referendum, the Federal Reserve Act’s geographic requirements would remain on the books.

But having geography matter on paper is one thing; making it matter in practice, not just occasionally, but consistently, is another. Doing so means making the statute tamper-proof, or at least a lot more tamper-resistant. That shouldn’t be hard: as Hildabrand notes, it could be accomplished by amending the Fed’s geographic diversity provision so as to have it specify that a candidate’s geographic origin be determined by his or her residence as reported to the IRS, or (alternatively) by where he or she has been registered to vote in the years leading to the candidate’s initial nomination.

On the other hand, legislators should keep in mind that geographic diversity is but one of many sorts of diversity one might wish to see exhibited by the Fed’s governing body. It happens to have been a form of diversity Congress considered especially important in 1913. But today there are other diversity goals for which arguments have been offered, including having the board include at least one community banker, more women and minorities, or fewer PhDs. To pile-on diversity objectives is to limit the pool of prospective governors having other desirable qualifications, such as familiarity with various non-financial industries, or being a good communicator. It’s possible, in other words, to go too far in mandating Fed Board diversity, geographic or otherwise. So Congress must decide, again, what sort of diversity it cares about most.

In the meantime, should any Senators choose to play the geography card during the coming confirmation hearings, we should allow that they’ll have the spirit, if not the letter, of the law on their side. But let no one suppose that, in playing that card, they aren’t also playing politics.

[Cross-posted from Alt‑M.org]

The Community Reinvestment Act is supposed to ensure that banks lend to low- and moderate-income households wherever they operate. But there are reasons to doubt its effectiveness.

In the Washington Post this summer, I reported findings (from a forthcoming paper with Andrew Forrester) that more than two-thirds of recent home mortgages in the District of Columbia for which banks can get CRA points went to high- rather than low-income borrowers. This is because current CRA regulations count loans to low-income borrowers and loans made in low-income census tracts (Figure 1a). D.C. has rapidly gentrified in recent years, as young professionals flocked into historically low-income neighborhoods, and many among these “gentrifiers” have bought homes. At present, CRA regulators take loans to gentrifiers into account when they evaluate banks, even though gentrifiers are not usually underserved borrowers.

Figure 1a: Loans to Low-Income Borrowers and in Low-Income Census Tracts Qualify for CRA Points

Gentrification, as a rule, is a good thing for both new arrivals and historic residents. A recent paper from the Federal Reserve Bank of Philadelphia finds that gentrification benefits the original residents of low-income neighborhoods. While more-educated homeowners seem to gain most, even renters and the less-educated are better off as a result of the improved living conditions and increased opportunity that gentrification brings about. The impact of gentrification on migration by less-educated renters, arguably the most vulnerable group, to other neighborhoods is relatively small: 4 to 6 percentage points.

The Philly Fed paper uses data from the 100 largest metropolitan statistical areas (MSAs), which needless to say differ widely in their local zoning laws, economic policies, history of segregation and discrimination, and other traits important for our analysis. It may well be that particular MSAs have worse outcomes from gentrification, for example, because zoning restrictions make it difficult for housing supply to respond to higher demand, causing displaced renters to face greater cost pressures and longer commutes. That, however, is not a direct consequence of gentrification but of local housing policy.

Regardless of one’s views on the desirability of rapid neighborhood change, there is wide agreement that government policy should not promote gentrification. High-income young professionals have the means to buy a home. Besides, the excitement of moving to an up-and-coming neighborhood and the lure of capital gains provide ample incentive for many of them to do so.

Moreover, in specific instances, there may be displacement of poorer (often minority) original residents, throwing into question the desirability of government helping to accelerate an inevitable development. For D.C., Andrew and I found that the minority share of a census tract’s population had declined by three percentage points for every additional percentage point of CRA-eligible lending between 2012 and 2017. That does not mean the CRA caused the displacement, nor does it negate other benefits of gentrification. But it should help persuade policymakers that counting gentrifier mortgages for CRA purposes is unnecessary if not outright harmful (Figure 1b).

Figure 1b: Loans to High-Income “Gentrifiers” Currently Count for Banks’ CRA Evaluations

That is why I have praised Comptroller of the Currency Joseph Otting and Federal Deposit Insurance Corporation Chairman Jelena McWilliams’ decision to no longer count gentrifier loans in banks’ CRA evaluations. Their proposal, unveiled in December, says the following about gentrifier mortgagers:

Although the agencies remain committed to encouraging banks to meet the credit needs in LMI areas, for banks evaluated under the general performance standards, the proposal would not apply a geographic distribution test to a bank’s consumer and home mortgage product lines. Under the geographic distribution test in the current CRA framework, banks receive positive consideration for home mortgage and consumer loans made in LMI areas, even if they are made to middle- or upper-income individuals or families. Unlike small loans to businesses and small loans to farms in LMI areas that may result in additional job creation or other positive effects for the larger community, home mortgage and consumer loans to middle- or upper-income individuals and families in LMI areas are generally not as beneficial to LMI communities and may result in displacement.  Accordingly, this proposal would not apply the geographic distribution test to these banks’ home mortgage and consumer product lines. The result of this is that under the proposal, a mortgage loan to a high-income individual living in a low-income census tract would no longer qualify for CRA credit.

Otting and McWilliams are right. In the 1970s context of urban flight and decline, encouraging mortgages to high earners in low-income neighborhoods might have helped stem their migration to the suburbs---although the impact can only have been marginal, and the dramatic drop in house prices was the more meaningful spur for ambitious buyers. But those circumstances no longer apply. Instead, many large MSAs are changing rapidly, with a growing number of residents finding it hard to afford to live in them.

Ahead of Wednesday’s House Financial Services Committee hearing with Comptroller of the Currency Joseph Otting, Andrew and I have expanded our analysis to the five most-populated MSAs in the country: New York, Los Angeles, Chicago, Dallas, and Houston. We suspected our finding for D.C., that a large share of CRA-eligible 1-to 4-family (known as single-family) mortgages go to gentrifiers, would also apply to these MSAs. But, because gentrification in D.C. has been more rapid, and the original residents’ starting position arguably more precarious, we also anticipated a weaker gentrifier bias for other MSAs.

Table 1 lays out our findings. Three patterns are worth highlighting. The first is the substantial share of gentrifier mortgages in all CRA-eligible mortgages for all five MSAs, despite significant variation between them. The second is a steady increase in the share of gentrifier mortgages in the five years from 2012 to 2017. The third pattern is the large difference in gentrifier loans between New York and three of the four other MSAs, with L.A. somewhere in the middle but converging with New York more recently.

Table 1. Share of CRA-Eligible Single-Family Mortgages to High-Income Borrowers, by MSA and Year (%)

As we suspected, D.C. has an even greater share of gentrifier loans than other MSAs. This may be due to idiosyncratic economic factors related to the District’s profound, decades-long decline and its swift rebirth since the mid-2000s. Alternatively, Andrew and I only looked at mortgages in D.C. proper, rather than for the whole metropolitan area (which includes Arlington and Alexandria), which may bias our results since much recent gentrification has focused on the District – although some parts of Arlington have also undergone great change during this time period.

I can only speculate about the differences between New York and L.A., the Texas MSAs, and Chicago. Texas is known for its relatively flexible zoning rules, which help call forth new supply in response to housing demand, lowering prices and making homeownership more affordable to low-income families. Chicago's experience may have more to do with the city’s rising crime rate and the state of Illinois' economic underperformance since the 2008 recession ended. New York and L.A., on the other hand, are high-cost cities whose zoning codes appear to make housing needlessly unaffordable.

Comptroller Otting and Chairman McWilliams' proposal to stop counting high-income mortgages under a statute that aims at helping the underserved will not, on its own, make housing more affordable in America’s biggest cities. But it will focus CRA regulations on the borrowers for whose sake it was enacted, while helping researchers answer the most important policy question regarding this 42-year-old law: does it in fact encourage banks to lend without increasing risk?

In some previous posts, I’ve taken Federal Reserve officials, including former New York Fed President William Dudley, to task for continuing to insist that the Fed’s post-2008 “floor” operating system is a “simple” means for keeping overnight interest rates on target. Whatever the floor system’s merits may be, simplicity isn’t one of them.

But in weighing the advantages of the Fed’s floor system compared to those of a “corridor system,” Fed officials haven’t just put their thumbs on the floor-system scale by exaggerating its merits. They’ve also exaggerated the drawbacks of a corridor system. In particular, they’ve framed the choice as one between the current floor system (or rather an idealized version of it), and a revival of the Fed’s pre-2008 arrangement, with zero interest on reserves, a relatively wide (but variable) corridor, and heavy reliance upon open-market operations.

In fact, none of the “pro-corridor” economists I know —and there are more than a few of us—favors a return to the pre-2008 set-up, or anything like it. Instead, we mostly have in mind a symmetrical corridor, with the (usually though not always positive) interest rate on reserves as its lower limit, and the rate charged by some Fed lending facility—it could be the proposed standing repo facility—as its upper limit. Finally, most of us would argue for a relatively narrow corridor of 50 basis points or so, with its correspondingly limited role for open-market purchases and sales.

I had intended to elaborate upon this point. But thanks to Sir Paul Tucker, a former Bank of England Deputy Governor and author of Unelected Power: The Quest for Legitimacy in Central Banking and the Regulatory State, I don’t have to. For Paul argued the same point, very eloquently, at a Hoover Institution conference last year, in commenting on a presentation by Fed Vice Chair Randy Quarles. The conference proceedings, including Quarles’ contribution with Paul’s comments, are available online, so you can read the whole thing. Still, I can’t resist sharing some substantial excerpts, the better to tempt you to read the rest.

Paul begins by repeating a central argument of his book, to wit, that central banks should “live by a principle of parsimony in order to aid public comprehensibility and accountability”:

Central banks are very powerful bodies, led by unelected technocrats who are insulated from day-to-day politics. In our democracies, the delegation of government power can be legitimate only if we can track what the legislature’s agents are doing. Central banks should make that as straight-forward as possible. And, in jurisdictions that have chosen to have a market economy, they should distort market mechanisms no more than required to achieve their objectives.

This precept entails that central bank balance-sheet operations should at all times be as parsimonious as possible consistent with achieving their objectives. Thus, if price stability can be achieved using only interest rate policy, it should be; and if banking system resilience can be maintained without a permanently enormous central bank balance sheet, it should be.

In view of this Paul concludes that, “if there are other options, a floor system violates the principle of parsimony as it involves the central bank choosing to have a larger balance sheet than is necessary for monetary policy.”

But according to officials at the New York Fed (which is responsible for overseeing monetary operations), a corridor system is no longer a practical option. Their claim, Paul notes, rests upon two propositions. The first holds that, to manage a corridor the Fed would have to be capable of forecasting banks’ demand for reserves very accurately. The second asserts that it would have to engage in frequent open market operations.

Paul’s response, boiled down, is “rubbish.”

Conceptually, neither proposition is true in general. Nor, for what it’s worth, are they true in practice other than in rather particular circumstances.

Those circumstances are, broadly, where banks are set a reserves
target; they have to meet it very precisely; the spread between the lending rate and deposit rate is large; and the maintenance period is effectively short (so that there is little or no inter-temporal arbitrage across days). As it happens, nearly all those conditions held in the Fed’s pre-crisis operating system, but they were choices. Having to conduct frequent open market operations and to strive for precision in their forecasts of reserves-demand were consequences of those choices, nothing to do with corridor systems as such.

There are, instead (Paul goes on to say), all sorts of corridor systems, “with none having an exclusive right to the label.” These differ according to the width of the corridor, whether it is symmetrical or not, the length of the “reserve maintenance period” to which any reserve requirements refer, and various other specifications. (Readers wishing to learn more about the many choices and their pros and cons should start with this excellent Ulrich Bindseil article.) It is even possible, Paul notes, to have a corridor system that “does not require any open market operations at all or, indeed, any forecasting of the demand for reserves.”

What all this means, Paul concludes, is that “when the governors debate the merits of floor versus corridor systems, they do not need to be constrained by the Fed’s rather idiosyncratic pre-crisis system.” The Fed is therefore “not condemned …to stick with a giant balance sheet and a ‘floor system’ for rates forever.” Not condemned, that is, so long as those governors will allow themselves to revisit the floor-vs.-corridor question, with all the possible alternatives in mind, and without pretending that the present system has worked according to plan.

[Cross-posted from Alt‑M.org]

As we start off the New Year, we thought it might not be a bad idea to remind our readers of the need to resist status-quo bias in assessing both the Fed’s performance and the merit of alternative institutional arrangements. ‑Ed.

***

Although the movement to “End the Fed” has a considerable popular following, only a very tiny number of economists—our illustrious contributors amongst them—take the possibility seriously. For the rest, the Federal Reserve System is, not an ideal currency system to be sure (for who would dare to call it that?), but, implicitly at least, the best of all possible systems. And while there’s no shortage of proposals for reforming it almost all of them call only for mere tinkering. Tough though their love may be, the fact remains that most economists are stuck on the Fed.

This veneration of the Fed has long struck me as perverse. Its record can hardly be said, after all, to supply grounds for complacency, much less for the belief that no other system could possibly do better. (Indeed that record, as Bill Lastrapes, Larry White and I have shown, even makes it difficult to claim that the Fed has improved upon the evidently flawed National Currency system it replaced.) Further, as the Fed is both a monopoly and a central planning agency, one would expect economists’ general opposition to monopolies and to central planning, as informed by their welfare theorems and by the general collapse of socialism, to prejudice them against it. Yet instead of ganging up to look into market-based alternatives to the Fed, the profession, for the most part, has relegated such inquiries to its fringe.

Why? The question warrants an answer from those of us who insist that exploring alternatives to the Fed is worthwhile, if only to counter people’s natural but nevertheless mistaken inclination to assume that the rest of the profession isn’t interested in such alternatives because it has already carefully considered—and rejected—them.

It’s tempting to blame Fedophilia, and the more general phenomenon of what Larry White calls “status quo” bias in monetary research, on the Fed’s direct influence upon the economics profession. According to White, in 2005 the Fed employed about 27 percent more full-time macro- and monetary (including banking) economists than the top 50 US academic economics departments combined, while disseminating much of their research gratis through various in-house publications or as working papers. Perhaps not surprisingly, despite a thorough review of such publications, White could not find “a single Fed-published article that calls for eliminating, privatizing, or even restructuring the Fed.” That professional monetary economics journals are not much better may, in turn, reflect the fact, also documented by White, that Fed-affiliated economists also dominate those journals’ editorial boards.

But I doubt that a reluctance to bite the hand that feeds them is the only, or even the most important, reason why most economists seldom question the Fed’s desirability. Another reason, I suppose, is their desire to distance themselves from… kooks. Let’s face it: more than a few persons who’d like to “End the Fed” want to do so because they think the Rothschilds run it, that it had JFK killed because he planned to revive the silver dollar, and that the basic plan for it was hatched not by the Congressional Committee in charge of monetary reform but by a cabal of Wall Street bankers at a top-secret meeting on Jekyll Island.

Oh, wait: the last claim is actually true. But claims like the others give reasonable and well-informed Fed critics a bad name, while giving others reason for wishing to put as much space as possible between themselves and the anti-Fed fringe.

I’m convinced that imagination, or the lack of it, also plays a part. To some extent, the problem is too much rather than too little imagination. With fiat money, and a discretionary central bank, it’s always theoretically possible to have the money stock (or some other nominal variable) behave just like it ought to, according to whichever macroeconomic theory or model one prefers. In other words, a modern central bank is always technically capable of doing the right thing, just as a chimpanzee jumping on a keyboard is technically capable of typing-out War and Peace.

Just as obviously, any conceivable alternative to a discretionary central bank, whether based on competition and a commodity standard or frozen fiat base or on some other “automatic” mechanisms, is bound to be imperfect, judged relative to some—indeed any—theoretical ideal. Consequently, an economist need only imagine that a central bank might somehow be managed according to his or her own particular monetary policy ideals to reckon it worthwhile to try and nudge it in that direction, but not to consider other conceivable arrangements.

That there’s a fallacy of composition of sorts at play here should be obvious, for a dozen economists might hold as many completely different monetary policy ideals; yet every one might be a Fedophile simply because the Fed could cater to his or her beliefs. In actual fact, of course, the Fed’s conduct can at most satisfy only one of them, and is indeed likely to satisfy none at all, and so might actually prove distinctly inferior to what some non-central bank alternative would achieve. So in letting their imaginations get the best of them, all twelve economists end up endorsing what’s really the inferior option.

If you don’t think economists are really capable of such naivete, I refer you to the literature on currency boards, in which one routinely encounters arguments to the effect that central banks are always better than currency boards because they might be better. Or how about those critics of the gold standard who, having first observed how, under such a standard, gold discoveries will cause inflation, go on to conclude, triumphantly, that a fiat-money issuing central-bank is better because it might keep prices stable?

But if economists let their imaginations run wild in having their ideal central banks stand in for the real McCoys, those same imaginations tend to run dry when it comes to contemplating radical alternatives to the monetary status quo. Regarding conventional beliefs concerning the need for government-run coin factories, which he (rightly) dismissed as so much poppycock, Herbert Spencer observed, “So much more does a realized fact influence us than an imagined one, that had the baking of bread been hitherto carried on by government agents, probably the supply of bread by private enterprise would scarcely be conceived possible, much less advantageous.” Economists who haven’t put any effort into imagining how non-central bank based monetary systems might work find it all too easy to simply suppose that they can’t work, or at least that they can’t work at all well. The workings of decentralized markets are often subtle; while such markets’ ability to solve many difficult coordination problems is, not only mysterious to untrained observers, but often difficult if not impossible even for experts to fathom except by means of painstaking investigations. In comparison monetary central planning is duck soup—on paper, anyway.

Nor does the way monetary economics is taught help. In other subjects, the welfare theorems are taken seriously. In classes on international trade, for example, time is always spent, early on, on the implications of free trade: never mind that the world has never witnessed perfectly free trade, and probably never will; it’s understood that the consequences of tariffs and other sorts of state interference can only be properly assessed by comparing them to the free trade alternative, and no one who hasn’t studied that alternative can expect to have his or her pronouncements about the virtues of protectionism taken seriously.

In classes in monetary economics, on the other hand, the presence of a central bank—a monetary central planner, that is—is assumed from the get-go, and no serious attention is given to the implications of “free trade in money and banking.” Consequently, when most monetary economists talk about the virtues of this or that central bank, they’re mostly talking through their hats, because they haven’t a clue concerning what other institutions might be present, and what they might be up to if the central bank wasn’t there.

Since monetary systems not managed by central banks, including some very successful ones, have in fact existed, economists’ inability to envision such systems is also evidence of their ignorance of economic history. That ignorance in turn, among younger economists at least, is a predictable consequence of the now-orthodox view that history can be safely boiled down to a bunch of correlation coefficients, so that they need only gather enough numbers and run enough regressions to discover everything worth knowing about the past.

Those who’ve been spared such “training,” on the other hand, often have a purblind view of the history of money and banks—one that brings to mind Saul Steinberg’s famous New Yorker cover depicting a 9th-Avenuer’s view of the world, with its almost uninhabited desert between the Hudson and the Pacific, and China, Japan, and Russia barely visible on the horizon. If he or she knows any monetary history at all, the typical (which is to say American) economist knows something about that history in the U.S., and perhaps considerably less about events in Great Britain. Theirs is, in short, just the right amount of knowledge to be very dangerous indeed.

And dangerous it has been. In particular, because the U.S. before 1914, and England before the Bank of England began acting as a lender of last resort, happened to suffer frequent financial crises, economists’ historical nearsightedness has given rise to the conventional wisdom that any fractional-reserve banking system lacking a lender of last resort must be crisis-prone, and to clever (if utterly fantastic) formal models serving to illustrate the same view (or, according to economists’ twisted rhetoric, to “prove” it “rigorously”). It has, correspondingly, led economists to ignore or at least to underestimate the extent to which legal restrictions, including unit banking laws in the U.S. and the six-partner rule in England, contributed to the deficiencies of those countries’ banking systems. Finally, and most regrettably, it has caused economists to overlook altogether the possibility that the monopolization of paper currency has itself been more a cause of than a cure for financial instability.

The good news is that Fedophilia is curable. Milton Friedman, for one, was a recovering Fedophile: later in his career, he repudiated the mostly-conventional arguments he’d once put forward in defense of a currency monopoly. Friedman, of course, was a special case: a famous proponent of free markets, he had more reason than most economists do to view claims of market failure with skepticism, even if he’d once subscribed to them himself. Even so, his was only a half-hearted change of heart, in part (I believe) because he still hadn’t drawn the lessons he might have from the banking experiences of countries other than the U.S. and England.

Friedman’s case suggests that it will take some pretty intense therapy to deprogram other Fed inamoratos, including a regimen of required readings. Charles Conant’s History of Modern Banks of Issue will help them to overcome their historical parochialism. Vera Smith’s The Rationale of Central Banking will do more of the same, while also exposing them to the lively debates that took place between advocates and opponents of currency monopolies before the former (supported by their governments’ ravenous Treasuries) swept the field. The Experience of Free Banking, edited by Kevin Dowd (with contributions by several Alt‑M contributors including yours truly) gathers studies of a number of past, decentralized currency systems, showing how they tended to be more stable than their more centralized counterparts, while another collection, Rondo Cameron’s Banking in the Early Stages of Industrialization, shows that less centralized systems were also better at fostering economic development. Finally, instead of being allowed to merely pay lip service to Walter Bagehot’s Lombard Street, Fedophile’s should be forced, first to read it from cover to cover, and then to re-read out-loud those passages (there are several) in which Bagehot explains that there’d be no need for lenders of last resort had unwise legislation not created centralized (“one reserve”) currency systems in the first place. The last step works especially well in group therapy.

Of course, even the most vigorous deprogramming regimen is unlikely to alter the habits of hard-core Fed enthusiasts. But it might at the very least make them more inclined to engage in serious debate with the Fed’s critics, instead of allowing the Fed’s apologists to go on believing that they answer those critics convincingly simply by rolling their eyes.