Traditional Risk Management in Banks followed the Hallowed 3-6-3 Rule

Traditionally, risk management in banks was simple. Banks' main risks were credit risks, and managing these boiled down to a few rules of thumb that bankers understood well: you lend conservatively, be careful who you lend to, build long-term relationships, and so on. The only quantitative rule that mattered was the hallowed 3-6-3 rule, the basis of banking: borrow at 3%, lend at 6%, and be on the golf course by 3 p.m.

The main source of market risk for the banks -- the risk of loss due to changes in market prices or rates -- was their exposure to changing interest rates. This had caused major problems in periods of high inflation and volatile monetary policy in the 1970s and 1980s, but banks had learned to handle this risk using stress tests and interest rate swaps.

--Kevin Dowd and Martin Hutchinson, Alchemists of Loss: How Modern Finance and Government Intervention Crashed the Financial System (Chichester, UK: John Wiley and Sons, 2010), 111.

During the European Sovereign Debt Crisis, Various Politicians and Intellectuals Raised the Cry That the Bond Market Had Displaced Democracy in Imposing Austerity Policies

This desire for security is crucial, too, in explaining the leverage which the government exercises upon the bond market when it comes to its own debt. Those who deny this leverage, who instead hold that it is exercised by the bond market over governments, often point to that species of financial life known as the bond vigilante. Originally uncovered by Ed Yardeni, a well-known investment research consultant, a bond vigilante is someone who roams the sovereign debt market on the lookout for governments that are pursuing macroeconomic policies to which investors are liable to object. Such policies include elevated budget deficits, escalating debt, and a loose monetary regime. Once such malefactors are identified, the bond vigilante will join forces with his or her fellows in the cause of market justice and aggressively bet against the debt securities of the country involved. With the costs of funding its debt increasing as a result, the country is forced to obey the bond vigilante. Depending on the problem at hand, the budget deficit will have to be slashed, or the money supply tightened, or both. Given that those who take part in this type of trading are described as vigilantes, the case is already stacked against their actually pursuing justice. It is a way of speaking very much in accord with the opinion of bond market critics who see traders there as having usurped the democratically granted authority of governments to oversee the economy. There was a slew of books and articles published in the 1990s stating this charge. The issue then went dormant in the early to late 2000s, until it reemerged amid the European sovereign debt crisis that began in 2010. Various politicians and intellectuals once again raised the cry that the bond market had displaced democracy in imposing austerity policies.

--George Bragues, Money, Markets, and Democracy: Politically Skewed Financial Markets and How to Fix Them (New York: Palgrave Macmillan, 2017), 109-110.

The Austrian School of Economics Sees the Interest Rate as a Real Phenomenon, but the Keynesian Liquidity Preference Theory Sees the Interest Rate as a Monetary Phenomenon

However, this changed with the work of the economists of the Austrian School of Economics and the (neo-)classical school. They interpreted the interest rate as a real phenomenon.  As such, the interest rate phenomenon would not be related to the existence of money as such. They showed that even in a barter economy there would be an interest rate. . . .

The interpretation of the interest rate as a real phenomenon was challenged by the work of John Maynard Keynes (1883–1946). According to his liquidity preference theory, the interest rate is a monetary phenomenon, determined by the supply of and demand for money.

--Ansgar Belke and Thorsten Polleit, Monetary Economics in Globalised Financial Markets (Berlin: Springer-Verlag, 2009), 151-152.

The Financial Crisis Evolved into a European Sovereign Debt Crisis in Euro Area Periphery Countries

The financial crisis evolved into a European sovereign debt crisis as investors started to doubt the sustainability of government debt in euro area periphery countries. Capital left Greece, Ireland, Portugal, and later Spain and Italy. The capital flight from South to North sharply increased government bond yields in the euro area crisis economies. Discrimination between bonds did not only depend on debt-to-GDP ratios. Instead, investors revised expectations about future developments, tax revenues, or the sustainability of current account balances, pushing up government borrowing costs.

--Andreas Hoffmann and Nicolas Cachanosky, "Unintended Consequences of ECB Policies in Europe," in Banking and Monetary Policy from the Perspective of Austrian Economics, ed. Annette Godart-van der Kroon and Patrik Vonlanthen (Cham, CH: Springer International Publishing, 2018), 114.

From Hayek's Point of View, the Economic and Monetary Union (EMU) Focused Too Much on Macroeconomics as Developed or Understood by the Keynesians

From Hayek’s point of view we can say that the EMU [Economic and Monetary Union] focused too much on ‘‘macroeconomics’’ as developed or understood by the Keynesians. The interpreters of Keynes, and perhaps Keynes himself, believed that an all-powerful central authority can perform fiscal and monetary policy to increase employment and income at practically no cost. Hayek opposed that view on microeconomic grounds, based on the subtle operations of credit expansion and monetary policy through the channels of the economy. In a sense, the Keynesian arguments call for a ‘‘quick and dirty’’ dealing with the recession whereas the more subtle Hayekian arguments deal with the causes of the depression which can be traced back to credit expansion and monetary policy before the recession. Of course, the all-powerful central authority of Keynes materializes in the modern Bureaucracy of the EU and the roots of the Keynesian idea, in that respect, can be traced back to the Soviet paradigm of the early 1920s.

--Efthymios G. Tsionas, The Euro and International Financial Stability, Financial and Monetary Policy Studies 37 (Cham, CH: Springer International Publishing, 2014), 47.

The Greek Economy Is Completely under the Influence of Monopolies or Cartels

The Greek economy, for example, is completely under the influence of monopolies or cartels and the actual work produced by the Competition Committee is quite small. Five hundred job descriptions or occupations are ‘‘protected’’ in Greece, since the 1920s, including for example taxi drivers, dentists, pharmacies, lawyers etc. In industry or retail, oligopolies rule freely the entire market. It is not surprising then, that since 2008 prices have remained high for most if not all retail products without any tendency to fall, despite the dramatic reduction in household incomes.

--Efthymios G. Tsionas, The Euro and International Financial Stability, Financial and Monetary Policy Studies 37 (Cham, CH: Springer International Publishing, 2014), 5.

The Income Effect Was the Central Problem in the Neoclassical Controversy over the Demand Curve

The income effect was the central problem in what Leland Yeager referred to as the “Methodenstreit over demand curves.” Milton Friedman initiated this controversy in 1949 with his famous article, “The Marshallian Demand Curve,” and the debate was carried on sporadically during the 1950s. Friedman challenged the prevailing Hicksian interpretation of the Marshallian demand curve, arguing that: 1. it misrepresented the ceteris paribus conditions of Marshall’s derivation of the demand curve; and 2. it was less useful for the analysis of practical problems than Marshall’s demand curve, properly understood.

--Joseph T. Salerno, "The 'Income Effect' in Causal-Realist Price Theory," in The Economic Theory of Costs: Foundations and New Directions, ed. Matthew McCaffrey, Routledge Frontiers of Political Economy 236 (London: Routledge, 2018), 28.

Keynes Describes Communism As a Religion and Marxian Socialism as an Illogical Doctrine

At the time, Keynes saw only two alternatives to capitalism, protectionism and Marxian socialism. He opposed both, not simply because they interfered with a free society, but because they were based on "logical fallacy. Both are examples of poor thinking, of inability to analyze a process and follow it out to its conclusion . . . Marxian socialism must always remain a portent to the historians of opinion -- how a doctrine so illogical and dull can have exercised so powerful and enduring an influence over the minds of men".

He preferred a managed, capitalist system. . . .

In "A Short View of Russia", written after a trip to Russia in 1925, Keynes describes communism as a religion. He defines religion to include "the pursuit of an ideal life for the whole community of men".

--Allan H. Meltzer, Keynes's Monetary Theory: A Different Interpretation (Cambridge, UK: Cambridge University Press, 2005), 39-40.

The Farm Lobby in Germany Had Held the Country Captive Since the Tariff-Wall Days of Otto von Bismarck

Polls suggest that people agree with the statement that farm subsidies are necessary to guarantee a secure food supply; economists, on the other hand, see farm subsidies as wasteful and unnecessary for these ends. He then asks, 'Why are economists not listened to?' One might think that people just have not thought about it, but even when explained well, economists' analyses are not persuasive or interesting to many people. Thus, consumers become increasingly 'rationally ignorant' that they are paying elevated prices for their food -- it is not worth the effort of becoming informed, protesting or caring.

Blame is normally laid at the feet of the French for the CAP [the Common Agricultural Policy]. Many see Germany as being the poor soul that was dragged into accepting the CAP as the price for a free market in industrial goods. It should be noted, however, that German agriculture opposed the policy even more so because it feared the CAP would reduce its protections, which were the highest in Europe at the time. The farm lobby in Germany had held the country captive since the tariff-wall days of Otto von Bismarck. With the highest support prices in the EEC, Germany feared that harmonization would bring painful price cuts for its politically influential arable farmers.

--Brian Ó Caithnia, "Compounding Agricultural Poverty: How the EU's Common Agricultural Policy Is Strangling European Recovery," in Institutions in Crisis: European Perspectives on the Recession, ed. David Howden, New Thinking in Political Economy (Cheltenham, UK: Edward Elgar Publishing, 2011), 202.

Professor Yeager Recognizes the Misleading Use of the Comparative-Statics Method by Reswitching Theorists

In his section on the consumption paradox, Professor Yeager clearly recognizes the misleading use of the comparative-statics method by reswitching theorists. . . . Aren't the reswitching theorists really only comparing alternative steady states rather than analyzing a process of change? Yes, this seems to be it. In his own words: "References to changes in the interest rate and switches in technique serve stylistic convenience only". Recognizing that comparative-statics analysis has been dressed up in a dynamic garb, Professor Yeager blows the whistle on the Cambridge theorists.

--Roger Garrison, "Comment: Waiting in Vienna," in Time, Uncertainty, and Disequilibrium: Exploration of Austrian Themes, ed. Mario J. Rizzo (Lexington, MA: Lexington Books, 1979), 223.

Using Single-Interest-Rate Analysis, Reswitching Is a Fact, BUT Using Multiple-Interest-Rate Analysis, Reswitching Is a Chimera

The present values of the two income streams never cross and therefore, in the Fisher model, there is neither switching nor reswitching when the interest rate variable is redefined to include all the simultaneously determined interest rates previously thought devoid of economic significance, and the dual expression applies. Seen through the spectacles of single-interest-rate analysis, reswitching is a theoretical and empirical fact. Seen through the alternative spectacles of multiple-interest-rate analysis, reswitching is a chimera.

--Michael J. Osborne, Multiple Interest Rate Analysis: Theory and Applications (Houndmills, UK: Palgrave Macmillan, 2014), 99.

Some Countries in the European Periphery (Greece Being the Leading Example) Continued the Keynesian Practices up until the Early 1990s

In the period after the World War II, governments were totally devoted to the Keynesian ideas of irresponsible fiscal and monetary expansion up to late 1970s when ‘‘stagflation’’ appeared. Some countries in the European periphery (Greece being the leading example) continued the Keynesian practices up until, roughly, the early 1990s. It is true that the problems of inflation in the mid 1980s necessitated the adoption of certain austerity measures, but pure fiat money creation as well as fiat money creation through excess borrowing, continued. Despite inflationary expectations, the private sector was expecting ‘‘cheap money’’ in the long run. By late 1990s, the credit expansion was booming, and the Greek Olympic Games put much more pressure on public finances as well as on the public debt—which began skyrocketing since the early 1980s, under a socialist administration.

--Efthymios G. Tsionas, The Euro and International Financial Stability, Financial and Monetary Policy Studies 37 (Cham, CH: Springer International Publishing, 2014), 86.

With the Eclipse of Austrian Economics in the 1930s, a Key Perspective on the Importance of the Economy’s Supply Side in Economic Fluctuations Was Lost

After the publication of the General Theory, which Hayek never formally reviewed, and the apparent triumph of Keynesianism, Hayek’s The Pure Theory of Capital was virtually ignored. The Pure Theory was an attempt by Hayek to provide theoretical foundation for an eventual fully developed theory of a money-production economy to compete with Keynes’s “general” theory. Sadly, the whole debate became a mostly forgotten side note in the history of economic thought. What was lost? Backhouse and Laidler  sum it up nicely: “With the eclipse of Austrian Economics in the 1930s, a key perspective on the importance of the economy’s supply side in economic fluctuations was lost.” By ignoring that current investment has an impact on not just the size but also the composition of the future capital stock, Keynes and IS-LM Keynesians, to an even greater degree, lost sight of key insights developed most fully by the Austrians but also by Keynes’s English contemporaries, such as Robertson,  that “mistaken investment decisions made in the present had a capacity to disrupt future equilibria between supply and demand” in either the economy as a whole or in key sectors.

--John P. Cochran, "Capital-Based Macroeconomics: Austrians, Keynes, and Keynesians," in The Oxford Handbook of Austrian Economics, ed. Peter J. Boettke and Christopher J. Coyne (New York: Oxford University Press, 2015), 166.

The Golden Rule of Banking Is Designed To Prevent Insolvency

For much of its history, banking abided by a “golden rule” that is still alluded to today but rarely followed: the duration to maturity of a bank’s assets should correspond to that of its liabilities. Any incongruence opens the bank to risk in the event of liquidity shocks. . . .

The golden rule was still upheld at the turn of the last century. Ludwig von Mises, building upon his German predecessor Karl Knies, expanded on this sound banking rule:

For the activity of the banks as negotiators of credit the golden rule holds, that an organic connection must be created between the credit transactions and the debit transactions. The credit that the bank grants must correspond quantitatively and qualitatively to the credit that it takes up. More exactly expressed, “The date on which the bank’s obligations fall due must not precede the date on which its corresponding claims can be realized.” Only thus can the danger of insolvency be avoided.

--Philipp Bagus and David Howden, Deep Freeze: Iceland's Economic Collapse (Auburn, AL: Ludwig von Mises Institute, 2011), 8.

Iceland's Banking System Was Heavily Engaged in Maturity Mismatching

Iceland has something in common with other developed economies that the recent economic crisis has affected: its banking system was heavily engaged in maturity mismatching. In other words, Icelandic banks issued short-term liabilities in order to invest in long-term assets. Thus, they had to continuously roll over (renew) their short-term liabilities until their long-term assets matured. . . .

The question that immediately comes to mind is, why did Icelandic banks engage so heavily in this risky practice in the first place? One reason is that maturity mismatching can turn out to be a very profitable business involving a basic interest arbitrage. Normally, long-term interest rates are higher than the corresponding short-term rates. A bank that sells short-term rates (borrows money short-term), while buying long-term rates (investing money long-term) may profit from the difference (the “spread”) between short- and long-term rates. Yet while maturity mismatching can turn out to be profitable, it is also very risky, because the short-term debts require continual reinvestment (that is, there must be a continual “rollover”).

--Philipp Bagus and David Howden, Deep Freeze: Iceland's Economic Collapse (Auburn, AL: Ludwig von Mises Institute, 2011), 7-8.

France Made Gains at the Expense of the Germans Due to the Socialization of Seignorage When the Euro Was Introduced

Some countries, especially France, made gains at the expense of the Germans due to a socialization of seignorage wealth. Seignorage are the net profits resulting from the use of the printing press. When a central bank produces more base money, it buys assets, many of which yield income. For instance, a central bank may buy a government bond with newly produced money. The net interest income resulting from the assets is seignorage and transmitted at the end of the year to the government. As a result of the introduction of the Euro, seignorage was socialized in the EMU. Central banks had to send interest revenues to the ECB. The ECB would remit its own profits at the end of the year. One could imagine that this would be a zero sum game. But it is not. The ECB remits profits to national central banks based not on the assets held by individual central banks, but rather based on the capital that each central bank holds in the ECB. This capital, in turn, reflects population and GDP and not the national central banks' assets.

The Bundesbank, for instance, produced more base money in relation to its population and GDP than France, basically because the Deutschmark was an international reserve currency and was used in international transactions. The Bundesbank held more interest generating assets in relation to its population and GDP than France did. Consequently, the Bundesbank remitted relatively more interest revenues to the ECB than France, which were then redistributed to central banks based on population and GDP figures. While this scheme was disadvantageous for Germany, Austria, Spain and the Netherlands it was beneficial to France. Indeed, the Bundesbank profits remitted back to the German government fell after the introduction of the Euro. In the ten years before the single currency, the Bundesbank obtained €68.5 billion in profits. In the first ten years of the Euro the profit fell to €47.5 billion.

--Philipp Bagus, The Tragedy of the Euro, 2nd ed. (Auburn, AL: Ludwig von Mises Institute, 2012), 45-46.