Inflation as Loss Function

Banks create money and then lend it to borrowers. The quality of projects that banks select will cause inflation, stable prices or deflation. The best quality projects would cause productivity to exceed the amount of money created, and so monetary expansion to be deflationary. If projects that banks select just equal the average quality of economic productivity then there will be neither deflation nor inflation. If banks consistently choose projects that are inferior to the average project with respect to productivity then there will be inflation.

This suggests that inflation can be viewed as a quality loss function (see discussion in Taguchi). The target loss should be negative. Economically, diminishing marginal productivity suggests that as more money is created losses will be greater. However, if banks are competently run and have adequate quality processes with respect to project selection, they can offer loans to projects and sustain zero inflation.

The management of banks becomes a critical problem to economic welfare if the banks themselves lack quality management capacity to select loans. This has been the case. It is impossible for outsiders to design quality processes that will improve loan selection because this depends on identification of borrower and project characteristics that are only known to lenders.

There is no literature on selection of entrepreneurial risk by lenders. This is not a topic that academics have treated and it is not a topic that bankers have carefully considered.

As a result of the absence of quality processes in making loans, the financial system has failed to make loans effectively. The current financial process results from quality losses, i.e., the Taguchi loss function among banks is large and so results in bad loans. Consistent inflation since the establishment of the Fed suggests that banks have failed to develop competent quality processes in lending.

Anecdotal evidence suggests that banks have consistently made loans based on incompetent criteria: to large institutions who cannot make good use of the funds; to firms with close connections to the banks and to firms engage in activities that loans other banks are making. This mimetic pattern suggests a financial system that is, in Deming's terms, "out of control". A competently run banking system would permit economic expansion coupled with stable prices.

The banking system requires restructuring to facilitate adoption of competent, quality driven practices with respect to lending. Banks must become competitive. Banks which fail to produce loans that generate net gains to society (i.e., deflationary loans) should be refused access to Federal Reserve bank credit.

Are Banks' Problems a Mortgage Meltdown? Or a Derivatives Meltdown? Two, Two, Two Excuses in One!

One thing I have learned after nine years in the corporate world, a few years consulting and 18 years teaching business in college is that it is difficult to understand someone else's business. In the recent discussion about a number of banks' financial problems I have heard that this was a "sub-prime crisis". The banks lent exhuberantly and to low income borrowers to whom they were pressured to lend, and the result was widespread defaults.

Today, the Belmont Club writes that the Washington Post now blames the banks' problems on derivatives trading. Which is it? Mortgages? Derivatives trading? I guess the banks, like the old Certs candy commercials, have two, two, two crises in one.

The Washington Post's familiar solution is of course regulation. But would regulators do a competent job? For regulation to work, the regulator must be smarter than the profit-maximizing investment banker. The question is whether reasonable, ethical, and profit maximizing bankers would have lost the money they have lost. If the answer is yes, then I'm not sure that regulators would have done much better. If the answer is no, then the problem is not regulation. Criminal, enforcement rather than better regulation is needed. Moreover, bankers already have a legal fiduciary duty to ensure the ongoing viability of their banks and to maximize profits. They obviously violated that "regulation". Why would a more esoteric form of regulation fare better? And why would government, which cannot even manage an election competently, be good at overseeing the esoteric world of credit swaps?

The pathology of Progressivism is that even where they do not understand the implications of their proposals, Progressives aggressively argue for them. The proposals inevitably involve expanding the state's powers, and the state then becomes the source of more severe problems than it solves. It is likely that the banks' current problems (and they are the banks' problems, not America's problems) are due to pressure from government, e.g., a form of regulation, to extend loans to low income borrowers who could not afford to repay the loans. Alternatively, and probably even more true, the problems are due to bad ethics on the bankers' part.

The article states:

"Derivatives did not trigger what has erupted into the biggest economic crisis since the Great Depression. But their proliferation, and the uncertainty about their real values, accelerated the recent collapses of the nation's venerable investment houses and magnified the panic that has since crippled the global financial system."

The authors note that AIG suffered a loss due to derivatives, but they do not seem to know how much of a loss, just that it was attributable to $440 billion in mortgage swaps. Was three percent in default? Twenty percent? If AIG does not know, then why was AIG in the business? And if the reporters don't know, why do they claim to know what the solution is to a problem that they do not understand? I would not trust a physician who does not know whether I had a stomach virus or a heart attack and prescribes me medication anyway.

Markets are capable of evaluating and punishing banks that engage in excessively risky behavior better than regulators are at assessing what risks banks ought to take. Markets are attempting to do that, but President Bush and Congress have decided not to let the markets work and to let AIG and other financial institutions fail. If banks fail, the government ought to protect depositors, but they ought not to support incompetent investment decisions and bad ethics.

The media is discussing this issue without providing facts, and then offering specific solutions that are not based on evidence. Perhaps the Washington Post should provide their reporters with packs of Certs, and leave it at that.