At least since Keynes, there has been general recognition that the analysis of aggregate economic activity and the analysis of an individual’s economic behavior require different tools.  The reason for this is simple, individuals can often be viewed as price-takers, who have no effect on the aggregate economy.  Effectively micro-economic analysis abstracts from the problem of liquidity, whereas macro-economic analysis must confront this problem directly (which is not to claim that the dynamic stochastic general equilibrium models that dominate the field of “macroeconomics” today  typically do confront the problem of liquidity, but that’s a different debate).

Alea points out (see comment here) that Basel II discourages banks from lending to each other on an unsecured basis.  The fallacy that regulators appear to be engaging in when they favor collateralized interbank transactions is precisely the fallacy that Keynes criticized forcefully in Chapter XII of the General Theory:

Of the maxims of orthodox finance none, surely, is more anti-social than the fetish of liquidity, the doctrine that it is a positive virtue on the part of investment institutions to concentrate their resources upon the holding of “liquid” securities. It forgets that there is no such thing as liquidity of investment for the community as a whole.

Regulators are failing to distinguish between what is optimal for the individual bank and what is optimal for society.   Liquid assets are supposedly “safe” – but for the problem that liquidity itself is inherently ephemeral.  How precisely do the regulators imagine that collateral posted by a systemically important financial institution (SIFI) is going to protect the lenders?  If the SIFI goes down, there is, in the absence of central bank intervention, a fire sale.  And if they’re counting on central bank intervention to make it possible for collateral to function to protect the borrowers from losses (e.g. via a PDCF or TSLF), why not just rely on traditional central bank lending to banks in a crisis?  What precisely does collateral posting by a SIFI add to the existing system of central bank crisis support for regulated financial institutions?

As discussed in my previous post, the biggest problem with allowing SIFIs to post collateral to one another is that it discourages them from restricting credit to banks that are poorly managed.  By discouraging normal market forces from working to limit the growth and interconnectedness of bad banks with the rest of the financial system, a collateralized interbank lending regime places an enormous burden on regulators to both identify and shrink a bank that has deep connections with the rest of the financial system.  Arguably collateralized interbank lending places an impossible burden on regulators.

The second major problem with shifting from a system of unsecured interbank lending to a collateralized banking system is that in the process of purging the money supply of unsecured debt, the money supply may well have to shrink to the size of the collateral base. Precisely because the shift to collateralized interbank lending creates strong contractionary pressure on the money supply, there is a call for governments to create “safe” assets – that is to increase the size of the collateral base to accommodate the money supply.

Why not call on the banks to create safe assets by underwriting loans carefully?  Such loans after all have historically been all that is necessary to back the money supply.  Perhaps the answer to the question is that “safe” privately issued loans aren’t part of the economic model being used?  I sometimes feel that macroeconomic models that treat government as the social planner’s deus ex machina have so infiltrated some economists’ thought processes that they actually expect a real world government to successfully play the role of a benevolent deity.

If the financial system is so fundamentally unsound that the banks should not be extending unsecured interbank credit each other, the government is not going to be able to do anything to save it.

Related Posts:
What banks do:  monetize human capital

I have long believed that we need to reconceive our understanding of the financial system:  the basic ideas on which most of the discourse is based – i.e. intermediation between lenders and borrowers with decisions based on the weighing of risk and return, and the concept that systemic risk originates in a partial reserve banking system’s conversion of risky assets into safe assets – fail to capture the essentials of the financial system.

Faulty modeling means that we fail to understand the nature of the tradeoffs we face (e.g. TED:  But lowering the risk of loss we are willing to accept as a society will have ironclad implications on the types of returns we enjoy. Surely there is a happy medium between a low-growth, capital-constrained economy hobbled by unlimited liability to capital providers and the reckless bacchanal we financed with “other” people’s money up to the financial crisis.) and also results in egregiously bad regulatory decisions (e.g. the incentives created by Basel II).

The claim that finance is just a simple risk-return tradeoff ignores the fundamental truth of the industrial revolution.  Society went from millennia of washing clothes down by the river (or in a washtub in the house if someone hauled water in) to not even getting one’s hands wet – much less engage in physical labor – over the course of barely more than a century.  While the causes of the revolution are debatable, there’s a strong case that it’s all finance:  that is, that the risk-return tradeoff exists at different levels and within the context of different financial regimes.

An alternative model:  Banks monetize human capital

I want to propose an alternative model: the most important role of banks in the economy is to monetize human capital.[1]  When banks fund the working capital of entrepreneurs on an unsecured basis, they make it possible for the economy to realize the value of what’s inside people’s heads – independent of the other resources available to those individuals.  If banks could know in advance who would and would not default, the most human capital possible would be realized.  Of course, this maximum is unobtainable in practice, so the amount of capital available to the economy is a function of the quality of bank underwriting mechanisms.

The implications of the model are: (i) Banks “create” capital.  They don’t simply move capital from one place to another, but are essential to the process by which an intangible and inalienable asset is converted into tangible, alienable assets.  (ii) Unsecured debt is a cornerstone of a modern economy.

Creating capital

The traditional models referenced above treat finance as if it’s about stocks of capital and how they are allocated, when in many ways finance is a matter of managing flows of money with the stock of capital only relevant in extreme circumstances.  In the simplest framework a disabled landowner, a laborer, and a disabled seed owner can work together to produce food for their themselves, but don’t trust each other.  In a world without a coordination device, the land, the seed, and the labor are worth nothing and everybody starves to death.  If everybody trusts the bank and the bank is willing to lend (at a spread), then (i) the landowner can borrow from the bank (at x%) hire the laborer and “rent” the seed – returning new seed after the crop cycle, and pay both the laborer and the seed owner with bank IOUs or (ii) the laborer can rent the land and the seed, paying with bank IOUs or (iii) the seed owner can rent the land and hire the laborer paying with bank IOUs.  The point is that the bank isn’t lending money that it has or savings that someone has accrued and deposited with the bank, it’s borrowing and lending simultaneously with the result that output, that would not come into existence in the absence of bank intermediation, is produced.  In short, banking can facilitate the creation of capital simply by being trustworthy and managing flows without actually “allocating capital” at all.

Maybe the bank is more willing to lend to the landowner or the seed owner, because they have an alienable asset that can secure the debt, but I would argue that historically economic development starts to take off precisely when the collateralized debt constraint is broken; that is, when institutional structures develop such that banks are willing to lend on an unsecured basis and the owners of inalienable capital can get a small line of credit fairly easily at a reasonable rate (e.g. 5%) and can, with careful management, earn the right to have a much larger line of credit.

The role of unsecured credit

The idea that the financial system monetizes intangible, inalienable assets doesn’t apply only to entrepreneurs and human capital.  The financial system itself is arguably built on the monetization of such assets.  It’s precisely because people trust their banks and the bankers trust each other that the money supply that we have is sustainable.  In economic models, this is sometimes called “reputation.”  (Existing models however rarely include the liquidity problems that banking is designed to address, and in the absence of such frictions often find that reputation-based equilibria do not create enough value to be stable.)

Implications for regulation

A key goal of financial regulation is to preserve this trust in the banking system.  It appears, however, that faulty modeling has meant that regulators don’t have a good sense of the foundations of this trust.

The key here is that lending is unsecured.  When lending by banks is secured, what is being monetized is not trust, reputation or human capital, but only the assets themselves.  Regulators need to understand that there is a “use it or lose it” aspect to unsecured lending.  Unsecured lending forces banks to put in place mechanisms that make unsecured lending reasonable (at least in a world where banks are allowed to fail).  These mechanisms then undergird trust in the financial system itself.

When banks are told to seek collateral for their loans to each other (see Alea’s comment here), these mechanisms start to fall into disuse.  My concern is that it appears that, as the mechanisms supporting unsecured lending by the banking system disappear, so does trust in the financial system itself.  After all, collateralized lending is the easiest and oldest form of lending – it was apparently regulated by the Code of Hammurabi.

In a well-regulated financial system the banks themselves would start the process of shutting down bad banks by restricting their access to credit.  The bankers themselves  are best positioned to do this:  with the movement of employees from one bank to another they can get a very good sense of how their competitors are being managed or mismanaged, and because they compete in the same markets they know when their competitors are mispricing assets.  This is exactly the information that is needed to determine which banks are not trustworthy and it would almost certainly be used by banks that (a) know their competitors can fail and (b) regularly extend sizable lines of credit to these competitors.

In our current system it appears that regulators are trying to do the job that banks are better equipped to do.  The regulators are searching for some fixed formula (called Basel?) that will be “the” source of financial stability.  The underlying problem is that there’s no reason to believe that such a formula exists.  Trust, also known as credit, is an amorphous concept that can be capitalized, but when reduced to a simple formula is usually undermined by the existence of a formula that can be gamed.  The job of the banker is to stay ahead of the game – possibly by not using simple formulas.

In short, I think regulators should make sure that we have a system where (i) banks can fail and (ii) banks have to lend to each other on an unsecured basis.  Bank failures should be a normal enough occurrence that banks are prepared to write off the debt of other banks – and focus on creating safe assets themselves rather than looking to the government to provide such assets in the form of bank liability insurance.

Would this be enough to stabilize the financial system in the absence of increasing the personal liability of the bankers?  I don’t know.  To return to ideas in my initial post, perhaps in order to address the asymmetric information problems that pervade the financial industry we would also need a policy such that in the event that a bank fails there is a lower standard for creditors to pierce the corporate veil than in non-financial corporations.  Imposing the possibility of liability (that would have to be made uninsurable by statute) on directors, officers, employees, and shareholders – to the extent that any of these parties received income from the bank over the previous 10-15 years – may be necessary to prevent misuse of “other people’s money.”  Employees should be granted the strongest safe harbors (including, for example, the first $100K per year of income, but not including decisions to gather nickels before steamrollers) and shareholders the weakest.

In addition — or perhaps alternatively — it may be necessary to circumscribe competition in the financial industry.  But I’ll leave that to a future post.

“There will always be a tail of financial risk that society must absorb”  – David Murphy

[Note:  TED deserves a more thorough response than I have time for right now, but David Murphy's riff on TED's latest post generated this brief reply -- using time that really should have been devoted to one of my three deadlines.  More to come, but maybe not for a week or so.]

Needless to say I can’t judge the truth of David Murphy’s statement about the future, but the historical evidence is clear:  society as a whole has not always stood as the loss absorber of last resort for the financial system.  (Asteroids, I hope we can all agree, belong to a different class of events).  Our banking system was founded in an environment where the bankers absorbed the losses.  Crises were costly, because bankers’ assets were wiped out.

(Note: in environments without lenders of last resort, society tended to bear more of the losses, after the bankers were wiped out because there was so much collateral damage — e.g. Venice 1300 – 1600.  In a traditional environment with a lender of last resort, e.g. England 1763 – 1900 or so, the last resort lender has to fail before society bears a significant portion of the losses.  Note that the Depression can be viewed as the failure of a last resort lender, since the Bank of England went off gold.)

Treating society, and not the bankers, as the financial system’s “loss absorber” is a new phenomenon, for which the seeds were laid in the reforms of the 1930s.  The evidence lies in the facts:  the Federal Reserve’s non-recourse loan supporting the purchase of Bear Stearns and the TARP legislation were unprecedented events in the nation’s history.  We are treading new ground here – and the response of the financiers is to try to persuade us that society has “always” passed bills bailing out bankers.  Nonsense.

I think that Mr. Murphy’s approach to “tail risk” illustrates the dangers of “putting financiers less on the hook.”  The business of banking used to be about how one can lend without losing money, it used to be about how to turn ordinary commercial loans (and I mean whole loans) into safe assets.  Banking was based on “the science of credit” (Thorton in 1801) and careful underwriting of short-term loans was the bread and butter of banking.

I am happy to acknowledge the theoretic possibility that putting financiers less on the hook is better for society, I just don’t see many facts that support the theory.  The facts indicate that putting financiers “less on the hook” (starting in the 1930s with ever more support from the 1980s on ) and then forcing them to compete with each other (mostly after the 1980s growth of money market funds, commercial paper markets, repeal of Reg Q, etc.) induces them to issue loans without underwriting them – and to be unwilling to lend even to each other without collateral.  How’s that supposed  to be good for society?

I don’t get why arguing that requiring that financial tail risk be born by those who make the decisions determining how much financial tail risk society will have to bear constitutes a “knee-jerk response which is unlikely to lie on the efficient frontier.”  Especially given the amount of money financiers manage to make while creating that excessive measure of tail risk.  In economic terms, the standard description of such an argument is internalizing an externality – and it is very likely to bring society closer to the efficient frontier.

In short I agree with TED entirely when he writes:

the decisions we make about how we allocate, limit, and distribute financial risk throughout society—including how much to put financial intermediaries on the hook—will reverberate broadly through the system and ultimately affect our very living standards and prospects

It is precisely because the current allocation of financial losses is undermining our living standards — and gives every appearance of continuing to make them worse — that we need to reallocate financial risk to ensure that financial tail risk is correctly priced.  The easiest way to do so is to make those who are in a position to price that risk, bear it.  But I’m open to other suggestions.

Updated 2-7-12:  ”the” removed from title and replaced with “some.”  See Sonic Charmer’s comment below.

I worry that those who argue for a wholesale return to unlimited liability for the owners of financial intermediaries simply have not thought out the problem of scale inherent in the current global economy.

and I’m first to admit that a wholesale return to unlimited liability in banking by congressional fiat is — shall we say — unrealistic.  But I also think some of TED’s concerns about insufficiency of capital and excessive interest rates in a system with unlimited liability are overblown.

The system of unlimited liability banking grew up in an environment with usury laws, so interest rates (on short-term debt) did not exceed 5% per annum.  Market rates often fell as low as 2%.  It’s far from clear that low interest rates for borrowers are inconsistent with unlimited liability on the part of lenders who choose to use their ability to borrow to leverage their returns (i.e. to act as partial reserve banks).

Furthermore, from a theoretic point of view, a banking system doesn’t need capital, it needs trust (aka credit).  If the institutional framework is carefully structured (that is, debts are enforceable, outright fraud is disincentivized/rare, etc.) there is no shortage of capital — capital is created out of thin air by a plethora of unsecured, but trustworthy, promises.  Effectively, capital is cheap, because the institutional structure of finance reduces the risk of losses to a minimum.

One of the most worrisome aspects of our current financial evolution is the shift to ever-increasing use of collateral, which to me is testimony to the fact that the institutional structures supporting a financial system with cheap capital are disappearing before our eyes.  Collateral adds expenses that are unnecessary when the unsecured financial system works well.  One of the first policies I would propose is a (phased-in) prohibition on the posting of collateral by our largest financial institutions.

I’d be more optimistic about the future of our financial system if certain aspects of banking were understood.

(i)  Total collapse of the financial system is possible.  I’m talking about the kind of event that will cast a shadow over the Great Depression.  I am reminded of the fact that China had a fiat money system that lasted for about 200 years before it imploded, creating a vast demand for silver that fueled the silk and spice trade of the middle ages, and arguably set off the development of European finance.

(ii)   “Safe assets” like deposits and bills of exchange were created by a merchant class subject to common law (i.e. law for the commoners) at a time when the idea of a government guarantee of a financial asset was somewhat ridiculous.  (Kings have a habit of taking property — with or without your leave — and failing to return it.)  That is, when assets were “safe,” they were safe because of a complex web of social characteristics including law, social norms, property rights, etc.  Such safety cannot be recreated by a myth of governmental infallibility — all that will be demonstrated by seeking refuge in government guarantees is the weakness of the governance structures.  To recreate an environment with relatively “safe” assets will require reworking of the institutional structure of the financial system, so that it can provide these assets on its own with little reliance on government.

(iii)  It would be helpful if the members of our financial elite could take a long enough break from their rent extraction activities to take a look at the path we’re on — and whether they’re sure the world they’re leaving to their children is the one they want to leave behind.  And, maybe, throw their weight behind some wholesale reform themselves.  (Pace, TED, I don’t mean you, because you do worry and you are speaking up.  You give me hope.)

With a little fear of total financial collapse, maybe we can manage to change the the system enough to keep it running for another few decades.

“Opacity is absolutely essential to modern finance.” “Societies that lack opaque, faintly fraudulent, financial systems fail to develop and prosper.” Steve Waldman

This is a response to three posts at Interfluidity that argue that banking is essentially a con job.   The quotes here are from those posts except as noted.

While I agree on the issue of “opacity” (bankers lend money and it is difficult or impossible for depositors and creditors to monitor bank assets), I also think that Waldman is confusing two things:  modern finance and the financial systems that facilitated economic development.  They have/had very different characteristics:

• Modern banking:  limited liability, government-guaranteed deposits, high risk of loss to bank creditors (in the absence of government intervention).
• Before 1930:  at least double liability, deposit “contracts” that were always implicitly conditional, and comparatively low risk of loss to bank creditors (in the absence of government intervention).

In short, prior to the 1930s the assets of the bank-owners themselves were very much at stake with the result that their leverage ratios were much, much lower than in modern times.  (Econometric analysis indicates that  in the late 1800s neither the leverage ratio nor the size of banks was a predictor of either bank profitability or stability of profits.   Lamoreaux, Insider Lending, pp. 97-98.)

History:  Unlimited liability and the nature of the deposit “contract”: 

“A banking system is a superposition of fraud and genius”  “Banks guarantee all investors a return better than hoarding, and they offer this return unconditionally, with certainty,”  “First and foremost, they offer an ironclad, moneyback guarantee.”

Waldman’s model of banking has these properties, perhaps, because he’s referencing a world with deposit insurance instead of bank failures – that is, a world with explicitly government backed deposits:  this form of banking has been around for just three quarters of a century.  Historically banking is built on a conditional promise to depositors to return the money unless the bank closes its doors.  When the bank closes its doors, “time” is lost, but because nobody would entrust his money to a banker who wasn’t wealthy and subject to liability (either unlimited or capital calls on stock owners to pay debts), once the banker’s horses, etc. are sold, you get your money back.  Depositors understood that “time” could be lost and that only a fool would leave his money with someone who wasn’t wealthy.  The contract was conditional on the risk of temporary illiquidity and, in practice, conditioned on the assets of the banker.

To the degree that Waldman’s concept of banking is based on the Diamond and Dybvig model, even they acknowledge that the 19th century solution to the problem of bank runs, suspension (i.e. closing the bank and liquidating) also solved the problem.  It is only dominated by deposit insurance if the insurer has the ability to target a tax to those who withdrew money during a run (or to achieve the same result via inflation).

History:  Bank losses were put to the owners of the bank:  While crises and bank failures were common, there are many historical examples of major bank crises that didn’t result in losses to depositors’ principal.  (See for example the failure of Overend and Gurney in England, which was the Lehman’s of 1866.)

“Second, they point to all the other people standing in front of you to take the hit if anything goes wrong.”

This is a pure invention of modern “limited liability” banking.  Even through the early years of the 20th century, bank shareowners were subject to capital calls in the event the bank failed.  In Britain bank stock was usually purchased by paying only a fraction of par, leaving stockholders subject to a capital call that could be a multiple of the original payment.  In the US the norm was double liability, so stockholders who bought shares with a par value x, were liable for a “second” capital call of x. (Double liability was part of the National Bank Act of 1864 and also enacted by most state legislatures.  It was the law in Massachussets even earlier.)  It’s not clear that losses of principal (i.e. excluding “time”) to depositors due to bank failures were either common or large.  It’s my understanding that there were no such losses in England from 1850 through 1900 – and probably very few between 1800 and 1850.  In the US there were most likely some losses, but how significant were they after the whole legal process was complete?

 “ ‘Shadow banks’ are nothing new under the sun, just another way of rearranging the entities and guarantees so that almost nobody believes themselves to be on the hook.  This is the business of banking.”  “Since no one (most especially the financiers) believes themselves to have agreed to be the bagholder, we are left in an ocean of conflict over who must bear what costs.”

I disagree.  This is the modern business of banking.  When our financial system developed the ones who were most at risk were the bankers themselves.

Bagehot’s Lombard Street is in many ways about the growth and contraction of a shadow banking system.  The “bill-brokers” — of which Overend was by far the largest — grew up as undercapitalized shadow banks that relied extremely heavily on the lender of last resort facilities of the Bank of England in crisis.  The Bank objected to the quantity of Overend bills it had discounted and told Overend/the bill-brokers that they would have to find their own source of capital in the next crisis.  In 1866 the Bank of England kept its word and Overend failed.  As noted above, the Overends had to sell their personal assets (and there was a capital call on shareowners), but every penny was repaid to creditors.

After this crisis, British finance continued to flourish.   The lesson I draw from this is that the key to central banking and a strong financial system is knowing when to close the liquidity spigot.

In fact, it is possible that the problem created by bank failures in the depression may not have been losses to depositors (although they were certainly the more visible), but the wiping out of the stratum of society that had the reputational and financial assets to be bankers or invest as shareholders in banks (i.e. the capacity to answer and the willingness to risk a capital call).

Opacity, confused creditors and growth

“Societies that lack opaque, faintly fraudulent, financial systems fail to develop and prosper.”
“Industrialization occurs in societies with corrupt and fragile big banks.”

From a historical perspective this is unsupported by the evidence.  Societies that develop and prosper have banks that pay their depositors back from the assets of the owners of the bank, should the bank fail.  This is the reason bankers were trusted with “other people’s money” in Venice, in Amsterdam (each, the center of world trade in its time), in 18th and 19th c. England and in the US through the 1920s.  Only in modern times did anyone imagine it is possible to have financial system populated by entities with complete limited liability.  (Observe that banking systems will full liability also can collapse – usually because the flourishing economic activity that made it worthwhile for bankers to take the risk of losing all their property evaporates for external reasons.)

I think the truth that underlies Waldman’s argument is that it’s impossible to have a truly competitive financial system, without destroying the financial system itself – and this is one of the greatest errors of modern finance. Why?  Historically, bankers must take risks and their assets must be at risk; bankers will only do this if they make a hefty return.  In modern times, they must be highly compensated simply to keep them from taking advantage of their access to other people’s money and their abundant opportunities to profit from activities that tend towards fraud.  They will be wealthy, they will control the payments system, and they will favor policies that are in their own interests, not those of the general public.  They will be the target of populist complaints.  If you try to address these complaints by introducing too much competition, you will compete away the profits that will compensate them for their risk (or their access to pilferable funds).  Theory tells us that given too much competition, bankers will decide they’re better off stealing people’s money.

(cf. “Information asymmetry (the source of opacity) is built into the very fabric of the division of labor in complex societies. …  insiders’ privileged position and knowledge enable them to extract rents.”  http://epicureandealmaker.blogspot.com/2012/01/all-together-now.html  )

Banking and capitalism

Bankers have historically been the “capitalists” of their time, but only if one understands “capitalism” in the Marxist sense of the word.  Bankers are the wealthy making profits off their wealth.  In modern times where non-wealthy individuals enter the banking profession, the bankers are profiting from their position in a company that has vast amounts of money at its command.  Because these companies have limited liability — and abundant government support systems — however, society, not the owners of the bank are the true sources of their capital.  When profits are being made off of capital provided by the public, a better word for what the bankers are doing is probably best characterized as socialism.  (cf.  Prof. Varma on safe assets, h/t Ashwin Parameswaran)

“Part of what makes an FDR different from a Mitt Romney is that an FDR understood his power to be derived from more or less arbitrary privilege, while a Mitt Romney imagines himself to have “eaten what he killed” in brutally efficient markets.”  Yes.

“They persuaded themselves, long before they persuaded the rest of us, that any games they played for their own enrichment would necessarily lead to social gain over the long term.”  This is very true too.  One thing I’ve learned from blog discussions is that traders think it’s socially efficient for them to make money off of the sorry, uninformed creature who thinks that asset is worth what he’s paying for it.  (They  obviously missed the Econ 101 class on asymmetric information and efficiency.)

“What the market will bear” is not a sufficient statistic for ones social contribution. Sometimes virtue and pay are inversely correlated. Really! People have always been greedy, but bankers have sometimes understood that they are entrusted with other people’s wealth, and that this fact imposes obligations as well as opportunities.

I’m not sure that the right approach to this problem is to place “obligations” on bankers.  I’d opt for incentives.  Jamie Dimon’s houses and financial assets should go on the block to pay creditors if J.P. Morgan fails.

Would this reduce risk-taking?  Absolutely.  But in a good way.  Bankers need to be incentivized to take reasonable risks, not unreasonable ones.  Keep in mind that industrialization and modern banking was born in an environment with precisely these characteristics.

Does (financially-supported) growth require misinformed bank creditors? No

“I claim we would forego a lot of plain booms, the kind that ultimately enrich investors as well as society at large, if we didn’t have a financial sector skilled at getting people to assume risks they’d not directly consent to take.”

I think that what Waldman is missing here is that historically bank accounts in industrial regions start out as loans.  That is they are discounts not accounts.  So no bank creditor is putting their savings at risk, instead the bank (as noted above most likely the wealthiest person in town) is lending to the local entrepreneurs and tradesman, but avoiding having to maintain much of a stock of gold by clearing the whole town’s transactions on his books.  In a well functioning financial system, the town banker can send those debts to the big city and sell them off if he happens to need cash.  There ends up being a large network so that long-distance transactions can be cleared in the big city.  Basically finance is a debt clearing system that requires, in theory, no capital or actual savings at risk at all — but only a bunch of entrepreneurs/tradesmen who are willing to lend to each other because an entity with reputation (the bank) is underwriting the loans. In practice, people with money to lose have to guarantee that the system is sound.  These bank-guarantors make it possible for the system of unsecured trade credit that makes the economic world go round to operate.

Can finance solve the problem of systemic risk?  No, and neither can government.

“Diversification and maturity transformation can protect us from idiosyncratic shocks, and Murphy is right to point that out. But they cannot protect us from systematic misfortunes.”

Finance is unstable, so if a basic precept upon which most banker’s decisions have been based (e.g. the Bank of England will maintain its peg to gold) a lot of bankers can fail and lose their fortunes, taking the economy down with the bankers. (The worst of the bank failures in the Depression took place around the same time or after the Bank of England went off gold in Sept 1931 — causing a big hit to balance sheets around the world.)  Bagehot recognized that banking is a system of credit, so by definition its always within the realm of possibility that the whole system collapses.  There’s no reason the system can’t be born again – as long as there’s someone with assets to lose who recognizes trading activities he’s willing to finance.  But, of course, the process is excruciating.

“But on systematic risk allocation, I think it unquestionable that status quo finance is completely terrible.”  Agreed.  But this is not a problem with banking.  It’s a problem with limited liability banking where the people making the lending decisions can put the ultimate losses to someone else.

Regulation

If regulation will be very intensive, we need regulators who are themselves good capital allocators, who are capable of designing incentives that discriminate between high-quality investment and cost-shifting gambles.

I’m not convinced there is an alternative to the threat of personal losses to keep managers of “other people’s money” honest.  The banks have too much incentive to infiltrate whatever regulatory system is put in place, so it’s probably close to impossible to keep it from being captured in one way or another.

Have we reached the apotheosis of finance?  That is, did we once have a functional (though always changing) financial system that evolved to the degree that it is now on the path to implosion?  Far from Waldman’s view that finance has always been this way and this is the way it must be for growth to take place, I think that finance once had very different characteristics from that which it has today and that the loss of those characteristics significantly increases the likelihood of the total collapse of which  Bagehot warned.

The questions, for me, are:  Is the financial system dying from the effort to turn it into a competitive industry?  And can we save it?

Note: I edited  a phrase that was too strongly worded, and tweaked the text.

There was hurricane going on outside and the banks needed shelter.  The Fed provided the shelter.  But it turns out the shelter wasn’t just for one night and it wasn’t just for one bank.  The Fed provided shelter to all the banks for months on end.  Some banks were sheltered at the Fed for more than a year.

It is this long-term aspect of the Fed’s “emergency” lending that forces one to question whether this was emergency lending at all.  And raises the following questions:

Did the banks have a duty to construct their own shelters to weather the hurricane?
Or is the Fed their liege lord with a duty to protect them?  If the Fed has a duty to protect the banks in a hurricane, then what is the likelihood that the existence of that duty is the reason the hurricane lasted so long?  (These storms are clearly not acts of God, but entirely endogenous to the actions of the banks.)
By providing such extensive shelter, does the Fed discourage the banks from building their own storm-worthy shelters?

Did the banks pay a fair rate for the shelter?  Did they just do the dishes every night or did they pay a “normal times” market rent of say 5% of the market value of the shelter per annum or did they pay a rate closer to the value to them of the shelter?  Aren’t liege lords entitled to something like a third of their clients’ gross revenue annually in good times and in bad?

What about the decision the Fed makes about who gets shelter?  Does the Fed provide shelter to all the banks, or only to a select few banks?  Should consumers — or non-financial firms — have access to this shelter?  If not, why not?

There are two basic ways to make a financial system safer: insurance and regulation.

There is undoubtedly a third way to make the financial system safer:  regular failure of financial institutions.  This is the only proven way to make a financial system safe, since its the one that existed from the 13th century and was the foundation on which the modern financial system was built over more than half a millenium.

Minsky is regularly discussed, but his ideas don’t seem to have actually penetrated the discourse:  stability is destabilizing.  The most stable financial system it is possible to achieve is one with regular bank failures.  The analogy is to the management of forest fires which when allowed to occur regularly have the beneficial effect of clearing the undergrowth, revitalizing the forest, and reducing the likelihood of a truly destructive conflagration.

The problem in our financial system is not an insufficient supply of safe assets, but the concept that there is such a thing as a safe asset.  Keynes’ clear explanation of the ephemeral nature of liquidity debunked this view generations ago. (See Ch 12 of the General Theory, well discussed here).

Regular failures of financial institutions are the best way to ensure that the risks inherent in every financial asset are constantly being taken into account.  It is far more likely to be successful than insurance, which given the political muscle of the financial industry is guaranteed to be underpriced (see the experience of the FDIC, from 1996 to 2006 most banks paid nothing in FDIC premia) or regulation, as the regulators are unlikely to ever have a deep enough understanding of the current structure of the industry (which is always morphing in light of new regulations) to keep banks from making short-term profits while putting the losses to the taxpayer.

The only long-term solution to this problem is financial institution failure, regular, repeated and built into the very structure of the market.

The Bank of England was founded in the 1690s to fund the British debt.  In 1711 the Bank was required by law to discount exchequer bills on demand.  As North and Weingast observed in their seminal paper, the Bank’s support of government debt (e.g. through discounting exchequer bills) was crucial to the British ability to finance (and win) the Napoleonic Wars.  This is indubitably an important role of a central bank — but then every British county wasn’t issuing its own debt and the Bank certainly wasn’t buying the debt of the counties.   The modern European situation is more complicated than the early British case.

The lender of last resort role that DeLong claims “got its start” in 1825 was played by the bank in 1763 at end of the Seven Years War, in 1772 not altogether willingly after causing the collapse of the speculative activities of Alexander Fordyce’s bank, in 1783 at the end of the American Revolution (anticipating the normalization of trade the Bank in fact conserved gold reserves that fell to 8% by favoring private credit and restricting discounts of exchequer bills) and of course in 1797 when the strains of financing the wars led the Bank to seek authority for an emergency suspension of gold payments from the Privy Council (later confirmed by Parliament).  (See Clapham’s history of the Bank of England and Jacob Price’s articles on the Bank.)

Finally, once again we see that DeLong grossly misinterprets the point of Lombard Street.  Bagehot most definitely did not support lending against assets independent of the quality of their origination.  He states explicitly:

The cardinal maxim is, that any aid to a present bad Bank is the surest mode of preventing the establishment of a future good Bank.

It happens, however, that in 19th century England the combination of personal liability of the banker and capital calls on shareholders to honor the debts of bankrupt joint banks was sufficient to ensure that origination practices were extremely careful.  Needless to say when origination practices are sound, a central bank’s practices do not need to be “over-nice.”  However, when rot has been allowed to grow in the financial system to the degree that the largest banks are being sued for fraud over their origination practices of their loans, central bank practices will have to be more careful than those of the19th c. Bank of England — at least if the goal of the central bank is to preserve financial stability (and not simply to bail out the banks).

The underlying problem in the Eurozone is the intra-European balance of payments problem.  Until a politically feasible plan to manage European imbalances is in place, the aggressive action by the ECB, called for by Martin Wolf and Paul DeGrauwe, may well turn out to be nothing more than a palliative.  Such palliatives are dangerous, because the need for political action is so great that anything that lulls Europe’s politicians into a sense that they do not need to act boldly today, may have the effect of aggravating the fissures leading to crisis and create a problem that is even harder to resolve.

My reference point in these thoughts is the central bankers’ decision in 1925 to work with the Bank of England in its project of maintaining the peg to gold.  Over six years the imbalances that made the peg unsustainable did not resolve, but instead were aggravated by politicians making parochial decisions and by a general sense of stability that allowed imbalances to grow ever greater.  In 1931 when Britain finally abandoned the peg to gold, the world economy faced a greater crisis than it probably would have faced in 1925.

I think the ECB is doing a good job of making sure that the politicians know that they are the ones who need to act.  While none of us can be sure that Europe’s politicians will successfully muddle through and give birth to a stronger Eurozone, the likelihood of success is much greater while the pressure of looming financial crisis bears heavily on the shoulders of the politicians.

Rortybomb directs us to Matt Rognlie‘s critique of “deleveraging.”  Rortybomb correctly points out Rognlie’s error in using aggregate data to discuss consumer behavior and links to a year-old analysis explaining that it’s the middle class that’s overleveraged.  I have a different bone to pick.

While Rognlie nominally acknowledges that the deleveraging problem is specific to the aftermath of an asset bubble (“consumers and businesses experienced an enormous hit to net worth”), he restates the problem as something that is not precisely the same, that consumers desire to spend less and save more.

The aftermath of an asset bubble implies that many economic participants owe more than the value of the assets securing the loan.  This has the immediate implication that either (i) defaults must take place, transferring full ownership of the assets to the lenders or (ii) assets are “locked in” and those who hold title to the assets cannot sell them (because the assets undersecure a lien, so in some sense this title is only nominal) or (iii) some combination of (i) and (ii).

The theory to which Rognlie refers tends to assume that (i) takes place instantaneously:  After a bad economic realization,  borrowers who owe more than the asset is worth strategically default, and losses are immediately recognized as lenders sell the foreclosed assets off to the highest bidder == highest value user.  Economic recovery takes place quickly because the model doesn’t allow for assets to be held and used by low value users.

As I understand his argument, Richard Koo sees solution (i) as so full of costs that typical economic models don’t recognize that it can be rejected out of hand.  And indeed most policy-makers seem to agree with him.  Banks are not asked to recognize their losses, borrowers are induced through temporary payment reduction plans like HAMP to continue making payments on loans that would lead to strategic default in an economic model, etc.

The balance sheet recession theory focuses on a world, like the one we are experiencing now, where strategic default does not take place on a large scale, and assets continue to be held by entities that are paying more money for them then they are worth on the market.  Such debtors have the use of the asset, but cannot sell it because the market value is insufficient to pay off the debt.  They are “locked in” at least until such time as they choose to default and transfer ownership to the lender.  This implies that we are now are in a world where assets are not as easily transferred to their highest value use (whether due to policy decisions, social pressures, or other concerns) as economic models tend to assume.

Observe, in addition, that spending less in order to have the means to make a debt payment on an underwater loan to a financial institution is very different in macroeconomic terms than spending less in order to invest the money in some asset.  The reason for this is a simple matter of accounting:  banks assume when they lend that the debt will be repaid (at least until such time as there is a significant default and they transfer the loan to an impaired asset category).  Thus the payment of debt has already been accounted for by the bank in its assets and adds nothing to the economy’s capacity to lend.  Savings/investment are a very different matter, because these are sums that an entity sets aside to provide itself with future income, but there aren’t many realistic future housing market scenarios in which reducing the negative equity in your home from 50% to 49% by making a year’s worth of payments is going to result in future income within the next decade or two.

Thus, it’s not true that all the two-earner households who have become one-earner households and are now cutting back on consumption in order to make their mortgage payments on underwater homes are “saving” in a meaningful macroeconomic sense — because many of these households don’t expect these payments to result in home equity for at least a decade (and since they are likely to lose the house in the end anyhow, they are really just renting == consuming housing services), and the banks’ current balance sheets are founded on the assumption that these payments will be made.  These households are cutting back on their economic activity, but the “savings” from doing so added to economic activity in the year in which they took out the loan and bought the house, not now.  Only if you want to argue that when banks don’t have to recognize losses on the bad loans they made, that also constitutes savings for macroeconomic purpose, can you claim that the vast amounts currently being paid on underwater mortgages are savings.  This is, however, at best a disputable position.

In short, in order for Rognlie’s theory to apply to our current situation he needs to consider the effectiveness of monetary policy in an environment where a principal goal of policy-making is to protect financial institutions from experiencing (or at least realizing) losses and where the policy is implemented at the cost of obscuring the valuation information available to shareholders and of encouraging deeply underwater consumer-mortgagors to continue making payments on their loans (e.g. HAMP).   Confusing the macroeconomic effects of paying off debt for the purpose of incrementally reducing negative equity (and in many cases insolvency) with the macroeconomic effects of saving is a serious error, but one that is easily made by those who work with models that don’t take insolvency and the bankruptcy process into account.