As any reader of this blog knows, in my view proposals to eliminate financial instability by adopting 100% reserve banking are a mistake because lending is integral to banking and to money itself. In commenting on John Cochrane’s blog, I think I found a good way to explain the intuition behind this view of banking, so I’m expanding on it here.
First, let me point out that my basic intuition for banking comes from new monetarism, and in particular from the search model of money. As Williamson and Wright point out in their addendum to their Handbook article:
Suppose the government were to, misguidedly as it turns out, impose 100 percent reserve requirements. At best, this would be a requirement that outside money be held one-for-one against bank deposits. We are now effectively back to the world of the model without banks in the previous section, as holding bank deposits becomes equivalent to holding currency. Agents receive no liquidity insurance, and are worse off than with unfettered banking, since the efficiency gains from the reallocation of liquidity are lost. . . . This obviously reduces welfare. A flaw in Old Monetarism was that it neglected the role of intermediation in allocating resources efficiently.
Here I want to, first, give a simple verbal explanation of what underlies this conclusion. (I will be using a search type framework rather than the Lagos-Wright type framework that Williamson and Wright use.) Second, explain my own view of banking. Third, give an illustrative real-world example of why this matters. And, finally, to tie this back into proposals for narrow banking.
The Intuition Behind New Monetarist Models
Monetary frictions are created when buying and selling take place at different points in time, so it is valuable for an economic actor to be able to carry purchasing power over from one time period to the next. If some kind of a chit is introduced into a model with monetary frictions, efficiency increases: people who start with a chit can buy at their first opportunity, and people who have an opportunity to sell in exchange for a chit can then use the chit to buy when they get an opportunity to do so. Note that even though the introduction of chits is welfare improving, chits impose a “cash-in-advance” constraint and the first best can’t be achieved: as long as the monetary friction allows for situations where people would like to buy and are willing to sell in the future to pay their debt, but these people are constrained by the fact that they don’t have a chit, valuable opportunities to trade are being wasted.
Thus, the basic intuition of monetary friction models can be expressed very simply:
- Sometimes people want to sell before they buy.
Cash — or chits or some other transferable asset — solves this problem.
- Sometimes people want to buy before they sell.
Debt is needed to solve this problem.
This is the basic intuition behind new monetarist models. And it is hard to argue that these models don’t capture something fundamentally important about monetary economics. After all, in fact for every economic actor buying and selling take place at different points in time. This matters. And leaving it out of the models which economists use to develop their intuition about the economy is a mistake.
Banking and New Monetarism
Where I diverge from the mainstream of the New Monetarist literature is that this literature has focused on how to make money in the form of cash or chits essential, whereas the banking historian in me can’t help but simply see short term debt as just another form of money (cf. bills of exchange).
What is money? Money is something (often a piece of paper) that allows people to either sell before they buy or buy before they sell.
In order to make the form of money that they are interested in essential, the New Monetarist literature assumes away the ability to commit to future payments and/or to keep records. While the banks in New Monetarist models almost always play a monetary role because they affect commitment and/or record-keeping, I have long argued that the whole point of banking is to solve the problem that people want to buy before they sell. In short, we should be using New Monetarist models to study how financial intermediation can be structured so that debt functions as money — and so that we maximize our ability to solve monetary frictions.
Overall, the whole point of banking is that increases efficiency by eliminating the cash-in-advance constraint for most economic actors and by making it possible for debt to function as money. In my view, it is a historical fact that fiat money (which I date to 1797 in Britain) grew out of banking — and in particular the system of inland bills that made up the British money supply in the late 18th century. Only after private economic actors in the form of banks had solved the incentive problem that prevented debt from serving as money, was it possible for a government/central bank to gain the credibility necessary to issue fiat money.
In short, the New Monetarist literature tells me that the study of banking should focus on the study of the institutional structures that make the repayment of short-term debt incentive compatible. My most recent efforts to advance this study can be found here and here.
What do banks do? Banks are the enforcement agents that make it possible for short-term debt to circulate as money. The precise role of banks will always depend on the institutional structure within which they function.
A simple modern example of why we want short-term debt to be liquid
The typical worker extends a short term loan of a week or two to his/her employer, since paychecks are periodic and work is a daily activity. Because of this structure employers get to buy before they sell. In a world that where liquidity constraints did not bind, the worker would be able to turn the employer’s debt into cash at very low cost – after all the worker is the creditor of a creditworthy entity.
In fact, workers with bank accounts were (up to 2014) offered “paycheck advance” services, but only at interest rates of 200% or more per annum. Such fees are not dissimilar to the payday advance services offered by non-banks. It seems to be an extraordinary market failure that banks that can borrow at 0% and are virtually guaranteed repayment by direct deposit do not offer these services at competitive rates to their own customers.
It is, of course, not just consumers who face such liquidity constraints. Businesses, small and large, also need to buy before they sell. Banks today as in the past provide a large number of services that make it possible for businesses to borrow on a short-term basis.
Why narrow banking proposals are wrong
The reader has probably gathered by now that the problem with narrow banking proposals is that they ignore how important it is for debt to function as money. In the real world the need for economic actors to buy before they sell is ubiquitous: employers owe their employees and many of them would face a serious cash-crunch if their wage bill had to be prepaid. Similarly it is much harder for businesses to operate on a COD basis, than on a 30 days payable basis.
The goal of a banking system should be to make sure that as much of this simple transactional credit is available as possible at very low cost — because that’s a baseline requirement for the economy to be functioning reasonably efficiently. By eliminating simple short-term bank loans — without providing for the government to provide the service instead — narrow banking proposals are likely to hobble the economy, turning it from one where debt-based money is available to one where such money has dried up entirely.
Martin Wolf in Shifts and Shocks does a remarkable job of taking a comprehensive view of all the moving parts that have played a role in creating our current financial malaise and ongoing risks to financial stability. He also does a wonderful job of laying them out clearly for readers. Furthermore, I am entirely convinced by his diagnosis and prognoses of the Eurozone’s problems. When it comes to the question of the financial system more generally, however, even though I’m convinced that Wolf understands the symptoms, I don’t think he’s on target with either his diagnosis or his solutions. In fact, I think he too shows signs of being hampered by the problem of intellectual orthodoxy.
This post is therefore going to combine commentary on Shifts and Shocks with an introduction to my own views of how to understand the boondoggle that is the modern financial system. (I have nothing to say about the Eurozone’s grief except that you should read what Martin Wolf has to say about it.) For the long form of my views on the structural reform of the financial system, see here.
First, let me lay out the many things that Wolf gets right about the financial system.
- The intellectual failures are accurately described:
- orthodox economics failed to take into account the banking system’s role in creating credit, and thus failed to understand the instability that was building up in the system.
- this has led to a dysfunctional and destabilizing relationship between the state and the private sector as suppliers of money
- His basic conclusion is correct:
- the system is designed to fail because banks finance long-term, risky and often illiquid assets with short-term, safe and highly liquid liabilities.
- The inadequacy of the solutions currently being pursued is also made clear. Combining macro-prudential policy and “unlimited crisis intervention” with resolution authorities
- just worsens the dysfunctional relationship between the state and the private sector
- forces rulemaking that is designed to preserve a system that the regulators don’t trust and that is so complex it is “virtually inconceivable that it will work” (234)
- His focus on the need for more government expenditure to support demand instead of attempts to induce the private sector to lever up yet again is correct.
- The key takeaways from his conclusion are also entirely correct (349)
- “The insouciant position – that we should let the pre-crisis way of running the world economy and the financial system continue – is grotesquely dangerous.”
- “leveraging up existing assets is just not a particularly valuable thing to do; it creates fragility, but little, if any, real new wealth.”
I think Wolf makes a mistaking in diagnosing the problem, however. One can view our current financial system as simply exhibiting the instability inherent in all modern economies (a la Minsky), or as exhibiting an unprecedented measure of instability even taking Minsky into account, or something in between. Wolf takes the hybrid position that while the basic sources of instability have been present in financial systems since time immemorial, “given contemporary information and communication technologies, modern financial innovations and globalization, the capacity of the system to generate complexity and fragility, surpasses anything seen historically, in its scope, scale and speed.” (321) This, I believe, is where the argument goes wrong.
To those familiar with financial history the complete collapse of a banking system is not a particularly unusual phenomenon. The banking system collapsed in Antwerp in the mid-15th century, in Venice in the late 16th century, in France in the early 18th century, and in Holland in the late 18th century. What is remarkable about 19th and 20th century banking is not its instability, but its lack of total collapse.
Indeed, the remarkable stability of the British banking system was founded in part on the analysis of the reasons behind 18th century financial instability on the continent. (There is no important British banking theorist who does not mention John Law and his misadventures in France.) In particular, a basic principle of banking used to be that money market assets — and bank liabilities — should not finance long-term assets; capital markets should have the limited liquidity that derives from buyers and sellers meeting in a market. Thus, when Wolf finds that our modern system is “designed to fail” because money market assets are financing risky long-term assets, and that market liquidity is a dangerous illusion that breeds overconfidence and is sure to disappear when it is most needed (344), he is simply rediscovering centuries-old principles of what banks should not do.
By arguing that the structural flaws of modern finance are as common to the past as to the present, Wolf embraces the modern intellectual orthodoxy and sets up his radical solution: that our only option for structural reform that stabilizes banking is to take away from banks the ability to lend to the private sector and require that all debt be equity-financed. Thus, Wolf obfuscates the fact that the 19th and 20th century solution to banking instability was to limit the types of lending to the private sector that banks were allowed to engage in. Britain had a long run of success with such policies, as did the U.S. from the mid-1930s to the 1980s. (Recall that the S&Ls were set up in no small part to insulate the commercial banks from the dangers of mortgage lending — as a result the S&L crisis was expensive, but did not destabilize the commercial banks, and was compared to 2007-08 a minor crisis.) Thus, there is another option for structural reform — to stop viewing debt as a single aggregate and start analyzing which types of bank lending are extremely destabilizing and which are not.
The real flaw, however, in Wolf’s analysis is that he doesn’t have a model for why banking lending is important to the economy. Thus, when he acknowledges that it is possible that the benefits of “economic dynamism” due to banking exceed the massive risks that it creates (212-13), he doesn’t have a good explanation for what those benefits are. As a result, Wolf too is intellectually constrained by the poverty of modern banking theory.
19th c. bankers were far less confused about the benefits of banking. When everybody is willing to hold bank liabilities, banks have the ability to eliminate the liquidity constraints that prevent economic activity from taking place. The merchant who doesn’t have enough capital to buy at point A everything he can sell at point B, just needs a line of credit from the bank to optimize his business activities. This problem is ubiquitous and short-term lending by banks can solve it. Furthermore, because they solve it by expanding the money supply, and not by sourcing funds from long-term lenders, the amount of money available to borrow can easily expand. Of course, there are problems with business cycles and the fact that the incentives faced by banks need to be constantly monitored and maintained, but these are minor issues compared with the asset price bubbles that are created when banks get into long-term lending and that destabilized the financial system in 2007-08.
Overall, banks can do a lot to improve economic efficiency without getting into the business of long-term lending. And a recipe for financial stability should focus on making sure that long-term lending, not all bank lending, is funded by equity.
I’m working on a series of papers on traditional banking theory as an alternative framework for understanding the relationship between banking, finance and the macroeconomy, (part 1 is here) and in this post I’m just jotting down some thoughts on the history of economic thought.
As my papers argue by the early 20th century there was a fairly coherent theory of the relationship between banking, economic activity, the price level, and the guidance of these factors using the central bank policy rate — I call this “traditional banking theory.” With the growth of the “quantity (of money) theorists,” this school was sometimes described as “qualitative,” but it’s proponents pointed out (Beckhart, AER 1940) that the two schools didn’t differ in the importance they placed on the use of data, but rather in the value of using aggregate quantities to determine policy.
There are two points to make here:
After the Depression (and I believe massive policy influence in the 1930s), this traditional school of monetary thought was entirely displaced by two aggregate theory approaches: Monetarists and Keynesians. The histories I am familiar with focused on the debate between the two macro schools and the view that macro cannot be understood without a micro-understanding of debt disappeared from academic discourse. (I still don’t understand how this happened, but maybe the “invention” of macro played a role in it.)
Traditional banking theory didn’t really disappear. Instead it became part of the vast gulf that developed between market practitioners and academic theorists. For example, Marcia Stigum’s Money Market, a textbook written based on interviews with practitioners, reflects aspects of traditional banking theory.
This is a commentary on Chapter 5 of Martin Wolf’s book, The Shifts and the Shocks.
Martin Wolf’s explanation of the euro zone crisis, and of the problems created for the currency union by countries that are determined to run a surplus is clear and convincing. (Indeed, if my memory serves me correctly, his reasoning echoes the initial rationale for the IMF, with its deliberate penalties for countries that run a surplus.)
The discussion of the savings glut is however less effective. The problem is that there are two aspects to this story: first the policies of emerging market countries that undervalue their currencies and make it easy for them to run current account surpluses and, second, the uncharacteristic movement of the U.S. business sector into surplus around the same time period.
Wolf makes it clear that the latter played an important role in the savings glut. The problem faced by Wolf and other advocates of the savings glut view is, however, that there is a coherent explanation for the surplus only in the case of the emerging market countries. Not surprisingly the text focuses on the explainable aspects of the glut and restricts its discussion of the U.S. business sector surplus mostly to remarks on the significance of its size.
This omission is extremely important, because Wolf makes it clear that an important factor in the crisis was the dysfunctional manner in which U.S. markets responded to both the savings glut and the subsequent reduction in the federal reserve’s policy rate which was designed to stimulate the U.S. economy and offset the adverse effects on U.S. employment of the combination of a huge trade imbalance and a deficit of business borrowing. U.S. financial markets responded to these two phenomena by creating unsustainable leverage and balance sheet deterioration in the household sector.
My concern is with the causality that Wolf assumes. Let me propose an alternative interpretation of the facts. We know that when a bubble pops there is a transfer of resources away from those who purchased at the peak and to those who buy at the nadir. One function of the massive extension of credit to households was to ensure that there was a lot of underinformed, “dumb” money buying into the peak of the bubble. To the degree that corporate decision-makers have access to investment funds where knowledgeable financiers either can navigate the bubble successfully or are just successful at convincing the decision-makers that they can do so, a profit maximizing corporate decision maker may prefer to invest in financial assets than to risk money on the production of products that need to be marketed to the already over-extended household sector. In short, the possibility that (i) the U.S. business sector was the important factor in the savings glut “at the margin,” and that (ii) the causality for the U.S. business sector’s participation in the savings glut runs from the overindebtedness of the U.S. household sector and a general tendency of the modern financial sector to misallocate resources to the financialization of the U.S. business sector’s use of funds, at least needs to be entertained and evaluated.
In short, I am uncomfortable with the assumption of causality implied by sentences like the following: “What the market demanded the innovative financial sector duly supplied . . . By creating instruments so opaque that they were perfectly designed to conceal (credit) risk.” (at 172). Given how difficult it is to establish causality, should we not be asking whether financial innovation, and in particular the ability of the financial sector to create assets that one side of the transaction did not understand, drove a demand to take the other side of transactions with such “dumb” money (of course, giving a substantial cut of the returns to the innovators and originators of these assets)?
Thus, while Wolf argues that household leverage and balance sheet deterioration were necessary to offset the massive demand deficiency created by the savings, he doesn’t really address the problem that a big chunk of this demand deficiency was endogenously created by the business sector itself. Blaming the crisis on foreign lenders who were only interested in riskless assets is too easy. Any genuine explanation of what was going on needs to include an explanation of the behavior of the U.S. business sector, and Martin Wolf does not offer such an explanation.
Overall, this chapter does a very good job of describing the trends that fed into the financial crisis. This careful description, however, is what made this reader see a gap in the explanation that made me question the causal story as it was presented. On the other hand, Wolf also draws the conclusion that a financial system capable of such extraordinary dysfunction is in need of serious reform. So perhaps my criticism of this chapter will turn out to be only a quibble with the full book. I’ll let you know.
In the acknowledgements to The Shifts and the Shocks (which I am currently reading) Martin Wolf has stated that friends like Mervyn King encouraged him to be more radical than initially intended, and I suspect, as I read Chapter 4, “How Finance Became Fragile,” that this was one of the chapters that was affected by such comments. In particular, I see a contradiction between the initial framing of financial fragility which focuses on Minsky-like inherent fragility, and the discussion of regulation. Was this a crisis like that in the U.K. in 1866 or in the U.S. in the 1930s, or was this an “unprecedented” crisis that was aggravated by the elimination of legal and regulatory infrastructure that limited the reach of the crisis in 1866 and the 1930s? I am troubled by Wolf’s failure to take a clear position on this question.
Because Martin Wolf understands that the government intervention due to the crisis was “unprecedented” (at 15), I had always assumed that he understood that the nature of the 2007-08 crisis was also unprecedented. He appears, however, to be of the opinion that this crisis was not of unprecedented severity. Martin Wolf really surprised me here by taking the position that: “The system is always fragile. From time to time it becomes extremely fragile. That is what happened this time.” And by continuing to treat the crisis as comparable to the 1930s in the U.S. or 1866 in the U.K. (at 123-24).
His treatment of how regulation played into the crisis could be more thorough. He concludes that “the role of regulation was principally one of omissions: policymakers assumed the system was far more stable, responsible, indeed honest, than it was. Moreover, it was because this assumption was so widely shared that so many countries were affected.” (at 141). Wolf is undoubtedly aware of the many changes to the legal framework that protected the U.K. financial system in 1866 and the U.S. financial system in the 1930s that were adopted at the behest of the financial industry in both the U.S. and the U.K. (Such changes include the exemption of derivatives from gambling laws, granting repurchase agreements and OTC derivatives special privileges in bankruptcy, and the functional separation of commercial banking from capital markets.) Is the argument that these changes were not important? or that these changes fall in the category of omission by regulators? Given the preceding section of this chapter, it would appear that he believes these changes were not important, but given the conclusion of the chapter, I am not so sure.
In the conclusion, Wolf takes a somewhat more aggressive stance than he does in the body of the chapter: “The crisis became so severe largely because so many people thought it impossible.” (at 147). So maybe the crisis is unprecedented compared to 1866 and the 1930s. (In 1866 at least the possibility of financial collapse seems to have been recognized.) He also adds two more points to the conclusion that I didn’t see in the body of the chapter: the origins of the crisis include “the ability of the financial industry to use its money and lobbying clout to obtain the lax regulations it wanted (and wants)” and the fact that “regulators will never keep up with” the ability of the financial industry to erode regulation (at 147).
Thus, once I reached the conclusion of the chapter, it was no longer clear that Wolf views this crisis as primarily an example of inherent fragility. He has laid out the argument for how the financial industry successfully removed the legal and regulatory protections that were in place in 1866 and the 1930s. So this is my question for Mr. Wolf: Was the crisis itself “unprecedented” in the course of the last two centuries of Anglo-American financial history, or was this just a Minsky moment like many that have come before?
I have a nit to pick with Tracy Alloway’s recent reporting on the repo market. She writes:
What remains of the $4.2tn market is increasingly being taken up by non-bank entities such as real estate investment trusts (Reits), mutual funds and hedge funds . . . The growing use of repo has been particularly marked among Reits, which have overtaken banks and broker-dealers as the largest borrowers in the market, according to Federal Reserve data. To purchase long-term mortgage assets, Reits have increased their repo borrowings to $281bn, up from $90.4bn in 2009. Closed-end funds, which invest in assets ranging from corporate bonds to municipal debt, also have increased their borrowing in the repo market, from $2.74bn at the end of 2007 to almost $8bn now, according to Fitch Ratings data.
Her data is apparently derived from the flow of funds data, which states that in Dec 2013 REITS has $281 bn in repo borrowings and broker dealers had $135 bn in *net* repo borrowing.
If REITs had indeed “overtaken” banks and broker-dealers as the largest borrowers in the market with a share of $281 bn, it would be very hard to explain how the market could possibly be a $4.2 tn market. In fact, of course, the broker-dealers are using their own (government supported) creditworthiness to intermediate access to the repo market for their customers, who don’t have the credit to borrow directly on the tri-party repo market. For this reason, it is almost certain that broker-dealers remain the largest borrowers on the market. In fact on page 170 of JPM’s 2013 10-K we find that this one bank had $156 bn of borrowings in the repo market. GS 10-K has $165 bn in such borrowings (p 173). In short, the fact that the broker-dealers are intermediating access to credit should not be used to obfuscate the fact that they are the largest borrowers on the repo market.
Paul Krugman writes: “while banks are indeed more complicated creatures than the mechanical lenders of deposits we like to portray in Econ 101, this doesn’t mean either that they have unlimited ability to create money or that they are somehow outside the usual rules of economics”
I want to propose a very different view of banking than the one Krugman embraces. Banking is what makes the “usual rules of economics” conceivable. Remember that Adam Smith wrote the Wealth of Nations in 1770’s Scotland, which was one of the birthplaces of modern banking — and banking was having an extraordinary effect on the economy that Smith acknowledged. (Book II, Chapter 2, paras. 40-41 )
If one discards the neo-classical framework and conceives as the economy as an environment where the average person’s life is defined by liquidity constraints that preclude profitable investment, then one can understand banking as the crucial innovation that allows the average person to overcome liquidity constraints and, thus, that makes the neo-classical framework a meaningful model of economic behavior.
Of course, banks have never had “unlimited ability to create money” — even though the statement that banks “create money at the stroke of a pen” is a shorthand description that can be misread if taken out of context. Banking functions to alleviate liquidity constraints because of the institutional constraints on banks’ ability to create money — just as debt can alleviate liquidity constraints only if institutional constraints make it enforceable.
It is true that banks “create money at the stroke of a pen,” but it is also true that they are liable for the deposits that they create when doing so — just as they are liable for liquidity puts that make the issue of asset-backed commercial paper possible. It is the institutional structure in which banks operate which controls the money supply.
In my view, when there is an institutional infrastructure that makes it possible for banks to issue safe private sector assets abundantly, the economy performs well — because the new-classical framework becomes a not-unreasonable approximation of the economy. By contrast, when this institutional infrastructure starts to break down as it has in recent years, we begin to inhabit an economy where liquidity constraints are one of the most important forces in the average individual’s life and vast amounts of profitable investment never see the light of day.
Other blogposts and articles related to this topic are:
Atif Mian & Amir Sufi, 100% Reserve Banking — The History
Paul Krugman, Is a Banking Ban the Answer
Martin Wolf, Strip Private Banks of Their Power to Create Money
John Cochrane, Toward a Run-Free Financial System
Isabella Kaminsky, Martin Wolf on Funny Money Creation, On the Elimination of Privately Issued Money
Stephen Cecchetti & Kim Schoenholtz, Narrow Banks Won’t Stop Bank Runs
I’ve finally organized the thoughts about banking that poured onto the pages of this blog in January. Unfortunately, the argument does not lend itself to convincing exposition in a blog post. So anybody who’s interested is going to have to trundle over to SSRN and download the paper, Shadow Banking: Why Modern Money Markets are Less Stable than 19th c. Money Markets but Shouldn’t Be Stabilized by a ‘Dealer of Last Resort’. I’ll warn you upfront, it’s tl;dr with a vengeance. On the other hand, I’m a pretty concise writer, so you’ll find I cover an awful lot of ground, if you give me an hour or two of your time.
- I start with Shadow Banking is an Unstable Funding System for Banks, Not Assets (so if you’re already familiar with the blogpost, you can skip that part).
- I continue with my interpretation of why the industrial revolution took off in Britain: the banking system, of course — and it’s ability to create money. To make the point, I very briefly explain the nature of early modern financial markets, and how they gave birth to fiat money.
- I then explain the components of the system that allowed 19th c. bankers to create risk-free private sector assets. Next I explain how these components fit in with a theoretic model of banking, and distinguish this model from Gorton and Ordonez model of “informationally insensitive” bank debt. (Don’t worry, no math.)
- Then I argue that the 19th c. lender of last resort, as it was understood by Bagehot, did not only serve as a source of liquidity, when panics threatened a crisis of confidence in the (fundamentally sound) banking system, but also actively managed moral hazard by explicitly withdrawing support from institutions that were undermining the quality of the money supply.
- At last I come back to modern shadow banking, explaining how the modern perversion of the “lender of last resort” into “too big to fail” has led to the growth of extraordinarily unstable forms of funding, including financial commercial paper and repo. Collateralized money markets in particular maximize the value of the central bank put, by draining liquidity when it’s most needed.
- I explain why a “dealer of last resort” cannot support asset market prices in general, but can only protect asset markets from forced sales by the specific dealers who are granted access to the central bank.
- Finally, I distinguish the tight connection that exists between traditional commercial banking and the real economy from the much more ambiguous relationship between traditional dealer banks and the real economy. After all, traditional dealer banks don’t hold assets on their balance sheets over the long term and are far more focused on their short-run ability to sell off an asset, than in the asset’s performance over the long run.
- It is because of the important role that commercial banks play in the real economy that they have privileged access to the lender of last resort facilities of the central bank. Dealer banks don’t play the same role and don’t deserve similar support. As for shadow banking, repo markets, to the degree that they fund private sector assets at all, fund market-traded assets and don’t support unsecured lending to smaller businesses, whereas asset backed commercial paper markets are steadily shrinking now that avenues of regulatory arbitrage are being closed.
I had the good fortune to attend the INET 2014 conference this past weekend, to hear speak a variety of luminaries whose work I have been reading for years, and to meet bloggers with whom I have debated arcane points that none of my non-internet-based friends care about. I had a conversation there that I think sheds light on the causes of the Great Depression.
The thesis of Golden Fetters, Barry Eichengreen’s magnum opus, is this:
The gold standard is conventionally portrayed as synonymous with financial stability. … A central message of this book is that precisely the opposite was true. Far from being synonymous with stability, the gold standard itself was the principal threat to financial stability and economic prosperity between the wars.
More recently Eichengreen and Peter Temin conclude that a gold standard ideology played an important role in worsening the Depression. They quote in their conclusion an author who wrote in 1932:
What is astonishing is the extraordinary hold which what is called the gold mentality has obtained, especially among the high authorities of the world’s Central Banks. The gold standard has become a religion …
Certainly in retrospect it seems likely, that had Britain gone off gold in 1924 — before the accrual of seven years of credit imbalances built on a disequilibrium exchange rate — the world economy’s adjustment to that event would have been less traumatic than the events that took place after 1931. The question then is why there was such a strong commitment on the part of the world’s central bankers to supporting Britain in the maintenance of the gold standard.
I had a conversation at INET in which the following question was discussed: Why are the central bankers committed to coordinating with the ECB on protecting the Eurozone when there is a significant possibility that the politicians will fail to make the necessary adjustments, that the Eurozone will break apart, and that in retrospect their actions will appear ill-advised? The conclusion was this: from the point of view of the central bankers the immediate costs of failing to support the Eurozone are so high, that the central bankers have no choice but to have faith that the politicians will play the role they need to play.
If the same dynamic was at play historically, perhaps the golden fetters that chained central bankers in the 1920s and 30s were not ideological at all. But simply the fact that given a choice between causing an immediate crisis and leaving open the possibility, even if small, that the crisis can be avoided by political action, they could not bring themselves to take the pessimistic-realistic view. Maybe the central bankers in the 1920s and 30s felt that they had no choice but to place their faith in politicians, who were not worthy of that faith.
Matt Levine writes:
Prices very quickly reflect information, specifically the information that there are big informed buyers in the market.
That’s good! That’s good. It’s good for markets to be efficient. It’s good for prices to reflect information.
Let’s take this argument to the limit. Every order contains some small amount of information. Therefore every order should move the market (as they do in building block models of market microstructure)– and of course big orders should move the market even more than small orders. Matt Levine is claiming that this is the definition of efficiency.
But wait: What is the purpose of markets? Do we want them to be informationally efficient about the fundamental value of the assets, or do we want them to be informationally efficient about who needs/wants to buy and sell in the market? These are conflicting goals. When a hedge fund is forced to liquidate by margin calls, those sales contain no information about the fundamental value of the asset. Should prices reflect the market phenomena or should they reflect fundamental value? According to Matt Levine they should reflect the market not the fundamentals.
Matt Levine supports his view by referencing an academic paper that assumes on p. 3 that all orders contain some information about fundamental value — and thus assumes away the problem that some market information has nothing to do with fundamental value. With only a few exceptions the theory supporting the view that trade makes markets informationally efficient in the academic literature assumes (i) that informed traders trade on the basis of fundamental information about the value of the asset and (ii) that the informed traders have no opportunity to use their information strategically by delaying its deployment. Almost nobody models the issue of intermediaries trading on the basis of market information. And the whole literature by definition has nothing to say about efficiency in the sense of welfare (i.e. the Pareto criterion) because it assumes that liquidity traders are made strictly worse off by participating in markets.
It has long been recognized that liquidity is one of, if not, the most important service provided by secondary markets. Liquidity is the ability to buy or sell an asset in sizable amounts with little or no effect on the price.
Matt Levine’s version of informational efficiency presumes that there is no value to liquidity in markets. Every single order should move the market because there is some probability that it contains information.
I thought the reason that financial markets attract vast amounts of money from the uninformed was because they were carefully structured to provide liquidity and to ensure that the uninformed could get a fair price. Now it’s true that U.S. markets were never designed to be fair — and were undoubtedly described in extremely deprecating terms by London brokers and dealers for decades — at least prior to 1986. But there’s a big difference between arguing that markets don’t provide liquidity as well as they should, and arguing, as Matt Levine does, that the provision of liquidity should be sacrificed at the altar of some poorly defined concept of informational efficiency.
If Matt Levine is expressing the views of a large chunk of the financial world, then I guess we were all wrong about the purpose of financial markets: as far as the intermediaries are concerned the purpose of financial markets is to improve the welfare of the intermediaries because they’re the ones with access to information about the market. Good luck with that over the long run.