The economy may not be in a recession, but it still isn’t performing very well. A variety of explanations have been floated for this poor performance:
- Larry Summers argues that “secular stagnation” takes place because interest rates are bounded below and cannot fall to the market clearing level, so we will suffer from insufficient investment until the zero lower bound problem is solved (which may require changing expectations of inflation). He also argues that growth since the late 1990s has been powered by unsustainable increases in the household debt burden, so the underlying economic malady may be of long-standing.
- Ben Bernanke argues that the global savings glut can explain low interest rates and that to the degree that the U.S. is in an economic slump, this can be addressed by removing barriers to the flow of U.S. funds into foreign investments and reducing intervention in foreign exchange markets.
- Steve Williamson (h/t Nick Rowe) makes the point that low interest rates can be explained by a financial problem — a safe assets shortage where there is too little government debt outstanding relative to the demand for its use as collateral — and he argues that it may be this safe asset shortage that causes poor economic performance.
I want to take Williamson’s view one step further and argue that we have a safe asset shortage, and therefore low interest rates and lethargic growth, because we broke the banking system. This argument is premised on the view that the most important economic function of the banking system is the creation of safe privately issued assets that are not secured by collateral. (The long form version of this argument is available here, and I outline below how a banking system can be structured to create safe privately issued unsecured assets.)
When the banking system creates an environment where participants in the economy are able to borrow on a short-term, but unsecured, basis and are incentivized by long-term relationships with their banker to borrow wisely, banking promotes economic activity and fosters entrepreneurship by making it possible for the average person to slowly grow a business alongside a credit history. In short, by providing a stable source of short-term credit for almost everybody banking can mitigate the problem that only a select sub-group of the population is ever likely to have access to substantial sums of long-term business credit.
Thus, the principal economic function of the banking system is to make short-term unsecured debt available in ample quantities and thereby ensure that liquidity constraints are not too binding on most economic agents. This system of unsecured debt works because it is a mutual system: the same people who borrow from the banks on an unsecured basis also use bank deposits as money and vice versa. Short-term credit can be provided abundantly because the funds that are lent don’t leave the banking system as a whole, but are simply recirculated from one account to another.
The modern banking system, by contrast, has been evolving in ways that undermine its mutual nature. Since the early years of the current millennium, the cash assets of institutions, including asset managers and corporate treasuries, have been moved away from unsecured bank and money market liabilities and into collateralized short term liabilities, such as repurchase agreements. (Pozsar 2011). In addition, since the crisis unsecured interbank lending markets, such as the Federal Funds and London markets, have collapsed and been replaced with collateralized debt. In other words, both institutional cash pools and the banks themselves have started to opt out of the mutual uncollateralized system that has supported economic activity for more than a century.
Low interest rates and the savings glut may therefore just be the most obvious symptoms of an increasingly dysfunctional financial system where the largest participants have difficulty borrowing unsecured — except from the central bank. An even greater problem is that a banking system built on unsecured debt works because the incentive structure that supports the debt is calibrated and adjusted as the banking system evolves. Thus, when interbank markets break down and remain inoperational for years, the capacity of the system to create unsecured debt may end up being irreparably broken. If my thesis that unsecured debt is an engine of economic performance is correct, then the broken banking system is a very serious problem.
How can a financial system create safe privately issued assets?
The London money market at the turn of the 20th century provides a model of how safe assets are created by a banking system. The elements of the model are this:
- In order for a trade debt (owed by one non-bank to another) to become a tradable asset on the money market, the payor’s bank had to accept (or guarantee payment on) the debt. Accepted bills traded freely on the money market, because …
- The central bank provided liquidity to the money market by standing ready to discount accepted bills a long as the discounting bank was different from the accepting bank.
- To emphasize, what made a bill eligible at the central bank’s discount window, and therefore liquid, were the overlapping guarantees of payment. Many bills were not collateralized.
In short, one way to ensure that the banking system creates safe assets is for the central bank to provide liquidity against paper that has two bank guarantees and one commercial promise of payment. Because a bank accesses central bank liquidity by discounting bills originated by a different bank, this structure ensures that the banks monitor each other and it helps prevent the type of interbank competition that can undermine credit standards.
Thus, it’s possible to have safe privately issued assets — if the incentive structure of the banking system is correctly calibrated.
The mid-20th century U.S. banking system (which I need to study in much more detail than I have to date) took a different form than the model described above, but it was not prone to excessive risk-taking. Instead, competition was repressed, and bankers had the luxury of living by the 3-6-3 rule.