Access to Credit is the Key to a Win-Win Economy

Matt Klein directs our attention to an exchange between Jason Furman and Dani Rodrik that took place at the “Rethinking Macroeconomic Policy” Conference. Both argued that, while economists tend to focus on efficiency gains or “growing the pie”, most policy proposals have a small or tiny efficiency effect and a much much larger distributional effect. Matt Klein points out that in a world like this political competition for resources can get ugly fast.

I would like to propose that one of the reasons we are in this situation is that we have rolled back too much of a centuries-old legal structure that used to promote fairness — and therefore efficiency — in the financial sector.

Adam Tooze discusses 19th century macro in follow up to Klein’s post:

Right the way back to the birth of modern macroeconomics in the late 19th century, the promise of productivist national economic policy was that one could suspend debate about distribution in favor of “growing the pie”.

In Britain where this approach had its origins, access to bank credit was extremely widespread (at least for those with Y chromosomes). While the debt was typically short-term, it was also the case that typically even as one bill was paid off, another was originated. Such debt wasn’t just generally available, it was usually available at rates of 5% per annum or less. No collateral was required to access the system of bank credit, though newcomers to the system typically had to have 1 or 2 people vouch for them.

I’ve just completed a paper that argues that this kind of bank credit is essential to the efficiency of the economy. While it’s true that in the US discrimination has long prevented certain groups from having equal access to financial services — and that the consequences of this discrimination show up in current wealth statistics, it seems to me that one of the disparities that has become more exaggerated across classes over the past few decades is access to lines of credit.

The facts are a harder to establish than they should be, because as far as I can tell the collection of business lending data in the bank call reports has never carefully distinguished between loans secured by collateral other than real estate and loans that are unsecured. (Please let me know if I’m wrong and there is somewhere to find this data.) In the early years of the 20th century, the “commercial and industrial loans” category would I believe have comprised mostly unsecured loans. Today not only has the C&I category shrunk as a fraction of total bank loans, but given current bank practices it seems likely that the fraction of unsecured loans within the category has also shrunk.

This is just a long form way of stating that it appears that the availability of cheap unsecured credit to small and medium sized business has declined significantly from what it was back when early economists were arguing that we could focus on efficiency and not distribution. Today small business credit is far more collateral-dependent than it was in the past — with the exception of course of credit card debt. Charge cards, however, charge more than 19% per annum for a three-month loan which is about a 300% markup on what would have been charged to an unsecured business borrower in the 19th century. To the degree that it is collateralized credit that is easily available today, it will obviously favor the wealthy and aggravate distributional issues.

In my paper the banking system makes it possible for allocative efficiency to be achieved, because everybody has access to credit on the same terms. As I explained in an earlier post, in an economy with monetary frictions there is no good substitute for credit. For this reason it seems obvious that an economy with unequal access to short term bank credit will result in allocations that are bounded away from an efficient allocation. In short, in the models with monetary frictions that I’m used to working with equal access to credit is a prerequisite for efficiency.

If we want to return to a world where economics is win-win, we need a thorough restructuring of the financial sector, so that access to credit is much more equal than it is today.

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Bank deposits as short positions

A quick point about monetary theory and banking.

Monetary economics has a basic result: nobody wants to hold non-interest bearing fiat money over time unless the price level is falling, so that the value of money is increasing over time. Many, if not most, theoretic discussions of money are premised on the assumption that fiat money is an object and that therefore one can hold no money or positive quantities of money, but one can’t hold a short position in fiat money.

Maybe this is one of macroeconomics greatest errors. Perhaps the whole point of the banking system is to allow the economy as whole to hold a short position in fiat money. After all, from the perspective of a bank what is a bank deposit if not a naked short position in cash? And by lending to businesses and consumers banks allow the rest of us to be short cash, too. This makes sense, because the basic principles of intertemporal economic efficiency state that we should all be short cash.

Is medicine as flawed as finance?

Events that took place this past holiday season have set me to thinking not just about the awful nexus that takes place when illness, addictive drugs, and the American medical system meet, but also about the nature of observation-based (as opposed to controlled-study-based) science and the relationship between the practice of this science and the giant corporations that have an interest in this practice. In short, I’ve been thinking about how failures in the world of medicine look very similar to failures in the world of finance.

What happens in an environment where data is important, but its interpretation is necessarily imprecise, and there are corporations whose goal is to profit off of any structural weaknesses in the methods used to interpret the data? The combination of weak antitrust enforcement that has placed immense power in the hands of a very small number of corporations and a corporate focus on shareholder value rather than stakeholder value means that there simply aren’t that many influential corporations left whose core business strategy is to serve those who buy their products to the best of the corporation’s ability.

In finance this means that clients are often treated as “the mark”, and client losses are justified by those who generate them on the Darwinian principle that good things will happen when dumb or uneducated people lose money. Financiers know that the nature of the data ensures that they can almost always come up for some kind of an explanation for why the product they use to garner some “dumb money” is in some way beneficial and should not be banned. (e.g. “in an efficient market, only people who need product X will buy product X, so we don’t need to worry about the losses of the “dumb money,” which exists to make the market more efficient.”) The tools of the academics are used, not for the purpose for which they were invented, but to make the world a worse place to live in.

Unfortunately I’m beginning to suspect that our drug companies function on the same principles as the financial industry. It seems to me that doctors have been trained not to listen too closely to patient complaints about side effects. Now there are probably good reasons for this: if the doctor is conservative about prescribing medicine so that you really need the medicine when you get it, then the side effects will need to be quite severe in order for them to outweigh the need for the medication. And it is true that doctors almost certainly receive many complaints about perceived side effects that are in fact due to other causes. In short, doctors have a very hard job.

It seems to me that pharmaceutical have turned the challenge of medicine into a profit opportunity through two mechanisms. First, they work aggressively to get doctors to prescribe their medications for minor ailments that could be addressed through over-the-counter or non-pharmaceutical means. When the pharmaceutical companies are successful, doctors end up prescribing drugs that are net “bads” for their patients, and frequently choose to address side effects not by taking the patient off the medication, but by prescribing another medication to address the side effect. A patient with a minor complaint can end up on a cocktail of drugs that causes far more damage to the patient’s health than the minor complaint itself. Who has not heard a doctor state when the patient questions whether her growing health problems are not in fact being caused by the cocktail of medication that “It’s not cause and effect,” pooh-poohing the patient’s concerns? While there are certainly very good doctors out there (and I recommend that you seek them out), the medical profession has done far too little to offset the nefarious influence of drug company incentives.

Secondly, it appears that drug companies have learned that addictive drugs are some of the most profitable. In my view this is likely to be due to the fact that these drugs often have the side effect of causing the malady they are prescribed to cure. That is, once you have become addicted to the drug, trying to get of the med will often cause you to experience the illness that you took it to address — but even worse than before you took it. It’s not unusual for patients to get into a pattern where the doctor keeps prescribing higher and higher doses of these medications and that the patient ends up facing very strong disincentives to go off the medicine. A profit-maximizing pharmaceutical company will likely prefer to develop this type of medicine than a medicine that can treat the ailment, but that is non-addictive. That is, the profit motive is very much adverse to what is in patients’ best interests. When you add to this dynamic the tendency of many doctors to pooh-pooh patient concerns about side-effects and in particular concerns that the medication may be worsening the condition (“It’s not cause and effect. Your symptoms are probably just the progression of your ailment.”), it hardly surprising that the way these medications are being used is often toxic.

Overall, when I hear complaints about how too much of the public doesn’t believe in science anymore, I can’t help wondering: Well, what is their experience of how science is applied in the modern world?

Re-imagining Money and Banking

I’ve written a new paper motivated by my belief that the recent financial crisis was in no small part a failure of economic theory and therefore of economic thinking. In particular, there is a missing model of banking that was well understood a century ago, but is completely unfamiliar to modern scholars and practitioners. The goal of this paper is to introduce modern students of money and banking to the model of money that shaped the 19th century development of a financial infrastructure that both supported modern economic growth for more than 100 years and was passed down to us as our heritage before we in our hubris tore that infrastructure apart.

Another goal is to illustrate what I believe is a fundamental property of environments with (i) liquidity frictions and (ii) a large population with no public visibility but a discount factor greater than zero: in such an environment anyone with a notepad, some arithmetic skills, and some measure of public visibility can offer – and profit from – the account-keeping services that make incentive feasible a much better allocation than autarky for the general populace. Importantly collateral is completely unnecessary in a bank-based payments system.

This model has two key components. First, banks transform non-bank debt into monetary debt. Thus, the transformative function of banking is not principally a matter of maturity, but instead of the nature of the debt itself, that is, of its acceptability as a means of exchange. Second, monetary debt is money (contra Kocherlakota 1998). There is no hierarchy of moneys where some assets have more monetary characteristics than others. Instead there is only monetary debt and non-monetary debt. When we study this very simple model of money in an environment with liquidity frictions using the tools of mechanism design, we see that the economic function of the banking system is to underwrite a payments system based on unsecured debt and thereby to make intertemporal budget constraints enforceable or equivalently to make it possible for the non-banks in our economy to monetize the value of the weight that they place on the future in the form of a discount factor. Banking transforms an autarkic economy into one that flourishes because credit is abundantly available. In this model, constraints on the economy’s capacity to support debt are not determined by “deposits” or by “collateral”, but instead by the incentive constraints associated with banking.

In this environment, banking provides the extraordinary liquidity that is only possible when the payments system is based on unsecured debt. Underlying this form of liquidity is the banks’ profound understanding of the incentive structures faced by non-banks, as it is this understanding that makes it possible for banks to structure the system of monetary debt so that it is to all intents and purposes default-free. (This is actually a fairly accurate description of 19th century British banking. The only people who lost money were the bank owners who guaranteed the payments system. See Sissoko 2014.) Although this concept of price stable liquidity is unfamiliar to many modern scholars, Bengt Holmstrom (2015) has given it a name: money market liquidity.[1] In such a system the distinctions between funding liquidity and market liquidity collapse, because the whole point of the banking system is to ensure that default occurs with negligible probability. Thus, the term money market liquidity references the idea that in money markets, the process by which assets are originated must be close to faultless or instability will be the result, because the relationship between money – when it takes the form of monetary debt – and prices is not inherently stable (cf. Smith 1776, Sargent & Wallace 1982).

This paper employs the tools of New Monetarism, mechanism design, and more particularly the model of Gu, Mattesini, Monnet, and Wright (2013) to explain the extraordinary economic importance of the simplest and most ancient function of a bank: in this paper banks are account-keepers, whose services support a payment system based on unsecured credit. Unsecured credit is incentive feasible, because banks provide account-keeping services and can use the threat of withdrawing access to account-keeping services to make the non-bank budget constraint enforceable.

The basic elements of the argument are this: an environment with anonymity, liquidity frictions and somewhat patient agents is an environment that begs for an innovation that both remedies the problem of anonymity and realizes the value of the unsecured credit that the patience of the agents in the economy supports. I argue that the standard way in which economies from ancient Rome to medieval Europe to modern America address this problem is by introducing banking – or fee-based account-keepers – in order to alleviate the problem of anonymity that prevents agents from realizing the value inherent in the weight they place on the future. I demonstrate that in this environment, the introduction of a bank improves welfare. The improvement in welfare can be dramatic when the discount factor is not close to zero.

This paper uses the environment of Gu, Mattesini, Monnet, and Wright (2013) but is distinguished from that model, because here the focus is on a different aspect of banking. We study how the account-keeping function of banks serves to support unsecured credit, whereas GMMW studies how the deposit-taking function of banks is able to support fully collateralized credit.

The model of banking in this paper has implications that are very different from much of the existing literature on banking. This literature typically assumes the anonymity of agents and then argues – contrary to real-world experience – that unsecured non-bank credit is unimaginable (see, e.g., Gorton & Ordonez 2014, Monnet & Sanches 2015). In other words, the existing literature takes the position that in the presence of anonymity, no paid account-keeper will arise who will make it possible for agents in the economy to realize the value of unsecured credit that their discount factor supports. In the absence of unsecured credit, lending is generally constrained as much by the available collateral or deposits, as by incentive constraints themselves. This paper argues that standard assumptions such as loans must equal deposits (see, e.g. Berentsen, Camera & Waller 2007) or debt must be supported by collateral (see e.g. Gu, Mattesini, Monnet, and Wright (2013), Gorton & Ordonez 2014) are properly viewed as ad hoc assumptions that should be justified by some explanation for why banking has not arisen and made unsecured credit available to anonymous agents.

[1] While Holmstrom (2015) and this paper agree on the principle that money market liquidity is characterized by price stability, the mechanism by which that price stability is achieved is very different in the two papers: for Holmstrom it is the opacity of collateral that makes price stability possible.

Collateral and Monetary Policy: A Puzzle

A stylized fact about post-crisis economies is that asset markets have become segmented with “safe assets” trading differently from assets more generally. I have argued elsewhere that the collateralization of financial sector liabilities has played an important role in this segmentation of markets.

I believe that this creates a puzzle for the implementation of monetary policy that provides at least a partial explanation for why we are stuck at the zero lower bound. Consider the consequences of an increase in the policy rate by 25 bps. This has the effect of lowering the price of ultra-short-term Treasury debt, and particularly when combined with a general policy of raising the policy rate over a period of months or years this policy should have the effect of lowering the price of longer term Treasuries as well (due to the fact that long-term yields can be arbitraged by rolling over short-term debt).

A decline in the price of long-term Treasuries will have the effect of reducing the dollar value of the stock of outstanding Treasuries (as long as the Treasury does not have a policy of responding to the price effects of monetary policy by issuing more Treasuries). But now consider what happens in the –segmented — market for Treasury debt. Assuming that demand for Treasuries is downward sloping, then the fact that contractionary monetary policy tends to shrink the stock of Treasuries itself puts upward pressure on the price of Treasuries that, particularly when demand for Treasuries is inelastic, will tend to offset and may even entirely counteract the tendency for the yield on long-term Treasuries to rise. (Presumably in a world where markets aren’t segmented demand for Treasuries is fairly elastic and shifts into other financial assets quash this effect.)

In short, a world where safe assets trade in segmented markets may be one where implementing monetary policy using the interest rate as a policy tool is particularly difficult. Can short-term and long-term safe assets become segmented markets as well? Given arbitrage, it’s hard to imagine how this is possible.

These thoughts are, of course, motivated by the behavior of Treasury yields following the Federal Reserves 25 bp rate hike in December 2015.fredgraph

 

The 19th c. bank “bailout” that never happened

I’ve just read Eugene White’s Bank Underground post on the Baring liquidation in 1890. He is notable in getting the facts of what he calls the “rescue” mostly right. He accurately portrays the “good bank-bad bank” structure and the fact that the partners who owned the original bank bore the losses of the failure. What he doesn’t explain clearly is the degree to which the central bank demanded insurance from the private sector banks before agreeing to extend a credit line that would allow the liquidation of the bad bank to take place slowly.

These facts matter, because a good central banker has to make sure that the incentives faced by those in the financial community are properly aligned. In the case of Barings macroeconomic incentives were aligned by making it clear to the private banks that when a SIFI fails, the private banking sector will be forced to bear the losses of that failure. This brings every bank on board to the agenda of making sure the financial system is safely structured.

In the 19th c. the Bank of England understood that few things could be more destabilizing to the financial system than the expectation that the government or the central bank was willing to bear the losses of a SIFI failure. Thus, the Bank of England protected the financial system from the liquidity consequences of a fire sale due to the SIFI, but was very careful not to take on more than a small fraction (less than 6%) of the credit losses that would be created by the SIFI failure.

This is the comment I posted:

While this is one of the better discussions of the 1890 Barings liquidation, for some reason modern economic historians have a lot of difficulty acknowledging the degree to which moral hazard concerns drove central bank conduct in the 19th c. White writes:

The Barings rescue or “lifeboat” was announced on Saturday November 15, 1890. The Bank of England provided an advance of £7.5 million to Barings to discharge their liabilities. A four-year syndicate of banks would ratably share any loss from Barings’ liquidation. The guarantee fund of £17.1 million included all institutions, and some of the largest shares were assigned to banks whose inattentive lending had permitted Barings to swell its portfolio.

Clapham (cited by White), however makes it clear that the way the Bank of England drummed up support for the guarantee fund was by making a very credible threat to let Barings fail. Far from what is implied by the statement “The Bank of England provided an advance of £7.5 million to Barings to discharge their liabilities”, the Bank of England point blank refused to provide such an advance until and unless the guarantee fund was funded by private sector banks to protect the central bank from losses, Clapham p. 332-33.

In short, treating the £7.5 million (which is actually the maximum liability supported by the guarantee fund over a period of four years, Clapham p. 336) as a Bank of England advance may be technically correct because of the legal structure of the guarantee fund (which was managed by the Bank), but gets the economics of the situation dead wrong.

19th century and early 20th century British growth could only take place in an environment where central bankers in London were obsessed with the twin problems of aligning incentives and controlling moral hazard. Historians who pretend that anything else was the case are fostering very dangerous behavior in our current economic climate.

Note: Updated to make the last paragraph specific to Britain.

Lenders of Last Resort have duties in normal times too

I have a paper forthcoming in the Financial History Review that studies the role played by the Bank of England in the London money market at the turn of the 20th century. The Bank of England in this period is, of course, the archetype of a lender of last resort, so its activities shed light on what precisely it is that a lender of last resort does.

The most important implication of my study is that the standard understanding of what a lender of last resort does gets the Bank’s role precisely backwards. It is often claimed that the way that a lender of last resort functions is to make assets safe by standing ready to lend against them.

My study of the Bank of England makes it clear, however, that the duties of a lender of last resort go far beyond simply lending against assets to make them safe. What the Bank of England was doing was monitoring the whole of the money market, including the balance sheets of the principal banks that guaranteed the value of money market assets, to ensure that the assets that the Bank was engaged to support were of such high quality that it would be a good business decision for the Bank to support them.

In short, a lender of last resort does not just function in a crisis. A lender of last resort plays a crucial role in normal times of ensuring that the quality of assets that are eligible for last resort lending have an extremely low risk of default. This function of the central bank was known as “qualitative control” (although of course quantitative measures were used to predict when quality was in decline).

Overall, if we take the Bank of England as our model of a lender of last resort, then we must recognize that that the duty of such a lender is not just to lend, but also to constantly monitor the money market and limit the assets that trade on the money market to those that are of such high quality that when they are brought to the central bank in a crisis, it will be a good business decision for the bank to support them.

A central bank that fails to exercise this kind of control over the money market, can expect in a crisis to be forced, as the Fed was in 2008, to support the value of all kinds of assets that it does not have the capacity to value itself.

Note: the forthcoming paper is a new and much improved version of this paper.