Reasons to reform macro by rejecting “M” #2: To End the Mission-Creep of Central Banks

New monetarist theory tells us that monetary frictions can only be fully addressed by unsecured private sector debt — and thus can only be solved by designing incentive structures that make unsecured private sector debt enforceable, or in other words by a carefully designed banking system.

Prior to the 1930s, the central bank played two main roles: it supported the private sector money supply through panics and monitored the growth of credit, taking action to prevent credit-boom-driven inflation. (The latter was the real bills approach to bank regulation, which the Fed unfortunately was not well-equipped to address — explained here.)

Monetarism introduced a new era in which it was believed that government “control” of the money supply played an important role in economic activity. The financial system has evolved to match the theory. There has been a steady increase in the role of the central bank over the past few decades, and this evolution culminated in the vast expanse of the central bank role subsequent to the crisis of 2007-08.

With the collapse of interbank lending markets, the growth of central bank reserves, and the shift to secured lending backed by government debt, the role of unsecured private sector debt in the money supply has declined dramatically. In short, the better part of a century after it was first set forth the monetarist agenda of putting in place government control over the money supply and of minimizing the role of the private sector in the money supply is finally being achieved.

And just as new monetarist theory would predict, the decline in the use of unsecured, private sector instruments as money is associated with sluggish economic activity — because “M” is a poor substitute for the money that a well-structured banking system can provide.


Reasons to Reform Macro by Rejecting “M” #1: Banking is no longer a mystery

In my previous post, I explained that when one actually models monetary frictions (as new monetarist models do), it becomes immediately clear that the only full solution to these frictions is a debt-based form of money. The intuition behind this fact is simple: some people need to buy before they receive payment for what they have sold. For example, consider the case of the employee who won’t be paid until two weeks after he starts work, but who needs to eat in the meanwhile. Or alternatively, consider the case of his employer who needs to pay her employee but won’t actually receive payment for the good the employee produced until two weeks after the paycheck is due. The earliest banking systems existed to turn these claims to future payment (i.e. those which are already “earned” or receivable in accounting terms) into immediate cash at a slight discount.

In many of these cases there is virtually no uncertainty that payment will be forthcoming, so it is inefficient for employee or his employer to be unable to draw on his or her expected earnings. Observe in these examples how important debt is not just to the flow of money through the economy, but also to the flow of economic activity through the economy. Thus, banking institutionalizes and stabilizes the system of monetary debt which makes possible the flow of economic activity to which we are accustomed. The stabilization that is provided by banking includes both monitoring to minimize the degree to which cheaters are able to take advantage of the system of debt, and controls on the growth of monetary debt to make sure that it is commensurate with economic activity — and to limit the likelihood of inflation. (This stabilizing anti-inflation policy was known by the term “real bills,” but is a matter of profound confusion for modern scholars particularly in the U.S. as is explained here.)

Given the conclusions that can be drawn from the formal models that make up the new monetarist literature, from a logical point of view it is remarkable that most of modern macroeconomics studies “M” or a form of money that is not based on private sector debt. (As noted in my previous post, this phenomenon can, however, be explained by taking a sociological view of the economics profession.) It is important to be clear that it is not just monetarists, and their intellectual heirs, who make this error. James Tobin was equally confused about this issue, writing that “the linking of deposit money and commercial banking is an accident of history.” (h/t Matthew Klein).

These entirely misguided beliefs about the nature of money and the nature of banking can almost certainly be attributed to the fact that the models that were being used in the mid-20th century when the field of macroeconomics was being developed did not include monetary frictions. Thus, Friedman and Tobin and the vast majority of their colleagues failed to comprehend the simple truth that in the absence of loans to the individuals who seek to trade in an economy, there is no reason to believe that the monetary friction will be solved at all.

In short, theory tells us that that the linking of what circulates as money and commercial loans is necessary in order for an efficient economic outcome to be attainable. Under these circumstances, it seems extremely unlikely that the well-established link between the two in modern economies is an “accident of history.” It is much more plausible that, because in the presence of monetary frictions an efficient outcome is only possible when money is based on the debt of the traders in the economy, banks developed to institutionalize this efficiency-enhancing phenomenon.

Rebutting the “It Takes a Model …” Defense of Modern Macroeconomics

Steve Williamson writes “It takes a model to beat a model. You can say that you don’t like [modern macroeconomics], but what’s your model? Show me how it works.” Well, I’m going to take up that challenge, because I wrote that model.

In my view, the challenge is not to write a model that works, but to write a model that the macroeconomic establishment will find “convincing.” And that generally requires writing a model that comes to conclusions that are closely related to the existing literature and therefore “make sense” to the establishment. The problem, however, is that many of the implications of the existing literature are batshit insane. (My personal pet peeve is explained in detail below, but there are others … ) The choice faced by a young economist is often to join the insanity or leave the profession. (This is actually a conversation that a lot of graduate students have with each other. Many compromise “temporarily” — with the goal of doing real research when they are established.)

Williamson’s own area of macro, new monetarism, which is the area that I was working in a decade ago too, illustrates the gravitational pull of conformity that characterizes the macroeconomics profession, and that interferes with the development of a genuine understanding by economists of the models they work with.

Williamson acknowledges, as every theorist does, that the models are wrong. The problem with macro (and micro and finance) is that even as economists acknowledge that formally there is a lot to criticize in the market clearing assumptions that underlie far too much of economic theory, they often dismiss the practical importance of these critiques — and this dismissal is not based on anything akin to science, but instead brings to mind a certain Upton Sinclair quote. (Note that there are sub-fields of economics devoted to these critiques — but the whole point is that these researchers are separated into sub-fields — in order to allow a “mainstream” segment of the profession to collectively agree to ignore the true implications of their models.)

Let’s, however, get to the meat of this post: Williamson wants a model to beat a model. I have one right here. For non-economists let me, however, give the blog version of the model and its implications.

(i) The model fixes the basic error of the neo-classical framework that prevents it from having a meaningful role for money. I divide each period into two sub periods and randomly assign (the continuum of) agents to “buy first, sell second” or to “sell first, buy second” with equal probability.

Note that because the model is designed to fix a well-recognized flaw in the neo-classical framework, it’s just silly to ask me to provide micro-foundations for my fix. The whole point is that the existing “market clearing” assumptions are not just microunfounded, but they interfere with the neo-classical model having any relationship whatsoever to the reality of the world we live in. Thus, when I adjust the market clearing process by inserting into it my intra-period friction, I am improving the market-clearing mechanism by making it more micro-founded than it was before.

Unsurprisingly, I wasn’t comfortable voicing this view to my referees, and so you will see in the paper that I was required to provide micro-foundations to my micro-foundations. The resulting structural assumptions on endowments and preferences make the model appear much less relevant as a critique of the neo-classical model, since suddenly it “only applies” to environment with odd assumptions on endowments and preferences. Thus, does the macroeconomics profession trivialize efforts to improve it.

(ii) An implication of this model in an environment with heterogeneous agents is that (a) money in the form of Milton Friedman’s “M” cannot solve the monetary problem, but that instead (b) a monetary form of short-term credit is needed to solve the monetary friction. To be more precise, in order to support a good outcome using “M” in an environment with heterogeneous agents the monetary authority needs to impose different lump-sum taxes for every type of agent (otherwise either some agents face a binding cash-constraint or the transversality condition that keeps agents from forever holding and never spending increasing amounts of money is violated). Thus, technically “M” can solve the monetary problem but only if an all-knowing monetary authority is constantly tweaking the amount of money that each member of the economy holds — that is, only if “M” does not have the anonymous properties that we associate with money.

In short, when the neo-classical model is corrected for its obvious flaws, we learn that the basic premise of monetarism, that there is some “M” which is clearly distinguishable from credit and which can solve the monetary problem, has no logical foundations. This whole approach to money is a pure artifact of the neo-classical model’s fatally flawed market-clearing assumptions.

These issues with “M” are actually well-established in the new monetarist literature. (See, e.g. here or here.) The problem is that this motivated changes in the literature, discussed below, that protect the concept of “M.” (Moral: if you want to get published be careful to rock the boat with a gentle lulling motion that preserves the comfort of senior members of the profession — they don’t like swimming in unfamiliar waters.)

(iii) I interpret (ii)(b) as a wholesale rejection of the concept of “M.” The fact that the fundamental monetary problem can only be fully addressed by credit points directly to the importance of the banking system. We need the transactional credit that banking systems have long provided — not incidentally starting at the dawn of modern growth trends — in order to solve the monetary problem.

This is where, in terms of modern macroeconomics, I go completely off the rails. Correctly viewed, however, this is where modern macroeconomics goes completely off the rails. Every modern macroeconomist, whether of the salt- or of the fresh-water school was trained to ignore the banking system. They are persuaded that it doesn’t matter, because if banking is a fundamental determinant of economic performance, then the whole of their understanding of how the economy works is fundamentally flawed. (See Upton Sinclair above.)

So we have the development of a sub-field of macroeconomics, new monetarism, and the implications of this literature should be understood as a direct challenge to the concept of “M.” What, in fact, happened to this literature? The basic model was tweaked, so the workhorse model in this area is now the Lagos-Wright model. What does this model do? After every trading period with frictions it introduces a frictionless stage in which money balances, “M,” can be reallocated using standard neo-classical market clearing assumptions. (To make this work the axioms of preference are also relaxed with respect to one good, but that’s another issue.) That is, it guts the basic intuition that economists should derive from the older new monetarist literature. Why does it do this? Because it turns the model into something that simply tweaks the traditional understanding of “M” and makes it easier for economists to continue to ignore the fundamental monetary role of the banking system — carefully lulling the macroeconomic boat.

To conclude, the models Williamson has been working with for years should tell him to reject the monetarist view of money. While he and other researchers in this area have explored bank money and its benefits, they do so in a tentative manner without in fact directly challenging the conceptual foundations of “M.” In short, the problem with macroeconomics today is not the models we have, but the illogical, emotionally-tied manner in which economists choose to interpret them.

Comparing bankers past and present

Even after verifying that banking was indeed an unlimited liability enterprise in the 19th century, TED appears to struggle with the idea that anybody with wealth would be willing to take on such risks — especially for a measly return of 5% or less on assets.  TED writes:

My intuition about unlimited liability is that capital providers subject to it have a natural limit to the amount of credit they are willing to extend regardless of price. Each lender sets her individual limit based on her estimation of the likelihood of loss beyond initial capital invested. Beyond that there is no price at which she would be willing to lend. This certainly would be my preference: if I faced the loss of my home and possessions, penury, and utter ruination, you can damn well be sure I would not extend just one more loan to capture an extra fifty, hundred, or even thousand basis points of yield. I do not think I am alone among heartless, flinty-eyed rentiers in this regard.

What this sounds like to me is that the employees of our financial institutions are so habituated to making outrageously large risk-free (i.e. government guaranteed) returns, that the idea of risking one’s own assets in order to make a profit seems patently ridiculous — which of course it is — if you happen to be one of the few privileged enough to be able to spend your life sucking at the government’s teat.

(My apologies to TED, Alea, Sonic Charmer and all the other financiers looking for a better system, but this bit of hyperbole seems close enough to the truth to me that I couldn’t bring myself to edit it out of existence.)

Given the growth of unlimited liability banking in the past and the plethora of Americans living lives of quiet desperation in the present, I suspect that the risks of unlimited liability banking could in fact attract many, many small lenders whose initial capital may be little more than significant equity in their own home — if it were not the case that the whole industry is overshadowed by government sponsored mega-lenders.  After all, how many small businessmen and women in this country have already signed up to be personally liable for their business debts?  Putting all of one’s assets at risk to start a business is hardly an unknown or rare phenomenon in this country.

To support the view that unlimited liability banking operates as a constraint on the economy, TED writes:

The historical evidence Andrew Haldane cites from early 19th century Britain is entirely consistent with this: compared to the situation today, banks were massively overequitized and highly liquid, and bank assets and hence lending were a very low proportion of the economy. If my intuition is correct, it may well be that prevailing market rates of interest during that period evidence less that capital was plentiful and demand fully satisfied and more that supply and demand were balanced in a regime of artificially limited supply. Certainly Mr. Haldane contends—based upon what, I do not know—that the system of unlimited liability was not capable of supplying the growing need for capital during the rapid industrialization of the mid 19th century.

Given that Britain spent the 19th c. growing economically into its role as a premier world power (“the sun never sets …” etc.) and by the late 19th c. was exporting capital around the world, it’s hard to understand the foundation for TED’s argument that the supply of capital must have been “artificially limited,” since banks were lending at 5%.  If banks in Britain were “overequitized,” there’s little or no evidence that this had an adverse effect on the economy.  As long as banks could be operated profitably, to the degree that existing lenders were at the limit of their ability/willingness to lend, new entrants into the industry — or new partners — could probably be found to expand the business and take advantage of good lending opportunities.

The data on the United States indicates that banks subject to double liability were not “overequitized.”  In 1919 the ratio of the aggregate total capital account for all Federal Reserve member banks to total assets was 11%. (See column 1 of Chart No. 57 here.  This ratio rose to 15% at the depths of the Depression and then dropped with the advent of deposit insurance.)  At the start of the recent financial crisis the Fred database indicates that this ratio was hovering around 10%.  Thus, it’s far from clear that double liability in the US resulted in “overequitized” banks.

I believe that the claim that “the system of unlimited liability was not capable of supplying the growing need for capital during the rapid industrialization of the mid 19th century,” is just an explanation for the growth of stock markets and limited liability non-financial companies.  It is widely recognized – and I do not dispute this claim – that certain industries with extremely high fixed costs but significant risks in the form of aggressive competition to take advantage of recent technological developments, like railroads or fiber optic cables, can, more or less, only be financed via a limited liability shareholder structure.  Since banking developed as a successful industry before the rise of stock markets, and as Andrew Haldane notes the banking industry was very slow to embrace limited liability, it is far from clear that limited liability is an essential element of a efficient banking system.

Mr. Haldane appears to argue that because systems of extended liability did not protect depositors in the Depression, such systems were rejected.  While this may be a historical explanation for the growth of limited liability banking, it is far from clear that Depression-era problems should be taken as conclusive evidence against extended liability.  It’s doubtful that any banking system could have survived Depression-like events, marked most notably by the world’s reserve currency delinking itself from gold and setting off a reserve currency transition, without significant losses.

In short, while unlimited or extended liability banking would almost certainly mean that the economy was populated with a greater number of smaller banks, it’s far from clear that credit itself would be constrained.  Nor should one assume that interest rates would rise.  After all the risk premium portion of interest rates depends as much on the quality of bank underwriting and social enforcement mechanisms as on the characteristics of the borrower, so incentivizing banks to screen borrowers and lend carefully may actually reduce the interest rates available to most borrowers.

Related posts:
What banks do
The problem of collateral
What is capital?

What is capital?

TED recently discussed “the pool of capital available to the economy” as if this were a concept with a clear meaning.  Capital is sometimes used to refer to the equity in a business, to the working capital used to operate a business or simply to the investable funds that investors have and fund-managers or IPO-issuers want to get.

Equity capital is something that we think we understand – until we think about it a little longer.    It often incorporates the value of many intangible assets that may be alienable only as part and parcel of the whole business and/or fragile in the sense that they may be easily destroyed by bad managerial decisions (e.g. goodwill).  Furthermore it is axiomatic that equity capital is inflated when asset prices are too high and it evaporates when they fall.  (Steve Waldman has expounded on these issues much more thoroughly and penetratingly than I do here.)  In order to have a meaningful “pool of [equity] capital,” it’s necessary to have some kind of stability in asset prices – but this is precisely what we don’t have in our current system.

Thus, it’s a mistake in my view to think of equity capital as part of the “pool of capital available to the economy,” as if there were a simple fixed quantity of “capital” in the world and it’s only the price that varies.  What precisely the aggregate value of the stock market represents is far from clear – and that’s why it is in some sense not particularly surprising when this value drops by 40% over the course of a year.  What comes to my mind when I hear “pool of capital” is the “K” of economist’s models working to constrain our ability to think about what capital is.

In addition, the focus on equity capital obfuscates the important role played by the finance of working capital in the economy.  Many real goods come into existence only because of the availability of working capital.  While only a fraction of the output financed by working capital is converted via retained earnings into equity capital, the ubiquitous finance of working capital may mean that it plays a more important role in the economy and production process than equity capital itself.  I get the impression that most people don’t consider working capital to be an important component of the “pool of capital available to the economy,” but it’s far from clear to me why this is the case and whether it could possibility be justified.

As I have argued elsewhere, the finance of working capital plays an important role in the transformation of human capital from an inalienable asset into tangible, alienable assets.  The realization of human capital is, possibly, the most important role played by financial institutions in the economy — and this requires unsecured lending and well developed underwriting processes that distinguish borrowers who are likely to repay from those who will not.  Capital is created along with “good” debt and destroyed when the enforcement mechanisms for debt weaken.

In short, capital should be understood as a social construct, not in fixed supply or growing due to investment, but a product of institutional infrastructure.

Related posts:
What banks do
The problem with collateral
Comparing bankers past and present

The Problem of Collateral

There are two major problems with collateralized interbank lending.  The first is that there’s no reason to believe that collateral will function to protect the lender in the event that a major bank fails and the second is that the shift from unsecured interbank lending to collateralized interbank lending is likely to have a contractionary effect on the money supply.

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
What is capital?
Comparing bankers past and present 

What banks do: monetize human capital

After an outpouring of excessive and unwarranted humility, TED gave a nice critique of some of the  points in my previous post, which I will summarize (probably inaccurately) as (i) Can a system of unlimited liability for banks provide enough capital or does the risk-return tradeoff mean that such a system would hamper growth? (ii) What I meant when I claimed that from a theoretical point of view financial systems don’t require capital was unclear.  (iii) TED seems to posit that there is a tension between accurate pricing of risk (i.e. when losses aren’t socialized) and the provision of enough capital to keep the economy growing.  I don’t agree that the first and the last points are an accurate description of the tradeoffs faced by society, and rather than address TED’s points directly, in a series of posts I’m going to present my own vision of the relationship between the financial world and the economy – in the process, I hope, addressing the second issue.  (And I must admit that it was a sense of immense relief that I realized the piece titled “The Standard Model” was not TED producing a new post on this debate before I’d even managed to reply to the first one, but an entirely different topic.  I’m a snail of a writer and look on with envy at the prolific output of bloggers like TED.)

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. TEDBut 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.

[1] Notably Rajiv Sethi just put out a post along these lines, observing that the subprime mortgage industry was able to capitalize the dishonesty of locally-connected mortgage brokers.

Related posts:
The problem of collateral
What is capital?
Comparing bankers past and present