Bank equity: a mechanism for aligning incentives

Kudos to John Cochrane. To address criticism of his narrow banking proposal, he is willing in a recent blog post to “Suppose it really is important for banks to ‘create money,’ and to take deposits, and to funnel those into risky, illiquid, and otherwise hard-to-resolve assets.” He asks the question: How can we fund banks with deposits while at the same time ensuring that banks are easy to resolve? and argues that the solution is to issue the deposits not at the level of the bank (which funds itself only with equity), but at the level of a holding company whose only asset is bank equity, but which is funded by both deposits and equity. Resolution takes place when holding company equity is wiped out and remaining losses are put to depositors.

Cochrane misses the point about what it is that banks do. As I write in a hopefully soon to be published paper:

The fundamental problem of finance is that even though debt plays an important role in production and growth, what constitutes ‘safe’ debt for a lender is precisely the opposite of what constitutes ‘safe’ debt for a borrower. Because the future is uncertain, borrowing is safe when debt is long-term, unsecured, and expected revenues more than cover interest payment on the debt. Lending on the other hand is safe when debt is extremely short-term and grants the lender the immediate right to seize the borrower’s assets as soon as there is any risk of default. The banking system offers a modicum of safety to both lenders and borrowers, not just by transforming the maturity of the debt, but more importantly by placing the burden of loss due to default on the bank owners, whose interests thus lie in making the system of maturity transformation work.

Banking was able to develop in an environment where the owners and the managers of the banks were the same people — that is, banking developed in an earlier era without access to the corporate form and where unlimited liability was the norm. Thus, an important function of the liability structure of the bank was to align the interests of the owners — and originators of the bank’s assets — with those of the depositors. Depositors could only loose money after every single one of the bank’s owners had declared personal bankruptcy (for a famous 1878 example see here).

So what are the economic functions of a bank? First, to offer both lenders and borrowers an asset that is somewhat safe for each of them; and, second, to warrant the safety provided to the lenders by engaging to bear the first loss on any bad loans. A key function of  banking is the alignment of the incentives of the originators of the illiquid, hard to value assets that finance entrepreneurial activity in the economy with those of the lenders who provide the funding for these loans. The fact that the originators bear the first loss is extremely important to the incentive structure of banking.

The U.S. experimented with corporate banking early in its history, but after a first major crisis that extended from 1837 well into the 1840s, adopted a modified form of the corporate structure. From the 1840s until the reforms of the 1930s U.S. bank owners typically faced double liability — so that an amount equal to the par value of the shares could be called up in the event that a bank failed. The assumption built into the 1930s reforms was presumably that bank regulators would be an adequate substitute for the incentives formerly created by the liability structure of the bank.

Thus, Cochrane’s plan has two flaws: First, he insulates the owners of the bank from the consequences of originating bad assets. Instead of being in a first loss position with respect to the bad assets, the owners share only proportionately in those losses. This structure ensures that their interests are not aligned with those of the depositors. Second, his system puts losses on bad assets in excess of holding company equity immediately to the depositors. But this surely means that the depositors will be unwilling to fund traditional illiquid, hard-to-value bank assets. Given the risk of loss, a reasonable depositor would surely insist that the bank’s portfolio be transparent and full of easy to value assets. As a result, Cochrane’s plan would almost certainly result less funding availability for traditional bank borrowers.

In short, while one appreciates that Cochrane acknowledges that his plan needs to address the role played by banks in ‘creating’ money, he has not yet mastered the ideas underlying this view of banking. I look forward to evaluating his next effort.



Banking theory: a monetary theory that’s more heterodox than heterodoxy (revised)

Note: This post has been revised on the basis of Nick Rowe’s excellent comments.

A basic premise of monetarism is that money defines a relationship between the government and the market and that nothing essential about the economy is lost by assuming that the banking system’s monetary role is wholly determined by the government. That is, monetarist models allow for banks, but then limit their function to that of “multiplying” deterministically the government supply of money.  Because the role played by banks in providing liquidity to the economy is not modeled, monetarism effectively assumes away any meaningful role for the banking system. On the basis of this framework, monetarism proposes that the government by controlling the money supply can promote optimal economic activity in the market. In short, while there is long tradition in economics of arguing that the banking system exists to create liquidity (Thornton 1802; Hawtrey 1919: 9-16), monetarism explicitly rejects this view. Indeed, rejection of banking theory was a primary motivation driving the development of monetarism (Mints 1945, Friedman & Schwartz 1963: 169, 192, 253, 266). By abstracting from bank-provided liquidity, the monetarist framework implicitly posits that there are only two fundamental sources of liquidity in an economy: liquidity is either generated by markets spontaneously when buyers and sellers get together or liquidity is generated by government guarantees of payment.

Unfortunately the other major macroeconomic school that developed over the course of the 20th century, Keynesianism (particularly as espoused by New Keynesians, but also by many Post-Keynesians) has embraced monetarism’s rejection of the traditional view that banking plays an essential role in generating liquidity within an economy (see e.g. Tobin 1963). While Keynesians place more emphasis on the role played by government in the economy and less on markets, they are generally in agreement with the monetarists that the fundamental sources of liquidity in an economy are either markets or the government. In short, the more nuanced banking school view that liquidity is generated by the structured interaction of banks, markets, and government has been almost entirely lost in the modern macro-economic discourse.

Because the agenda of limiting the view of money’s role in the economy to that of defining a relationship between markets and the government can be attributed clearly to Milton Friedman, and cannot be attributed to the more diverse writings of J.M. Keynes, I consider this limited vision to be part of the “monetarist” agenda, and describe modern Keynesians as having bought into the monetarist agenda when they embrace this approach. Here I discuss how a variety of strains of heterodox monetary analysis embrace this basic premise of monetarism, even as they reject the specific policy proposals associated with monetarism. Interspersed throughout this discussion is an explanation of banking theory’s approach to the same issues.

I will address in particular four themes in the heterodox literature on money that emphasize the role of government in the money supply and are revisited by many different authors[1]:

  • The government establishes the unit of account and retains the sovereign right to revalue it.[2]
  • The government puts money into circulation by accepting in payment of taxes a token that it also spends. For cartalists this is the essential means by which money is created.
  • When credit is used to trade it must be settled in cash.[3]
  • Markets and prices are derived from government forms of money.[4]

Sovereign control of the unit of account

That the government establishes the unit of account and retains the sovereign right to revalue it is a claim associated with Ingham (2006: 265, 271). It is entirely consistent with the monetarist framework, although heterodox theorists correctly observe that its importance is rarely acknowledged by mainstream monetary theorists. Of the four claims, this has the strongest support historically. For example, the U.S. Constitution arrogates to the government the power to “regulate the value” of the coinage. And medieval and early modern history has abundant examples of sovereigns that devalue or revalue the unit of account. Furthermore, modern examples of countries of which we can state clearly that this claim does not apply are few and generally consist only of countries that have so abused their authority over the currency via inflation that the government itself has lost a great deal of legitimacy and as a result the populace has chosen to denominate transactions in a more stable foreign unit of account.

On the other hand, I have argued elsewhere that an essential aspect of the transition to a modern economy involved the creation of a unit of account based on a convertible paper money supply that was managed by private sector banks. Given modern bank-based monetary systems, the authority exercised by the sovereign over the nominal value of the unit of account is much weaker than in those days when it could simply “cry up” the value of a coin with a fixed weight in gold. And, subsequent to the 2008 crisis with its origins in excessive money issue by shadow banks, the measure of control exercised by the government over the value of the unit of account is surely a little less clear than it was in the past.

Such nuances are in fact encompassed in the broader picture of Ingham’s Nature of Money. Ingham ties his analysis of the sovereign unit of account into an analysis of the role of money in markets and in capitalism itself. He argues that modern capitalism is founded on a “memorable alliance” between currency defined by the state and the issuance of credit-money by the banking sector. Indeed, Ingham acknowledges that networks of traders can form their own money of account (Ingham 2006: 271). The distinction in our approaches lies in the importance that we attribute to such private moneys of account. For Ingham they are fundamentally unstable, and not worthy of too much emphasis. By contrast, I argue that it was the integration in Britain of the sovereign unit of account with the specie-linked private money of account supported by a network of elite international merchants that laid the foundations for modern capitalism. Thus, in my view even at the level of the unit of account a private-public partnership played an essential role in the development of capitalism.

Aside: The metallist approach to money

Most of the literature on money is not focused on its role as a unit of account, but as a transactional medium that circulates, serving both as a means of payment and a store of value. There are two basic approaches to the question: What makes it possible for something to enter into circulation as money? (Observe that this is not a question regarding how something, once it gets its start as money, can become a dominant form of money. Menger described what in modern terms are called the network effects that entrench the use of a given money after its initial entry into circulation.) The Metallist approach claims that money circulates because of its intrinsic value, and treats gold coin as a quintessential form of money. Menger clearly falls within the Metallist category as his focus is commodity money. Cartalists challenge this view, arguing that all that is necessary for money to enter into circulation is that an authority – for example a government or a major bank – treats the money as a liability and accepts it in payment for amounts due as taxes or on loans.[5] In this section, I argue that Metallism, as a school of thought, originated alongside and in support of bank money, and thus that our understanding of Metallism should go well beyond the simplistic appearance that the approach presents. (Cartalism will be discussed in the following section.)

The idea that intrinsic value can serve as a foundation for the circulation of money  proved through the European experience of money in the Middle Ages to be an extremely flawed approach to money. As the appellation Metallist implies almost all proponents of the intrinsic value approach view metals as having characteristics that make them the most suitable commodities to serve as money. In the Middle Ages it became clear that the problem with a metal coinage that is meant to circulate based on intrinsic value is that the process of circulation itself reduces the metal in the coins through both wear and tear, and deliberate clipping. Thus it became clear that the ideal form of Metallist money isn’t very good at holding its value. For this reason it is extremely costly to maintain a money supply based on fixed weight metal coins as the principal medium of exchange. The typical compromise that medieval sovereigns opted for was to slowly reduce the metal weight of their coins so that existing low-weight coins did not need to be collected and recoined and could continue to circulate on a par with new coins.[6] In short, medieval experience demonstrated that as practical matter a metallist currency can only operate if inflation is built into the system.

On the other hand, the philosophy of metallism – that is, the claim that coins should have a fixed and stable value in terms of specie – was presented and argued most forcefully by John Locke at the end of the 17th century. While arguing against a reduction in the metal content of the coinage and in favor of the demonetization of below-weight coins he wrote: Metals have “as money no other value but as pledges to procure what one wants or desires, and they procur[e] what we want or desire only by their quantity” (Locke 1824[1691]: 22). “Men in their bargains contract not for denominations … but for the intrinsic value; which is the quantity of silver by public authority warranted to be in pieces of such denominations. … it is only the quantity of the silver in [the coin] that is, and will eternally be, the measure of its value.” (Locke 1824[1695]: 144-45, quoted in Desan 2014: 347).

I argue here that this claim that coins should have a fixed and stable metal content could only develop in an environment where coins were more of a reference point than an important medium of exchange. I have argued elsewhere that it was abstract “bank money” not coinage that had demonstrated the capacity to maintain a fixed relation to a specific weight of gold or silver: this was the advantage of being an abstract unit of account that was convertible into, but not tied to, the steadily deteriorating coinage. It is, therefore, no surprise that John Locke, a founding philosopher of metallism, was writing in the late 17th century when “bank money” was well-established in European money markets and indeed, when his political allies were advocating for the establishment of the Bank of England (Desan 2014: 345) in hopes of playing an important role in the European money market. In other words, when monetary scholars refer to coin as the means by which bank money was settled, they are getting the relationship backwards. Coin was able to serve as a stable reference point for the value of bank money precisely because the vast majority of transactions could take place using bank money alone and coin was used very rarely.

What the founders of the Bank of England were seeking was not a metallist money supply, but a unit of account that had a fixed value in terms of metal. (This is made clear in Paterson’s 1694 proposal for the Bank.) The elite bankers had been able to establish such a measure of value for their own transactions since the mid-16th century. By founding the Bank of England and simultaneously reforming the British coinage on metallist principles they sought a stable sovereign unit of account to which their bank money could be tied.

Thus, the philosophy of metallism, even as it espoused the view that money circulates because of its intrinsic value, was developed in order to support a system of paper-based bank money. Not only that, but the paper-based bank money in question was designed from the start to be backed by a combination of specie, sovereign debt, and private debt (in the form of commercial bills). That is, the Bank of England was founded as a partial reserve bank (in contrast to the Dutch Wisselbank), and it was understood from the start that the Bank of England’s circulating liabilities would not be fully backed by specie. On the other hand, the founders of the Bank were undoubtedly confident that the sovereign, private and metal assets of the Bank had an “intrinsic value” sufficient to support the Bank’s liabilities.

The metallists who succeeded Locke would argue that money circulates not because of its intrinsic value, but because it is backed by something with intrinsic value. The term “backed” itself already implies that there exists an entity with a balance sheet and the liability-side of the balance sheet is “backed” on the asset-side by specie or its equivalent.

In summary, Locke’s original metallist argument was actually an argument in favor of stabilizing the sovereign unit of account by tying it to specie. And even though this argument was carefully framed by Locke as a matter of “natural law,” the actual goal appears to have been to lay the foundations for a new type of monetary system, one where a bank credit-based money supply was anchored by a specie-based sovereign unit of account. Thus, the metallist argument morphed quickly into an argument in favor of bank money that is backed by specie or its equivalent and that can be redeemed in specie.

Cartalism: government puts money into circulation by accepting it in payment of taxes

Cartalism, by contrast, explains how a “token” with no intrinsic value can serve as unit of account, means of payment, and store of value. All that is necessary for token-money to circulate is that an authority to whom money is owed stands ready to accept the token in payment. The feasibility of this means of putting money into circulation was demonstrated empirically by the many colonial powers that used tax policy to put their preferred money into circulation (h/t Nick). Note, however, that the authority which puts money into circulation can also be a bank that accepts the notes that it issues in payment of loans.

One can think of cartalism as a theory of synthetic value rather intrinsic value. Even though the tokens that circulate are nominally valueless, the authority makes them valuable by accepting them in payment of obligations. In the case of taxes the obligations are imposed by force (or social contract); in the case of (voluntary) loans the obligations are generated by the authority’s wealth or lending capacity. In both cases, the tokens have value — it is just value created by the promise to accept them in payment rather than intrinsic value.

In fact, Knapp’s original statement of the cartalist view is that it is necessary for the government to accept a token in order for it to circulate as money. This was, however, true as a matter of definition: Knapp defined “circulating as money” to require that all parties accept the token including the government. Knapp also explained that banks could put notes into circulation by the same mechanism which governments use to put tokens into circulation. Thus, “when a bank note … [can] be used unrestrictedly for making payments to the bank,” it becomes “a chartal means of payment – issued privately,” and the bank’s “customers and the bank form, so to speak, a private pay community.” These bank notes cannot, however, be “currency” until the State announces that it will accept them (Knapp 1924: 133-35). Thus, the original statement of cartalism is a “state theory of money,” only by definition. The analysis explicitly allows for a cartal means of payment to be private or public (see also Minsky 1985: 4).[7]

On the other hand, because the state can demand payment of taxes from all citizens and residents, governments are understood to be particularly well-placed to put cartal means of payment into circulation. Thus, the “cartalist” theory of money is sometimes viewed simply as the claim that money has value because the government accepts it in payment of taxes. Like the role played by the sovereign in defining the unit of account, this too is entirely consistent with the monetarist framework, where formal models include a government budget constraint which assumes that the government is empowered to withdraw money through taxes or distribute it through cash grants. On the other hand, heterodox theorists are correct that mainstream monetary theorists rarely ask how money gets into circulation and thus rarely mention the cartalist approach.

The validity of the claim is somewhat more difficult to evaluate. It is certainly true that in many – or even most – environments that which is accepted as money is also accepted in payment of taxes, so there is abundant evidence that is consistent with the cartalist view. This view includes, however, a causal statement and, as always, correlation is much easier to demonstrate than causation.

The strongest version of the cartalist claim, that it is sufficient for the government to accept a token in payment of taxes in order for it to circulate as money, is easy to disprove, since a single example will do. In particular, when a government seeks to put something into circulation as money by accepting it in payment of taxes, but there is a better alternative form of money already available, the effort has in some cases failed. An example is the Exchequer bill in late 17th century England (discussed here).

Modern proponents of cartalism typically focus their attention on the role of the state and not on the way in which banks play a very similar role in putting money into circulation (Bell-Kelton 2001, Desan 2014, Glasner 2017). Thus, the weakness of the modern cartalist approach lies in the way that the modern literature edits out the earlier, more sophisticated, approach to the banking system.

Indeed, one can interpret banking theory as a means of uniting the metallist and the cartalist approaches to money. Metallists claim that to circulate bank money must be backed by “intrinsic value,” and banking theorists would reply that good bills, denominated in a stable unit of account, have intrinsic value. Thus, through banking theory metallism is converted into two requirements: (i) that the unit of account be anchored, for example, to gold or by a central bank, and (ii) that the origination practices of the banks must produce assets that have almost no risk of loss. (I refer those who reflexively assume that private sector assets are risky and never as safe as government debt to Sissoko 2016.) Cartalists claim that to circulate money must be accepted by an authority in payment of obligations to the authority, and banking theorists explain that this is precisely what banks do: they accept bank liabilities in payment of the good bills that back their balance sheets. For banking theorists, bank money circulates both because it is a cartal means of payment and because it is backed by assets that are of indisputable quality and denominated in a stable unit of account.

Cash settlement of debt

Another common heterodox claim is that credit-based forms of money must be settled in cash. Indeed, this is the premise underlying the “hierarchy of money” framework. Bell-Kelton (2001: 160) argues that “bank money is converted into bank reserves so that (ultimately)” payment is in government liabilities. Similarly, the tiers of the hierarchy as Mehrling (2012) describes it are based on settlement: securities are at the bottom and settled in bank money, bank money is settled in currency (including central bank reserves), which in turn must be settled in some form of international means of payment (e.g. gold or SDRs).

Mehrling observes that in the design of his hierarchy he is building on the distinction traditionally made by economists between money and credit. He fails to note, however, that the importance of drawing this distinction is a fundamental monetarist principle (Friedman and Schwartz 1963; Meltzer 2003: 27).[8] Thus, when Mehrling states that he seeks to avoid “sterile debates about what is money and what is credit” and instead to focus “on the point that the system is hierarchical in character” (p. 4), he is indicating that his goal is simply to refine the monetarist approach to money. This is made especially clear when he explains that the “money from the level above serves as a disciplinary constraint that prevents expansion” (p. 8). This echoes the claim in Friedman and Schwartz that the quantity of deposits is determined by the underlying supply of reserves.

Banking theorists, by contrast, view bank money – backed by high-quality private sector assets – as the form of money that sits at the top of any hierarchy.[9] Gold or central bank reserves play an important role in anchoring the value of the unit of account and thus in defining the environment in which bankers function, but are ultimately less important to determination of the quantity of money available than the quality of the debt origination practices followed by the banks when issuing bank money. (Indeed, it was only the robustness of these practices that constrained the British money supply – and inflation – when the original debate between the Currency and Banking Schools took place, since money was not convertible into gold and Bank Rate was set at its legal maximum from 1797 to 1822. As Nick observes, these practices were almost certainly influenced by the expectation that there would be a return to the old gold standard.)

Banking theorists focus on the fact that bank money transactions are settled by clearing. While it is, of course, true that some balances remain after clearing, the bank clearing system provides for the balances to be settled by borrowing. As a result of the structure of the clearing process, reserves (or gold) play a minimal role in the settlement process. (Note that I am not claiming that they play no role in the settlement process, just that it is remarkably small.) Their principal function is instead to anchor the value of the unit of account.

This function of anchoring the value of the unit of account is integral to the operation of the banking system. Without such an anchor it is far from clear that the decentralized credit-based structure of the banking system could over the long-term avoid generating so much price inflation that the banking system itself would be destabilized. Thus, from the perspective of banking theory liquidity crises are best viewed as part of the process by which the anchor constrains the credit growth generated by the banking system. As I argue below this constraint is different in nature from Mehrling’s “disciplinary constraint that prevents expansion.” To the degree that the anchor “prevents expansion,” it does so through its effect on each bank’s decision-making process with respect to loans, not through quantitative constraints. And the anchor’s effect in a liquidity crisis is not to “prevent expansion,” but on the contrary to prevent a sudden contraction of the money supply.

In a liquidity crisis, either the public that usually holds bank money or the banks that lend on a regular basis to each other are concerned about a bank default that could reduce the value of their bank-issued assets and leave them holding losses. From a metallist viewpoint, the intrinsic value of the assets backing the money supply is in doubt. From a cartalist viewpoint, the public fears that the authorities will demonetize some tokens. Such a crisis has the potential to throw into doubt the foundations upon which the monetary system is built. In this situation the authorities must draw a bright line distinguishing any bank money that will be demonetized from bank money that will not – or equivalently distinguishing those banks whose assets fail the intrinsic value test from those with adequate assets. Because of the doubts that have been generated by the (fear of) default, proof of the authorities’ support of a bank will generally be required and the classic means of indicating such approval is by providing the approved banks with a temporary but abundant supply of reserves in exchange for their assets. In a genuine liquidity crisis, no bank fails and the declaration that support is available for all the banks is sufficient to end the crisis. When a liquidity crisis is set off by an actual bank insolvency, the process can take longer. Because periodic bank failure is unavoidable in a decentralized banking system and indeed plays a part in constraining the growth of bank credit, this process of supporting the banking system through a liquidity crisis is integral to anchoring the value of the unit of account.

In short, banking theory indicates that reserves are not a “higher” form of money than bank money. Instead they are an integral part of the system of bank money. From the perspective of banking theory the “hierarchy of money” misrepresents the role of reserves or gold in the monetary system by implying that the value of this “higher” form of money exists independent of the system of bank money. This latter claim is precisely the claim made by the monetarists when they marginalized the role of the banking system in their models.

Sovereign money gives value its objective existence

Ingham presents a very subtle heterodox point. Capitalist markets can only exist if (i) there is coordination on a unit of account and (ii) that unit is sufficiently stable that market participants have reasonable predictability of future values for purposes of business planning and entering into debt contracts. Given such a money of account which in general must be imposed by the state (Ingham 2013: 300), “money is the stable measure of value which makes it possible to establish the relative prices of all commodities” Ingham (2008: 68). The idea is further explained: “ ‘value only attains social existence by means of its monetary embodiment. It is money which makes value exist objectively for all’ (Orlean p. 52 this volume), which is accomplished by its capacity to gain general assent as the legitimate expression of value” (Ingham 2013: 313).

Let me restate the argument as I understand it. The communication that must take place in order for market transactions to be effected depends fundamentally on the existence of a language in which market participants can communicate. An essential element of this language is the unit of account. Furthermore, that unit must be stable enough for market participants to engage in the forward-looking analysis of benefits and costs that underlies rational price-based behavior. Only given these antecedents can market trade generate prices that both put a value on goods and have meaning for the traders. This is the sense in which “value attains social existence by means of its monetary embodiment.”

In this literature markets are sometimes defined with reference to the neo-classical model, that is, markets are viewed as venues where traders meet and generate a single price for each uniform good before trading (Ingham 2006: 260). Ingham’s argument then provides the antecedents that are necessary in order for “market” prices to be produced, where market prices refer to what is apparently a neo-classical price vector.

As was discussed in the first section, Ingham observes that such a unit of account is usually, but not always, provided by the state. I argued above that Ingham underestimates the role of bank money in determining and stabilizing the unit of account. I continue that argument here: banks play an essential role in “making it possible to establish the relative prices of all commodities.” Economic theory indicates that achieving this goal requires not only a stable unit of account, but also that there be very many participants on both sides of every market (Geanakoplos 1987). The crucial element that ensures the presence of many buyers is the absence of liquidity constraints, or in other words generalized access to credit lines supporting the payments system (Sissoko 2007). When such credit lines are not available, price variations will be common due to the ubiquitous liquidity constraints generated by the need for working capital in order to engage in production.

In short, the bargaining problem that Ingham associates with barter is equally present in any environment where traders enter the market subject to liquidity constraints that force them to sell – their labor if they have nothing else – before they can make purchases. The neo-classical economic model with its simple price vector assumes that traders who enter the market with knowledge of how to produce can seamlessly hire workers and rent capital to take advantage of that knowledge and create goods for sale in the market to those workers and capitalists. Implicit in the seamlessness with which the production process takes place in this model is easy access to the short-term credit needed to finance the wage and rent bills. This is, of course, precisely the role played by banks in the early years of their existence.

Before capitalist bank money, the sovereign provided a unit of account, but its value was limited because liquidity constraints frequently determined prices. After capitalist bank money – at least for those with the privilege of access to bank money – short-run liquidity constraints were largely eliminated, so that prices became more neo-classical in character. At this time it made sense to generate and publish price lists of commodities, because many “market” prices were no longer determined by a process of bilateral bargaining. The key innovation making such “value” possible was the banking system and the credit that it offered to merchants and tradesmen.

In short, Ingham should revise his list of the antecedents necessary in order for “market” prices to be produced. The relative prices imagined by the neo-classical market are founded not only on a stable unit of account, but also on a banking system that provides payments system credit to finance working capital. Given that historically such a banking system was successfully established only in a “memorable alliance” with the state, the banking system should be viewed as a complement to and not a substitute for the role of the state in stabilizing the unit of account.


Heterodox monetary theory is often influenced by the basic monetarist framework which envisions markets and the state as the only sources of liquidity and deliberately denies the importance of the banking system. By explaining how banking theory relates to several heterodox approaches I demonstrate both how heterodox theory allows itself to be constrained by mainstream theory and how its horizons can be expanded by combining it with banking theory. Although Ingham recognizes the essential role played by banks in the monetary system and in capitalism itself, he underestimates the role played by banks in determining the unit of account and in the process of price formation. Similarly, banking, properly understood, turns the hierarchy of money on its head, as it is the system of bank money that gives central bank reserves their value.

Banking theory explains what makes price-stable liquidity possible (cf. Holmstrom 2015). The banking system offers a fixed rate of exchange between bank money and the money of account while stability of the money of account is managed by the central bank. On this foundation banks expand the money supply, extending payments credit and ensuring that markets are not beset by episodic local liquidity events. This has the effect of stabilizing the price structure of these markets. In short, banks provide the liquidity that makes it possible for markets to approach the neo-classical ideal. Because of the essential role played by banks in the economy, the most important factor in financial stability is the “intrinsic value” of bank assets or, in other words, the origination practices of the banks.

[1] My interest in these themes was generated by Christine Desan’s Making Money.

[2] See Keynes Treatise on Money 1930 p. 4, Ingham 2004.

[3] Some authors assume that if a debt is denominated in cash this implies that it must be settled in cash (Briggs 2009: 200; Desan).

[4] Orlean (2013) calls this the Institutionalist approach: “value and money are ontologically inseparable” and cites to Keynes and Ingham.

[5] For more on metallism and cartelism see Schumpeter 1954: 60; Goodhart 1998; Bell-Kelton 2001.

[6] Desan 2014 explains this issues in extraordinary detail. See also Lane and Mueller 1985.

[7] In the terminology of modern economic analysis it is network effects that support bank money as a cartal means of payment. For example, David Glasner reframes Knapp and Minsky’s basic intuition using network effects and concludes with “the following preliminary conjecture: the probability that a fiat currency that is not acceptable for discharging tax liabilities could retain a positive value would depend on two factors: a) the strength of network effects, and b) the proportion of users of the existing medium of exchange that have occasion to use an alternative medium of exchange in carrying out their routine transactions.” In short, modern analysis supports the view that the early cartalists were correct: the state’s power to tax may be an important means of getting money into circulation, but it is far from the only means by which a token money can be put into circulation.

[8] “Monetary policy ought to be concerned with the quantity of money and not with the credit market. The confusion between ‘money’ and ‘credit’ has a long history and has been a major source of difficulty in monetary management.” Milton Friedman, 1964 Congressional Testimony (discussion with Congressman Vanik) p. 1151 cited in Hetzel 2007.

[9] Inappositely, Mehrling cites Hawtrey’s Currency and Credit, which takes a banking theory approach, on the traditional distinction between money and credit. In fact, Hawtrey (1919: 377) “treat[s] credit as the primary means of payment and money as subsidiary.” Indeed, Hawtrey disputes the relevance of settlement itself: “Purchasing power is created and extinguished in the form of credit” (380). For Hawtrey “Credit possesses value, and it is more correct to say that the value of gold is due to its convertibility into credit than that the value of credit is due to its convertibility into gold” (371). In short, the thesis of Currency and Credit is that Mehrling’s hierarchy – from bank liabilities on up – is false, because bank liabilities are the ultimate form of money and it is bank liabilities that give value to currency, central bank reserves, and even gold.

How Banking Created the Wealth of Nations: A Riff on Desan’s Making Money

How banking created the wealth of nations
Did the British reforms constrain sovereign power over money excessively?
Was the “liberal” market vision born of “good” banking?
Did the British reforms grant excessive power to the banks?

How banking created the wealth of nations

A closing sentence of Desan’s Making Money encapsulates what I find truly extraordinary about her book: “Arguably capitalism … constructed a money [based on] individual exchange for profit, institutionalizing that motive as the heart of productivity.” In her closing chapters Desan effectively argues that Britain’s reconstruction of its monetary system over the course of a long 18th century (starting in 1694) by transferring the “making of money” to the private sector and constraining the role of the government to that of an “administrator that standardized money and stabilized it” also had the effect of generating an enormous flow of liquidity that was tied to real economic activity. Desan aptly observes that the famed “commitment” to private property rights of the British polity was in many ways less a matter of constitutions and more a matter of the closely interrelated development over the course of the 18th century of the monetary and fiscal systems.[1] While her focus tends to be on a critique of these changes, she in effect explains how the reform of the monetary system may have set the stage for modern economic growth.

In short, in my view Desan’s greatest contribution in Making Money is a clear explanation of how monetary reform set the stage for modern economic performance. On the other hand, Desan is so critical of these changes that I believe her argument needs to be reframed in order to set forth a more positive view of these transformative events. This is what I would like to do here.

In the process of reframing Desan’s thesis, I am going to position the reforms of the long 18th century in the context of European banking history with an emphasis on the private issue of money. This contrasts with Desan’s approach which builds on a fascinating and very detailed history of England’s currency and argues that even at its founding Bank of England notes were effectively public, not private, liabilities. As will be seen below, my analysis raises the possibility that the reformers of the long 18th century knew what they were doing – not in the sense that they could predict the details of its transformative effect, but in the sense that they were deliberately laying the foundations of transformative change by transferring control over the money supply to the private sector – with the acquiescence of the government.[2]

The Bank of England was established in 1694 by sophisticated financiers who were familiar with the European money market of their day. The contemporary European money market was centered in Amsterdam and together with earlier incarnations of the money market had been using “bank money” rather than any sovereign money as its unit of account for more than a century and half prior to the Bank’s founding. Bank money, unlike sovereign money, had a fixed value in terms of gold and could on this basis be converted into any sovereign coin.[3] In the mid-16th century the money market had been centered on fairs in Lyons where the imaginary ecu de marc was the unit of account (see Boyer-Xambeu et al. 1994). At the end of the 16th century Venice made a successful play for the European money market by establishing the Banco della Piazza di Rialto which used the imaginary bank ducat as its unit of account. Amsterdam’s Wisselbank was modeled on the Venetian bank and anchored the European money market by the time the Bank of England was founded.

Thus, the merchant elite of Europe preferred to use bank money rather than a sovereign currency as the unit of account for their liabilities. Bank money was preferred, because the Bank was run by people who were a part of the network of European merchants and could be trusted to maintain bank money’s value whereas no king or politician could be trusted to do so. Thus, when we study the founding of the Bank of England from the point of view of the bank origins of money, we find that Bank liabilities circulated because they were issued by a merchant-run corporation that was immediately integrated into the European money market and the network of merchants that operated the money market.

In fact, of course, the full explanation for the circulation of Bank notes probably lies somewhere between the public origins and the bank origins explanation. The Bank of England’s structure likely was shaped by the lessons learned in Venice and Amsterdam. When the European money market left Venice, the circulating currency of the Venetian bank was replaced in domestic trade within a short period of time by the liabilities of the Banco del Giro, which was essentially a fund of public debts.[4] And the managers of the Wisselbank had probably already found that the Dutch government turned to it (in secret) for resources when exigent circumstances loomed. By designing a bank that had a very public and clearly delineated relationship with the government – like the Banco del Giro, the European merchant elite were able to combine the benefits of an internationally-recognized bank money with a form of public support that the merchants, as lenders, could at least to some degree control. The Bank of England was truly a public-private partnership and extraordinary emphasis should be placed neither on the public nor the private aspects of the partnership.[5]

Evidence of this interdependence is to be found in a form government debt that is often presented as a purely public liability of the British government in the late 17th, 18th and 19th centuries, the Exchequer bill (Desan, p. 369). When first issued, the government had difficulty getting these bills into circulation – even after making them acceptable in payment of taxes (Clapham v. I, pp. 54 to 71). Only after the management of the bills including the business of “exchang[ing] all Exchequer bills for ready Money upon demand” was transferred to the Bank, was the government able to get them widely accepted. Indeed, because of the onus place on the Bank of England by the issue of such bills, the government was by law required to first obtain the consent of the Bank before any increase in the supply of Exchequer bills (Clapham v. I, p. 65). Thus, even Exchequer bills should be viewed as public-private instruments and not as “purely” public instruments.

This banking history-based perspective on the origins of the Bank of England also allows us to reevaluate the role played by John Locke in the Great Recoinage which commenced just two years after the Bank of England was founded. Locke persuaded the British government to reform the silver coinage by taking the unusual step of maintaining its current value and demonetizing undervalued coins. Locke argued that the value of coin is – and should be – measured by its intrinsic value or by the quantity of silver that public authorities warrant to be in the coin.[6] This is, of course, the same standard that the merchant elite where using when they denominated their transactions in bank money, and it is this standard for bank money that Paterson proclaimed was necessary in order for a banking system to operate. Thus, from the perspective of banking history Locke appears to have been deliberately laying the intellectual foundations for a world in which the European merchant elite’s bank money would have the political support to become the measure of the unit of account for a sovereign nation, and would be insulated from the sovereign’s authority to revalue the unit of account.[7] Desan astutely observes that when this structure evolved in the 19th century into the Gold Standard, the purpose was “to discipline the amount of bank currency in circulation” (p. 409, emphasis in original). This is certainly correct and is, indeed, made explicit in Paterson’s 1694 definition of bank money.

Did the British reforms constrain sovereign power over money excessively?

Desan criticizes this reform of the monetary system for two reasons. First, the gold standard committed the sovereign not to devalue the unit of account in terms of gold and, thus, removed from the government an important tool for readjusting the distribution of wealth in society and for improving overall welfare (p. 381). Second, the power to expand the paper money supply was transferred to the banking system, giving it too much power and profit while at the same time requiring periodic subsidies from the state (pp. 418-19, 428-29).

The first criticism is very interesting, because Desan – who does not have training in economics – does not apparently realize that one of the most robust results in economics is that when an agent gains the ability to commit to a future action the set of choices available to that agent expands dramatically. Britain’s 18th century reforms did commit the country to prioritize creditors over other government uses of funds, but it also enabled the government to fund far greater expenditures than had previously been imaginable while at the same time enabling the domestic economy to foster an Industrial Revolution. In short, from a theoretic point of view the fact that Britain’s commitment to a gold-based monetary system preceded one of the most extraordinary and unexplained phenomena in all of economic history could potentially be more than a coincidence. Overall, given Britain’s subsequent economic performance it does not seem unreasonable to conclude that even though commitment tied the government’s hands, this policy may well have been advantageous for society as a whole.

An interesting question is whether the architects of England’s monetary reform understood the value of commitment. Desan argues that the reformers were “unfamiliar” with the mechanisms by which domestic currencies were issued and functioned (p. 347), but given the merchant background of many reformers this seems unlikely. Surely it is possible that they wanted to promote a monetary principle which they believed to be superior to the old-fashioned domestic currencies – while at the same time understanding that this system would also be advantageous to them personally as creditors. While this issue will not be settled here, Europe’s merchant elite in the late 17th century certainly viewed commitment to a specie standard as a necessary foundation for a banking system (e.g. Paterson), and a century later the Bullion Committee would express a similar view (Desan, pp. 414-15). Through experience they had apparently seen how such commitment can underpin the credit necessary to support robust trade. Indeed, Paterson’s proposal is testimony to the fact that the reformers understood that their actions would promote economic activity (pp. 14-15).

Was the “liberal” market vision born of “good” banking?

From this perspective the relationship between banking and Locke’s “liberal” vision of the market is also worth exploring. As Desan explains medieval markets – where strangers traded – were dependent on the sovereign to provide a unit of account, means of exchange, and legal infrastructure. Medieval markets were thereby shaped by sovereign decisions. Locke, however, frames markets, trade, contracts, and even the emergence of money as phenomena that required only “mutual consent” and could take place in the absence of sovereign money and law. Desan explains that Locke’s vision was of “a world that worked on the basis of real exchange alone” where “law depended on convention, much like the customs that drew longtime trading partners together” (p. 359). The latter is, of course, also a reasonable approximation of the economic environment in which the merchant elite who managed Europe’s money market operated. This money market did not just use bank money as its unit of account, but centered in those cities which applied to the merchants’ activities the Law Merchant with its deference to the customs of merchants and juries that were carefully balanced in terms of nationality (Rogers 1995 Ch. 1). (Update 2-2-2017: Note that the Law Merchant as used by Rogers and medieval lawyers refers to a set of legal procedures and not to a body of substantive or autonomous law.) Furthermore, as Desan emphasizes, Locke’s approach to money is a good description of the use of money in international trade – according to Desan the flaws of this approach lie in its application to a domestic unit of account and the domestic economy.

This raises questions: Was Locke’s liberal vision of a market where only real exchange mattered and where money did not constrain market activity also a good description of the environment in which Europe’s international banking elite operated? The neoclassical model, which is the modern realization of Locke’s vision, makes it clear that an environment where only real exchange matters effectively assumes a credit system that operates perfectly (Sissoko 2007). Is it then possible that it was because the European money market in the 17th century was so effective at financing the trade of Europe’s merchant elite that it was possible for them to conceive of a “liberal” market where only real exchange mattered? That is, was it because European banking was so highly developed that the model of a “liberal” market economy which abstracts from money became imaginable? Does this model assume that liquidity does not constrain market activity, because the development of banking had created a world where it was possible to imagine trading in a world without liquidity constraints?

Desan’s critique of this liberal vision of the market is that, once it grew to be the predominant theory through which the economy was understood, money became invisible in a way that had never been possible in medieval economies beset with a shortage of coin (p. 421). The “market” in the modern economy is often discussed as if it were operating independent of money. In fact, money and liquidity constraints are central to much that takes place in the modern economy, just as they were central to transactions in the medieval economy. Desan is almost certainly correct that by obfuscating the centrality of money to everything that takes place in a modern economy, this liberal vision has likely played a role in the development of our current economic problems of troubled currency unions and hard-to-stabilize banking systems.

Did the British reforms grant excessive power to the banks?

Desan’s second critique of Britain’s 18th century monetary reform focuses on the power granted to the banking system over the money supply. She is certainly correct that banking constitutes a “distributive decision about money design” (p. 429), but in my view Desan underestimates the extraordinary value created by the shift from sovereign coinage to bank money. This error is a function of her basic monetary framework which is essentially monetarist, and treats cash in the form of claims on the government as the ultimate form of liquidity.[8] This framework fundamentally underestimates the transformative nature of banking and the role that bank money plays in supporting modern economic growth. By contrast, both the promoters of the Bank of England and the Directors who determined its policies a century later understood that the value of a monetary system based on bank money lay in its ability to respond dynamically to the needs of the real economy in a way that no centralized sovereign authority could possibly achieve.[9]

When criticizing this power granted to the banking system, Desan emphasizes that the State allowed the banking system to reap excessive profits from its role and was forced to subsidize it at significant cost. These concerns have much more relevance to the modern monetary system than to the one that grow out of the monetary reforms of the long 18th century, because an important principle of liberalism in the early centuries of its development was that subsidies from the government to the private sector had adverse effects on economic performance. Thus, banks in 18th and most of 19th century Britain operated with unlimited liability. Liquidity support to the banking system during panics was made available on paper that had at least three private sector guarantees of payment, and as a result through the first two centuries of its existence the Bank of England had to write off only a trivial fraction of bills (Bignon et al. 2012, p. 602).[10] Even in those rare cases, such as the Baring Crisis of 1890, where a “bailout” of a bank was organized, the Bank was very careful to place the burden of the losses first personally on the bankers who required bailout, and secondly on those members of the banking system that were most exposed to the defunct bank.[11] For a more detailed analysis of how the British banking system was structured so that it was both stable and effective in keeping the costs of banking to society quite low I refer the reader to Sissoko 2016.

Desan also argues that the modern monetary system can be understood through the lens of Britain’s long 18th century reforms and finds that in the modern system, too, banking is subsidized at significant cost to the government. I agree with her entirely on these points. Our modern monetary system is a direct descendent of 19th century British banking. Unfortunately the evolution of the banking system over the past century has left us with a monetary system that is extraordinarily unstable and remarkably dependent on government support. Indeed, the evidence that Desan cites with respect to the costliness of banking system bailouts is far more relevant to the modern banking system than to its 19th century forebear (Reinhart and Rogoff 2009; Ricks 2011; Gorton 2012; Calomiris and Haber 2014 cited at 417, 419, 429).[12]


Thus, the lesson that I draw from Desan’s Making Money is this: whereas the challenge faced by those who sought to reform the monetary system in the late 17th century was how to constrain the authority of the sovereign over the money supply, the challenge faced by modern reformers is how to constrain the power of the banks over the money supply. I believe that monetary history demonstrates that a bank-based monetary system can be well-structured so that its benefits far exceed its costs. I am in perfect accord with Desan, however, in condemning the modern bank-based monetary system as a costly boondoggle.

[1]pp. 288-292. cf. North and Weingast (1989), “Constitutions and Commitment.” Desan also observes that reform was not really a matter of a general commitment to property rights but more of a deliberate policy of favoring certain property rights over others, p. 293.

[2] Desan argues that many of the effects of these reforms were “unforeseen,” p. 376.

[3] Indeed, William Paterson’s 1694 proposal for the Bank of England is explicit on this point, pp. 9-10: “in the first place it is necessary to premise … 1. That all Money or Credit not having an intrinsick value, to answer the Contents or Denomination thereof, is false and counterfeit, and the Loss must fall one where or other. 2. That the Species of Gold and Silver being accepted and chosen by the Commercial World, for the Standard or Measure of other Effects; every thing else is only counted valuable, as compared with these. 3. Wherefore all Credit not founded on the Universal Species of Gold and Silver, is impracticable, and can never subsist neither safely nor long; at least till some other Species of Credit be found out and chosen by the Trading part of Mankind, over and above, or in lieu thereof.  Thus having said what a Bank ought to be, it remains to shew what this is designed, and wherein it will consist”

[4] We see this knowledge reflected in Paterson’s proposal where he refers repeatedly to the “Banks and Publick Funds” of Europe.

[5] This is a very different view not just with comparison to Desan, but also with respect to Calomiris and Haber 2014.

[6] Locke “Further considerations concerning raising the value of money”, p. 415 cited in Desan p. 347.

[7] Desan observes that it’s hard to tell whether Locke’s intellectual convictions derived from his political goals or vice versa, p. 345. In addition, while Desan acknowledges that an important goal of the revaluation was to “legitimate public credit” p. 374, the implications of this are much more limited than the implications of a sovereign legitimating bank money.

[8] An analysis of the monetary framework used throughout Making Money is presented elsewhere [link to be added].

[9] Paterson 1694; Bullion Committee Report 1810 quoted in Desan p. 418.

[10] Vincent Bignon, Marc Flandreau, & Stefano Ugolini, Bagehot for beginners: the making of lender-of-last-resort operations in the mid-nineteenth century, 65 Econ. Hist. Rev. 580, 602 (2012).

[11] A Baring partner and family member who had retired some years prior to the crisis set aside money to support those members of the family who were impoverished by the crisis, Ziegler 1988 p. 251.

[12] Desan cites at length Bullion Committee Report comments to the effect that profits that accrued to banks during the Suspension were improper, pp. 419-20, but fails to note that subsequent suspensions (of Peel’s Act during crises) were accompanied by the transfer of any profits from any excess note issue to the British government.

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?

Evaluating heterodox monetary theory through a New Monetarist lens

I. Using New Monetarism to motivate a closer look at credit-based payments systems
a. The failure of economic theory to incorporate banking is as old as economic theory itself
II. Important implications of a credit-based payments model
a. Settlement by clearing is a substitute for settlement by cash
b. The credit-based payments model undermines the distinction between consumption and production credit
III. A final note

Money and the issues that the economy’s dependence on money raises are some of the most difficult topics to analyze in economics. All discussions of money are founded on some underlying framework explaining what money is and what money does. My preferred framework is based on “New Monetarist” models of the economy. A variety of competing approaches are typically described as “heterodox” in the economics literature. This post is a preliminary effort at organizing a comparison of these frameworks and was stimulated by Chapter 5 of Christine Desan’s Making Money which is a highly recommended and fascinating study of the historical development of money. Desan builds her argument based on the heterodox approaches.

My organizing structure will build on a verbal discussion of the implications of new monetarism. Three related, but distinct, heterodox approaches will be addressed in the context of this structure: the hierarchy of money developed by Stephanie Bell-Kelton (explained with extraordinary clarity in Perry Mehrling 2012), the cartalist approach to money, and Geoffrey Ingham’s focus on money as a unit of account and store of value as distinct from money as a means of payment. (I am aware that both Ingham and Kelton may fall into the cartalist category, but find it convenient to discuss each of these approaches independently.)

Using New Monetarism to motivate a closer look at credit-based payments systems

New monetarism is a sub-field of macroeconomics that has grown up over the past few decades and that uses formal economic modelling techniques to study money. While the principal innovation that this literature brings to economic theory comes from liquidity frictions that generate a role for a means of payment, as in the older monetary literature, money also serves as a store of value and via the study of relative and intertemporal prices as a unit of account.

The basic intuition that can be derived from the formal analysis of a means of payment is that at any point in time a given transaction in the economy may be viewed as taking one of the following forms:

  • Barter (requires double coincidence of wants)
  • Cash purchase-Cash sale
  • Credit purchase-Credit sale
  • No trade (takes place if there is either no coincidence, or the parties are unable to settle on terms)

Because economic agents are on both sides of any transaction, every cash purchase and every credit purchase must have a corresponding cash sale or credit sale. Because both credit and cash transactions can only take place if the seller anticipates that cash or credit will have value in the future, only barter transactions do not depend on future expectations about the value of some means of payment.

Some basic results that derive from this literature are:

i.  From a theoretic perspective cash payments and credit payments are alternative payments systems (Gu, Mattesini, & Wright 2016). Because conceptually a payments system can be based entirely on one or on the other, credit – or in the extreme case gift-giving – can be the basis for the payments system.

This result may be consistent with Ingham (2004)’s argument that the payments system is dependent on the sovereign for its unit of account, since the new monetarist literature can be viewed as assuming some institutional infrastructure arguably including coordination on a unit of account. On the other hand, this result contrasts with the basic premise of the hierarchy of money theory which states that bank money – or the modern credit-based payments system – is dependent on sovereign-authorized cash for settlement.

This theoretic result is a valuable insight, because it is far from clear that the banking system – abstracting from regulatory requirements that did not exist when the system was developed in the 19th century – is dependent on sovereign “cash” for settlement. Whatever remaining balances aren’t cleared by the banking system may be carried as debt by a member of the system to the next period, and it is unclear that sovereign “cash” is necessary to the system – except perhaps as a unit of account. (This is discussed in more detail below.)

 ii. Cash and credit transactions are similar because they can only take place if the seller anticipates that cash or credit will have value in the future.

This can be viewed as a formal realization of Ingham’s contention that all forms of money can be properly viewed as debt in the sense that the holder of money, whether cash-based or credit-based, has a claim with a future value determined by social relations (2004, Ch. 4). This is also related to the cartalist view (embraced by Ingham but also espoused by many others before him) that what is money is fundamentally determined by what the state accepts in payment of taxes. On the one hand, the theoretic result is a general finding that both cash and credit depend on future expectations, whereas the cartalist view is more of an empirical claim that the most important real-world source of those expectations comes from the state’s power to tax. The theoretic literature then raises two issues with respect to the cartalist view: first, are there any other means by which money enters into circulation in addition to sovereign tax policy; and, second, what makes it incentive compatible for a public or private issuer of money to accept/redeem it.

iii.  An ideal form of credit is strictly better than cash: the set of equilibria that can be attained using cash is a subset of the set of equilibria that can be attained using credit (cf. Kocherlakota 1998. See also Sissoko 2007).

Not just the heterodox hierarchy of money approach, but also most mainstream macroeconomics — and indeed a great deal of the New Monetarist literature  –emphasizes cash as the cornerstone of the payments system. The implication that I draw from this New Monetarist result is that this emphasis is misguided. We need to re-center the discussion so that the focus is on credit- or bank-based payments systems and then evaluate the role that cash may play in supporting these systems.

The failure of economic theory to incorporate banking is as old as economic theory itself

Treating the “cash” solution to the monetary problem as the reference point and then asking how credit expands the cash system has been the default approach in economic analysis dating back to Adam Smith. Indeed, from this point of view the heterodox hierarchy of money approach is similar to the monetarist treatment of banking: banking serves only to expand an existing monetary base. (If these arguments were limited to the claim that banking is dependent on an external unit of account, they might be sustainable, but these arguments always go well beyond such modest claims.)

Banking scholars have been attempting to debunk the economists’ approach to banking for more than 200 years. Henry Thornton, the banker who first explained the role of the lender of last resort and how it affected domestic and foreign trade differently, took Adam Smith to task for failing to understand the nature of Britain’s paper monetary system in 1802. Schumpeter was engaged in much the same debate with his contemporaries a hundred years later. And today we still find that economists have difficulty with the very concept of a credit-based payments system. One might hope that the formal modeling framework of New Monetarism will help the profession remove these intellectual blinders.

Important Implications of a Credit-Based Payments Model

Settlement by clearing is a substitute for settlement by cash

Hierarchy of money theorists tend to ask “in what will this transaction be settled” and to categorize credit based on the purported means of settlement.[1] This approach accurately models the relationship to bank money of near-monies that are settled in bank money, and thus it is a very useful approach. However, when this approach is extended by analogy to the relationship between bank money and cash (or claims on the state), the approach breaks down and it loses its usefulness. (Indeed, Knapp whose cartalist approach to money underlies the hierarchy of money theory did not draw this distinction.[2]) Not only is a cancelled check – or the transfer of bank money – legally proof of settlement of tax payments as well as civil obligations, but even in a financial crisis it is central bank liabilities that expand to support the system, not “cash.” While hierarchy of money theorists seek to reconcile this fact with the theory by explaining that these central bank liabilities are like “cash” in some sense sovereign obligations, it is more accurate to view these liabilities as a core part of the system of bank money itself.

The modern credit-based monetary system is indeed anchored by a central bank that issues bank money in the form of reserves that can expand to support the system in crisis. It is also true that the central bank could not operate in this way without the sanction of the government. These facts do not, however, mean that the best way to understand this system of bank money is that it is dependent on the stock of government liabilities. The system of bank money was made effective only when it became dependent on an expandable source of central bank liabilities, and the concept of a central bank developed simultaneous with this system of bank money. Thus, bank money and the central bank liabilities that serve as the high-powered money of the banking system are part of a single bank money system such that the two parts of it cannot be disarticulated. It is misleading both to treat this relationship as analogous to the relationship between near-monies and bank money and to treat central bank liabilities as effectively sovereign liabilities.[3] Such an approach collapses the institutional detail of what is actually going on to such a degree that it risks misleading rather than clarifying the role played by money in the economy.

The processes of clearing and of interbank lending that are integral to every banking system ensure that only a small fraction of bank liabilities need to be settled at all and that many of these remaining balances are carried rather than settled. Thus, it is inaccurate to claim that when one pays by check (or otherwise by transfer of bank money) the transaction is settled by central bank reserves. The transaction is settled within the banking system itself. Furthermore, it is well established that central banks do not exercise quantity control over the stock of central bank reserves, but must issue reserves in a manner that is responsive to the demands of the banking system.[4] This is true both in normal times and in crises. Thus, the hierarchy of money framework when it claims that bank money is settled using central bank reserves creates an illusion of quantity-based central bank control over the money supply that is both erroneous and just one small step removed from the deterministic approach of the “old” monetarists.

For example, Perry Mehrling, whose theory of money relies heavily on the hierarchy, states: “At every level of the system, the availability of money from the level above serves as a disciplinary constraint that prevents expansion; credit is payable in money, but money is scarce.” Given that the specific hierarchy Mehrling is discussing explicitly places currency as a central bank liability above bank deposits, his implication is clearly that the quantity of central bank liabilities constrains the growth of bank deposits. My point is that this view misunderstands the basic function of the central bank: in order for a banking system to work central bank liabilities must expand in response to the demands of the banking system. It is true that the central bank constrains the growth of bank money, but it most definitely does not do so using quantitative controls on the supply of central bank liabilities. Instead the central bank uses interest rate policy, microprudential, and macroprudential supervision of the instruments on bank balance sheets (see Sissoko 2016).

Thus, by failing to understand the fundamentally credit-based nature of the modern payments system and by modeling the payments system as “inherently” cash-based with the banking system as simply an extension of the cash-based system, the heterodox literature perpetuates the error of the old monetarists. As Thornton argued in 1802 and many have tried to explain after him, the modern monetary system is a credit-based payments system that has properties very different from a cash payments system. Errors that can arise when scholars who are studying money fail to recognize either the possibility of or the characteristics of a credit-based payments system include:

  • The assumption that movements in a sovereign money supply determine movements in a contemporaneous credit-based money supply. This is of course a foundational principle of Old Monetarism. It is, however, also a fundamental principle of many heterodox approaches (see the discussion of Mehrling 2012 above). Desan too posits such a relationship and seeks support for it in the data on medieval English money. Unfortunately the data available from this era is sufficiently sparse that others find support for the view that credit actually expanded when the sovereign money supply shrank (pp. 225 ff).
  • The assumption that a deficiency of cash will constrain transactions. In an environment where there is clear evidence of credit-based payments, the possibility that credit fully substitutes for cash – at least within the group of individuals who participate in the system – must be considered. Even if cash is used sporadically (for example, seasonally during the harvest when it is suddenly available in a village economy), this does not necessarily imply that transactions are constrained by the absence of cash when it is unavailable.
  • The assumption that debts are paid in cash. In the absence of clear data indicating that this is the norm, the likelihood that some system of clearing or of transfer of claims is used to settle debts must be carefully evaluated. This possibility certainly cannot be rejected out of hand – and evidence that some currency is the unit of account is in no way evidence that this currency is also the means of payment. After all, almost every one of my transactions is denominated in dollars, but only a very small fraction of them are settled using dollar bills.
  • The assumption that debt that specifies a due date is actually expected to be paid off on that date. The rolling over of short-term debt obligations is such a fundamental part of historical payments systems that one must always evaluate whether or not a social norm was in place that would make it difficult to demand payment when due. For example, when studying credit in a 15th century English village, Elaine Clark establishes that 61% of the litigation over payments that arose involved debt that was incurred 4 or more years earlier and in more than half of these cases the debt was more than 7 years old. Thus, Clark concludes that in this small scale credit network the norm was for debt to be open-ended. Given examples such as this, one needs to consider the possibility that the due date for a debt is simply the date on which the terms of the credit line may be reset rather than assuming that it is a date on which payment is expected to be delivered.

The credit-based payments model undermines the distinction between consumption and production credit

The New Monetarist credit-based payments model points to an important fact about credit that is easily missed when the neoclassical model is your framework: the line that is sometimes drawn between consumption credit and productive credit begins to disappear in an environment where everybody needs to borrow in order to trade.

Desan has a very nice discussion of the implications of the ubiquitous use of what she calls “liquidity credit” (pp. 214 ff), and I prefer to call payments credit. She discusses the fact that payments credit does not sit easily within a dichotomy of (potentially exploitative) “exigency credit” and “investment credit”, but is best understood from the “revisionist” perspective that assigns a more affirmative role to credit.

I would add that payments credit lies squarely between the two poles of the dichotomy: it typically finances working capital – after all foodstuffs themselves can be considered inputs for someone whose main product is labor services and who needs payments credit in order to purchase food. While working capital has always been distinguished from fixed capital and it is the latter that is typically associated with investment, the productive role of working capital is indisputable.

Thus the credit-based payments model indicates that just as mercantile credit is viewed as being productive – precisely because it finances working capital (Desan pp. 228-29), the same reasoning justifies the view that payments credit in a rural village was also likely to have been productive.

A credit-based payments system may not be worse than a cash-based credit system

Desan discusses at length the ways in which the rural system of payments credit may have imposed costs on the poor. The main criticism I have of her analysis is that she does not spend enough time explaining how such costs might have been avoidable given a cash-based payments system. After all, the question is not whether the poor suffered in rural villages (given the heavy burden of taxation that Desan argues was a cornerstone of the monetary system, we know they did). The question is whether the fact that the payments system was credit-based made things worse.

For example, Desan argues that sellers on credit and those paying in advance could drive hard bargains with the poor (p. 223). But, as the New Monetarist framework makes clear, the presence of cash does not eliminate the bargaining problem. The poor are disadvantaged in a cash or a credit economy: if a buyer can only afford to pay cash for a quarter loaf of bread, the seller may well choose to charge that individual more than a quarter the price of a full loaf. In fact, in a world where everybody uses payments credit it may be easier to be poor, precisely because the need to borrow is unexceptional and can go unnoticed.

Desan also argues that enforcement of debt by litigation is costly, unpleasant, and can have the effect of souring relationships (pp. 218 ff). This is certainly true, but the relevant question is whether cash bargaining makes it possible for a community to avoid or at least reduce the measure of unpleasantness and soured relationships. The answer to this question is far from obvious. (While I pay my phone bills in full every month, I can assure you that the fact that I regularly have to call and have them corrected makes me feel that I know very well what a sour commercial relationship is – and it doesn’t require debt.) In short, disputes arise when people transact. When payments mostly take the form of credit, then debt litigation will frequently feature in the disputes. This is not, however, evidence that no dispute would have taken place without debt.

Desan remarks on how the credit-based payments system required vetting and long-term relationships that would be unnecessary in a cash economy (p. 218). This is certainly true, but cash is usually viewed as being most advantageous in stranger-trades where credit is impossible. Given the signs of almost universal access to credit in rural villages (Spufford, cited by Desan 209) – and the fact that these were the kind of close knit environments where credit is likely to be most effective – it’s not at all clear that these characteristics of credit were a handicap in rural villages. On the other hand, it seems reasonable to claim that the lack of cash and the reliance on a credit-based payments system may have slowed the growth of stranger trade and in this sense slowed the expansion of the economy.

Finally, Desan argues that the nonproductive nature of English credit exacerbated its dangers (p. 223), including “habituat[ing] people to living on prospect” (p. 224). As was discussed above it’s far from clear that this is the best way to view payments credit, which is indeed forward looking, but in a way that makes it possible for economic production to take place.

A final note

One of the advantages of the new monetarist approach is that it rejects the neoclassical model entirely in order to explore a variety of environments where trade is not easy. As a result, there are aspects of the heterodox monetary literature that are more reliant on the neoclassical framework than new monetarism. For example, Geoffrey Ingham appears to treat the idealized market of the neoclassical model as the basis for his general definition of a market. He writes: “a market is a system of multilateral exchanges in which bids and offers, priced in a money of account, can in principle produce a single price for a uniform good” (Ingham 2006). I find it surprising and unnecessarily restrictive to treat the idea of a market itself as referring to an environment where each good trades at a single price. Having spent time in parts of the world where the term “market” typically refers to an environment where many goods are sold and prices are reached through a process of one-on-one bargaining, the single price of the neoclassical model has always appeared to me a characteristic of the model, not of the “market.”

Precisely because discussions of money are inherently macroeconomic, requiring focus on the general operation of trade in the economy as a whole, close attention to the subtle ways in which simplifications drawn from the neoclassical model color the discourse is very important. For example, reading Desan I find that she periodically implies that if cash were in sufficient supply, prices would be neoclassical in character.[5] While this accords with Ingham’s claim that “a genuine market presupposes the existence of a money of account in which demand and supply can be expressed in prices,” it is far from obvious to me that Ingham’s market – or neoclassical prices – can be expected to exist anywhere but in the realm of purely abstract theory.[6] By introducing the reference point of idealized prices into the analysis of historical monetary phenomena and assuming that such idealized prices are specifically associated with the coin that served as a unit of account, Desan allows the neoclassical model to color her discussion of money and credit. In short, it seems to me that proponents of heterodoxy can sometimes end up taking the neoclassical pricing mechanism more seriously than many modern economists – who have after all been trained in all the shortcomings of the neoclassical model.

[1] See, e.g., Gabor & Vestergaard 2016.

[2] See Bell 2001 at 159.

[3] Bell writes: “Although bank money is part of the ‘decisive’ money of the system, its acceptance at state pay offices really requires its conversion to state money (i.e. bank reserves). That is, bank money is converted to bank reserves so that (ultimately) the state actually accepts only its own liabilities in payment to itself.” (p. 160). First, most bank money is cleared, and only a tiny residual shows up in reserves, so there is no “require[ment of] conversion to state money.” Second, central bank reserves are not state liabilities, but central bank liabilities. The fact that the archetype of a central bank operated as a privately-owned institution for most of its history should make one think twice about casually asserting an equivalence between the central bank and the state.

[4] See Stigum & Crescenzi on the Fed’s so-called monetarist experiment, pp. 372 ff, 503. See also McLeavey et al. 2014 p. 21.

[5] “The process [of monetizing an economy with coin] shakes the items traded into particular relationships of value. Eventually, those relationships produce prices for goods and other resources in terms of pennies, the units of account. The pennies, as they are spent, traded, and taxed, ultimately create a set of equivalences: 5 pennies = a sword, 5 pennies = two cows. But there is nothing essential about the sword and the cows and their equivalence. To the contrary, they are interchangeable only in the world created by this community’s activity with [pennies]” (pp. 60-61). And later, the scarcity of small coin “effectively added a burden to those most handicapped by it, whether by increasing their vulnerability to [adversely-timed lawsuits] or affecting bargaining power over prices because they had credit not coin” (p. 223). Observe that the latter statements also implies that if the supply of coin is sufficient, sellers will be price-takers (which in economic theory is a prerequisite for neoclassical prices).

[6] Indeed, in the neoclassical model money is superfluous. So it is far from clear how neoclassical prices could possibly result from the introduction of money into an economy.

In search of financial stability II: Re-thinking money and banking

I.   Acceptance banking
II.  A simple model of money based on acceptance banking
III. What is money? An origin narrative
IV. So what do banks do?
V.  Conclusion: Banking as the fundamental source of liquidity

The challenge for any model of money and banking is to explain the two basic elements of the modern payments system.

  • First, the money supply is comprised mostly of private sector liabilities
  • Second, this money supply is backed on the asset side of bank balance sheets by a combination of (i) “cash” (e.g. central bank liabilities), (ii) private sector short-term debt, and (iii) private sector long-term debt (e.g. mortgages)

Why this is the structure of the payments system? I will simplify the question a little by observing that the backing of the money supply by long-term debt is a very recent phenomenon (see Jorda, Schularick, and Taylor 2014), and therefore by restricting my focus to the explanation of why the modern monetary system developed backed by private sector short-term debt. (Note that this post is designed to motivate in layman’s language a formal economic model of banking that is available here.)

There two common frameworks used to discuss the two sides of bank balance sheets in the bullet points above, a standard view and a heterodox view. The standard view is the “loanable funds” approach that assumes that cash is brought to the bank by depositors and then the bank takes some of that cash and lends it out. In this framework, no loan can be made unless a depositor first brings cash to the bank. (Classic economic models of banking such as Diamond-Dybvig rely on this framework.) The heterodox view claims that it is by making loans that a bank creates deposits. In this framework, a bank first underwrites a loan, and after the loan is approved the bank funds the loan by giving the borrower a deposit account with the value of the loan in it.

Charles Goodhart (2016) points out that both of these two frameworks are missing something very important about the relationship between the asset and the liability side of the bank balance sheet: the standard view implies that it is the depositor that drives the process, the heterodox view implies that it is the bank that drives the process, and both of these are wrong.[1] Goodhart explains that it is more accurate to think of banks as setting the parameters by which loans will be made – and in fact of typically offering borrowers credit lines on pre-specified terms – and then allowing the borrowers to determine whether or not to take out the loans that will cause the money supply to expand. In Goodhart’s framework banks are simply the intermediaries that allow the private sector to expand the money supply on an “as needed” basis. I will call this the “private money” model of banking.

Since the “loanable funds” approach models the “deposit taking” function of banks and is closely tied to the “goldsmith” story of bank origins, I think it is useful to connect Goodhart’s “private money” model with a specific banking activity, acceptance banking, and to present a corresponding origin narrative.

Acceptance banking

Banking in 19th century Britain largely took the form of acceptance banking. Whereas a bank that receives a deposit opens an account for a client, a bank that approves acceptance credit for a client opens for a client a discount – or an account that may go negative to the extent of the client’s credit line. The terms of the discount are set in advance, and the client draws down the credit line on an “as needed” basis. A bank discount is identical to a bank account in terms of the ability to deposit and to and withdraw funds. The only distinction between the two is that the discount is designed to carry a negative balance for an indefinite period of time.[2]

When a bank client draws a discount down from zero, the action simultaneously creates a bank asset and a bank liability. First, the draw automatically creates a bank loan on terms pre-specified at the time the discount was approved as noted above. But, secondly, because the draw is used to make payments using bank liabilities (that is, using either bank notes or bank acceptances), bank liabilities are also increased by the amount of the draw. Thus, acceptance banking – or for that matter any form of banking based on credit lines – doesn’t just have loans causing bank liabilities to be created, but also has the private sector driving the process by which bank liabilities are created.

A simple model of money based on acceptance banking

Before discussing an origin narrative that corresponds to the “private money” view of banking, let me lay out in abstract terms how we should think about this function of banking. The crucial point of this discussion is that in Goodhart’s “private money” model the money supply is expandable to meet the needs of the private sector, subject to the terms set out by the banks. Tying this view into the credit facilities with which we are familiar in the US, one may think of credit in the private money model as being as readily available as it is to businesses today through credit cards, but – because of careful underwriting and therefore the safety of the debt – bearing a low interest rate, such as 5% per annum.

The simplest model of money is a game with three people, each of whom produces something another seeks to consume: person 2 produces for person 1, person 3 produces for person 2, person 1 produces for person 3. Trade takes place over the course of three sequential pairwise matches: (1,2), (2,3), (3,1). Thus, in each match there is never a double coincidence of wants, but always a single coincidence of wants. We abstract from price by assuming that our three market participants can coordinate on an equilibrium price vector (cf. the Walrasian auctioneer). Thus, all these agents need is liquidity.

Let the liquidity be supplied by bank credit lines that are sufficiently large and are both drawn down by our participants on an “as needed” basis, and repaid at the earliest possible moment. Assume that these credit lines – like credit card balances that are promptly repaid – bear no interest. Then we observe, first, that after three periods trade has taken place and every participant’s bank balance is zero; and, second, that if the game is repeated foerever, the aggregate money supply is zero at the end of every three periods.

In this model the money supply expands only to meet the needs the trade, and automatically contracts in every third round because the buyer holds bank liabilities sufficient to meet his demand.

Consider the alternative of using a fiat money “token” to solve the infinitely repeated version of the game. Observe that in order for the allocation to be efficient, if there is only one token to allocate, we must know ex ante who to give that token to. If we give it to person 3, no trade will take place in the first two rounds, and if we give it to person 2 no trade will take place in the first round. While this might seem a minor loss, consider the possibility that people who don’t consume in the first stage of their life may have their productivity impaired for the rest of time. This indicates that the use of fiat money may require particularized knowledge about the nature of the economy that is not necessary if we solve the problem using credit lines.

Why don’t we just allocate one token to everybody so that we can be sure that the right person isn’t cash constrained in early life? This creates another problem. Person 2 and person 3 will both have 2 units of cash whenever they are making their purchases, but in order to reach the equilibrium allocation we need them to choose to spend only one unit of this cash in each period. In short, this solution would require people to hold onto money for eternity without ever intending to spend it. That clearly doesn’t make sense.

This simple discussion explains that there is a fundamental problem with fiat money that ensures that an incentive compatible credit system is never worse and in many environments is strictly better than fiat money. This is one of the most robust results to come out of the formal study of economic environments with liquidity frictions (see e.g. Kocherlakota 1998).

Now let’s continue our discussion of the payments function of credit lines by taking our simple model (the original one without fiat money), duplicating it twice (using ‘ and ‘’ to indicate the duplicates), assuming that preferences are such that participants do not wish to trade across duplicate groups, and offsetting the trading periods for our duplicate economies. In period 1 three pairwise matches take place: (1,2), (2’,3’) and (3’’, 1’’). Posit also that at the start of time there is a banking system that has loans outstanding to agents 1’ and 1’’, and deposits owed to agents 2’ and 3’’. (This is just the simplest way of creating a more complex, overlapping pattern of trade.)

Thus, we have an environment where there is always a stock of deposits and a stock of loans outstanding. Even so, every agent is regularly paying off his debt. The money supply still exists only to meet the needs of trade, and every participant’s account balance returns every third period to zero.

Now imagine that for every one of the participants in our triplicate economy there are n identical agents who have been excluded from the economy historically. If these agents are suddenly incorporated into the economy, then the money supply will increase by a factor of n. Because this increase in the money supply occurs only to meet the needs of trade, the increase in the money supply is entirely consistent with the existing price vector.

In short, because the debt created by the banking system is carefully constructed so that its only purpose is to provide liquidity to facilitate the operation of the payments system, the bank-based money supply is able to expand to meet the needs of trade, and will – in certain circumstances – expand without any tendency to affect the price level.[3]

Observe that this framework is the basis for the “real bills doctrine.” If the only debt in the economy finances the purchase of productive inputs, and if the banking system can enforce the requirement that this debt be paid off as soon as production takes place, then expansions of a money supply backed by this debt are not necessarily inflationary, but may reflect changes in the underlying real economy. (Note that, because we have assumed an equilibrium price vector, the question of how prices are anchored in this framework remains to be answered and is not addressed here.)

What is money? An origin narrative

We have laid conceptual underpinnings that explain: first, the relationship between the use of bank liabilities as money and the fact that these liabilities are backed by short-term private sector debt; and second, the fact that a system of “private money” has the advantage that it can very naturally expand to meet the needs of trade. We now demonstrate that there are also historical foundations for the model of money presented here. Before expanding upon the historical details, we discuss in more general terms the implications of a private monetary system that is not anchored by any sovereign unit of account.

One of the great inventions at the dawn of the early modern era in Europe was that of monetary systems that existed in the abstract without any physical embodiment of the unit of account. Specifically, by the 1530s the process of clearing and settling European trade was taking place using the ecu de marc, a unit of account that was stable precisely because it was not tied to the coin issued by a sovereign.[4]

When such an abstract unit of account is combined with a sophisticated system of clearing and settlement, a monetary system is established that is purely abstract. Such a monetary system exists only in account books. While net balances will be convertible into real goods or traditional financial assets, the monetary system itself has an existence that is independent of the real economy. For example, even if the monetary system typically pays off net balances in francs, the sovereign government that issues the francs can go bankrupt and the monetary system will simply shift to paying off net balances in the next best instrument, whether it be dollars or euros or drachmae.

While a monetary system can exist purely in the abstract, the danger that the value of the abstract unit of account will be devalued is every bit as much a risk as the danger that a more traditional sovereign unit of account will be devalued. On the other hand, the abstract unit of account typically develops because a sovereign instrument is being devalued and the bankers seek to maintain the value of their own interactions. The decision to treat the “old” value of the sovereign instrument as the “true” value for the purposes of the monetary system has the effect of converting the monetary system into one that is purely abstract – but convertible into real instruments. Thus, just as a complex web of institutions (e.g. independent central bank, separate public Treasury, democratic polity) supports the value of sovereign money, so an equally complex institutional structure (e.g. personal liability for debt, shunning of bankrupts, hierarchical structure that exploits reputation effects at every level from the international to the local) is required to protect the value of an abstract unit of account.

The first observation of this phenomenon of a monetary system that existed only in the abstract took place in the mid-16th century at the Lyons fairs where the “imaginary” ecu de marc was the unit of account for the money market.[5] By the turn of 17th century the European money market had moved to Venice where the Banco della Piazza di Rialto and its bank ducat became the next “imaginary” currency of account for European trade. In 1609 Amsterdam founded the Wisselbank which deliberately copied the model of the Venetian bank and its bank ducat. By the end of the 1620s the European money market, along with its international trade had shifted to Holland.[6]

During the same time period Amsterdam adopted the techniques of decentralized clearing that had been developed in Antwerp (during a period when banking was a prohibited activity). Clearing was decentralized by formalizing legally the rules for endorsement and circulation of bills of exchange. Thus, by the time the Bank of England was established in 1694 (with the advice of Dutch financiers), (i) the intellectual foundations for a stable and imaginary bank-based unit of account – that is for fiat money – had been firmly established by a century and a half of practice in Europe; and (ii) Europe’s system of clearing and settlement had been so thoroughly established in international trade that bills drawn on European banks could circulate among merchants in Russia, India, and the Americas.

The brilliant innovation of the founders of the Bank of England was to address a political problem: sovereign authorities understood very well the challenge to their authority posed by an autonomous abstract monetary system, [7] and sometimes deliberately took action to weaken it. Thus, by combining the issue of Bank of England notes with an important role in the finance of government debt, the bankers successfully aligned the interests of the sovereign with those of the issuer of the bank-based unit of account.[8] In short, the founders of the Bank of England deliberately laid the foundations of a fiat money that was backed, not as it had been in the past by gold and private debt, but by a combination of gold, sovereign and private debt. The effectiveness of the institutional structure established in 1694 was proven a century later as the Bank of England note enabled the British economy to shift very smoothly to a Bank-based monetary standard and the Bank was thus able to play a crucial role in the finance of the Napoleonic Wars.

The point of my brief review of monetary history is this: clearing and settlement is money. There is no need for some sovereign token to serve as a final means of payment. In short, the theory of the essential role of government in the monetary system is, just that, a theory. It is true in the sense that monetary systems that develop without the consent of the governments within the boundaries of which they function rarely last more than a few decades because they compete with governments which are therefore incentivized to undermine their stability. It is not true, however, in the sense that monetary systems cannot function without being tied to some government unit of account. The history of Europe in the modern era is proof of this latter statement.

By contrast to the consensus view, there is a strong argument that the inverse of the conventional view – that is, of the view that monetary systems are dependent on sovereigns that are institutionally capable of issuing debt without defaulting and base money without inflating – is equally true: modern sovereigns are only able to issue sound debt and money, because of their close ties to banking systems that support robust economic activity by underwriting unsecured, but safe (and therefore low-cost), debt that allows the payments system to operate smoothly and facilitates access to the payments system for a broad spectrum of society. After all, historically bank-based units of account and payments systems were established centuries before British government debt became a safe asset, and the role played by the Bank of England in establishing the safety of British debt ensured that this debt was inextricably tied to the performance of both the banking system and the British economy.

So what do banks do?

So what do banks do? Banks operate the payments system. This entails not just mechanistically processing customer payment orders, but also the design and maintenance of a safe system of short-term lending to support the payments system.

Economic efficiency is fundamentally dependent on the banking system to manage and alleviate the fundamental problem that for each market participant the flow of funds is not synchronized. In the absence of unsecured credit to support payments, many market participants will face prices that are determined by the fact that they are liquidity constrained and that result in an inefficient allocation relative to an economy where these liquidity constraints are obviated by short-term credit. (In our toy model the economy is autarkic if there is no monetary instrument.)

Precisely because payments system credit addresses only the inherent timing problem in payments, these systems can be designed so that they are extremely safe. Thus, from the 17th through the 19th centuries the interest rates paid by businessmen on such credit were typically in the range of 2 to 6% per annum.[9] Then, when we say that banks operate the payments system, we need to include in that description the business of setting the terms of credit lines and monitoring borrowers’ behavior, so that borrowing for purposes of transacting is an activity that can be done at very low cost.

So what are the most important functions of the banks? They:

  • set parameters for credit lines including the credit limit and the interest to be paid
  • monitor borrowers’ use of credit lines and financial positions more generally, adjusting credit terms as needed, and
  • impose penalties on (or withdraw the credit line from) borrowers who violate the terms of the credit line

When these activities take place in an environment where there is interbank competition, the interest rates charged to businessmen with no history of default for such a credit line should be in the low single digits. If we don’t see this kind of unsecured credit readily available to almost all businessmen,[10] then we can assume that something is going very wrong with our banking system and that it is failing in its most important function.

Conclusion: Banking as the fundamental source of liquidity

The modern payments system should be understood as the modern evolution of an abstract monetary system that dates back to the 16th century and one of the earliest money markets established in Europe. At the heart of the payments system lies a system of unsecured credit in which banks set the terms of credit lines and individual market participants draw down those credit lines on an “as needed” basis. This clearing and settlement process together with the short-term credit lines that are intrinsic to its functioning comprise the fundamental source of liquidity in a modern economy.

This analysis indicates that there’s another way to define liquidity. Liquidity is created by the unsecured credit lines that are extended by the banking system in order to make the payments system function smoothly. Thus, one can define liquidity itself as the unsecured credit lines that facilitate the settlement of asset trades and other obligations. This definition is almost the same as that of “funding liquidity” or “the ability to settle obligations with immediacy,”[11] but focuses attention not on settlement, but on the extension by banks of unsecured credit lines that facilitate settlement.

Market liquidity, by contrast, is the ease with which an asset can be bought or sold and is determined by the difficulty of finding a counterparty for your trade (see Harris 2003, p. 394). Clearly when buyers have access to unsecured credit lines, this plays an important role in making it easy for sellers to find buyers, to trade in large size, and to get a good price for the asset. Thus, liquidity, as we have defined it, is also likely to be an important determinant of market liquidity. By contrast, temporary fluctuations in market prices (driven for example by bargaining dynamics in an over-the-counter market) are unlikely to have a significant effect on liquidity. After all, credit lines are generally committed, so temporary fluctuations will frequently disappear before the bank has the opportunity to change the terms of the credit line. This structure makes economic sense, because such temporary fluctuations are unlikely to affect a borrower’s capacity to repay the loan over time. Thus, while we might expect the structure of market liquidity (e.g. whether most assets can be traded on an exchange vs. over-the-counter) to affect the willingness of banks to extend unsecured credit lines and therefore to affect liquidity, as we have defined it, there is little reason to expect that day-to-day changes in market prices should affect liquidity.

Overall, by defining liquidity as the unsecured credit lines that facilitate the settlement of asset trades and other obligations we have a single definition of liquidity that determines both funding liquidity and to a large degree market liquidity. Contrast this approach to liquidity with that of Brunnermeier & Pedersen 2008 (BP). BP define funding liquidity as the fraction of an asset that a trader can finance. That is, BP assume that what is defined as liquidity here – that is, the extension of unsecured credit lines – is necessarily nonexistent. Thus, given our definition of liquidity, BP can be reinterpreted as stating that when liquidity is unavailable, adverse dynamics are easily generated by the interaction between market price fluctuations and collateralized financing constraints.

This analysis raises a host of questions: If the unsecured credit lines that make the payments system function smoothly are liquidity, then are these credit lines also money? Should they be money? If these credit lines that are so important to the operation of the payments system are not money, then what is the point of defining money at all? I am still puzzling over these questions so I only ask them and don’t pretend to answer them here.

[1] Paper presented at the Macro, Money and Finance Conference, Bath University, UK, September 8, 2016.

[2] For accounting purposes, a discount (like a derivative) creates complications. When the discount has a positive balance, it is equivalent to a deposit account and is therefore a bank liability. However, when the discount has a negative balance it is a loan made by the bank and therefore is a bank asset. For analytic simplicity the text here assumes that discounts always have negative balances and therefore are always bank assets.

[3] If we take this simple model as a metaphor for a much more complex monetary system with the same properties, we can consider the kind of monetary expansion that drove Schumpeter’s process of creative destruction (see Schumpeter 1939 which I discuss here). Thus, imagine a Walrasian economy with trading frictions where the banking system operates as described above to eliminate the frictions and make competitive equilibrium attainable. Now assume that someone has an idea for a better production method. Using the credit-based transactions system that individual can buy inputs and convert the production method into an operating business easily. Assuming the new production method is genuinely more efficient than the older one, the newcomer will sell his product more cheaply, demand for the product will slowly (due to information transmission costs and the costs of building up production capacity) shift to the new production method, and the payment system will shift very smoothly to financing the better method.

[4] The inevitable and steady devaluation of all the late medieval coinage systems due simply to the use and circulation of the coins is documented in great detail by Lane and Mueller (1985).

[5] Boyer-Xambeu, Deleplace & Gillard (1994, p. 78).

[6] This history is recounted in detail in a chapter of my dissertation, “The Political Economy of Private Paper Money,” Sissoko (2003).

[7] Montesquieu, The Spirit of Laws, XXII(13).

[8] Martin (2013) calls this monetary innovation the Great Monetary Settlement.

[9] Barbour (1963), p. 85.

[10] Those who are just starting out may be expected to have very low credit limits and/or be required to have a co-signor.

[11] Matthias Drehmann & Kleopatra Nikolaou, Funding Liquidity Risk, BIS Working Paper No. 316 (July 2010).

In search of financial stability: A comparison of proposals for reform

I. The liquidity view
a. Solution: Expansive LOLR
b. Solution: Narrow banking

II. The solvency view
a. Solution: PFAS – the dealer of last resort meets narrow banking
b. Solution: Controls on credit

The vast literature on the financial crisis includes a segment comprised of books that propose reforms to the financial system that are designed to promote financial stability. The initial goal of this post was to evaluate and compare some of the more recent contributions to this literature: Morgan Ricks’ The Money Problem (2015), Adair Turner’s Between Debt and the Devil (2015), and Mervyn King’s The End of Alchemy (2016). In order to help balance the discussion, I am also including Perry Mehrling’s The New Lombard Street (2011), Hal Scott’s Interconnectedness and Contagion (2012), and John Cochrane’s Toward a Run-Free Financial System (2014).

A first basic organizing principle for comparing these proposals is to separate the works by their view of the essential problem to be solved: some argue that we should focus on panics or on avoiding liquidity droughts, whereas others see the fundamental problem as one of solvency or too much private sector debt. Those who take the liquidity view make proposals that fall into two broad categories: the establishment of an expansive lender of last resort, and narrow banking proposals where the government backstops short-term debt. While some proponents of the solvency view also put forth narrow banking proposals, their proposals typically attempt to address the potential danger of too much government support for short-term debt and therefore are distinguished from the liquidity-based narrow banking proposals. Finally some advocates of the solvency view argue that financial stability necessitates controls that limit the private sector’s ability to originate debt.

This post addresses each of these arguments in turn.

The liquidity view

The list of authors who argue that the key to addressing financial stability is to focus on liquidity crises and their prevention is long. Here we will discuss the proposals put forth by John Cochrane, Perry Mehrling, Morgan Ricks, and Hal Scott.

Each of these authors is explicit that in his view the key to financial stability is the prevention of liquidity crises. For example, Morgan Ricks writes: “when it comes to financial stability policy, panics— widespread redemptions of the financial sector’s short- term debt— should be viewed as ‘the problem’ (the main one, anyway). More to the point: panic-proofing, as opposed to, say, asset bubble prevention or ‘systemic risk’ mitigation, should be the central objective of financial stability policy” (p. 3). This view is echoed by both John Cochrane: “At its core, our financial crisis was a systemic run. … The central task for a regulatory response, then, should be to eliminate runs” (p. 197); and Hal Scott: “Contagion occurs when short-term creditors run on solvent institutions, or institutions that would be solvent but for the fire sale of assets that are necessary to fund withdrawals” (CNBC comment) and “contagion, rather than asset or liability interconnectedness, was the primary driver of systemic risk in the recent financial crisis” (p. 293). Perry Mehrling also frames the crisis as fundamentally a matter of liquidity, acknowledging first that it was catalyzed by the decline in collateral valuations, but then explaining: “from a money view perspective, price is first of all a matter of market liquidity, and this perspective focuses attention on the dealer system that translated funding liquidity into market liquidity.” (p. 125).

All four of these authors focus on the fact that the financial system that faced crisis in 2007-09 was constructed upon a foundation of short-term liabilities of non-banks. They differ, however, on the question of whether central bank policy was a cause or a consequence of this financial structure. Both Mehrling and Scott focus on what the Federal Reserve did to address the 2007-09 crisis, whereas Cochrane and Ricks argue that lender of last resort support played an important role in moral hazard and the deterioration of financial institution balance sheets in the decades leading up to the crisis (Cochrane pp. 231-32; Ricks p. 195). Indeed Ricks argues against not just the implementation of last resort lending in the lead-up to the crisis, but even against the traditional lender of last resort, because, first, in his view it functions as a distortionary subsidy to financial institutions and, second, it will fail if these institutions do not have enough of the right sort of collateral (pp. 186-87).

Threading a path between these views I would argue that during the decades preceding and fostering the growth of this financial system built on the short-term liabilities of non-banks, a naïve view of the lender of last resort was promoted by Federal Reserve officials. Alan Greenspan declared that: “The management of systemic risk is properly the job of the central banks. Individual banks should not be required to hold capital against the possibility of overall financial breakdown. Indeed, central banks, by their existence, appropriately offer a form of catastrophe insurance to banks against such events” (speech 1998). And through these formative decades Timothy Geithner, who would be President of the Federal Reserve Bank of New York and then Treasury Secretary during the crisis, was learning to ignore moral hazard concerns when dealing with crises (Geithner 2014).

Before exploring the details of the “panic-proofing” proposals, let’s briefly preview the contrary view that the crisis was a solvency crisis, and the critiques that the solvency proponents have to offer of the liquidity view. Mervyn King references Keynes’ exposition of uncertainty, animal spirits, and the fact that “a market economy is not self-stabilizing” to explain that sometimes an interim period of disequilibrium may be part of a necessary adjustment process as it becomes clear that the current pattern of behavior is no longer sustainable and that “the debts and credits that have built up … will eventually have to be cancelled” (pp. 294-323). In short, due to radical uncertainty, liquidity neither is nor should be “a permanent feature of financial markets” (p. 151). He remarks that: “Political pressures will always favor the provision of liquidity: lasting solutions require a willingness to tackle the solvency issues” (p. 368).

Adair Turner is more direct in his critique. His view that modern economies are reliant on too much private sector debt is supported by extensive empirical research (Jorda, Schularick & Taylor 2014, Mian & Sufi 2014), and he argues that those who deny that too much private sector debt has been originated are misled by a “presumption in favor of … as many financial contracts as possible as widely traded as possible [that] was an accepted article of faith” prior to the crisis (p. 29). Thus, from the perspective of Between Debt and the Devil, proponents of the liquidity view are likely to be captive minds who simply cannot conceive of the possibility that the debt that was originated prior to the crisis was in fact unsustainable and will at some time in the future end up in default.[1]

Only Ricks directly addresses and rejects the solvency view. His discussion does not, however, reach the question of whether a systemic panic is a necessary consequence of an environment with an unstable build-up of debt. Instead he focuses on how damaging the panic itself was. Thus, while one can read Ricks as arguing that the problem can be addressed either at the level of the debt bubble or at the level of the panic, the fact that he chooses to address the problem at the latter stage because it is only then that the problem becomes acute indicates that he considers “too much debt” to be a distinctly secondary concern.[2] This approach lends credence to Turner’s view that current modes of thought about finance preclude serious discussion of the problem of too much debt.

Unsurprisingly, neither King nor Turner supports the broad government guarantees that underlie all of the solutions proposed by the liquidity view proponents. Despite the common reliance of all four liquidity view authors on government guarantees to prevent crises, the form that these guarantees take is very different. Perry Mehrling and Hal Scott would implement these guarantees through expansive access to the lender of last resort without requiring major structural reform to the financial system. John Cochrane and Morgan Ricks, by contrast, propose complete transformation of the financial system before they would advocate government liquidity support.

Solution: Expand the role of the lender of last resort

Perry Mehrling’s argument in support of an expansive role for the lender of last resort is premised on the assumption that complete transformation of the financial system is not a practical solution. He writes: the “capital-market-based credit system … is now a more important source of credit than the traditional banking system. I take it as given that this brave new world is here to stay.” (p. 113). Similarly, even though Hal Scott does discuss proposals that place a cap on short-term funding for banks (p. 160 ff), he does not clearly address the possibility that such caps could be applied to non-banks as an alternative to lender of last resort support. In short, Scott implicitly, though not explicitly, adopts Mehrling’s approach: financial stability is a problem of stabilizing a financial system constructed upon a foundation of short-term liabilities of non-banks. (As we will see below, Cochrane and Ricks do not share this view.)

The most famous proponent of the lender of last resort as a form of “panic-proofing” is probably Timothy Geithner, who views 2007-09 as fundamentally a liquidity crisis and argues that the right way to deal with such a crisis is by providing government support to the financial institutions involved until such time as their balance sheets are repaired and they can function without government support.[3] This naïve view of the lender of last resort treats the moral hazard concerns of this central bank function as something that must be ignored during a crisis.[4]

Mehrling and Scott seek to lay analytic foundations for an expansive lender of last resort as a solution to panics. Scott in his book recounts the aggressive actions that did indeed have the effect of saving the financial system from contagion (though many have observe that economic performance subsequent to this bailout of dysfunctional finance has left much to be desired, e.g. Mian and Sufi 2014) and argues that: “History has taught us that contagion is an unavoidable risk of financial intermediation and that a strong lender of last resort is necessary to prevent it” (CNBC). In fact, Scott views the Lehman bankruptcy as a lesson that “to be effective, a central bank lender-of-last-resort must be unlimited and non-discretionary. The current [post Dodd-Frank] regime leaves open the risk that lender-of-last-resort assistance will be withheld from a distressed financial institution at a critical moment, and thus short-term creditors remain incentivized to withdraw in the face of such distress. An explicit guarantee, as opposed to the implied guarantee that existed before Lehman’s failure, assures short-term creditors that they will recover all of their funds, thus removing their incentive to run in anticipation of large losses” (p. 292). He makes clear in a later article that “the ability to lend to non-banks in a crisis is a crucial matter, and will become even more important, as over regulation of banks fuels the further growth of the shadow banking sector” (CNBC).

Perry Mehrling does not advocate for an “unlimited and non-discretionary” lender of last resort. Instead he argues that the Federal Reserve should convert into a regular facility the Primary Dealer Credit Facility, which was a program the Federal Reserve put into place during the crisis to support the value of private sector assets that were used as collateral in the tri-party repo market. (At its peak this facility held more than $60 billion of equities. See PDCF data .) Mehrling argues that the modern capital-market-based financial system needs such a “dealer of last resort” to set a price floor on private sector assets and that any moral hazard concerns created by this proposal can be addressed by careful pricing (pp. 134, 137-38).[5] Mervyn King doubts that central banks can implement such a policy successfully: “one of the most difficult issues in monetary policy today is the extent to which central banks should intervene in these asset markets – either to prevent an ‘excessive’ rise in asset prices in the first place or to support prices when they fall sharply. … I am not sure that their track record justifies an optimistic judgment of the ability of central banks [to do this]” (p. 265).

Overall, proponents of an expansive lender of last resort as a solution to the problem of liquidity crises generally start with the assumption that the existing financial structure cannot change and do not address the argument the existing financial structure is in fact a product of the expansion of central bank guarantees in the 1980s and 1990s. Adair Turner (likely with substantial agreement from Charles Goodhart, Mervyn King, and Martin Wolf) would probably argue that proponents of this view are captivated by pseudo-economic delusions and mistaken ideas that forestall an understanding of the fundamental problem of “too much debt.” In short, critics of the expansive lender of last resort proposal argue that far from stabilizing the financial system, the policy has a history of being destabilizing.

Solution: Narrow banking

John Cochrane and Morgan Ricks are united in their view that, even though excessive origination of debt is a predictable consequence of misguided government support for the financial system, the correct way to address this problem is to focus on run-prone (or short-term) financial claims and to design a monetary system backed by government obligations that will put an end to runs. While both authors favor structural financial reform that would effectively end – or at least severely restrict – private short-term debt, the monetary frameworks that the two authors adopt as they formulate their solutions are very different: Cochrane’s view of money is a fairly direct distillation of Milton Friedman’s approach, whereas Ricks develops more of a practitioner’s view that owes as much to Marcia Stigum and Diamond-Dybvig-type coordination problems as to any particular monetary theorist. The only common ground in the two views of money is that both treat money issued by the government as the anchor of their systems (Cochrane p. 224, Ricks p. 146).[6]

Both Cochrane and Ricks would transform the financial system by aggressively restricting the ability of both banks and non-banks to issue short-term, run-prone debt. In Cochrane’s proposal “demand deposits, fixed-value money-market funds, or overnight debt must be backed entirely by short-term Treasuries”(p. 198). Cochrane would restrict the degree to which any other short-term debt (except for trade credit) could be used to finance intermediaries by imposing a tax on such liabilities (p. 199). The result would be that “Intermediaries must raise the vast bulk of their funds for risky investments from run-proof securities [i.e. equity]” (p. 198). Ricks’ plan is more comprehensive because it would entirely prohibit nonbank issue of short-term debt, but somewhat less restrictive because it relies on government guarantees of bank liabilities rather than a mandate that banks hold government debt. Specifically, Ricks restricts the issue of short-term debt (except for trade credit) via “unauthorized banking provisions” that only permit banks to issue such debt, and requires that all short-term bank liabilities be explicitly guaranteed by the government (pp. 201, 235). Ricks’ proposal also imposes bank regulation similar to, but more strict than, what we have today including portfolio restrictions and capital requirements (p. 211). Ricks indicates that this proposal can be viewed as making explicit government guarantees that were formerly implicit (p. 25).

Both Cochrane and Ricks argue that government backing of short-term debt will eliminate the danger of runs (with of course the caveat that we are talking about the right sort of government). Whereas Ricks focuses in some detail on the structure of the monetary system, Cochrane’s emphasis is on the value of ensuring that most financial assets are backed by equity: “For the purpose of stopping runs, what really matters is that the value of investors’ claims floats freely and the investors have no claim on the company which could send it into bankruptcy” (p. 215). Ricks’ critique of Cochrane’s proposal is that he underestimates the demand for money-claims on banks and thus ties the supply of money to the quantity of short-term Treasuries available to back them. The advantage of Ricks’ sovereign guarantees of bank liabilities is that it allows the money supply to be backed in part by private sector assets and thus makes it possible for monetary policy to operate independent of fiscal policy (p. 182).

This significant difference in the two proposals is a consequence of the different monetary frameworks that the two authors employ. As noted above, Cochrane’s approach derives directly from Friedman’s and thus bank money, when it exists, is simply a function of government constraints. Ricks, by contrast, views banks as creating money and thus as playing an important part in determining the money supply. It is this latter approach that motivates Ricks to design a “narrow banking” system that nevertheless can allow for expansion of the money supply independent of government debt. Ricks observes that proposals like Cochrane’s (and Friedman 1960’s) envision a monetary system without a significant role for banks (p. 171).

In short, when Cochrane argues that the costs of his transformational plan are not too large, he does so without first modeling why money claims issued by banks are backed by private sector assets. Not only Ricks, but also Adair Turner, Martin Wolf and Charles Goodhart have argued that there are “positive benefits to private rather than public creation of purchasing power” and indeed, that this structure may play a role in “investment mobilization and thus economic growth” (Turner 188-89; see also Wolf 212-13).

Given that Cochrane – and all those who rely on Friedman’s monetary framework – have not thought through why we have the monetary and banking system that we have, his assertions appear “mystical and axiomatic” to use his own words (p. 223). For example, Cochrane writes that by limiting finance to equity finance “we can simply ensure that inevitable booms and busts, losses and failures, transfer seamlessly to final investors without producing runs” (p. 202). “Liquidity is now provided by the liquid markets for these securities, not by banks’ runprone redemption promises.” 226 This Friedman-esque vision of markets plus government as providing all the liquidity that an economy needs is combined with the remarkable claim that we no longer have a transactions need for bank liabilities.[7] Cochrane asseverates that “technology renders this ‘need’ [for short-term bank debt in transactions] obsolete. … We can now know exactly the prices of floating-value securities. Index funds, money market funds, mutual funds, exchange-traded funds, and long-term securitized debt have created floating-value securities that are nonetheless information-insensitive and thus extremely liquid. Consumers already routinely make most transactions via credit cards and debit cards linked to interest-paying accounts, which are in the end largely netted without anyone needing to hold inventories of runnable securities” (p. 222).

In short, Cochrane, because his theoretic framework is devoid of liquidity frictions, does not understand that the traditional settlement process whether for equity or for credit card purchases necessarily requires someone to hold unsecured short-term debt or in other words runnable securities. This is a simple consequence of the fact that the demand for balances cannot be netted instantaneously so that temporary imbalances must necessarily build up somewhere. The alternative is for each member to carry liquidity balances to meet gross, not net, demands. Thus, when you go to real-time gross settlement (RTGS) you increase the liquidity demands on each member of the system. RTGS in the US only functions because the Fed provides an expansive intraday liquidity line to banks (see Fed Funds p. 18). In short RTGS without abundant unsecured central bank support drains liquidity instead of providing it. (See Kaminska 2016 for liquidity problems related to collateralized central bank support.) In fact, arguably the banking system developed precisely in order to address the problem of providing unsecured credit to support netting as part of the settlement of payments.

Just as RTGS systems can inadvertently create liquidity droughts, so the system Cochrane envisions is more likely to be beset by liquidity problems, than “awash in liquidity” (p. 200) – unless of course the Fed is willing to take on significant intraday credit exposure to everybody participating in the RTGS system. (Here is an example of a liquidity frictions model that tackles these questions, Mills and Nesmith JME 2008). Overall the most important lesson to draw from Cochrane’s proposal is that we desperately need better models of banking and money, so we can do a better job of evaluating what it is that banks do.[8]

Another aspect of money that Ricks takes into account, but Cochrane with his simple Friedman-based monetary framework barely addresses is that banks are able to expose themselves to runnable, short-term debt even when they aren’t financing their balance sheets. Ricks argues: “Our monetary theory of banking … suggests that derivatives dealing is properly the domain of nonbank financial firms,” because “the amount of cash exchanged upfront [and therefore the money provided] is almost always very small in relation to the risk taken” (p. 208). Cochrane would not restrict such off-balance-sheet activities, and argues that “a few regulators” will be able to detect any dangerous behavior since leverage ratios will be very low (p. 216). Of course, one of the lessons of the crisis is that off-balance-sheet bank liabilities can be very large: Citibank (as well as UBS and Merrill Lynch) had to recognize upwards of $50 billion of derivatives exposures in the form of super-senior CDOs when its “liquidity puts” were drawn down (FCIC  Report, p. 260).

When we combine Cochrane’s casual approach to the danger of off-balance-sheet bank exposures with the view that “invoices [and] trade credit … are not runprone contracts” (p. 202), we find that his formulation of narrow banking leaves open the possibility that after his reforms the financial system could regenerate a very old – but not necessarily very stable – form of banking, acceptance banking. Whatever is classified as trade credit in Cochrane’s regime may be accepted or guaranteed by banks or unacknowledged shadow banks – and these acceptances may circulate as money just as they did in the 19th century with destabilizing effect. In fact, Ricks’ proposal is also permissive of trade credit and therefore is subject to a similar critique: nothing prevents nonbanks from guaranteeing trade credit obligations and this is an avenue through which a new, unstable banking system can develop. This analysis points to another common criticism of narrow banking proposals: they may be impossible to design due to the “remarkable ability of innovative financial systems to replicate banklike maturity transformation” (Turner p. 189).

Overall, narrow banking proposals raise very important questions about whether our monetary system can be better designed to avoid liquidity crises, but (i) will be very hard to formulate in a way that precludes their circumvention, and (ii) are probably best read as evidence that we need much better models of money and banking, so that we can actually understand what the connections are between money, bank liabilities and private sector bank assets, before pursuing transformative change.

The solvency view

Transformational reform is also proposed by scholars who believe that the essential problem that must be addressed in modern financial systems is not liquidity, but solvency. “The fundamental problem is that modern financial systems left to themselves inevitably create debt in excessive quantities, and in particular debt that does not fund new capital investment, but rather the purchase of already existing assets” (Turner p. 3-4). Turner argues that when banks expand the money supply by creating debt that is used to purchase existing assets, the result is an increase in the prices of the assets thus purchased, which then justifies an increase in the debt collateralized by the asset – and thus an expansion of the money supply. The ultimate consequence of this “self-reinforcing credit and asset price cycle” is an asset price bubble (p. 6). When the bubble bursts, as eventually it must, the problem is not liquidity, but solvency. The economy is then burdened with an overhang of debt that is either bad in the sense that repayment is not feasible or uneconomic, because the debtor is servicing debt that is greater than the value of the asset. This basic critique of modern finance – and in particular of the finance of real estate – is advocated not just by Turner, but also by Martin Wolf 2014 and Charles Goodhart & Enrico Perotti 2015.

Mervyn King in The End of Alchemy takes a slightly different approach. He argues that “the most serious fault line in the management of money in our societies today” is “the alchemy of banking” or the system by which money “is created by private sector institutions” and then used to finance illiquid and risky investments (pp. 86, 104). In his view, however, it is important to emphasize that the causal force generating “too much debt” was not the banks themselves, but the demand for borrowing to finance real estate investment due to the savings generated by the structural current account surpluses of Asian countries and Germany together with the decline in real interest rates that resulted from deficit countries’ efforts to keep their economies growing when faced by these surpluses (p. 319, 325).[9] In short, while King agrees that we are currently faced with a state of disequilibrium characterized by too much debt, he explains this outcome via a change in our understanding of the state of the world, not via an inherently unsustainable asset price bubble (pp. 356-57).

Proponents of the solvency view believe that not only does financial stability require that our financial structure be transformed, but also that the only path forward will require debt forgiveness of some sort (King p. 346, Turner p. 225ff). Because the focus of this essay is on proposals for transformational reform of the financial system, devices to deal with the debt overhang will not be discussed. Instead we evaluate King’s proposal for a pawnbroker for all seasons and Turner’s argument that direct controls on the financial sector’s origination of debt instruments are necessary.

Solution: PFAS – the dealer of last resort meets narrow banking

Like John Cochrane and Morgan Ricks, Mervyn King focuses his attention on the design of a more stable monetary system. His proposal for a pawnbroker for all seasons (PFAS) combines aspects of the dealer of last resort and narrow banking proposals. In particular, he would allow the central bank to lend against risky collateral, but only upon terms that are specified well in advance, and he would combine this policy with a restriction that all short-term unsecured liabilities of a bank must be backed by a combination of cash, central bank reserves, and the committed central bank credit line.

King motivates his proposal as an improvement over the traditional lender of last resort, which he (like Ricks) views as suffering from a time inconsistency problem: “The essential problem with the traditional LOLR is that, in the presence of alchemy, the only way to provide sufficient liquidity in a crisis is to lend against bad collateral – at inadequate haircuts and low or zero penalty rates. Announcing in advance that it will follow Bagehot’s rule … will not prevent a central bank from wanting to deviate from it once a crisis hits. Anticipating that, banks have every incentive to run down their holdings of liquid assets” (p. 269). But in contrast to some proponents of an expansive lender of last resort, King argues that moral hazard concerns must be addressed ex ante: “It is not enough to respond to the crisis by throwing money at the system … ensuring that banks face incentives to prepare in normal times for access to liquidity in bad times matters just as much” (p. 270).

Specifically, under King’s proposal, as under the dealer of last resort, the central bank provides liquidity against risky assets and does so subject to a haircut, but importantly the PFAS would not just specify the haircut in advance, but would specify it with the expectation of not changing it for years (p. 277). Thus, the first step of the PFAS proposal is that assets must be pre-positioned as collateral for a specific loan amount. The second step of the proposal caps the short-term unsecured debt of the bank by the sum of the cash, the central bank reserves held by the bank, and the amount that the bank can draw from the central bank on the basis of pre-positioned collateral (p. 272). “The scheme would apply to all financial intermediaries, banks and shadow banks, which issued unsecured debt with a  maturity of less than one year above a de minimis proportion of the balance sheet” (p. 274).

King’s proposal addresses two important design concerns. First, even though banks can create money, “only the central bank can create liquidity” or “the ultimate form of money” (pp. 190, 259). For this reason, King finds that “liquidity regulation has to be seamlessly integrated with a central bank’s function as the lender of last resort” (p. 259).[10] This is achieved by using the credit line commitment of the central bank as a determinant of the cap on a bank’s runnable assets. Second, when a central bank increases its collateralized lending to a bank, the bank’s unsecured lenders are disadvantaged and this form of central bank liquidity support can have the effect of reducing the availability of – or even generating a run on – unsecured market-based lending to the bank. For this reason what is needed is a “single integrated framework within which to analyze the provision of money by central banks in both good time and bad times” (p. 208). Because unsecured lenders will know in advance that the pre-positioned collateral will be used to draw from the central bank, they will not expect it to be available to support their own claims and will demand to be paid a rate on the unsecured debt that compensates them for this fact.

This proposal achieves stability in much the same way that narrow banking does: “all deposits are backed by either actual cash or a guaranteed contingent claim on reserves at the central bank” (p. 271). Unlike Cochrane’s narrow banking, however, only indirect control is exercised over the bank’s asset portfolio. In comparison with Morgan Ricks’ proposal, the public guarantee is provided not with respect to the liabilities of a bank but instead with reference to its assets, and it is the central bank – or the ultimate provider of liquidity – not bank regulators who will make the decisions that affect the bank’s asset portfolio.

The issue of the degree of control exercised by the PFAS is, in fact, an interesting question. One of King’s goals is to “design a system which in effect imposes a tax on the degree of alchemy in our financial system” (p. 271). While each bank nominally is left to determine how to allocate its asset portfolio, the central bank has almost total control over how the tax is structured and, in particular, over which assets will be highly taxed and which will not. According to King the central bank “should be conservative when setting haircuts and, if in doubt, err on the high side. … on some assets they may well be 100%. … It is not the role of central banks to subsidize the existence of markets that would not otherwise exist” (p. 277-78). At least to the degree that a financial intermediary finances itself with deposits and other forms of unsecured short-term debt, it would appear that the PFAS will exercise a great deal of control over the assets that are thus financed.

Unsurprisingly End of Alchemy includes a robust defense of central bank discretion (p. 167). Thus, whether or not this proposal is subject to Ricks’ criticism of narrow banking as serving as an excessive constraint on the money supply will depend on the decisions of central bankers and how they exercise the control over the banking system granted to them by the PFAS proposal.

Solution: Controls on credit

Control over the types of assets that are financed by bank credit creation is also the solution that Adair Turner proposes. It is Turner who advocates most strongly for the view that “too much debt” explains the increasing instability of modern economies. Thus, for Turner “the amount of credit created and its allocation is too important to be left to the bankers; nor can it be left to free markets in securitized credit” (p. 104); instead it is necessary for bank regulators to control the growth of credit. Turner argues more specifically that the most important driving force behind instability was the “interaction between the potentially limitless supply of bank credit and the highly inelastic supply of real estate and locationally specific land. … Credit and real estate price cycles … are close to the whole story [of financial instability in advanced economies]” (p. 175).

Thus, Turner proposes that bank regulation should directly constrain certain types of finance including lending against real estate and shadow banking (p. 195). He would also constrain borrowers’ access to credit and slow international capital flows, which when they took the form of short-term debt simply increased the excess of funds flowing into “hot” real estate markets (p. 196).

Constraints on shadow banking are necessary because in the run-up to the recent crisis it had the effect of “turbocharg[ing] the [credit] cycle, [and] increasing the danger of the wrong sort of debt” (p. 90). Like Ricks and King (p. 94), Turner emphasizes that it was shadow banks that caused bank funding markets to seize up when “wholesale secured funding markets went into a meltdown driven by the very risk management tools that were supposed to make them safe” (p. 103).

While Adair Turner does not promote any version of narrow banking, he draws inspiration from narrow banking’s vision of a system where financial assets are financed by equity. Because “in principle the more that contracts take an equity and not a debt form, the more stable the economy will be,” “implicit taxes on credit creation can be a good thing” (p. 192) and “free market approaches to [credit markets] are simply not valid” (p. 190).

Turner’s focus is, however, very different. Whereas John Cochrane argues that there is no need to differentiate between the different types of credit markets (p. 213), Turner emphasizes the importance of the real estate market: Nowadays “most bank lending … finances the purchase of real estate. … [This] also reflects a bias for banks to prefer to lend against the security of real estate assets … [which] seems to simplify risk assessment” (p. 71). As “banks, unless constrained by policy, have an infinite capacity to create credit, money, and purchasing power … [this combination results in] credit and asset price cycles [that] are not just part of the story of financial instability in modern economies, they are its very essence” (p. 73).

Overall, Turner’s bottom line is that “we should not intervene in the allocation of credit to specific individuals or businesses, but we must constrain the overall quantity of credit and lean against the free market’s potentially harmful bias toward the ‘speculative’ finance of existing assets.” This policy “does not mean less growth, since a large proportion of credit is not essential to economic growth” (p. 208).


Discussions of financial stability and how to achieve it are characterized by a remarkable breadth of views. At one extreme are those who believe that modern finance is here to stay and that its stabilization requires a lender of last resort which plays a much expansive role than in the past. Critics of this approach argue that on the contrary, the expansion of the lender of last resort’s responsibilities over the course of the last three or four decades is what generated the modern financial system which is so very unstable.

Some of these critics of the modern financial system emphasize the liquidity problems it generates and others the solvency problems. All, however, are in agreement that, if financial stability is the goal, substantial reform of the modern financial system is necessary.

Proponents of the solvency view explain that the design of the modern financial system is so flawed that the origination of too much debt is a structural problem. As a result proponents of the solvency view find that either regulators or the central bank must constrain the capacity of all financial intermediaries to finance certain forms of debt – and real estate loans, in particular – using short-term instruments.

The proponents of the liquidity view who propose transformational reform of the financial system argue that only government backing of short-term liabilities can stabilize them. They differ on the degree to which banks have a role to play in a reformed financial system, however. And the comparison of these proposals leads me to conclude that we are in desperate need of better – formal, economic – models of money and banking in order to evaluate these questions.

So what’s my bottom line? I’ve been working on a model of money, bank liabilities, and private sector debt that speaks to all these issues. This model demonstrates that banks’ economic function is to underwrite the unsecured debt that makes the payments system work. By doing so banks bring agents who would otherwise be anonymous and autarkic into the economy. In effect, banks are paid enforcers of intertemporal budget constraints – and it is only because they provide this service that you and I can participate in the payments system and therefore in a modern economy. In short, I think we need a “banking school” model to help us tackle these problems. (Warning to Friedmanites: banking school is the devil that it was Friedman’s agenda to exterminate.) The details will, however, have to wait for another day.

[1] While Hal Scott’s opus has been described as showing “that none of the banks that fell or were rescued were important enough to another big institution to cause its failure” (Authers 2016), this fails to address the question of whether the whole system was beset by too much debt. The danger to the financial system of a “bad equilibrium” in which every participant underwrites too much debt has been recognized for decades (Goodhart 1988 p. 48).

[2] He writes: “this chapter offers reason to doubt that debt-fueled bubbles and the like pose a grave threat to the real economy in the absence of a panic” (p. 106) and “my claim is not that debt-fueled bubbles are insignificant … Rather, my claim is that panics appear to pose a far graver threat to the broader economy” (p. 141). This certainly seems to imply that is possible to have debt-fueled bubbles without also having a panic.

[3] In an interview Geithner states: “What’s unique about panics, and most dangerous, is the amount of collateral damage they do to the innocent, to people who had borrowed responsibly, who weren’t overexposed. The banking system is the lifeblood of the economy. It’s like the power grid. You have to make sure the lights stay on, because if the lights go out, then you face the damage like what you saw in the Great Depression … That requires doing things that are terribly unfair and look deeply offensive. It looks like you are rewarding the arsonist or protecting people from their mistakes, but there is no alternative. We didn’t do it for the banks. We did it to protect people from the failures of banks” (Wessel 2014).

[4] For a view of the lender of last resort which is more nuanced see Sissoko 2016. In fact, the origins of the term “lender of last resort” itself indicates that the central bank is rightly the “court of last appeal” which makes the ultimate determination of whether a financial firm is solvent or not. Implicit in the moniker is the idea that central banks should sometimes uphold the market’s death sentence for a financial firm – just as courts must sometimes uphold real-life death sentences (Sissoko 2014).

[5] Cochrane’s dry comment on the expansion of policy to the regulation of prices is: “What did the old lady eat after the horse?” (p. 238).

[6] This is unsurprising given that almost all modern academic analyses of money, including the heterodox literature, also emphasize the role of government in the money supply. Whether or not this consensus is well-founded is a topic for a different post.

[7] Perhaps Cochrane’s view of the capacity of markets to provide liquidity has changed in recent years. He writes in an October 2016 essay titled Volume and Information: “Information seems to need trades to percolate into prices. We just don’t understand why.” which would seem to imply that markets both demand liquidity and provide it.

[8] Indeed, this is clearly Morgan Ricks agenda (see p. 210). The weakness of Ricks’ approach is that he is a legal scholar and the agenda calls for formal economic analysis.

[9] Note that Turner and Wolf both agree that current account imbalances played an important role in generating the asset price bubbles.

[10] Here King is apparently questioning whether the liquidity coverage ratio specified by the Basel III accords makes sense.