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

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

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

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

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

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

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

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

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

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

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

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Equity financed banking is inefficient

I see that Tyler Cowen and John Cochrane are having an exchange about banking. First, Cowen expresses a nuanced view of banking, then Cochrane takes the opportunity to promote his narrow (aka equity-financed) banking proposal, and Cowen questions how successful equity-financed is likely to be in practice.

With my latest paper, I have something different to contribute to the discussion: a model of how banking — and the leverage of banks — promotes efficiency. From a macro perspective the argument is really very simple: we all know from the intertemporal Euler equation that it is optimal for everyone to short a non-interest bearing safe asset. (The Friedman Rule is just an expression of this fact.) The point of my paper is that we should understand banking as the institutionalization of a naked short of the unit of account.

How is this efficiency-enhancing? A naked short position requires you to sell something that you do not have. It is a means of creating a temporary “phantom” supply of what is sold, until such time as the short position is closed out. The Euler equation tells us that a “phantom” supply that supports short positions is exactly what the economy needs to achieve intertemporal allocative efficiency.

Of course, the problem with a naked short position is that if a short squeeze (aka bank run) forces the closure of the positions too early, bankruptcy will be the result. The paper is a careful study of what is necessary to make this role of the banking system incentive feasible, and finds (alongside many other studies) that competitive banking is inherently unstable. Two means of stabilizing banking in the context of the model are (i) the natural monopoly approach: permit a non-competitive industry structure, but regulate what banks can charge; or (ii) the central bank approach: set a lower bound on the interest rate banks can charge.

So I don’t think that Cowen really captures what banks do when he presents “transforming otherwise somewhat illiquid activities into liquid deposits” as the primary liquidity function of banks. In my model banks promote allocative efficiency by creating “phantom” units of account. But I think Cowen does capture a lot of the regulatory complexity that is created by the liquidity function of banks.

Cochrane is the one, whom I really think is working from the wrong model. I’ll go through his points one by one.

1) We’re awash in government debt.

So what. Unless the government is going to start guaranteeing private sector naked short positions in government debt, it doesn’t matter how government debt we have, because it will do nothing to solve the monetary problem. We need banks because they do make possible for the private sector in aggregate to support a naked short position in the unit of account (that’s what bank deposits are) and this is necessary for intertemporal allocative efficiency.

2) Liquidity no longer requires run-prone assets. Floating value assets are now perfectly liquid

This view fundamentally misunderstands the settlement process in securities transactions. I responded to this view in a previous post and will simply quote it here:

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.

3) Leverage of the banking system need not be leverage in the banking system.

Because the purpose of banking is to promote economic efficiency by providing society with “phantom” units of account, we need leverage in the banking system. What Cochrane calls “banking” cannot play the role of banks as I model them.

4) Inadequate funds for investment

My model of banking does not provide funds for investment — as least as a first order effect. My model of banking only provides funds for transactions. On the other hand, as a second order effect by promoting allocative efficiency, it seems likely that banks make investing more profitable than in an environment without banks. So an extension of the model that shows that banking promotes investment should not be difficult.

In short, both Tyler Cowen and John Cochrane are in desperate need of a better model relating the macroeconomy to banking. It’s right here.

 

Bank deposits as short positions: the details

So I’ve finally posted the paper I’ve been working on — a New Monetarist model of bank money — on SSRN. Warning for non-economists: lots of Greek  in this one.

Here’s the title and introduction.

The Nature of Money in a Convertible Currency World

This paper studies the nature of money in an environment where the means of payment is convertible at a fixed rate into the numeraire consumption good. By focusing on this environment we eliminate the possibility that the means of payment changes value over time, and deliberately construct a situation where the price level is disabled as a means of equilibrating the supply of money with the demand for it. To our knowledge no one else has studied such an environment in a Lagos-Wright-type framework. Our goal in this paper is to demonstrate that in this environment the first-best can still be attained – if the means of payment is effectively a naked short of the unit of account.

A naked short has the effect of creating a “phantom” supply of the shorted object that disappears when the short is closed out. We demonstrate here that banks can create this “phantom” supply of the unit of account in the form of acceptances of private debt.[1] This type of bank liability is issued when the bank stamps a private commercial bill “accepted,” and the bank obligation is put into circulation when the borrower makes purchases. Then, when the borrower pays off the loan, the phantom supply of the unit of account along with the outstanding, but contingent, bank liability that was used to create it is closed out.

Why do we model the means of payment as a naked short of the unit of account? We argue, first, that this is the best way to understand the nature of the banking system in its developmental stages. Second, by modelling the means of payment in this way our model demonstrates the efficiency gains that can be created through the introduction of a banking system. Third, by carefully evaluating the incentive feasibility conditions for our bank money equilibria, we are able to relate the monetary system to banking stability. We find that the implementation of central bank monetary policy via interest rates can be explained by the need to stabilize the banking system. Finally, we also find support for the use of usury laws as a means by which policymakers choose amongst multiple equilibria to favor the interests of non-banks over those of banks.

The monetary system modelled in this paper is based on the 18th century British monetary system as described in Henry Thornton (1802) An enquiry into the nature and effects of the paper credit of Great Britain. Privately issued bills function as a means of payment because they are “accepted” as liabilities by the banks that underwrite the monetary system. While these bills were denominated in a gold-based unit of account,[2] as a practical matter there was no expectation that they would be settled in gold. Instead, they were used as a means of transferring bank liabilities from one tradesman to another. Thus, bills that are simultaneously private IOUs and bank liabilities are used to make payment. The non-bank debtor pays off her debt by depositing someone else’s bank-certified liability into her account. (The 18th century monetary system was the precursor of the checking account system and operates just like a system of overdraft accounts.) The bank’s liability on a deposited bill is extinguished when funds are credited to the depositor’s account.

In our model productivity is stochastic, and as a result the demand for money is stochastic. We show that the bank-based money described in our model can accommodate this stochastic money demand so that a first best is attained. Thus, our model can be viewed as a model of the “banking school” view where money is issued on an “as needed” basis at the demand of non-banks.

We argue that the convertible currency environment forces a reconsideration of the nature of money. Typically the monetary literature views money as “an object that does not enter utility or production functions, and is available in fixed supply” (Kocherlakota 1998). Shifts in the price of money equilibrate the economy in these environments. Historically, however, stabilization of the price of money by tying it to a fixed quantity of gold was a foundation of economic success in the early modern period (van Dillen; Bayoumi & Eichengreen 1995). Thus, we consider how money functions in an environment where its price is “anchored”. We show that a solution is for the means of payment to be a debt instrument that is denominated in the anchored unit of account and is certified by a bank. This solution is based on actual market practice in the early modern period.

This approach allows us to reinterpret general results such as Gu, Mattesini, and Wright (2014)’s finding that when credit is easy, money is useless, and when money is essential, credit is irrelevant. While their conclusion is correct given their definitions of money and credit, we argue that this standard definition of money is not the correct definition to apply to an environment with banks. We argue that the means of payment in an environment with banks is a naked short of the unit of account, which would be categorized in GMW’s lexicon as “credit”.

This paper employs the methods of new monetarism. Our model combines an environment based on Berentsen, Camera, and Waller (2007) with an approach to banking that is more closely related to Gu, Mattesini, Monnet, and Wright (2013) and Cavalcanti and Wallace (1999a,b). Our model of banking is distinguished from GMMW because non-bank borrowing is supported not by collateral, but by an incentive constraint alone, and from Cavalcanti and Wallace because our banks don’t issue bank notes, but instead certify privately issued IOUs. We find that for values of the discount rate that accord with empirical evidence, such a payments system can be operated with no risk of default simply by setting borrowing constraints.[3] We start by finding the full range of incentive feasible equilibria of the model, and then discuss how, when there are multiple equilibria, a policymaker may choose between these equilibria.

In this environment competitive banking is incentive feasible only when enforcement is exogenous. In the case of endogenous enforcement, competition in banking typically drives the returns to banking below what is incentive feasible and the only equilibrium will be autarky. This result is consistent with many other papers that have found that the welfare of non-banks is improved when there is a franchise value to banking (Martin and Schreft 2005, Monnet and Sanches 2015, Huang 2017. See also Demsetz et al. 1996).

Thus, the challenge for a policymaker is how to regulate competition in the banking sector so that banking is both incentive compatible – and therefore stable – and also meets the policymaker’s goals in terms of serving non-banks. One solution is to treat banking as a natural monopoly, allowing an anti-competitive structure while at the same time imposing a cap on the fees that can be charged by banks. This solution explains usury laws, which by capping interest rates at a level such as 5%, the rate in 18th century Britain, is able to generate both a robust franchise value for the banks that provide payments system credit and at the same time to ensure that a significant fraction of the gains created by the existence of an efficient means of payment accrue to non-banks. An alternate solution is to impose a competitive structure on the banking industry, but also to set a minimum interest rate as a floor below which competition cannot drive the price. We argue that this is the practice of modern central banks and thus that monetary policy should be viewed as playing an important role in preventing competition from destabilizing the banking sector.

Section I introduces the model of a convertible currency. Section II describes the equilibria of the model. Section III presents the equilibria using diagrams. Section IV discusses the means by which policymakers choose between the difference equilibria of the bank-based monetary system. Section V concludes.

[1] While it would be easy to reconfigure the means of payment to be deposits or bank notes, we believe the monetary function of bank liabilities in this paper is sufficiently different from the existing literature that it useful to present it using an unfamiliar instrument.

[2] For the purposes of keeping the exposition simple, assume that we model the monetary system prior to 1797 (when gold convertibility was suspended).

[3] Indeed, we argue elsewhere that the credit based on precisely such constraints constituted the “safe assets” of the monetary system through the developmental years of banking (Sissoko 2016). Treasury bills, the modern financial world’s safe assets, were introduced in 1877 and modeled on the private money market instruments of 19th century Britain (Roberts 1995: 155).

Bank deposits as short positions

A quick point about monetary theory and banking.

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

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

In Defense of Banking II

Proposals for reform of the monetary system based either on public access to accounts with the central bank or on banking systems that are 100% backed by central bank reserves and government debt have proliferated since the financial crisis. A few have crossed my path in the past few days (e.g. here and here).

I have been making the point in a variety of posts on this blog that these proposals are based on the Monetarist misconception of the nature of money in the modern economy and likely to prove disastrous. While much of my time lately is being spent working up a formal “greek” presentation of these ideas, explaining them in layman’s terms is equally important. Thanks to comments from an attentive reader, here is a more transparent explanation. Let me start by quoting from an earlier post that draw a schematic outline of Goodhart’s “private money” model :

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).

In response to this I received the following question by email:

In your 3 person model, [why not allocate] a token to everybody? – I don’t understand how you reached the conclusion that “this solution would require people to hold onto money for eternity without ever intending to spend it”. If people have more units of cash than they need for consumption, the excess would be saved and potentially lent to others who need credit?

This question arises, because I failed in the excerpt from my post above to explain what the implications of “allocating a token to everybody” are when translated into a real world economy. In order for an efficient outcome to be achieved, you need to make sure that everybody has enough money at the start of the monetary system so that it is not possible that they will ever be cash-constrained at any point in time. In my simple model this just implies that everybody is given one token at the start of time. In the real world this means that every newborn child is endowed at birth with more than enough cash to pay the full cost of U.S. college tuition at an elite institution (for example).

Turning back to the context of the model, if the two people with excess currency save and lend it, we have the problem that the one person who consumes at the given date already has enough money to make her purchases. In short there is three times as much currency in the economy as is needed for purchases. What this implies is that we do not have an equilibrium because the market for debt can’t clear at the prices we have assumed in our model. In short, if we add lending to the model then the equilibrium price will have to rise — with the result that nobody is endowed with enough money to make the purchases they want to make. Whether or not an efficient allocation can be obtained by this means will depend on the details of how the lending process is modeled. (The alternative that I considered was that there was no system of lending, so they had to hold the token. Then when they had an opportunity to buy, choose to spend only one token, even though they were holding two tokens. This is the sense in which the token must be held “for eternity” without being spent.)

Tying this discussion back into the college tuition example. If, in fact, you tried to implement a policy where every child is endowed at birth with enough cash to pay elite U.S. college tuition, what we would expect to happen is that by the time these children were going to college the cost would have increased so that they no longer had enough to pay tuition. But then of course you have failed to implement the policy. In short, it is impossible to “allocate a token to everybody”, because as soon as you do, you affect prices in a way that ensures that the token’s value has fallen below the value that you intended to allocate. There’s no way to square this circle.

Connecting this up with bitcoin or deposit accounts at the central bank: the currently rich have a huge advantage in a transition to such a system, because they get to start out with more bitcoins or larger deposit accounts. By contrast in a credit-based monetary system everybody has the opportunity to borrow against their future income.

The problem with the credit-based monetary system that we have is that guaranteeing the fairness of the mechanisms by which credit is allocated is an extremely important aspect of the efficiency of the system. That is, in a credit-based monetary system fairness-based considerations are not in conflict with efficiency-based considerations, but instead essential in order to make efficiency an achievable goal.

Because of the failure to model our monetary system properly, we have failed to understand the importance of regulation that protects and supports the fair allocation of credit in the system and have failed to maintain the efficiency of the monetary system. In my view appropriate reforms will target the mechanisms by which credit is allocated, because there’s no question that in the current system it is allocated very unfairly.

The problem with proposals to eliminate the debt-based system is that as far as I can tell, doing so is likely to just make the unfairness worse by giving the currently rich a huge advantage that they would not have in a reformed and well-designed credit-based monetary system.

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).

Conclusion

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.

Re-imagining Money and Banking

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

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

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

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

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

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

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

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

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