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.

Do “net financial assets” matter?

I’ve just read Steve Waldman’s post on “net financial assets” and am connecting it up with Michael Pettis’ excellent discussion. (See also Cullen Roche’s comment on the issue.)

Steve discusses the decomposition of financial positions on which MMT is based. He points out that the term “net financial assets” is used for the “private sector domestic financial position” which refers exclusively to the aggregate netted financial position of both households and firms and explicitly excludes “real” savings such as any housing stock that is fully paid up. By definition, if the “private sector domestic financial position” is positive, then it must be the case that on net the private sector holds claims on either the government or on foreign entities. Of course, the value of such claims depends entirely on the credibility of the underlying promises — this is the essential characteristic that distinguishes a claim to a financial asset from a claim to a real asset.

For Steve, there is a tradeoff between holding financial claims and holding real claims, and a principal reason for holding financial claims is to offset the risk of the real claims. Thus, Steve goes on to claim that to the degree that such a positive private sector financial position is due to claims on government, the government is using its credibility to provide a kind of insurance against real economy risk.

This is where I think Steve both gets what happened in 2008 right, and gets the big picture of the relationship between the financial and the real, and between the private sector and the public sector wrong. Steve is completely correct that in 2008 the issue of public sector liabilities played a huge insurance and stabilization role.  But Steve extends his argument to the claim that: “The domestic private sector simply cannot produce assets that provide insurance against systematic risks of the domestic economy without the help of the state.”

The key point I want to make in this post is this: the financial and the real are so interdependent that they cannot actually be divorced. The same is true of the private and the public sectors. Financial activity and real activity, public sector activity and private sector activity are all just windows into a single, highly-integrated economy. Thus, I would argue that it is equally correct to state that: “The domestic public sector simply cannot produce assets that provide insurance against systematic risks of the domestic economy without the help of the private sector.”

That financial activity and real activity are two sides of the same coin is most obvious when one considers that the credibility of private sector financial liabilities depends fundamentally on the performance of the real economy. But it is equally true that the credibility of public sector liabilities (when measured in real terms) depends fundamentally on the robustness of the real economy as well. Those countries that have very highly rated debt did not achieve this status ex nihilo, but because of the historical performance of their economies and the robustness of their private sectors.

Thus, it is entirely correct that the public sector can temporarily step in to provide insurance for the private sector when it is struggling, but the view that it is the public sector that is the primary provider of insurance fails to capture the genuine interdependence that lies at the heart of a modern economy.

Indeed, Steve recognizes the danger of framing the financial and the real and the public and the private in this way in his last paragraph, where he acknowledges that this publicly-issued insurance is in fact provided in real terms at the expense of a segment of the private sector — the segment that does not hold the claims on government.

Michael Pettis on Creating Money out of Thin Air

Now let’s turn to Michael Pettis (whom I’ve never met, so I’ll call him by his last name). Pettis has long stood out as an economist with a uniquely strong understanding of the relationship between the financial and the real. He argues that “When banks or governments create demand, either by creating bank loans, or by deficit spending, they are always doing one or some combination of two things, as I will show. In some easily specified cases they are simply transferring demand from one sector of the economy to themselves. In other, equally easily specified, cases they are creating demand for goods and services by simultaneously creating the production of those goods and services. They never simply create demand out of thin air, as many analysts seem to think, because doing so would violate the basic accounting identity that equates total savings in a closed system with total investment.”

His two cases are a full employment economy (without growth) and an economy with an output gap. He argues that it is only in the latter case that the funding provided by banks (or government) can have an effect on output. In a comment to Pettis’ post I observed that his first case fails to take into account Schumpeter’s theory of growth. An economy is at full employment only for a given technology. Once there is a technical innovation, the full employment level of output will increase. Schumpeter’s theory was that the role of banking in the economy was to fund such innovation. Thus, there is a third case in which bank finance in a full employment economy does not just transfer resources to a different activity, but transfers them to an innovative activity that fundamentally alters the full employment level of output. Thus, it is not only when the economy is performing below potential that bank funding can create the production that makes savings equal to investment. When banks fund fundamental technological innovation, it is “as if” the original economy were functioning below potential (which of course if we hold technology constant at the higher level, was in fact the case — but this deprives the concept of “potential GDP” of its meaning entirely.)

Schumpeter was well aware that the same bank funding mechanisms that finance fundamental technological innovation, also finance technological failures and a vast amount of other business activity. Indeed, he argued that even though the banking system was needed to finance innovation and growth, the consequences of the decision making process by which banks performed this role included both business cycles and — when banking system performed badly — depressions.

In short, there is very good reason to believe that even in a “full-employment” economy when banks create debt, some fraction of that process creates additional demand. The problem is that the fraction in question depends entirely on the institutional structure of the banking system and its ability to direct financing into genuine innovation. It’s far from clear that this fraction will exhibit any stability over time.

How Did We Get Here: The Fault Lies in Our Models

So why do economists fall into the trap of treating the financial and the real as separable phenomena? Why do macroeconomists of all persuasion look for solutions in the so-called public sector?

The answer to the first question is almost certainly the heavy reliance of the economics profession on “market-clearing” based models. In models with market-clearing everybody buys and sells at the same time and liquidity frictions are eliminated by assumption. Of course, one of the most important economic roles played by financial assets is to address the problem of liquidity frictions. As a result, economists are generally trained to be blind to the connections between the financial and the real. People like Michael Pettis and proponents of MMT are trying to remove the blindfold. They are, however, attempting to do so without the benefit of formal models of liquidity frictions. This is a mistake, because the economics profession now has models of liquidity frictions. The future lies in the marriage of Schumpeter and Minsky’s intuition with New Monetarist models.

The answer to the second question is that we have a whole generation of macroeconomic policy-makers who think that the principal macroeconomic economic debate lies between Keynesians and Monetarists, when in fact both of these schools assume that the government is the insurer of last resort. The only distinction between these schools is whether the insurance is provided by fiscal or by monetary means. (To understand why our economies are struggling right now one need only understand how the assumption that the government is the fundamental source of liquidity has completely undermined the quality of our financial regulation.)

The concept of liquidity as a fundamentally private sector phenomenon that both drives the process of growth and periodically requires a little support from the government (e.g. giving the private sector time to weather a financial panic without the government actually bearing a penny of the losses) has been entirely lost. Only the future can tell us the price of this intellectual amnesia.

Growth and financial instability: Schumpeter’s hypothesis

I have taken my own advice and read (most of) Schumpeter’s Business Cycles with some care. He has completely blown my mind — and I am left bewildered by how it is possible that this body of work has been all but forgotten.

All the elements of what is now known as the Kindleberger-Minsky model of financial crises were present in Chapter IV of Schumpeter’s Business Cycles, and indeed Minsky cites his advisor as an important source for the financial instability hypothesis.

There is a crucial aspect of Schumpeter’s analysis that is, however, typically omitted from discussions of “Minsky moments.” Schumpeter separated out the “displacement” and “boom” phases of crises as fundamentally productive phenomena: displacement is naturally caused when a transformative innovation is funded by credit creation through the financial system and a boom is the inevitable result. Thus, Schumpeter is careful to construct his argument so that there is no doubt that we need the financial system to create credit. Credit creation ensures that growth due to innovation is accompanied by growth in the money supply, and thus that innovation does not result in deflation.

In short, for Schumpeter displacements and booms are an essential part of the process by which innovation drives economic growth.

Unfortunately the same financial system that creates credit to fund innovation, also creates credit to fund many other activities, including the finance of inventories, expansion of existing businesses, and consumption, all of which appear initially to be justified by the dynamics of the boom, but which in the end cause the economy to overheat. Kindleberger calls this phenomenon “overtrading.” The counterpart to an overheated economy is bad debt. As this economy works through the bad debt, “abnormal” liquidation takes place and “destroys many things which could and would have survived without it. In particular, it often liquidates and weeds out firms which do not command adequate financial support, however sound their business may be.” 155. When the economic circumstances are particularly adverse, debt deflation can set in and cause a depression. This is the stage that Kindleberger named “revulsion.”

Overall, Schumpeter didn’t just describe the dynamics of bubble, he also argued that there was a close connection between these dynamics and the capacity of an economy to take advantage of innovation and to grow. In the process, he concluded that almost every economic “catastrophe” can be attributed to dysfunction in the banking sector – and in particular to a failure on the part of bank lenders and business borrowers to exert appropriate control on the use of credit.

Schumpeter’s error presumably was to acknowledge that it was beyond the scope of economic theory to determine how to discipline the banking and business communities in their use of credit. 156. Thus, the intellectual debates of the middle of the 20th were dominated by economic theorists who could offer simpler answers (spend money, increase the money supply) to extraordinarily complex problems.

Schumpeter’s Monetary Theory of the Macroeconomy

Brad DeLong needs to give Schumpeter’s 1939 work “Business Cycles” a read. DeLong writes that Schumpeter “genuinely seems to have no clue at all that the business cycle is a feature of a monetary economy,” that he did not understand Wicksell, and that he was a sound money ideologue. I have never studied the history of Schumpeter’s thought, so it is possible that there is an “early” Schumpeter of whom these accusations may be accurate, but by 1939 Schumpeter had not only grappled with Wicksell’s approach but written a very cogent critique of it, had worked out a monetary theory of the business cycle, and had aggressively criticized sound money advocates.

The problem is not that Schumpeter was not a monetary economist, but that he offered a fundamental critique of the way money is introduced into the Walrasian model upon which both modern Keynesianism and much of modern neo-monetarism are built. With Tobin and Friedman allied against his ideas, all that has been passed down into the modern canon of Schumpeterian macro is Minsky.

DeLong apparently has missed something very important about Schumpeter: His “entrepreneurs-disrupt-the-circular-flow-and-cause-structural-change-and-growth-theory of enterprise” is fundamentally a monetary theory. Schumpeter’s analysis is built on a whole theory of the monetary system that makes it possible for entrepreneurs to obtain the funds for their yet-to-be-realized projects without diverting too much in the form of real resources from the already established — and reasonably well functioning — economy. In Schumpeter’s theory at the core of a capitalist economy lies not just innovation, but more importantly the monetary finance of innovation.

This is what Schumpeter has to say about Wicksell (pp. 128 ff.):

The necessity of reconciling a nonmonetary theory with obvious facts of the sphere of money and credit is, in particular, responsible for the idea that there are two kinds if interest rates, a “natural” or “real” one which would also exist in a barter economy and which represents the essence of the phenomenon, a permanent net return from physical means of production, and a monetary one, which fundamentally is but the former’s reflex in the monetary sphere. The two may, nevertheless, differ of course or be made to differ by monetary policy or by an expansion or contraction of bank credit, but this constitutes a disturbance from which a definite string of consequences, among them the business cycle itself, has been deduced. The roots of this idea reach very far into the past and are clearly discernible in the English monetary discussions of the fourth and fifth decades of the nineteenth century. Its role in the thought of our own time is due to the teaching of Knut Wicksell and to the work of a brilliant group of Swedish and Austrian economists. For us, however, there is no such thing as a real rate of interest, except in the same sense in which we speak of real wages : translating both the interest and the capital items of any loan transaction into real terms by means of the expected variation in an index of prices, we may derive an expected and, by performing the same operation ex post, an actual rate of interest in terms of “command over commodities.” But nominal and real rates in this sense are only different measurements of the same thing or, if we prefer to speak of different things even in this case, it is the monetary rate which represents the fundamental phenomenon, and the real rate which represents the derived phenomenon. Hence, the money market with all that happens in it acquires for us a much deeper significance than can be attributed to it from the standpoint just glanced at [i.e. Wicksell]. It becomes the heart, although it never becomes the brain, of the capitalist organism.41

Note 41: Moreover, profits in our sense display no tendency toward equalization. This and the essentially temporary character of profits in our sense should be sufficient to make it quite clear that both our distinction between profit and interest and the relation between them is not identical with an old distinction between normal business profits and contractual interest. However much the writer welcomes anything that will link his teaching to older doctrine, he must point out, first, that normal profits and interest are, according to this view, still the same thing— exactly as contractual and directly earned rent of natural agents is— which he thinks erroneous, and, second, that the analytic problem which he undertook to solve by his theory of interest was precisely to show how it is possible that a theoretically permanent income flows from essentially transient sources and that it should not disappear as a net return through a process of imputation.

One of the points that Schumpeter is making is that if you are going to bring up Walras’s Law then it is clear that you are talking about a barter and not a monetary economy, because the model in which Walras’s Law can be derived is fundamentally a barter economy. (See Jakab and Kumhof for a modern treatment of this issue.) Schumpeter doesn’t tack money onto a model of barter and call it “monetary economics.” Instead he studies the banking system to understand what it does, and then develops a model where the business cycle is driven by phenomena in the money market.

Schumpeter goes on to explain that he has a completely different notion of “capital” than that used by Wicksell. Roughly speaking Schumpeter views capital as financing rather than as a stock of productive goods. He writes (pp. 130 ff.):

Capital in this sense is not goods but balances, not a factor of production but a distinct agent which stands between the entrepreneur and the factors. It can be created by banks because balances can. Its increase and decrease are not the same as increase and decrease of commodities or any particular class of commodities. Its market is simply the money market, and there is no other capital market. No realistic meaning attaches to the statement that, in the latter, “capital” (= some kind or other of producers’ goods) is being ‘lent in the form of money.” But again as in the case of interest the introduction into our analysis of this concept of capital does not do away with the problems of what is traditionally referred to as real capital—on the contrary, they reappear though in a new garb—and results arrived at by means of a monetary theory of capital not always invalidate, but in many cases only reformulate, the proposition of “real” theories of capital. If our understanding of the processes of capitalist society hinges on realizing the fact that monetary capital is a distinct agent, it also hinges on realizing how it is related to the world of commodities.

In addition, Schumpeter explained very clearly that “catastrophes” in capitalist economies are usually due to defective regulation of the banking system. If I remember correctly, DeLong has acknowledged that one of his errors prior to the crisis was to underestimate dysfunction in the banking system. Perhaps if he were more familiar with Schumpeter, he would have been less likely to make that error. Schumpeter writes (p. 117):

Moreover, bankers may, at some times and in some countries, fail to be up to the mark corporatively : that is to say, tradition and standards may be absent to such a degree that practically anyone, however lacking in aptitude and training, can drift into the banking business, find customers, and deal with them according to his own ideas. In such countries or times, wildcat banking develops. This in itself is sufficient to turn the history of capitalist evolution into a history of catastrophes. One of the results of our historical sketch will, in fact, be that the failure of the banking community to function in the way required by the structure of the capitalist machine accounts for most of the events which the majority of observers would call “catastrophes.” [my emphasis]

Thus, Schumpeter’s error is not to fail to write monetary economics, but to have such a profound understanding of the relationship between money and finance that his work was not understood by the founders of modern macroeconomics.

Furthermore, when it comes to “sound money” Schumpeter writes of the 1830s experience with “reckless banking” in the U.S. (pp. 236 ff):

Whatever our opinion might be if we placed ourselves on other possible standpoints, however strongly we may feel it our duty to condemn both the misconduct involved and the public opinion that not only condoned but fostered it, the fact still remains that we have before us the clearest historical instance by which to illustrate the function of credit creation. It was the financing of innovation by credit creation— the only method available, as we have seen in the course of our theoretical argument, in the absence of sufficient results of previous evolution—which is at the bottom of that “reckless banking.” This undoubtedly sheds a different light upon it. Those banks filled their function sometimes dishonestly and even criminally, but they filled a function which can be distinguished from their dishonesty or criminality. Sound money men of all times, hence, threw and still throw away the baby with the bath by condemning the principles of that practice, however understandable their clamor for policing and controlling the practice itself may have been. The people felt this. So did some of the advocates of inflation, though they were unable to formulate their case correctly.

Thus, Prof. DeLong is making very unfair accusations against Schumpeter when he claims that Schumpeter “denies that anything other than budget surpluses and ‘sound money’ can ever be appropriate economic policies.” Schumpeter indicates that the problem with people like DeLong is that they are unable to formulate their case correctly, because they don’t have a good understanding of the relationship between money and finance.

I think that Schumpeter would agree with my view that those who claim that monetary policy can solve the problem of “a shortage of safe assets” are confused. We have a shortage of safe assets, because we have a dysfunctional banking system that is currently incapable of creating safe assets. If this is correct, then holding interest rates at zero will not solve the problem and get the capitalist engine running again. That is like pouring gas into a broken engine and expecting it to run, when of course what is needed is that you make the effort to learn how to fix the engine.

“Behavioral” finance approaches are mainstream in macro

Noah Smith, a finance professor, has written a piece arguing that the finance approach to “behavioral” economics/finance has been very successful, whereas it has been largely rejected by the macroeconomics profession. The piece is confusing, however: even though Smith explains that the term “behaviorial economics” refers to a much narrower field of study than the term “behavioral finance,” he does not explore fully the implications of these two different definitions.

Smith explains the different terms:

To most economists, behavioral economics means using findings from psychology to modify models of individual behavior. But behavioral finance has come to have a much more expansive meaning, basically encompassing anything that doesn’t conform to the Efficient Markets Hypothesis (which says that you can only earn market-beating returns by taking on extra risk).

What is left out of Smith’s piece is that many of the approaches that are categorized as “behavioral” in finance, are categorized as mainstream in macroeconomics. There’s no division between saltwater and freshwater macroeconomists on whether macro needs to study frictions using the whole of the microeconomic toolbox including contract theory, mechanism design, etc. The study of the many ways in which Arrow-Debreu (and more generally the efficient markets hypothesis) fails has been fundamental to the macroeconomic research agenda for at least three decades.

By contrast, when the finance profession categorizes mainstream economic theory as “behavioral,” this has the effect of defining as mainstream finance that which is consistent with the efficient markets hypothesis. As a result finance is probably the only economics-related field that has not yet integrated the mid-20th century critiques of the competitive model into its “mainstream” body of theory. For this reason, the fact that “behavioral finance” is alive and well is hardly surprising: if this were not the case, the field of finance theory would be decades behind the theory that is used throughout the economics profession.

The real question then is why the finance profession has not dropped the “behavioral” moniker from behavioral finance, and renamed non-behavioral finance “frictionless finance.”

 

Note: It is clear that Paul Romer finds that macroeconomists have a lot of work to do when it comes to incorporating decades-old critiques of the competitive model into the their work. As I understand his argument, he objects to the way the critiques have been incorporated in macro, because this constitutes a pluralistic “views about the shape of the earth differ” approach, rather than an effort to  fully acknowledge and integrate the logical implications of these critiques into what constitutes mainstream theory.  I suspect that Romer would agree, however, that macro theory is several steps ahead of efficient-markets-based finance theory — if only because mainstream macro at least includes theory that is not price-taking and frictionless.

Beyond Diamond and Dybvig: the banking system as a mutual society

In almost all models with monetary frictions, such as the search model of money, the first best outcome can be reached by what is sometimes called a gift-giving equilibrium: if we can convince everybody to participate in trust-based gifting (for example, until there is a deviation), the first best outcome can be achieved. In my view, banking should be understood as the means by which society creates the enforcement mechanisms that make something close to a gift-giving equilibrium possible.

Thus, in my view at the heart of the banking system lies the ability of (almost) everyone to borrow — or receive gifts — by “issuing” money. The real-world mechanism by which this money is created may, for example, be by drawing on an overdraft or credit line offered by a bank. (Historically this took other forms, such as the bill of exchange.) Because in a first-best equilibrium everybody needs to be able to borrow, the first-best form of money requires underwriting. That is, in order to sustain the system we need banks to eliminate from the system those individuals who will choose to cheat rather than to repay their debts — or give gifts.

One immediate implication of this view of money is that short-term bank credit cannot be distinguished from money, because the issuance of such credit is fundamental to how the money supply is created. This view underlies my skepticism of narrow banking proposals that purport to back all bank deposits by government debt or central bank reserves. Economic efficiency — or a first-best outcome — depends fundamentally on the ability of (almost) every individual in the economy to issue money by drawing on a bank credit line. A central bank — which is not equipped to underwrite such credit lines — by issuing reserves, but not making loans, cannot substitute for the role played by the banking system in the money supply.

Thus, the Diamond and Dybvig model, where bank deposits are literally objects deposited at the bank, leaves out an essential aspect of banking and how it can help make an efficient economic equilibrium possible. This is due to the fact that Diamond and Dybvig has no monetary frictions. In a model with monetary frictions, it becomes immediately obvious that in order for a first-best equilibrium to be reached transactional credit — or money that takes the form of debt — is necessary.

Banking is thus a mutual system in this sense: even though the deposits held in the banking system are assets that have been earned (in the accounting sense of the word) by their owners who have given value in exchange for money, the system of deposits should be viewed as completely integrated with the system of bank lending. And thus, the whole depository system should be understood as a mutual society through which some members of the economy lend to others in a way that makes the economy work better. In short, there is a sense in which bank deposits are fictional — because their value can only be realized if the debts that back them are actually paid. But this tension between assets earned and assets realized is always present in a mutual society.

To the degree that this view of banking is correct, the movement we have experienced over the past few years towards a system of bank money backed by central bank reserves may be problematic. After all, in the extreme case, where banks are wholly dependent on the central bank and therefore do not lend, we would expect this change to reduce the capacity of the economy to support economic activity.

In my view failure to understand the nature of banking — which can probably be attributed in large measure to the influence of Milton Friedman and James Tobin  on the economics profession — has had very adverse effects on the evolution of the banking system. And has led to “competitive” reforms that are destabilizing to the efficient equilibrium that can be obtained through banking.