Collateral and Monetary Policy: A Puzzle

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

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

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

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

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

 

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Lenders of Last Resort have duties in normal times too

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

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

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

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

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

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

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

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.

A question for our times: the role of the central bank

Peter Conti-Brown and Philip Wallach are having a debate that cuts right to the heart of what appears to me to be the most important economic question of the current era: what is the proper role of the central bank?

Conti-Brown takes what I think is a fairly mainstream view of the central bank’s role as lender of last resort: In a crisis, the central bank should intervene to rescue a troubled bank as long as, given Fed support, the bank can over time be restored to solvency. He writes:

in a systemic crisis, the problem of determining whether a specific asset class is sufficiently valuable to justify its temporary exchange for cash isn’t just “murky,” it can be impossible to determine. This is true for two reasons: first, the reason the systemic crisis exists at all is because the line between illiquidity and insolvency has become a mirage. And second, whatever line is left is endogenously determined: what the central bank does in response to the crisis has immediate consequences on both liquidity and solvency. There is essentially no way, in the depth of a crisis, to draw the line meaningfully between solvency and illiquidity. After Lehman, the Fed recognized this and extended loans through 13(3) so quickly on so many different kinds of collateral that we saw an explosion in its 13(3) lending.

The clear implication here is that if there is doubt as to whether a firm is illiquid or insolvent, the Fed should err on the side of supporting the firm.

Wallach responds that if one follows this logic to its end, there appear to be no limits to the Fed’s powers:

If I’m understanding him correctly here, Peter means to put in the Fed’s mouth some version of an infamous 2004 pronouncement of a Bush administration aide: “when we act, we create our own reality.” Amidst the chaos of crisis, it is for the Fed to decide which firms are solvent and which kinds of assets are really valuable as collateral and, whatever they decide, the markets will follow, allowing the central bank to benefit its own balance sheet and the larger financial system through self-fulfilling optimistic prophecy. As they forge this new reality, making the security on loans satisfactory to themselves will be the least of their miracles.

Teasing aside, I think that’s far from crazy, but one can get carried away. It can’t be the case that the Fed is capable of rescuing any institution through this kind of heroic thinking: if a firm is in a downward spiral, and the only collateral it has is rotten, then the Fed does not have the legal authority to funnel money into it.

I think that there are actually three question raised by this exchange: First, what are the Fed’s potential powers; that is, what is it feasible for the Fed to do? Second, what were the Fed’s powers in 2008; or alternatively, what was both legal and feasible for the Fed to do? And, third, what should the Fed have legal authority to do? Conti-Brown and Wallach are debating the second question, but I think it’s important to explore the first question regarding what the Fed can do, before moving on to the second and third questions regarding what the Fed is legally authorized to do.

A little history on the concept of the lender of last resort is useful in exploring the first question. A previous post makes the point that the term lender of “last resort” was initially coined, because the central made the self-fulfilling determination of whether or not a bank was solvent and worthy of support. The fact that the central bank has the alternative of saving a bank, but chooses not to is what defines the power of a lender of “last resort.” From the earlier post:

The term “lender of last resort” has its origins in Francis Baring’s Observations on the Establishment of the Bank of England and on the Paper Circulation of the Country published in 1797. He referred to the Bank of England as the “dernier resort” or court of last appeal. The analogy is clear: just as a convicted man has no recourse after the court of last appeal has made its decision, so a bank has no recourse if the central bank decides that it is not worthy of credit. In short, the very concept of a “lender of last resort” embodies the idea that it is the central bank’s job to determine which banks are sound and which banks are not — because liquidity is offered only to sound banks. And the central bank’s determination that a financial institution is insolvent has the same finality as a last court of appeal’s upholding of a lower court’s death sentence.

In short, for a partial reserve bank “solvency” is a state of affairs that exists only as long as the bank has access to central bank support. Solvency in the banking system does not exist separate and apart from the central bank – and this concept was fundamental to the 18th and 19th century understanding of banking in Britain [where the concept of lender of last resort was developed].

There is a long list of banks that were deliberately allowed by the Bank of England to fail in Britain, including the Ayr Bank in 1772, and Overend, Gurney, & Co. in 1866. The latter was, second to the Bank of England, the largest bank-like intermediary in England at the time, and its failure triggered a Lehman-like financial crisis — that was, however, followed by only a short, sharp recession of unexceptional depth. Bagehot made it very clear in Lombard Street that he did not believe that the Bank of England had mishandled Overend Gurney. He argued, on the contrary, that it was always a mistake to support a “bad bank.”

In short, just as it is in some cases the job of a court of last appeal to uphold the law in the form of a death sentence, so it is in some cases the job of a central bank to pronounce a death sentence on a bank in order to promote healthy incentives in financial markets. The fact that the bank would still be alive in the absence of the death sentence is as obvious and irrelevant in the case of the lender of last resort as it is in the case of the court of last appeal.

So let’s go back to the original question: What are the potential powers of the Fed? Can it in fact determine “which firms are solvent and which kinds of assets are really valuable as collateral” and expect markets to follow that determination? We have a partial answer to this question: from past experience we know that a central bank can choose not to support a bank in a crisis in which case it is almost certain the bank will fail, or that a central bank can choose to support a bank and with equal certainty carry it through a crisis of limited duration. We also know that sometimes a bank that was saved fails a few years or a decade after it was saved (e.g. City of Glasgow Bank). The British history also indicates that it is possible for a central bank to have a similar effect on assets (see here).

Thus, the fact that ex post the Fed did not lose money on any of the Maiden Lane conduits — or more generally on the bailout — is not evidence that the Fed exercised its lender of last resort role effectively. Instead this fact is simply testimony to powers of a central bank that have been recognized from the earliest days of central banking.

What we don’t know are the limits of a central bank’s ability to “create it own reality.” Can a central bank continue to support banks and assets for a prolonged period of time and still be successful in leading markets? At what point, if ever, does the central bank’s intervention stop being a brilliant act of successful alchemy, and end up looking like fraud?

What makes a lot of people in the financial industry nervous about the current state of central bank intervention (see for example here, here or here) is that they are not sure that the central banks will be able to exit their current policies without causing a crash in financial markets of the sort that none of us has ever seen before. Of course, we are sailing uncharted waters and literally nobody knows the answer. Let’s just hope that Janet Yellen and Mario Draghi are brilliant and creative helmsmen. (Should that be helmspeople?)

In summary, the term lender of “last resort” itself makes it clear that a fundamental aspect of a central bank’s duties is to refuse to support firms such as Lehman. Thus, in my view Conti-Brown, even though he gives a description of a lender of last resort that many modern scholars would agree with, envisions a lender of last resort that is very different from that of Bagehot and 19th century bankers. Whereas Conti-Brown appears to argue that, because the line between solvency and insolvency is so murky in a crisis, if a bank can be saved, it should be saved, Bagehot clearly understood that even though Overend Gurney could have been saved (ch X, ¶ 11), it was correct for the Bank of England to choose not to save it.

This very traditional view of the central bank, as the entity that determines which banks are managed in such a way that they have the right to continue operating, indicates that the Fed’s error in 2008 was not the decision to let Lehman fail, but the failure to prepare the market for that decision beforehand. The Bank of England announced its policy of not supporting bill-brokers such as Overend, Gurney & Co. in 1858, fully eight years before it allowed Overend to fail. This failure was followed by a full century of financial stability. The Federal Reserve, by contrast, never clearly stated what the limits of its lender of last resort policy would be in the decades preceding the 2007-08 crisis. Indeed, the Fed was busy through those decades expanding the expectations that financial institutions had of support from the Fed. Thus, the post-Lehman crisis was decades in the making, and was further aggravated by the inadequate warning signs provided to markets subsequent to the Bear Stearns bailout.

The definition of the proper role of the central bank is probably the most important economic question of our times. We are learning through real-time experimentation what are the consequences of extensive central bank support of the financial system — and whether financial stability is better promoted by a 19th century lender of last resort that very deliberately allows mismanaged banks to fail or by a 21st century lender of last resort that provides much more extensive support to the financial system.

Discount Markets, Liquidity, and Structural Reform

Bengt Holmstrom has a paper explaining the “diametrically opposite” foundations of money markets and capital markets.* This dichotomy is also a foundation of traditional banking theory, and of the traditional functional separation that was maintained in the U.S. and Britain between money and capital markets.

Holmstrom explains that “the purpose of money markets is to provide liquidity,” whereas price discovery is an important function of capital markets. In a paper I extend this view a step further: money markets don’t just provide liquidity but a special form of price stable liquidity that is founded on trade in safe short-term assets; by contrast capital markets provide market liquidity which promotes price discovery, not price stability.

A century ago in Britain privately issued money market assets were, like capital market assets, actively traded on secondary markets. The two types of assets traded, however, on completely different markets with completely different structures that reflected the fact that money market assets needed to be “safe.”

To understand why the markets had different structures consider this question: how does one ensure that the safety of the money market is not undermined by asymmetric information or more specifically by the possibility that when the owners of money market assets have information that the assets are likely to default they do not use the market to offload the assets, adversely affecting the safety of the market itself, and therefore its efficacy as a source of price stable liquidity? The answer is to structure the market as a discount market.

In a discount market, every seller offers a guarantee that the asset sold will pay in full. (You do this yourself when you endorse a check, signing its value over to a bank — while at the same time indemnifying the bank against the possibility that the check is returned unpaid.) This structure was one of the foundations upon which the safety of the London money market was built. The structure ensures that the owner of a dubious asset has no incentive to attempt to sell it, and in fact is very unlikely to sell it in order to hide from the public the fact that it is exposed to such assets.

From their earliest days it was well-understood that discount markets were designed to align the incentives of banks originating money market assets and to promote the safety of the assets on the money market. (See van der Wee in Cambridge Economic History of Europe 1977.) Any bank that originates or owns a money market asset can never eliminate its exposure to that asset until it is paid in full. For this reason a discount market is specifically designed to address problems of liquidity only. That is, a bank that is illiquid can get relief by selling its money market assets, but if it has originated so many bad assets that it is insolvent, the money market will do nothing to help.

Contrast the structure of a discount market with that of an open market. On an open market, the seller is able to eliminate its exposure to the risks of the asset. This has the effect of attracting sellers (and buyers) with asymmetric information and as a result both increasing the riskiness of the market and creating the incentives that make the prices of the risky assets that trade on open market informative. Thus, it is because price discovery is important to capital markets, that they are structured as open markets. Capital markets can only offer market liquidity — or liquidity with price discovery — rather than the price stable liquidity of the money market. On the other hand, an entity with asymmetric information about the assets that it holds can use the open market structure of capital markets to improve its solvency as well as its liquidity position.

Historically it appears that in order for a money market to have active secondary markets, it must be structured as a discount market. (Does anyone have counterexamples?) That is, it appears that when the only option for secondary trading of money market instruments is an open market, then secondary markets in such instruments will be moribund. This implies not only that the absence of incentives to exploit asymmetric information plays an important role in the liquidity available on money markets (cf. Holmstrom) — but also that price stable liquidity is an important benefit of the discount market structure.

Both discount markets and open markets can be adversely affected by extraordinary liquidity events. But only one of the two markets is premised on safe assets and price stable liquidity. Thus, the lender of last resort role of the central bank developed in Britain to support the money (discount) market only. (In fact, I would argue that the recognized need for a provider of liquidity support to the discount market explains why the Bank of England was structured as it was when it was founded, but that goes beyond the scope of this post. See Bowen, Bank of England during the Long 18th c.) One consequence of the fact that the central bank supported only assets that traded on a discount market is that it was able to support the liquidity of the banks, without also supporting their solvency.

Given the common claim that one hears today that it is unreasonable to ask a central bank to distinguish illiquidity from insolvency in a crisis, perhaps it is time to revisit the discount market as a useful market structure, since acting through such a market makes it easier for a central bank to provide liquidity support without providing solvency support.

 

*His focus is actually money markets and stock markets, but in my view he draws a distinction between debt and equity that is far less clear in practice than in theory. In a modern financial system unsecured long-term bonds are not meaningful claims on the assets of a firm, because as the firm approaches bankruptcy it is likely to take on more and more secured debt leaving a remnant of assets that is literally unknowable at the time that one buys an unsecured long-term bond.

New Monetarism and Narrow Banking: Take Two

The new monetarist framework makes it possible to draw a distinction between two types of liquidity: monetary liquidity and market liquidity. First, observe that market liquidity is the type of liquidity that is modeled in a competitive equilibrium framework. Or to be more precise, because models of competitive equilibrium are driven by market clearing which by assumption converts individual demand and supply into a price-based allocation, they give us information about the kind of liquidity that derives from the meeting of demand and supply. Not only do prices change in such market models, but it is an essential aspect of market liquidity that prices must change in response to fundamental changes in supply and demand.

Of course, money is not essential in competitive equilibrium models and the new monetarist framework grew out of the project of figuring out how to make money essential. The short version of the outcome of this project (discussed at somewhat greater length in my first post on New Monetarism and Narrow Banking) is that money is essential in models where agents buy and sell at different points in time.

As I have argued elsewhere, an implication of new monetarism is that the competitive equilibrium framework can be easily augmented to make money essential. All that is necessary is to divide each period into two sub periods and randomly assign (the continuum of) agents to “buy first, sell second” or to “sell first, buy second” with equal probability. (Note that the demand for micro-foundations meant that I was required to introduce the monetary friction in the form of assumptions regarding endowments and preferences — that as far I as am concerned simply muddy the model.)

An important advantage of introducing this simplest of monetary frictions into competitive equilibrium models is that all the implications that have ever been drawn from such models are still valid given one proviso: they must explicitly assume that the process of providing within period (or short-term) credit is perfect. In short, careful use of new monetarist methods can be used to illuminate the assumptions underlying the concepts of competitive equilibrium and market liquidity.

Monetary liquidity is then the process of addressing the within period frictions. It becomes immediately obvious in this framework that cash is an inadequate means of addressing the monetary friction, because an endogenous cash-in-advance constraint is generated. Any agent who is assigned to buy first and doesn’t hold enough cash will be liquidity constrained. In this framework, it is essential to have enforceable short-term debt contracts in order to eliminate the monetary friction and have perfect provision of monetary liquidity.

This last point is why narrow banking proposals are misguided. They misconceive of what is necessary to have perfect provision of monetary liquidity. Cash or sovereign/central bank solutions to the monetary problem generate a cash-in-advance constraint. Only a form of money that includes short-term debt can fully address the monetary friction.

A Counterproposal to “Shifts and Shocks”

Martin Wolf in Shifts and Shocks does a remarkable job of taking a comprehensive view of all the moving parts that have played a role in creating our current financial malaise and ongoing risks to financial stability. He also does a wonderful job of laying them out clearly for readers. Furthermore, I am entirely convinced by his diagnosis and prognoses of the Eurozone’s problems. When it comes to the question of the financial system more generally, however, even though I’m convinced that Wolf understands the symptoms, I don’t think he’s on target with either his diagnosis or his solutions. In fact, I think he too shows signs of being hampered by the problem of intellectual orthodoxy.

This post is therefore going to combine commentary on Shifts and Shocks with an introduction to my own views of how to understand the boondoggle that is the modern financial system. (I have nothing to say about the Eurozone’s grief except that you should read what Martin Wolf has to say about it.) For the long form of my views on the structural reform of the financial system, see here.

First, let me lay out the many things that Wolf gets right about the financial system.

  • The intellectual failures are accurately described:
    • orthodox economics failed to take into account the banking system’s role in creating credit, and thus failed to understand the instability that was building up in the system.
    • this has led to a dysfunctional and destabilizing relationship between the state and the private sector as suppliers of money
  • His basic conclusion is correct:
    • the system is designed to fail because banks finance long-term, risky and often illiquid assets with short-term, safe and highly liquid liabilities.
  • The inadequacy of the solutions currently being pursued is also made clear. Combining macro-prudential policy and “unlimited crisis intervention” with resolution authorities
    • just worsens the dysfunctional relationship between the state and the private sector
    • forces rulemaking that is designed to preserve a system that the regulators don’t trust and that is so complex it is “virtually inconceivable that it will work” (234)
  • His focus on the need for more government expenditure to support demand instead of attempts to induce the private sector to lever up yet again is correct.
  • The key takeaways from his conclusion are also entirely correct (349)
    • The insouciant position – that we should let the pre-crisis way of running the world economy and the financial system continue – is grotesquely dangerous.”
    • “leveraging up existing assets is just not a particularly valuable thing to do; it creates fragility, but little, if any, real new wealth.”

I think Wolf makes a mistaking in diagnosing the problem, however. One can view our current financial system as simply exhibiting the instability inherent in all modern economies (a la Minsky), or as exhibiting an unprecedented measure of instability even taking Minsky into account, or something in between. Wolf takes the hybrid position that while the basic sources of instability have been present in financial systems since time immemorial, “given contemporary information and communication technologies, modern financial innovations and globalization, the capacity of the system to generate complexity and fragility, surpasses anything seen historically, in its scope, scale and speed.” (321) This, I believe, is where the argument goes wrong.

To those familiar with financial history the complete collapse of a banking system is not a particularly unusual phenomenon. The banking system collapsed in Antwerp in the mid-15th century, in Venice in the late 16th century, in France in the early 18th century, and in Holland in the late 18th century. What is remarkable about 19th and 20th century banking is not its instability, but its lack of total collapse.

Indeed, the remarkable stability of the British banking system was founded in part on the analysis of the reasons behind 18th century financial instability on the continent. (There is no important British banking theorist who does not mention John Law and his misadventures in France.)  In particular, a basic principle of banking used to be that money market assets — and bank liabilities — should not finance long-term assets; capital markets should have the limited liquidity that derives from buyers and sellers meeting in a market. Thus, when Wolf finds that our modern system is “designed to fail” because money market assets are financing risky long-term assets, and that market liquidity is a dangerous illusion that breeds overconfidence and is sure to disappear when it is most needed (344), he is simply rediscovering centuries-old principles of what banks should not do.

By arguing that the structural flaws of modern finance are as common to the past as to the present, Wolf embraces the modern intellectual orthodoxy and sets up his radical solution: that our only option for structural reform that stabilizes banking is to take away from banks the ability to lend to the private sector and require that all debt be equity-financed. Thus, Wolf obfuscates the fact that the 19th and 20th century solution to banking instability was to limit the types of lending to the private sector that banks were allowed to engage in. Britain had a long run of success with such policies, as did the U.S. from the mid-1930s to the 1980s. (Recall that the S&Ls were set up in no small part to insulate the commercial banks from the dangers of mortgage lending — as a result the S&L crisis was expensive, but did not destabilize the commercial banks, and was compared to 2007-08 a minor crisis.) Thus, there is another option for structural reform — to stop viewing debt as a single aggregate and start analyzing which types of bank lending are extremely destabilizing and which are not.

The real flaw, however, in Wolf’s analysis is that he doesn’t have a model for why banking lending is important to the economy. Thus, when he acknowledges that it is possible that the benefits of “economic dynamism” due to banking exceed the massive risks that it creates (212-13), he doesn’t have a good explanation for what those benefits are. As a result, Wolf too is intellectually constrained by the poverty of modern banking theory.

19th c. bankers were far less confused about the benefits of banking. When everybody is willing to hold bank liabilities, banks have the ability to eliminate the liquidity constraints that prevent economic activity from taking place. The merchant who doesn’t have enough capital to buy at point A everything he can sell at point B, just needs a line of credit from the bank to optimize his business activities. This problem is ubiquitous and short-term lending by banks can solve it. Furthermore, because they solve it by expanding the money supply, and not by sourcing funds from long-term lenders, the amount of money available to borrow can easily expand. Of course, there are problems with business cycles and the fact that the incentives faced by banks need to be constantly monitored and maintained, but these are minor issues compared with the asset price bubbles that are created when banks get into long-term lending and that destabilized the financial system in 2007-08.

Overall, banks can do a lot to improve economic efficiency without getting into the business of long-term lending. And a recipe for financial stability should focus on making sure that long-term lending, not all bank lending, is funded by equity.