– Page 9 of 22 – Blog of the Young Scholars Initiative

Is the COVID-19 Crisis a “Mehrling’s Moment”?

Derivatives Market as the Achilles’ Heel of the Fed’s Interventions

By Elham Saeidinezhad | Some describe the global financial crisis as a “Minsky moment” when the inherent instability of credit was exposed for everyone to see. The COVID-19 turmoil, on the other hand, seems to be a “Mehrling moment” since his Money View provided us a unique framework to evaluate the Fed’s responses in action. Over the past couple of months, a new crisis, known as COVID-19, has grown up to become the most widespread shock after the 2008-09 global financial crisis. COVID-19 crisis has sparked historical reactions by the Fed. In essence, the Fed has become the creditor of the “first” resort in the financial market. These interventions evolved swiftly and encompassed several roles and tools of the Fed (Table 1). Thus, it is crucial to measure their effectiveness in stabilizing the financial market.

In most cases, economists assessed these actions by studying the change in size or composition of the Fed’s balance sheet or the extent and the kind of assets that the Fed is supporting. In a historic move, for instance, the Fed is backstopping commercial papers and municipal bonds directly. However, once we use the model of “Market-Based Credit,” proposed by Perry Mehrling, it becomes clear that these supports exclude an essential player in this system, which is derivative dealers. This exclusion might be the Achilles’ heel of the Fed’s responses to the COVID-19 crisis.

What system of central bank intervention would make sense if the COVID-19 crisis significantly crushed the market-based credit? This piece employs Perry Mehrling’s stylized model of the market-based credit system to think about this question. Table 1 classifies the Fed’s interventions based on the main actors in this model and their function. These players are investment banks, asset managers, money dealers, and derivative dealers. In this financial market, investment banks invest in capital market instruments, such as mortgage-backed securities (MBS) and other asset-backed securities (ABS). To hedge against the risks, they hold derivatives such as Interest Rate Swaps (IRS), Foreign exchange Swaps (FXS), and Credit Default Swaps (CDS). The basic idea of derivatives is to create an instrument that separates the sources of risk from the underlying assets to price (or even sell) them separately. Asset managers, which are the leading investors in this economy, hold these derivatives. Their goal is to achieve their desired risk exposure and return. From the balance sheet perspective, the investment bank is the mirror image of the asset manager in terms of both funding and risk.

This framework highlights the role of intermediaries to focus on liquidity risk. In this model, there are two different yet equally critical financial intermediaries—money dealers, such as money market mutual funds, and the derivative dealers. Money dealers provide dollar funding and set the price of liquidity in the money market. In other words, these dealers transfer the cash from the investors to finance the securities holdings of investment banks. The second intermediary is the derivative dealers. These market makers, in derivatives such as CDS, FXS, and IRS, transfer risk from the investment bank to the asset manager and set the price of risk in the process. They mobilize the risk capacity of asset managers’ capital to bear the risk in assets such as MBS.

After the COVID-19 crisis, the Fed has backstopped all these actors in the market-based credit system, except the derivative dealers (Table 1). The lack of Fed’s support for the derivatives market might be an immature decision. The modern market-based credit system is a collateralized system. To make this system work, there should be a robust mechanism for shifting both assets and the risks. The Fed has employed extensive measures to support the transfer of assets that is essential for the provision of funding liquidity. Financial participants use assets as collaterals to obtain funding liquidity by borrowing from the money dealers. During a financial crisis, however, this mechanism only works if a stable market for risk transfer accompanies it. It is the job of derivative dealers to use their balance sheets to transfer risk and make a market in derivatives. The problem is that fluctuations in the price of assets that derive the value of the derivatives expose them to the price risk.

During a crisis such as COVID-19 turmoil, the heightened price risks lead to the system-wide contraction of the credit. This occurs even if the Fed injects an unprecedented level of liquidity into the system. If the value of assets falls, the investors should make regular payments to the derivative dealers since most derivatives are mark-to-market. They make these payments using their money market deposit account or money market mutual fund (MMMFs). The derivative dealers then use this cash inflow to transfer money to the investment bank that is the ultimate holder of these instruments. In this process, the size of assets and liabilities of the global money dealer (or MMMFs) shrinks, which leads to a system-wide credit contraction.

As a result of the COVID-19 crisis, derivative dealers’ cash outflow is very likely to remain higher than their cash inflow. To manage their cash flow derivative dealers, derive the prices of the “insurance” up, and further reduce the price of capital or assets in the market. This process further worsens the initial problem of falling asset prices despite the Fed’s massive asset purchasing program. The critical point to emphasize here is that the mechanism through which the transfer of the collateral, and the provision of liquidity, happens only works if fluctuations in the value of assets are absorbed by the balance sheets of both money dealers and derivative dealers. Both dealers need continuous access to liquidity to finance their balance sheet operations.

Traditional lender of last resort is one response to these problems. In the aftermath of the COVID-19 crisis, the Fed has indeed backstopped the global money dealer, asset managers and supported continued lending to investment banking. Fed also became the dealer of last resort by supporting the asset prices and preventing the demand for additional collateral by MMMFs. However, the Fed has left derivative dealers and their liquidity needs behind. Importantly, two essential actions are missing from the Fed’s recent market interventions. First, the Fed has not provided any facility that could ease derivative dealers’ funding pressure when financing their liabilities. Second, the Fed has not done enough to prevent derivative dealers from demanding additional collaterals from asset managers and other investors, to protect their positions against the possible future losses.

The critical point is that in the market-based finance where the collateral secures funding, the market value of collateral plays a crucial role in financial stability. This market value has two components: the value of the asset and the price of underlying risks. The Fed has already embraced its dealer of last resort role partially to support the price of diverse assets such as asset-backed securities, commercial papers, and municipal. However, it has not offered any support yet for backstopping the price of derivatives. In other words, while the Fed has provided support for the cash markets, it overlooked the market liquidity in the derivatives market. The point of such intervention is not so much to eliminate the risk from the market. Instead, the goal is to prevent a liquidity spiral from destabilizing the price of assets and so, consequently, undermining their use as collateral in the market-based credit.

To sum up, shadow banking has three crucial foundations: market-based credit, global banking, and modern finance. The stability of these pillars depends on the price of collateral, price of Eurodollar, and price of derivatives, respectively. In the aftermath of the COVID-19 crisis, the Fed has backstopped the first two dimensions through tools such as the Primary Dealer Credit Facility, Term Asset-Backed Securities Loan Facility, and Central Bank Swap Lines. However, it has left the last foundation, which is the market for derivatives, unattended. According to Money View, this can be the Achilles’ heel of the Fed’s responses to the COVID-19 crisis.

Elham Saeidinezhad is lecturer in Economics at UCLA. Before joining the Economics Department at UCLA, she was a research economist in International Finance and Macroeconomics research group at Milken Institute, Santa Monica, where she investigated the post-crisis structural changes in the capital market as a result of macroprudential regulations. Before that, she was a postdoctoral fellow at INET, working closely with Prof. Perry Mehrling and studying his “Money View”. Elham obtained her Ph.D. from the University of Sheffield, UK, in empirical Macroeconomics in 2013. You may contact Elham via the Young Scholars Directory

Is our Monetary System as Systemic and International as Coronavirus?

By Elham Saeidinezhad | The coronavirus crisis has sparked different policy responses from different countries. The common thread among these reactions is that states are putting globalization on pause. Yet, re-establishment of central bank swap lines is making “money,” chiefly Eurodollars, the first element that has become more global in the wake of the Coronavirus outbreak. This is not an unexpected phenomenon for those of us who are armed with insights from the Perry Mehrling’s “Money View” framework. The fact that the monetary system is inherently international explains why the Fed reinstalled its standing U.S. dollar liquidity swap line arrangements with five other central banks just after it lowered its domestic federal fund’s target to zero percent. However, the crisis also forces us to see global dollar funding from a lens closer to home; the fact that the Eurodollar market, at its core, is a domestic macro-financial linkage. In other words, its breakdown is a source of systemic risk within communities as it disrupts the two-way connection between the real economy and the financial sector. This perspective clarifies the Fed’s reactions to the crisis in hand. It also helps us understand the recent debate in the economics profession about the future of central bank tools.

The Great Financial Crisis of 2008-09 confirmed the vital importance of advancing our understanding of macro-financial linkages. The Coronavirus crisis is testing this understanding on a global scale. Most of the literature highlights the impact of sharp fluctuations in long-term fundamentals such as asset prices and capital flows on the financial positions of firms and the economy. In doing so, economists underestimate the effects of disturbances in the Eurodollar market, which provides short-term dollar funding globally, on real economic activities such as trade. These miscalculations, which flow from economists’ natural approach to money as a veil over the real economy, could be costly. Foreign banks play a significant role in the wholesale Eurodollar market to raise US dollar financing for their clients. These clients, usually multinational corporations, are part of a global supply chain that covers different activities from receiving an order to producing the final goods and services. Depending on their financial positions, these firms either wish to hold large dollar balances or receive dollar–denominated loans. The deficit firms use the dollar funding to make payments for their purchases. The surplus firms, on the other hand, expect to receive payments in the dollar after selling their products. The interconnectedness between the payment system and global supply chains causes the Eurodollar market to act as a bridge between the real economy and the financial sector.

The Coronavirus outbreak is putting a strain on this link, both domestically and globally: it disrupts the supply chain and forces every firm along the chain to become a deficit agent in the process. The supply chain moves products or services from one supplier to another and is essentially the sum of all firms’ sales. These sales (revenues) are, in effect, a measure of payments, the majority of which occur in the Eurodollar market. A sharp shock to the sale, as a result of the outbreak, precipitates a lower ability to make payments. When an output is not being shipped, the producer of final goods in China does not have dollar funding to pay the suppliers of intermediate products. As a result, firms in other countries do not have a dollar either. The trauma that coronavirus crisis injects into manufacturing and other industries thus leads to missed payments internationally. Missed payments will make more firms become deficit agents. This includes banks, which are lower down in the hierarchy, and the central banks, which are responsible for relaxing the survival constraints for the banking system. By focusing on the payments system and Eurodollar market, we were able to see the “survival constraint” in action.

The question for monetary policy is how far the central bank decides to relax that survival constraint by lowering the bank rate. This is why central banks, including the Fed, are reducing interest rates to zero percent. However, the ability to relax the survival constraint for banks further down in the hierarchy depends also on the strength of foreign central banks to inject dollar funding into their financial system. The Fed has therefore re-established the dollar swap line with five other major central banks. The swap lines are available standing facilities and serve as a vital liquidity backstop to ease strains in global funding markets. The point to hold on to here is that the U.S. central bank is at a level in the hierarchy above other central banks

Central banks’ main concern is about missed payments of U.S. dollars, as they can deal with missed payments in local currency efficiently. In normal circumstances, the fact that non-U.S. central banks hold foreign exchange reserves enables them to intervene in the market seamlessly if private FX dealers are unable to do so. In these periods, customer-led demand causes some banks to have a natural surplus position (more dollar deposits than loans) and other banks to have an inherent deficit position (more dollar loans than deposits). FX dealers connect the deficit banks with the surplus banks by absorbing the imbalances into their balance sheets. Financial globalization has enabled each FX dealer to resolve the imbalance by doing business with some U.S. banks, but it seems more natural all around for them to do business with each other. During this crisis, however, even U.S. banks have started to feel the liquidity crunch due to the negative impacts of the outbreak on financial conditions. When U.S. banks pull back from market-making in the Eurodollar market, there will be a shortage of dollar funding globally. Traditionally, in these circumstances, foreign central banks assume the role of the lender of last resort to lend dollars to both banks and non-banks in their jurisdiction. However, the severity of the Coronavirus crisis is creating a growing risk that such intermediation will fracture. This is the case as speculators and investors alike have become uncertain of the size of foreign central banks’ dollar reserve holding.

To address these concerns, the Fed has re-established swap lines to lend dollars to other central banks, which then lend it to banks. The swap lines were originally designed to help the funding needs of banks during 2008. However, these swap lines might be inadequate to ease the tension in the market. The problem is that the geographic reach of the swap lines is too narrow. The Fed has swap lines only with the Bank of Canada, the Bank of England, the Bank of Japan, the European Central Bank and the Swiss National Bank. The reason is that the 2008-09 financial crisis affected banks in these particular jurisdictions severely. But the breadth of the current crisis is more extensive as every country along the supply chain is struggling to get dollars. In other words, the Fed’s dollar swap lines should become more global, and the international hierarchy needs to flatten.

To ease the pressure of missed payments internationally, and prevent the systemic risk outbreak domestically, the Fed and its five major central bank partners have coordinated action to enhance the provision of liquidity via the standing U.S. dollar liquidity swap line arrangements. These tools help to mitigate the effects of strains on the supply chain, both domestically and abroad. Such temporary agreements have been part of central banks’ set of monetary policy instruments for decades. The main lessons from the Coronavirus outbreak for central bank watchers is that swap lines and central bank collaborations, are here to stay — indeed, they should become more expansive than before. These operations are becoming a permanent tool of monetary policy as financial stability becomes a more natural mandate of the central banks. As Zoltan Pozsar has recently shown, the supply chain of goods and services is the reverse of the dollar funding payment system. Central banks’ collaboration prevents this hybridity from becoming a source of systemic risk, both domestically and internationally.

This piece was originally part of “Special Edition Roundtable: Money in the Time of Coronavirus” by JustMoney.org platform.

Can Trade in Services Deliver for Developing Nations?

Industrialization was long considered the path to economic development. But as the global south stands to lose its competitive edge to increasing levels of automation in the global north, this trajectory is no longer obvious. Some developing countries have leveraged the digital age to offer low-cost services, rather than manufacturing. Is that a promising strategy?

By Jack Gao | For the vast majority of countries, growing rich meant learning to make things. In the 19th century, Britain produced half of the world’s cotton cloth; manufacturing sector in America was a quarter of its gross domestic product 50 years ago; Japan’s post-war economic miracle ushered in a generation of powerful keiretsu from Mitsui to Mitsubishi; China, currently the largest manufacturer in the world, perfected the tactic by moving hundreds of millions from farmland into factories. In short, development equaled industrialization.

And for good reasons. The manufacturing sector boasts unique properties—scale, trade-ability, existing technology, and employment intensity—that makes it stand out as the coveted national development strategy for low-income countries. India, Vietnam and much of Africa have all tried to emulate the rise of Chinese industrialization and hop on the escalator to achieve economic development, with varying degrees of success.

When the latest digital revolution brought in automation and industrial robots, many feared that the path to prosperity for developing countries might be short-circuited. Machines that produce goods more cheaply and efficiently in rich economies might make trading with poorer countries unnecessary. McKinsey Global Institute sees the forces of automation particularly impacting lower-income countries; Harvard economist Dani Rodrik uses the term “premature deindustrialization” to describe ever earlier and lower peaks of industrial output and employment shares already observed in many countries. As automation erodes the cost-advantage of developing economies, the prospect to grow one’s way out of poverty through industrialization has become bleak.

Some scholars, however, don’t think things will turn out so badly for the developing world. In a new paper, Richard Baldwin from the Graduate Institute in Geneva and Rikard Forslid from Stockholm University argue that trade in services presents ample opportunities for poor countries to catch up even if manufacturing were to become jobless. The dramatic fall in the trade costs for services brought forth by the latest technologies, coupled with vast wage differences between rich and poor countries, will make a wide range of previously localized services tradable across national borders and could turn out to work to the advantage of low-income countries. Think call centers, data analysis, and medical billing.

The authors back their sanguine prediction by the experiences of two large developing counties—India and the Philippines. After modest success in the attempt to modernize its manufacturing industry, India embarked on the service route partly through the liberalization of investment restrictions in the 1980s. Research and development departments of multinational companies, call centers, as well as other business administration services flooded into India to take advantage of the low-cost but skilled labor force. Kaushik Basu’s explanation that India’s overproduction of engineers throughout the decades matched Silicon Valley’s demand for tech workers is an illustration of how services were exchanged between India and the US. The Philippines has developed a similarly booming service sector since 2000, becoming a preferred destination for IT-based business process outsourcing from global banks and tech companies. Experience from both countries highlighted the rise of trade in services made possible by computerization and the internet, while an educated workforce with specialized skills, including English-language communication, captured the opportunity where services became geographically unbundled.

The prediction made by the authors, if true, is certainly good news for low-income countries facing the dual challenges of a digital revolution and a reduced appetite for global trade in goods. Technological advancement is only poised to continue and render more services potentially tradable, given trends in “telemigration” (online service workers employed by foreign-based companies) and “telecommuting” (the use of collaborative online platforms for business meetings).

However, there’re reasons to be skeptical. The current share of global trade in services is still far smaller than that of trade in goods, and developing countries as a whole remain net importers of services from developed countries. Perhaps more importantly, while countries such as the Philippines, India, and Bangladesh have participated in global trade in services, it is not clear that other developing economies are as well-positioned to partake in this trend, especially given the woefully low level of human capital widely observed today.

Economic development has always been a challenging task and the challenge evolves as circumstances change. Countries will do well by focusing on improving binding constraints at home while keeping an open eye on new opportunities presented by a changing global economy, but many questions remain.

Jack Gao is a Program Economist at the Institute for New Economic Thinking. He is interested in international economics and finance, energy policy, economic development, and the Chinese economy. He previously worked in financial product and data departments in Bloomberg Singapore, and reported on Asian financial markets in Bloomberg News from Shanghai. Jack holds a MPA in International Development from Harvard Kennedy School, and a B.S. in Economics from Singapore Management University. He has published articles on China Policy Review and Harvard Kennedy School Review.

Is “Tokenisation” Our Apparatus Towards a Dealer Free Financial Market?

By Elham Saeidinezhad | The death of the Jimmy Stewart style “traditional banking system” was accelerated by the birth of securitization in the financial market. Securitization made the underlying assets, such as mortgage loans, “tradable” or “liquid.” Most recently, however, a new trend, called “tokenization,” i.e., the conversion of securities into digital tokens, is emerging that is decidedly different from the earlier development. While securitization created a dealer centric system of market-based credit that raise funds from investors, tokenization is a step towards building a “dealer free” world that reduces fees for investors. In this world, dealers’ liquidity provision is replaced by “smart” or “self-executing” contracts, protocols, or code that self-execute when certain conditions are met. The absence of dealers in this structure is not consequential in standard times. When markets are stable, people assume the mechanical convertibility of the tokenized asset into its underlying securities. However, the financial crisis threatens this confidence in the convertibility principle and could lead to massive settlement failures. These systemic failures evaporate liquidity and create extensive adjustments in asset prices. Such an outcome will be responded by policymakers who try to limit these adverse feedback loops. But the critical question that is remained to be answered is the central banks will save whom and which not very smart contract.

New technologies created money and assets. For centuries, these assets, mostly short-term commercial papers, were without liquidity and relied upon the process of “self-liquidation.” However, the modern financial market, governed by the American doctrine, improved this outdated practice and relied on “shiftability” or “market liquidity” instead. Shiftability (or salability) of long-term financial securities ensured that these assets could be used to meet cash flow requirements, or survival constraints, before their maturity dates. The primary providers of liquidity in this market are security dealers who use their balance sheets to absorb trade imbalances. The triumph of shiftability view, because of depression and war, has given birth to the “asset-backed securities” and securitization. This process can encompass any financial asset and promotes liquidity in the marketplace.

ABS market continues to evolve into new securitization deals and more innovative offerings in the future. Tokenization is the next quantum leap in asset-based securitization. Tokenization refers to the process of issuing a blockchain token that digitally represents a real tradable asset such as security. This process, in many ways, is like the traditional securitization with a twist. The “self-executing” feature of these contracts discount the role of dealers and enable these assets to be traded in secondary markets by automatically matching buyers with sellers. The idea is that eliminating dealers will increase “efficiency” and reduce trading costs.

The issue is that digital tokens may be convertible to securities, in the sense that the issuer of digital tokens holds some securities on hand, but that does not mean that these tokenized assets represent securities or are at the same hierarchical level as them. When an asset (such as a digital token) is backed by another asset (such as security), it is still a promise to pay. The credibility of these promises is an issue here, just as in the case of other credit instruments, and the liquidity of the tokenized instruments can help to enhance credibility. In modern market-based finance, which is a byproduct of securitization, the state of liquidity depends on the security dealers who take the imbalances into their balance sheets and provide market liquidity.

The only constant in this evolving system is the natural hierarchy of money. Tokenization disregards this inherent feature of finance and aims at moving towards a dealer free world. A key motivation is to create a “super asset” by lowering the estimated $17–24 billion spent annually on trade processing. The problem is that by considering dealers as “frictions” in the financial market, tokenization is creating a super asset with no liquidity during the financial crisis. Such shiftability ultimately depends on security dealers and other speculators who are willing to buy assets that traders are willing to sell and vice versa and use their balance sheets when no one else in the market does. Tokenization could jeopardize the state of liquidity in the system by bypassing the dealers in the name of increasing efficiency.

Meet Gonçalo Fonseca, creator of the history of economic thought website

Every so often, we highlight one of the senior scholars that has supported the Young Scholars Initiative as a mentor. We share their perspective on the discipline, their past experiences as a young scholar and their thoughts on New Economic Thinking. This time, we talk to Gonçalo Fonseca, Research Fellow at INET and creator of the ever-expanding History of Economic Thought Website. His research is on the intersection of the history of economic thought and economic theory.

Were you always interested in economics, even at a young age?

Not really; I did read a lot as a kid, but not necessarily economics. I grew up in Zambia, where people hardly had anything. But then at 18, I moved to New York, to attend the New School. I actually started off as an Africanist, doing African studies; mostly politics, history. There actually wasn’t much economics offered at the undergraduate level, but one way or another, African studies inevitably leads to questions of development. So when Gunseli Berik allowed me to sit in on her graduate-level economic development class, it blew my mind; she opened the door, and from then on, I was in. I delved deeper into economics, Alice Amsden and Tom Palley being perhaps the strongest influences among many great professors I have had. I continued my graduate studies at Johns Hopkins, studying under M. Ali Khan, then returned to the New School to finish my Ph.D. with Duncan Foley.

Was it tough being a young scholar?

In the early days, I did experience a lot of the same challenges that young scholars today express; economics is a restrictive discipline, and I felt that too. Young people tend to be very anxious, particularly about choices that might affect their careers. They tend to see their futures too narrowly, thinking that there is only one path, or that they have to do things one way, or everything will go wrong. But I managed to do my own thing. I ended up giving myself a lot of leeway; perhaps more so than other people. I let myself chase shiny objects; I let myself pursue my interests. Partly because nobody told me what the path was, or was supposed to be! So I just did what made sense to me. I allowed myself to get immersed in things. And I developed myself broadly by combining my New School education, where the teaching was more unconventional, with my training at Johns Hopkins.

What is your advice to young scholars?

Chase the shiny objects! By which I mean pursue things that really interest you, or that really irritate you, that you’re really furious about, or dissatisfied with. Really pursue them, so that they can become yours. As strange as it sounds, if you can find one small thing that’s really yours, you will always be the reference for it. Don’t be the nth person working on a generic problem. Be the point person working on the thing that really interests you, and become the expert in that. Economics may seem unforgiving, but it’s not. There is leeway! Even in conventional departments. It’s valued when someone is really knowledgeable about something that they care about. It takes a little courage to get there. But it’s worthwhile.

My experience with students is that they are very curious and engaged with the world. And it takes years to beat that out of them. So the key is to retain that curiosity and to follow it. Don’t let publications be the only metric that matters to you. Don’t make the publication the goal. Make the goal that you contribute to the field.

But don’t get mistaken. It’s chasing shiny objects, and it’s fun, but it’s hard work. I’m really trying to understand something. What people are trying to say. How they fit with others. All that is work; lots of not sleeping, and pain. It’s like building anything else.

A lot of it is going to corners you didn’t expect to. Topics you didn’t think you were interested in. Stuff you didn’t imagine you cared about. Realizing hold on, there’s something here. And poking at it, and then getting lost, overwhelmed, start bringing your own narrative on it; you make it yours. And there’s really something to learn from everyone.

As a general strategy, in order to understand something, you have to be able to explain in plain English. To reach that, you really have to go deep and try to get a perspective and understand how it fits in its context. It’s work, but it’s very pleasurable. Once you get a grip on it, you get the “ah..” But before that, you may be frustrated. I’ve made myself learn obscure math just to be able to understand something, in order to understand something related to that. And once you have it, you’ve made it yours. It’s an armament.

Your point touches on the importance of being able to explain something to others, on teaching!

Yes, I’ve been teaching economics as long as I’ve been learning economics. Once you’re teaching something, you can start to really understand it. Already in undergrad, we’d organize with classmates to teach each other. Then we TA’d, and taught entire courses. At that point, it is harder to cut corners. You can, but you’re not doing yourself any favors. Especially once you start teaching people who don’t have a background in the subject, it forces you to think about it systematically. And the more you work on that, the more it becomes yours. This is why teaching is vital.

And it doesn’t even matter what the topic is. I have taught everything from econometrics to philosophy, and every time, I am happy, because I get to learn something; there’s something to learn from everything.

Who is the best teacher you’ve ever had?

Ali Khan, at Johns Hopkins. He taught mathematical economics, which is something people can easily get lost in. And he was very systematic. So I took a lot of tips from how he teaches. And what I always keep in mind is that my students are not there for me; I’m there for them. A lot of them have made sacrifices to be able to study, and they deserve the best. You can make a big difference if you manage to inspire those who are taking their first economics course. Even if they do not end up being economists, their understanding of the economy, civically, is very important. Similarly, I love being a mentor to young scholars in YSI.

How did the History of Economic Thought Website come to be?

It was actually a favor…! Heilbroner was teaching a course at the New School, while I was at Johns Hopkins. He was assigning a lot of reading, much of which was actually available online; it was just that nobody had put anything together. These were the early days of the web.. 1997. So one of his students, who was a friend of mine, asked me if I could gather these readings in one place online. She knew nothing about coding and I didn’t either. But she asked me if I could figure it out, and I did! And then it grew. From excitement, and because once you’ve covered this person, you know you should also cover that person, and then you just keep going. It became a lot bigger than I thought.

It was pre-Wikipedia, so it was a new thing to let one piece link to another and then another. Which is fantastic, because it means things don’t have to be linear like a book. The purpose is for it to be non-linear, so that you can roam, see what thoughts connect with what theories, what mentors connect with what students, what approaches there are between various groups.

What makes the History of Economic Thought such a powerful field, for you?

Many reasons. For one, it’s beautiful. But more importantly, it really helps you understand the theory. It can help you understand why a theory developed one way or another. It can allow you to see things more clearly, and help you understand the reasons why it’s structured the way that is. Because economics is not leveled or settled. And it’s not just models! At the end of the day, economics is constructed by people. It’s driven by people, and the questions they have. Their interests, the relationships they have, whether those are relationships of mentorship or rivalry.

Sometimes, the math in economics obscures this. But math in economics is like the notes on the page for music. Music is what you hear from a violin. The notes on the page are not the music. So some people condemn mathematics. And they shouldn’t. You can’t get mad at the mathematics in economics, just like you can’t be mad at sheet music. You can only be mad at whether the tune sounds good or not. By studying the History of Economic Thought, you get to see the full picture. You hear the full tune; and then you can decide for yourself.

Take a look at Gonçalo’s History of Economic Thought website! If there is another new economic thinker that you’d like to see featured here, let us know! Share your thoughts in the comments below, or email us at contact@economicquestions.org

Promises All the Way Down: A Primer on the Money View

By Elham Saeidinezhad | It has long been tempting for economists to imagine “the economy” as a giant machine for producing and distributing “value.” Finance, on this view, is just the part of the device that takes the output that is not consumed by end-users (the “savings”) and redirects it back to the productive parts of the machine (as “investment”). Our financial system is an ornate series of mechanisms to collect the value we’ve saved up and invest it into producing yet more value. Financial products of all sorts—including money itself—are just the form that value takes when it is in the transition from savings to investment. What matters is the “real” economy—where the money is the veil, and the things of value are produced and distributed.

What if this were exactly backwards? What if money and finance were understood not as the residuum of past economic activity—as a thing among other things—but rather as the way humans manage ongoing relationships between each other in a world of fundamental uncertainty? These are the sorts of questions asked by the economist Perry Mehrling (and Hyman Minsky before him). These inquiries provided a framework that has allowed him to answer many of the issues that mystify neoclassical economics.

On Mehrling’s “Money View,” every (natural or artificial) person engaged in economic activity is understood in terms of her financial position, that is, in terms of the obligations she owes others (her “liabilities”) and the obligations owed to her (her “assets”). In modern economies, obligations primarily take the form of money and credit instruments. Every actor must manage the inflow and outflow of obligations (called “cash flow management”) such that she can settle up with others when her obligations to them come due. If she can, she is a “going concern” that continues to operate normally. If she cannot, she must scramble to avoid some form of financial failure—bankruptcy being the most common. After all, as Mehrling argues, “liquidity kills you quick.” This “survival constraint” binds not only today but also at every moment in the future. Thus, generally, the problem of satisfying the survival constraint is a problem of matching up the time pattern of assets (obligations owed to an actor) with the time pattern of liabilities (obligations an actor owed to others). The central question is whether, at any moment in time, there is enough cash inflow to pay for the cash flows.

For the Money View, these cash flows are at the heart of the financial market. In other words, the financial system is essentially a payment system that enables the transfer of value to happen even when a debtor does not own the means of payment today. Payment takes place in two stages. When one actor promises something for another, the initial payment takes place—the thing promised is the former’s liability and the latter’s asset. When the promise is kept, the transaction is settled (or funded), and the original asset and liability are canceled.

The Hierarchy of Debt-Money

What makes finance somewhat confusing is that all the promises in question are promises to pay, which means that both the payment and the settlement process involve the transfer of financial assets. To learn when an asset is functioning as a means of payment and when it is operating as a form of settlement requires understanding that, as Mehrling has argued, “always and everywhere, monetary systems are hierarchical.” If a financial instrument is higher up the hierarchy than another, the former can be used to settle a transaction in the latter. At the top of the hierarchy is the final means of settlement—an asset that everybody within a given financial system will accept. The conventional term for this type of asset is “money.” In the modern world, money takes the form of central bank reserves—i.e., obligations issued by a state. The international monetary system dictates the same hierarchy for different state currencies, with the dollar as the top of this pyramid. What controls this hierarchy in financial instruments and differentiates money (means of final settlement) from credit (a promise to pay, a means of delaying final settlement), is their degree of “liquidness” and their closeness to the most stable money: the U.S. central bank reserves.

Instruments such as bank deposits are more money-like compared to the others since they are promises to pay currency on demand. Securities, on the other hand, are promises to pay currency over some time horizon in the future, so they are even more attenuated promises to pay. Mehrling argues that the payments system hides this hierarchy by enabling the firms to use credit today to postpone the final settlement into the future.

The Money View vs. Quantity and Portfolio Theories

Viewing the world from this perspective allows us to see details about financial markets and beyond, that the lens of neoclassical economics does not. For instance, the lack of attention to payment systems in standard monetary theories is a byproduct of overlooking the essential hierarchy of finance. Models such as Quantity Theory of Money that explore the equilibrium amount of money in the system systematically disregards the level of reserves that are required for the payment system to continuously “convert” bank deposits (which are at the lower layer of the hierarchy) into currency on demand.

Further, unlike the Money View, the Portfolio Choice Theory (such as that developed by James Tobin), which is at the heart of asset pricing models, entirely abstracts from the role of dealers in supplying market liquidity. These models assume an invisible hand that provides market liquidity for free in the capital market. From the lens of supply and demand, this is a logical conclusion. Since a supplier can always find a buyer who is willing to buy that security at a market price, there is no job for an intermediary dealer to arrange this transaction. The Money View, on the other hand, identifies the dealers’ function as the suppliers of market liquidity—the clearinghouse through which debts and credits flow—which makes them the primary determinant of asset prices.

The Search for Stable Money

The Money View’s picture of conventional monetary policy operations is very distinct from an image that a trained monetary economist has in mind. From the Money View’s perspective, throughout the credit cycle, one constant is the central bank’s job to balance elasticity and discipline in the monetary system as a way of controlling the flow of credit. What shapes the dynamic of elasticity and discipline in the financial system is the daily imbalances in payment flows and the need of every agent in the system to meet a “survival” or “reserve constraint.”

In normal times, if a central bank, such as the Fed, wants to tighten, it raises the federal fund target. Raising the cost of the most liquid form of money in the system will then resonate down the monetary hierarchy. It immediately lowers the profitability of money market dealers (unless the term interest rate rises by the full amount). Because money market dealers set the funding cost for dealers in capital markets (i.e. because they are a level up in the hierarchy of money), capital market dealers will face pressure to raise asset prices and long-term interest rates. These security dealers are willing to hold existing security inventories only at a lower price, hence higher expected profit. Thus the centrally determined price of money changes the value of stocks.

Central Bankers as Shadow Bankers

The Money View’s can also help us see how the essence of credit has shifted from credit that runs through regulated banks to “market-based credit” through a shadow banking system that provides money market funding for capital market investing. Shadow banking system faces the same problems of liquidity and solvency risk that the traditional banking system faces, but without the government backstops at the top of the hierarchy (via Fed lender of last resort payouts and FDIC deposit insurance). Instead, the shadow banking system relies mainly on dealers in derivatives and in wholesale lending. Having taken on responsibility for financing the shadow banks, which financed the subprime mortgage market, these dealers began to run into problems during the financial crisis. Mehrling argues that the reality of the financial system dictates Fed to reimagine its role from a lender last resort to banks to the dealer of last resort to the shadow banking system.

Conclusion

We have been living in the Money View world, a world where almost everything that matters happens in the present. Ours is a world in which cash inflows must be adequate to meet cash outflows (the survival or liquidity constraint) for a single day. This is a period that is too short for creating any elasticity or discipline in production or consumption, the usual subject matter of economics, so we have abstracted from them. Doing so has blinded us to many important aspects of the system we live in. In our world, “the present determines the present.”

This post is originally part of a symposium on the Methods of Political Economy in Law and Political Economy Blog.

Is Money View Ready to Be on Trial for its Assumptions about the Payment System?

A Review of Perry Mehrling’s Paper on the Law of Reflux

By Elham Saeidinezhad | Perry Mehrling’s new paper, “Payment vs. Funding: The Law of Reflux for Today,” is a seminal contribution to the “Money View” literature. This approach, which is put forward by Mehrling himself, highlights the importance of today’s cash flow for the survival of financial participants. Using Money View, this paper examines the implications of Fullarton’s 1844 “Law of Reflux” for today’s monetary system. Mehrling uses balance sheets to show that at the heart of the discrepancy between John Maynard Keynes’ and James Tobin’s view of money creation is their attention to two separate equilibrium conditions. The former focuses on the economy when the initial payment takes place while the latter is concerned about the adjustments in the interest rates and asset prices when the funding is finalized. To provide such insights into several controversies about the limits of money finance, Mehrling’s analysis relies deeply on one of the structural premises of the Money View; the notion that the payment system that enables the cash flow to transfer from a deficit agent to the surplus agent is essentially a credit system. However, when we investigate the future that the Money View faces, this sentiment is likely to be threatened by a few factors that are revolutionizing financial markets. These elements include but are not limited to the Fed’s Tapering and post-crisis financial regulations and constrain banks’ ability to expand credit. These restrictions force the payment system to rely less on credit and more on reserves. Hence, the future of Money View will hinge on its ability to function under new circumstances where the payment system is no longer a credit system. This puzzle should be investigated by those of us who consider ourselves as students of this View.

Mehrling, in his influential paper, puts on his historical and monetary hats to clarify a long-standing debate amongst Keynesian economists on the money creation process. In understanding the effect of money on the economy, “old” Keynesians’ primary focus has been on the market interest rate and asset prices when the initial payment is taking place. In other words, their chief concern is how asset prices change to make the new payment position an equilibrium. To answer this question, they use the “liquidity preference framework” and argue that asset prices are set as a markup over the money rate of interest. The idea is that once the new purchasing power is created, the final funding can happen without changing asset prices or interest rates. The reason is that the initial increase in the money supply remains entirely in circulation by creating a new demand for liquid balances for various reasons. Put it differently, although the new money will not disappear on the final settlement date, the excess supply of money will be eliminated by the growing demand for money. In this situation, there is no reflux of the new purchasing power.

In contrast, the new Keynesian orthodoxy, established by James Tobin, examines the effects of money creation on the economy by focusing on the final position rather than the initial payment. At this equilibrium, the interest rate and asset prices will be adjusted to ensure the final settlement, otherwise known as funding. In the process, they create discipline in the monetary system. Using “Liquidity Preference Framework”, these economists argue that the new purchasing power will be used to purchase long-term securities such as bonds. In other words, the newly created money will be absorbed by portfolio rebalancing which leads to a new portfolio equilibrium. In this new equilibrium, the interbank credit will be replaced by a long-term asset and the initial payment is funded by new long-term lending, all outside the traditional banking system. Tobin’s version of Keynesianism extracted from both the flux of bank credit expansion and the reflux of subsequent contraction by only focusing on the final funding equilibrium. It also shifts between one funding equilibrium and another since he is only interested in final positions. In the new view, bank checkable deposits are just one funding liability, among others, and their survival in the monetary system entirely depends on the portfolio preferences of asset managers.

The problem is that both views abstract from the cash flows that enable a continuous payment system. These cash flows are key to a successful transition from one equilibrium to another. Money View labels these cash flows as “liquidity” and puts it at the center of its analysis. Liquidity enables the economy to seamlessly transfer from initial equilibrium, when the payment takes place, to the final equilibrium, when the final funding happens, by ensuring the continuity of the payment system. In the initial equilibrium, payment takes place since banks expand their balance sheets and create new money. In this case, the deficit bank can borrow from the surplus bank in the interbank lending market. To clear the final settlement, the banks can take advantage of their access to the central bank’s balance sheet if they still have short positions in reserve. Mehrling uses these balance sheets operations to show that it is credit, rather than currency or reserves, that creates a continuous payment system. In other words, a credit-based payment system lets the financial transactions go through even when the buyers do not have means of payment today. These transactions, that depend on agents’ access to liquidity, move the economy from the initial equilibrium to the ultimate funding equilibrium.

The notion that the “payment system is a credit system” is a defining characteristic of Money View. However, a few developments in the financial market, generated by post-crisis interventions, are threatening the robustness of this critical assumption. The issue is that the Fed’s Tapering operations have reduced the level of reserves in the banking system. In the meantime, post-crisis financial regulations have produced a balance sheet constrained for the banking system, including surplus banks. These macroprudential requirements demand banks to keep a certain level of High-Quality Liquid Assets (HQLA) such as reserves. At the same time, the Global Financial Crisis has only worsened the stigma attached to using the discount loan. Banks have therefore become reluctant to borrow from the Fed to avoid sending wrong signals to the regulators regarding their liquidity status. These factors constrained banks’ ability to expand their balance sheets to make new loans to the deficit agents by making this activity more expensive. As a result, banks, who are the main providers of the payment system, have been relying less on credit and more on reserves to finance this financial service.

Most recently, Zoltan Pozsar, a prominent scholar of the Money View, has warned us that if these trends continue, the payment system will not be a credit system anymore. Those of us who study Money View realize that the assumption that a payment system is a credit system is the cornerstone of the Money View approach. Yet, the current developments in the financial ecosystem are fundamentally remodeling the very microstructure that has initially given birth to this conjecture. It is our job, therefore, as Money View scholars, to prepare this framework for a future that is going to put its premises on trial.

Building an Online Platform for a Global Community

The YSI website is one of a kind. Literally, because it’s being built from scratch by a small company in Copenhagen. Entropy Fox spends the majority of their time building on the online platform that supports our community. Every few weeks or months, the team will deploy an update to the site, sometimes changing a lot in the front-end, making it look better, sometimes changing a lot in the back-end, making it work better. Here’s a peak behind the scenes to show the work process, and a way for you to get more involved:

So how is it decided what gets built?

Determining what features get built is an exercise of impact vs time-required. When discussing new features, the YSI team assigns an impact score between 1 and 10. A feature with an impact score of 9 would be expected to serve as a big improvement to the community. But given the resource constraints we face, it is also important to take into account how much developer-hours a given feature requires. So aside from the impact score, a time-estimate is computed. Naturally, the features with the highest impact-to-time ratio represents the biggest bang for the buck. Those are the ones to put on the top of the list.

And what does ‘building’ look like?

Often times, the first step is a conversation in the INET office, where the YSI team will try to reach agreement on what a feature should do exactly. Recently, the “need to browse all upcoming projects in one place” turned into the need for a “Project Directory,” where users would be able to look through projects, searching by keyword, project type, date, location, and working group. Once there’s some level of clarity around the idea, the team will produce a visual mock-up of what they envision the feature to look like; essentially, a pdf file that shows what the website would look like if this feature were implemented.

That pdf goes to Entropy Fox, who will comment on the feasibility of the specific request, and may suggest modifications to enhance the efficiency of the build, and the experience of the user. With those modifications agreed upon, they turn to their code, and create first iterations of the feature on a parallel test site. YSI’s test site looks just like the real one, but is distinct in that its okay to make mistakes there, because there are no real users who could get hurt. That means it’s a good way to see the feature in action, and learn what needs improvement before bringing it out to the world. Once things look good on the test site, the same thing is deployed to the real one, and tada, the update is done!

I’m a user! How can I get involved?

If you’re a member of the YSI community, the YSI platform is being built to help you. It’s being created to help you connect to peers, do the research you want to do, and transform the discourse in economics. If you have ideas for new features, or would like to be involved in testing new features, let us know by filling the form below. This way, we can get in touch with you to hear about your ideas, or let you know when we could use your help to test the latest build. We are excited to hear from you!

Click here to supply ideas and help with testing!