Credit Archives

Minsky is more than a moment

After the Great Financial Crisis, Minsky rose to fame. But few people grasp the breadth and depth of his work beyond the “Minsky Moment”. If that’s you, Daniel Neilson’s recent book is a worthy read. By Ayoze Alfageme.

A decade after the Great Financial Crisis, Minsky presents a meticulous reconstruction of Hyman Minsky‘s lifework that goes well beyond the mere explanation of financial bubble bursts. Indeed, Neilson devotes only a few pages to what Minsky is best known for—his Financial Instability Hypothesis. The reason is not for its lack of relevance within Minsky’s theory, but because the author places it as one piece of an overall financial theory of capitalism that he painstakingly elaborates in a mere 150 pages. Presenting Minsky’s ideas in a comprehensive and exhaustive way is not an easy task, given that he worked out his thinking by sketching his theory piecemeal in various places as he witnessed history pass by. Thus, the author elaborates three different threads through which he deconstructs Minsky’s work into elements to be then reconstructed and presented as a thorough vision of capitalism.

A financial theory of capitalism

The first thread comprises four out of eight chapters of the book and deals with Minsky’s financial theory. In modern societies, a matrix of balance sheets connects all agents via debt and credit commitments—assets and liabilities—that have arisen from past payment decisions. Minsky shows that payment structure, intrinsic to capitalist societies, is prone to recurrent crises due to the imperative requirement to repay debts. This requirement, or ‘survival constraint’ as Minsky termed it, forces everyone to generate greater monetary inflows than outflows. When debts come due, debtors search for a liquid position that allows them to redeem their debts using money or, as Minsky said, whatever the lender will accept to write off the debt. Position making is the action through which assets and/or liabilities are sold if a unit is illiquid and in need of cash. The famous hedge, speculative, and Ponzi positions are nothing more than a form of position making—a search for liquidity. A crisis might be triggered by the effect upon other units of a unit’s inability to pay i.e. to find liquidity. A widespread financial crisis unfolds when the market for position making for liquidity comes to a halt. At this point, the role of the central bank is to step in as a lender of last resort—the market maker of last resort—that can blow liquidity into the system as its only initiative.

The making of a maverick economist

The second thread, interwoven with the first, narrates Minsky’s path to becoming the economist he was. For example, we learn from Henry Simons, his professor in Chicago, how Minsky adopted a practical outlook view of Simon’s view on the requirement to pay debts and how he added the theoretical and institutional issues of liquidity to Schumpeter and Keynes’ monetary theory of production. In Neilson’s account, liquidity is at the core of Minsky’s financial theory. Minsky’s considerations about liquidity, uncertainty, and time, stand as the main divergences between his approach and that of the mainstream.

The third and final thread of the book deals with the position Minsky took towards the rest of the economist profession, disentangling the contradictions between the two. In need of a new language through which he could express the knowledge he wanted to convey, Minsky found himself at the margins of the profession and in conscious opposition to the mainstream. Interestingly, the book also reveals how even interpretations by those who, as post-Keynesians of different strands claiming to Minsky’s insights, sometimes fail to understand his core contributions.

Throughout the book, Neilson successfully presents Minsky’s theory and policy and the intellectual challenges he faced during his career as an economist. The book also encompasses his Ph.D. thesis, the writing of his two books—John Maynard Keynes and Stabilizing an Unstable Economy—his collaborations with the financial sector, his financial analyses for the public sector, as well as the economic and financial crises he witnessed and eagerly strove to analyze. Overall, the author conveys, with a dash of critical insights of his own, what he and his professor, Perry Mehrling, consider to be the most important thing we can learn from Minsky: his vision of how financial capitalism works

Buy the book: Minsky. By Daniel H. Neilson. Polity Press: Cambridge, 2019. 224 pages, £16.99.

About the Author: Ayoze is teaching assistant and PhD candidate at the University of Geneva. Twitter: @_Ayoze_

Want to review a book you read? YSI will reimburse you for the price of the book, and will consider your piece for publication on Economic Questions. Reach out to contact@economicquestions.org to get started.

This article was originally posted in Economic Issues, Vol. 25, Part 1, 2020.
Access here.

Is the Government’s Ambiguity about the Secondary Market a Terminal Design Flaw at the Heart of the PPP Loans?

The COVID-19 crisis has created numerous risks for small and medium enterprises (SMEs). The only certainty for SMEs has been that the government’s support has been too flawed to mitigate the shock. The program’s crash is not an accident. As mentioned in the previous Money View blog, one of the PPP loan design flaws is the government’s reliance on banks to act traditionally and intermediate credit to SMEs. Another essential, yet not well-understood design flaw at the heart of the PPP loan program is its ambiguity about the secondary market. The structure I propose to resolve such uncertainty focuses on the explicit government guarantee for the securitization of the PPP loans, similar to the GSE’s role in the mortgage finance system.

Such flaws are the byproduct of the central bank’s tendency to isolate shadow banking, and its related activities, from traditional banking. These kinds of bias would not exist in the “Money View” framework, where shadow banking is a function rather than an entity. “Money market funding of capital market lending” is a business deal that can happen in the balance sheet of any entity- including banks and central banks. One way to identify a shadow banker from a traditional banker is to focus on their sources and uses of finance. A traditional banker is simply a credit intermediary. Her alchemy is to facilitate economic growth by bridging any potential mismatch between the kind of liabilities that borrowers want to issue (use of finance) and the nature of assets that creditors want to hold (source of funding). Nowadays, the mismatch between the preferences of borrowers and the preferences of lenders is increasingly resolved by “price changes” in the capital market, where securities are traded, rather than by traditional intermediation. Further, banks are reluctant to act as a financial intermediary for retail depositors as they have already switched to their more lucrative role as money market dealers.

Modern finance emphasizes that no risk is eliminated in the process of “credit intermediation,” only transferred, and sometimes quite opaquely. Such a conviction gave birth to the rise of market-based finance. In this world, a shadow banker, sometimes a bank, uses its source of funding, usually overnight loans, to supply “term-funding” in the wholesale money market. In doing so, it acts as a dealer in the wholesale money market. Also, financial engineering techniques, such as securitization, by splitting the securitized assets into different tranches, allows a shadow banker to “enhance credit ” while transferring risks to those who can shoulder them. The magic of securitization enables a shadow banker to tap capital-market credit in the secondary market. Ignoring the secondary market is a fatal problem in the design of PPP loans.

To understand the government pandemic stimulus program for the SMEs, let’s start by understanding the PPP loan structure. The U.S. Treasury, along with financial regulators such as the Fed, adopted two measures to facilitate aid to SMEs under the CARES Act. First, the Fed announced the formation of the Paycheck Protection Program Loan Facility (the “PPPLF”). This program enables insured depository institutions to obtain financing from the Fed collateralized by Paycheck Protection Program (“PPP”) loans. The point to emphasize here is that the Fed, in essence, is the ultimate financier of such loans as banks could use the credits to SMEs as collateral to finance their lending from the Fed. Second, PPP loans are assigned a zero-percent risk-weight for purposes of U.S. risk-based capital requirements. This feature is essentially making PPP loans exempt from risk-based (but not leverage) capital requirements when held by a banking organization subject to U.S. capital requirements.

Despite the promising appearance of such programs, the money is not flowing towards SMEs. One of the deadly flaws of this program is that it overlooks the importance of the secondary market. Specifically, ambiguity exists regarding the Small Business Administration (SBA)’s role in the secondary market due to the nature of the PPP loans and how they are regulated. The CARES Act provides that PPP loans are a traditional form of the SBA guaranteed loan. Such a statement implies that the PPP loans would not be 100% guaranteed in the secondary market as the SBA guaranteed loans are subject to certain conditions that should be satisfied by the borrower. First, the SBA wants to ensure that the entity claiming a right to payment from the SBA holds a valid title to the SBA loan. Second, the SBA requires the borrower to fulfill the PPP’s forgiveness requirements. Securitization requires the consent of the SBA. What is not mentioned in the CARES Act is that the SBA’s existing regulations restrict the ability of such loans to be transferred in the secondary market. Such restrictions block the credit to flow to the SMEs.

Under such circumstances, free transfer of PPPs in the secondary market could result in chaos when the PPP loans are later presented to the SBA by the holder for forgiveness or guarantee. Some might propose to ask for approval from the SBA before the securitization process. Yet, prior approval requirements for loan transfers, even though it might reduce the confusion mentioned above, hinder the ability to transfer newly originated PPP loans into the secondary market. Given that the PPP entails a massive amount of loans – $349 billion – to be originated in a short period, transfer restrictions could have a material impact on the ability to get much-needed funding to small businesses quickly. The program’s failure to notice such a conflict is a byproduct of the government’s tendency to ignore the role of the secondary market in the success of programs that aims at providing credit to retail depositors.

A potential solution would be for a government agency, such as the Small Business Administration (SBA), to guarantee the PPP loans in the secondary market in the same manner as Fannie Mae and Freddie Mac do for the mortgage loans. Fannie Mae and Freddie Mac are government-sponsored enterprises (the GSEs) that purchase mortgages from banks and use securitization to enhance the flow of credit in the mortgage market. The GSEs help the flow of credit as they have a de facto subsidy from the government. The market believes that the government will step in to guarantee their debt if they become insolvent. For the case of the PPP loans, instead of banks keeping the loans on their balance sheet until the loan was repaid, the bank who made the loan to the SMEs (the originator) should be able to sell the loan to the SBA. The SBA then would package the PPP loans and sells the payment rights to investors. The point to emphasize here is that the government both finance such loans in the primary market- the Fed accepts the PPP loans as collateral from banks- and ensures the flow of credit by securitizing them in the secondary market. Such a mechanism provides an unambiguous and ultimate guarantee for the PPP loans in the credit market that the government aims at offering anyways. This kind of explicit government guarantee could also help the smooth flow of credit to SMEs, which has been the original goal of the government in the first place.

Money View, through its recognition of banks as money market dealers in market-based finance and originators of securitized assets, could shed some light on the origins of those complications. Previously in the Money View blog, I proposed a potential solution to circumvent banks and directly injecting credit to the SMEs, through tools such as central bank digital currencies (CBDC). In this piece, the proposal is to adopt the design of the mortgage finance system to provide unambiguous government support and resolve the perplexities regarding marketing PPP loans in the secondary market. Until this confusion is resolved, banking entities with regulatory or internal funding constraints may be unwilling to originate PPP loans without a clear path for obtaining financing or otherwise transferring such credits into the secondary market. Such failures come at the expense of retail depositors, including small businesses.

Acknowledgment: Writing this piece would not be possible without a fruitful exchange that I had with Dr. Rafael Lima Sakr, a Teaching Fellow at Edinburgh Law School.

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

Why Does “Solvency” Rule in Derivatives Trading?

Hint: It Should Not

By Elham Saeidinezhad | The unprecedented increase in the Fed’s involvement since the COVID-19 has affected how financial markets function. The Fed has supported most corners of the financial market in an astonishingly short period. In the meantime, there have been growing anxieties that the Fed has not used its arsenals to help the derivatives market yet. To calm market sentiment, on March 27, 2020, regulatory agencies, led by the Fed, have taken steps to support market liquidity in the derivatives market by easing capital requirements for counterparties- typically banks who act as dealers. The agencies permit these firms to use a more indulgent methodology when measuring credit risk derivatives to account for the post-COVID-19 crisis credit loss. The goal is to encourage the provision of counterparty services to institutional hedgers while preventing dealers that are marginally solvent from becoming insolvent as a result of the increased counterparty credit exposure.

These are the facts, but how shall we understand them? These accommodative rulings reveal that from the Fed’s perspective, the primary function of derivatives contracts is a store of value. As stores of value, financial instruments are a form of long-term investment that is thought to be better than money. Over time, they generate increases in wealth that, on average, exceed those we can obtain from holding cash in most of its forms. If the value of these long-term assets falls, the primary threat to financial stability is an insolvency crisis. The insolvency crisis happens when the balance sheet is not symmetrical: the side that shows what the banks own, the Assets, is less valuable than Liabilities and Equity (i.e. banks’ capital). From the Fed’s point of view, this fearful asymmetry is the principal catastrophe that can happen due to current surge in the counterparty credit risk.

From the Money View perspective, what is most troubling about this entire debate, is the unrelenting emphasis on solvency, not liquidity, and the following implicit assumption of efficient markets. The underlying cause of this bias is dismissing the other two inherent functions of derivatives, which are means of payment and means of transferring risk. This is not an accident but rather a byproduct of dealer-free models that are based on the premises of the efficient market hypothesis. Standard asset pricing models consider derivative contracts as financial assets that in the future, can generate cash flows. Derivatives’ prices are equal to their “fundamental value,” which is the present value of these future cash flows. In this dealer-free world, the present is too short to have any time value and the current deviation of price from the fundamental value only indicates potential market dislocations. On the contrary, from a dealer-centric point of view, such as the Money View, daily price changes can be fatal as they may call into question how smoothly US dollar funding conditions are. In other words, short-term fluctuations in derivative prices are not merely temporary market dislocations. Rather, they show the state of dealers’ balance sheet capacities and their access to liquidity.

To keep us focused on liquidity, we start by Fischer Black and his revolutionary idea of finance and then turn to the Money View. From Fischer Black’s perspective, a financial asset, such as a long-term corporate bond, could be sold as at least three separate instruments. The asset itself can be used as collateral to provide the necessary funding liquidity. The other instrument is interest rate swaps (IRS) that would shift the interest rate risk. The third instrument is a credit default swap (CDS) that would transfer the risk of default from the issuer of the derivative to the derivative holder. Importantly, although most derivatives do not require any initial payment, investors must post margin daily to protect the counterparties from the price risk. For Fischer Black, the key to understanding a credit derivative is that it is the price of insurance on risky assets and is one of the determinants of the asset prices. Therefore, derivatives are instrumental to the success of the Fed’s interventions; to make the financial system work smoothly, there should be a robust mechanism for shifting both assets and the risks. By focusing on transferring risks and intra-day liquidity requirements, Fischer Black’s understanding of the derivatives market already echoes the premises of modern finance more than the Fed’s does.

Money View starts where Fischer Black ended and extends his ideas to complete the big picture. Fischer Black considers derivatives chiefly as instruments for transferring risk. Money View, on the other hand, recognizes that there is hybridity between risk transfer and means of payment capacities of the derivatives. Further, the Money View uses analytical tools, such as balance sheet and Treynor’s Model, to shed new light on asset prices and derivatives. Using the Treynor Model of the economics of dealers’ function, this framework shows that asset prices are determined by the dealers’ inventory positions as well as their access to funding liquidity. Using balance sheets to translate derivatives, and their cash flow patterns, into parallel loans, the Money View demonstrates that the derivatives’ main role is cash flow management. In other words, derivatives’ primary function is to ensure that firms can continuously meet their survival constraint, both now and in the future.

The parallel loan construction treats derivatives, such as a CDS, as a swap of IOUs. The issuer of the derivatives makes periodic payments, as a kind of insurance premium, to the derivative dealers, who have long positions in those derivatives, whenever the debt issuer, makes periodic interest payment. The time pattern of the derivatives holders’ payments is the mirror image and the inverse of the debtors. This creates a counterparty risk for derivatives dealers. If the debtor defaults, the derivatives dealers face a loss as they must pay the liquidation value of the bond. Compared to the small periodic payments, the liquidation value is significant as it is equal to the face value. The recent announcements by the Fed and other regulatory agencies allow derivatives holders, especially banks and investment banks, to use a more relaxed approach when measuring counterparty credit risk and keep less capital against such losses. Regulators’ primary concern is to uphold the value of banks’ assets to cement their solvent status.

Yet, from the point of view of the derivatives dealers who are sellers of these insurances, liquidity is the leading concern. It is possible to create portfolios of such swaps, which pool the idiosyncratic default risk so that the risk of the pool is less than the risk of each asset. This diversification reduces the counterparty “credit” risk even though it does not eliminate it. However, they are severely exposed to liquidity risk. These banks receive a stream of small payments but face the possibility of having to make a single large payment in the event of default. Liquidity risk is a dire threat during the COVID-19 crisis because of two intertwined forces. First, there is a heightened probability that we will see a cascade of defaults by the debtor’s aftermath of the crisis. These defaults imply that banks must be equipped to pay a considerable amount of money to the issuers of these derivatives. The second force that contributes to this liquidity risk is the possibility that the money market funding dries up, and the dealers cannot raise funding.

Derivatives have three functions. They act as stores of value, a means of payment, and a transfer of risk. Thus, they offer two of the three uses of money. Remember that money is a means of payment, a unit of account, and a store of value. But financial instruments have a third function that can make them very different from money: They allow for the transfer of risk. Regulators’ focus is mostly on one of these functions- store of value. The store of value implies that these financial instruments are reported as long-term assets on a company’s balance sheet and their main function is to transfer purchasing power into the future. When it comes to the derivatives market, regulators ‘main concern is credit risks and the resulting long-term solvency problems. On the contrary, Money View uses the balance sheet approach to show the hybridity between means of payment and transferring risk functions of derivatives. This hybridity highlights that the firms use insurance instruments to shift the risk today and manage cash flow in the future.

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.

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.

Central Banks and the Folk Tales of Money

By Pierre Ortlieb.

On June 10th, 2018, Swiss voters participated in a referendum on the very nature of money creation in their small alpine republic. The so-called “Vollgeld Initiative,” or “sovereign money initiative,” on their ballots would have required Swiss commercial banks to fully back their “demand deposits” in central bank money, effectively stripping private banks of their power to create money through loans in the current fractional reserve banking system.

In the build-up to this poll, the Swiss National Bank (SNB) tailored their statements on credit creation based on their audience: when speaking to the public, the SNB chose to promulgate an outdated “loanable funds” model of money creation, while it adopted an endogenous theory of credit creation when speaking to market participants. This served to mollify both audiences, reassuring them of the ability and sophistication of the SNB. Yet the contradicting stories offered by the SNB are part of a broader trend that has emerged as central banks have expended tremendous effort on trying to communicate their operations, with different banks offering different explanations for how money is
created. This risks damaging public trust in money far more than any referendum could.

***

At the SNB annual General Shareholders Meeting in April 2018, Governor Thomas Jordan was verbally confronted by two members of the audience who demanded Jordan explain how money is created – Jordan’s understanding of credit, they argued, was flawed and antiquated. Faced with this line of questioning, Jordan rebutted that banks use sight deposits from other customers to create loans and credit. The audience members pushed back in disagreement, but Jordan did not waver.

On the surface, Jordan’s claim on money creation is an explanation one would find in most economics textbooks. In this common story, banks act as mere intermediaries in a credit creation process that transforms savings into productive investment.

However, only months earlier, Governor Jordan told a different story in a speech delivered to the Zürich Macroeconomics Association. Facing an audience of economists and market professionals, Jordan had embraced a portrayal of money creation that is more modern but starkly opposed to the more folk-theoretical, or “textbook” view. Jordan described how “deposits at commercial banks” are created: In the present-day financial system, when a bank creates a loan, “an individual bank increases deposits in the banking system and hence also the overall money supply.” This is the antithesis of the folk theory offered to the public, presenting a glaring contradiction. Yet the SNB’s duplicity is part of a broader trend: central banks are unable to provide a unified message on credit creation, both internally and among themselves.

For instance, in 2014, the Bank of England published a short, plainly-written paper that described in detail how commercial banks create money essentially out of nothing, by issuing loans to their customers. The Bank author’s noted that “the reality of how money is created today differs from the description found in some economics textbooks,” and sought to correct what they perceived as a popular misinterpretation of the credit creation process. Norges Bank, Norway’s monetary authority, has made a similar push to clarify that credit creation is driven by commercial banks, rather than by printing presses in the basement of the central bank. Nonetheless, other central banks, such as the Bundesbank, have gone to great lengths to stress that monetary authorities have strict control the money supply. As economist Rüdiger Dornbusch notes, the German saving public “have been brought up to trust in the simple quantity theory” of money, “and they are not ready to believe in a new institution and new operating instructions.”

***

While this debate over the mechanics of money creation may seem arcane, it has crucial implication for central bank legitimacy. During normal times, trust in money is built through commonplace uses of money; money works best when it can be taken for granted. As the sociologist Benjamin Braun notes, a central bank’s legitimacy depends in part on it acting in line with a dominant, textbook theory of money that is familiar to its constituents.

Yet this is no longer the case. Since the financial crisis, this trust has been shaken, as exemplified by Switzerland’s referendum on sovereign money in June 2018. Faced with political pressures and uncertain macroeconomic environments, some central banks have had to be much more proactive about their communications, and much more frank about the murky nature of money. As quantitative easing has stoked public fears of price instability, monetary authorities including the Bank of England have sought to clarify who really produces money. In this sense, taking steps to inform the public on the real source of money – bank loans – is a worthwhile step, as it provides constraints on what a central bank can be reasonably expected to do, and reduces informational asymmetries between technical experts and lay citizens.

On the other hand, a number of central banks have taken the dangerous approach of simply tailoring their message based on their audience: when speaking to technical experts, say one thing, and when speaking to the public, say another. The janus-faced SNB is a case in point. This rhetorical duplicity is important as it allows central banks to both assuage popular concerns over the stability of money, by fostering the illusion that they maintain control over price stability and monetary conditions, while similarly soothing markets with the impression that they possess a nuanced and empirically accurate framework of how credit creation works. For both audiences, this produces a sense of institutional commitment which sustains both public and market trust in money under conditions of uncertainty.

Yet this newfound duplicity in central bank communications is perilous, and risks further undermining public trust in money should they not succeed in straddling this fine line. Continuing to play into folk theories of money as these drift further and further away from the reality of credit creation will inevitably have unsettling ramifications. For example, it might lead to the election of politicians keen to exploit and pressure central banks, or the production of crises in the form of bank runs.

Germany’s far-right Alternative für Deutschland, for instance, was founded and achieved its initial popularity as a party opposed to the allegedly inflationary policies of the European Central Bank, which failed to adequately communicate the purpose of its expansionary post-crisis monetary program. Once a central bank’s strategies and the public’s understanding of money become discordant, they lose the ability to assure their constituents of the continued functioning of money, placing their own standing at risk.

Central banks would be better off engaging in a clear, concise, and careful communications program to inform the public of how credit actually works, even if they might not really want to know how the sausage gets made. Otherwise, they risk further shaking public trust in critical monetary institutions.

About the Author: Pierre Ortlieb is a graduate student, writer, and researcher based in London. He is interested in political economy and central banks, and currently works at a public investment think tank (the views expressed herein do not represent those of his employer).

Let’s face it: Monetary Policy is Failing

By Nikolaos Bourtzis.

Monetary policy has become the first line of defense against economic slowdowns — it’s especially taken the driver’s seat in combating the crisis that began in 2007. Headlines everywhere comment on central bank’s (CB) decision-making processes and reinforce the idea that central bankers are non-political economic experts that we can rely on during downturns. They rarely address, however, that central banks’ monetary policies have failed repeatedly and continue to operate on flawed logic. This piece reviews recent monetary policy efforts and explains why central bank operations deserve our skepticism–not our blind faith.

What central banks try to do

To set monetary policy central banks usually target the interbank rate, the interest rate at which commercial banks borrow (or lend) reserves from one another. They do this by managing the level of reserves in the banking system to keep the interbank rate close to the target. By targeting how cheaply banks can borrow reserves, the central bank tries to persuade lending institutions to follow and adjust their interest rates, too. In times of economic struggle, the central bank attempts to push rates down, such that lending (and investing) becomes cheaper to do.

This operation is based on the theory that lower interest rates discourage savings and promote investment, even during a downturn. That’s the old “loanable funds” story. According to the neoclassical economists in charge at most central banks, due to rigidities in the short run, interest rates sometimes fail to respond to exogenous shocks. For example, if the private sector suddenly decides to save more, interest rates might not fall in response. This produces mismatches between savings and investment; too much saving and too little investment. As a result, unemployment arises since aggregate demand is lower than aggregate supply. In the long run, though, these mismatches will disappear and the loanable funds market will clear at the “natural” interest rate which guarantees full employment and a stable price level. But to speed things up, the CB tries to bring the market rate of interest towards that “natural” rate through its interventions.

Recent Attempts in Monetary Policy

However, interest rate cuts miserably failed to kick-start the recovery during the Great Recession. That prompted the use of unconventional tools. First came Quantitative Easing (QE). Under this policy, central banks buy long-term government bonds and/or other financial instruments (such as corporate bonds) from banks, financial institutions, and investors, which floods banks with reserves to lend out and financial markets with cash. The cash is then expected to eventually filter down to the real economy. But this did not work either. The US (the first country to implement QE in response to the Crash) is experiencing its longest and weakest recovery in years. And Japan has been stagnating for almost two decades, even though it started QE in the early 2000s.

Second came “the ‘natural rate’ is in negative territory” argument; Larry Summers’ secular stagnation hypothesis. The logic is that if QE is unable to increase inflation enough, negative nominal rates have to be imposed so real rates can drop to negative territory. Since markets cannot do that on their own, central banks will have to do the job. First came Sweden and Denmark, then Switzerland and the Eurozone, and last but not least, Japan.

Not surprisingly, the policy had the opposite effect of what was intended. Savings rates went up, instead of down, and businesses did not start borrowing more; they actually hoarded more cash. Some savers are taking their money out of bank accounts to put them in safe deposits or under their mattresses! The graph below shows how savings rate went up in countries that implemented negative rates, with companies also following suit by holding more cash.

Central bankers seem to be doing the same thing over and over again, while expecting a different outcome. That’s the definition of insanity! Of course, they cannot admit they failed. That would most definitely bring chaos to financial markets, which are addicted to monetary easing. Almost every time central bankers providea weaker response than expected, the stock market falls.

There is too much private debt.

So how did we get here? To understand why monetary policy has failed to lift economies out of crises, we have to talk about private debt.

Private debt levels are sky high in almost every developed country. As more and more debt is piled up, it becomes more costly to service it. Interest payments start taking up more and more out of disposable income, hurting consumption. Moreover, you cannot convince consumers and businesses to borrow money if they are up to their eyeballs in debt, even if rates are essentially zero. What’s more, some banks are drowning in non-performing loans so why would they lend out more money, if there is no one creditworthy enough to borrow? Even if private debt levels were not sky high, firms only borrow if capacity needs to expand. During recessions, low consumer spending means low capacity utilization, so investing in more capacity does not make sense for firms.

How to move forward

So, now what? Should we abolish central banks? God no! Central banks do play an important role. They are needed as a lender of last resort for banks and the government. But they should not try to fight the business cycle. Tinkering with interest rates and buying up financial instruments encourages speculation and accumulation of debt, which further increases the likelihood of financial crises. The recent pick-up in economic activity is again driven by private debt and even the Bank of England is worried that this is unsustainable and might be the trigger of the next financial crisis.

The success of monetary policy depends on market mechanisms. Since this is an unreliable channel that promotes economic activity through excessive private debt growth, governments should be in charge of dealing with the business cycle. The government is the only institution that can pump money into the economy effectively to boost demand when it is needed. But due to the current misguided fears of large deficits, governments have not provided the necessary fiscal response. Investment requires as little uncertainty as possible to take place and only fiscal policy can reduce uncertainty. Admittedly in previous decades, monetary responses might have been responsible for restoring some business confidence as shown in the figure below.

This effect, though, cannot always be relied upon during severe slumps. And no doubt, more attention needs to be given to private debt, which has reached unprecedented levels.

Monetary policy has obviously failed to produce a robust recovery in most countries. It might have even contributed in bringing about the financial crisis of 2008. But central bankers refuse to learn their lesson and keep doing the same thing again and again. They don’t understand that their policies have failed to kick-start our economies because the private sector is drowning in debt. It’s time to put governments back in charge of economic stabilization and let them open their spending spigots. A large fiscal stimulus is needed if our economies are to recover. Even a Debt Jubilee should not be ruled out!

About the Author
Nikos Bourtzis is from Greece, and recently graduated with a Bachelor in Economics from Tilburg University in the Netherlands. He will be pursuing a Master in Economics and Economic analysis at Groningen University. Research interests are heterodox macroeconomics, anti-cyclical policies, income inequality, and financial instability.

The Shortage of Money: A Fallacious Problem

Whether they are implemented in Latin America (1970-90s), in the UK (under Thatcher) or in Greece (since 2012), austerity measures are all justified by the fact that “there is not enough money.” People are told that “there is no alternative,” and that the state needs to implement structural adjustment programs—usually including across-the-board spending cuts—to restore investors’ confidence and to hope for a better future.

What if this shortage of money could be overcome? What if this problem was ultimately the wrong one? What if we could have money for everything we needed?

In her latest book, The Production of Money: how to break the power of Bankers, Ann Pettifor argues that:

YES the society can afford everything that it needs,
YES we are able to ensure enough money for education, healthcare, sustainable development and the well-being of our communities,
YES we can discard money shortage, contrary to the human or physical (land and resources) ones.

However, one condition needs to be fulfilled: our monetary system should be well-regulated and managed.

To understand how and why, Ann Pettifor takes us back to basics. She starts by defining money as a “social construct based primarily and ultimately on trust”. One of the reasons why we use money in the first place is because we know that others will accept it in the future; it is the means “not for which we use to exchange goods and services, but by which we undertake this exchange” (Law). Your 100-dollar bill would be worthless if others didn’t accept it. The value of money depends on the “acceptance” of money, i.e. on the trust you and others have in money.

Contrary to popular belief, 95% of (broad) money (i.e. cash and coins + bank deposits) is created by private banks and not by the central bank. When a bank makes a loan to a firm, it creates simultaneously a deposit account from which the firm withdraws the loan. Money is therefore created “out of thin air” when the account of the borrower is credited—i.e. when loans are made. This has two implications:

When money is created, so is debt. This debt needs to be repaid. Ann Pettifor uses the example of a credit card which allows you to purchase goods and services today. The spending (= purchasing power) on a credit card “is created out of thin air”. You will ultimately need to pay back the amount spent plus a pre-agreed interest rate. Money is therefore a promise of a future productive value.
The money supply depends on private borrowers and their demand for loans. Central banks influence (but do not control) the money supply by increasing or decreasing the cost of borrowing with their policy interest rate. Money creation is therefore a bottom-up process rather than a top-down one.

Does this mean that we should create as much money as people want loans? Of course not. According to Ann Pettifor, there are constraints that make unlimited borrowing impossible: inflation (and deflation). Indeed, if money is not channeled toward productive purposes, the claim associated to it might not be reimbursed. In other words, the promise of a future productive value might not be fulfilled. When there is too much money “chasing too few goods and services”, reflecting over-confidence in the economy, it results in inflation, eroding the value of assets (such as pensions). Similarly, when there is not enough borrowing (either because borrowers need to repay their debts, as it has been the case in Japan and the US right after the last recession, or because the cost of borrowing is effectively too high), reflecting distrust in the ability to repay debt, deflation steps in.

Therefore, as money can be created “out of thin air”, there is no reason to have a shortage of money as long as it is channeled towards productive purposes. An unlimited amount of money can be created for projects that will ultimately result in the production of value, which will allow the repayment of debt. However, the author does not define what “value” or “productive purposes” are, which in my opinion is the main drawback of the book.

Although Pettifor does give some hints by opposing “productive purposes” to “speculative” ones and by associating “value” to the notion of “income, employment and sustainability”, her approach is rather imprecise and in this sense disappointing. To her credit, defining value is a difficult task, especially if we want to define what is valuable to the society as a whole. Pinning down the definition of value is, in my opinion, ultimately a political debate. If one considers that democracies reflect “collective preferences”, it can be said that societies decide through elections on what is most valuable to them at a given point in time.

Unfortunately, the current monetary system does neither enable nor guarantee that money and credit are used for productive purposes. It is characterized by “easy” and “dear” money; the former refers to unregulated and easy access to borrowing, while the latter conveys the idea of expensive borrowing, i.e. with loans charged at high interest rate. The issue with this system is that (1) with unregulated borrowing, money will be used for unproductive purposes, (2) with high interests, debtors will meet difficulties reimbursing their loans.

Such a system is harmful to society. In the words of Ann Pettifor:

“If rates of interest are too high, debtors have to raise the funds of debt repayment by increasing rates of profits, and by the further extraction of value. These pressures to increase income at exponential rates for the repayment of debt implies that both labor and the land (defined broadly) must be exploited at ever-rising rates. Those who labor by hand or brain work harder and longer to repay rising, real levels of mortgage or credit card debt. It is no accident therefore that the deregulation of finance led to the deregulation of working hours.”

A sound financial and monetary system would precisely have opposite features, with “tight but cheap credit” (Keynes), in which loans are regulated but cheap. “Tight credit” would ensure the soundness and creditworthiness of loans, while “cheap credit”, secures the affordability and thus the repayment of loans.

Hence, Ann Pettifor makes a remarkable argument by providing an in-depth but accessible insight into the workings of the monetary system and the debates surrounding it. Both economists and non-economists should give it a read.

It is indeed quite astonishing that money, ever-present in our lives, is so poorly understood; even by many economic experts themselves. According to Ann Pettifor, this incomprehension stems from the deliberate efforts of the financial sector to “obscure its activities” in order to maintain its omnipotence. The Production of Money aims at addressing this “crisis of ignorance” by providing an intelligible and comprehensive overview of money in the hope of empowering people against finance’s grip over society.

By Céline Tcheng
Disclaimer: views are my own.

About the Author

Céline grew up between Paris, China and Singapore. After graduating in a Master’s degree in Economics and Public Policy, she now works for a public policy institution in France. In her free time, she coordinates INET (Institute for New Economic Thinking) YSI (Young Scholars Initiative)’s Financial Stability Working Group and performs with her dance crew “Slash Art”. Her main interests are: macroprudential policy, financial stability, monetary policy. Follow her on Twitter: @celine_tcheng