A think-nugget from Arnold Kling inspires a very long riff…

Arnold Kling offers a very concise view of the financial intermediation:

[T]he nonfinancial sector would love to issue risky long-term liabilities to fund investments, while consumers would love to hold riskless short-term assets to maintain liquidity. The financial sector intermediates by holding risky long-term assets and issuing riskless short-term liabilities. The more the financial sector expands, the more long-term investment is undertaken in the economy.

In order for the financial sector to do its job properly, it needs to enjoy the right amount of confidence from the public. With too little confidence, the economy suffers from credit scarcity and insufficient long-term investment. With too much confidence, the economy suffers from bubbles and excess credit creation, followed by crashes.

I think this is an eloquent statement of a very common view. It also beautifully isolates the problem with how we have constructed financial intermediation.

I am certain it is true that the nonfinacial sector would love to hold short-term risk-free assets, especially if they pay a high return. It is also true that businesses that invest in real projects and seek to minimize financial risk would prefer to issue long-term liabilities that try to match payouts to lenders with expected project cashflows. However, this gap is not, in fact, intermediable. An intermediary that claims to offer truly riskless assets against investments in risky projects must rely upon subsidy, subterfuge, or both.

An intermediary can “add value” by reducing investors’ risk in comparison to disintermediated investment, by for example, investing in a better-diversified portfolio than an investor would. An intermediary can very effectively reduce liquidity risks to investors, again by since idiosyncratic liquidity demands are themselves diversifiable. But risk reduction via these techniques can never reduce risk to zero. In fact, investing via an intermediary can never alter the fact that 100% of invested capital is at risk — business performance is not uncorrelated and projects can fail completely. Also, usually idiosyncratic liquidity demand occasionally become highly correlated, due to bank runs or real need for cash. Statistical attempts to quantify these risks are misleading at best, as the distributions from which inferences are drawn are violently nonstationary — the world is always changing, the past is never a great guide to the future for very long. Fundamentally, the value intermediaries can add by diversifying over investments and liquidity requirements is very modest, and ought to be acknowledged as such.

Furthermore, if diversifying across operation and liquidity risk was the value provided by financial intermediaries, they should have largely been competed out of the business, as investors can buy and sell diverse portfolios of liquid securities as easily as investing in bank deposits, either constructing them directly or purchasing diverse vehicles, like ETFs or ABS.

So, what is the “value-add” of the financial sector? Let’s go back to Arnold’s think-nugget. Investors cannot, on their own, create short-term truly riskless assets that pass through the returns of risky and illiquid busines projects. So, we can see why there’s demand for banks: They do give the people what they want, on both sides of the funding equation. But, as we’ve already seen, in reality they can’t give the people what they want without subsidy or subterfuge. Either some truly riskless guarantee has to backstop both liquidity and solvency risk, or intermediaries have to lie and pretend that their assets are riskless.

Note that insurance is an insufficient means of squaring this circle. If a bank purchases private sector deposit insurance or liquidity commitments, that is an asset purchase that may reduce its overall portfolio risk, but that cannot eliminate it, especially during times when correlations run high. A private sector insurance policy is a risky asset. Governments can offer riskless liquidity insurance and insurance against the nominal (but not real) value of financial sector liabilities. But it cannot do so at “a market rate”. Government is structurally the monopoly seller of this form of insurance for assets denominated in the currency that it issues. Further, the risks it must insure cannot be actuarially priced without heroic assumptions — the distribution of systemic risk is nonstationary, the future is everchanging and extrapolations always break eventually. (It’s fair to say, however, that zero is too low a price.)

So how does the financial sector seem to offer risk-free assets against risky projects? I think “constructive ambiguity” is the right phrase. The government provides subsidies in the form of literally priceless deposit and liquidity backstops, but those are explicitly limited. Banks work to diligently to increase both the level of insurance and degree to which assets are perceived to be insured by becoming so large that social costs of a bank default on even notionally risky assets are thought to exceed the costs to government of paying out on insurance policies to which it never agreed. Even a very careful observer cannot tell a priori whether many assets offered are genuinely riskless or not, that is to what degree the risk-free status of bank assets is due to subsidy, and to what degree to subterfuge. But there is an ingenious tinkerbell aspect to the risk status of bank assets: If, with a bit of subterfuge, risky assets can be sold as riskless assets, then the social costs of default rise, since asset holders will not have privately managed the risk that the asset might fail. The increase in social costs created by a mischaracterization of a risky asset as riskless, however, alters the likelihood that an asset will be de facto insured. There is a game theoretic equilibrium, that works to the advantage of intermediaries and their customers on both sides of the funding stream, whereby banks offer assets in large quantities as though they are risk-free, and investors accept and treat those assets as risk-free, and by believing together in what is formally not true, they create costs to the sovereign so large if it is not true that the sovereign makes it true. This is an equilibrium, a predictable outcome, not an aberration. And it does happen all the time.

In theory, this is a repeated game, and governments might eliminate the bad equilibrium by committing to bearing social costs that are higher than the immediate costs of providing ex post insurance, in order to prevent the subsidy-extracting equilibrium from taking hold. That’s what people who’d like to see a lot of banks go bust due to “moral hazard” concerns think should happen. But, if governments are unable to credibly commit to accepting large social costs, investors, borrowers, and intermediaries will test them by trying to extract the subsidy of infinite insurance. In practice, it’s clear that governments have rarely been able to credibly commit to stick to the letter of their limited insurance commitments.

Alternatively, governments can accept the extraction of a de facto insurance subsidy, but supervise intermediaries to try to mitigate the cost of future claims. But that’s a difficult task, as all private sector actors, borrowers, lenders, and intermediaries, have an incentive to maximize the subsidy extracted from the state, and will collude in creative ways to do so. (Of course, eventually these actors pay taxes, but even if they are sufficiently far-sighted to consider that, the distribution of benefits from the extracted subsidy is not coincident with the distribution of expected tax liabilities or inflation costs.) As long as it is possible to create a situation where the social costs of failure imply a bail-out, creative financiers will work to capture the huge value of what is essentially an option on an entire macroeconomy (even a global economy).

So, what is to be done? Here are some suggestions:

  1. Eliminate the “constructive ambiguity” that permits private sector actors to offer apparently risk-free, instantaneously redeemable securities. Eliminate government insurance of deposits and all other assets except for direct obligations of the state. This is insufficient — AIG, for example, has extracted a very large bailout despite having never offered insured deposits, and there have been bank bailouts since long before formal deposit insurance. But banks’ ability to muddy the waters between explicitly guaranteed and other assets seems to facilitate the process by which investors naively or cynically confuse risky for risk-free assets. Banking crises are larger and more frequent than any other sort of financial crisis that compels a state subsidy.

  2. Keep financial firms small enough and sufficiently well compartmentalized from one another that a failure of one or several does not create social costs large enough to force a sovereign payout. Discourage portfolio correlation by creating a fiduciary obligation of independent evaluation that places agents who copycat or herd in jeopardy of investor lawsuits.

  3. When possible, disintermediate. Nonfinancial firms are subject to clear operational risks, which forces direct investors to manage risks privately. Risk-management by private investors reduces the social cost of failure that compels government bailouts. Nonfinacial firms sometimes succeed at extracting bailouts, but much more rarely and with a larger fraction of the costs borne by investors than when financial firms do so.
  4. Prefer equity to debt arrangements. All business risks must eventually be borne by investors. Debt financing concentrates enterprise risk among equity holders, and enables debt-holders to manage their investment risk less carefully. Risk-management by private investors reduces the social cost of failure that compels government bailouts.
  5. Vaccinate investors by maintaining some level of asset price risk. Governments should limit liquidity and promote short-term price volatility of risky assets, perhaps quite artificially, to ensure that investors are always provisioning to manage risk. Risk-management by private investors reduces the social cost of failure that compels government bailouts.
  6. Carefully ration risk-free obligations offered by the state. As Winterspeak likes to point out, states do not need to issue debt to fund themselves in their own currency. States can more equitably and transparently promote price stability via taxation than by borrowing and intervening in sprawling debt markets. Government debt ought not be viewed as loans to fund operations, but as a form of insurance offered by the state to private savers in strictly limited quantity, in order that people of modest means don’t have to perform the work and bear the risk of managing uncertain investments. Governments should strive to guarantee a near-zero, but always positive, real return on these obligations, permitting risk-averse savers to transport purchasing power into the future, but not magnify real wealth. Those who want a high return must do the work and bear the risk of achieving it. The state should not guarantee that.

I know that the political economy of these suggestions is, well, iffy. But one should never underestimate how much political economy considerations might change during the turbulence of a global financial crisis.

Update History:
  • 15-Mar-2009, 4:50 p.m. EDT: Fixed ungrammatical “so larger” that was embarrasingly quoted by Free Exchange. (Changed to a lovely “so large”.) Also eliminated an unwanted “if” in the same sentence (which had been caught awkwardly between two constructions.)

16 Responses to “A think-nugget from Arnold Kling inspires a very long riff…”

  1. BSG writes:

    Steve – I couldn’t help but notice the absence of a pretty obvious solution: eliminating fractional reserve banking and the authority to “print” any amount of money by a central bank, which it uses mostly to subsidize and/or bail out/backstop banks and sometimes to reduce the need of politicians to explicitly tax their constituents.

    Rather than belabor points we’ve discussed before, I offer for your consideration that your suggestions may very well be non-starters for the same reason the above is: it substantially reduces the lucrative subsidies of the financial sector, especially the big banks.

    Furthermore, even if some of your suggestions are somehow accepted and prove effective, the history of various reforms consistently demonstrates that before long they will be undermined and we’ll be back where we started.

    If anyone finds it worthwhile to take on the powerful beneficiaries of the current system, perhaps that energy would be better spent on a solution that is much more likely to stand the test of time.

  2. BSG — “Eliminate the “constructive ambiguity” that permits private sector actors to offer apparently risk-free, instantaneously redeemable securities…” + “Governments should limit liquidity and promote short-term price volatility of risky assets, perhaps quite artificially, to ensure that investors are always provisioning to manage risk.” It’s hard to see what sort of “fractional reserve banking” would survive that.

    “I offer for your consideration that your suggestions may very well be non-starters for the same reason the above is: it substantially reduces the lucrative subsidies of the financial sector, especially the big banks.” No argument. Are we disagreeing somehow?

    I’m trying to theorize in a pretty general way, but I think the ramifications of that theorizing include the reforms you suggest. There would still be room for investment funds under the regime I’m proposing, and all investment funds are fractional-reserve, as invested funds are tied in capital and not available for immediate redemption. But since investment in those funds could not be confused as money-like or riskless claims (they are explicitly illiquid and variable in price), I think most of what you dislike about fractional reserve banking would be covered.

  3. Gu Si Fang writes:

    I have the same reaction as BSG. For a long time I was surprised every time I read “what a bank does is transform long term investment into short term liquid assets”. I thought : where is the magic wand?

    There is a similarity between FRB and transformation : FRB means that a bank apparently turns short term T-bonds into bank deposit; transformation apparently turns assets into more liquid assets.

    The problem with both FRB and transformation is that the contract between both parties is defective, because banks are subject to bank runs. In case of a run on Northern Rock (FRB) or Bear Stearns (transformation) what we have is several parties claiming a property right on the same stuff. If this case had not been foreseen in the contract, jurisprudence would take care of it. The remaining contracts, therefore, rest on a fundamental misunderstanding of both parties.

    The way it is taken care of is deposit insurance : collectivized property. If both parties claim the same stuff simultaneously they will both get it because, well…, FDIC or the government will provide more stuff to satisfy all claims. The problems with this “solution” are obvious.

    This does indeed lead to a faster growth of the financial sector. The underlying reason is that there is an incentive to get as many claims on collective property as one can. Does this cause more long term investments and faster growth? No. It might seem so because both can occur simultaeously, but this is a post hoc ergo propter hoc fallacy.

  4. RueTheDay writes:

    Another great post! I have a bunch to add, unfortunately, I need to keep it short before I head to a client.

    1. A fundamental rule of risk is that financial risk is never really eliminated, it is just transferred between parties and counterparties and sometimes to third parties. Sometimes that third party is the system as a whole, which then means that ultimately the government has picked it up. There is nothing inherently bad about risk transfer, in fact, it’s one of the functions of the financial system to efficiently transfer risk to those most willing and able to bear it. The problem, in my view, is when risk is transferred to a third party covertly without knowledge and compensation (or overtly with knowledge but without compensation in the case of some recent government assumptions of risk) while the first party retains the greater reward associated with the risk they originally undertook. In addition to being patently unfair, this causes enormous moral hazard and adverse selection problems.

    2. Re: FRB and maturity transformation – FRB is simply a special case of maturity transformation where the liability end has a maturity length of 0 (on demand redemption) and so is considered to be money. One can have maturity transformation without FRB (indeed, one can have it without banks). Maturity mismatch combined with variable liquidity preferences due to future uncertainty is the underlying cause of the business cycle. Add leverage into the mix, and it’s the cause of sudden financial panics.

    Where I differ with some posters on here is that I don’t believe a modern economy can exist without maturity transformation. Firms simply will not be able to fund long-term capital investment projects under conditions of uncertain future profits if they had to rely on maturity-matched current savings to do so as the savers will not be willing to part with their savings for the duration of the project nor will they be willing to bear the risk. At least not at an interest rate that would make the real capital investment profitable. This was, IMO, the fundamental message of Keynes – that the interest rate mechanism cannot possibly equilibrate savings and investment, at least not at a level that ensures full employment of all labor and existing capital.

  5. JoshK writes:

    IMHO #1 is actually spot on. A large part of this transformation happens just b/ of the FDIC guarantee. Considering that the FDIC could be on the hock for $2T in liabilities that doesn’t seem to have worked out well.

    It would be am much better system if true cash holders paid for fee-based accounts that got something like SPIC insurance. The accounts would charge for cash management, ATM access, transfers, etc.

    If you wanted to get interest then you would have to turn to a fund and you could slice it as you wish. Some funds would have tougher gates than others.

  6. septizoniom2 writes:

    a wonderful post.

    what’s distressing is i suspect there is no political will to do anything meaningful. as simon johnson would point out, the oligarcy in the financial industry wins. also maybe means the smartest bet is out of the money calls on too big to fail bank stocks.

  7. Anarchus writes:

    Great post – in part because it raises more good questions than it answers, IMHO.

    I thought Rue-Day’s comments started approaching the problem from the right angle . . . . . thinking analytically out loud:

    1. It’s been correctly highlighted here many times that the “identity” that Savings = Investment obfuscates rather than illuminates. Individuals with an excess of income over consumption generate wealth that creates demand for savings (wealth stored like inventory=”safe savings”) and demand for return (wealth invested in risky assets with Maturity>0=”investment savings”).

    1a. Life was simpler and perhaps better in the days prior to the end of Reg Q (1980) and Money Market funds (Bruce Bent’s Reserve Fund 1971). Dividing lines then were clearer, though imperfect still.

    2. Non-financial businesses, local &state governments and the federal government have needs for long-term funding of risky investments. To the extent that the need for long-term funding of risky investments is greater than the supply generated by “investment savings” of individuals, then there’s a real need for some kind of intermediation which will require borrowing short and lending long.

    3. That’s a wonderful construct and illustrates part of the system (and reading the history as background it’s discouraging how many times the name “St. Germain” comes up!); unfortunately it misses entirely the part of the system that malfunctioned so badly – mortgages and the consumer finance revolution.

    3a. I’m running too long, but it seems to me that a much larger portion of this crisis is related to consumer lending practices gone awry than to the intermediation/maturity mismatch situation. I may be off base with this allegation, but the hedge fund carry trade relative value madness took off back around 1990-91 when the Greenspan Fed all but guaranteed carry traders a fortune with the sharply sloped yield curve plan to reliquify the banking system. And while what happened with LTCM in 1998 should have led to a scaling back of risk in the carry trade/relative value sector, the world took off in the opposite direction. I was talking with Dr. Andrew Lo in 2003, and he scared me to death by warning of systemic risk based on relative value assets being 2x-5x larger then than when LTCM had blown up in 1998. While there is no single root cause of the crisis, wasn’t part of the problem that there were so many hundreds of billions if not trillions of relative value money in hedge funds demanding a carry trade spread with leverage that there was just too much demand for longer maturity or higher risk credit.

  8. BSG writes:

    Steve – my main objection, born of exasperation with the likes of our Treasury Sec. and Fed chairman (who are typical of those in positions of authority,) is that aside from elimination of explicit government insurance, as far as I can tell there is no categorical elimination of underlying authority in the formulation.

    My basic assertion is that even the most prudent of regulatory regimes will gradually be undermined as long as the agencies involved retain sufficient authority and those doing the undermining retain the incentives to do so. While hope does spring eternal, I’m not aware of historical exceptions, so I think a root and branch operation is essential.

    More specifically on the suggestions you make in this post, the only one that jumped out at me as problematic is the “artificial” in #5. I think the weight of the evidence suggests that such manipulations are usually gamed and abused, not to mention often accompanied by adverse unintended consequences.

    With all of that said, I very much appreciate your cogent analysis. It is quite refreshing.

  9. joebhed writes:

    The Chicago Plan.

    100 percent reserve banking.

    Eliminate the NEED for government deposit-insurance.

    And all of the FED’s open-market machinations.

    Put the risk back on the investor.

    Direct government-issue of a debt-free money supply Q.


  10. LetUsHavePeace writes:

    The Morgan Bank – the one that did a better job of managing financial market and government solvency panics than the Federal Reserve and the Treasury has – never offered its clients “riskless” deposits. Neither Morgan Sr. nor Jr. would have been so presumptuous. Only the government has that degree of hubris. What they did promise – and what they successfully delivered for over a century – was the certainty that they would manage risk prudently. They were able to do so because they never confused Constitutional Money – specie and the promise to pay specie by reliable banks – with credit. They would have understood Congressman Paul’s desire for 100% reserve banking but they would have rejected his peculiarly Puritanical notion that ALL BANKS must adopt that position. If a customer wanted was to deposit their gold coins for safe-keeping, a properly managed trust company would be sufficient. If they wanted to deposit their money and earn a return, then they would be dependent on the judgment of the fiduciary to invest that money in the credit market. The Morgans would have been appalled at the notion that government should be the sole recipient of those investments. The government in imprudent hands could be the worst of all possible risks.

    How, then, were the Morgans able to pull this off? They were as interested in the character of their depositors as they were in the character of the people with whom they invested the depositors money. They were not snobs, but they insisted that their depositors be people who were themselves prudent and sensible about money. Anyone gullible enough to believe that paper issued by politicians was “risk-free” would not have qualified as a customer. Nor would anyone greedy enough to speculate with unhedged leverage greater than the daily fluctuations of the market. They let those people go elsewhere.

  11. What I have written to Senator Shelby and my elected reps:

    1. bring back Glass-Steagal

    2. no banks bigger than $250 bil assets

    3. void all CDSs held by speculators (naked)– expropriate the speculators! That should sell!

    The Economist did a survey on banking a few years ago and cited academic research showing no gains to scale over about $20 bil for banks–it’s all about CEO and top management pay.

    My heart throbbed when Sheila Bair said on PBS that she thought bank size should probably be limited. No more too big to fail.

    You got to keep it simple to get the politicians to focus.

  12. ChrisA writes:

    Another solution; have the regulator have the right, at any time and with no notice, transform part of the bank’s liabilities (deposits, debt, and any insurance-like obligation) into equity. This right can be exercised whenever, in the view of the regulator, the bank has insufficient capital ratios or when a bank run starts, with no legal right of redress. If the lenders/depositors are aware of this right prior to lending their funds to the bank, then moral hazard as described will be managed by lenders/depositors. Property rights are also preserved, since if the bank is really solvent, equity for debt is just exchanging one form of an asset for another. Maybe then we will see banks competing for business on the basis of their safety and risk profile.

  13. Ingolf writes:

    Steve, thanks for that. I’ve been following most of your ruminations on these fundamental structural issues and, as far as I can see, you’re one of the few digging deep enough.

    Given the core problem is maturity transformation and given that the current system is irrevocably wedded to this fatal flaw, any effective and lasting solution will almost certainly have to be radical (hence the great need for the sort of conversation you’re encouraging and seeding). Although the problem got entirely out of control this time around, it’s of course a perennial. As you and others here have often noted, the recurrent cycles of boom and bust that have plagued most economies for centuries are almost entirely the consequence of this internal contradiction, this systemic desire to get something for nothing.

    The doubts that RuetheDay expresses go to the heart of the matter, I think. He may be right in his concerns, but I don’t really think so. If we imagine a world in which it’s not possible to get returns on call money, and where yields tend to increase with maturity, what are investors going to do? For those who are looking to truly hold cash, the solutions would seem quite simple, whether it be fee-based accounts as JoshK suggests or some other form of “narrow banking”. For the rest, many will confront this difficult choice for the first time given that they’ve generally been able to at least partially sidestep it because of the ambiguities of the current system.

    So, would they really withdraw their capital? And if so, what happens then? Wouldn’t it simply mean the yield available on various investments would rise so high as to gradually bring them back into the market? I confess I struggle to envision anything like a permanent “boycott” (what possible end would it serve)? My guess is that for the great bulk of investors who don’t have sufficient funds to independently diversify, new (and reworked) ways of aggregating capital would arise to spread these funds across a range of projects. Some of these would presumably end up being listed themselves, so that some kind of continual evaluation of their performance (and liquidity) would result. Whatever specific form they took, all of them would have the virtue of being viewed more like equity investments are now; even though it’s been very painful, the fall of over 50% in the equity market hasn’t occasioned any real systemic stress.

    To the extent that such a structure made investment suddenly seem like a very serious business, this would surely be no bad thing. After all, the illusions fostered by the current system haven’t really served us all that well.

    It seems to me it’s desperately important to find a way (such as the above, perhaps) to draw a clear line between holding cash and investing, a line that’s simple and clean enough to be understood by even the most unsophisticated participants. This may be the only way in which BSG’s entirely reasonable concern (that any new system will be progressively undermined) can be addressed.

    Or at least partially so, to be slightly more realistic . . . .

  14. Tom writes:

    On your #2 — keep financial firms small and well-compartmentalized — by that logic the pre New-Deal US, with numerous tiny banks tied to limited geographic areas, should have been an oasis of financial sector stability. Which of course, it wasn’t. It was less stable than what we have now.

  15. john c. halasz writes:

    “The more the financial sector expands, the more long-term investment is undertaken in the economy.”

    O.K. That contention makes little sense to me. How does an increasing accumulation of a stock of undifferentiated debt correspond to long-run real productive capital investment, except as a multiplication of claims on its uncertain realization? Wouldn’t a better distribution of flows from such investment through successive inter-temporal phases of its realization serve better to sustain such investment and its realization? Me thinks it’s just another bit of libertarian/neo-classical hooey.

    All told, this post is too “Austrian”-leaning for my tastes. In the first place, the current crisis is not due to the inherent flaws and overwhelming dangers of ordinary commercial banking and FRB, but rather to the development of “capital markets” and the “shadow banking system” well beyond the regulated banking system. In which leverage built up on the basis of vapor-bucks, without any corresponding productive purposes, sheerly inflating financial “assets”. And more fundamentally, the current debacle is the result of huge global trade imbalances in the real economy, which itself can partly be traced to relentless “cost-cutting” with respect to the wage-labor share in output and aggregate demand, which, in turn, is not entirely unrelated to the dis-inflationary cult of monetary policy to maintain the profit-share in the face of lagging real investment. Further, the post only focuses on the aggregation of savings for investment or “investment” purposes and ignores the whole dimension of rising consumption debt.

    But then the whole attempt to design a financial system that would accord it a certificate of immaculate conception, by ignoring the intrication of the financial “economy” with the real productive economy and the endogeneity and necessity of credit to the latter and its production/business cycles is a mis-direction, the tail waging the dog, by mis-recognizing the “origins” of economic crises in the difficulties of the real productive economy and the way the financial system at once prolongs and diverges from it with its accumulations of fictitious capital, until the underlying crisis in profitability, over-capacity, and lagging aggregate demand is manifested in financial disruption of the re-production of the former. The illusion that a purely “market” orientation in economics can somehow aligned the flows of the financial and real economies by assuming a continuity between them, such that some set of “reforms” in finance would assure that alignment misplaces the blame for economic failure onto government regulation and intervention to compensate for market failures, rather than on the ideology of government de-regulation in favor of the self-regulating, “competitive” equilibrium of “free” markets, (which is actually a symptom of regulatory capture by dominant economic interests, which are less “competitive” than oligopolistic and rent-seeking in nature).

    Yes, FRB is “dangerous”, which is why any such system of finance needs to be strongly regulated, in exchange for the lender-of-last-resort liquidity of a central bank and deposit insurance to prevent irrational bank-runs. And such a strong regulatory hand ought to be able to impose a “death penalty” on banks that violate and exceed systemic safe-guards, as well as be able to impose regulatory capital and reserve requirements counter-cyclically without fear or favor, in exchange for the license to operate what is, in effect, a public utility, essential both to the payments system and the aggregation of dispersed household savings. Blaming the failure to so regulate on government intervention in the “free market” is, er, too rich. Likewise, unlike industrial oligopolies whose giant size is partly “justified” by economies-of-scale and high technical levels of productivity, there is no reason for commercial banks to attain excessive size; in fact, the evidence shows that larger banks are actually less capital-efficient and proportionally profitable than smaller ones. So keeping down the size of banking “institutions” and limiting their profitability are legitimate regulatory goals. For that matter, it is the tax-deductibility of interest that encourages the building up of debt-structures to enable financial rent-seeking off of the real productive economy, (as with, e.g., LBOs), so if one wants to encourage equity or retained-earnings financing for productive investment, (which latter used to be far more the case), then it’s less a matter of altering institutional design than government policy. But two basic points need to be made: 1) in any reasonably prosperous and equitable society, in which all households enjoy a standard-of-living above a subsistence level, there will be household savings own-demand, and there needs to be some way of recycling such savings back into circulation, rather than withdrawing them into hoarding and reducing the effect of such savings on aggregate demand, whether given to consumption or productive investment, and, further, there is no reason why such modest savings should be recirculated for free, rather than given some modest secure returns; and 2) not only is the obsessive focus on maturity transformation a red herring, since the issue is endemic, as all investment in the building of future enhanced productive capacity is actually a matter of production-switching within a present frame, regardless of the exact financial implements by which it would be accomplished, but the idea that savings must precede investment is a half-truth, at best, since it’s just as much the case that investments in improved productivity produce savings, and that the actual supply of savings “hoarded” for productive investment, the supply level of loanable funds, is primarily determined by the recycling of the level of corporate profits.

    Far from government intervention being the root-of-all-evil, the fact of the matter is that a decentralized system of production and market-exchanges and its corresponding financial expression is endemically subject to gathering dysfunctions and recurrent production/business cycles, such that government policy interventions are needed to compensate for them and lessen the burdens they impose. And it is public spending and debt that compensates for the mismatches in savings-and-investment in economic cycles, by providing for the shortfalls and mismatches in private savings, aggregate demand and long-run investment through affording private savings opportunities through public dissavings. The aim of such public policy, fiscal and regulatory, should be to limit the growth in private debt stocks within the bounds of sustainable “private” incomes and revenues, while keeping the growth of public debt within the boundaries of sustainable economic growth. The government as sovereign is the ultimate bearer of risks, (which is why the sovereign has traditionally been imaged as a power over life-and-death, the ultimate image of risk), which is not the same thing as complete insurance. But the worry that the government’s public subsidy of underlying risks invites extortionate leveraging of such risks seems to me misplaced, since the government can just as well limit such risks of extortionate behavior through its own power and authority, as providing a public good. The sovereign is not just that which enforces the rule of law, but that which decides the exceptions.

    I posted a comment in a thread below, explaining in reduced conceptual terms the need for credit. I’ll just reproduce a bit of it here, and invite anyone to poke holes in such conceptual logic:

    “Let’s supposed that there is a fixed supply of money-stock, whether gold or any other medium, corresponding somehow to a fixed or constant supply of resources produced and exchanged, such that any exchange or transfer of a fixed amount of resources would exactly correspond to the exchange of a fixed amount of money. This would be a world in which Say’s Law would be immutably true, in which a system of monetary circulation and exchan
    ge would be a transparent reflection of an industrial barter system. Savings would be defined as deferred consumption, whether such savings were hoarded through being withdrawn from circulation, or lent, and lending would involve ego forswearing current consumption for claims on future consumption, in exchange for alter currently spending the money, whether on current consumption or investment in production, in exchange for alter supplying ego’s claim on future consumption. Now let’s suppose that productive investment is made by alter, to build productive capacity for future output and consumption, that would increase technical rates of productivity and thus increase output and lower prices, i.e. would produce more unit output per the same unit input of resources. However, given fixed resources and fixed corresponding money-stock, this would involve production-switching, as productive goods were withdrawn from meeting current consumption demand to build future production capacity. Hence, there would be a lower supply of production to meet current consumption demand, but, note, the work force building the future production capacity would still be paid out of current output. Hence a gap between current production supply and current consumption demand opens up, which can be met either through inflating prices or deflating wages, but, either way, involves lowered current aggregate demand.

    Hence there’s a dilemma here, maybe even something approaching a paradox: the re-entry in the future of increased productive capacity would occur in a lowered aggregate demand condition, which it’s own production would have occasioned. It’s true,- even if ignoring that the new capital stocks competitively would drive out older stocks and the costs incurred thereby of recycling the remaining value of bankrupt businesses and re-employing unemployed laborers-, that lowered output costs would nonetheless imply higher real wages and thus some increase in overall consumption demand and productive output. But the gains to output would be limited by the constraint of such lowered demand and thus the incentive to productivity-improving investment would be diminished. The “solution” that bridges this dilemma is credit, which is not primarily a matter of “teleporting” future money into the present, thereby creating “artificial” demand, but rather of “teleporting” current productive capacity into increased productive output in the future. It’s true that not all extensions of credit will work out and be repaid, not least because older capital stocks will be competitively driven out and result in bankruptcies, and also because the sharing of risks and uncertainties, as well as gains, through credit arrangements will not map, perfectly somehow, onto future prospects and outcomes. That’s what interest rates and term curves are all about, and it’s a matter not of avoiding any losses, but whether the gains out-weigh the losses.”

  16. AlanM writes:

    My opinion is that this crisis was caused by China’s enormous trade imbalances combined with failure of Western corporate governance to manage the consequent capital flows.

    The problem is inevitably confused, particularly as it seems that financial innovation and increasingly broad and deep global linkages contributed both to the fragility of the system and the scope of the crisis.

    Many of your proposals seem to throw the baby out with the bathwater. Limiting the overall scale of financial enterprises and their leverage seems adequate to me, provided trade imbalances are addressed (new meme: currencies can be “too big not to float”).

    The consequences of acknowledging failure of corporate governance under the current system should allow new forms to appear and compete. I would bet on models which draw explicitly on biological systems and the open source movement.

    Cheers for a terrific blog!