July 12th, 2014
in Op Ed
Something is Rotten in the State of Denmark
by L. Randall Wray, New Economic Perspectives
Horatio: He waxes desperate with imagination.
Marcellus: Let's follow. 'Tis not fit thus to obey him.
Horatio: Have after. To what issue will this come?
Marcellus: Something is rotten in the state of Denmark.
Horatio: Heaven will direct it.
Marcellus: Nay, let's follow him.
Hamlet Act 1, scene 4
Marcellus is right, the Fish of Finance is rotting from the head down. It stinks. As Hamlet remarked earlier in the play, Denmark is "an unweeded garden" of "things rank and gross in nature" (Act 1, scene 2). The ghost of the dead king appears to Hamlet, beckoning him to follow. In scene 5, the ghost tells Hamlet just how rotten things really are.
Denmark, is of course Wall Street or London. Far more rotten than anyone can imagine.
In the aftermath of the Great Recession, we all wax "desperate with imagination", looking for explanation. For solution. For retribution!
The financial system is rotten. Our banking regulators and supervisors failed us in the run-up to the crisis, they failed us in the response to the crisis, and they are failing us in the reform that we expected in the aftermath of the crisis.
Heaven will not save us, either. The Invisible Hand is impotent. Just wait for Scene 5!
In times like these, we thrash about, desperate for ideas, for imagination, for leadership. There's nothing unusual about that. Read the entry, monetary cranks, by David Clark in The New Palgrave: A Dictionary of Economics, First Edition, 1987, Edited by John Eatwell, Murray Milgate and Peter Newman.
You'll find many of the same proffered reforms bandied about now. Many of them make sense, or at least partial sense. I've always used that entry in my money and banking courses as an example of sensible ideas being rejected by the mainstream, labeled "crank" to discredit them.
When I use the term monetary cranks, I use it as a term of endearment. We need some cranky ideas because all the respectable ones failed us. There is nothing, and I mean literally nothing, that will come out of the mainstream that will be of use.
The "Great Crash" (as JK Galbraith called it, AKA the "Great Depression") generated a similar outpouring of "cranky" proposals. Even quite mainstream and respectable economists got involved. A group of them published "the Chicago Plan"-supported by Irving Fisher, Milton Friedman, and Henry Simons.
The idea was to prevent another run-up in speculative fever by restricting banks. They could issue deposits but could not make loans. To ensure safety of the deposits, they'd hold only the safest assets-such as US Treasuries. (For more on the history of the Chicago Plan, see the great book by my good friend and Levy colleague, Ronnie Phillips, (1995) The Chicago Plan & New Deal Banking Reform, Armonk, NY: M.E. Sharpe.)
Hyman Minsky wrote an endorsement for the book, but he also wrote that the Narrow Banking plan was aiming to "fix what is not broke". Yes, the plan would carve out a section of the financial system that would remain safe-the payments system. However, with a central bank that acts as a lender of last resort and with the treasury providing deposit insurance, our payments system is perfectly safe.
You want proof? We just went through the worst (global) financial crisis since the 1930s with not even a hiccup in our insured deposit system.
True, our uninsured money market mutual fund system faced disaster, and required expansion of the government safety net to save it. And virtually every other part of our financial system also had to be rescued. As my Ford project team has documented, it took $29 TRILLION of subsidized loan originations by the Fed to prop up Wall Street, London, and Brussels.
But the protected deposit-based payments system went through unscathed.
(The UK did have a hiccup, precisely because it did not offer 100% insurance; it had to expand insurance to 100% to stop bank runs that never occurred in the USA.)
So what do our monetary cranks want to do? Well, a lot of them want to go back to the Chicago Plan. They want to solve a problem that does not exist.
Like Minsky, I don't object. Maybe there is a better way to do the payments system. Personally, I've always liked the idea of a nationwide, universally accessible, government-funded, postal savings system. Let's go for it.
It's a crazy idea only in the USA. It is easy to find PSSs around the world. Last time I looked, the Japanese PSS was the biggest "bank" in the world (but maybe one of the bankster banks has surpassed it now-propped up, fed, clothed and diaper-changed by Uncle Sam).
We do not have to reinvent the wheel. We don't need a Chicago Plan. Let's just restore the US Postal Saving System (which, as I recall, lasted into the 1960s).
Centralized Committee of Experts
However, the crank can be taken too far. Some-even the FT's Martin Wolf??-are not talking about carving out a tiny part of the financial system, but rather are talking about lock-stock-and-barrel replacing it with narrow banks. (See the great critique by Ann Pettifor, Out of thin air - Why banks must be allowed to create money.)
Now that is cranky.
The idea seems to be that we don't need no stinking banks-at least the kind we've got now.
As I've been arguing, our banks "create money" (in the form of demand deposits) "out of thin air" when they make loans. It seems that everyone except Paul Krugman now gets this. And lots of people don't like it, including Martin Wolf.
So we'll eliminate that kind of banking, and just let narrow banks take in deposits and then buy safe treasuries. No more money creation out of thin air.
Who will do the lending? There are two options. We could allow specialized intermediaries that would take in savings and lend them out. Or we could have special government banks. I'm only discussing the first of these today.
While the cranks who support private intermediaries have not explicitly stated it, what they seem to be proposing is a riff on Islamic banking. The idea is that savers can lend their saving to investors. Sure it is risky! The savers effectively share in the rewards or the losses incurred by the investors.
In many religions, interest is (or at least was-damn usury!) prohibited, but there is nothing wrong with sharing profit (or loss). Since matching savers and investors is time-consuming, special intermediaries rise up to perform that function (taking some of the profit off the top).
As an enterprise model, this is as old as the hills-going back to Mesopotamia. As Michael Hudson argues, the interest rate charged was 20% or 33% depending on the type of economic activity (lower for commercial, higher for consumer).
In its modern dress, the proposal is to set up a centralized nongovernmental committee of experts to decide who gets the loans.
According to Pettifor, this is pushed by the "UK NGO, Positive Money. They agree that all 'decisions on money creation would ... be taken by a committee independent of government'. Furthermore, Wolf argues, private commercial banks would only be allowed to:
'...loan money actually invested by customers. They would be stopped from creating such accounts out of thin air and so would become the intermediaries that many wrongly believe they now are.'"
For me, that's a crank too far.
First, I do not like centralization and I worry about a committee of experts deciding who is going to get credit. I like the idea of having thousands of decentralized financial institutions making such decisions.
I like a variety of types of financial institutions as well: credit unions, local community banks, mutual savings and loans (those were the old thrifts that offered mutual shares and made mortgage loans; they never failed and they served their communities), and even some mid-sized banks with a few branches.
(I also support government development banks, which lend for public purposes. And there is a need for direct lending by Treasury for student loans and other public purposes. However I would not want to eliminate private lenders or cooperatives and mutuals. I do not believe government will generally do a good job of underwriting-so I would favor government direct lending where the public interest trumps good underwriting, and leave the rest to "private" lenders, including coops etc.)
Second-and maybe more importantly-the proposal is based on a fundamentally flawed view of the saving-investment and deposit-loan relationship.
For those who've got Econ 101 under their belt, it is based on the loanable funds notion that "saving finances investment". As we've known since Keynes, that is precisely wrong. I won't go into it here, but it is best to think of this the other way round: investment creates the income that can be saved.
But if the Keynes view is right (and of course it is right), then what finances investment (and any spending in excess of income)? Credit. Where does it come from? Out of thin air.
I can just hear our cranks: "There you go again, that is what we want to eliminate!"
Yes, I understand. But crankiness can only take you so far. You've got to have the correct theoretical framework. As Pettifor rightly says in her piece, if we really did limit our finance to saving, then we'd run our economy right into the ground.
Saving is a two-step decision: a decision to NOT spend, and then a decision to hold your saving in some form. Only a portion of saving will ever make it into our intermediary to finance loans. (Some portion will go into the narrow bank, some portion will go under the mattress in the form of currency.) Each period, the amount saved, lent, and then spent would probably decline (leakages into those mattresses).
We need that thin air money creation to keep the lending, spending, and growing moving forward.
Now, before I'm accused of advocating the full-speed-ahead excesses of late 1920s banking or early-to-mid 2000s banking, let me say that (with rare exceptions, as discussed above) lending requires underwriting (credit assessment). I do want "experts" to do that. I want every community bank, credit union, or mutual thrift to have committees of loan officers to do the underwriting.
What failed us is that the biggest global banks decided underwriting is not needed. They got rid of their loan officers. They off-loaded all their loans to securitization. There is absolutely no hope that a Citi or a BofA will ever do good underwriting again.
I agree with our cranks (I'm as cranky as they are) about shutting down all of the biggest financial institutions. They serve no public purpose, and their business model ensures they cannot serve any private purpose, either, except enriching the top tenth of one percent.
However, we need "thin air" money creation, albeit with decentralized and incentivized underwriting determining which activities ought to get financed. (Good underwriting is incentivized if loans are held to maturity.)
The Limits of Legislation
But here's a more fundamental question. Is it really possible to legislate away "thin air money creation"?
As Minsky said, "Anyone can create money" (How? Thin air.), "the problem is to get it accepted."
How can government prevent me from writing "IOU five bucks"? Our economy is based on "I-O-U's" and "U-O-ME's". Since the time of Mesopotamia, we've run up bar tabs-cleared at harvest time on the threshing floor. Retailers routinely receive wares on trade credit, payable thirty days hence.
If you think about it, it's all trade credit of some sort or other. You work for a month and accumulate wage claims on your employer. At the end of the month he gives you a credit redeemable at a bank, which gives you a credit redeemable at another bank.
And we've carried this to the "nth" degree-$700 trillion of contingent commitments, promises to pay if exchange rates move, if someone's credit gets downgraded, if a peasant dies, if the Fed moves rates.
Now, how the heck do you eliminate all of that? And why would you want to?
Yes, some of it stinks, like that rotten fish head in Denmark. But do you really want a centralized committee somewhere trying to tell you whether you can write an IOU for five buckaroos? Or whether you can place a bet that sterling will rise against the dollar?
Or that your peasant will die? (Wait a minute, that one certainly ought to be illegal-a go to jail or to the gallows sort of crime.)
Here's my proposal: let a thousand flowers bloom, but don't protect all of them from wilting.
Carve out various sectors of the financial system that are designated "public-private partnerships" that do have safety net protection, but are closely regulated with respect to what they can do. Further carve them up so that they perform designated public purpose activities. Some help to run the payments system (keep them very safe); others make mortgage loans (closely watched to guard against lender fraud); some make commercial loans (with good underwriting); others provide investment services (with more risk but transparently revealed).
Horses for courses. We've got a huge and complex economy with varied financial services needs.
Right now, we have far more finance than we need. Exactly how much of it we could eliminate as unnecessary is up for debate. I wouldn't be surprised if our economy would actually run better if finance was downsized by 90%-that would put it somewhere near where it was in the early postwar period-the so-called golden era of US capitalism.
But we're not going to eliminate all excesses through legislation. We can, however, refuse to support excess and refuse to rescue the perps of excess. The warning should be explicit and it must be believable. That is hard, no question about it.
Some will say that with Wall Street running our government, you'll never remove the safety net of the biggest, crookedest, riskiest banks. They might be right. But if they are, I cannot see how they will do the impossible: legislate away Wall Street's excesses.
Simon Johnson, who wants to break up the biggest banks, made an interesting point when we shared a panel in Washington last year. He really believes it is not only possible to break them up, but that it will happen. Why? Because there is growing support among all the banks that are not "too big to fail".
For the most part, those smaller banks played no role in the shenanigans that led to the crisis. They increasingly recognize the huge public subsidies given to the "banksters" (I use that term accurately to designate those institutions that are run as control frauds-as Bill Black calls them) in the form of low interest rates plus a government backstop in the event that their bad bets go wrong.
He might be right. It might be easier to break them up and shut them down than to legislate away their excesses. Heck, much of what they did is already illegal!
The Role of Monetary Cranks
Yes, the rotting fish on Wall Street and in London stinks. We need downsizing. We need reform-not only of the financial system that exists, but also of the crisis response that we will need when the system fails next time. You can be sure there will be a next time.
This is the time for monetary cranks.
No good ideas will come out of the mainstream. They never saw the crisis coming, indeed, their advice in the speculative run-up made the crash not only inevitable but much worse than it would have been. They were behind the bail-outs of Wall Street and London. Their rescue of the banksters will hasten and deepen the next crisis. Do not listen to them.
We need to remember two things, however, as we assess the proposals of our cranks.
First, there is no final solution. There is no magic reform that will prevent another crisis. As Minsky said, "stability is destabilizing". Any successful reform will lead to the recreation of instability that will lead to another crisis.
Second, it is essential that the reform proposal is based on a coherent and valid theoretical framework.
One way to judge the monetary cranks that are proposing reforms is to ask:
"Where were you a decade ago?" Did you see "it" (the crisis) coming? Did you have a coherent theory which explained why a financial crisis would occur? Is your proposal consistent with that theoretical framework? What the heck is your monetary framework?