the random oracle

I recently read The End of Banking and found it to be a very articulate exploration of a lot of things that have been floating around in my head for quite a few years.  The book claims that the nature of the financial economy has evolved such that the financial crisis of 2007 was inevitable, and goes on to propose some remedies.  In particular, it proposes a very interesting and enlightening interpretation of the causes of the Financial Crisis of 2007.

The primary problem the book points to is the conflation of money and credit in a fractional reserve banking system.¹⁾Actually I tend to disagree that conflating money and credit is itself a problem; in fact I believe that money and credit in the digital age are almost necessarily the same thing.  Nevertheless, most of the book’s points hold even if we are not worried about conflating money and credit per se, because the key point is how money and credit are tied together via fractional reserve banking.  I’ll expand on my personal views in a later post.  Here’s Wikipedia’s article on fractional reserve banking.  The book makes a clear distinction between two kinds of money in a fractional reserve banking world: “outside money”, money created by the central bank, and “inside money”, money created by private banks.

The primary purpose of banking and the financial system in general is to allocate capital to where it can most productively be used.  Banks do this by taking deposits, which appear as liabilities on their balance sheet, and making loans, which appear as assets.  Because borrowers then redeposit their borrowed funds at banks, banks can then reloan this same money out again.  This is one of the primary features of fractional reserve banking, conflating money and credit: the credit (loans) that the bank issues then become deposits (money) that can be loaned out again.

This is circular, of course, and results in problems: at any given time, the amount of “real” assets at a bank, i.e. central bank or “outside” money, can only cover a small fraction of the bank’s total liabilities (deposits on record).  This means that in the event that many depositors want to withdraw at once, the bank cannot fulfill all the withdrawal requests, resulting in a bank run.  Bank runs are a primary weakness of fractional reserve banking; to deal with this, governments set up deposit insurance and lenders of last resort.  This backstop legitimizes the perception that private bank deposits are “as good as” cash.

These measures create the new problem of moral hazard: private banks have incentive to take excessive risk because the downside will be borne by government backstops.  To reduce this moral hazard, banks are heavily regulated.  One of the primary requirements is in capital: a bank must keep a certain amount of capital as a function of liabilities in order to be able to honor withdrawals.

This is the point at which the book gets really interesting: its main thesis is that due to the power of information technology and modern communication networks, banking as it functions now has become unregulatable.  It is too easy to use technology to set up new instruments that superficially look like special-purpose securities but in reality behave exactly like bank deposits and loans.

The book runs through examples of how asset-backed securities and collateralized debt obligations (and higher-order CDOs) were used in the run-up to the financial crisis to hide the money creation process.  I will defer to the book on the precise description of the process because it does a very good job, and it would be a digression to get into details here.  I only summarize a few of the book’s points:

• Money doesn’t have to mean deposits or cash, it can be any instrument that has the following properties: it is highly granular (e.g. one can trade 1 single cent’s worth of the instrument), it is highly liquid, and it is perceived as riskless.  Let’s call these instruments shadow money.
• Many risky forms of credit (e.g. mortgages) can be transformed into shadow money with the above properties using various convoluted contractual tools.  This shadow money can then be transformed back into more credit (e.g. more mortgages), which is transformed into more shadow money, ad infinitum.
• By moving these instruments off their balance sheet to special-purpose vehicles (shell companies set up for the purpose of creating a financial instrument), banks can create shadow money that evade banking regulation on capital requirements.
• Without capital requirements, banks will continue creating new shadow money beyond reasonable levels.
• With too much (shadow) money in the system, bad loans are made.
• When bad loans default, shadow money all of a sudden is no longer perceived as riskless, sparking what is essentially a bank run.
• When the bank run involves institutions that are too big to fail without damaging the real economy, the government steps in and effectively guarantees the shadow money even though these instruments are not covered under traditional deposit insurance.

Thus, according to the book, the real problem that led to the Financial Crisis of 2007 was excessive liquidity in the financial system due to the excessive creation of shadow money.  This is a very insightful and, for me at least, a new way of viewing the events.

In light of this interpretation, the ensuing actions of the Federal Reserve seem to make more sense.  Because the financial system had gotten used to a large amount of shadow money, when it evaporated all of a sudden there was not enough liquidity left for the markets to function.  Thus the Federal Reserve plugged the gap by creating (non-shadow) money to substitute for the missing shadow money.

This leads to at least one puzzling question: when there is excessive liquidity in an economy, inflation should rise.  Why did this not happen as a result of excessive shadow money?  Furthermore, why did it not happen when the Fed started replacing shadow money with real money?

More questions and comments in future posts…