A graphic short story in this month's "capital ideas." Click on the link or the image to read the whole thing (4 panels). If you can find the print magazine, the visual quality is much better. I think it does a great job of making economic ideas visual without too many talking heads and big balloons full of text. More of these to come in future "Capital Ideas." More work from this unusually talented graphic novelist here. (My side of this "debate" is a bit captured here.)
I take it that the unusually talented graphic novelist is your son, who, I guess, is named after your father, may he rest in peace and may his memory be a blessing.
ReplyDeleteDiamond is wrong to say we need private banks to create "liquid assets" (near the end of the cartoon).
ReplyDeleteThe way in which private banks create liquidity or liquid assets is inherently expensive. That is, various people deposit collateral at those banks, the bank checks up on the value of the collateral (which is not a costless activity) and then credits the accounts of relevant people with liquid assets, i.e. dollars.
In contrast, the government / central bank machine can simply create and spend new money into the economy when stimulus is needed. That money creation can be done at the click of a computer mouse: almost costless.
I agree, but let's be fair to Doug - he's spent a distinguished lifetime thinking about these issues, in ways much more subtle than can be captured by a few balloons in a cheery piece in our alumni magazine.
DeleteThe real lesson here is that no one seems to really understand the impact of banks on the economy. It does seem that Professor Cochrane is advocating a giant, peer to peer, capital market extending shadow banking to more lenders and borrowers. But we know that the financial crisis hit first and hardest in the shadow banking sector.
ReplyDeleteIf Professor Cochrane's proposal was economically efficient it seems to me that the shadow banking sector would have survived and thrived.
Actually no. In my view a lot of "shadow banking" was simply a way to game regulations. My view, as expressed in the cartoon, and better in the linked oped, is pretty radically different: anything involving run-prone short term debt has to be backed by treasuries. Anything else has to have floating values. That is a "shadow capital market" if you'd like, but not a "shadow bank."
DeleteI went back and re-read your editorial. You basically propose a financial system where anyone who wants a guaranteed return of capital has to invest in treasuries. The investment may be through intermediaries but basically the government becomes the only deposit taking institution. Every other investment is an equity investment. There will be no government guarantees of the paper being issued.
DeleteThe problem with the idea that everything is "equity" in the sense of being risk capital is that that is precisely what shadow banking was all about. Large borrowers went to the commercial paper market and borrowed directly from sophisticated borrowers and money market mutual funds. Neither the non-bank issuer nor the money market fund intermediary had a government guarantee. Which is precisely what you advocate should apply more broadly. The investors were equity investors. And when there were problems, investors refused to roll over the notes and we effectively had a run on major industrial companies. The government stepped in with the Commercial Paper Funding Facility which intervened to keep the market for commercial paper liquid and advanced almost $350 Billion at the peak.
I think it is easy to forget or overlook just how serious the freeze in the commercial paper market was. Warren Buffett invested in GE. By my calculation at the time GE agreed to pay Buffett about 25% per annum for three year equity money. That is how bad the market was.
One can be a purist and say that the government should have let GE and other commercial paper issuers go bankrupt to encourage future corporate investors, lenders and management to be more prudent. I think is more economically efficient and the country is better served with a government guarantee (explicit or implicit) of liquidity for some private sector investments.
Maybe I can express my point differently. GE Capital does maturity transformation issuing commercial paper due in less than a year to fund capital loans extending five to ten years. GE Capital is therefor subject to roll over risk which is effectively the same as a run (even though it might take several months to fully develop). Do you advocate that GE should not be permitted to do maturity transformation or that the people who buy GE commercial paper should not have the right to sue if they are not paid promptly on maturity? It seems to me that you have to advocate one or the other.
ReplyDelete“And when there were problems, investors refused to roll over…”. But there wouldn’t be any “problems”, or at least the problems would be much reduced under JC’s system. Under that system, when a bank (or any lending entity whether it’s called a bank or not) performs poorly, all that happens is that its shares decline in value. There is no “run”.
DeleteWhen BP performed poorly in the Gulf of Mexico, i.e. made a huge mess there, it was obvious BP would have to pay compensation amounting to billions. But there wasn’t a “run” on BP. All that happened was that its shares dropped a bit.
And JC is nowhere near the first to advocate the “JC” system. Milton Friedman advocated the same system in the 1960s. I put a relevant extract from Friedman’s book here:
http://ralphanomics.blogspot.co.uk/2014/01/milton-friedman-set-out-positive-money.html
Others advocating that system include Richard Werner (economics prof at Southampton in the UK), John Kay (Financial Times columnist).
As to maturity transformation, I agree that the JC system means an end to MT. My reaction is, “good riddance”. Of course, ending MT would have an initial deflationary effect, but that’s easily countered simply by having the government / central bank machine create and spend enough new money into the economy (and / or cut taxes) to keep employment at the maximum level consistent with acceptable inflation (i.e. NAIRU).
And as I pointed out above, the central bank can create money more cheaply that commercial banks.
Ralph,
DeleteYou are not making sense.
"Of course, ending MT would have an initial deflationary effect, but that’s easily countered"
Why do you need to counter inflation, when there is no debt under your system?
"..simply by having the government / central bank machine create and spend enough new money into the economy (and / or cut taxes).."
Why would you need any taxes in your system?
"to keep employment at the maximum level consistent with acceptable inflation (i.e. NAIRU)."
Why do you think there would be a trade off between inflation and employment?
Government prints money and gives it to a company to produce widgets. Company uses money to pay workers to produce widgets. No one buys widgets - widgets are immediately thrown in a land fill. Full employment, zero inflation.
Under your system, you do not need demand for a good to equal supply of the good. Supply can exceed demand because there are no financial contracts (debt).
Frank,
DeleteYou ask “Why do you need to counter inflation, when there is no debt under your system?”
Where do you get the idea that there is “no debt” under this system? If firm A supplies goods to firm B, then there is debt owed by B to A until A pays for the goods – just as is the case under the existing fractional reserve system.
Also under this system, where anyone wants $C of their money to be 100% safe, they essentially have their money lodged at the central bank (with their commercial bank acting as agent between them and the CB). In which case, the central bank owes that person $C. That’s another form of debt: essentially the same as your bank owes you $B if you deposit $B at your bank.
Next, when you said “counter inflation” I assume that’s a typo. I actually said I thought the initial effect of the new system would be deflationary, not inflationary: reason being that the new system puts obvious constraints on what banks can do.
Next, I’m baffled by your question “Why would you need any taxes in your system?” My answer is: “for exactly the same reason as we need taxes under the existing system”. I.e. if government wants to spend an extra $Y, it has to suppress private sector spending by $Y, and a good way of doing that is to grab around $Y off the private sector.
Next, I’m baffled by your claim that under the new system (which is actually full reserve banking) government pays firms to produce stuff which is then thrown away. Completely bizarre. Can you explain?
Finally, you claim there are “no financial contracts”. I’m baffled again. Under the new system, I would have a stock of 100% safe full reserve money. When I want to purchase a holiday, groceries or shares in General Motors or whatever, I pay with my debit card or a check, just as I do now. And $Z gets transferred from my account to the account of the firm that sells me the above stuff. Is that sort of transaction what you meant by a “financial contract”, or do you mean something else?
Ralph
DeleteMilton Friedman said that a lender should only be able lend money it raised by selling shares or issuing debentures (plus presumably retained earnings). I assume that he had in mind perpetual debentures. Fixed term debentures must be paid off eventually and therefor create rollover risk.
So under that system, an investor would have a choice between lending his money to the government or buying a perpetual investment. There would be no middle ground. It would be illegal for GE Capital and an investor to agree that the investor would lend money to GE for any limited period - whether it was 24 hours or 24 years.
I personally think that the efficiencies that can arise from allowing GE to issue commercial paper with maturity dates before the end of time outweigh the costs of regulating that market place and the occasional need for the government to inject liquidity via programs like the Commercial Paper Funding Facility (which was repaid in full).
If it was more economically efficient for GE to issue perpetual bonds then it would have done so. We should be concerned about moral hazard and implicit subsidies that arise from things like deposit guarantees but we should not blow those concerns out of proportion either. ( I don't mean to pick on GE capital but they are an important and well known source of industrial finance and highly respected so they make a good example. I could have used Caterpillar Finance instead. )
A run on banks or shadow banks is a contraction of credit. We can suffer serious contractions of credit without a bank run. In the thirty years I have seen banks which were solvent decide to significantly cut back lending to some sectors or geographic regions. I have seen banks reduce lines of credit to their best customers (like my law firm) as part of a general policy shift and the customers (including my law firm) turn around and cut credit to their customers so there is a telescoping of credit through the business chain.
Ralph,
Delete"If firm A supplies goods to firm B, then there is debt owed by B to A until A pays for the goods"
Why would a firm wait any significant time period to be paid without being compensated for waiting? Any vendor financing that exists that I have ever heard of involves the buyer paying an interest rate. Also, why wouldn't the government step in to bridge the gap between when a good is delivered and when the buyer can pay for it?
"where anyone wants $C of their money to be 100% safe, they essentially have their money lodged at the central bank"
Why would anyone do this when they can simply have the government print new money (free of charge) to replace any money that is lost / stolen?
"Next, when you said counter inflation I assume that’s a typo."
Yes that was a typo. The question should have been "Why do you need to counter deflation, when there is no debt under your system?". You answered that debt still exists in the form of delayed payment for goods - goods received in one period, payment received in another.
I then ask, why would any firm allow for payment after receipt of goods without being compensated for the risk of non-payment - default risk?
"Why would you need any taxes in your system? - My answer is: for exactly the same reason as we need taxes under the existing system. I.e. if government wants to spend an extra $Y, it has to suppress private sector spending by $Y"
That could only work under a fixed money supply regime (regulating demand through taxation). When private individuals are allowed to create debts, then the only trade off is the willingness of private lenders to roll over existing debts and / or the willingness of private individuals to stay current on existing debts.
Government only taxes income, they do not tax newly incurred debt. When you buy a new car or house by borrowing money - does the government tax that borrowed money?
"Next, I’m baffled by your claim that under the new system (which is actually full reserve banking) government pays firms to produce stuff which is then thrown away. Completely bizarre. Can you explain?"
I brought this up as an example of why you don't need inflation to realize full employment under a money only (no debt) system. You indicated that debts still exist in this system so I will let my example slide by the wayside.
"Is that sort of transaction what you meant by a financial contract, or do you mean something else?"
I should have been more specific. What I meant to say was a contract in which no goods are exchanged (hence financial contract).
John,
ReplyDeleteLast panel:
"But your plan relies on a solvent government"
You do realize that the federal government does not face either bankruptcy or solvency risk don't you?
Your plan relies on a fiscally imprudent federal government. When the federal government runs a surplus, the supply of Treasuries dwindles.
Also, what happened to more equity and less debt?
This comic strip is very interesting because it protrays the American federal reserve banking system and how it is lacking in structure. In this comic strip we can see the monopoly pieces represented as individuals in the society and the purple monopoly man is depicted as the bank. This comic strip is basically stating that when we give our money to the bank the bank then uses 90% of that money to make loans for other people. Therefore, if everyone in the society wanted their money back the government would not have enough money to give back to everyone and the whole system could crash. Furthermore, I agree with the professor when he states that there does not need to be a centrally regulated banking system. I believe that there should be many small, regulated banks, that way there doesn't have to be so much power in just a couple banks.
ReplyDeleteLoved the comic. Great artwork. So I hate to be too nit-picky, but... The "Go" arrow on the Monopoly board should point up (clockwise), not to the right. Or is the fact that they are going backwards around the board some kind of metaphor that I missed? Feel free to retcon something...
ReplyDelete-Mike McCaffrey