Last month, I participated in an excellent panel on the Future of Money at the Bristol Festival of Economics. In preparation for the event, UWE undegraduate students taking my course on Economic Theory and Policy worked together to produce two-sided briefs on what they thought to be the most interesting questions for the future of money, and distributed them in advance of the panel. These briefs provided a great background to our conversation, exploring questions of digital money, endogenous money (and its heretics) and shadow money.
Given that we are economists with a certain respect for the power of (fair) competition, we had a contest for the best brief. The quality was excellent, so I chose three out of the seven to be distributed (see Money1 (1), Money2 and Money3). Given the size of the audience, we could have easily distributed the rest as well (see Money Brief 4 , Money Brief 5Money at a glance 6Money Brief 7).
My opening remarks focused on shadow money. Read them below.
Modern controversies about money typically focus on two topics – the power of banks to create money and the threats to this power posed by crypto-currencies. We suspect banks of yielding too much political power, having convinced states to enter a social contract that makes bank deposits into the ultimate money of the financial system. Bank of England recently confirmed this suspicion, in a widely discussed paper that confirmed what heterodox economists – Steve Keen here a famous example – have been saying for a long time.
There is somewhat of a paradox in this. If we consider the regulations that central banks have introduced since the crisis, they have not sought to limit banks’ power to create money. Rather, the new rules introduce by the Basel committee, and by the newly created Financial Stability Board, want banks to issue more of traditional bank deposits, and less of a new type of money, that I will call shadow money.
What is this shadow money? It is money created by banks and other financial institutions through the mysterious universe of shadow banking. If we accept the argument that a society’s money reflects the way in which the credit system is organised, then I think the future is shadow money.
Shadow money is, like all credit money, an IOU. Bank money is an IOU through which the bank promises to pay you a pound of cash for each pound in our bank deposit. You trust the bank that it will convert the deposit into cash at par if you wish to. The difference, however, is that the IOU in shadow money does not rely on trust, but on collateral. When a bank issues shadow money, it issues an IOU backed by tradable securities like government bonds, or corporate bonds, or other securities issued in shadow banking, like the famous CDOs.
Let me give you an example. You and I keep some of our wealth in a bank deposit because we trust the bank, or the deposit guarantee behind it, and because it is convenient for our daily payment routines. This is not the case for a pension fund, or an insurance company or what we call institutional investors and their asset managers. For them, traditional bank money is not an attractive option. The deposit guarantee is too small for what they consider ‘pocket money’. So the bank says ‘look, I will issue you an IOU that gives you the same kind of safety a bank deposit gives a small depositor. To create that safety, I will give you government bond collateral. I still get the interest payments on that bond but I will allow you to become the legal owner of that bond so you can sell it if I go bankrupt’. See how this clever legal arrangement behind shadow money is also advantageous for the bank – it can now fund that government bond with an IOU held by the pension fund.
The issuer of that bond – the government in our case – is also benefitting. Surely if banks and shadow banks have an IOU that allows them to borrow from institutional investors, it creates more demand and more liquidity for their government bonds. Liquidity is the magic word for governments wanting low and stable funding costs to run fiscal policies (at least until we get an MMT-inspired government). The seductive appeal of liquidity applies to securities markets and their issuers more broadly – what we have here is clever system of organizing credit creation via capital markets. And it’s a big system – the cyryto-currency universe is worth roughly USD 200 bn. Shadow dollars, shadow euros and shadow yuan together amount to USD 20 trillion. That is, 100 times more (remember I wrote this before the Bitcoin frenzy).
This shadow money sounds really safe, you may be thinking. Why would regulators seek to limit its creation? The politics of this shadow money is both exceedingly intricate and fundamental to modern financial markets. Shadow money comes with two words that keep regulators awake at nights: leverage and interconnectedness. Going back to my example, it often occurs that the bank would be an intermediary between the pension fund who wants a safe IOU and a hedge fund who wants to borrow more to buy more securities. The hedge funds issued shadow dollars to the bank, and the bank issues shadow dollars to the pension fund. In this way, collateral has changed hands twice, it belongs to the hedge funds, but sits with the pension fund in case of default. They are all interconnected, and dependent on the hedge funds’ leverage decisions. If something goes wrong with the hedge fund, then everyone else stands to suffer.We get runs on shadow money.
Indeed, if you look close at how the global financial crisis unfolded, it started as a run on shadow dollars triggered by the collapse of Lehman Brothers – the familiar Gorton and Metrick story that proved influential in shaping how regulators think about regulating global (shadow) banking. The run then travelled to shadow euros, where it evolved quietly but powerfully to engulf what we now call ‘periphery countries’ under the impotent eyes of the ECB, forced by its mandate to use the wrong cure (looking at you L-TROs) and make the crisis worse. Yes, this crisis is not a simple story of naive investors, fiscally irresponsible governments and European politics unable to credibly enforce rules stoping these governments. It was a crisis of shadow euros, despite ECB protestations. It may soon resurge again in China, who is liberalising the production of shadow money in a bid to attract foreign investors and further RMB internationalisation (paper coming soon).
The future of shadow money is uncertain. One thing we know is that it takes a lot of room for manoeuvre for central banks to expand their crisis framework in order to stabilise shadow money. It is not a coincidence that the only that has done so formally – the Bank of England – is led by Mark Carney, who is also head of the Financial Stability Board. Bank of England has now formally assumed role of market-maker of last resort for systemic collateral markets (very different from lender of last resort), the only solution to stabilise shadow money outside prohibiting it all together (something the European Commission nearly – and accidentally – proposed when it planed to slap an FTT on shadow euros). The FSB & Basel III rules constrain it – and so the Trump administration is quietly making plans to free securities markets from the shackles of international regulation. To reduce the Minsky-type vulnerabilities, significantly magnified in this new world, we need a social contract around shadow money. It wont be a panacea, but it will make life a bit easier. This is not a mere question of better plumbing – it goes to the heart of ongoing discussions about the welfare state, inequality and our capacity to collectively provision for an uncertain future through the state, rather than through markets.
Do you know what the BoE is calling this formalisation of it’s role as MMOLR? I’m trying to dig through their website. Will they also apply procyclical collateral-valuation practices?