Money

by Felix Martin

  When the excesses of the 1920s ended in the crash of 1929 and the Great Depression that followed, there was a similar depth of soul-searching over the institutional structure of the banking system in the U.S. Then as now, the unwarranted enjoyment of sovereign support by activities inessential to the provision of money to the public was identified as a major cause of the problem. In 1933, the Glass-Steagall Banking Act therefore established a rigid separation of firms permitted to engage in securities dealing, or investment banking, from those permitted to engage in deposit-taking, lending, and payments services to companies and individuals, or commercial banking. And the McFadden Act of 1927 placed effective restrictions on the size of banks by prohibiting National Banks from opening branches outside their home state. Both restrictions lasted right into the 1990s.11 And it is notable that it was the relaxation of these structural constraints on the activities and size of banks that contributed to the unmanageable size of the problem that was exposed by the 2007–8 crash. It was when the mid-century interlude of strict structural regulation ended that the age of “too big to fail” definitively arrived.12

  Since the crisis, this historical experience has constituted the default framework for the flurry of legislative activity aimed at changing the structure of the banking sector itself. In early 2009, President Obama appointed an Economic Recovery Advisory Board, chaired by ex-Chairman of the Federal Reserve Paul Volcker, to make proposals on thoroughgoing reform of the financial sector. On the other side of the Atlantic, the newly elected coalition government of the U.K. appointed an Independent Commission on Banking under the leadership of the eminent Oxford economist Sir John Vickers, in June 2010. Both groups recommended a new segregation of banking activities. There were differences of nuance—Volcker chose to distinguish client-oriented and proprietary trading, whilst Vickers drew the line between banks’ activities in retail and wholesale markets; and Volcker recommended that segregated activities be done in legally separate companies, whereas Vickers thought “ring-fencing” them within existing conglomerates would be enough—but the underlying philosophy was the same. Let Wall Street and City traders gamble as much as they like on their own tab, was the spirit of both sets of recommendations, so long as sovereign support is henceforth statutorily available only to strictly regulated institutions.

  There appears, therefore, to be a rare international consensus on the counter-insurgency tactics of choice. But there remains a problem. “Tactics without strategy,” runs the famous maxim of the great Chinese military thinker Sun Tzu, “is the noise before defeat.” What exactly is the objective of these structural reforms? At first glance, the answer would seem to be simple: “financial stability.” It is financial stability that the new institutions established since the crisis are charged with maintaining.13 It is financial stability that the newly chastened central banks acknowledge they must aim at, in addition to the overly simplistic objective of low and stable inflation (and perhaps low unemployment) that was their single-minded goal before. Above all, it is financial stability that is the stated goal of all the new legislation.14 Yet for all the sound and fury, there remains a deafening silence when it comes to the obvious question this raises: what exactly is financial stability?

  It is a question to which neither of the dominant intellectual frameworks for contemporary economic policy-making are equipped to provide a sensible answer. As the Governor of the Bank of England has pointed out, modern, orthodox macroeconomics “lacks an account of financial intermediation, so money, credit, and banking play no meaningful role.”15 So as one of the founding members of the Bank of England’s Monetary Policy Committee has lamented, it “excludes everything relevant to the pursuit of financial stability.”16 But neither does the modern theory of finance, with its blind spot for money’s macroeconomic role, supply any new and specialised theory of financial stability to slake the thirst of the expectant reformers. “For all the attention paid to financial stability analysis in the last few years,” Governor Daniel Tarullo of the U.S. Federal Reserve dolefully concluded in October 2012, “it is still—relatively speaking—a fledgling enterprise.”17 The root of the failure in both cases, as we discovered, is the conventional understanding of money. Stuck in its Looking-Glass world, the policy-makers are flying blind. Can the alternative traditions of monetary scepticism help instead?

  THE BOLDEST MEASURES ARE THE SAFEST

  The global financial crisis has raised the stakes in the debate over regulatory reform. As a result, there is an openness to unorthodox ideas that has not been seen for decades. Fortunately, there is also a rich seam of such ideas to be mined, if we look beyond the last fifty years of economics and finance. Some contemporary thinkers have already begun to float more adventurous proposals. Robert and Edward Skidelsky advocate a hearts and minds campaign—arguing that nothing short of ethical reconstruction is necessary to enable people to answer for themselves the fundamental question of How Much Is Enough and thereby free themselves from the militant insatiability intrinsic to monetary society.18 The philosopher Michael Sandel hints instead at the Soviet strategy. He suggests counter-insurgency by cantonment—reforms to make sure that there remain some things that money can’t buy.19 For others, nothing less than the Spartan solution will do. According to U.S. congressman Ron Paul, for example, the way to solve the intrinsic problems of our current monetary system is simple: End the Fed.20

  The most important thing the unconventional tradition provides, however, is not any one particular proposal. It is the alternative understanding of money not as a thing, but as a social technology. The world, we have to admit, is an uncertain place. King Solomon’s biblical warning that “the race is not to the swift, nor the battle to the strong, neither yet bread to the wise, nor yet riches to men of understanding, nor yet favour to men of skill” might sound defeatist—but few would dispute his fundamental point that “time and chance happeneth to them all.”21 It is as true of the field of economic activity, as in every other, that there is a certain amount of inescapable risk in the world. Money is, on the unconventional view, a system for deciding how this risk is shared out. In the jargon of economists, genuine economic risk—uncertainty about whether the harvest will be plentiful or poor, or whether next month’s meticulously planned product launch works or it doesn’t—is “exogenous”: it is essentially beyond our control. Financial risk, by contrast, is “endogenous”: we decide, through the design of the monetary system, how those unpredictable economic gains or losses get shared around the community. Money answers the question of who bears which risks under what circumstances. Of course, money is not the only system for organising society that can answer this question. The redistributive engine of the Western welfare state, in which social rights rather than economic value determine who gets what, is an obvious example of an alternative. But the way that money organises the distribution of economic risk in society—by making a simultaneous promise of stability and freedom—has made it epidemically successful throughout history. It is a brave promise.

  For money issued directly by the sovereign, we have seen that the promise works because the sovereign, by definition, has political authority. A sovereign’s authority is in turn a function of its legitimacy. That’s why, when governments lose their citizens’ confidence it becomes much easier for private moneys to circulate, as the example of Argentina’s private and provincial currencies showed. In monetary society, how the sovereign can best preserve its legitimacy is therefore a critical question. It becomes all the more pressing because money’s promise of stability means that debt crises are bound to arise—and the sceptical tradition has understood since ancient times that a critical prerequisite for the sustainability of monetary society is therefore the safety valve of a variable monetary standard. So long as citizens permit the sovereign a discretionary power to recalibrate the financial distribution of risks by adjusting the monetary standard when it becomes unfair, sovereign money can work. This is why the conventional understanding of money as a physical thi
ng is so dangerous. Whereas with physical concepts it is essential that the standard we use to measure and manipulate them should be an immutable or even a natural constant, with the social concept of value exactly the opposite is true. If money is to generate a just society then it is essential not that the standard of economic value is irrevocably fixed, but that, as Solon showed, it is unflinchingly responsive to the demands of democratic politics.

  So much for sovereign money. In the modern world, nearly all the money in circulation is not issued by the sovereign any more: it is issued by banks. So how do banks pull off money’s promise to deliver both stability and freedom? The answer—according to the theory, at least—is that banks achieve “liquidity transformation”: they “transform” their liquid, short-term deposit liabilities into illiquid, long-term loans. But the notion of “liquidity transformation” is, quite literally, a euphemism.22 Nothing is actually transformed at all. Banks’ liabilities remain short-term and of fixed nominal value, and their assets remain long-term and of uncertain nominal value, and never the twain shall meet. Instead, banks give the impression of achieving a transformation by artfully synchronising the payments in and out of their balance sheets. No matter how artfully this is done, though, there is always the possibility that people will lose confidence in a bank’s ability to do it. That is the problem that plagues every private issuer of money—and even did for the great international bankers’ money of the sixteenth century in the end. The international shadow banking sector and its horrified regulators relearned the lesson in the early 2000s: private money that sustains itself purely on its own resources works in good times but not in bad. So the only way to make bank money work sustainably is by piggybacking off the sovereign and its authority—that is, by striking a Great Monetary Settlement. For three centuries, this has seemed like a reasonable solution. But the crisis has exposed the fact that the distribution of risks that today’s system of bank-based money dispenses has become intolerably unjust.

  Such is the alternative understanding of money that our unauthorised biography has described, and the interpretation of what is wrong with the banking system that it implies. Global banking’s current structure generates an unjust distribution of risks, where losses are socialised—taxpayers are on the hook for bail-outs—while gains are private—the banks and their investors alone reap any profits. So how can the situation best be fixed? Two extreme options help frame an answer. The first would be to privatise all the risks—to restructure the banking system so that investors bear all potential costs, as well as all the profits. The other would be the opposite: to redesign the system so that the financial system socialises all risks. Taxpayers keep all the downside risk—but now they get the upside too.

  The first option is a modern version of the Scotsman’s strategy—John Law’s revolutionary idea for a structural fix for money. The core principle of Law’s plan was the transfer of risk from the sovereign to his subjects, by the creation of what was, in effect, sovereign equity in the form of shares in his conglomerate System. Law’s hope had been that these uncertain claims on the revenues of the French economy would come to replace the fixed claims represented by banknotes, billets, and other sovereign debt securities. The moribund economic culture of the rentier state would be abolished for ever, and there would be no more debt crises—since there would be no more fixed obligations to get out of kilter with uncertain tax receipts. Two birds would be killed with one stone.

  Surprisingly, this fundamental principle is far from alien to the current regulatory response to the crisis. The structural reform proposals of Volcker and Vickers make a nod to Law’s fundamental idea of realigning the distribution of risks implicit in the current structure of the banking system. There are more aggressive contemporary reform proposals under debate as well. The prominent U.S. economist and public intellectual Laurence Kotlikoff has put forward one of the more important ones: “Limited Purpose Banking.”23 Under Kotlikoff’s radical proposal, banks as we now know them would cease to exist. All economic risk would simply pass unimpeded through an infinitely expandable spectrum of mutual funds from borrowers to savers. The phoney claims of financial intermediaries to practise “liquidity transformation,” and the intrinsic mismatches that lie at the root of what is wrong with the current system, would be exorcised once and for all. Only manual gearboxes would be allowed on the roads.

  Kotlikoff’s vision is a bold one—but even it stops short of taking the Scotsman’s strategy all the way to the revolutionary conclusion which John Law himself attempted. Under Limited Purpose Banking, although private banks are henceforth forbidden to issue short-term liabilities of certain nominal value whilst holding long-term assets of uncertain nominal value, the sovereign itself is not. Sovereign money remains just as we know it today at the heart of the system: a safe and liquid promise to pay under all circumstances. Law’s idea was to rid money-users of even this last resort of risk aversion. At the heart of his new financial world was to be not sovereign debt, but sovereign equity. Once again, it is an idea that sounds incredible to modern ears—but it is one that has its influential advocates today. The U.S. economist Robert Shiller—a modern Projector, as well as one of the world’s most distinguished academic economists—has for many years urged sovereigns to share with investors the risk to the public finances inherent in uncertain economic growth by issuing bonds that pay interest linked to GDP.24 Shiller’s proposals urge a gradual shift towards such innovative financial instruments. In the midst of the greatest economic and fiscal crisis France had ever seen, Law lacked the luxury of time.

  Law’s strategy of creating a monetary system which privatises all risk represents one extreme option. At the opposite end of the spectrum is a reformed monetary system structured to socialise all risk. This alternative extreme would see the banks replaced not by mutual funds, but by the sovereign. Money’s seductive promise would not be abolished. Instead, the one issuer actually capable of making good on it—the sovereign—would be the only issuer permitted to do so. Both capital markets and the banking sector would continue to coexist; and money would remain the special preserve of the latter. But under this extreme option, it would be entirely owned and operated by the state. Once again, it is a reform that sounds dramatic, but is not as far-fetched as it first appears. Indeed it is towards this extreme that the crisis, with governments’ nationalisation of banks and central banks’ unprecedented interventions in the money markets, has thrust us by default. When the U.S. Federal Reserve has taken over more than U.S.$1 trillion of mortgages, and the balance sheet of the European Central Bank has absorbed everything from car loans to credit card receivables, why not finish the job?25

  As counter-insurgency strategies designed to disable the Monetary Maquis and secure a new Great Monetary Settlement, these extreme strategies have the merit that they would eliminate once and for all the problematic distribution of risks inherent in the current structure of the banking system. Unfortunately, they would do so only at the cost of destroying monetary society itself. The Scotsman’s solution would represent the apotheosis of the vision of modern academic finance: the abolition of banks and money in favour of capital market securities, the value of which would vary in perfect sympathy with the underlying risks present in the real world.26 The sovereign’s ability to redistribute these risks by adjusting the monetary standard would cease, because there would be no sovereign liabilites the value of which was fixed in terms of it. Money would no longer be a tool of government. Instead of a rule for anarchy there would be just anarchy—until some other system for organising society took its place. Rather than reimposing legitimate government, this is defeating the insurrection by permitting a free-for-all.

  Meanwhile, the alternative extreme of a return to sovereign money alone—a society in which all money is issued by the state because all banking is operated by it too—presents an equally nightmarish prospect. Money would no longer be a tool of government, it would have become government. All the benefits of decentralised
decision-making in finance would be gone, replaced by a monetary system that replaced the injustice of taxpayers’ enforced insurance of the bankers by the alternative injustice of their insuring absolutely everybody all the time instead. Like encouraging a descent into anarchy, this is a counsel of despair: defeating the insurgency by becoming a totalitarian state.

  If we are to turn the locusts into bees, we do need a radical reform of the banking system. The unconventional view of money suggests three useful principles to begin from: two regarding where we want to go, and one regarding how we get there. First, the solution to the problem of moral hazard at the heart of the modern banking system lies neither in redesigning the system to privatise all financial risk, nor in redesigning it to socialise it. What is required is a closer match—not a perfect one—between the costs and benefits that taxpayers, bankers, and their investors are at risk of bearing. The current regulatory response is on the right track. U.S., U.K., and EU proposals all argue that more risk must be borne privately, and less socialised and borne by the taxpayer. But the reforms they propose do not go far enough.

  Second, since money is a tool for organising society, and since the only authority with the political legitimacy to command how society should be arranged is by definition the sovereign, any redesign must maximise the room for monetary policy. Money’s fantastic promise to deliver both stability and freedom has become a boondoggle in the hands of the banks: the specious claim of “liquidity transformation” has become camouflage for a one-way bet, and should be forbidden. Yet that same promise is nothing other than the essence of money, one of the most powerful and important tools of democratic government the world has ever known. So long as democratic politics commands the escape valve of a flexible monetary standard, it should therefore be preserved.