Shadowlands

The fallacy [that the Bank cannot overissue money] lies in not distinguishing between an advance of capital to Merchants and an additional supply of currency to the general mass of circulating medium

Bullion Report, 1810

If, it is argued, the central bank has both the will and the means to control the supply of money . . . all will be well. Our view is different…  Though we do not regard the supply of money as an unimportant quantity, we view it as only part of a wider structure of liquidity in the economy… It is the whole liquidity position that is relevant to spending decisions. . . . The decision to spend thus depends upon the liquidity in the broad sense, not upon immediate access to money. . . .  The spending is not limited to the amount of money in circulation but it is related to the amount of money people think they can get hold of, whether by receipts of income (for instance from sales), by disposal of capital assets, or by borrowing –

Radcliffe Committee Report, 1959

My doubts begin with the more detailed analysis and its consequences for policy. To begin with, there is this curious repudiation of some alleged over-emphasis somewhere on the supply of money which occurs like a leitmotiv throughout the argument as though some peculiarly discreditable connection were being repudiated. I am not at all sure that I have got to the bottom of this, any more than that I always understand the precise meaning of the Committee’s substitute notion—the so-called liquidity of the system as a whole. But, speaking as one who still finds the influence of money supply a useful central guiding concept, perhaps I might say [that]… I do not know a single economist since the 17th century who has argued that the supply of money is the only factor determining the volume of spending and the level of employment and prices.

Lord Robbins, Radcliffe Report Debate, House of Lords 1959

Four years ago, the sudden, if not entirely unforeseen, outbreak of financial crisis swept away the disastrously intertwined business models associated with Fannie & Freddie, GMAC, GE Capital, the monoline insurers, AIG, and the entire Bulge Bracket (of whom only one was not to be taken under the sheltering wing of the corporatist state, with the rest, despite their undeniable failure, surviving to exercise their often baleful influence on world affairs today).

Since then there has been much understandable focus on the activities of this motley crew, together with their main partners-in-crime who together comprise what has come to be called ‘shadow banking’. A good deal of that attention has, in turn, been concentrated on the repo-collateral based system of credit which largely connected its members.

Justifiably so, perhaps, given that the extraordinary growth of this particular course of the inverted pyramid which forms our over-proportioned and highly unstable financial infrastructure was as much a salient feature of the last Boom-Bust cycle as any of the arcane of CDO-squareds and PIK LBO loans. This can be seen in the fact that the ratio of total non-money (non-equity) liabilities of US financial business to the actual money kind shot up 45% from Sept ‘02s cyclical trough (itself a 53% gain from the previous local minimum in Dec’93) to June ‘08’s soaring pinnacle.

Evading the flailing attempts at half-hearted regulatory restraint imposed by populist governments all too happy to enjoy the soft budgets and favourable electoral calculus offered by their version of financial alchemy; waxing mischievously inventive in the sensory lacunae of those Wise Monkeys of central banking who can hear, see, or say nothing  if their preferred version of core CPI seems to be rising with due moderation; empowered by a Moore’s Law of rising leverage and exploding complexity in a world where a too-lax and too-predictable monetary policy had coupled with vast, currency-fixing ‘deficits-without-tears’ to engender the inevitably fatal ‘search for yield’, these were the Shadows which ultimately led the charge over the Cliff.

Nonetheless, if it sometimes seemed as if This-Not-Different Time’s equivalents of the old-fashioned, small depositors’ bank run had been professionalised into a wholesale grab for collateral which was greatly exacerbated by an often predatory demand for extra margin amid what the jaundiced might view as a global falling out of thieves, we must resist the temptation to conflate the idiosyncrasies of this particular cycle with a superficial appeal to the writings of certain ‘authorities’ (past, present, and putative) into a much more profound rewriting of economic law.

The intent here is not to deny that far too much credit had this time been extended outside as well as inside of the banks – i.e., by the non-monetary, as well as by what the Europeans usefully differentiate as ‘monetary financial institutions’. Nor was it insignificant that much of that non-bank credit depended on the illusory safety of security collateral – a fantastical bootstrap of paper claims of often dubious provenance, typically owned by some usually unidentified other than their immediate profferer, which were being used to support the issue of a whole chain of other such insubstantial claims.

However, what we must insist is that this latter-day version of that abuse so deplored by the Victorians of the so-called accommodation bill – a speculative piece of paper all too often resting on the ephemeral surety of the contractually unenforceable guarantee offered by a fee-taking ‘man of straw’ of limited resources – can be somehow treated as ‘money’ or that the disappearance of even trillions of dollars from the ledgers of those who traffic in them is, per se, a matter of ‘deflation’.

Yes, there are times when such claims will pass readily from one player to another with few questions asked and, during such excesses of wishfulness, much financial business – some of it even representing transactions in the real world – will be conducted without much in the way of actual money ever changing hands. But such a circumstantial facility still does not transmute these claims into money, properly understood. To argue so is both to confuse what is meant by being ‘liquid’ (able to be realised for cash without a large concession in price and a long search for a taker) with being ‘current’ (passing from hand to hand as a means of overcoming the restrictions of barter) and somehow to confer upon the clearing house the abilities of the mint.

The curious view that it does is hardly novel, either, being associated not just with James Tobin (he of the infamous transaction tax so beloved of the globalists), but also with the High Keynesian, Cambridge Circus worthies who delivered the notorious Radcliffe Committee Report excerpted at the head of this piece which condemned Britain – and, by imitation, several other afflicted nations – to the gathering stagflationary horrors of the two decades of misconceived policy which succeeded its release.

Somewhat ironically, given the man’s lifelong disdain for both Keynes’ faulty economics and the cult-like nature of his disciples, modern proponents of this ‘money doesn’t matter’ view often seek to give credence to their advocacy by quoting some of the musings of F. A. Hayek. These are carefully and selectively culled from various points in an intellectual lifespan which ran in excess of a half-century, a time during which – with a maddening degree of inconsistency for such an otherwise impressive intellect – his penchant for contriving unusual hypothetical examples which ran counter to the received wisdom about the impact of this or that economic approach even stretched to contradicting the results of his own earlier analyses.

Was he for a series of fixed international exchange rates, presided over by well-reserved central banks, or did he favour a complete privatisation of the money creation function? Both. Did he feel that any rise in the value of money would ultimately elevate its real value to the point where a formerly anxious populace again sought to reduce their holdings by spending it or, despairing of such a natural feedback process ever halting a depression, did he advocate some form of what we might now cell nominal GDP targeting? Both. Was he for a gold standard, or a quasi-index standard defined by the price of a basket of several selected commodities, or a limited token standard? All three. Did this inveterate deprecator of macro-aggregates wish to stabilize a general price level or did he bemoan the fact that any such an artificial attempt at stabilization would, in the hands of the central bank, prove horribly pro-cyclical whether productive efficient rose or fell? Both again.

Thus, when we read of him arguing that ‘money’ could sometimes consist of more than currency in circulation plus demand deposits at the banks – and so, by implication, enlist him anachronistically to the ranks of those who insist that shadow bank credit dealings also create and destroy money – we need to stop and think about what the exact occasion was for Hayek’s remarks. Specifically, we need to recognise that even if you do allow him his gentler postulates – which closely follow the work of Chicago economist H. C. Simons – that such things as savings accounts, bills of exchange, and overdraft facilities can sometimes act as if they were money and of how far this concept can be transferred to the routine chicanery practiced today around the tables of the global financial casino. Incidentally, savings accounts may be money to the extent they are themselves subject to cheque and/or readily ‘breakable’ at little cost; bills of exchange were briefly money, as they certainly played such a role in pre-deposit banking, 19th century England; but the last is surely nothing more a confusion of cash-at-hand with potential creditworthiness – or ‘financial strength’, as T. Newlyn put it in 1964.

The Price of Everything

The first point we would make is that it is one thing to say that activities taking place in the Land of Mordor (‘where the Shadows lie’) can impact people’s decisions to about how much money to hold and so can change the quantity of things which a given quantum of that money will buy (as Robbins pointed out in our header), but it is quite another to say that this makes the associated instruments into money themselves. After all, if I can persuade you that you should empty out your bank account to acquire a store of canned food, or a cache of Canalettos, or if your life suddenly becomes incomplete without a Tiffany bracelet or a variegated tulip bulb, it will surely alter both your holdings of and, by extension, the societal value placed by everyone at large on the existing stock of money, without any of these objects of desire ever threatening to take the place of the euro or the dollar. Conversely, if you ‘pop’ your granny’s false teeth so you can get your hands on the latest incarnation of the iPad, that doesn’t mean her dentures have miraculously transubstantiated into currency.

Repo collateral may certainly oil the wheels of financial speculation and the effect of such speculation on asset prices (and hence on the cost of financial capital means) can equally exert an influence on decisions to save, dissave, invest or consume – and hence bring about alterations to a whole range of critical price relations – but that does not mean you would ever routinely accept an owned-at-multiple-removes T-bill in lieu of your wages, or that you can pay for your groceries or a tankful of gasoline by whipping out someone else’s thrice-loaned evidence of Sallie Mae’s past indebtedness and lodging it with the check-out or petrol pump attendant in your turn.

Apart from this quality of ready, near-universal acceptance in payment at par (that’s par – 100% – all you happy haircut merchants in the wannabe-money crowd) which marks out ‘money’ by the fundamental distinction that it serves as the medium of exchange, there is another litmus test of what separates the pecuniary sheep from the non-pecuniary goats, one to which Hayek (to mimic our opponents’ argumentum ad verecundiam) himself alludes in the course of a discussion about cross-border flows in his 1937 work, ‘Monetary Nationalism and International Stability’. This is namely that a transfer of ownership in money (a ‘payment’) does not create any new claim but rather, by implication, it extinguishes one – i.e., the assignment of money is the final consummation of any exchange whereas the passing on of a debt claim is only a deferral of such an act of completion.

Ironically, the only time the collateral underpinning one of Sauron’s latest borrowings can be said to do the same is when the Dark Lord either fails to redeem it on the agreed date, or he is unable to meet his next margin call when it declines in value (ever seen one of those made on money, either?) and the paper is sold out from under him – and sold, moreover, for whatever money it might fetch!

There are two other, slightly more subtle characteristics inherent to the medium of exchange which we can marshal in our defence of the uniqueness of a true money – i.e., notes, coin, and bank-issued demand deposits – which these other pseudo-monies do not possess.

The first sounds like a quibble, but is actually of profound importance. This is that while money itself has no single price, everything else has a money price. We cannot categorically say that the price of a $1 is three apples, because it is also five tomatoes, one pineapple, 40 grams of cheese, four pints of crude oil, and 3/10 of a grain of gold, etc., etc., but we can, of course, say the converse. So, ask yourself this: is the price of the current, on-the-run, 5-year Treasury note 98 ½ cents per $100 face value or is a dollar 1.105 T-notes? Do we price Agency MBS in dollars or dollars in Agency MBS? The answer might give us a clue as to which was the money and which the hapless pretender.

The reason this is important is that if there is an excess supply of bonds, or stocks, or bell-bottomed trousers, their individual price will fall (and, in the case of the first two, their yields will rise) to the point that they attract a new cohort of buyers and the market for them again clears. Let there be an excess supply for money, however, and no single price change can operate to bring about the adjustment. Instead, there is set in train a generalized – but highly differentiated – rise in the price of most, if not all, other goods, services, and assets over time to the point that the increased nominal supply once more becomes consistent with the real worth people wish to hold. Such a pervasive re-ordering – which entails both varying magnitudes and sequences of response, with the implied disruption of input-output and present-future price relations in what can be a highly arbitrary and unpredictable process – is the very reason that ‘monetary disequilibrium’ can be so uniquely pernicious in a way that a shortage of left-handed screwdrivers or a surfeit of Gibson Les Pauls can never be.

Thus, to admit that a sudden realisation of the parlous condition of the loans one has made,  or a four-in-the-morning epiphany as to the unsoundness of the collateral one has been accepting will suddenly increase one’s desire to sell them for money is precisely to demonstrate that they are different from money, not cognate with it.

Money is distinct by virtue of one critical facet of its primary function. This is that it flows. Just think about this for an instant and you will realise that the vast bulk of the money that ever came in to your hands, or into the cash registers of a business, or the coffers of the state treasury never stuck there but was soon sent off on its merry way to its next, eager but equally temporary owner. So much is this instant transmission the key attribute of a money, in fact, that any augmentation or diminution to that mighty flow caused by more or less of it being siphoned off into the typically small-scale reservoirs which we do each tend to maintain can have a pervasive influence on the economic data.

A practical demonstration of this assertion may lie just ahead of us for it is a signal fact that, since the crisis broke, US non-financial corporates have been unusually avid holders of money  Thus, in devoting 85% of retained earnings—or 20% of ex-dividend, after-tax cash flow—to accumulating a $630 billion mountain of money (cash plus demand deposits) over the past 2 1/2 years, these most unlikely of ’hoarders’ have so far helped retard the most incendiary effects of the Fed’s extraordinary actions.

In part this has been a result of the ‘regime uncertainty’ which has arisen as the authorities have dispensed with the rulebook in trying to shore up the tottering edifice of Western finance, and as they have unveiled some radical new measure with each turn of the news-cycle in much the same counterproductive way as did that inveterate tinkerer and cynical political fixer, Franklin D Roosevelt.

In part, it has been a defensive response to the salutary experience of watching the crepuscular credit engine seize up around them, in 2008. Given the possibility of being cut off from all sources of funds, foolish not too keep a war chest stoked with readies, even at the cost of a little balance sheet efficiency.

In part, too, the move has been an artefact of policy in the sense that bank deposits have been subject to more governmental guarantees than many of the alternatives, while the Fed’s near-zero rate policy has erased most of the opportunity cost of staying as liquid as possible.

A welcome pause in policymaking on the hoof might soon lessen the first incentive; continued recovery – coupled with healthier financial balance sheets (and less shadow banking!!) – might diminish the second anxiety; and the ‘sunset’ provisions to remove those same Federal backstops at the end of 2012 will automatically terminate the third.

If so, the key issues will be whether these same corporates will begin to spend this cash, or whether they will simply rediscover an appetite for alternative, non-money assets (and the Fed should certainly take the opportunity to trim its swollen security portfolio by helping satisfy this reawakened urge, should it arise) and then, if they do, what those to whom they redirect the funds will do with them in their place. If the upshot is that there is a sizeable remobilisation of this money, things could quickly get very hot on the inflationary front if the transition is not managed well.

Too Much of a Good Thing

But, to return to our theoretical considerations, this property of being useful principally as a half-way house between buying and selling also means that, to reiterate a point which Leland Yeager was often at pains to remind us, the medium of exchange, money, is not subject to the ordinary law of supply and demand since an increase in the supply of money, by raising the price of the things it buys, automatically raises the transactional demand for it (certainly once we allow for any transitory effect such changes may have on the voluntary holding of cash balances) and hence, eventually neutralises the change.

Strictly speaking, money cannot be in a surplus because its greater profusion will raise prices, meaning it will take more units to move the same number of goods than it did when it was formerly less abundant. The change in nominal flows may also lead us to hold on to a slightly greater proportion of what comes our way in order to maintain an effective precautionary reserve. As Andrew Dickson White once remarked of the great French Assignat inflation, men never feel that money is quite so scarce as when there is too much of it about.

For as long as money is money then – for as long as it has not excited such distrust in it customary users in a violent inflation that people repudiate it, or it has not become so scarce as to become an impediment to trade in a deflation that they seek to substitute for it in their everyday dealings – it will bend the entire matrix of prices to its will so that its absorption is complete. No other asset possesses so much power since the take-up of these others will ultimately be rationed by changes in their price (and hence their yield).

Thus, even if the commercial banks lose their will or ability to issue more demand liabilities to their customers through increasing their loans, the central bank knows no such constraint, short of a complete catastrophe. If money cannot be lent into existence, it can always be spent into circulation, so long as it is not refused in the payment of wages, doles, rents, or other forms of income, or as settlement for the purchase of non-money assets or goods. Truly, as Charles Goodhart opined long ago, for those countries with access to the printing press, ‘deflation is a policy choice’. It is certainly one that the Federal Reserve has decided against taking.

Now, forgive me if I’m being a trifle antediluvian in this Looking Glass world of negative real interest rates juxtaposed with yawning peacetime budget deficits, but can anyone really argue that we could say the same about, e.g., UK government paper – that, no matter how much of the blessed stuff HMT was offering on the market, it would be readily taken up absent the sweetener of a sufficient, glut-induced decline in its unit price (which would, of course, serve to reduce the aggregate sterling sum needed to acquire the whole increment) or lacking a sufficient, countervailing increase in the supply of money so that people would individually seek to reduce their holdings of that money, some of them choosing to buy enough extra bonds with their new surplus so as to stabilise their price? Forget George Osborne: not even Apple can do this with its securities, though the limits might be harder to find in the latter case than the former, at present!

So, while not denying that there are indirect linkages between the stock of Shadow claims – or between the ever-shifting, thoroughly-subjective attractiveness attached thereto – and the primary economic relation between goods, services, and money-proper, we must resist the urge to attach too much importance to the post-Crash decline of the number of claims each hypertrophied financial entity holds on the other, or to assume that this reduction must permanently cast an immediate pall over the doings of industry and commerce in quite the manner being suggested and regardless of developments in both the supply of money and the avidity with which it is held on to.

Gilding the Lily

It is, in truth, hard to resist the though that much of this fascination with an ill-defined ‘liquidity’ is merely narcissistic navel-gazing; that it is case of the very practitioners of the sin agonising over the sort of financial market incest which those ever-perceptive Victorians used to decry as ‘pig on pork’ – i.e., as an unnecessary and unwholesome duplication of exposures between thinly-capitalised, lightly–reserved zero-summers which could only divert any participating bank from its real purpose of collecting savings and reallocating them to fund the most productive enterprises  it could identify. And heaven forbid, too, that any of our forefathers’ lending was done to a ‘finance company’ – a prototypical, captive ‘shadow bank’ which, having seen its promoters’ parent company exhaust its legitimate appeal to equity or bond investors, sought to disguise its true role in tying up short-term, working capital in the long-term, fixed assets of that same parent!

So, if today, the likes of JPM lends to CS which lends to HSBC which funds a Deutsche Bank SIV which finances receivables from Ford whose treasury antes up for some trade put on by Quantum allowing it to buy a share in an metals ETF which invests the float in some paper issued by Pimco which invests in Fannie whose pension fund takes a participation in KKR which, pending finalisation of a buy-out, buys in to the ‘cash management’ programme of Blackrock which takes some CMBS from JPM on repo – whether or not they shuffle the same tatty piece of US Treasury paper between them as a supposed added guarantee along the way – who really cares about this little La Ronde apart from the scalpers and commission jockeys salivating all along the chain?  No ‘Muppets’ were involved in the making of this picture, after all – at least no real world ones who actually MAKE the things and provide the (non-financial) services which keep us clothed, fed, groomed, and entertained.

This is a daisy chain, not an intermediation of useful credit or the creation of productive capital. If it disappeared tomorrow, there might certainly be a repricing of gambling chips and the change would not go entirely unregistered in the machine shops of Wolfsburg, or the grain elevators of Winnipeg, but neither would it stop the hard-working welder of the first from buying bread made with the wheat shipped from the second, nor would it prevent the shift supervisor at the latter from putting some of his pay packet towards the down payment he needs for that shiny, new Audi A4 he’s been eyeing up in the local showroom.

Far better then to acknowledge that swings in the acceptability of non-money claims can add a wholly spurious volatility to their valuation both as means in themselves and as the suspect underpinning for the generation and transmission of other claims.

When the skies are blue and the game’s participants are at their least critical, one may be piled upon another up to the very face of heaven without any proportionate need for money to buttress the construction. But, when a change of wind brings a chill to the exposed nether regions of our most naked financial emperors, the desire for precisely those sums of money that their pretensions had long deemed to be an entirely antiquated consideration will give rise to the awful, toppling corrective to their earlier delusion.

Up by the staircase – down by the elevator, as the old market adage has it.  Or, in a passage we never tire of citing, from the pen of the great Richard Cantillon:

“In 1720 the capital of public stock and of Bubbles which were snares and enterprises of private companies at London, rose to the value of 800 millions sterling, yet the purchases and sales of such pestilential stocks were carried on without difficulty through the quantity of notes of all kinds which were issued, while the same paper money was accepted in payment of interest. But as soon as the idea of great fortunes induced many individuals to increase their expenses, to buy carriages, foreign linen and silk, cash was needed for all that, I mean for the expenditure of the interest, and this broke up all the systems.”

“This example shews that the paper and credit of public and private Banks may cause surprising results in everything which does not concern ordinary expenditure for drink and food, clothing, and other family requirements, but that in the regular course of the circulation the help of Banks and credit of this kind is much smaller and less solid than is generally supposed.”

“Silver alone is the true sinews of circulation” – and not Shadows, we might add!