Monetary Institutions

It’s not self evident that a theory of long-term lending must be derived analytically from a theory of short-term lending. Businesses need short-term capital and long-term capital, and investors have a mix of short and long term goals.

Anyway, let’s get back to the fruit-tree example, which is an excellent one.

Let’s make the terms of the loan explicit, and say it takes 3 years for the tree to produce fruit. Because the yield curve slopes upward, FruitCo is borrowing in the market for 30-day loans.

The missing side of this example is the situation from the lender’s point of view.

In my view, MT will not exist in a free market, because no rational lender will make this loan. Rather, FruitCo will have to issue a 3-year bond and pay the higher long-term rate.

Suppose you are the lender. You lend money to FruitCo for 30 days. That means you are signing a contract in which you pay FruitCo X dollars now, and in 30 days FruitCo pays you X+q dollars.

And where will FruitCo get these X+q dollars? Not from fruit, that’s for sure! Oh, no. It will have to find another lender, who loans it the money to pay you back. If you choose to roll over, of course, this lender is you. But if you’re sure you’re going to roll over, why not lend at 60 days, not 30 days? The yield will be higher.

Thus the success of your transaction, as the lender, depends not just on the proper growth and nourishment of FruitCo’s tree. It depends on the presence of other lenders like you in the loan market. You will sometimes see this referred to as “liquidity.”

FruitCo is what might be called an internal maturity transformer. It borrows short for a long-term project which it conducts itself. The picture clarifies somewhat if we separate FruitCo into two accounting units, FruitFarm and FruitBank. FruitFarm issues a 3-year bond to FruitBank, which buys it with your 30-day loan. This is profitable for FruitBank, because the yield curve slopes upward.

In this structure we can see how the loan is collateralized. Let’s assume that the fruit tree is a good one, and the “hold-to-maturity value” (thanks, Professor Bernanke!) of the 3-year bond is all it’s cut out to be.

So you, as a lender, have an additional reason to participate: FruitBank is solvent. The fact that the market price of its assets exceeds the market price of its liabilities makes your loan a safe one. Even if, when the 30 days are up, FruitBank can’t find a new lender, it can always sell FruitFarm’s bond and you’ll get all your money back.

But this is not true! Once again, we’re ignoring collective effects in the loan market. If the supply of lenders willing to fund 3-year projects with 30-day loans dries up, the FruitFarm bond will decrease in price.

Maturity transformation, by converting 30-day lenders into 3-year lenders, has increased the supply of 3-year loans. Thus, it has reduced the yield on 3-year bonds, and increased their price. Turn MT off in the fruit-financing market, initiate crunch mode, and the interest rate goes through the roof. And the bond price drops. And FruitBank, quite likely, becomes insolvent. Is all this starting to sound a little bit familiar?

This is what Professor Bernanke is missing in his “hold-to-maturity” pricing. The price of a loan depends on two factors: interest rates, and he is assuming an MT-on long-term interest rate. Whereas if you actually had to match 30-year borrowers with 30-year lenders, the interest rate would be much higher. Making the price of the loan much lower. Making the banks much more insolvent…

The reason that lenders and borrowers in today’s market generally ignore this effect is not that they’re stupid, but that they assume a financial market with a “lender of last resort.” The basic problem with the LLR model is that the LLR needs to (a) control interest rates, (b) have an infinite stash of money, and (c) worst of all, verify that FruitFarm’s fruit tree is a good one.

Given (c) especially, the LLR might as well just be making the loan itself. And the only reason it doesn’t, I think, is that it would look fishy. Thus MT becomes essentially a surreptitious way for the government to print money and lend it – which, IMHO, is just weird.

Mencius, there is one aspect of your argument that confuses me. What makes the market for debt so much different than other markets?

For example: I need to eat every day for the rest of my life, call that 80 years of food. The consequences of a month without food are at least as bad for me as FruitCo’s month without debt is for them. So theoretically I should be signing a contract for 80 years of food. But in reality, I keep a week or two of food at home, and can trust that two weeks from now, there will be people with food on hand who want to sell it at a price I can afford – the market works.

What makes the market for debt different? Is it just that we don’t have as much practice with it in the markets, or the governmental intervention? Why can’t FruitCo trust that in a month there will still be people who want to lend money at a price they can afford?

I would say that the common theme in discussion is a model which assumes it’s possible to make money by pooling risky investments. This business model works fine if these risks are uncorrelated but if they due to some circumstance suddenly become correlated it collapses (realization of the systemic risk).

So a basic model for risk pooling is the insurance business. You make X amount of, say, fire insurance contracts with X people. If you assume the fire department works as it should, under normal circumstances is quite safe to assume that the the probabilities that the X ppl’s houses get burned are independent. Thus, because of law of large numbers you only tiny percentage of ppl will burn their houses down and you can make money.

However, this business model fails if risks become correlated.

Mortgage market and the subprime mess:
Mortgage backed securities pooled together mortgages. If there is no housing bubble, everything goes fine (tiny fraction of the loans default). If there is a housing bubble and it bursts, a lot of the loans default & value of the mortgages takes a dive. So because of the bubble the value of the mortgages comprising the MBSs were correlated and thus the failure.

Banks & MT:
one borrows short and lends long. This works fine as long as there is enough lenders in the short term market. The assumption is that if one lender doesn’t want to lend you short you can find somebody who will. In circumstances where lender behavior is not independent (e.g. a run), this model fails. For instance, a bank run when depositors find out that bank is holding toxic MBSs and is insolvent.

ARNOLD: You ask a good question, and you have isolated the right two kinds of risk.

1. Liquidity risk: will there be other people willing to lend at the moment I need to borrow?

2. Solvency risk: will the fruit trees bear fruit?

The problem is that with banks, these two risks create a positive feedback loop. If you actually had to borrow for 3 years, no MT, no rolling over, it might cost you 10%. But, in an MT world, it might just cost you 5%.

So, on the banks balance sheet, the asset side has $100M, which is the price at 5% interest rates. If MT turns off, the interest rate on those assets goes from 5% to 10%. The value of those assets now falls from $100M to, say, $50M to reflect this higher cost of financing. This is like someone paying $500K for a house with 20% down, but $1M for a house with 10% down. Same house, but the value has changed because the financing costs have changed.

The bank now has a $50M hole on the left side of its balance sheet. If the Equity on the right side of the sheet is <$50M, the bank is now insolvent. We WANT banks to assess solvency risk: are the fruit trees good or diseased? Unfortunately, in an MT system, they need to work on both solvency risk AND liquidity risk, and it is impossible to model liquidity risk because bank runs are spontaneous and unstable. They cannot be modeled. No risk manager will use a scenario where there is a generalized bank run. It cannot be done. So, to have banks CONTINUE to assess solvency risk, and not worry about liquidity risk, we eliminate liquidity risk by eliminating the mechanism that enables it: MT. The alternative is that you keep MT, keep solvency risk, and keep liquidity risk. Then, when a bank run happens, the Government just lends to everyone: businesses, banks, you name it, directly. Which is what is happening now. -winterspeak

Mencius Moldbug I lean with you but it think this, where Jeffrey Rogers Hummel makes a case for fractional reserve banking, is worth a listen:

http://www.fee.org/Audio/YSC/FINAL%20YSC%20-%20Jeffrey%20Rogers%20Hummel%20-%20Why%20Fractional%20Reserve%20Banking%20Is%20more%20Libertarian%20than%20the%20Gold%20Standard.mp3

tobbic,

You’re right in a general sense, but there is a qualitative distinction between the two kinds of pooling: one involves an intrinsic dual equilibrium which creates its own correlation. The other is merely exposed to external unknown correlations, aka black swans.

9/11 is your classical black swan. There is no way 9/11, or a similar event, is not going to have a correlated effect on the financial markets. This is what stress testing is for. But the market should not be generating its own intrinsic instabilities, and it should damp extrinsic ones rather than magnifying them.

I think Hummel is a member of the same free-banking school as, say, Lawrence White.

One basic error in the Rothbard-De Soto model of fractional-reserve banking (again, a special case of MT) is their belief that FRB is in some sense unethical, a point that stems ultimately from Rothbard’s rather strange model of contract law. The free bankers have decisively and in my view effectively challenged this.

But what they’ve failed to show is that FRB is prudent, stable and safe. They’ve invented a number of financial gimmicks which they claim enable FRB without a central bank. I put this in the general category of perpetual-motion devices. For example, an “option clause” which allows banks to suspend redemption cannot force the notes of suspended banks to trade at par, and in an efficient market they will never recover from this discounted state.

Winterspeak,

Sunspots will indeed do it. The so-called equilibrium is just not stable.

We don’t usually think of deposits as negotiable securities, but in an efficient market they are. These notes cannot trade above par, and if the bank is maturity-transformed there is a chance of a bank run in which they will be worth less than par. Even if this chance is epsilon, the notes will be discounted by epsilon. But this is like a pencil balancing on its point, which is always epsilon away from stability. The epsilons are self-reinforcing, and turn into deltas…

winterspeak,

I would put it a little more directly: FRB is a case of MT. You can’t have FRB without MT for the same reason that you can’t have a sheep that’s not a mammal.

Another way to state your conclusion is to say that the reason the Austrians are right about narrow banking is that the natural interest rate at a term of 0 is 0. There are no actual productive endeavors which can be financed at a term of one hour, one minute, one second or one nanosecond. Therefore, just keeping the money in the vault is the only game in town.

As for FRB without fiat, you are right but only in the most elastic sense of the word “fiat.” Banking in the 18th and 19th centuries, at least in the Anglo-American world (I think Hamburg was the last full-reserve monetary system) was nominally on a specie standard, but it used several tricks to work effectively as fiat. For example, if the State accepts bank notes in payment of tax or other obligations, it can easily allow banks to suspend redemption while still accepting gold at par with paper. Gresham’s law will operate and gold will disappear, of course. But many subtleties can be applied.

So, basically, if you’re looking for a sharp line between a redemption standard and a fiat currency, there isn’t one. The sharp line is between narrow, 100%-reserve banking and MT.

The answer is that your mutual fund is not really a maturity transformer in the classic sense, because it does not have constant-dollar obligations to its shareholders. Ie: its obligation to you is equity, not debt.

Ok, but by that definition many money market funds are not maturity transformers either. And isn’t that where the crisis is occurring?

Also, is there a hard line distinction between equity and debt? It seems you have a continuum based on the details of the particular contract. At one end of the continuum you have actual Federal Reserve Notes, then you have safe deposit slips, then loans, then convertible notes, then preferred stock, then common stock.

One could say that the mistake is maturity transformation. One could also say that the mistake is that everyone treated money market funds as currency deposits rather than equity in a fund of loans. That led them to believe there was no risk, and so $1 in a fund traded as if it was a $1 federal reserve note. This in turn led to a bubble analogous to your commodity bubble example ( actually a bit different, in a commodity bubble the price goes up and up as the underlying asset remains the same, in the money market bubble, the price stays the same as the underlying asset (home loans) deteriorates. But the effect is the same).

It’s also analogous to the internet bubble. Instead of the bubble being in shares of internet stocks, the bubble is in shares of money market funds. The trouble is that there is an enormous amount of money in these funds, and an enormous number of balance sheets and loan contracts count on these shares being risk free.

When it turns out the shares in the money market funds are not risk free – (too many mortgages default and the fund breaks the buck) – then people run away from them. A whole class of assets are not as safe as people thought. The bubble in these assets implodes, and people are lot less wealthy than they thought. Even worse, people have no idea which investments are safe. Companies now can’t borrow to meet payroll, workers get laid off, and you have a full scale implosion. A money market share bubble is far worse than a dot com stock bubble, simply because the extent of it is far greater, not because there is a difference in kind.

My point is that while you and the Austrians see the general problem as being MT, it seems to me that the general problem is that people will stupidly invest in bubbles. The object of the bubble could be a bank note in a fractional reserve bank, it could be a share in a money market fund, a house, a share of Pets.com, or the Nikkei. And not only will individuals invest in bubbles, everyone in society might systematically invest in bubbles. If the investment is big enough – like the money market bubble of 2008 or the bank note bubble of 1929 – the pop could destroy everything.

And while MT is pernicious because people think they are investing in one thing ( a safe deposit) they are really buying another ( a share in a risky bond fund), that could be said of a lot of other investments. When people buy a share in a Nikkei index fund, they think they are buying shares in companies. Except most Nikkei companies don’t pay dividends. So in reality, they are buying a baseball card with the stats of the company. Like a baseball card, the shares are only worth what other people will pay for it. It could be $50 trillion or it could be nothing. This is systematic delusion on a multi-trillion dollar scale too. You don’t need MT to get systematic fraud and delusion.

These are good questions. The precise line between an asset bubble and a credit bubble is a fascinating question, and it’s not one that I’ve thought about much. Or at least, not enough.

I’d say the difference between a simple asset bubble and a credit bubble is the existence of a tier of mandated payments, ie liabilities, and the construction of a financial model which breaks if these liabilities are not renewed. You don’t have an MT crisis if you don’t have a rollover dependency.

Libra is right that there are a lot of very junior instruments that smell a little like credit and a little like debt. But the fundamental distinction between mandated and discretionary payments, stocks and bonds/notes, is pretty sharp IMHO. Things that seem to blur the line are just combinations of the two in a single security – I think. Feel free to try to convince me otherwise.

Winter is right that the entity which promises to pay these liabilities can be speculating in anything. In the ’20s, for example, deposits were taken to speculate in equities. So we have the formula for a credit bubble: an asset bubble on one end, a structure of rollover-dependent liabilities on the other.

Again, you can have an asset bubble in any security or commodity. Add buyers to the market, and the price goes up. In an MT bubble, the asset bubble is a bubble in future money. (In this case, that future money is collateralized by house prices, which of course are part of the bubble too.) But it could be cotton, or Honus Wagner baseball cards, or whatever.

The structure is unstable because the asset bubble will pop as soon as the noteholders refuse to roll over. And then they have an incentive to depart the building as soon as possible, because the corpse needs to be buried and not all of it will be. Ie, when the asset bubble pops, not all the liability holders can be made whole, because falling asset prices render the intermediary insolvent. The result: FAIL.

Winter is also right about money-market funds. They are certainly maturity transformers, if on an oddly short timeframe. The stretch between zero-maturity and 1-month or 3-month maturity is, in financial terms, small. Certainly small enough that it’s very hard to break the buck on a money-market fund. It’s really into the “Bobby and Dwight” range.

I’d say there are two basic problems with the CP market these days. One is this small-time, Bobby-and-Dwight MT. This could easily be rectified by USG as follows: (1) convert all MMFs to present FRNs, (2) hold all the CP to maturity, (3) redeem it. This solution is completely portfolio-neutral for everyone, including even USG.

There is just one leetle problem with this solution: it leaves the entire US economy in a smoking heap of rubble. “Other than that, Mrs. Lincoln, how did you enjoy the show?”

The second problem is that most CP is not used for the original purpose of the CP market, so-called “real bills” to finance receivables. Rather, it is used by America’s largest companies for financing needs that are genuinely long-term. Precisely like Arnold’s FruitCo example. Real bills used to be described as “self-liquidating,” ie, like a note for a shipload of wool payable in Venice, or something like that. What makes them “real” is simply that they are not dependent on a continuous stream of rollover’s, like Arnold’s fruit tree.

(Note that I am not endorsing the “real bills doctrine” here – any more than I’m endorsing Bobby and Dwight, who were doing pretty much the same thing.)

I propose another bet. Right now this is like two kids in a dorm room at 3am arguing over whether the US would be better off with a parliamentary system of government.

If Moldbug is right, I’d like him to state what the world might look like in 12-24 months, so we can watch and see if it happens.

If this crisis is really so terrible, then it ought to be sufficient to trigger something beyond a typical proportional recession unwinding.

If within 12-24 months the banking system continues to function, and commercial paper is back on the move, and unemployment is below 10%, then I propose that his MT thesis be put to rest.

Mencius-

The precise line between an asset bubble and a credit bubble is a fascinating question, and it’s not one that I’ve thought about much.

It seems pretty fine indeed. For instance, I couldn’t even determine from this New York Times article if the investors in the money market fund in question own a contract to redeem dollars or if they own shares. At any rate, the fund did not seem to have a problem converting from MT debt into shares. The line was gray. The problem seems to be that the investors lost a lot of money on what they thought was a risk free, good as FRN’s investment. That’s why I don’t think MT is the core problem with money market funds, but rather systematic bad investments and misperception of risk.

I think we are all in agreement on the fact there is a credit bubble. I think I’m just putting the emphasis on “bubble” rather than “credit” or “MT”. At any rate, the solution seems to be the same. You can let the bubble collapse, leaving the economy in pile of rubble. Or you can convert the credit into the one bubble that never pops – money (Federal Reserve Notes).

This could easily be rectified by USG as follows: (1) convert all MMFs to present FRNs, (2) hold all the CP to maturity, (3) redeem it. This solution is completely portfolio-neutral for everyone, including even USG. There is just one leetle problem with this solution: it leaves the entire US economy in a smoking heap of rubble.

I thought this is basically the Moldbug solution you described in your blog post?

The second problem is that most CP is not used for the original purpose of the CP market, so-called “real bills” to finance receivables. Rather, it is used by America’s largest companies for financing needs that are genuinely long-term.

That’s more troubling. I was unaware of extent that this problem exists ( and if you happen to have any links I’d love to read them, I really don’t know much at all about the CP markets).

Whether it’s a straight up credit bubble or an MT bubble, it’s likely that many of those long term investments will not be profitable if companies have to pay interest rates according to people’s current preferences for credit risk. What would the solution for this be? Bail the companies out? Have the government print money to subsidize the loans, and then gradually turn off the spigot? Let the loans go bad, and accept the consequences?

It seems pretty fine indeed. For instance, I couldn’t even determine from this New York Times article if the investors in the money market fund in question own a contract to redeem dollars or if they own shares.

I’m not saying it’s fine in practice! I’m just saying it’s fine in theory.

All I actually know about money market funds is all I know from the perspective of a retail investor: they are sort of like bank accounts, except earning a higher rate, but subject to all kinds of funny restrictions.

I am not particularly concerned about the actual details of these contracts in actual corporate law. A securities lawyer is one thing I am not, and I feel it’s acceptable at the economic layer to gloss over this point. The point is, you put money in, there is no real risk, and you can take it out any time. Whatever you call it, that’s basically deposit banking.

I thought this is basically the Moldbug solution you described in your blog post?

Ha. No. It is except for one point: I wouldn’t redeem instantly. I’d convert CP loans to, say, 5-year bonds. They were expected to work this way, via rollovers, and an economic administrator should always strive to work precisely but invisibly. If your goal is to make everyone’s life basically what it was before the crisis, this is the sort of way to do it.

Redeeming instantly on all CP notes would destroy the long-term projects in process that were financed by the CP. This is simply an act of economic masochism. Indiscriminate vandalism.

What will probably happen, of course, is that the CP purchased by the Fed will be rolled over for an indefinite period of time, most likely becoming infinite. The acquired paper will turn into, more or less, consols: rollover permanently guaranteed. With guaranteed liquidity, this is more or less what CP is.

Libra: I hear what you are saying, and I agree that people can speculate in anything, and they can create instruments that let them speculate in anything.

That said, I still think there are material differences between asset bubbles and credit bubbles.

In a credit bubble, the bubble is create by an (unsustainable) increase in money supply through debt. The money supply increase by excessive lending, as under the FRB system, banks can (and do) create money out of nothing. In commercial banking they are (sort of) limited by reserve requirements, although they routinely get around these with SIVs and other off balance sheet vehicles. In investment banking (the shadow banking system) there were no reserve requirements, and we saw much greater use of debt and leverage.

This debt, which is a key part of credit bubbles, is term transformed, and so subject to bank runs (aka a “liquidity crises” or “failure to roll over short term deposits to cover long term loans”).

When credit bubbles pop, money supply shrinks (as credit is written off) and that’s why we end up in a broader deflationary macro environment. That is exactly what we are seeing here. It is accompanied by a bank run, which is the “liquidity crises” we read about in the news.

By contrast, asset bubbles are not fueled by debt, and so are not subject to a liquidity crises. There was no bank run, or liquidity issue, or failure to roll over short term deposits to fund long term debt when the internet bubble popped. Internet stocks were fueled by equity, not debt, and the difference is real.

Money market funds “breaking the buck” were such a problem because people actually thought they were putting cash in the bank. Now that the Fed has extended FDIC protection to them, the two are equivalent, but it should be clear that money market funds, by themselves, cannot exist in the wild.

You ask if we’re making a distinction without a difference. Let me put it this way: in a no-MT world, we would not have bank runs, liquidity crises, or credit bubbles. But we *would* still have asset bubbles. Suppose a new technology sector became hot, venture capitalists began to fund start-ups in the area, some went public, people rushed into their shares, more went public etc. etc. This would be a classic asset bubble, and MT, or lack thereof, would have no impact on it. *BUT* we would not see the sort of widespread liquidity problems, non-traded assets, and discussion of inflation/deflation that we’re having today. I think this is a meaningful difference, worth a distinction.

By “fine” I mean, as should be obvious, precise – a boolean, not a floating point.

Maybe you should go edit the wikitionary entry:-)? That’s the usage I’ve commonly heard.

Winterspeak and Mencius-

The point is, you put money in, there is no real risk, and you can take it out any time. Whatever you call it, that’s basically deposit banking.

Let me put it this way. There is a demand for risk free place to put money that has on demand withdrawals. Currently that demand is met roughly in three ways:

1) holding actual green bills
2) buying shares in fund that holds many low risk bonds and trades at high volume.
3) having a deposit in a bank that’s practicing MT

Most savers put most of their money in 2) and 3).

Mencius’s original post argued that the problem was that people were putting their money in 3). I’m arguing that even if everyone had their money in 2) we still would have had the financial crisis.

The systematic financial crisis arises when the following events unfold. First, everyone has large amounts of money tied up in funds they think are risk free. Second, the perception of risk free is so great, they trade as if they were FRN’s, people use them to calculate net worth, ability to pay loans, etc, and so their existence is essentially factored into the money supply. Third, they find out these assets are actually very risky. And fourth, no one can price these assets anymore, because anyone who might buy these assets on the cheap, has their own wealth tied up in the risky assets.

The only way to prevent the crises is for people to keep their near risk-free savings in actual green backs, or a bond fund that actual does invest only in very low risk loans. However, I think the second option is unworkable in practice, as most people are bad at judging risk. So in the end, the only way to prevent crises is that people should hold what they believe to be risk free deposits as actual risk free deposits ( ie 100% reserve, FRN deposits).

Are we in general agreement, or are we far apart?

It seems the big difference is that you both think that if we just found a way to end MT, we could prevent financial crises. I think that as long as the average Joe – ( or even the average CFO or pension fund manager ) – keeps the majority of their savings in anything other than 100% reserve cash deposits (whether it be bond funds, stocks, etc), they are going to get scammed in a systematic way.

Libra,

The only place in which I disagree with your interpretation is that I’d replace “risk-free” with “zero-maturity.” The ratio between MZM and M0, for example, is extremely telling.

Almost all of the CP which is now frozen, for example, is not in the slightest sense risky. Many of the MBS which are frozen are probably obviously fine. But these CP, MBS, etc, nonetheless refuse to trade at prices which imply their actual default risk, ie, the notorious “hold-to-maturity pricing.” The missing variable is the MT phase, which anywhere outside the MT-on condition requires users of the formula to use a rate much higher than the rate on risk-free Treasuries.

It is this risk amplifier which is distinct about the MT situation. I say: you can’t remove risk, even asset-bubble risk. But at least remove risk amplifiers.

As for your comments about how the world should work, I offer the following fact: have you ever noticed that when you read, say, Jane Austen, the characters tend to say “I have two hundred pounds a year,” or the like? Not, of course, that they have anything so humble as a job?

The old aristocracy, and in consequence basically all serious money in the 19th century, lived off a quaint device which still exists. Both centuries refer to this humble, but extremely effective, widget as the “annuity.” Another related instrument, even cooler in some ways, is the “tontine.” Tontines, alas, are a thing of the past – the regulated era did not admit them.

An annuity or a tontine has excellent lending properties for maturity-matched financial intermediaries, because its option structure is a function of the human lifecycle. Sort of like the amount of food people eat.

WIth these classic retirement structures, actuarial techniques can predict the terms of appropriate financing quite effectively. Voluntary early withdrawal is quite rare, and very unlikely to be triggered in some kind of feedback loop by intrinsic effects. And the pool of retirement savings on which they draw is, in general, the largest money pool in the world.

So put it this way: if you didn’t have MT, would you invent it? And if the answer is “no,” why stick with it?

Libra,

I agree with your essential point that dumb money is a cause of asset bubbles.

In fact this is pretty much a tautology: a bubble is a sort of pattern on a chart, in which asset prices fluctuate in a way that looks silly. This usually has a sort of sawtooth pattern. Typically the sawtooth is due to a market becoming gradually ever more wrong, then suddenly becoming right. Perhaps sometimes it’s the opposite, but righteousness tends to come on in a flash, whereas wrongtiousness builds up gradually over the ages.

If you allow markets to display aggregate stupidity – for instance, stupid regulation is a trivial cause of aggregate stupidity – you can make them print more or less any chart.

However, one of the nice things about traditional types of investments – annuity, tontine, CD, etc – is that they do not involve personal money management on the part of the investor. At most, this involves selecting a financial provider. It is the provider who has to think, not the retail investor.

On dividends, while I agree that the absence of dividends in today’s market is atrocious, this does not actually prove that the profit rate of the actual enterprise is that low. Google has never paid any dividends, but its search monopoly is absurdly profitable. The question is whether you believe figures for retained earnings. The nice thing about a real dividend, obviously, is that it involves no credulity whatsoever, but it is certainly not impossible that retained earnings are real.

Financial professionals of a century ago would certainly be shocked by the relative absence of dividends. They would also be appalled to discover the omnipresence of what they called “watered stock.” Modern accountants know this “water,” of course, as the wholly benign “goodwill.” Such is the decline of American capitalism, once the wonder of the world.

Moldbug,

A very interesting original post and discussion here.

As a USG staffer said at one of the various emergency bail-out meetings:

“This would be analytically interesting if it wasn’t happening to us.”

So it is with MT.

I think the MT framework requires additional analytical decomposition.

No complete proposal here, but some rough ideas:

Pure maturity transformation is one element in a complex set of risk transformations that may apply to single or group financial asset combinations.

There are at least two other risks that should be separated within the meaning implied here by ‘maturity transformation’.

The first is interest rate risk. It is quite possible to construct MT where exposure to interest rate changes is minimized. This is done by using 30 day funding for example to finance a 5 year loan whose interest rate resets every 30 days according to the rate set on the 30 day funding rollover. The entire Libor loan market is built on this mechanism. One partitions the yield curve into two components in this way. The first corresponds to the pure (i.e. “risk free” benchmark) interest rate expectations component. The “other” is the curve without pure interest rate expectations.

(The “risk free” rate is worthy of a longer discussion in itself. It is risk free only in a very constrained way, even in theory, particular in relation to interest rate risk. It is a core bastardization within academic theory.)

The ‘other’ above is still greater than the applicable MT yield curve. This can be split once again into two more components. One corresponds to the MT curve for the reference “risk-free” rate – e.g. the Treasury curve – a relatively small spread perhaps, but non-zero. The other corresponds to the MT curve for the net credit risk embedded in the transaction. This final curve is the true MT yield curve for the credit in question.

Another aspect that requires fleshing out, as you’ve noted, is the analytical decomposition of intersections and non-intersections of redeemable money, fractional reserves, and MT. Redeemable, 100 per cent reserves reflect MT-off for reserves. But FRB doesn’t preclude MT-off for non-reserves. MT-off still requires liquidity and solvency protection. Credit risk still exists, and both liquidity and solvency are required to repay an MT-off depositor when the “matched” asset fails.

This is all very quick and sloppy, possibly with errors – insufficient time today unfortunately.

enderv,

Although it seems to be the product of independent thinking, your view – that depository institutions should be one thing, and lending another – is pretty much the Austrian orthodoxy. This would be unusual if both you and the Austrians are wrong, but it is less surprising if both of you are right 🙂

Good discussion here:

LIBRA: You and I are in agreement about stupid decisions (which are unavoidable) being a cause of bubbles and all manner of misallocation.

That said, I don’t think stocks not paying dividends is a problem, and I still think CREDIT is more important in CREDIT BUBBLE than BUBBLE. We can’t do away with bubbles, but we can do away with CREDIT bubbles (while keeping CREDIT — which is an important and useful part of the economy!)

In your examples of 1, 2, and 3, 3 is essentially the same as 1 because of FDIC insurance. People may do 2 thinking it is the same as 1 and 3, but in fact it is not — when MT turns off this becomes obvious.

JKH: To moldbug’s point, separating a floating interest rate does not save you from the bank run problem.

And you are correct, maturity matched deposits still have credit risk — banks need to separate good risks from bad etc. — but they do NOT have liquidity risk (ie. are subject to bank runs). The word “liquidity” is tossed around in lots of different forms, but I’m using it in this context to mean: can I roll over short term deposits to pay long term debt, or am I in a bank run situation.

-winterspeak

Libra wrote:

Except most Nikkei companies don’t pay dividends. So in reality, they are buying a baseball card with the stats of the company. Like a baseball card, the shares are only worth what other people will pay for it. It could be $50 trillion or it could be nothing. This is systematic delusion on a multi-trillion dollar scale too.

It’s disingenuous — or at least misguided — to claim that a stock is “only worth what other people will pay for it,” because it pays no dividends — implying that it’s inherently worthless and just a piece of paper.

Granted, mature companies probably don’t need to hold on to cash, but growing companies probably do. If a company has good (positive-NPV) ways to invest internally, then investors should prefer to see the company invest internally rather than hand out a dividend.

And dividends are not the only way to give money back to investors. Stock buy-backs are not some crazy scheme to manipulate the market. They let a mature company give cash to investors who want cash, while increasing the value of the equity of investors who want equity.

Moldbug, Winterspeak –

My point regarding risk decomposition was not to deny the incidence of MT risk, but to highlight embedded pricing components that are unrelated to pure MT risk. E.g. the credit spread for a 5 year loan that prices according to 3 month Libor is very different from the credit spread of a 5 year fixed rate loan. Both have the same MT risk when funded by 3 month Libor, but very different credit spreads. The second spread incorporates the price of interest rate risk. So we need to be careful about this when attributing the true cost of MT.

Hmmmmm… I have a question:

If borrowing short and lending long is essentially unstable, why did so many people lend to these unstable institutions? In particular, why did anyone lend to the so called shadow banks, who didn’t have any of the government guarantees (i.e. FDIC, discount window, etc.) that non-shadow banks had?

Molberg’s exposition is clever, but his conclusions are incorrect. If MT is magic, so is much that markets routinely accomplish, including the ability to facilitate multi-party exchanges (the non-coincidence of wants) through a common exchange medium, or scale economies achieved through collectively sufficient demand to drive down average costs.

Pooled short deposits, in effect, offer funds available for long term investment. If the mediation is transparent, and the terms of the deposit acceptance clear, then there is no fraud or deception. The law of large numbers permits this “magic” to make sense. One of Molberg’s errors is confusing the basic regulatory requirement of capital sufficiency with his notion that a depositor is cheated if all deposits could not be simultaneously returned by a bank — or by the entire banking system.

As others have noted, under normal conditions that persist for decades at a time, there is no pervasive “pressure” to start bank runs. But as Diamond-Dybvig have formalized in their model, the non-run equilibrium can become unstable given a sufficiently large perturbation, one that calls solvency into doubt (as the Lehman bankruptcy apparently did).

Still, not all Bagehot-like banking systems are government insured. Australia, for instance, does not insure its system, but rather places depositors ahead of unsecured creditors in the event of a bankruptcy. Result, less moral hazard in Australia, where banks are faring well through the current “global” crisis. One reason: depositors monitored how risky lending practices are at banks, which led to much more responsible mortgage design and origination down under (see http://online.wsj.com/article/SB122325772150706655.html ). How does Moldberg explain the stability of Australia’s uninsured banking system? Australian depositors know that in the event of a bankruptcy, perhaps related to a run, they might only receive a partial return of their deposits; that is simply part of the deal, made worthwhile by the prospect of earning interest, and the relative safety of banks (compared to mattresses).

Where I agree with Moldberg is that FDIC does partially integrate the Federal government’s balance sheet with those of “private” banks — on the down side, anyway, socializing losses. But profits remain private, which in turn explains the casino-risk taking we observed through mid-2007 and the subsequent insolvencies.

Though MT is not responsible for the crisis, the paradox of explicit deposit and implicit “too-big-to-fail” insurance needs to be resolved going forward. Without insurance, Diamond-Dybvig runs cannot be stopped. With insurance, moral hazard leads to excessive risk, bad assets, and insolvency that puts banks under just as surely as a run. Insurance breaks the link between depositor prudence and bank lending practices, and provides banks with low-cost funding. As Moldberg observes, that funding is ultimately financed with tax revenue. Neither does regulation offer a promising solution, given the history of regulatory capture and politically motivated regulatory policies.

Many papers on SSRN address how to best design deposit insurance, based on historical experience and theory. All worth considering, but in the end, there may be a paradox here that requires more fundamental re-thinking regarding the design of private financial institutions going forward.

winterspeak, not sure what was confusing about my simple nuts-and-bolts explanation, let me go a bit more basic. Maturity transformation is turning short-term loans into long-term loans. A loan means you give someone money and you don’t get it back, no matter what, till the term ends. FRB, on the other hand, you give the money and you can take it out any time, which is what causes money stock inflation and the instability of the system. The trick that the FRB bankers play on you is that they try to represent it as a loan of zero time, or 0 maturity as I said before, that’s rolled over infinitely, until you ask them to stop by taking your deposit out. This is not really MT as there is no term to the loan, it’s zero! What it all comes down to is that when you make a real loan, the money is gone. You can’t make a $1000 3-year loan to your friend and then decide the next day that you will buy a HDTV with the SAME money. It’s gone for 3 years. With FRB, the bankers give you the illusion that you can both lend and use the money at THE SAME TIME. Now, the person who the FRB bank gave the money to and you can both bid on that new HDTV, inflating the price because the money stock has been inflated. This FRB scam works as long as times are going good and most of their loans are working. When they inevitably make mistakes, particularly when they fuel a bubble like the current one, it all comes crashing down like the world trade center.

Sigh, you clearly don’t know what they are. Despite my repeatedly pointing out that FRB is not just a case of MT, because a zero-term “loan” is fundamentally different than a finite-term loan, you do not seem to grasp this simple fact. There are two separate and fundamental constructs to our monetary system: fiat money and FRB. Each has its own problems but FRB is the fundamentally unstable one in our current system. It is possible for fiat money alone to be very unstable, if the printing presses run wild at the government’s behest, but that’s not the problem in this country at this time. As for your question, yes, a bank deposit is not a loan to the bank, because it is missing the fundamental feature of a loan, that the money is not accessible to you while it’s loaned. Rather, a bank deposit is something else entirely. You’re essentially telling the bank, “Go ahead and counterfeit my money by lending 90% out while simultaneously promising me that you will return 100% to me at the time of my choosing.” All this does is create many more dollars chasing the same goods, ie massive inflation, and a fundamentally unstable banking system. Now, rather than bank losses being losses alone, they also destroy the money stock as the process works in reverse. Please read about how FRB works in more detail and how it is fundamentally different than loans/MT.

Ajay,

Rothbard’s model – fleshed out at great length in De Soto’s Money, Bank Credit, and Economic Cycles – argues that the depository contract in FRB is a fraudulent variation of the warehouse-receipt contract in a 100%-reserve bank.

Indeed, this is its historical origin, both in our financial era and in others. But the history is of no importance. The contract is well-understood today – and even if it wasn’t, a libertarian government has no business telling any two private parties what contracts they may or may not sign.

Moreover, the FRB contract can be modeled perfectly as a time deposit of term epsilon. Rothbard has no objection to time deposits, and nor does anyone else. Even if you have a problem with the number zero, if you reduce the term of the loan to one hour, one minute, one second, etc, you get an instrument that behaves exactly like an FRB deposit.

Furthermore, the phenomenon of an FRB bank run is not dependent on the term of the deposit contract being zero. Any maturity mismatch will do it. FRB is not a special case.

In summary: Rothbard was a titan, but not a god. I’m sure Mises and Rothbard themselves would have been the first two people to agree that Austrian economics is a way of thinking, rather than a cult. Infallibility can be left to the Pope.

Still, not all Bagehot-like banking systems are government insured. Australia, for instance, does not insure its system, but rather places depositors ahead of unsecured creditors in the event of a bankruptcy. […] How does Moldberg explain the stability of Australia’s uninsured banking system?

As the consequence of insurance that is informal, but politically assured. This is (or was until recently) the nature of a number of essential facilities, such as Treasury’s protection of FDIC, the GSEs, etc, etc.

FDIC is a good case: at least assuming rational actors, if we learned suddenly that FDIC did not have an infinite line of credit, we would all go to the ATM right now. FDIC’s own funds are sufficient for sporadic solvency failures due to malfeasance. In a true systemic bank run, it is inadequate by orders of magnitude.

Yet no bank run occurs. Why? Because depositors aren’t stupid. They vote, and they know that the government will protect them. And this is how MZM can exceed M0 by a factor of 10. I don’t know where to find the equivalent ratio for Australia, but I imagine it’s comparable.

Basically, in the modern world, a retail depositor thinks of a bank as a safe place to deposit money. And he assumes that his government makes this safe, as with so many other things. And in practice, this is basically how it plays out – the required formal insurance tends to appear quite rapidly.

When the government issues a loan guarantee, it issues an option – a CDS, basically. This is dilutive, as the ratio of MZM to M0 shows. Pretending not to issue these options, but really issuing them anyway, is not an increase in transparency. If Australia really made it clear to its citizens that the deposits in its banks were not in any sense guaranteed, and the message was both true and believable, Australia’s banks would vaporize overnight just like anyone else’s.

But I readily agree that term mismatch leads to potential instability in banks’ balance sheets given a big enough black swan shock. The question is, do we achieve better economic results preventing that possibility by prohibiting term mismatch, or by simply accepting the risk and getting on with life? Seems to me that’s definitely an empirical question, not one that can be reasoned out a priori.

If we can agree that uninsured term mismatch is unstable, I don’t think we disagree on any question except for this one.

On this one, see my earlier answer to Arnold in which I construct an equivalence between insured term mismatch and direct government lending. Again, if you believe it is economically productive for the government to provide insurance that allows banks to mismatch maturities, you must also believe it is economically productive for the government to simply print money and lend it out. This is a legitimate perspective, but not one that is often defended.

Wow, the ignorance shown by the responses of Mencius and winterspeak is mind-blowing. Let’s start with Mencius. First, he mentions some irrelevant history, presumably to demonstrate he knows of what he speaks, before saying the history is unimportant. Then, he says the government shouldn’t intervene although nobody’s calling for government intervention: I specifically said that capital ratios should be left up to depositors and whatever ratio they’re comfortable with. Then, he simply repeats the claim that deposits are zero-term loans, that I’ve already debunked. He is right that FRB is not a special case, it’s a whole different scenario, as I stated earlier. The critical difference is that MT does not create money as FRB does and that banks have to plan for the possibility of some maturities not being rolled over under MT, while there is no way to plan for on-demand deposits as everybody can pull out at once. Finally, he says that Rothbard is no god, as though my analysis depends on Rothbard in any way. All I know about Rothbard is that he’s against FRB and for full-reserve banking, I have never read his writings on either subject. Really, this shallow and evasive retort from Mencius made me lose what little respect I had for him.

As for winterspeak, let me reduce my explanation to the drooling neanderthal level as you and Mencius clearly don’t understand even the simple prior explanations. Let’s suppose that Arnold and Bryan live in a tropical village, where Don, the chief of the village, gives them each 1000 pooka shells (PS) to use as currency (total currency in circulation [M1]: 2000 PS). Russ comes along and borrows 200 PS each from Arnold and Bryan, saying he’ll pay them back in 3 months, leaving them each with 800 PS. Then, Tyler comes along with some extra snails that he dug up and offers to sell them. Arnold and Bryan bid and the snails are sold to Arnold for 700 PS.

Now, suppose an alternate scenario where there’s a bank instead. Again, after loaning 200 PS each to Russ, both Arnold and Bryan put their 800 PS in the bank and the bank turns around and loans them each 400 PS. Now, both Arnold and Bryan think they have 1200 PS, as they have 400 PS each from the bank loans in their pockets and think they have 800 PS sitting in the bank (M1: 2800 PS). This time when Tyler comes along with the same snails, they bid and Bryan buys them for 1000 PS, which he pays with the 400 PS on hand and 600 PS more that he pulls out of the bank (M1: 2800 PS). The price for Tyler’s goods have inflated by almost half because of the increase in the money stock caused by FRB, which would have never happened if all Bryan had were his original 800 PS. Notice the critical difference between the actual loan made to Russ, from which the money will not come back for another 3 months and so cannot be used in the snail bidding, and the deposits in the bank which can be pulled out “on-demand.” The bank can get away with this because both Arnold and Bryan did not withdraw their money at once: this is what an unstable system like FRB, really a Ponzi scheme, fundamentally relies on.

Continuing on with this banking scenario, now let’s move on to the reverse delevering process, analogous to the current financial situation in the real world. The bank now has 200 PS on hand and proceeds to loan out 150 PS to Brad (M1: 2950 PS). Brad comes back the next day and says he had a hole in his pocket and he lost 100 PS in the swamp, which he cannot possibly pay back (M1: 2850 PS). Now the bank is worried. It has 1000 PS on deposit versus only 50 PS in reserves. Also, if all its assets and liabilities were unwound, it would only have 900 PS on hand to pay back 1000 PS deposited, leaving it insolvent. So, it decides to build back its reserves a bit to project confidence. The bank goes to Arnold and asks him for 200 PS back out of the 400 PS it lent him, as he happens not to have spent it yet (in the real world they liquidate assets but this is a close enough alternative to keep the example simple). Now, the bank has 250 PS in reserves and feels a bit safer about its day-to-day activities but M1 has now dropped to 2650 PS. Prices then proceed to drop as M1 has dropped: there are less pooka shells in circulation to buy stuff with.

Monetary inflation through FRB is prone to this reverse process of deflation when trouble hits, and I haven’t even talked about the bank run contagion that happens when one bank’s failure causes another to fail and then another, like a stack of dominoes. The alternative that I’d prefer is full-reserve banking. Want to make a loan? Put 30% of your money into a bond or some other instrument that has a real maturity, ie you cannot pull it out till the maturity date comes around. It is irrelevant whether the loan is used for MT or not, what matters is a finite maturity date. If some want to put their money in a FRB bank with capital ratios in the 10-90% range, be my guest. What matters is that depositors think about the money creation and inflationary effects of this decision and act accordingly. However, most people currently are completely ignorant of fractional-reserve banking; I suspect they would not put any money in FRB if they knew what was really going on. The current crisis offers a great opportunity for Austrians to make this case. The really difficult part is making the transition from FRB to higher capital ratios without undergoing massive short-term deflation. I suggested a possible solution for this in my original comment more than a week ago.

winterspeak: “Richard: Whenever you have a “credit crunch” or a “crisis of liquidity” it is caused by short term deposits no longer bring available to support long term loans. This is the definition of MT.”

Disagree. Suppose every 30 year bank loan were matched by a 30 year depository CD (sort of calls into question whether banks have any residual function in this hypothetical world). Now suppose the 30 year loans are imprudent in the sense I used the term in my prior comment: NINJA, based on bubble-valued collateral and assuming only continued increase in collateral value, and so on. Surprise, the loan goes bad. The bank is insolvent and cannot now service the 30 year CD. Why is that not a financial system crisis similar to the one we’re in now?

Granted, term mismatch means that insolvency might be followed by a bank run, but the essence of the problem is not the bank run but the bad banking assets prior to the run. The bank run is then merely a symptom and not a cause of crisis, perhaps an amplifier, or perhaps, as some might suggest, a form of needed market discipline (discipline that is ineffective when risks at all banks are correlated). Moreover, even if deposit insurance stanches the run, the insolvency and crisis remain, since such banks are out of the business of generating new credit.

Consequently, it is incorrect to assert that any credit crunch must be caused by MT. Sometimes it can be caused by bad prior loans stinking up the balance sheet, and MT plays no first-order role.

Richard: As you say, if you make a 30 year loan with a 30 year CD, and the 30 year loan was imprudent, you would see a loss on the CD. If enough of these happen, the bank would be insolvent.

And this is certainly happening now to some degree in some banks. And I would also agree that that triggered the current bank run at those banks.

BUT the element that makes it so contagious is that bank runs reduce the value of long term assets. Long term assets have two prices, the bank run price and the non bank run price. Liquidity and Solvency become intrinsically linked.

http://www.winterspeak.com/2008/09/liquidity-solvency.html

MT turning off (a liquidity crises) is a systemic event that takes a few bad loans and makes them into a collapse of the financial system. People will always make bad loans, but a robust banking system should be able to survive it, and MT without FDIC insurance (aka the shadow banking system) is not robust. A solvency problem at one bank (caused by bad loans) becomes a solvency problem across the entire system because MT, at a systematic level, turns off.

An institute level bank run can be caused by insolvency. But a systemic bank run (credit crunch, liquidity crises etc.) can only be triggered by MT turning off.

-winterspeak