By Arnold Kling
Mencius Moldbug sent an email asking me to comment on this post, and we have been corresponding back and forth. I should say that monetary theory gives me a headache.Let us think of real investment in terms of a fruit tree. I spend resources planting a fruit tree today, but I won’t be able to harvest any fruit for several years. Suppose I don’t have all the resources I need today, so I need to borrow.
One way to borrow is to borrow short term and then roll over my debt until enough years have passed and I have sold enough fruit to pay off the loan. Each time I roll over the debt, I do not necessarily need to use the same lender. I can trust that the market will always provide a lender who will roll over the debt at the prevailing short-term interest rate, adjusted for whatever risk is associated with my fruit tree investment.
In this simple example, what would constitute a financial crisis? Could there be a liquidity squeeze? I think we need a more elaborate model to create a crisis or a liquidity squeeze, but I’m not sure.
Why would a bank come into the picture? A bank might say to the fruit tree entrepreneur, “Look, every time you roll over your debt, you are going to have to pay a fee to have your project evaluated by new lenders. Why don’t you just make a long-term commitment to roll over your debt with me?”
The entrepreneur says, “That sounds good. But if I commit to you, then what stops you from charging me a huge monopoly interest rate when I roll over my loan?”
The bank says, “OK, we’ll lock in the interest rate for 15 years. That will be our guarantee that we won’t exploit our monopoly power.” The bank in turn relies on short-term debt, rolled over frequently.
Thus, what Moldbug calls Maturity Transformation (MT) is born. What the market supplies–short term debt frequently rolled over–is transformed by the bank into a long term loan. Moldbug writes as if MT is some sort of original sin of a fiat monetary system,. However, I have not introduced fiat money at all. I just said that it costs resources to evaluate a project, and to economize on having to evaluate a project every time the debt rolls over, a bank comes in and offers long-term lending. Maybe this MT increases the risk of financial crises. I’m not sure. But I do think we need a theory of how long-term lending emerges in order to say anything about monetary institutions.