The key point is that money market funding is at lower rates than capital market funding. Society is apparently willing to pay a premium (lower yield) to hold money claims rather than capital claims. Why is that?
Read the whole thing. Pointer from Mark Thoma.
The Modigliani-Miller theorem rests on at least two assumptions.
1. Individuals “see through” firms and understand that they hold the underlying assets.
2. Individuals can “undo” the leverage decisions of firms. If a firm borrows less, the individual can borrow more, and vice-versa.
Mehrling is saying that the key real-world violation of Modigliani-Miller in the real world is (2). That is, individuals cannot create money, and banks can.
I say that the key real-world violation of Modigliani-Miller is (1). Individuals do not know the underlying assets of banks (and other firms). Instead, they rely on signals.
As I have said many times, as individuals we want to issue risky long-term liabilities (long-term mortgages, shares in fruit trees) and hold riskless short-term assets (demand deposits). Financial firms accommodate this desire by doing the reverse. Up to a point, they can accomplish this through diversification, asset selection, and asset management. But beyond that point, they get away with signaling. When they get too good at signaling, they expand too much, leading to a buildup of risk.
Governments are similar to banks in this respect. They can hold risky long-term assets (future tax revenues) and issue riskless short-term liabilities (money and government bonds). Governments rely a great deal on signaling and on confidence.
In fact, government usually helps banks to maintain confidence. From lender of last resort to deposit insurance to “too big to fail,” government helps with confidence.
The problem is that nobody knows what the right level of confidence is. Too little confidence, and the financial sector is too small and economic activity is inhibited. Too much confidence, and the financial sector is too large and too many bad risks are undertaken.
My judgment is that we had too much confidence in our financial sector until a few years ago. I base that judgment on the spectacular growth in the share of GDP and profits of the financial sector in recent years, on the spectacularly stupid choices that financial institutions made, and on the huge amount of wealth that we wound up transferring from taxpayers to financial institutions after the crisis (I am including the transfers involved in paying interest on reserves and in the Fed taking on risky assets).
Policymakers, as well as folks like Perry Mehrling, do not share my judgment. They think that it was the loss of confidence in 2008 that was inappropriate, not the high level of confidence in the years leading up to the financial crisis. This is a huge divide, with major implications for how you think about financial policy going forward.
Those who are on my side (many of whom are on the left) want to see government offer less support to financial institutions. Some of us see breaking up large banks as critical to altering the political balance of power in order to reduce that support.
READER COMMENTS
PrometheeFeu
Jun 13 2011 at 10:55am
That is the best case I ever heard for breaking up banks. Most people say something along the line of: Make them small enough to fail. But that is absurd as a systemic risk distributed across a few large institution is no different than the same risk distributed across many small institutions if the incentives make everyone act the same way. But if the banks are smaller it may indeed undercut their political power. Unfortunately, that is the very reason why it won’t happen. They have the political power to prevent them from being broken up.
Charles R. Williams
Jun 14 2011 at 10:06pm
Firms are not transparent. Management has different incentives than investors. Deposits are convenient and banks provide a service that has a cost.
Put another way, bank equity sits on a continuum with insured deposits at one extreme and stuff like used cars at the other extreme. Most people would prefer money in a checking account to a used car in the back yard sitting on concrete blocks and slowly rusting away. Now if you are a creative mechanic who knows how find parts in a junkyard, has tools and plenty of spare time, you might prefer the used car. But if you’re not, you don’t even want to lend this guy money.
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