Table of Contents
List of papers of the thematic issue
“The Global Financial Crisis in Historical Perspective: An Economic Analysis Combining Minsky, Hayek, Fisher, Keynes and the Regulation Approach” by Robert Boyer DOI 10.1515/ael-2013-0030
“Hyman Minsky’s Financial Instability Hypothesis and the Accounting Structure of Economy” by Yuri Biondi DOI 10.1515/ael-2013-0045
“Minsky Financial Instability, Interscale Feedback, Percolation and Marshall–Walras Disequilibrium” by Sorin Solomon DOI 10.1515/ael-2013-0029
“Control of Finance as a Prerequisite for Successful Monetary Policy: A Reinterpretation of Henry Simons’ “Rules versus Authorities in Monetary Policy”” by Thorvald Grung Moe DOI 10.1515/ael-2013-0023
“What Do Banks Do? What Should Banks Do? A Minskian Perspective” by L. Randall Wray DOI 10.1515/ael-2013-0033
“What Financiers Usually Do, and What We Can Learn from History” by Pierre-Cyrille Hautcoeur DOI 10.1515/ael-2013-0034
“Why Banks Do What They Do. How the Monetary System Affects Banking Activity” by Luca Fantacci DOI 10.1515/ael-2013-0017
“Back to Basics in Banking Theory and Varieties of Finance Capitalism” by Kurt Mettenheim DOI 10.1515/ael-2013-0008
To discuss the function of banks is of vital importance, both for theory and for policymaking, especially in a period when private businesses, public finances and entire economies have been disrupted by the failure of banks to do their job – whether this failure has taken or not the form of an outright bankruptcy. I thoroughly subscribe, therefore, to the starting point of Randall Wray’s paper: “Before we can reform the financial system, we need to understand what banks do; or, better, what banks should do” – given that, as most people would agree, there is indeed a difference between the two. However, in order to assess, and possibly to reduce the gap, we also need to understand why banks do what they do (and don’t do what they ought to). I am convinced, and will argue more extensively, that Wray, together with a large part of the literature on the current global financial crisis, tends to overemphasize the role played by fraudulent behavior. This is not to say that there haven’t been violations of the law, but rather to suggest that the latter do not fully explain the shortcomings of financial institutions in performing their task. To put it bluntly, I believe that the current crisis did not deflagrate because the rules were broken, but because they were followed.
To the extent that the problem is fraud, the solution lies in the enforcement of existing laws. Yet, even if all current laws were respected, crises would still happen. This is not to say that crises are “an unavoidable concomitant of the functioning of financial markets” (Eichengreen, 2002, p. 4), but rather, as I argue further in the course of this article, that the persistence of endemic crises can be overcome only by a drastic overhaul of the financial system.
Indeed, the main proposition that I maintain in this article is that there is a structural feature of the monetary and financial system that largely determines the conditions and incentives for banking activity, driving them astray from their proper task. This feature is liquidity, i.e. the interchangeability of assets and money. Liquidity is commonly viewed as a positive and desirable characteristic of the financial system, since it is assumed to encourage the funneling of money toward the most promising investments. However, as crises show, liquidity also allows the opposite flow, the liquidation of investments and the accumulation of idle money balances, which eventually obstruct the financing of trade and investments by the banking system.
Let me also make this point clear from the outset: crises make the problem apparent, but they are not themselves the problem. Crises are merely a symptom and a consequence of liquidity. It is liquidity that causes investors to focus on the short term, to underestimate risk and to misallocate savings in the “irrational exuberance” that leads up to a crisis. Hence, due to liquidity, even when crises don’t happen, banks might still systematically fail to perform their most essential functions in supporting economic activity.
Consequently, I shall also argue that, if banks are to be reintegrated as a vital and sound organ and not as a pathogenic agent in the body of the economy, it is essential not merely to sanction illegal behaviors and to correct perverse mentalities but to change radically the way money and credit are conceived and established. This involves essentially, depriving money and credit of their liquidity.
In order to support this argument, I will have to start by discussing the reasons why banks are essential to the functioning of the economy (1). I will then analyze the structural features of the monetary and financial system that have caused banks to fail their task (2). Finally, I will try to outline the principles that ought to guide a radical reform of the system if that task is to be fulfilled (3).
1 The function of finance
The first merit of Wray’s paper is to address explicitly, from the very title, a set of questions that is seldom raised by the plethora of contributions dedicated to the current crisis. Many talk about the need to “reform finance”. Now, it is difficult to imagine how we are to detect the flaws of the financial system and to devise the reforms required to adjust them, if we do not start by asking what the purpose of finance is and whether its actual configuration is apt to attain that purpose. Yet, very few studies tackle the problem from the outset as this one does.
According to Wray, a definition of the purpose of finance is to be found in Minsky’s work, and in particular in his idea that “the proper role of the financial system was to promote the ‘capital development’ of the economy” and thereby, more broadly, “economic development to improve living standards” (abstract). I believe that this definition is at the same time too narrow and too broad.
It is too narrow because it does not cover other functions that are equally essential to the economy and that Wray (2013) lists when he describes the operations that are to be provided by the financial system: these include, for example, not just long-term finance for capital development but also payments systems and short-term loans. In order to include these further functions, we could perhaps state that the task of finance is more generally to provide an anticipation for all those activities that structurally involve the need to sustain costs before earning revenues. Indeed, if one only stops to consider the economy from this viewpoint, expenditures always precede revenues. This is apparent in the case of the entrepreneur, who makes an investment in fixed capital (e.g. a new productive plant or process) and has to wait some time before he eventually “breaks even” and starts to earn a profit. But it also applies to merchants, who simply distribute what others have produced: even they have to buy before they can sell, and hence need some sort of anticipation to finance their circulating capital in the meantime, whether the anticipation comes from a bank, from a partner in the firm, or from a supplier who accepts a deferred payment. More generally, any person who lives and works needs to consume and spend for her own subsistence, before she and others can eventually enjoy the fruits of her toil. A definition of the scope of banking must, therefore, include not just the funding required to produce new goods and services but also the funding and the payments system required to circulate goods and services that have already been produced.
At the same time, the promotion of “capital development”, and even more of “economic development”, is too broad to offer an appropriate definition of the scope of finance – and this, for at least three interconnected reasons. First, these concepts are vague and liable to various specifications. Second, they do not allow to discern ex ante, as a definition should, whether a particular type of banking activity actually accomplishes the tasks of finance. Indeed, even the activities that Wray criticizes, such as securitization, contributed to capital development and economic development in general – at least for a certain time. In fact, until the subprime frenzy lasted, houses were built and people were employed to build them and GDP increased accordingly. Only when the bubble burst did it become evident that the costs exceeded by far the benefits, in terms of production, employment and home ownership.1 Third, and more substantially, this way of defining the role of finance fails to mention an essential feature that the author implicitly assumes as a decisive criterion in his subsequent analysis, i.e. that banks should promote and finance only those activities that can be reasonably expected to yield sufficient revenues to pay off the loan that made them possible. In order to mention this criterion explicitly, we could complete the definition by stating that the function of finance is not only to provide an anticipation but also to provide an anticipation in view of its repayment.2
The constituent element of finance is the relationship between creditor and debtor, established in view of the eventual repayment. Only with the repayment is the purpose of the relationship fulfilled. This is indeed what the word “finance” suggests, if only we pay attention to its etymology: the root “fin-” is the same as in the word “finish”, and it evokes the settlement as the ultimate deed involved in the creditor–debtor relationship, as the end envisaged from the very beginning (Skeat, 1888, p. 290). Only insofar as repayment is acknowledged by creditor and debtor as the eventual accomplishment of their relationship does finance attain its “finished workmanship”. Repayment thus defines the limit and scope of finance within the economic system as a whole, ensuring that the financial system remains strongly anchored to the real economy and that financial services actually serve the purpose of providing adequate anticipation for production and trade.
However trivial this definition of the purpose of finance may appear, many recent financial innovations would not have been considered beneficial, or even legitimate, if the scope of finance had been defined and delimited in these terms. For example, a similar definition would have excluded from the number of legitimate financial practices any form of subprime lending where the originator did not even envisage the repayment of the loan but relied entirely on the possibility of selling it through securitization. More generally, it would have ruled out the idea of “lending even to those who don’t deserve it”, which was advocated as a virtue of so-called financial democratization.3 Indeed, a definition of finance that includes repayment as an essential feature seems to be implicit in many criticisms and proposals made by Wray, such as the idea that it is the duty of the banker to “be skeptical” and that underwriting is an indispensable element of sound banking. In other terms, if finance is conceived as an anticipation in view of a repayment, this means that it involves a responsibility, not only of the debtor but also of the creditor: the debtor is responsible for doing all he can to repay his debt at the time and conditions predetermined in the contract; but also the creditor has an obligation to carefully assess the solvency of the debtor (the “due diligence” is actually “due” by the creditor, it is her “duty”) and to manage delinquencies by restructuring debt and postponing installments when there is good faith on part of the debtor (Ishikawa, 2013).
The transformation of the creditor–debtor relationship into a negotiable security undermines the structure of finance and jeopardizes its capability of performing its task, since it obliterates the payment from the horizon of debtor and creditor alike, lifting them both from their respective responsibilities. If the lender doesn’t have to wait for the repayment of a loan to have his money back, because he can securitize the loan and sell it on the market, then he will have no reason to assess the solvency of the borrower. And, if the creditor is not concerned about the repayment, there is no reason why the debtor should. The obliteration of payment makes the financial system, together and ambiguously, extremely powerful and extremely fragile.
The moment of payment is the moment of truth, where financial activity is reconciled with the economic activity it is intended to serve. The payment is the end of finance, understood both as its termination and as its purpose. A finance that builds on the obliteration of payment and on the transformation of the creditor–debtor relationship into a negotiable security is a finance that never attains its end, a finance that never finishes. The removal of its end allows finance to expand without limit, but also without any relationship with actual production and trade (Amato & Fantacci, 2012).
The possible departure of finance from its original goal is nothing new. Already in the 1930s, Marc Bloch identified the distinctive feature of capitalism, with respect to all previous financial systems, in its tendency to obliterate payment:
Delaying payments or reimbursements and causing such delays to overlap perpetually with one another: this was in short the great secret of the modern capitalist system, which could perhaps be most precisely defined as a system that would perish if all the accounts were settled at the same time. This system is fuelled by an optimism that constantly discounts the profits of the future, its eternal precariousness. (Bloch, 1954, p. 77)
Read today, in the wake of a global financial crisis, the remark sounds strikingly prescient. Of course, Bloch was writing in the midst of the Great Depression, in a context that, as Wray observes, presented many similarities to the current situation. But it is worth turning, now, to the more recent trends in financial activities, to see in what respect and to what extent they have further departed from the goals of finance as they have been briefly outlined in this first section.
2 Banking on liquidity
Let us then address the first question that is raised by Wray: “What do banks do?” To sum up the answer that is convincingly and extensively set forth in the article, we could perhaps state that banks have increasingly deserted banking activity proper, to engage in trading. Instead of linking savings to investments, by borrowing and lending, over recent decades banks have shifted toward a “new paradigm”, which consists in financing economic activity by issuing securities and selling them on the market (Boyer, 2013).
Until the outbreak of the subprime crisis, the new paradigm appeared to “contribute to the efficiency and stability of the financial system” (Knight, 2007), as stated by the general manager of the Bank for International Settlement as late as September 2007. Indeed, it allowed banks to avoid holding risky assets on their balance sheets and to earn fees on securities that they would only “originate to distribute”. Moreover, at least for some time, this model produced benefits also for other actors, offering opportunities of diversified and high-yield investments to risk-prone lenders and making abundant finance available even to subprime borrowers. However, the fact of not actually underwriting the loans distracted banks from their task of assessing the creditworthiness of borrowers, it relaxed their “skepticism” toward requests for funding, it reduced their attention toward the need to ensure that the investments would actually produce the cash flows required to repay capital and interests, and it ultimately undermined the sustainability of the entire credit system.4 Under the appearance of an enhanced stability, the paradigm shift masked a substantial fragility of an entirely new kind. Securitization appeared to distribute risk throughout the entire financial system, to the point of making it virtually disappear, while, in fact, as the crisis made apparent, it was only transforming the nature of the risk involved in financial relations – from credit risk to liquidity risk.5
This is best seen from a macroeconomic perspective, considering the interconnections between the banking system and the monetary system. As Wray rightly insists, following the lesson of Minsky and Schumpeter (but also of Keynes), when banks lend money, they don’t need to collect it in advance by taking in savings, but they can actually create it in the form of deposits. In other terms, in the traditional model of banking, investments are not financed from previous savings, but from the creation of new money by the banks: loans make deposits.6 As long as banks “originate and hold”, they finance their actual holding of assets (the loans) by creating equivalent liabilities (the deposits). By contrast, when banks “originate and distribute”, the assets are not held until their expiration, but they are immediately sold on the market in the form of securities. Hence, the corresponding loans are not financed through the creation of new money, but through the collection of old money from the buyers of the securities.7 In other words, whereas the old paradigm involves the potential inflationary and destabilizing pressures of a monetary expansion through the banking system, the new paradigm is apparently immune from this sort of risk.
Apparently. In fact, if it is true that securitization does not create money, it does however create liquidity. And not just for the bank that gives away a long-term debt in exchange for ready cash. Also the buyers of the securitized loans have the benefit of a liquid investment that can be readily converted into cash. Nobody – neither the bank nor the investor – is obliged to wait for the moment of payment. The payment disappears from the horizon of all actors. And, together with it, also the risk of a non-payment disappears. Nobody apparently bears the credit risk, that is the counterparty risk.8 What is relevant, for whoever holds the securitized loans, is not whether the actual loans will eventually be paid back by the original borrowers, but whether the holder will be able to resell the corresponding securities whenever she may wish to liquidate them.
This logic is incorporated in the accounting system by the adoption of the fair value approach, according to which the price of each asset is intended to reflect primarily the cash flow that would be generated by its sale on the market and not the cash flow that would be generated by its repayment at the conditions originally agreed upon by the debtor. Payment and non-payment thus disappear even operatively, as a basis of calculation, from the accounts of all actors.9 What counts, quite literally, is not whether a credit is payable, but whether the corresponding asset is tradable. Creditor–debtor relationships are thus replaced, even in accounting, and hence in the representation and operation of business activities, by negotiable assets: credit becomes a mere commodity.
Therefore, securitization transforms a long-term debt into a liquid asset for all … at least until the markets for securitized debts continue to be liquid.
Hence, the new paradigm has even more destabilizing effects than the old also in terms of the objectives of monetary policy – and for at least two reasons. First, because it may produce a subtle form of inflation, by artificially boosting the price of assets (and not only of financial assets but also of real estate, as in the case of securitized mortgages, and indirectly even of commodities). Second, because it may eventually force monetary authorities to issue the actual money which may be needed to ensure the liquidity of asset markets, on the maintenance of which the entire financial system now relies. In fact, the lack of liquid markets would imply not only the drying up of a source of finance, and major losses for the holders of securities, but also the impossibility of actually assessing the losses and of writing a balance sheet: you cannot “mark to market”, if there is no market. And the uncertainty in the assessment of actual losses contributes to aggravate the credit crunch, since it induces banks to mistrust borrowers and hence to reduce lending, both to businesses and to other banks. Therefore, after banks have created liquidity, there may well be no other option for central banks than to create actual money, in an effort to support or to substitute the funding normally provided by the interbank market.
In sum, in the traditional model, investments may indeed be financed through money creation by banks, but the amount of money created in the form of deposits is accurately recorded in the accounts of the banks and is strictly limited by reserve ratios, capital requirements, and other prudential measures. Moreover, banks are held responsible for the assets they create: they bear the credit risk for the loans that they originate.
By contrast, under the new paradigm, banks may not create money,10 but they still create assets in the form of tradable securities. However, the benefits of the new system, not only for the banks but also for the ultimate borrowers and lenders, rely on an assumption for which no one can be held accountable: the maintenance of the liquidity of those assets. This may force central banks to create money, at an unpredictable moment and in unpredictable amounts. The massive waves of quantitative easing undertaken by all central banks as a response to recurrent liquidity crises over the past years provide compelling evidence of such money creation. “Since 2007, central banks have flooded the world financial system with more than $11 trillion” (Hilsenrath & Blackstone, 2012). Total central bank assets (and liabilities) have roughly doubled in the last 5 years, since the outbreak of the crisis.
Figure 1 shows, for example, the expansion of the balance sheet of the European Central Bank (ECB) over the past decade.11 It illustrates how strongly the money supply in the euro area has been affected by the liquidity requirements of the banking system. In fact, the two hikes correspond to massive interventions by the ECB aimed at shoring up European banks that had suffered substantial losses on the market value of their assets. The first instance was triggered by the default of Lehman Brothers in September 2008 and saw the ECB increasing its total assets by 35% (roughly from 1.5 to 2 trillion euros) in just over a month. The second was in response to the worsening of the sovereign debt crisis in Europe, which called for a further growth of ECB assets by another 35% (from 2 to 2.7 trillion euros) over the last 5 months of 2011.
In both cases, the ECB extended loans to European banks with a view to substituting other sources of funding that had dried up, particularly the interbank market. In the words of the ECB, “constraints and higher costs in interbank market funding, as well as in funding through debt securities, have led banks to increase their recourse to central banking funding substantially with respect to the pre-crisis period” (ECB, 2012, p. 24).
The ultimate aim of those interventions was to avert not just the illiquidity of banks but also the interruption of lending to businesses. However, most of the funds secured through these facilities did not result in actual lending, since the liquidity injected into the system was merely re-deposited by the banks at the ECB. To use the vivid expression of one observer, it was like “spitting in the wind” (Figure 2).12
Apart from the scale and from the novelty of such monetary expansions, the fact that the new money created by the central bank does not eventually circulate is a further disquieting signal of the fact that money creation is occurring not just on an unprecedented scale but also in a form which is not under control even of monetary authorities themselves.
The diagnosis made in Wray’s paper is therefore convincing: the current troubles of the financial system do not come from the conflation of commercial banking and investment banking, but from the transformation of investment banking into a trading activity. “While many point to the demise of Glass Steagall separation of banking by function, the problem really was the demise of underwriting” (p. 11).13 And the demise of underwriting was indeed precipitated by a series of innovative practices: “The originate to distribute model virtually eliminated underwriting, to be replaced by a combination of property valuation by assessors who were paid to overvalue real estate, by credit ratings agencies who were paid to overrate securities, by accountants who were paid to ignore problems, and by mono-line insurers whose promises were not backed by sufficient loss reserves” (p. 16).
However, I do not agree with Wray in ascribing the erosion of underwriting standards to the triumph of a “trader mentality” (p. 11; emphasis added). Trading is not just a matter of “mentality”, nor even of practices following that mentality. Banking can be conceived and practiced as a trading activity only insofar as credit is conceived and treated as an object of trading, i.e. as a commodity, as a negotiable security instead of as a relationship between borrower and lender.
The change in banking activity over the past decades is not a moral issue, related to individual attitudes or behaviors (the supposed “greed” of bankers), but rather a strictly economic issue, related to the structure of monetary and financial institutions. The problem is not so much what banks do, but why they do it. Banks trade because money and credit are made tradable by ever more liquid financial markets.14
On the other hand, this structural change is not adequately described in terms of a passage from a “banks-based model” to a “markets-based model”. In fact, the problem is that, as banks act more and more like merchants, financial markets look more and more like oligopolies, so that you end up with having neither banks nor markets proper. This is rightly emphasized by Wray: “Many financial services were supposedly taken out of financial institutions to be performed by ‘markets.’ However, this was more apparent than real because the dominant financial institutions controlled those markets and set prices of financial assets” (p. 16). You can’t call it the triumph of the market model because the so-called markets are not transparent and competitive as ideal markets are deemed to be: “markets are highly manipulated by insiders, subject to speculative fever, and mostly over-the-counter” (p. 19).
Indeed, it is true that, in certain instances, bankers may have exploited dominant positions, or committed outright frauds, that their clients may have been more or less culpably uninformed and naïve and that certain deals may have been favored by a lack of transparency and oversight.15 However, as the author rightly points out, “questionable treatment of clients by investment banks has a long history. The only thing that appears to be relatively new is the dominance of traders and trading at these firms” (p. 21).
Hence, the distinctive problem of today is not the possible fraud in the sale, but the sale itself, i.e. the fact that banking activity is increasingly reduced to trading. In other terms, the problem is the financial market as such, the fact of assuming that it is desirable, and even possible, to assign the functions of finance to a market. Wray’s paper never states the question in such radical terms. However, there are several other remarks that may be cited in support of this view.
First, where the author provides valuable insights into the growth of trading by investment banks over the past decade, he observes that profitable deals were struck by managers, to the detriment of their clients, by exploiting the reputation of the bank. “From the perspective of hired management, the purpose of a good reputation is to exploit it” (p. 13). This suggests that part of the problem has to do with governance, with the relationship between shareholders and management, and specifically with the separation between shareholders and management which characterizes public companies listed on share markets. It is this separation, made possible by the existence of share markets, which explains the divergence between the short-term objectives of managers and the long-term interests of both their clients and their shareholders.16
Yet, this does not explain what allows managers to actually reach those goals: “Betting against the worst junk you can find is a good deal – if you can find a buyer to take the bet” (p. 19). The problem is: how do you find one? The author assumes that reputation plays an important part in finding gullible buyers. However, if this is the problem, it should be solved by itself: you can only sell your reputation once. Whenever the reproachable behavior of certain actors is also harmful to their counterparts, market discipline should indeed be disciplining. So, why doesn’t competition between investment banks on the market compel them to adopt practices that are more favorable to their customers?
I believe that the answer lies in the peculiar character of a “market”, which, in the case of securities and other financial instruments, is not in fact a zero sum game. Banks manage to sell and gain systematically, because this does not necessarily imply that the buyers are losing. On the contrary, as the case of securitized sub-prime mortgages shows, all actors may gain – as long as the assets involved continue to increase in price and maintain their liquidity. This explains why it has been so difficult to make banks pay for the losses they have caused, to introduce more restrictive legislation aimed at averting reckless behavior, or to impose caps on compensations and bonuses, despite popular outrage and almost unanimous political consensus on the desirability of such measures. Indeed, not only bankers, but everyone is better off if the burden of past debts is borne by the merciful and almighty father of all prodigal sons, i.e. the lender of last resort, who takes those debts upon his shoulders and even grants further credits, lifting spirits and asset prices, merely by creating out of thin air all the liquidity that is required.
On these peculiar markets that trade debts, and not goods, public vices are transformed into public virtues by the invisible hand of the central bankers. Liquidity is the catalyst of a reconciliation between public and private interests: thanks to the liquidity of financial markets, states have access to apparently unlimited funding, while, on the other hand, insolvent market participants (and particularly banks) can rely on government bailouts. Hence the sustainability of all debts, public and private, ultimately relies on the liquidity provided by central banks. Liquidity appears thus to be the solution to all problems and to all conflicts. The hidden cost is what economic theory refers to as “moral hazard”: the risk that credits are granted and debts are taken irresponsibly, since payment may be indefinitely deferred. The problem, however, is not moral, but strictly economic. And it is not merely a contingent effect of certain behaviors, but it is a structural and inevitable implication of a monetary and financial system built on the hypothesis of liquidity.
Let me clarify this important point. Liquidity is defined as “the interchangeability of assets and money”. Hence, when referred to assets, liquidity indicates their prompt convertibility into money. And, when referred to money, liquidity evokes the possibility of holding it as an asset, i.e. as a store of value. Now, economic theory has retained from Keynes the concept of liquidity – overlooking the fact that he considered it a misconception (Fantacci, 2005). In fact, Keynes considered liquidity quite literally as “a fetish”:
Of the maxims of orthodox finance none, surely, is more anti- social than the fetish of liquidity, the doctrine that it is a positive virtue on the part of investment institutions to concentrate their resources upon the holding of “liquid” securities. It forgets that there is no such thing as liquidity of investment for the community as a whole. (Keynes, 1936, p. 155)
A fetish is the object of a belief, which only has the appearance of a reality as long as you believe in it. That assets are convertible into money and that money is a form of wealth may be true for the individual, but it is definitely not true for the economic system as a whole. When everyone actually tries to liquidate assets and hold money, exchanges and investments are brought to a standstill and the economy sinks into depression. But even when this possibility is put into action only by a minority, remaining a mere possibility for all others, and financial markets appear to function properly, the liquidity of assets severs their price from the real returns on the underlying investments. Or, to put it in other terms, liquidity is responsible for the prevalence of speculation, intended as the orientation toward short-term gains on capital account reaped by buying and selling securities, as opposed to investment, understood as long-term financing of entrepreneurial activity in view of its prospective long-term yields.
Hence, the root of the problem is not the liquidity crisis, but liquidity itself. Trading is a bad substitute for banking regardless of its effects. Trading is at odds with banking, because it is the responsibility of a banker to bear the risk involved in investments, whereas, if he merely sells securities, he is lifted from that responsibility and hence he is not doing his job, even if he is doing no harm to anyone.17
3 Elements for reform
The outline of the argument sketched out at the beginning of the articlr betrays a concession toward this sort of consequentialism: the financial system has become more fragile, fragility may cause stagnation, and stagnation hinders capital development. This approach implies that, if the financial system were made to be less fragile, or if the potential depressive effects of fragility were offset by expansionary policies, all problems would be solved and the financial system would be reconciled with its goal of promoting capital development. I do not subscribe to this approach, and I am not even sure that it accurately reflects the view of the author, as it emerges from the complex of his arguments. The main problem is not the potential fragility, or even the actual failure, of the financial system, but its inability to finance real investments, or even to distinguish between real and unreal investments.
To put it in the terms of the author, the problem may be misallocated financing (Smithian failure), insufficient financing (Keynesian failure) – but also excessive financing.18 Booms are no less a problem than depressions. This is not explicitly stated in the article. However, there is one argument, in particular, that runs implicitly throughout the analysis and that goes decidedly in this direction: debts are to be made payable and the repayment of debts ultimately depends on the actual profitability of the investment.
Hence, the recommendations concerning what banks should do, which represent the second main point of the article. The principal suggestion of the author is to strengthen relationship banking, where lending does not take the form of negotiable securities, bought and sold on the market, but rather of long-standing relationships between the borrower and the bank. The idea is clearly not inspired by a nostalgic longing for the past. Banking ought to be decentralized not because “small is beautiful”, but because “small- to medium-sized banks are more profitable and relation-oriented. In other words, there was no reason to allow or promote the rise of hegemonic financial institutions with national markets and broad scope” (p. 23). To put it bluntly: local banks are more banks.19 They actually perform the function of finance, which consists in providing anticipation in view of a repayment. Global banks have not become dominant for economical reasons, as if they were always better at performing this task, but for political reasons, because, despite being less capable, they benefit from the support of governments and central banks.20 I therefore subscribe to the proposals of the paper to favor relationship banking (p. 24) and to “reduce government protection for less desirable banking activity” (p. 25).
The root of the problem, however, as I have suggested, lies in the form of monetary institutions. Hence, redefining how money is issued and managed by central banks is even more decisive than banking regulation. As long as money is issued through markets, through “injections of liquidity”, it will continue to be treated as a commodity. I am therefore deeply sympathetic with the idea of supplying reserves through the discount window rather than through open-market operations, provided that this is really done in order to strengthen oversight and control by the central bank (p. 31).21 This is very important. It is a good way to start shifting back from trading to banking, and hence to reduce the weight of financial markets in providing credit to the economic system. In the same vein, I also subscribe to the idea of preventing banks “from using insured deposits in a manner that causes the capital development of the country to be ‘ill done’” (p. 26) and of curtailing excessive lending not by raising interest rates nor by increasing capital requirements, but rather by direct credit controls (pp. 29–30).
However, in this perspective, it is all the more important to specify the exact scope of central bank oversight and control. Do we want central banks to pick investments, or to set the criteria for good investments? I definitely believe that it should not be the task of a central bank, or of any other financial authority, to decide who should be given credit or for what purposes. I am convinced, instead, that it is an essential and irremissible duty of authority to define the criteria according to which credit should be granted by private financial institutions in order to fulfill a function that is essentially in the public interest. And those criteria should be intended to preserve the relational form of credit and to affirm the responsibilities of both creditors and debtors within their relationship in view of its accomplishment in the actual payment. In practical terms, this means to reaffirm the centrality of underwriting, e.g. compelling banks to underwrite their loans in order to benefit from certain facilities, such as deposit insurance, access to central bank funding or specific legal protections. A further, concrete way to induce banks to sustain actual investments would be to raise the burden of keeping idle balances at the central banks, by exacting fees on excess reserves.22
The scope for public intervention is not in substituting or supplementing private enterprise, but in ensuring that the moment of truth arrives in the form of a payment maturity and in preventing that the weight of debts becomes intolerable. This will ensure that finance is truly at the service of the real economy, thus avoiding the two opposite, but equally pernicious, effects of a detachment of financial assets from real investments, whereby on the upturn of the financial market purely fictitious value is created, while on the downturn real wealth and productive capacity are destroyed.
Ultimately, finance has to perform two simple, yet vital functions: namely, to finance trade and investment. Its role is essential to the functioning of the economy. This is why it is a problem when finance fails. And yet, to paraphrase Keynes, if the tasks of finance are entrusted mainly to liquid financial markets and to banks that operate primarily as traders on those markets, “the job is likely to be ill-done” (Keynes, 1936, p. 159).
In order to perform their function, banks do not have to buy and sell securities, but grant credit to investment and trade, entering into a relationship with their debtors and discriminating between those who are creditworthy and those who are not. The form taken by the debtor–creditor relationship should vary, according to whether it is intended to provide funding for innovation, investment and the production of new goods and services or to provide funding for the circulation of what has already been produced. Two needs require two different forms of finance.23
It is beyond the scope of this article to analyze this sort of provisions in detail. However, before concluding, I wish to outline at least the principles that, following Keynes, should underlie the two forms of banking. Neither involves the existence of money as a store of value, the payment of interest on money loans, and still less the trading of money and credit on a market.
3.1 Financing of investments
The financing of investments ought to be based on a long-term relationship between the creditor and the debtor. This is to ensure that the time horizon of the creditor, in assessing the creditworthiness of the borrower, is the same as the one implied by the actual investment to be financed. And, since the prospective yield of the investment is uncertain, the return of the creditor cannot be set in advance, in the form of a rate of interest (a “fixed income”, in financial jargon, or more simply a “rent” in the lexicon of classical economists). The remuneration of the lender should be rather in the form of a participation in profits or losses. This is the idea implied by Keynes when he states “that to make the purchase of an investment permanent and indissoluble, like marriage, except by reason of death or other grave cause, might be a useful remedy for our contemporary evils” (Keynes, 1936, p. 160). Yet, this is not utopian or romantic as the metaphor might seem to imply. Indeed, it is the form that the funding of investment actually takes in a variety of consolidated practices, ranging from the traditional approach of Islamic finance to venture capital on the technological frontier.24
The same principle seems implicit in the recent bold proposal by Admati and Hellwig (2013) to reduce leverage, by inducing banks to rely less on borrowing and more on equity. Uncertain yields on investments expose the bank to a risk of losses. Insofar as a bank finances its activity by borrowing money, it promises to repay and remunerate that money at predetermined conditions (in terms of interest rate and maturity): hence, in case of losses, a mismatch with obligations to repay borrowed money occurs. Instead, insofar as a bank is financed by equity, the shareholders will have to assume the burden of that risk, since the repayment of their capital is not guaranteed (and still less the payment of interest): they accept to participate in profits and losses. However, this only holds true if the shares are not liquid and therefore the actual interests of the shareholders are tied to the long-term prospects of the bank and of its effective investments. Of course, if instead the shares continue to be negotiated on unconditionally liquid markets, the shareholders will always have the possibility to run away, leaving the burden of the losses on the lender of last resort. Furthermore, so-called shareholders’ equity mingles together actual funding provided by external investors, with accrued bank entity equity, while they should be distinguished (Biondi, 2012).
3.2 Financing of trade
On the other hand, still following Keynes, the purpose of financing trade is best served by a clearing system. There is no need for a preliminary accumulation of money to be lent on interest. Credit is granted in the form of a procrastination of payment made multilateral by a centralized clearing house. Money is required only as a unit of account for the denomination of debts and as a means of payment for their settlement.25 It cannot be used as a store of value since, in Keynes’s conception as embodied in the rules of the Clearing Union, positive balances are charged with a fee just like negative balances. And the symmetric fees paid by creditors and debtors alike can in no way be considered an interest on a loan. Within a clearing system designed according to these principles, credit-money is created and destroyed according to the actual requirements of trade, while the financial facility provided by the clearing system expands and contracts to the rhythm of the exchange of actual commodities. Money is not accumulated as a store of wealth and financial imbalances are systematically reabsorbed thanks to the concurrence of creditors and debtors to the readjustment process.
Even in this case, it is not pure theory. The Clearing Union still provides a blueprint for a possible reform of the international monetary system, and its revival was recently advocated in this perspective by the governor of the Chinese central bank (Zhou, 2009). It served as inspiration for the construction of the European Payments Union that allowed trade to grow and to be liberalized across Europe between 1950 and 1958, in years of great expansion. And the example would deserve to be followed today, to address the current European debt crisis. Finally, the principle of multilateral clearing underlies a number of private barter schemes between businesses, at both international and national level.26
It is conceivable, and indeed desirable, that banks offer clearing schemes as a way of financing the circulating capital of their customers.27 Adapting the model of Keynes’s International Clearing Union, each firm participating in the system would be entitled to a current account denominated and would benefit from an overdraft facility on that account. The current accounts would be denominated in a form of bank money not convertible in legal tender, but only in goods and services.28 A sale between two member firms would give rise to a credit on the account of the seller and to a debt on the account of the buyer. It is important to understand the nature of the credits and debts created within the clearing system: they are only originated and extinguished by a transfer of goods or services; a debt is not an obligation to repay money, but to sell goods or services for an amount equivalent to those purchased; symmetrically, a credit is not an entitlement to money, but to goods or services.29 Through a clearing system of this kind, a bank could finance trade between its customers, without lending money, and hence without having to borrow money from the interbank market or from financial markets generally. Of course, this would lower the cost of credit for businesses, and, more importantly, it would make the cost of credit independent from the volatile conditions prevailing on the market.
Participation in profits and losses and clearing represent, therefore, two forms of cooperative finance, soundly based on the relationship between debtor and creditor regulated by money as a mere intermediary and unit of account. If money and credit were conceived and established according to these principles, it would be easier for banks to do what they should.
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This article was conceived as a comment on Wray (2013). I would like to thank M. Amato, Y. Biondi, C. Columbano, P. Mottura and anonymous referees for their precious comments on previous versions. The usual disclaimer applies.↩
In fact, due to foreclosures, subprime lending had a net negative effect on homeownership already before the outbreak of the crisis (Center for Responsible Lending 2007). And it is difficult to see new houses as a positive contribution to capital development when they are repossessed by banks and left vacant.↩
As Wray recalls, it was Minsky who first denounced that, already in the 1980s, “bankers, the designated skeptic in the financial structure, placed their critical faculties on hold” (Minsky, 1992, p. 37).↩
Unless, of course, those who buy the securities borrow the money to do so.↩
In stark contrast to what happens with the assignment of receivables (e.g. through factoring), where the credit risk is transferred together with the corresponding asset according to detailed regulations concerning the respective rights and obligations of assignor, assignee and debtor (as testified, for example, by United Nations, 2004).↩
On the implications of the paradigm shift represented by the adoption of fair value as the core principle of international accounting standards, see Bignon, Biondi, and Ragot (2009), Biondi (2011b), and Biondi and Fantacci (2012).↩
In fact, as we shall see, they may even destroy the money created by the central banking, redepositing it in the form of excess reserves. In any case, whether they actually create or destroy money does not affect the following argument that they create liquidity.↩
The same occurred with other major central banks around the world, including US, UK and Japan.↩
It is important to note that “underwriting” here must be understood in the sense of “becoming answerable for” a loan granted to a borrower within a long-term relationship, and not merely in the sense of “agreeing to purchase” a loan in the form of a negotiable security. In other terms, the “demise of underwriting” described by Wray refers to the demise of the responsibility of the bank as a mediator between debtors and creditors.↩
In turn, what drove the liberalization and globalization of financial markets over the past 40 years was not merely technical innovation in ICT, nor neoliberal ideology, but also outright and deliberate intervention in the form of deregulation by governments, crisis management by international organizations and lending of last resort by central banks (Helleiner, 1996).↩
This is not said to advocate a shareholder model of the firm, and still less of the bank. On the contrary, it implies the need to question the very fact that ownership may take the unstable and unreliable form of liquid shares on a liquid market. The separation between ownership and management is highlighted by Keynes as the distinctive feature of financial markets and as the crucial factor of their intrinsic instability: “With the separation between ownership and management which prevails to-day and with the development of organised investment markets, a new factor of great importance has entered in, which sometimes facilitates investment but sometimes adds greatly to the instability of the system” (Keynes, 1936, pp. 150–151).↩
The alternative to this conclusion is to believe that Madoff only became a defrauder because of the crisis and that, had it not been for the crisis and for his own confession, he would have continued not only to appear but also to be and to deserve the good name of a banker. This, indeed, seems to have been the line of reasoning that led the SEC to acquit him of accusations in various probes that were started against him in previous years. “With no investors found to be harmed, the SEC concluded there was no fraud” (Skannel, 2009; on “the paradigmatic case of Bernie Madoff”, see also Amato & Fantacci, 2014).↩
It should be noted that there is nothing specifically “keynesian” in denouncing insufficient investment, as opposed to excessive investment. In fact, Keynes was concerned that credit be neither lacking nor overabundant, but sufficient to finance any enterprise that might provide reasonable prospects of profitability.↩
As bailouts and outright nationalizations of too-big-to-fail banks have proven ad nauseam over the past couple of years. But the argument had been already convincingly made, well before the countermeasures to the current crisis provided further evidence, by Helleiner (1996), who underlines the role of states in supporting financial globalization since the 1970s. In part, the support of nation states to liberalization was also driven by the intention of favoring “national champions” in the global arena (see Thiemann, 2013).↩
And not merely to enhance their liquidity, as was done by the ECB in December 2011: the granting of 3-year loans at a very low interest rate and in unrestricted quantities should have been accompanied by some measure aimed at ensuring that the funds were actually used to finance enterprise, and not merely to be re-deposited at the central bank or to be invested in public debt. The obligation to pay a deposit fee on reserves held by banks at the ECB, as proposed below, could provide an effective incentive in this sense.↩
As proposed in Amato and Fantacci (2014) and now taken in consideration also by central bankers, in particular Mario Draghi of the European Central Bank (ECB, 2013). The idea may be traced back to Keynes: already in the Tract on Monetary Reform, he had pointed toward the need to devise some scientific method to contrast the accumulation of idle money balances (Keynes, 1923, pp. 9, 53–58); again in The General Theory, he supported the proposals to introduce, for that purpose, artificial carrying-costs on money (Keynes, 1936, p. 234); and, finally, in his Proposals for an International Clearing Union, he proposed to introduce an international money, Bancor, that was supposed to be subject to a sort of negative interest rate on positive balances (Keynes, 1941, p. 79). The idea that money should be deprived of the function of a store of value in order to perform properly its other functions is indeed a pillar of Keynes’s theoretical work and even more of his policy recommendations (Fantacci, 2013b).↩
This is the rationale for the distinction between commercial and investment banking that inspired the Glass-Steagall Act adopted in the United States during the Great depression and, more recently, the Vickers banking reform in the United Kingdom. However, the segregation of the two functions in two different types of institutions may not be the only, nor even the better, solution to the problem.↩
Unless even venture capital is distorted, as it was during the so-called Nasdaq bubble, by an overwhelming tendency to seek IPOs – and hence the securitization of the initial investment – as the preferred exit strategy.↩
A comprehensive survey has been recently conducted on behalf of the City of London Corporation (Z/Yen, 2011), testifying that even high street banks are increasingly interested in the development of alternative forms of finance. On the meaning and diffusion of clearing systems, see also Fantacci (2013a, 2013b).↩
A similar business model was adopted by the Swiss cooperative bank WIR in the 1930s as a response to the credit constraints caused by the Great depression. In 70 years, the clearing system managed by WIR grew to comprise over 80,000 small businesses throughout Switzerland, and a turnover in excess of 2 billion Swiss francs (Stodder, 2009, p. 81).↩
The operation of a similar system is described in greater detail in Amato and Fantacci (2013).↩