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Rarefied Air

A few years ago I was fortunate to attend a lecture given by Paul Wilmott challenging the wisdom of modeling derivatives on the assumption that there is no arbitrage. He floated an alternative approach (as but one of many possible heterodox approaches) outlining the pitfalls therein – chiefly the difficulty of convincing investors to bear with you until your thesis proves out – and toward the end he took questions. Some brave soul asked him, “Where does the money come from?”
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The following post is by Dealbreaker reader and commenter Infinite Guest.

A few years ago I was fortunate to attend a lecture given by Paul Wilmott challenging the wisdom of modeling derivatives on the assumption that there is no arbitrage. He floated an alternative approach (as but one of many possible heterodox approaches) outlining the pitfalls therein – chiefly the difficulty of convincing investors to bear with you until your thesis proves out – and toward the end he took questions. Some brave soul asked him, “Where does the money come from?”

“Thin air?” he replied.

Whether you consider money a medium of exchange, a store of value, a means of paying taxes or a means of keeping score, money in aggregate is a denominator. It purports to measure things like wealth and income. A “stable” currency in some sense is therefore desirable, and we all have a common interest in seeing to it that money is created or destroyed, made available to the economy or not, in some sort of equitable or at least responsible fashion, by people and institutions we feel can somehow be held accountable for their actions. In ordinary times one you would have very little motivation to question where money comes from but after being told every day of your life for a few years that the global financial system, having lately suffered a near-death experience, is a social ill, inherently flawed, fragile and corrupt, which might at any time blow up the economy and abscond with your job, your house and your savings in tow, then you might become if not strictly speaking curious at least concerned. You might seek safety in a gold standard or some other type of commodity money. You might get worked up about the national debt or the Federal Reserve. You might even, as IMF economists Jaromir Benes and Michael Kumhof have been doing with their excellent working paper “The Chicago Plan Revisited” search for answers in the creative past and, with the benefit of modern technology, conclude that the time has come to end fractional-reserve banking once and for all.

“The Chicago Plan Revisited” applies mathematics borrowed from quantum physics to a set of ideas generated by creative political economists reeling from the shocks of the Great Depression with confirmatory results. It relies on what’s called a DSGE model of the economy, a type of “bottom-up” model that evaluates macroeconomic conditions more-or-less microeconomically. The monetary recommendations of the original Chicago Plan were eventually articulated by Irving Fisher et al. as “A Program For Monetary Reform,” a thoughtful document that reads as relevant today as it must have then if not more so, although like many old manifestos its commitment to the inevitability of its own premises ironically undermines the credibility of its argument. That is to say, were fractional-reserve banking so inadequate to meet demand for money and the public debt so unsustainably high (in 1939!) that Chicago-style monetary reform would necessarily occur, why bother advocating for it? “The Chicago Plan Revisited” is in that sense more tentative than the original. Full-reserve banking is mathematically superior to fractional-reserve banking given the right initial conditions of leverage and provided that the right institutions have adequate technology and sufficient incentives to behave properly. Both papers assert that full-reserve banking would smooth out the business cycle, reduce public and private debt and consign banking panics to the dustbin of history. The more recent analysis finds, over and above the claims of its ancestor, that full-reserve banking would eliminate inflation and stimulate economic growth. While reasonable people may quibble, let’s assume for the time being that under the right circumstances they’re dead right about all that. What then?

Among many appealing features of the narrative present in “The Chicago Plan Revisited” is its understanding of money creation, a practitioner’s understanding true to its roots in Fisher’s view of endogenous money. The money we use is not created as a multiple of some pre-existing reserve on a stock of deposits but quite the opposite. Deposits chase lending. Lenders really do create money out of thin air. Reserve requirements from that perspective don’t have as much power as we might like. They don’t effectively constrain lending. Credit creation under such a regime being bound to money creation, reserve requirements don’t constrain that either. Given that somewhere down the line inflation is related to money supply, policy rates don’t appear likely to do much, either. Lending is presumably like any other business. Lenders create as much credit as the can at some premium to the policy rate, one of their more relevant input costs, and when it stops being profitable, they stop lending. Such a decision process on such a production function doesn’t necessarily lend itself to producing a “stable” currency.

That sums up the supply side of things anyhow. Implicitly lenders are trying to meet some kind of demand. If markets work, they work because they clear at some price level where supply and demand are identical. The authors recognize that the value of liquidity services concentrated within a small group of privileged parties who are authorized to create money may be quite substantial. They seem recognize further, at least with respect to credit, that markets do not always clear. Here they note that at the bottom of the credit cycle lenders tend to avail themselves of the contractual right they bought at the top of the cycle to seize the collateral assets of borrowers who default. In private hands, both the value of liquidity and the legal seizure of assets are presented as types of usury, “the calculated misuse of a nation’s money system for private gain,” the sort of definition that reveals more about the perspective of the people who wrote it than perhaps it intends.

Money per se owes its existence to the rule of law. It should be apparent that all kinds of property are created by law. That fact does not necessarily argue in favor of state ownership of all kinds of property any more or less than it argues in favor of state control of money. Good laws distinguish between private and public property. As part of the social contract, good management of public property serves the owners of private property rather than punishing them. Good laws restrict the power of government, protect private property and facilitate the orderly and equitable transfer of private property rather than impairing it. If it is socially undesirable to leave control of the money supply to a privileged few capitalists, it does not absolutely follow that it would be socially desirable to place that control in the hands of appointed officials, either. Economic models are explicitly intended to describe human behavior and within some limited scope to predict it, and of course, economic models rest on assumptions about human behavior. But more than rest on assumptions —here I can’t help thinking about Emanuel Derman’s Models.Behaving.Badly., an extended meditation on the subject — economic models comprise assumptions. The beginning, middle and end of a model economy, no matter how rigorous, complex and lifelike it may appear to be, are all collections of falsifiable statements about who people are, what we do and why. Having that in mind, it’s striking that for all their depth and attention to detail, Benes and Kumhof do not admit the possibility of gross incompetence on the part of their government monetary authority; and specifically excluded from the plan is the possibility that governments may wage war from time to time. The assumption that war is an exceptional circumstance that may be avoided by responsible government underpins both their analysis of monetary history and their model economy. With one gorgeous flourish of a hand-wave, the authors state:

To be fair, there have of course been historical episodes where government-issued currencies collapsed amid high inflation. But the lessons from these episodes are so obvious, and so unrelated to the fact that monetary control was exercised by the government, that they need not concern us here. These lessons are: First, do not put a convicted murderer and gambler, or similar characters, in charge of your monetary system (the 1717-1720 John Law episode in France). Second, do not start a war, and if you do, do not lose it (wars, especially lost ones, can destroy any currency, irrespective of whether monetary control is exercised by the government or by private parties).

On the contrary, one might imagine that banks exist precisely because in this world governments are by-and-large larcenous, murderous and stupid.

The plan itself, following a “transition period” whose brutality is buried beneath a thick carpet of relatively harmless-looking stochastic differential equations, would leave banks largely intact with the same relationships and inter-relationships, under the same management and capital adequacy constraints they now face, and enjoying most of the same privileges and profits they do today, except that ongoing profits from the liquidity services of money would be repatriated to the government in the form of seigniorage. Private debt would be necessarily constrained to a level supported entirely by equity. Unless we share the authors’ optimistic perspective that government can separately (and wisely) dictate the total volume of available credit, reducing banks to beneficent allocators of available capital, it’s not easy to see why we should be so sanguine about the prospects of such an arrangement: if lenders can only lend on equity then they need to show big profits, so that their market value increases, so that they can issue more equity, so that they can make more loans. Eventually they might make really risky loans in order to show big paper profits. When the value of their lending portfolio decreases, if recent history is any guide, they may turn out to be reluctant to take write-downs. They restructure. Only catastrophic collapse is sufficient to restrain them.

Supposing despite these reservations that full reserve banking of the type that leaves government firmly in control of money would eliminate inflation and smooth out business cycle, would that really be better than the way things are? Peaks of the business cycle encourage innovation. Troughs penalize untimely ideas. The business cycle is a crude motivator, and it isn’t always fair by some universal definition of fairness, but it’s only one element of a larger integrated system that includes other remedies through other institutions. Fair or not, the business cycle is part of a dynamic society in which today’s oligarch may at least potentially be tomorrow’s pauper. Come to think of it, periodic unexpected changes in inflation can be a natural way of keeping the rentier class in check. While a static society may be easier for economists to explain and predict, smoothing the business cycle and eliminating inflation seem likely to have the unfortunate side effects of strengthening the very oligarchy the authors apparently want to unseat.

What if instead of leaving control of money to the whims of the elite or handing it over to bureaucrats we regard the creation of money as a human right? Informal lending predates official government money, after all. The laws we live with around money really represent past and current governments’ largely successful efforts to take power away from individuals and potential competitors, placing it in the hands of trusted allies. We have available technology today that would allow anyone with a cell phone to create money if only we would remove the artificial regulatory fences that prevent such democratization. On a small but growing scale, we already create credit that way, with no special regulatory framework on reserves, capital adequacy or anything else, for instance through websites like Prosper. The same creativity and freedom that got us out of the Great Depression is today applied in socially beneficial ways to the allocation of credit and might some day soon be used to diffuse seigniorage so broadly that it loses the value associated with any special privilege, leaving only pure money with whatever “real” value it actually has.

Ultimately the source of our disappointments with money is not that the air it comes from is too thin. It's too closely contained. You might say it’s downright stuffy.


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