The Money Problem: Rethinking Financial Regulation

The Money Problem

The Money Problem

Rethinking Financial Regulation

MORGAN RICKS

THE UNIVERSITY OF CHICAGO PRESS

CHICAGO AND LONDON

MORGAN RICKS is associate professor at Vanderbilt Law School. Previously, he was a senior policy advisor and financial restructuring expert at the US Treasury Department, a risk-arbitrage trader at Citadel Investment Group, and vice president in the investment banking division of Merrill Lynch & Co.

The University of Chicago Press, Chicago 60637

The University of Chicago Press, Ltd., London

© 2016 by The University of Chicago

All rights reserved. Published 2016.

Printed in the United States of America

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ISBN-13: 978-0-226-33032-7 (cloth)

ISBN-13: 978-0-226-33046-4 (e-book)

DOI: 10.7208/chicago/9780226330464.001.0001

Ricks, Morgan, author.

The money problem : rethinking financial regulation / Morgan Ricks.

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Includes bibliographical references and index.

ISBN 978-0-226-33032-7 (cloth : alk. paper)—ISBN 978-0-226-33046-4 (ebook) 1. Money market—United States. 2. Monetary policy—United States. 3. Banks and banking—United States. 4. Informal sector (Economics)—United States. 5. Financial crises—Prevention. I. TitleHG540. R534 2016332.4′973—dc

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TO MOLLY

Contents

Preface

Introduction

PART I. Instability

CHAPTER 1. Taking the Money Market Seriously

CHAPTER 2. Money Creation and Market Failure

CHAPTER 3. Banking in Theory and Reality

CHAPTER 4. Panics and the Macroeconomy

PART II. Design Alternatives

CHAPTER 5. A Monetary Thought Experiment

CHAPTER 6. The Limits of Risk Constraints

CHAPTER 7. Public Support and Subsidized Finance

CHAPTER 8. The Public-Private Partnership

PART III. Money and Sovereignty

CHAPTER 9. A More Detailed Blueprint

CHAPTER 10. Financial Reform Revisited

Notes

References

Index

Preface

This book found its genesis at the US Treasury Department in the fall of 2009. I had joined Treasury earlier that year as a member of the newly created Crisis Response Team. We were a small group of Wall Street professionals—investment bankers, traders, and buyout specialists—whom Secretary Timothy Geithner had brought on board to help engineer the Obama administration’s response to the financial crisis. That fall, with the financial system in fairly stable condition, Geithner asked us to turn our attention from financial rescue to financial reform. The team gathered one afternoon to review some ideas.

We quickly found ourselves converging on a key issue. We called it shadow banking. That term has come to mean different things to different people. Indeed, it has become so vague as to render it almost meaningless. Sometimes it is used as a synonym for nonbank credit intermediation; other times it is an all-purpose reference to unregulated or lightly regulated parts of the financial system. To us, though, the term meant something very different, and quite specific. When we talked about shadow banking, we were referring to the financial sector’s use of vast amounts of short-term debt to fund portfolios of financial assets.

The short-term funding markets are enormous, but they are fairly obscure. They exist largely in the background, as part of what might be called the operating system of modern finance. These markets have weird names—like repo, Eurodollars, and asset-backed commercial paper—but this confusing terminology belies their simplicity. These markets are not exotic at all. They are as simple as can be: they are just short-term debt. Borrowings in these markets mature very soon, often in a single day. Financial institutions that rely on these markets typically must continuously renew (or roll over) large quantities of short-term borrowings. Failing to do so on any given day would result in the immediate default and collapse of the firm.

In 2007 and 2008 the short-term funding markets unraveled in dramatic fashion. The unraveling started in mid-2007 with the failures of a number of big investment conduits that relied heavily on short-term borrowings. The following spring the crisis spread to the giant repo market—a multitrillion-dollar market in which Wall Street firms finance their securities portfolios on a very short-term basis, typically overnight. Bear Stearns, a major investment bank, collapsed that spring when it lost access to overnight repo funding. Finally, with the bankruptcy of Lehman Brothers in the fall of 2008, all the short-term funding markets seized up at once. Many key financial markets stopped functioning. The economy promptly went into free fall. Governments in the United States and abroad launched massive financial rescue operations. With few exceptions, these emergency measures were aimed at stabilizing the short-term funding markets.

To our team at Treasury, the short-term funding markets seemed dysfunctional: they were prone to damaging panics. We were not alone in reaching this conclusion. On the contrary, we had been deeply influenced by others. A few months before our fall meeting, Federal Reserve chairman Ben Bernanke had publicly described the acute phase of the financial crisis as a classic panic, which he defined as a generalized run by providers of short-term funding to a set of financial institutions.¹ Several Fed economists had been promoting this thesis for some time. Gary Gorton had done pioneering work in this area as well; his writings on the short-term funding markets were very influential in the financial policy community. Paul Krugman had also been an early and perceptive analyst of this problem. Our views at Treasury had been influenced by all these thinkers.

By no means did we think that shadow banking was the only problem with the financial system. There were other problems too, particularly in the consumer protection area. But our sense was that the fragility of the short-term funding markets was a central problem—perhaps the central problem—for financial stability policy. Any serious program for financial reform, we thought, should address this area directly. In fact, we believed that a coherent regulatory approach to shadow banking might go a long way toward addressing other major issues, such as the vexing too big to fail problem. But what if anything should be done?

After our team meeting I drew up a memo titled Liability Reform. The memo proposed a system of explicit federal guarantees for the short-term borrowings of financial firms. In return for this guarantee, financial firms that relied on short-term borrowings would pay periodic fees to the government. (Others later offered broadly similar proposals.)² The reasoning behind the proposal was straightforward. During the financial crisis, taxpayers had stood behind the short-term funding markets on a staggering scale, with commitments in the trillions of dollars. If the public was going to stand behind these markets, the memo reasoned, then the public should be compensated for bearing this risk. By the same token, the fees (if properly priced) would end the massive public subsidies that accrue to big financial firms by virtue of the prospect of public support. Furthermore, an explicit guarantee presumably would remove the incentive for short-term creditors to run. In this regard the long-standing US deposit insurance system provided an instructive model. The establishment of federal deposit insurance in 1933 put a stop to the recurring panics that had previously beset the US banking system.

The memo generated a fair amount of discussion within Treasury. To be honest, the memo was not very good. (Geithner called it wacky.) The proposal as conceived was crude and unworkable, and there were serious drawbacks—moral hazard in particular. Over the subsequent months, the financial reform process went in a very different direction. July 2010 saw the enactment of the Dodd-Frank Act, the most far-reaching financial reform bill since the Great Depression. The act was intended to address the root causes of the financial crisis and prevent a recurrence. It was a massive piece of legislation, with over eight hundred pages of dense statutory text. But the new law left the short-term funding markets practically untouched.

I doubted we had succeeded in striking at the root of financial instability, and I believed the failure had been mostly conceptual, not political. When I left Treasury in 2010 to join academia, I sought to improve on my initial analysis of the shadow banking problem. This book is the result. The direction of this project was shaped by a conclusion I reached early on—that shadow banking should be viewed as a problem of monetary system design. (Just what I mean by this will soon become clear.)

My professional background has had a big influence on the way I think about these matters. Before joining Treasury I worked on Wall Street. My career there had three phases. I was first a corporate takeover lawyer, then an investment banker, and finally a risk arbitrage trader at a big hedge fund. I had a particular specialty, which on Wall Street is known as FIG (pronounced like the fruit). FIG stands for Financial Institutions Group, and it refers to teams that specialize in investments in financial firms (as opposed to, say, industrial firms or health care firms). My career has afforded me considerable practical experience in asset pricing, transaction structuring, and the valuation of banking and securities firms. This experience provides a useful vantage point from which to approach the topics addressed in this book.

Recent years have seen no shortage of analyses of the problems with modern finance. I suppose this book represents yet another entry in this already overpopulated genre. I believe it is unique in framing the issue as one of monetary system design. In addition, I hope it will distinguish itself by conceptual clarity, a trait not always in evidence in the recent and ongoing financial reform debates.

Emblematic of the problem has been the recent fashion for analyzing and measuring something called systemic risk. This nebulous concept has yet to be defined, let alone operationalized, in anything approaching a satisfactory way. In a well-known line from a Molière comedy, a doctor explains that opium puts people to sleep because it contains a dormitive property. This explanation says nothing at all—that’s the joke. It is a kind of tautology: the phenomenon is explained in terms of itself. The concept of systemic risk has roughly the same status. If the term were used merely as a catchall for theories about the sources of financial instability, it would be harmless shorthand. But systemic risk has now been thingified³ into something that supposedly can be measured and monitored, and even managed through various regulatory techniques. This reflects, in my view, a lack of discipline and conceptual development in the financial reform process. We have moved forward based on vague ideas about the nature of the underlying problem.

Greater conceptual clarity makes possible, I think, an approach to reform far simpler than the one currently being pursued. Simplicity is of course essential to good design. This is as true in the design of institutions as in the design of anything else. Unfortunately, recent and pending financial reforms have been anything but simple; they are mind-numbingly complex. Some might interpret this technical complexity as a hallmark of sophistication, but I take exactly the opposite view: it is a sure sign of poor design. We should be aiming for something far simpler. Bear in mind that simple does not mean simplistic. Justice Oliver Wendell Holmes once distinguished between the simplicity on this side of complexity and the simplicity on the other side of complexity.⁴ It is the latter kind that he considered worthwhile, and it is not easy to get there. Steve Jobs, one of the greatest product designers in business history, made the same point: that simple is harder than complex. It takes a lot of hard work, Jobs said, to make something simple, to truly understand the underlying challenges and come up with elegant solutions.⁵

This book offers a blueprint for an updated monetary system—a fairly simple one at that. It is not a vague statement of principles but rather a concrete and realistic institutional design. The design is not radical or exotic; indeed, it is fairly conservative. It is best understood as a modernization of the current monetary architecture. I believe the approach described here would enable us to substantially scale back our existing unwieldy approach to financial stability regulation.

Apart from serving as a possible basis for reform, this blueprint offers another advantage: it helps to illuminate the logic and historical development of existing institutions. The analysis will reveal that, despite its design flaws, the existing US system of money and banking in many ways embodies a coherent economic logic—one that has not previously been clearly articulated. Surprisingly, much of this terrain has never been systematically explored. Many of the components of the analysis already exist in the literature, but in fragmentary form. A central task of the book (and a source of its novelty) will be to assemble these elements into a coherent and integrated whole.

Portions of this book draw on my previous work. Parts of the introduction and chapters 1, 2, 9, and 10 draw on Regulating Money Creation after the Crisis, Harvard Business Law Review 1, no. 1 (2011): 75–143; parts of chapters 4, 6, 7, and 8 draw on A Regulatory Design for Monetary Stability, Vanderbilt Law Review 65, no. 5 (2012): 1289–360; parts of chapter 5 draw on Money and (Shadow) Banking: A Thought Experiment, Review of Banking and Financial Law 31, no. 2 (2012): 731–48; parts of chapter 10 draw on Reforming the Short-Term Funding Markets, Harvard John M. Olin Discussion Paper 713 (2012); and parts of chapters 1, 9, and 10 draw on A Simpler Approach to Financial Reform, Regulation, Winter 2013–14, 36–41.

I have amassed many intellectual debts in formulating the ideas presented here. Without implicating any of them in my conclusions, I want to thank Margaret Blair, Christine Desan, Gary Gorton, Sam Hanson, Mike Hsu, Howell Jackson, Matt Kabaker, Roy Kreitner, Perry Mehrling, Andrew Metrick, Geoff Miller, Jim Millstein, Nadav Orian Peer, Zoltan Pozsar, Jim Rossi, Nick Rowe, Ian Samuels, David Scharfstein, Ganesh Sitaraman, David Skeel, Jeremy Stein, Adi Sunderam, Randall Thomas, Yesha Yadav, and participants in workshops and seminars at Vanderbilt Law School, Harvard Law School, NYU Law School, Fordham Law School, University of Colorado Law School, and Duke Law School. Thanks also to Luke Meyers for research assistance.

As this book neared publication, Chris Rhodes, my editor at the University of Chicago Press, passed away. Chris was a superb editor—a wise and honest critic, a patient sounding board, an advocate and cheerleader, a skillful project manager. This book owes much to him.

Introduction

I am tempted to believe that what we call necessary institutions are often no more than institutions to which we have grown accustomed.—Alexis de Tocqueville, 1850¹

This book is about the structure of monetary institutions. It is also about financial instability. These two topics are closely related; in fact they are inseparable. I argue that our existing monetary framework is outdated and defective—and that revamping it is a prerequisite to financial stability. More than that, such a revamp could pave the way for a dramatic reduction in the scope and complexity of modern financial stability regulation.

In short, financial instability is at bottom a problem of monetary system design. In a sense, this statement reflects the traditional wisdom. During the Great Depression, the academic debates over what had gone wrong centered on the monetary architecture. Reform-minded scholars, including many of the leading economists of the era, sought above all to stabilize the circulating medium of bank-issued money. They understood the core problem in distinctly monetary terms.²

Today’s prevailing viewpoint is quite different. The global financial crisis of 2007 to 2009 has produced a flood of literature on the sources of financial instability. With very few exceptions, though, that literature has neglected the topic of monetary system design. Instead, under today’s dominant line of thinking, financial instability is understood to be an inherent feature of capitalist economies. In the words of Hyman Minsky, a pioneer of this point of view, serious business cycles are due to financial attributes that are essential to capitalism.³ The financial system, we are told, has a built-in tendency to get badly out of kilter, endangering the broader economy.

In my view the prevailing viewpoint is not a useful way of thinking about financial instability. Just what is wrong with it is not easily stated in a few words. The case against the prevailing view won’t reach fruition until part 3 of the book. For now, let’s just say that the prevailing view has sent us on a wild goose chase, searching for systemic risk and other mythical creatures. I argue instead that the traditional wisdom still applies. When it comes to financial stability policy, our top priority should be to follow through on building a stable and efficient monetary framework. This project is not a new one, of course. Monetary system design is an age-old challenge of government. It is a discrete task of institutional engineering, not an open-ended search for systemic risk or anything like that.

This book is by no means the first to address monetary system design. As we’ll see later, though, the topic hasn’t been thought through as well as one might expect. To be clear, this book isn’t about the conduct of monetary policy—a topic that has received vastly more attention over the years. The conduct of monetary policy and the design of monetary institutions are distinct subjects. The latter analytically precedes the former: monetary policy takes place within a given institutional setting.

If my argument is right, then the financial stability reforms of recent years—in the United States and, by extension, abroad—have mostly been on the wrong track. We will look at those reforms in part 3. To the extent that they reflect an underlying theory, it is the prevailing viewpoint just described. Recent reforms have touched virtually every part of the US financial system, but they have left the monetary architecture practically untouched. I fear they could turn out to be both costly and ineffective.

The idea that financial instability is largely a problem of monetary system design is counterintuitive. It doesn’t mesh with the usual narratives about the recent financial crisis. Indeed, many readers may be wondering what this proposition even means. So this is where we need to start.

One View of the Challenge

It is useful to begin by discussing a subject that might initially seem unrelated to monetary system design: shadow banking. This term has taken on a variety of meanings lately, but I will use it in a very precise way. For our purposes, a shadow bank is an entity that uses large quantities of short-term debt to fund a portfolio of financial assets and that is not a chartered deposit bank. The shadow banking system is just the set of entities that meet these two criteria.⁴

The concept of shadow banking, as used here, is more or less interchangeable with the (nondeposit) short-term debt of the financial sector. Practically speaking, they are the same thing. The markets for this short-term debt—often called the short-term funding markets, the wholesale funding markets, or just the funding markets—are described in some detail in chapter 1. These markets are huge, and they were at the center of the recent financial crisis. In 2007 and 2008 the short-term funding markets unraveled in a series of classic panics. From the perspective of finance practitioners and policymakers, these panics were virtually synonymous with the financial crisis. The panics themselves were the emergency, and they coincided with the start of a severe economic slump.

This book argues that, when it comes to financial stability policy, panics—widespread redemptions of the financial sector’s short-term debt—should be viewed as the problem (the main one, anyway). More to the point: panic-proofing, as opposed to, say, asset bubble prevention or systemic risk mitigation, should be the central objective of financial stability policy—at least insofar as financial stability policy is about preventing macroeconomic disasters. I will have much more to say about this later.

We do of course have a policy response to panics, but it has major problems. The modern answer to panics consists of an implicit commitment of open-ended public support for the financial sector’s short-term debt, via the lender of last resort and other facilities. The very prospect of public support introduces potentially severe distortions into the financial system. It encourages the growth of individual financial firms and the financial sector as a whole; it rewards high degrees of leverage and generates an oversupply of credit; and it perversely subsidizes the financial sector through artificially low funding costs. These are not novel claims, but they do suggest that our modern approach to fighting panics might itself bear substantial responsibility for many of the apparent pathologies of modern finance.

So what does the financial sector’s short-term debt (shadow banking) have to do with the monetary system? Gary Gorton, a leading expert in this area, has said that the shadow banking system is, in fact, real banking.⁵ This is an important insight. Shadow banking clearly bears a close resemblance to ordinary deposit banking. Both shadow banks and deposit banks hold portfolios of financial assets that they fund largely with very short-term IOUs. In deposit banking those IOUs take the form of deposit liabilities. In shadow banking those IOUs consist of the myriad instruments of the short-term funding markets. But the basic structure is the same. Because of this heavy reliance on short-term debt funding, both business models are inherently susceptible to a liquidity crisis or run in which short-term claimants simultaneously seek to redeem.

So far so good; this comparison between shadow banking and deposit banking has become fairly standard. But the comparison can be taken one step further. It is a truism of finance that deposit banks are in the money creation business. Every student of introductory economics learns how this works. Deposit banks issue special instruments called deposits that function as money.⁶ This is a legally privileged activity: only chartered deposit banks are authorized to issue these instruments. And they issue them in amounts that far exceed their holdings of government-issued (or base) money. Deposit banks, then, really do augment the money supply.

Here we come to a threshold conceptual step. It turns out that the shadow banking system creates money too. The short-term IOUs that are issued by shadow banks are widely understood to be close substitutes for deposit instruments. For accounting and other purposes, these short-term debt instruments are called cash equivalents. Corporate treasurers and other businesspeople just call them cash. Economists sometimes refer to them as near money or quasi money. Central bankers include many of these instruments in their broad measures of the money supply. And, not coincidentally, the market for these short-term IOUs is known in the financial world as the money market, as distinct from the more familiar capital market in which stocks and ordinary bonds are traded.

Now, these cash equivalent instruments might not really seem like money. In particular, they are not typically used as a means of payment—a textbook attribute of money. In this respect cash equivalents look like ordinary bonds. An important task ahead will be to clarify what it means to say that cash equivalents have monetary attributes, whereas other financial instruments—like longer-term Treasury bonds, or shares in equity mutual funds—do not. The answer is not obvious, and it is not just a matter of asset liquidity. I will address this central topic in chapter 1.

Shadow banking, then, appears to be a monetary phenomenon, not just a financial one. This distinction might seem subtle, but it is conceptually significant. It implies that the shadow banking problem is bound up with the institutional structure of the monetary system. In other words, the question of what to do about shadow banking is inseparable from the question of how our monetary system should be designed. This recognition should not be very controversial; it emerges naturally from the analogy between shadow banking and deposit banking. Interestingly, though, shadow banking is seldom discussed in this way.

What would it mean to take this monetary perspective on shadow banking seriously? Deposit banks have long been viewed as special by virtue of their monetary function. In particular, disruptions in the deposit banking sector can and do inflict severe damage on the broader economy. In a classic analysis, Milton Friedman and Anna Schwartz argued that the Great Depression was largely the product of a monetary contraction caused by waves of banking panics.⁷ Those panics, they wrote, were the mechanism through which a drastic decline was produced in the stock of money. And the economic devastation that followed was a tragic testimonial to the importance of monetary forces. (Subsequent research on the Depression has stressed the causal role of the international gold standard. Note that these two explanations are complementary⁸—and both implicate the monetary framework.) The impact of Friedman and Schwartz’s study was profound. Ben Bernanke has described their achievement as nothing less than to provide what has become the leading and most persuasive explanation of the worst economic disaster in American history, the onset of the Great Depression.⁹ The relevance of the Friedman-Schwartz thesis to shadow banking is not hard to see. If the shadow banking system performs a monetary function similar to that of deposit banking, presumably it also presents similar macroeconomic risks.

This line of reasoning raises fundamental questions of institutional design. For the legal distinction between deposit banking and shadow banking is striking. Consider deposit banks first. In recognition of their special role in money creation, deposit banks have long been required to submit to a uniquely extensive regulatory regime. No other industry is subject to remotely comparable constraints and oversight. In the United States, deposit banks face detailed chartering criteria; strict limits on permissible activities and investments; leverage limits (capital requirements); special restrictions on affiliations and affiliate transactions; base money reserve requirements; extensive on-site supervision; a vigorous enforcement regime; special receivership in the event of failure; and so on. Deposit banks are also the beneficiaries of government stabilization facilities—central bank loans and deposit insurance—that are (normally) unavailable to other firms.

By virtue of submitting to this regulatory regime, deposit banks are endowed with an extraordinary legal privilege: they are licensed to issue deposit instruments. This privilege is accompanied by a logical corollary: enterprises other than chartered deposit banks are legally prohibited from issuing these instruments.¹⁰ This remarkable prohibition might be described, both logically and historically, as the first law of banking. It is worth dwelling on this point for a moment. In formal terms, a deposit instrument is merely a variety of IOU. The first law of banking thus establishes a sweeping limitation on freedom of contract. Parties not licensed as deposit banks are legally ineligible to be obligors under this particular type of IOU. The authority to issue them is the very legal privilege that a banking charter conveys.¹¹

Contrast the shadow banking system. Shadow banking entities have no legal or regulatory status as such. Issuing cash equivalent instruments—the hallmark of shadow banking—requires no license. This activity takes place pursuant to generally applicable background rules of property and contract (maybe with a dash of commercial law and organizational law thrown in). It is not legally confined, nor is it surrounded by the elaborate institutional architecture of the deposit banking system. What justifies this differential legal status? Assume for the moment that the monetary function of deposits is, in one way or another, what justifies the extraordinary regulation of their issuers. If cash equivalents perform a monetary function too, then perhaps the law of banking rests on an arbitrary and formalistic distinction. That is to say, perhaps the starting point for banking law should be not the deposit instrument but rather the broad array of short-term IOUs that serve a monetary function.

This analysis reveals a basic point that has vital implications for monetary system design: given the existence of some established medium of exchange, entrepreneurs can set up a distinctive money creation business model whose liabilities consist largely of instruments that are redeemable for that existing money on demand or in the very near term. (Why entrepreneurs would want to use such a funding model will be discussed in chapters 2 and 3; the short answer is that it is very profitable.) The portfolios of these enterprises tend to consist mostly of longer-term financial assets like loans and bonds. This is the familiar business model of banking—or shadow banking, as the case may be. Crucially, in the absence of any special legal impediments, this business model can arise through the operation of standard rules of property and contract. The law of deposit banking, however, establishes just such a legal impediment. It is the first law of banking: no person or entity may issue redeemable instruments styled as deposits unless it has a special charter to do so.

One sometimes hears that banking regulation should be extended to the shadow banking system, but this argument misapprehends the basic structure of banking law. To see why, imagine what it would mean to extend banking regulation to, say, a big securities dealer that relies heavily on short-term debt funding. I noted above that US deposit banks are strictly limited in their permissible activities and investments. Let’s now be a little more specific. In the United States, deposit banks are basically limited to holding diversified portfolios of credit assets—loans and investment-grade bonds. They generally may not buy equity securities or junk bonds, for example.¹² So deposit banks are not allowed to own many of the kinds of assets that securities dealers hold as a part of their core business. More fundamentally, deposit banks are explicitly prohibited by statute from engaging in securities dealing, subject to very narrow exceptions.¹³ Simply put, if deposit banking regulation were extended to a securities dealer, it could no longer be a securities dealer.

One might argue that these activity and portfolio constraints should be relaxed in the case of a securities dealer. But this is a strange argument; those constraints are part of the very core of banking regulation! Remember, banking law starts by confining the issuance of deposit instruments to a class of specially chartered entities that must abide by all sorts of requirements, including strict activity and portfolio constraints. If cash equivalents function as deposit substitutes, then the natural question is whether their issuance should also be so confined. In other words, the question isn’t whether banking regulation should be extended to (for example) securities dealers, but rather whether securities dealers should be prohibited from issuing cash equivalents, just as they are now prohibited from issuing deposits. We are talking here about updating the first law of banking—the general prohibition that is the starting point for banking law.

Here is another way of thinking about it. Imagine that the statutory definition of deposit¹⁴ were amended to encompass all the various types of short-term debt instruments on which the financial sector relies for funding. In that case, only chartered deposit banks would be authorized to issue such instruments. This would mean the end of shadow banking; the business of funding portfolios of financial assets with large quantities of short-term debt would be coextensive with the deposit banking system. We would then have a single set of chartered money creation firms, operating under terms and conditions established by the state.

It should now be apparent what it means to say that financial instability is a problem of monetary system design. The short-term IOUs of the financial sector are monetary instruments, and a panic—what Bernanke called a generalized run by providers of short-term funding to a set of financial institutions—is a defining feature of financial crises. To quote University of Chicago economist Douglas Diamond, a leading theorist in this area, Financial crises are everywhere and always about short-term debt.¹⁵ This is perhaps an exaggeration, but only a slight one.

The Broader Context

This discussion has offered a glimpse of the kinds of questions this book is occupied with. To bring these questions fully into view, it is useful to situate the foregoing discussion within a more general context. Some taxonomy will help. Consider the cash and equivalents line on the asset side of the balance sheet of an operating company, say IBM. We tend to think of this as just cash or money—and that is what IBM’s managers surely call it—but of course in reality it consists of specific kinds of instruments. What are they exactly? There are three basic categories. First, there is government-issued physical currency; IBM has only a tiny amount of this. Second, there are (checkable) bank deposit instruments, which the company uses to make virtually all its payments. Third, there are the various instruments of the short-term funding markets: cash equivalents.

Let’s look more closely at these three categories. Table 1 summarizes some of their essential legal-institutional attributes (the focus here is on the United States, but other jurisdictions are similar). The first row, physical currency, has been lurking in the background so far; we can now bring it forward. In modern monetary systems, physical currency is fiat currency, meaning it lacks intrinsic value and isn’t redeemable for anything else.¹⁶ The table indicates that issuing physical currency is legally privileged: having issued currency, the state prohibits others from producing identical instruments. This of course is the subject of anticounterfeiting law.¹⁷ Physical currency is also sovereign in status. This just means it represents a commitment of the state and not of any private entity.

Next consider bank deposits, which are the predominant medium of exchange in modern economies. We have already seen that their issuance is a privileged activity, inasmuch as it is legally confined to a class of specially chartered entities. In addition, most deposit instruments—those that are federally insured—are sovereign in status, meaning the government commits to honor them. Uninsured deposits, on the other hand, are private obligations and are susceptible to default.

The third category is cash equivalents. As we saw above, their issuance generally is not a legal privilege. Most cash equivalent instruments have no legal or regulatory status as such. They are issued (in immense quantities) pursuant to standard rules of property and contract. There are no legal restrictions on issuing cash equivalents, and they reside outside the purview of monetary authorities. In addition, cash equivalents generally are private obligations and are susceptible to default.

These three categories of monetary instruments roughly correspond to conventional measures of the money stock: the monetary base, M1, M2, and M3. Physical currency belongs to the monetary base, which under current arrangements is issued directly by the central bank. Bank deposits that are payable on demand belong to M1, which consists of types of money commonly used for payment. Some important cash equivalents are included in M2 and M3, which are broader measures of the money stock. The Federal Reserve stopped reporting M3 in 2006, but other central banks, including the European Central Bank, do report M3 measures (see chapter 1).

The taxonomy in table 1 raises some basic questions of institutional design. The most fundamental question is why the government should involve itself in monetary matters to begin with. We can safely stipulate that money serves a vital function in a market economy: it makes exchange much easier. But it doesn’t follow that the state needs to have a role here. The state could exit the monetary business altogether—including the issuance of physical currency—leaving it entirely to the market to establish a monetary framework.

In the area of money, however, the pure laissez-faire approach has few advocates.¹⁸ Even the most ardent proponents of laissez-faire usually concede that the market (as constituted by the legal institutions of property and contract) should not be expected to generate satisfactory monetary arrangements through some kind of spontaneous process. Consider the views of Milton Friedman, a champion of laissez-faire in other areas: Something like a moderately stable monetary framework seems an essential prerequisite for the effective operation of a private market economy. It is dubious that the market can by itself provide such a framework. Hence, the function of providing one is an essential governmental function on a par with the provision of a stable legal framework.¹⁹ More recently, another Nobel Prize–winning economist with equally impeccable laissez-faire credentials made a similar argument. The market will not work effectively with monetary anarchy, wrote James M. Buchanan. Clearly some defined process and institutional structure must be established over monetary affairs.²⁰

If the government is going to establish a monetary framework, it must decide how best to do so. In this regard it faces some fundamental design choices. An initial set of choices is evident in the privileged issuance column in table 1. Let’s suppose the state has successfully put some amount of fiat paper money into circulation, by whatever means. Assume also that it has established anticounterfeiting laws and is enforcing them adequately. As we have already seen, given the existence of this established medium of exchange, entrepreneurs can set up a money creation business (in other words, a bank) using generally available legal technologies. A threshold question for the state is whether to impose any limitations on this private activity.

The notion that the state should leave this activity unhindered—a proposal that sometimes goes by the name free banking—embodies a commitment to freedom of contract in this area. Note, however, that both theory and history suggest this business model is prone to damaging panics. (We will examine this topic in detail in part 1.) Perhaps for this reason, free banking has not been the historical norm. The issuance of deposit instruments and their historical predecessors, bank notes, has almost always been a legal privilege.²¹

Suppose the state were to conclude that free banking is dubious—that legal constraints should be placed on issuing redeemable instruments that function as money. (This is the first law of banking.) The state might then adopt the familiar licensing approach, permitting only selected third parties to issue these instruments under specified terms and conditions. But if the state sees problems with this activity—problems that justify curtailing freedom of contract—why let any third parties do it at all? After all, the state could make itself the exclusive issuer of monetary instruments, whether through a state-owned bank or through some other institutional arrangement. This would mean prohibiting all third parties from creating money; money creation would be a public monopoly. Lest this idea seem far-fetched, it is worth noting that one version of this proposal, called 100% reserve banking, has a very distinguished intellectual lineage.²²

Either way—whether the government grants the privilege of issuing monetary instruments to selected third parties or retains it exclusively for itself—the government needs to specify the precise contours of the privilege. A legal privilege logically implies a legal prohibition; parties without the privilege are prohibited from doing something.²³ So what, exactly, is the government