The Fetish for Liquidity (and Reform of the Financial System)

By L. Randall Wray

This post first appeared at "Great Leap Forward”, my EconoMonitor blog.

In his General Theory, J.M. Keynes argued that substandard growth, financial instability, and unemployment are caused by the fetish for liquidity. The desire for a liquid position is anti-social because there is no such thing as liquidity in the aggregate. The stock market makes ownership liquid for the individual “investor” but since all the equities must be held by someone, my decision to sell out depends on your willingness to buy in.

I can recall about 15 years ago when the data on the financial sector’s indebtedness began to show growth much faster than GDP, reading about 125% of national income by 2006—on a scale similar to nonfinancial private sector indebtedness (households plus nonfinancial sector firms). The run-up of the debt ratio of households and nonfinancial business were EACH about the same size as the debt ratio of the financial sector in 2006. I must admit I focused on the latter while dismissing the leveraging in the financial sector. After all, that all nets to zero: it is just one financial institution owing another. Who cares?

Well, with the benefit of twenty-twenty hindsight, we all should have cared. Big time. There were many causes of the Global Financial Collapse that began in late 2007: rising inequality and stagnant wages, a real estate and commodities bubble, household indebtedness, and what Hyman Minsky called the rise of “money manager capitalism”. All of these matter—and I think Minsky’s analysis is by far the most cogent. Indeed, the financial layering and leveraging that helped to increase the financial sector’s indebtedness, as well as its share of value added and of corporate profits, is one element of Minsky’s focus on money managers. I don’t want to go into all of that right now. What I want to do instead is to focus quite narrowly on liquidity in the financial sector.

So here’s the deal. What happened is that the financial sector taken as a whole moved into extremely short-term finance of positions in assets. This is a huge topic and is related to the transformation of investment banking partnerships that had a long-term interest in the well-being of their clients to publicly-held, pump-and-dump enterprises whose only interest was the well-being of top management.

It also is related to the rise of shadow banks that appeared to offer deposit-like liabilities but without the protection of FDIC. And it is related to the Greenspan “put” and the Bernanke “great moderation” that appeared to guarantee that all financial practices—no matter how crazily risky—would be backstopped by Uncle Sam.

And it is related to very low overnight interest rate targets by the Fed (through to 2004) that made short-term finance extremely cheap relative to longer-term finance.

All of this encouraged financial institutions to rely on insanely short short-term finance.

Typically, financial institutions were financing their positions in assets by issuing IOUs with a maturity of mere hours. Overnight finance was common—through repos, asset-backed commercial paper, and deposit-like liabilities.

On the other hand, the assets were increasingly esoteric positions in mark-to-myth structured assets with indeterminate market values—indeed, often with no real markets into which they could be sold. Further, many of these assets had no clearly defined income flows at all—virtually by definition, a NINJA loan (no income, no job, no assets) has no plausible source of income to service the debt. That is just the most outlandish example—but many or most of the “asset backed commercial paper” had no plausible source of income to service the liabilities issued.

It was all myth. US debt-to-GDP ratios reached 500%–there was a dollar of income to service $5 of debt. It was not going to happen. The short-term liabilities of financial institutions were not going to get serviced—they would only get rolled over, so long as the myths were maintained.

As I’ve said before, it worked until it didn’t. As soon as one holder of all this crap wondered whether the Emperor had any clothes, the whole house of cards collapsed. And that largely took the form of one financial institution refusing to “roll over” another financial institution’s short term crappy IOUs.

Four years and trillions of lost dollars of wealth later, here we are.

Since 2008 we’ve had a steady stream of recommendations concerning what to do to remedy the problem. Most of the “reforms” suggested misidentify the problem, or have no political viability.

As we now know, Dodd-Frank is toothless and will do almost nothing to remedy current problems or to prevent future crises. It does have one positive effect that I’ll come back to in a later blog: many of the Fed’s bail-out actions last time around are now illegal. That is good. But as they say, where there’s a will, there’s a way. Still, so far as legislative reforms, the best we can hope for is a crash much worse than the GFC that will open the possibility for real reform.

The most popular “reforms” today are a Tobin tax on financial transactions and higher capital ratios for financial institutions. Neither of these will have any significant impact. I won’t justify my position here—but there are fairly good analyses already, especially on capital ratios. Jamie Dimon at JPMorgan has proudly announced his bank is gaming the capital ratios, by managing the “hell out of RWA”—risk-weighted assets. If anything, the risk-weighting of the Basel requirements hastened the run-up of leverage that caused the GFC, and the recent proposals to enhance capital ratios based on RWA will only bring on the next crisis because they encourage every financial institutions to maximize risk within a risk-weighting.

More radically, some like Simon Johnson recommend breaking up the biggest institutions. I confess that I concur, but would go a bit farther: close all of the “dirty dozen”—the biggest 12 banks—and investigate, prosecute and punish all of the top management. Spare no expense, pursue both criminal prosecutions and sue them for civil damages. The goal should be to at least double the success achieved in the aftermath of the S&L crisis: put at least 2000 of the top management and traders of the dirty dozen behind bars. That would include two or three Secretaries of the Treasury plus most of Obama’s closest economic advisors and even some recent White House Chiefs of Staff (Obama’s choices so far have put first Wasserstein & Co, then JPMorgan and finally Citigroup management in charge of the White House).

OK, that will not happen with an Obama administration, which is run by and for the dirty dozen. And none of the Republican candidates with the possible exception of Ron Paul is going to do this, either. So, yes, prosecuting criminal banksters is a pipedream.

Is there any other proposal on the horizon that might save us from Armageddon?

In a very interesting piece, former Treasury advisor Morgan Ricks has offered a proposal. Let me make two remarks before summarizing his idea. First, it is amazing that this comes from an insider who advised President Obama. Second, I know Morgan and can attest that he is simultaneously a very smart guy, and he is no flaming radical. His proposal is thoughtful and while it won’t be popular among the biggest banks, it comes down squarely in the middle of those who want to tweak with a bit more capital and those who want to close down the biggest fraudsters.

So here’s the idea. Morgan quotes University of Chicago’s (!!) Douglas Diamond that “financial crises are always and everywhere about short-term debt”. Now that is a very good start, a far more interesting and accurate statement than the most famous quote by a Chicago economist—Uncle Milty Friedman—that “inflation is always and everywhere a monetary phenomenon” (demonstrably false, by the way). Financial crises occur because of this conflict between the desire for liquidity by individuals, and the impossibility of liquidity for society as a whole. Think of it this way: all assets—financial or real—must be held by someone. So we cannot all get out of them simultaneously.

In a crisis, that is precisely what happens: we all try to get out, but cannot. In the GFC, holders of the very short-term liabilities of financial institutions rationally decided to get out. Note that I said “rationally”. A lot of the analyses of a run to liquidity rely on the supposition of irrationality. There was nothing irrational about the run out of short-term financial institutions liabilities in 2008. It was rational. These institutions were holding pure crap as assets. They still are. It is entirely irrational to hold their short-term liabilities because in the short-term they are all insolvent. Massively.

That is why the Fed had to lend and spend (buying trashy assets) $29 trillion to keep them in business. There were no dupes to hold their liabilities, so the dupe of last resort—the Fed, guaranteed by Uncle Sam—stepped up to the plate. I’ll have a lot more to say on that topic over coming weeks.

The point, however, is that the creditors of these institutions held essentially overnight short-term liabilities. They refused to refinance them. The suspected insolvency led immediately to a liquidity crisis. As well it should! If you know your irresponsible drunk uncle is set to go bankrupt, you don’t lend him another thousand bucks for a night in Las Vegas. He can call that a liquidity crisis; you call it good sense.

So what is Morgan’s solution? “Term out”: force financial institutions that take risky bets to finance their positions in assets by issuing longer-term liabilities. In that case, there is no easy way to “run out”. The creditors are locked in to the crazy bets made by the debtors. Maybe they’ll pay off. Maybe they won’t.

If you think about investment banks before 1999, that is essentially how they operated. They played with partner’s money, with low leverage. But then they went public and adopted a new business model: maximize share prices to funnel money to hired management. They greatly increased leverage and moved to short-term finance. Customers and share-holders alike were treated like patsies. But the investment banks made people like Hank Paulson and Bob Rubin rich—and then bought them positions in Treasury to back-stop the banks’ risky positions.

The cult of the “Greenspan put” and the “Bernanke great moderation” convinced markets that these risky short term liabilities issued by banks betting in complex CDOs squared and cubed were actually as safe as FDIC-backed bank deposits. And then when the whole darned thing collapsed, Uncle Ben and Dauphin Prince Timmy really did bail them out—to the tune of tens of trillions of dollars.

Morgan’s Solution: segregate financial institutions into two mutually exclusive summer camps. One is subject to regulation and supervision of the asset side of its balance sheet. It gets to issue insured deposits. As these are payable on demand, they are by nature short-term, and are the primary medium of exchange and means of payment that is necessary in any monetary economy. It’s a safe and sound summer camp, albeit one that is a wee bit more Jimmy Stewart than Rod Stewart.

The other camp consists of all those who are not subject to such supervision and regulation. They are pretty much free to buy any crap they feel like buying, and can screw their customers and lose investors’ money. But they must “term out”—they finance using long-term liabilities. And they cannot issue anything that looks, smells, tastes, or feels like a deposit. Think of Altamont-era Rolling Stones—an exciting and necessary experience that is not quite suitable for everyone.

This will resolve the problem of short-termism with respect to financing positions in junk. It also mitigates the complaint about excessive regulation—any institution that hates regulation can avoid it almost completely by funding long-term. It makes the payments system safe by keeping the risky operators out. And it offers a good alternative to all the debates about capital ratios and Tobin taxes.

Now, will that long-term funded and unregulated partition of the financial sector periodically crash and burn? Yes it will. I think Schumpeter called that creative destruction.

OK this is admittedly only a short introduction. I’ll provide more argument in coming weeks. Meanwhile, take a gander at Morgan’s proposal here. It achieves a separation that is something like Glass-Steagall– i.e. only the safe summer camp institutions can issue deposits. The risky summer camp institutions cannot issue deposits. There’s nothing in Morgan’s proposal that is inconsistent with Warren Mosler’s proposal for permanent ZIRP (zero overnight rate target) – and I also support that policy. We wouldn’t need the silly expectations management that Bernanke is trying to do now. And, finally, Minsky’s loose version of real bills could be consistent with Morgan’s proposal–that is more about the kinds of assets the Jimmy Stewart summer camp banks are allowed to buy: self-liquidating loans, not investment finance.