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Elham's Money View Blog Search For Stable Liquidity Providers Series

Do Distributional Effects of Monetary Policy Passthrough Debt than Wealth?

By Elham Saeidinezhad

Who has access to cheap credit? And who does not? Compared to small businesses and households, global banks disproportionately benefited from the Fed’s liquidity provision measures. Yet, this distributional issue at the heart of the liquidity provision programs is excluded from analyzing the recession-fighting measures’ distributional footprints. After the great financial crisis (GFC) and the Covid-19 pandemic, the Fed’s focus has been on the asset purchasing programs and their impacts on the “real variables” such as wealth. The concern has been whether the asset-purchasing measures have benefited the wealthy disproportionately by boosting asset prices. Yet, the Fed seems unconcerned about the unequal distribution of cheap credits and the impacts of its “liquidity facilities.” Such oversight is paradoxical. On the one hand, the Fed is increasing its effort to tackle the rising inequality resulting from its unconventional schemes. On the other hand, its liquidity facilities are being directed towards shadow banking rather than short-term consumers loans. A concerned Fed about inequality should monitor the distributional footprints of their policies on access to cheap debt rather than wealth accumulation.

Dismissing the effects of unequal access to cheap credit on inequality is not an intellectual mishap. Instead, it has its root in an old idea in monetary economics- the quantity theory of money– that asserts money is neutral. According to monetary neutrality, money, and credit, that cover the daily cash-flow commitments are veils. In search of the “veil of money,” the quantity theory takes two necessary steps: first, it disregards the payment systems as mere plumbing behind the transactions in the real economy. Second, the quantity theory proposes the policymakers disregard the availability of money and credit as a consideration in the design of the monetary policy. After all, it is financial intermediaries’ job to provide credit to the rest of the economy. Instead, monetary policy should be concerned with real targets, such as inflation and unemployment.

Nonetheless, the reality of the financial markets makes the Fed anxious about the liquidity spiral. In these times, the Fed follows the spirit of Walter Bagehot’s “lender of last resort” doctrine and facilitates cheap credits to intermediaries. When designing such measures, the Fed’s concern is to encourage financial intermediaries to continue the “flow of funds” from the surplus agents, including the Fed, to the deficit units. The idea is that the intermediaries’ balance sheets will absorb any mismatch between the demand-supply of credit. Whenever there is a mismatch, a financial intermediary, traditionally a bank, should be persuaded to give up “current” cash for a mere promise of “future” cash. The Fed’s power of persuasion lies in the generosity of its liquidity programs.

The Fed’s hyperfocus on restoring intermediaries’ lending initiatives during crises deviates its attention from asking the fundamental question of “whom these intermediaries really lend to?” The problem is that for both banks and non-bank financial intermediaries, lending to the real economy has become a side business rather than a primary concern. In terms of non-bank intermediaries, such as MMFs, most short-term funding is directed towards shadow banking businesses of the global banks. Banks, the traditional financial intermediaries, in return, use the unsecured, short-term liquidity to finance their near-risk-free arbitrage positions. In other words, when it comes to the “type” of borrowers that the financial intermediaries fund, households, and small-and-medium businesses are considered trivial and unprofitable. As a result, most of the funding goes to the large banks’ lucrative shadow banking activities. The Fed unrealistically relies on financial intermediaries to provide cheap and equitable credit to the economy. In this hypothetical world, consumers’ liquidity requirements should be resolved within the banking system.

This trust in financial intermediation partially explains the tendency to overlook the equitability of access to cheap credit. But it is only part of the story. Another factor behind such an intellectual bias is the economists’ anxiety about the “value of money” in the long run. When it comes to the design of monetary policy, the quantity theory is obsessed by the notion that the only aim of monetary theory is to explain those phenomena which cause the value of money to alter. This tension has crept inside of modern financial theories. On the one hand, unlike quantity theory, modern finance recognizes credit as an indispensable aspect of finance. But, on the other hand, in line with the quantity theory’s spirit, the models’ main concern is “value.”

The modern problem has shifted from explaining any “general value” of money to how and when access to money changes the “market value” of financial assets and their issuers’ balance sheets. However, these models only favor a specific type of agent. In this Wicksellian world, adopted by the Fed, agents’ access to cheap credit is essential only if their default could undermine asset prices. Otherwise, their credit conditions will be systemically inconsequential, hence neutral. By definition, such an agent can only be an “institutional” investor who’s big enough so that its financial status has systemic importance. Households and small- and medium businesses are not qualified to enter this financial world. The retail depositors’ omission from the financial models is not a glitch but a byproduct of mainstream monetary economics.

The point to emphasize is that the Fed’s models are inherently neutral about the distributional impacts of credit. They are built on the idea that despite retail credit’s significance for retail payment systems, their impacts on the economic transactions are insignificant. This is because the extent of retail credit availability does not affect real variables, including output and employment, as the demand for this “type” of credit will have proportional effects on all prices stated in money terms. On the contrary, wholesale credit underpin inequality as it changes the income and wealth accumulated over time and determines real economic activities.

The macroeconomic models encourage central bankers to neglect any conditions under which money is neutral. The growing focus on inequality in the economic debate has gone hand in hand to change perspective in macroeconomic modeling. Notably, recent research has moved away from macroeconomic models based on a single representative agent. Instead, it has focused on frameworks incorporating heterogeneity in skills or wealth among households. The idea is that this shift should allow researchers to explore how macroeconomic shocks and stabilization policies affect inequality.

The issue is that most changes to macroeconomic modeling are cosmetical rather than fundamental. Despite the developments, the models still examine inequality through income and wealth disparity rather than equitable access to cheap funding. For small businesses and non-rich consumers, the models identify wealth as negligible. Nonetheless, they assume the consumption is sensitive to income changes, and consumers react little to changes in the credit conditions and interest rates. Thus, in these models, traditional policy prescriptions change to target inequality only when household wealth changes.

At the heart of the hesitation to seriously examine distributional impacts of equitable access to credit is the economists’ understanding that access to credit is only necessary for the day-to-day operation of the payments system. Credit does not change the level of income and wealth. In these theories, the central concern has always been, and is, solvency rather than liquidity. In doing so, these models dismiss the reality that an agent’s liquidity problems, if not financed on time and at a reasonable price, could lead to liquidations of assets and hence insolvency. In other words, retail units’ access to credit daily affects not only the retail payments system but also the units’ financial wealth. Even from the mainstream perspective, a change in wealth level would influence the level of inequality. Furthermore, as the economy is a system of interlocking balance sheets in which individuals depend on one another’s promises to pay (financial assets), their access to funding also determines the financial wealth of those who depend on the validations of such cash commitments.

Such a misunderstanding about the link between credit accessibility and inequality is a natural byproduct of macroeconomic models that omit the payment systems and the daily cash flow requirement. Disregarding payment systems has produced spurious results about inequality. In these models, access to liquidity, and the smooth payment systems, is only a technicality, plumbing behind the monetary system, and has no “real” effects on the macroeconomy.

The point to emphasize is that everything about the payment system, and access to credit, is “real”: first, in the economy as a whole, there is a pattern of cash flows emerging from the “real” side, production and consumption, and trade. A well-functioning financial market enables these cash flows to meet the cash commitments. Second, at any moment, problems of mismatch between cash flows and cash commitments show up as upward pressure on the short-term money market rate of interest, another “real” variable.

The nature of funding is evolving, and central banking is catching up. The central question is whether actual cash flows are enough to cover the promised cash commitments at any moment in time. For such conditions to be fulfilled, consumers’ access to credit is required. Otherwise, the option is to liquidate accumulations of assets and a reduction in their wealth. The point to emphasize is that those whose access to credit is denied are the ones who have to borrow no matter what it costs. Such inconsistencies show up in the money market where people unable to make payments from their current cash flow face the problem of raising cash, either by borrowing from the credit market or liquidating their assets.

The result of all this pushing and pulling is the change in the value of financial wealth, and therefore inequality.  Regarding the distributional effects of monetary policy, central bankers should be concerned about the effects of monetary policy on unequal access to credit in addition to the income and wealth distribution. The survival constraint, i.e., agents’ liquidity requirements to meet their cash commitments, must be met today and at every moment in the future.

To sum up, in this piece, I revisited the basics of monetary economics and draw lessons that concern the connection between inequality, credit, and central banking. Previously, I wrote about the far-reaching developments in financial intermediation, where non-banks, rather than banks, have become the primary distributors of credit to the real economy. However, what is still missing is the distributional effects of the credit provision rather than asset purchasing programs. The Fed tends to overlook a “distributional” issue at the heart of the credit provision process. Such an omission is the byproduct of the traditional theories that suggest money and credit are neutral. The traditional theories also assert that the payment system is a veil and should not be considered in the design of the monetary policy. To correct the course of monetary policy, the Fed has to target the recipients of credit rather than its providers explicitly. In this sense, my analysis is squarely in the tradition of what Schumpeter (1954) called “monetary analysis” and Mehrling (2013) called “Money View” – the presumption that money is not a veil and that understanding how it functions is necessary to understand how the economy works.

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Is the New Chapter for the Monetary Policy Framework Too Old To Succeed?

By Elham Saeidinezhad

Bagehot, “Money does not manage itself.”

In this year’s Jackson Hole meeting, the Fed announced a formal shift away from previously articulated longer-run inflation objective of 2 percent towards achieving inflation that averages 2 percent over time. The new accord aims at addressing the shortfalls of the low “natural rate” and persistently low inflation. More or less, all academic debates in that meeting were organized as arguments about the appropriate quantitative settings for a Taylor rule. The rule’s underlying idea is that the “market” tends to set the nominal interest rate equal to the natural rate plus expected inflation. The Fed’s role in this equation is to reduce or increase this market rate by changing the short-term federal funds rate whenever the inflation deviates from the target. The goal is to stabilize the long-run inflation. The Fed believes that the recent secular decline in natural rates relative to the historical average has constrained the power of the federal funds rate to achieve this mandate. The expectation is that the Fed’s decision to tolerate a temporary overshooting of the longer-run inflation to keep inflation and inflation expectations centered on 2 percent following periods when inflation has been persistently below 2 percent will address the framework’s constant failure and restore the magic of central banking. However, the ongoing issue with the Taylor rule-based monetary policy frameworks, including the recent one, is that they require the Fed to overlook the trends in the credit market, and only focus on the developments in the real economy, such as inflation or past inflation deviations, when setting the short-term interest rates. Rectifying such blind spots is what money view scholars were hoping for when the Fed announced its intention to review the monetary policy framework.

The logic behind the new framework, known as the average inflation targeting strategy, is that inflation undershooting makes achieving the target unlikely in the long run as it pushes the inflation expectations below the target. This being the case, when there is a long period of inflation undershooting the target, the Fed should act to undo the undershooting by overshooting the target for some time. The Fed sold forecast (or average) targeting to the public as a better way of accomplishing its mandate compared to the alternative strategies as the new framework makes the Fed more “history-dependent.” Translated into the money view language, however, the new inflation-targeting approach only delays the process of imposing excessive discipline in the money market when the consumer price index rises faster than the inflation target and providing excessive elasticity when prices are growing slower than the inflation target.

From the money view perspective, the idea that the interest rate should not consider private credit market trends will undermine central banking’s power in the future, as it has done in the past. The problem we face is not that the Fed failed to follow an appropriate version of Taylor rule. Rather, and most critically, these policies tend to abstract from the plumbing behind the wall, namely the payment system, by disregarding the credit market. Such a bias may have not been significant in the old days when the payment system was mostly a reserve-based system. In the old world, even though it was mostly involuntarily, the Fed used to manage the payment system through its daily interventions in the market for reserves. In the modern financial system, however, the payment system is a credit system, and its quality depends on the level of elasticity and discipline in the private credit market.

The long dominance of economics and finance views imply that modern policymakers have lost sight of the Fed’s historical mission to manage the balance between discipline and elasticity in the payment system. Instead of monitoring the balance between discipline and elasticity in the credit market, the modern Fed attempts to keep the bank rate of interest in line with an ideal “natural rate” of interest, introduced by Knut Wicksell. In Wicksellians’ world, in contrast to the money view, securing the continuous flow of credit in the economy through the payment system is not part of the Fed’s mandate. Instead, the Fed’s primary function is to ensure it does not choose a “money rate” of interest different from the “natural rate” of interest (profit rate capital). If lower, then the differential creates an incentive for new capital investment, and the new spending tends to cause inflation. If prices are rising, then the money rate is too low and should be increased; if prices are falling, then the money rate is too high and should be decreased. To sum up, Wicksellians do not consider private credit to be intrinsically unstable. Inflation, on the other hand, is viewed as the source of inherent instability. Further, they see no systemic relation between the payment system and the credit market as the payment system simply reflects the level of transactions in the real economy.

The clash between the standard economic view and money view is a battle between two different world views. Wicksell’s academic way of looking at the world had clear implications for monetary policy: set the money rate equal to the natural rate and then stand back and let markets work. Unfortunately, the natural rate is not observable, but the missed payments and higher costs of borrowing are. In the money view perspective, the Fed should use its alchemy to strike a balance between elasticity and discipline in the credit market to ensure a continuous payment system. The money view barometer to understand the credit market cycle is asset prices, another observable variable. Since the crash can occur in commodities, financial assets, and even real assets, the money view does not tell us which assets to watch. However, it emphasizes that the assets that are not supported by a dealer system (such as residential housing) are more vulnerable to changes in credit conditions. These assets are most likely to become overvalued on the upside and suffer the most extensive correction on the downside. A central bank that understands its role as setting interest rates to meet inflation targets tends to exacerbate this natural tendency toward instability. These policymakers could create unnaturally excessive discipline when credit condition is already tight or vice versa while looking for a natural rate of interest.

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Promises All the Way Down: A Primer on the Money View

This post is originally part of a symposium on the Methods of Political Economy in Law and Political Economy Blog.

By Elham Saeidinezhad

It has long been tempting for economists to imagine “the economy” as a giant machine for producing and distributing “value.” Finance, on this view, is just the part of the device that takes the output that is not consumed by end-users (the “savings”) and redirects it back to the productive parts of the machine (as “investment”). Our financial system is an ornate series of mechanisms to collect the value we’ve saved up and invest it into producing yet more value. Financial products of all sorts—including money itself—are just the form that value takes when it is in the transition from savings to investment. What matters is the “real” economy—where the money is the veil, and the things of value are produced and distributed.

What if this were exactly backwards? What if money and finance were understood not as the residuum of past economic activity—as a thing among other things—but rather as the way humans manage ongoing relationships between each other in a world of fundamental uncertainty? These are the sorts of questions asked by the economist Perry Mehrling (and Hyman Minsky before him). These inquiries provided a framework that has allowed him to answer many of the issues that mystify neoclassical economics.

On Mehrling’s “Money View,” every (natural or artificial) person engaged in economic activity is understood in terms of her financial position, that is, in terms of the obligations she owes others (her “liabilities”) and the obligations owed to her (her “assets”). In modern economies, obligations primarily take the form of money and credit instruments. Every actor must manage the inflow and outflow of obligations (called “cash flow management”) such that she can settle up with others when her obligations to them come due. If she can, she is a “going concern” that continues to operate normally. If she cannot, she must scramble to avoid some form of financial failure—bankruptcy being the most common. After all, as Mehrling argues, “liquidity kills you quick.” This “survival constraint” binds not only today but also at every moment in the future. Thus, generally, the problem of satisfying the survival constraint is a problem of matching up the time pattern of assets (obligations owed to an actor) with the time pattern of liabilities (obligations an actor owed to others). The central question is whether, at any moment in time, there is enough cash inflow to pay for the cash flows.

For the Money View, these cash flows are at the heart of the financial market. In other words, the financial system is essentially a payment system that enables the transfer of value to happen even when a debtor does not own the means of payment today. Payment takes place in two stages. When one actor promises something for another, the initial payment takes place—the thing promised is the former’s liability and the latter’s asset. When the promise is kept, the transaction is settled (or funded), and the original asset and liability are canceled.

The Hierarchy of Debt-Money

What makes finance somewhat confusing is that all the promises in question are promises to pay, which means that both the payment and the settlement process involve the transfer of financial assets. To learn when an asset is functioning as a means of payment and when it is operating as a form of settlement requires understanding that, as Mehrling has argued, “always and everywhere, monetary systems are hierarchical.” If a financial instrument is higher up the hierarchy than another, the former can be used to settle a transaction in the latter. At the top of the hierarchy is the final means of settlement—an asset that everybody within a given financial system will accept. The conventional term for this type of asset is “money.” In the modern world, money takes the form of central bank reserves—i.e., obligations issued by a state. The international monetary system dictates the same hierarchy for different state currencies, with the dollar as the top of this pyramid. What controls this hierarchy in financial instruments and differentiates money (means of final settlement) from credit (a promise to pay, a means of delaying final settlement), is their degree of “liquidness” and their closeness to the most stable money: the U.S. central bank reserves.

Instruments such as bank deposits are more money-like compared to the others since they are promises to pay currency on demand. Securities, on the other hand, are promises to pay currency over some time horizon in the future, so they are even more attenuated promises to pay. Mehrling argues that the payments system hides this hierarchy by enabling the firms to use credit today to postpone the final settlement into the future.

The Money View vs. Quantity and Portfolio Theories

Viewing the world from this perspective allows us to see details about financial markets and beyond, that the lens of neoclassical economics does not. For instance, the lack of attention to payment systems in standard monetary theories is a byproduct of overlooking the essential hierarchy of finance. Models such as Quantity Theory of Money that explore the equilibrium amount of money in the system systematically disregards the level of reserves that are required for the payment system to continuously “convert” bank deposits (which are at the lower layer of the hierarchy) into currency on demand.

Further, unlike the Money View, the Portfolio Choice Theory (such as that developed by James Tobin), which is at the heart of asset pricing models, entirely abstracts from the role of dealers in supplying market liquidity. These models assume an invisible hand that provides market liquidity for free in the capital market. From the lens of supply and demand, this is a logical conclusion. Since a supplier can always find a buyer who is willing to buy that security at a market price, there is no job for an intermediary dealer to arrange this transaction. The Money View, on the other hand, identifies the dealers’ function as the suppliers of market liquidity—the clearinghouse through which debts and credits flow—which makes them the primary determinant of asset prices.

The Search for Stable Money

The Money View’s picture of conventional monetary policy operations is very distinct from an image that a trained monetary economist has in mind. From the Money View’s perspective, throughout the credit cycle, one constant is the central bank’s job to balance elasticity and discipline in the monetary system as a way of controlling the flow of credit. What shapes the dynamic of elasticity and discipline in the financial system is the daily imbalances in payment flows and the need of every agent in the system to meet a “survival” or “reserve constraint.”

In normal times, if a central bank, such as the Fed, wants to tighten, it raises the federal fund target. Raising the cost of the most liquid form of money in the system will then resonate down the monetary hierarchy. It immediately lowers the profitability of money market dealers (unless the term interest rate rises by the full amount). Because money market dealers set the funding cost for dealers in capital markets (i.e. because they are a level up in the hierarchy of money), capital market dealers will face pressure to raise asset prices and long-term interest rates. These security dealers are willing to hold existing security inventories only at a lower price, hence higher expected profit. Thus the centrally determined price of money changes the value of stocks.

Central Bankers as Shadow Bankers

The Money View’s can also help us see how the essence of credit has shifted from credit that runs through regulated banks to “market-based credit” through a shadow banking system that provides money market funding for capital market investing. Shadow banking system faces the same problems of liquidity and solvency risk that the traditional banking system faces, but without the government backstops at the top of the hierarchy (via Fed lender of last resort payouts and FDIC deposit insurance). Instead, the shadow banking system relies mainly on dealers in derivatives and in wholesale lending. Having taken on responsibility for financing the shadow banks, which financed the subprime mortgage market, these dealers began to run into problems during the financial crisis. Mehrling argues that the reality of the financial system dictates Fed to reimagine its role from a lender last resort to banks to the dealer of last resort to the shadow banking system.

Conclusion

We have been living in the Money View world, a world where almost everything that matters happens in the present. Ours is a world in which cash inflows must be adequate to meet cash outflows (the survival or liquidity constraint) for a single day. This is a period that is too short for creating any elasticity or discipline in production or consumption, the usual subject matter of economics, so we have abstracted from them. Doing so has blinded us to many important aspects of the system we live in. In our world, “the present determines the present.”

This piece is also featured in justmoney.org website