Tag: Future of Money

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

Is Cryptocurrency Neutral?

“Money is pre-eminently a sanctuary, a haven for resources that would otherwise go into more perilous uses.” Gurley and Shaw

Cryptocurrencies, which first emerged in the wake of the global financial crisis, offered a vision of “money” free from central bank and intermediaries’ control. The idea is that crypto liberates both private parties and non-major central banks from the fundamental need to be as close as possible to the Fed, the ultimate controller and issuer of the world’s means of the final settlement. In other words, crypto flattens the monetary hierarchy and creates a structural break from Money View’s claim that money is inherently hierarchical. In this essay, I argue that cryptocurrency is not flattening the “existing” monetary system. It creates a parallel, unstable monetary arrangement based on personnel, such as Elon Musk, rather than institutions, including central banks, and false economic prophecies. First, it assumes “scarcity of money” is the source of its value. Second, it “eliminates intermediaries,” such as dealers and banks, and relies on crypto exchanges that act as brokers to set prices. And third, it aims at stabilizing the crypto prices by guaranteeing “convertibility” while liberating itself from the central banks who make such guarantees possible under distress.

Crypto is built on a virtual hierarchy. When it comes to instruments, though, the system is mostly flat. Different cryptos are treated equally. Yet, it remains hierarchical when it comes to the relative position of its players. Similar to the original monetary system, different agents belong to different layers of the hierarchy. In contrast to it, a few high-net-worth individuals rather than institutions are at the top of it. However, the most fundamental problem is its economic foundations, which are mostly misguided monetary prophecies.

The Crypto market is built on weak foundations to support the “value,” “price,” and “convertibility” of the virtual currency. To preserve the value of the virtual currency, advocates often point to the limited supply of bitcoin and the mathematics which governs it in stark contrast to fiat money’s model of unlimited expansion regardless of underlying economic realities. It’s an unpopular position with Money View scholars who don’t view scarcity as a pressing issue. Instead, the fundamentals such as liquidity or convertibility determine the value of these monetary instruments. However, the convertibility guarantor of the last resort is the central bankers, who are circumvented in the crypto-mania.

The degree of liquidity or “moneyness” depends on how close these instruments are to the ultimate money or currency. Ultimately, the Fed’s unlimited power to create it by expanding its balance sheets puts the currency at the top of the hierarchy. The actual art of central banking would obviously be in response to shocks, or crises, in the financial and economic environment. During such periods, a central bank had not only to ensure its own solvency but the solvency of the entire banking system. For this reason, they had to hold disproportionate amounts of gold and currency. The point to emphasize is that while they stood ready to help other banks with cash and gold on demand, they could not expect the same service in return.

Further, central bankers’ unique position to expand their balance sheets to create reserves allow them to accommodate liquidity needs without the risk of being depleted. Yet, if a central bank had to protect itself against liquidity drain, it has tools such as discount-rate policy and open market operations. Also, central bankers in most countries can supply currency on-demand with reciprocal help from other banks. In this world, the Fed was and will remain first among equals.

The mistake of connecting the value of money to limited supply is as old as money itself. In 1911, Allyn Young made it tolerably clear that money is not primarily a thing that is valued for itself. The materials that made money, such as gold, other metals, or a computer code, are not the source of value for money. The valuable materials merely make it all the more certain that money itself may be “passed on,” that someone may always be found who is willing to take it in exchange for goods or services. The “passing on” feature becomes the hallmark of Allyn Young’s solutions to the mystery of money. Money’s value comes from holders’ willingness to pass it on, which is its purchasing power. It also depends on its ability to serve as a “standard of payment” or “standard of deferred payments.” Therefore, any commodity that serves as money is wanted, not for permanent use, but for passing on. 

What differentiates the “means of payment” from the “purchasing power” functions is their sensitivity to the “macroeconomic conditions.” Inflation, an essential barometer of the economy, might deteriorate the value of the conventional monetary instruments relative to the inflation-indexed ones as it disproportionally reduces the former instruments’ purchasing power. Yet, its impact on their function as “means of payments” is less notable. For instance, we need more “currency” to purchase the same basket of goods and services when inflation is high, reducing currency’s purchasing power. Yet, even in this period, the currency will be accepted as means of payment. 

Young warned against an old and widespread illusion that the government’s authority or the limited quantity gives the money its value. Half a century later, Gurley and Shaw (1961) criticized the quantity theory of money based on similar grounds. Specifically, they argued against the theory’s premise that the quantity of money determines money’s purchasing power, and therefore value. Such a misconception, emphasized in the quantity theory of money and built in the crypto architecture, can only be applied to an economic system handicapped by rigidities and irrationalities. In this economy, any increase in demand for money would be satisfied by deflation, even if it will retard the economic development rather than by growth in nominal money. Paradoxically, similar to the quantity theory of money, crypto-economics denies money a significant role in the economy. In other words, crypto-economics assumes that money, including cryptocurrency, is “neutral.” 

Relying on the “neutrality” of money, and therefore scarcity doctrine, maintain value has real economic consequences. Monetary neutrality is objectionable even concerning an economy in which the neoclassical ground rules of analysis are appropriate on at least two grounds. First, the quantity theory underestimates the real impact of monetary policy in the long run. The theory ignores the effects of the central bank’s manipulation of the nominal money on permanent capital gains or losses. These capital gains and losses enduringly affect the aggregate spendings, including spending on capital and new technologies, and hence come to grips with real aspects of the economy in the long run.

Second, monetary neutrality overlooks the role of financial intermediaries in the monetary system. In this system, financial intermediaries continuously intervene in the flow of financial assets from borrowers to lenders. In addition, they regulate the rate and pattern of private financial-asset accumulation, the real quantity of money, and real balances desired, hence any demands for goods and labor that are sensitive to the real value of financial variables. In the quantity theory of money, financial intermediaries that affect wealth accumulation and the real side of the economy are reduced to a fixed variable, called the velocity. 

To stabilize the prices, crypto economists rely on a common misconception that crypto exchanges set prices. Yet, by design, the crypto exchanges’ ability to set the prices and reduce their volatility is minimal. These exchanges’ business model is more similar to the functions of the brokers, who merely profit from commissions and listing fees and do not use their balance sheets to absorb market imbalances and therefore stabilize the market prices. If these exchanges acted like dealers, however, they could set the prices. But in doing so, they had to use their balance sheets and be exposed to the price risks. Given the current price volatility in the cryptocurrency market, the exchanges have no incentive to become dealers.

This dealer-free market implies that the exchange rate of a cryptocurrency usually depends on the actions of sellers and buyers. Each exchange merely calculates the price based on the supply and demand of its users. In other words, there’s no official global price. The point to emphasize is that this feature, the lack of an official “market price,” and intermediaries— banks and dealers–, is inherent in this virtual system. The absence of dealers, and other intermediaries, is a natural consequence of the virtual currency markets’ structural feature, called the decentralized finance (DeFi). 

DeFi is an umbrella term for financial services offered on public blockchains. Like traditional intermediaries, DeFi allows clients to borrow, lend, earn interest, and trade assets and derivatives. This service is often used by clients seeking to use their crypto as collateral to increase their leverage and return. They borrow against their crypto holdings to place even larger bets in this market. In the process, they expose the lenders to the “credit risk.” In non-crypto segments of the financial market, credit risk can be contained either through intermediaries, including banks and dealers, or swaps. Both mechanisms are absent in the crypto market even though the risk and leverage are intolerably present.

In the market for monetary instruments, intermediation has always played a key role. The main reason for all the intermediation for any financial instrument is that the mix of securities, or IOUs, issued by funds-deficit agents is unattractive to many surplus agents. Financial intermediaries can offer such attractive securities for several reasons. First, they pool the funds of many investors in a highly diversified portfolio, thereby reducing risk and overcoming the minimum denominations problem. Second, intermediaries can manage cash flows. Intermediaries provide a reasonable safety in the payments system as the cash outflows are likely to be met by cash inflows. The cryptocurrency is not equipped to circumvent intermediaries.

Historically, major banks with their expertise in analyzing corporate and other credits were a natural for the intermediary business, both in the traditional market for loanable funds and the swaps market. The advantage of the swaps is that they are custom-tailored deals, often arranged by one or more intermediaries. Banks could with comfort accept the credit risk of dealing with many lesser credits, and at the same time, their names were acceptable to all potential swap parties. The dealers joined the banks and became the modern intermediaries in the interest rate, FX, and credit default swaps market. Similar to the banks, they transferred the risks from one party to the other and set the price of risk in the process. DeFi cuts these middlemen, and the risk-transfer mechanism, without providing an alternative.

The shapers of crypto finance also rely on “stablecoins” to resolve the issue of convertibility. Stablecoins have seen a massive surge in popularity mainly because they are used in DeFi transactions, aiming to eliminate intermediaries. They are cryptocurrencies where the price is designed to be pegged to fiat money. They are assumed to connect the virtual monetary system and the real one. The problem is that the private support to maintain this par, especially during the crisis, is too invisible to exist. Most recently, the New York Attorney General investigation found that starting no later than mid-2017, Tether, the most reliable Stablecoin, had no access to banking anywhere in the world, and so for periods held no reserves to back tethers in circulation at the rate of one dollar for every Tether.

The paradox is that the stability of the crypto market and DeFi ultimately depends on centralized finance and central bankers. Like traditional banks, DeFi applications allow users to borrow, lend, earn interest, and trade assets and derivatives, among other things. Yet, it differs from traditional banks because it is connected to no centralized system and wholesale market. Therefore, unlike banks, DeFi does not have access to the ultimate funding source, the Fed’s balance sheet. Therefore, their promises to maintain the “par” between stablecoins and fiat currencies are as unstable as their guarantors’ access to liquidity. Unless Elon Musk or other top influencers in the virtual hierarchy are willing to absorb the imbalances of the whole system into their balance sheet, the virtual currency, like the fiat one, begs for the mercy of the Fed when hit by a crisis. The question is whether Elon Musk will be willing to act as the crypto market’s lender and dealer of last resort during a crisis?

Those who have long positions in crypto and guarantee convertibility of the stablecoins, like traditional deficit agents, require constant access to the funding liquidity. Central banks’ role in providing liquidity during a crisis is central to a modern economic system and not a mere convenience to be tolerated. Further, the ongoing dilemma to maintain the “par” between deposits and currencies has made the original payment system vulnerable. This central issue is the primary justification for the existence of the intermediaries and the banks. Without fixing the “par” and “convertibility” problems, the freedom from intermediaries and central banks, which is the most ideologically appealing feature of crypto, will become its Achilles Hill. The crypto market has cut the intermediaries, including central banks, banks, and dealers, in its payment system without resolving the fundamental problems of the existing system. Unless crypto backers believe in blanket immunity to a crisis, a paradoxical position for the prodigy child of the capitalist system, crypto may become the victim of its ambitions, not unlike the tragedy of Macbeth. Mcbeth dramatizes the damaging physical and psychological effects of political ambition on those who seek power for its own sake. 

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

In a World Where Banks Do Not Aspire to be Intermediaries, Is It Time to Cut Out the Middlemen? (Part I)

This Piece Is Part of the “Search For Stable Liquidity Providers” Series.

By Elham Saeidinezhad

“Bankers have an image problem.” Marcy Stigum

Despite the extraordinary quick and far-reaching responses by the Fed and US Treasury, to save the economy following the crisis, the market sentiment is that “Money isn’t flowing yet.” Banks, considered as intermediaries between the government and troubled firms, have been told to use the liberated funds to boost financing for individuals and businesses in need. However, large banks are reluctant, and to a lesser extent unable, to make new loans even though regulators have relaxed capital rules imposed in the wake of the last crisis. This paradox highlights a reality that has already been emphasized by Mehrling and Stigum but erred in the economic orthodoxy.

To understand this reluctance by the banks, we must preface with a careful look at banking. In the modern financial system, banks are “dealers” or “market makers” in the money market rather than intermediaries between deficit and surplus agents. In many markets such as the UK and US, these government support programs are built based on the belief that banks are both willing and able to switch to their traditional role of being financial intermediaries seamlessly. This intermediation function enables banks to become instruments of state aid, distributing free or cheap lending to businesses that need it, underpinned by government guarantees.  This piece (Part l) uses the Money View and a historical lens to explain why banks are not inspired anymore to be financial intermediaries. In Part ll, we are going to propose a possible resolution to this perplexity. In a financial structure where banks are not willing to be financial intermediaries, central banks might have to seriously entertain the idea of using central bank digital currency (CBDC) during a crisis. Such tools enable central banks to circumvent the banking system and inject liquidity directly to those who need it the most.

Stigum once observed that bankers have, at times, an image problem. They are seen as the culprits behind the high-interest rates that borrowers must pay and as acting in ways that could put the financial system and the economy at risk, perhaps by lending to risky borrowers, when interest rates are low. Both charges reflect the constant evolution in banks’ business models that lead to a few severe misconceptions over the years. The first delusion is about the banks’ primary function. Despite the common belief, banks are not intermediaries between surplus and deficit agents anymore. In this new system, banks’ primary role is to act as dealers in money market securities, in governments, in municipal securities, and various derivative products. Further, several large banks have extensive operations for clearing money market trades for nonbank dealers. A final important activity for money center banks is foreign operations of two sorts: participating in the broad international capital market known as the Euromarket and operating within the confines of foreign capital markets (accepting deposits and making loans denominated in local currencies). 

Structural changes that have taken place on corporates’ capital structure and the emergence of market-based finance have led to this reconstruction in the banking system. To begin with, the corporate treasurers switched sources of corporate financing for many corporates from a bank loan to money market instruments such as commercial papers. In the late 1970s and early 1980s, when rates were high, and quality-yield spreads were consequently wide, firms needing working capital began to use the sale of open market commercial paper as a substitute for bank loans. Once firms that had previously borrowed at banks short term were introduced to the paper market, they found that most of the time, it paid them to borrow there. This was the case since money obtained in the credit market was cheaper than bank loans except when the short-term interest rate was being held by political pressure, or due to a crisis, at an artificially low level.

The other significant change in market structure was the rise of “money market mutual funds.” These funds provide more lucrative investment opportunities for depositors, especially for institutional investors, compared to what bank deposits tend to offer. This loss of large deposits led bank holding companies to also borrow in the commercial paper market to fund bank operations. The death of the deposits and the commercial loans made the traditional lending business for the banks less attractive. The lower returns caused the advent of the securitization market and the “pooling” of assets, such as mortgages and other consumer loans. Banks gradually shifted their business model from a traditional “originate-and-hold” to an “originate-to-distribute” in which banks and other lenders could originate loans and quickly sell them into securitization pools. The goal was to increase the return of making new loans, such as mortgages, to their clients and became the originators of securitized assets.

The critical aspect of these developments is that they are mainly off-balance sheet profit centers. In August 1970, the Fed ruled that funds channeled to a member bank that was raised through the sale of commercial paper by the bank’s holding company or any of its affiliates or subsidiaries were subject to a reserve requirement. This ruling eliminated the sale of bank holding company paper for such purposes. Today, bank holding companies, which are active issuers of commercial paper, use the money obtained from the sale of such paper to fund off-balance sheet, nonbank, activities. Off-balance sheet operations do not require substantial funding from the bank when the contracts are initiated, while traditional activities such as lending must be fully funded. Further, most of the financing of traditional activities happens through a stable base of money, such as bank capital and deposits. Yet, borrowing is the primary source of funding off-balance sheet activities.

To be relevant in the new market-based credit system, and compensate for the loss of their traditional business lines, the banks started to change their main role from being financial intermediaries to becoming dealers in money market instruments and originators of securitized assets. In doing so, instead of making commercial loans, they provide liquidity backup facilities on commercial paper issuance. Also, to enhance the profitability of making consumer loans, such as mortgages, banks have turned to securitization business and have became the originators of securitized loans. 

In the aftermath of the COVID-19 outbreak, the Fed, along with US Treasury, has provided numerous liquidity facilities to help illiquid small and medium enterprises. These programs are designed to channel funds to every corner of the economy through banks. For such a rescue package to become successful, these banks have to resume their traditional financial intermediary role to transfer funds from the government (the surplus agents) to SMEs (the deficit agents) who need cash for payroll financing. Regulators, in return, allow banks to enjoy lower capital requirements and looser risk-management standards. On the surface, this sounds like a deal made in heaven.

In reality, however, even though banks have received regulatory leniency, and extra funds, for their critical role as intermediaries in this rescue package, they give the government the cold shoulder. Banks are very reluctant to extend new credits and approve new loans. It is easy to portray banks as villains. However, a more productive task would be to understand the underlying reasons behind banks’ unwillingness. The problem is that despite what the Fed and the Treasury seem to assume, banks are no longer in the business of providing “direct” liquidity to financial and non-financial institutions. The era of engaging in traditional banking operations, such as accepting deposits and lending, has ended. Instead, they provide indirect finance through their role as money market dealers and originators of securitized assets.

In this dealer-centric, wholesale, world, banks are nobody’s agents but profits’. Being a dealer and earning a spread as a dealer is a much more profitable business. More importantly, even though banks might not face regulatory scrutiny if these loans end up being nonperforming, making such loans will take their balance sheet space, which is already a scarce commodity for these banks. Such factors imply that in this brave new world, the opportunity cost of being the agent of good is high. Banks would have to give up on some of their lucrative dealing businesses as such operation requires balance sheet space. This is the reason why financial atheists have already started to warn that banks should not be shamed into a do-gooder lending binge.

Large banks rejected the notion that they should use their freed-up equity capital as a basis for higher leverage, borrowing $5tn of funds to spray at the economy and keep the flames of coronavirus at bay. Stigum once said that bankers have an image problem. Having an image problem does not seem to be one of the banks’ issues anymore. The COVID-19 crisis made it very clear that banks are very comfortable with their lucrative roles as dealers in the money market and originators of assets in the capital market, and have no intention to be do-gooders as financial intermediaries. These developments could suggest that it is time to cut out banks as middlemen. To this end, central bank digital currency (CBDC) could be a potential solution as it allows central banks to bypass banks to inject liquidity into the system during a period of heightened financial distress such as the COVID-19 crisis.

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Is COVID-19 Crisis a “Mehrling’s Moment”?

Derivatives Market as the Achilles’ Heel of the Fed’s Interventions

By Elham Saeidinezhad

Some describe the global financial crisis as a “Minsky’s moment” when credit’s inherent instability was exposed for everyone to see. The COVID-19 turmoil, on the other hand, is a “Mehrling’s moment” since his Money View provided us a unique framework to evaluate the Fed’s responses in action. Over the past couple of months, a new crisis, known as COVID-19, has grown up to become the most widespread shock after the 2008-09 global financial crisis. COVID-19 crisis has sparked historical reactions by the Fed. In essence, the Fed has become the creditor of the “first” resort in the financial market. These interventions evolved swiftly and encompassed several roles and tools of the Fed (Table 1). Thus, it is crucial to measure their effectiveness in stabilizing the financial market.

In most cases, economists assessed these actions by studying the change in size or composition of the Fed’s balance sheet or the extent and the kind of assets that the Fed is supporting. In a historic move, for instance, the Fed is backstopping commercial papers and municipal bonds directly. However, once we use the model of “Market-Based Credit,” proposed by Perry Mehrling, it becomes clear that these supports exclude an essential player in this system, which is derivative dealers. This exclusion might be the Achilles’ heel of the Fed’s responses to the COVID-19 crisis. 

What system of central bank intervention would make sense if the COVID-19 crisis significantly crushed the market-based credit? This piece employs Perry Mehrling’s stylized model of the market-based credit system to think about this question. Table 1 classifies the Fed’s interventions based on the main actors in this model and their function. These players are investment banks, asset managers, money dealers, and derivative dealers. In this financial market, investment banks invest in capital market instruments, such as mortgage-backed securities (MBS) and other asset-backed securities (ABS). To hedge against the risks, they hold derivatives such as Interest Rate Swaps (IRS), Foreign exchange Swaps (FXS), and Credit Default Swaps (CDS). The basic idea of derivatives is to create an instrument that separates the sources of risk from the underlying assets to price (or even sell) them separately. Asset managers, which are the leading investors in this economy, hold these derivatives. Their goal is to achieve their desired risk exposure and return. From the balance sheet perspective, the investment bank is the asset manager’s mirror image in terms of both funding and risk.

This framework highlights the role of intermediaries to focus on liquidity risk. There are two different yet equally critical financial intermediaries in this model—money dealers, such as money market mutual funds, and derivative dealers. Money dealers provide dollar funding and set the price of liquidity in the money market. In other words, these dealers transfer the cash from the investors to finance the securities holdings of investment banks. The second intermediary is the derivative dealers. In derivatives such as CDS, FXS, and IRS, these market makers transfer risk from the investment bank to the asset manager and set the price of risk in the process. They mobilize the risk capacity of asset managers’ capital to bear the risk in the assets such as MBS.  

After the COVID-19 crisis, the Fed has backstopped all these actors in the market-based credit system, except the derivative dealers (Table 1). The lack of Fed’s support for the derivatives market might be an immature decision. The modern market-based credit system is a collateralized system. There should be a robust mechanism for shifting both assets and the risks to make this system work. The Fed has employed extensive measures to support the transfer of assets essential for the provision of funding liquidity. Financial participants use assets as collaterals to obtain funding liquidity by borrowing from the money dealers. However, during a financial crisis, this mechanism only works if a stable market for risk transfer accompanies it. It is the job of derivative dealers to use their balance sheets to transfer risk and make a market in derivatives. The problem is that fluctuations in the price of assets that derive the derivatives’ value expose them to the price risk.

During a crisis such as COVID-19 turmoil, the heightened price risks lead to the system-wide contraction of the credit. This occurs even if the Fed injects an unprecedented level of liquidity into the system. If the value of assets falls, the investors should make regular payments to the derivative dealers since most derivatives are mark-to-market. They make these payments using their money market deposit account or money market mutual fund (MMMFs). The derivative dealers then use this cash inflow to transfer money to the investment bank that is the ultimate holder of these instruments. In this process, the size of assets and liabilities of the global money dealer (or MMMFs) shrinks, which leads to a system-wide credit contraction. 

As a result of the COVID-19 crisis, derivative dealers’ cash outflow is very likely to remain higher than their cash inflow. To manage their cash flow, derivative dealers derive the “insurance” prices up and further reduce the price of capital or assets in the market. This process further worsens the initial problem of falling asset prices despite the Fed’s massive asset purchasing programs. The critical point to emphasize here is that the mechanism through which the transfer of the collateral, and the provision of liquidity, happens only works if fluctuations in the value of assets are absorbed by the balance sheets of both money dealer and derivative dealers. Both dealers need continuous access to liquidity to finance their balance sheet operations.

Traditional lender of last resort is one response to these problems. In the aftermath of the COVID-19 crisis, the Fed has backstopped the global money dealer and asset managers and supported continued lending to investment banking. Fed also became the dealer of last resort by supporting the asset prices and preventing the demand for additional collateral by MMMFs. However, the Fed has left derivative dealers and their liquidity needs behind. Importantly, two essential actions are missing from the Fed’s recent market interventions. First, the Fed has not provided any facility that could ease derivative dealers’ funding pressure when financing their liabilities. Second, the Fed has not done enough to prevent derivative dealers from demanding additional collaterals from asset managers and other investors, to protect their positions against the possible future losses. 

The critical point is that in market-based finance where the collateral secures funding, the market value of collateral plays a crucial role in financial stability. This market value has two components: the value of the asset and the price of underlying risks. The Fed has already embraced its dealer of last resort role partially to support the price of diverse assets such as asset-backed securities, commercial papers, and municipal bonds. However, it has not offered any support yet for backstopping the price of derivatives. In other words, while the Fed has provided support for the cash markets, it overlooked the market liquidity in the derivatives market. The point of such intervention is not so much to eliminate the risk from the market. Instead, the goal is to prevent a liquidity spiral from destabilizing the price of assets and so, consequently, undermining their use as collateral in the market-based credit.

To sum up, shadow banking has three crucial foundations: market-based credit, global banking, and modern finance. The stability of these pillars depends on the price of collateral (liquidity), price of Eurodollar (international liquidity), and the price of derivatives (risk), respectively. In the aftermath of the COVID-19 crisis, the Fed has backstopped the first two dimensions through tools such as the Primary Dealer Credit Facility, Term Asset-Backed Securities Loan Facility, and Central Bank Swap Lines. However, it has left the last foundation, which is the market for derivatives, unattended. According to Money View, this can be the Achilles’ heel of the Fed’s responses to the COVID-19 crisis. 

Download Table: Fed’s responses to the Covid-19 Crisis: A Money View Classification (As of March 25, 2020) (Pdf document)Download
Download Table: Fed’s responses to the Covid-19 Crisis: A Money View Classification (As of March 25, 2020) (Word document) Download
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Is Money View Ready to Be on Trial for its Assumptions about the Payment System?

A Review of Perry Mehrling’s Paper on the Law of Reflux

By Elham Saeidinezhad

Perry Mehrling’s new paper, “Payment vs. Funding: The Law of Reflux for Today,” is a seminal contribution to the “Money View” literature. This approach, which is put forward by Mehrling himself, highlights the importance of today’s cash flow for the survival of financial participants. Using Money View, this paper examines the implications of Fullarton’s 1844 “Law of Reflux” for today’s monetary system. Mehrling uses balance sheets to show that at the heart of the discrepancy between John Maynard Keynes’ and James Tobin’s view of money creation is their attention to two separate equilibrium conditions. The former focuses on the economy when the initial payment takes place. At the same time, the latter is concerned about the adjustments in the interest rates and asset prices when the funding is finalized.

To provide such insights into several controversies about the limits of money finance, Mehrling’s analysis relies intensely on one of the fundamental premises of the Money View; the notion that the payment system that enables the cash flow to transfer from a deficit agent to the surplus agent is essentially a credit system. However, when we investigate the future that the Money View faces, this sentiment is likely to be threatened by a few factors that are revolutionizing financial markets. These elements include but are not limited to the Fed’s Tapering and post-crisis financial regulations that constrain banks’ ability to create new credit. These restrictions force the payment system to rely less on credit and more on reserves. Hence, the future of Money View will hinge on its ability to function under new circumstances where the payment system is no longer a credit system. This puzzle should be investigated by those of us who consider ourselves as students of this View.

Mehrling, in his influential paper, puts on his historical and monetary hats to clarify a long-standing debate amongst Keynesian economists on the money creation process. In understanding the effect of money on the economy, “old” Keynesians’ primary focus has been on the market interest rate and asset prices when the initial payment is taking place. In other words, their chief concern is how asset prices change to make the new payment position an equilibrium. To answer this question, they use the “liquidity preference framework” and argue that asset prices are set as a markup over the money rate of interest. The idea is that once the new purchasing power is created, the final funding can happen without changing asset prices or interest rates. The reason is that the initial increase in the money supply remains entirely in circulation by creating a new demand for liquid balances for various reasons. Put it differently, although the new money will not disappear on the final settlement date, the excess supply of money will be eliminated by the growing demand for money. In this situation, there is no reflux of the new purchasing power.

In contrast, the new Keynesian orthodoxy, established by James Tobin, examines the effects of money creation on the economy by focusing on the final position rather than the initial payment. At this equilibrium, the interest rate and asset prices will be adjusted to ensure the final settlement, otherwise known as funding. In the process, they create discipline in the monetary system. Using the “Liquidity preference framework”, these economists argue that the new purchasing power will be used to purchase long-term securities such as bonds. In other words, the newly created money will be absorbed by portfolio rebalancing, which leads to a new portfolio equilibrium. In this new equilibrium, the interbank credit will be replaced by a long-term asset, and the initial payment is funded by new long-term lending, all outside the traditional banking system. Tobin’s version of Keynesianism extracted from both the flux of bank credit expansion and the reflux of subsequent contraction by only focusing on the final funding equilibrium. It also shifts between one funding equilibrium and another since he is only interested in final positions. In the new view, bank checkable deposits are just one funding liability, among others, and their survival in the monetary system entirely depends on the portfolio preferences of asset managers.

The problem is that both views abstract from the cash flows that enable a continuous payment system. These cash flows are critical to a successful transition from one equilibrium to another. Money View labels these cash flows as “liquidity” and puts it at the center of its analysis. Liquidity enables the economy to seamlessly transfer from initial equilibrium, when the payment takes place, to the final equilibrium, when the final funding happens, by ensuring the continuity of the payment system. In the initial equilibrium, payment takes place since banks expand their balance sheets and create new money. In this case, the deficit bank can borrow from the surplus bank in the interbank lending market. To clear the final settlement, the banks can take advantage of their access to the central bank’s balance sheet if they still have short positions in reserve. Mehrling uses these balance sheets operations to show that it is credit, rather than currency or reserves, that creates a continuous payment system. In other words, a credit-based payment system lets the financial transactions go through even when the buyers do not have means of payment today. These transactions, that depend on agents’ access to liquidity, move the economy from the initial equilibrium to the ultimate funding equilibrium. 

The notion that the “payment system is a credit system” is a defining characteristic of Money View. However, a few developments in the financial market, generated by post-crisis interventions, are threatening the robustness of this critical assumption. The issue is that the Fed’s Tapering operations have reduced the level of reserves in the banking system. In the meantime, post-crisis financial regulations have produced a balance sheet constrained for the banking system, including surplus banks. These macroprudential requirements demand banks to keep a certain level of High-Quality Liquid Assets (HQLA) such as reserves. At the same time, the Global Financial Crisis has only worsened the stigma attached to using the discount loan. Banks have, therefore, become reluctant to borrow from the Fed to avoid sending wrong signals to the regulators regarding their liquidity status. These factors constrained banks’ ability to expand their balance sheets to make new loans to the deficit agents by making this activity more expensive. As a result, banks, who are the leading providers of the payment system, have been relying less on credit and more on reserves to finance this financial service.

Most recently, Zoltan Pozsar, a prominent scholar of the Money View, has warned us that if these trends continue, the payment system will not be a credit system anymore. Those of us who study Money View realize that the assumption that a payment system is a credit system is the cornerstone of the Money View approach. Yet, the current developments in the financial ecosystem are fundamentally remodeling the very microstructure that has initially given birth to this conjecture. It is our job, therefore, as Money View scholars, to prepare this framework for a future that is going to put its premises on trial. 

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Elham's Money View Blog

Where Does Profit Come from in the Payments Industry?

“Don’t be seduced into thinking that that which does not make a profit is without value.”

Arthur Miller

By Elham Saeidinezhad

The recent development in the payments industry, namely the rise of Fintech companies, has created an opportunity to revisit the economics of payment system and the puzzling nature of profit in this industry. Major banks, credit card companies, and financial institutions have long controlled payments, but their dominance looks increasingly shaky. The latest merger amongst Tech companies, for instance, came in the first week of February 2020, when Worldline agreed to buy Ingenico for $7.8bn, forming the largest European payments company in a sector dominated by US-based giants. While these events are shaping the future of money and the payment system, we still do not have a full understanding of a puzzle at the center of the payment system. The issue is that the source of profit is very limited in the payment system as the spread that the providers charge is literally equal to zero. This fixed price, called par, is the price of converting bank deposits to currency. The continuity of the payment system, nevertheless, fully depends on the ability of these firms to keep this parity condition. Demystifying this paradox is key to understanding the future of the payments system that is ruled by non-banks. The issue is that unlike banks, who earn profit by supplying liquidity and the payment system together, non-banks’ profitability from facilitating payments mostly depends on their size and market power. In other words, non-bank institutions can relish higher profits only if they can process lots of payments. The idea is that consolidations increase profitability by reducing high fixed costs- the required technology investments- and freeing-up financial resources. These funds can then be reinvested in better technology to extend their advantage over smaller rivals. This strategy might be unsustainable when the economy is slowing down and there are fewer transactions. In these circumstances, keeping the par fixed becomes an art rather than a technicality. Banks have been successful in providing payment system during the financial crisis since they offer other profitable financial services that keep them in business. In addition, they explicitly receive central banks’ liquidity backstop.

Traditionally, the banking system provides payment services by being prepared to trade currency for deposits and vice versa, at a fixed price par. However, when we try to understand the economics of banks’ function as providers of payment systems, we quickly face a puzzle. The question is how banks manage to make markets in currency and deposits at a fixed price and a zero spread. In other words, what incentivizes banks to provide this crucial service. Typically, what enables the banks to offer payment systems, despite its negligible earnings, is their complementary and profitable role of being dealers in liquidity. Banks are in additional business, the business of bearing liquidity risk by issuing demand liabilities and investing the funds at term, and this business is highly profitable. They cannot change the price of deposits in terms of currency. Still, they can expand and contract the number of deposits because deposits are their own liability, and they can expand and contract the quantity of currency because of their access to the discount window at the Fed. 

This two-tier monetary system, with the central bank serving as the banker to commercial banks, is the essence of the account-based payment system and creates flexibility for the banks. This flexibility enables banks to provide payment systems despite the fact the price is fixed, and their profit from this function is negligible. It also differentiates banks, who are dealers in the money market, from other kinds of dealers such as security dealers. Security dealers’ ability to establish very long positions in securities and cash is limited due to their restricted access to funding liquidity. The profit that these dealers earn comes from setting an ask price that is higher than the bid price. This profit is called inside spread. Banks, on the other hand, make an inside spread that is equal to zero when providing payment since currency and deposits trade at par. However, they are not constrained by the number of deposits or currency they can create. In other words, although they have less flexibility on price, they have more flexibility in quantity. This flexibility comes from banks’ direct access to the central banks’ liquidity facilities. Their exclusive access to the central banks’ liquidity facilities also ensures the finality of payments, where payment is deemed to be final and irrevocable so that individuals and businesses can make payments in full confidence.

The Fintech revolution that is changing the payment ecosystem is making it evident that the next generation payment methods are to bypass banks and credit cards. The most recent trend in the payment system that is generating a change in the market structure is the mergers and acquisitions of the non-bank companies with strengths in different parts of the payments value chain. Despite these developments, we still do not have a clear picture of how these non-banks tech companies who are shaping the future of money can deal with a mystery at the heart of the monetary system; The issue that the source of profit is very limited in the payment system as the spread that the providers charge is literally equal to zero. The continuity of the payment system, on the other hand, fully depends on the ability of these firms to keep this parity condition. This paradox reflects the hybrid nature of the payment system that is masked by a fixed price called par. This hybridity is between account-based money (bank deposits) and currency (central bank reserve). 

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