Monetary Malfunction Blunts the Recovery
The year 1865 was profound for the United States in so many ways that lost in the euphoria of the end of the Civil War was a dramatic movement that laid the foundation for our current monetarist system, and thus our current economic predicament. To defeat the Confederacy the Lincoln administration needed to pay for the vast expansion of federal government expenditures on all things military. First, the Union tried paper dollars, but they devalued almost immediately, and kept falling throughout the war period. The only way to fund the military efforts was government bonds.
In order to sell this massive amount of new debt, the Union government turned to Jay Cooke. Through his personal connections and some innovative methods, Cooke was thoroughly successful in expanding the federal national debt to levels never before thought possible. As the war drew to a close, however, the natural impulse was to begin retiring both the "greenbacks", the fiat paper dollars issued in the early stages of the war, and the vast national debt.
To counter this "threat" to his business, Cooke, who had gained wide acclaim and reputation by 1865, circulated a pamphlet directed at persuading the general voting public that retiring outstanding bonds would not be in the best interests of the nation. The pamphlet was, in light of our current predicament of global national debt, humorously titled, "How Our National Debt May Be A Blessing". There was nothing really new in the pamphlet, it was a rehash of some of the ideas floating around Europe at the time, but it was significant in that it was the first very visible movement toward "soft" money in the US. That these thoughts were given currency (pun intended) by a celebrated financial wizard made it a watershed moment in American financial (and eventually economic) history.
"The funded debt of the United States is the addition of three thousand millions of dollars to the previously realized wealth of the nation. It is three thousand millions added to its available active capital. To pay this debt would be to extinguish this capital and to lose this wealth. To extinguish this capital and lose this wealth would be an inconceivably great national misfortune."
Traditionally wealth was believed to be the stock of productive assets, real economic projects, endeavors or physical interests that allowed a person to create something tangible for trade. Here, Cooke inserts that government paper would be a perfect substitute for that wealth since retiring it would require the subtraction of real wealth through increased taxation.
If you accept that premise, it is easy to make the next logical leap:
"The retention of our National Debt is necessary as the basis of a system of National Banking. The bonds of the United States, accepted throughout the United States as the highest security, and having a uniform value in every one of the States, are the only real and safe equivalent for gold and silver, and the only available basis for a uniform bank-note currency that shall be money all over the Republic. Commerce demands this uniform currency. Politics requires it. ...There is not now any other basis for this currency, nor can any other be devised, than the Debt of the whole United States."
Indeed, after Cooke's pamphlet was published the idea gained steam and eventually the national banking rules were changed in this most profound way. Whereas gold and silver were the only permissible bank "reserves" for most of our nation's history, the idea of government debt as wealth became entrenched when government bonds were given equal reserve status to precious metals. The moment that bank reserve restrictions were loosened to allow a form of paper claim as an official bank reserve was the moment the exogenous constraints upon credit creation, and thus the ability of central banks to "manage" credit and the real economy, was solidified. Paper wealth was given the official imprimatur and has never really looked back.
In reality, what happened was that bank reserves ceased being a true asset, the physical representation of stored wealth in the accumulation of a barbarous metal unencumbered by counterparty risk, and started to become a function of someone else's liability. This process itself reached full derivative status in the US in 1913 when the Federal Reserve system was created, whereby a national paper currency standard was established with precious metals and government bonds "backing" all the paper currency the Fed can and would issue. The "wealth" of the national, meaning by 1913 its accumulated debt, would provide "value" to all the paper issued for the exchange of real goods and services: the ability to tender all debts both private and public was given value by the amount of debt the government would incur and sell to banks.
The global banking system, of course, has significantly changed since these earlier experimentations with derivative, liability-based money. But at its heart still lies this 19th century idea of government debt as wealth. The global banking system may no longer be encumbered by cash restrictions, having switched to the accounting notion of equity in its liability structure, but liquidity is still largely governed by access to "quality" paper collateral. Because banks are so reliant on short-term funding, the ability to post collateral to generate liquidity is now the de facto "reserve" banking standard, and this has come about completely unintentionally.
Just to review the past decade: banks funded their credit operations largely through short-term interbank markets. Those markets were flush with cash due to central bank interest rate targeting regimes, where any and all demand for first derivative cash was met to maintain the low short-term rates (Fed funds in the US, LIBOR in eurodollars). Repo rates generally follow the central bank target rates, so overall short-term liquidity was controlled at the central bank level. In such a large and heterogenous system, collateralization was the prime second derivative currency (quality collateral) by which first derivative currency (cash) would flow. While so many commentators focus on the stock of various forms of money, ultimately is the flow, and the direction of flow, that is most important. During the housing bubble there was no shortage of quality collateral in the form of AAA-rated mortgage structure tranches, and so the perceived "value" of these bonds led to more money flowing to mortgage structures and the shadow banking system in a path of least resistance kind of methodology.
Since 2007, the pool of quality collateral has been narrowed significantly, leading directly to the panic of 2008 and the ongoing global bank funding crisis. There have been two pathways for that collateral tapering. First, what passes for "quality" has been re-evaluated, with that list first being limited to sovereign government issues (which would have made Jay Cooke tremendously happy), and since 2010, the list of acceptable sovereign issues has been pared. Second, the ability to rehypothecate quality collateral has been constrained by investors becoming actually aware of this second derivative fractional system. In other words, ownership of securities is not actually straightforward - there are, in a system that allows rehypothecation, numerous claims on every piece of collateral.
To accomplish first derivative liquidity necessarily requires access to second derivative currency. In today's banking system that means sovereign bonds. Again, because liquidity is the primary need of the banking system and it is tied directly to the market perception of quality, the flow of marginal money is tied directly to the perceived value of a class of securities. In the housing bubble, the high perceived value of mortgage products made liquidity via those same mortgage products easy. Therefore more money flowed to mortgage products. Now that mortgage bonds are no longer perceived within the defined list of quality collateral, money no longer flows to mortgage structures. Marginal flow is a product of first derivative liquidity parameters.
In Europe, the European Central Bank (ECB) has expanded the amount of first derivative currency (cash) available to the banking system, but requiring second derivative currency (collateral) to access the cash. This is an echo of interbank money market realities because unsecured short-term lending has all but ceased. Since the marketplace has once again narrowed the list of usable quality collateral, excluding even some sovereign debt, the cost of second derivative money has risen. As such, that second derivative interbank money is now demanded far and above any other type of credit security. If a bank wants to remain in business, avoiding the threat of massive firesales of assets, it must possess acceptable collateral.
In the years since 2008, the heightened demand for sovereign debt issues to be used as collateral in short-term funding arrangements has come at the expense of lending to other private sector sources. In the US and Europe, credit availability (from banks) to households and businesses contracted significantly while banks lent massive amounts of credit to national governments. Even after the first LTRO was conducted in late December 2011, with the expressed idea that this liquidity operation would allow the banking system to avoid credit retrenchment so that it would advance credit to the real economy, credit to the private sector in Europe still contracted in February 2012.
In this important way, government debt (which is supposed to be a perfect substitute for real wealth) actually cannibalizes credit to the real economy, thus reducing the level of economic activity (in my opinion, reducing the overall level of debt is not necessarily a bad idea, but it should be applied to both the public and private sector). Economists call this crowding out, but the financial genesis of this kind of crowding out is certainly not what they had in mind.
This current episode of crowding out is itself a product of the very idea of wealth being government debt in the first place. Without the placement of sovereign debt as a substitute for true wealth, the primacy of government debt in the second derivative capital sense would not necessarily have taken place. If the definition and traditional views of wealth as actual productive assets had still been widespread, the banking system would be scrambling to acquire the securities of successful businesses and lend money to create securities for real assets rather than continuing to perpetually fund the chronic malaise that passes for fiscal governments (or the housing bubble before it). Those that have been successful would be rewarded with plentiful, low cost funding, while those that have been profligate and irresponsible, including governments, would be forced to reduce their activities through market discipline. Overall, the economy becomes more efficient through this kind of monetary rebalancing, which is exactly what a recessionary process should be.
If liquidity were to be predicated on actual wealth, money would be flowing to exactly the places it is needed most - those most successful in the real economy. If we are to perpetuate a self-sustaining loop of monetary activity, it seems wise to do so where those that demonstrate an ability to create sustainable activity are favored with monetary largesse. Again, because money, in all marginal forms, now flows based on the statutory favoritism of government debt and bureaucratic notions of "safety", the entire monetary system has become an inefficient drag on the real economy. And this is occurring in an economic world where the shortage of productive businesses and assets is the primary problem.
For these national governments, including the US and its municipalities, the lack of "revenue" defines this recovery period. Central banks and their banking structures ensure that money flows to maintain the deficits of these fiscal authorities in the vain hopes that this indirect flow will eventually (some day, maybe) lead to the kind of economic growth that will cure all fiscal and financial problems. This is backwards. If it were instead desirable for money to flow to real successful enterprises and assets first, economic growth would eventually restore fiscal sanity (after a period of beneficial market discipline adjustments). The path to the virtuous economic circle does not flow through indirect claims on true wealth because that is an extremely inefficient way for money to function in the economy. The longer that backward preference remains, the longer the real recovery is delayed.
Money, in all its derivative forms, should be a tool that increases the general productivity of the real economy since productivity and efficiency allows the creation of real wealth, and thus the ability of members of the economic society to specialize their labor (increasing living standards). Therefore money should be efficient in its applications as an immediate tool for the exchange of goods and services, and, relevant to the economic problems of 2012, it should be efficient in how it allows the banking system to accomplish the goal of intermediation. Jay Cooke's principle of government debt as a substitute for wealth presupposes that government debt should receive priority in the scheme of intermediation simply due to the ability to tax, to the ultimate detriment of the real economy. Unless government deficits can circulate money as efficiently as real jobs and wages, then enforcing a banking regime that favors this paper wealth schematic will always be backwards and counterproductive.
In the end, money has no direct utility. Its value will always be derivative. How we derive that value is as essential an economic question as there is today because that value, in the 21st century iteration of intermediation, determines the marginal path of economic flow. Our problems are defined in these terms - we have a shortage of efficient pathways for money to flow to enhance the ability of the global economy to create sustainable enterprises and systems (true wealth). Being able to tax is no help when there is not enough real flow to pay that tax, yet central banks and fiscal authorities are determined to maintain this backwards regime.
Private sources of money continue to flow out of the global intermediation system, but central banks continue to fill the void and live up to their primary mandate of currency elasticity. But in doing so they have locked that system in a self-reinforcing feedback loop of inefficiency. The real economy cannot return to anything resembling real health so long as so much monetary inefficiency is present. No matter how hard authorities try, government debt is not wealth and, at present, the private sector is not obliged to act as if it is. This disagreement, though, will have to be resolved one way or the other at some point. As long as the collateral scheme remains the effective bank reserve requirement there is no way to resolve this conflict in favor of true productive wealth, and thus the system will remain in a chronic state of dysfunction.
