A Brief History of Modern Money's Inadequacy

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Every once in awhile you find a few nuggets of hope stashed away in pockets or out of the way corners of modern academic economics. I'm not speaking about the laundering of ECB money through the Greek central bank that seems to excite various asset markets. Rather, these nuggets often come in the form of contraindications to monetary impulses, such as the inferred recognition that authorities actually realize that commodity price pressures and uneven inflation have deleterious effects on the overall economic system. Sometimes they show up as general economic confusion, as the ongoing debate about the status of Okun's Law demonstrates or the new turn in monetary economics toward finding a bypass to "broken transmission mechanisms". All of these are implicit admissions that policies are not working as intended, and perhaps even further that canonical understanding of the economic system is incomplete at best.

Those ineffective policies are derived from the infamous, ideological centerpiece of monetary mechanics, the equation of exchange: M x V = P x Q. The Federal Reserve and its 21st century central bank compatriots operate directly through changes in M ("money" supply) and the V ("money" velocity) because they recognize the limitations of their monetary reach. The power of central banks is, at most, an indirect and imprecise influence-peddling scheme. The theory behind the equation of exchange is simply the idea that increasing M will, all else equal, indirectly lead to changes in P (prices) and Q (output). The assumption here is that even though there will be some side effects in the increase in P (known as inflation), there will also be corresponding increases in Q. When there is a distinct lack of growth in Q, desperate policymakers will dangerously appeal to even P.

This was once recognized as dangerous. From 1961 through 1981, money supply as measured by MZM (money at zero maturity) increased 190%. MZM velocity roughly doubled over the same period from 1.74 to 3.45. As this period encompassed the whole of the Great Inflation, there is little surprise as to these results. The equation of exchange, over the longer run, seems to have held up its end of the theoretical bargain. The problem, as central banks see it, is that there was no "all else equal" to the increase in M. The concurrent rise in V accelerated, according to the equation, the inflationary tendencies of intentional increases to bank reserves in the 1960's and 1970's.

The problem, of course, was that the US and global economy ended up with far too much P and too little Q. The challenge of "managing" the economy largely rested upon finding a mechanism or theory of just how to massage V. If central banks could hold V to that "all else equal", the dominion of economic management would be within their grasp - at least on the "demand" side of the economy.

Control over V was believed to be a function of managing expectations. The rational expectations theory, as it was developed out of the Great Inflation "question", held that rational economic agents reacted to expected changes in perceptions of future conditions. Thus, if economic agents believed a central bank was going to expand the money supply, they would act today on those inflation expectations and the end result was an increase in V. Managing expectations through the rational expectations theory became as important to central bank dogma as the plumbing of the financial system itself. In fact, central banks became far more interested in ephemeral expectations than the very real operational advancements in the banking system itself. In other words, they were more concerned about what the banking system was doing rather than how it was doing it.

At the same time the Fed began to assume it could indeed control V through managing economic perceptions and expectations, the financial system itself underwent a radical overhaul away from the traditional depository banking model. During the 1970's, depository banking was still firmly entrenched as the engine of credit production and dispersal, but already marginal changes were eroding banking structures. The Fed funds and eurodollar markets had already "evolved" as the next step in the changing nature of money itself. Money was not just throwing out the last chains of commodity money, represented by the gold exchange mechanism of Bretton Woods, it was also shedding any physical limitations as well.

These interbank markets began to increase their importance to bank liability funding. In that era of the Great Inflation, money began to fully transform from physical dollars to ledger dollars. By 1981, the GSE's had already begun to offer the precursors to securitized financial products, creating the very beginnings of the shadow banking system as the repo market took hold in bank liability funding. The allure of cheap financing was too much for the system to resist as it became more in tune with ideas of dollar leverage and regulatory leverage. This was especially true of that period since financial firms were often limited in how much they could charge on credit assets while simultaneously being squeezed by the double digit rates on nearly all their funding arrangements.

By the mid-1980's, the banking system sought to move out from under traditional regulatory constraints that largely restrained this new ledger money system. The old theories of banks and money were inapplicable to investment banking, securitization and wholesale money. In 1988, we got the Basel Accord whereby the restraining reserve factor on bank credit creation was shifted from the liability side of the balance sheet (cash in a vault as a percentage of deposit liabilities) to the asset side (equity capital as a percentage of risk-weighted assets). It was a profound change that shifted any remaining power over the banking system out of the hands of the public as depositors and put that power squarely in the hands of central banks. At the same time profit potential skyrocketed due to the now fungible manner by which the system would restrain itself - accounting rules. Regulatory leverage was more important than even risk/return considerations.

In that reserve change, the nature of money changed yet again. Entire banks could spring up from nothing without ever once possessing a single physical dollar or even selling itself to a potential depositor. The only necessary requirements were the ability to connect to wholesale money after raising equity capital. Credit in the real economy could be produced without even tangential transactions to what was previously believed to be money.

Around the same time as the Basel Rules were being ironed out, the Federal Reserve shifted its focus from targeting bank reserves in the interbank markets (ledger money) to targeting interest rates. No longer would bank reserves be limited to a defined quantity, they would be entirely determined by "demand" for credit, as in the ability of Wall Street to utilize its vast sales network. Interest rate targeting meant that the Federal Reserve committed itself to potentially unlimited funding of interbank reserves to maintain an interbank interest rate, in this case the Fed funds rate. Since US dollar LIBOR and Fed funds are interconnected by the New York/London nexus of multi-national banks and their various subsidiary outlets, the Fed essentially supplied unlimited ledger dollars to the global marketplace for dollars to meet whatever rate target it set forth regardless of true demand.

With that structural background, there actually was not much need for growth in interbank reserves because the investment bank model/system knew it could pyramid fractional credit through equity to any level it desired. The only real constraint, particularly in eurodollars, was the comfort of counterparties to accept short-term arrangements. Since everyone was increasing credit at pretty much the same rates and nothing systemically bad happened (the S&L crisis itself was limited to the traditional banking model thus proving the "superiority" of new definitions of money and the pyramid of credit), there was absolutely no check on the growth of institutions from inside or outside the system itself.

Between 1981 and 2001, MZM grew not by the 190% seen in the previous 20 years, but by 445%. At the same time V fell from 3.45 to 2.09. Monetary evolution had produced the greatest results possible - the Great Moderation. Money, viewed from this perspective, had appeared to become more productive in every sense of the word. It was a time still characterized by conventional wisdom as low inflation, steady growth. In other words, monetary magic had finally held V to "all else equal" while stuffing growth in M into less P and more Q. The Golden Age of monetary utopia was further cemented by something thought an economic impossibility - the unemployment rate fell below what was considered full employment, and remained there.

Of course we know full well what lay beneath the surface of that utopian monetary age. The equation of exchange is imperfect on its face since M, as it is measured by any of the common methods (MZM, M1, M2), is incomplete with regard to wholesale money, let alone shadow conduits, derivatives and OTC or bespoke funding arrangements. Further, money and credit are not interchangeable concepts. The varying definitions of money were not perfect substitutes for one another. While money elasticity was understood in the traditional age to be physical dollars or quantities of gold (real money), there are comprehensive differences to the store and circulation of those types of money versus the creation and circulation of credit and debt.

Modern ledger money, under the conception of monetary policy, takes no note of how or why it exists. Ledger money can equally take the form of a deposit account accessed by a debit card or a credit line accessed by a credit card. There is no difference to monetary policymakers or often to even account holders themselves. To increase M in the age of ledger money requires it to be borrowed into existence at some point along the way. Money cannot find its way into any account, deposit or credit, without having been borrowed at some point by some entity. Money in the modern age has to be credit-based. It is no longer tied to the demands of the productive economy to transact business and exchange; it is entirely a product of whatever central banks and the banking system want it to be. In that transformation, the informational content is lost with regard to real economy health and wealth. This new money is created without regard to real economy success.

Because of that vital distinction, the willingness of the banking system to produce credit now adds a new variable to the equation of exchange. The central bank cannot push M higher on its own, it needs the banking system to comply by circulating ledger dollars in the wholesale money markets. But even that requires an even newer form of money - financial collateral. The role of financial collateral in this bastardized system is to maintain a derivative level of reserve creation control through liquidity.

In terms of credit creation, however, there is a drawback to having money take the form of credit assets themselves. This new liquidity element that is vital to the fluidity and functioning of the modern ledger money system means that credit is no longer assigned solely based on characteristics of default probabilities and potential rewards for taking on default risks (real economy variables). In other words, the system itself built into itself a mechanism by which the function of intermediation would be diminished by its own success.

The marketplace that is supposed to decide the various inputs and proportions that govern the real economy's intersection with "macro" level management is not really just a simple marketplace where various agents exchange perceptions. The free market capitalist system has developed a self-correcting mechanism that ensures the long run productivity of money and credit: intermediation. That development took place because there was high value added to successful intermediation. The potential friction of paying the freight for intermediaries was worth it because the financial economy bolstered the real economy. Successful intermediation means that success begets further success. Since the traditional pool of savings is derived from economic health itself, successful intermediation means that economic health is maintained transferred into sequential iterations of transactions.

In the modern ledger money banking system the addition of the liquidity variable changed the preference for credit dispersal. Illiquid loans to smaller obligors were exchanged for liquid securities, favoring larger firms/obligors. The Basel rules also threw regulatory leverage into the mix, so liquid securities with favored Basel status and risk-weightings attracted new "credit money" because it concurrently led to the creation and acquisition of new "interbank money".

In terms of vital intermediation, however, these new preferences disabled the character of intermediation itself. The real economy's derived benefit from the financial economy was the careful examination and sifting of economically beneficial projects - the mechanism by which increases in M or V ended up as P or Q.

The erosion of intermediation favored financial gains over economic considerations. The banking system is not limited to P x Q. Instead, as Irving Fisher's original equation intimated, the real tradeoff is P x T (where T is the potential of all transactions, including real economy projects but also financial assets). As the new banking system began to direct more flow to financial T rather than Q, the Fed responded with even more M (through targeting interest rate levels far below normative or market-based, further screwing up financial calculations of risk). Since financial or asset inflation is discarded by monetary theory, the Fed only saw limited movement in consumer prices as a green light to try to increase Q as much as possible. So MZM increased 445% rather than 190%. Debt levels necessarily exploded since new modern money is borrowed into existence.

The declining V, then, is really just a plug line in an incomplete equation rather than a real expression of real economy expectations. If P x T were included, where P counted not just consumer inflation in the real economy but also asset inflation in all manner of asset markets, V would likely show an increase not all that dissimilar to the Great Inflation. The application of the rational expectations theory did not result in a Great "Moderation", it was the culmination of several evolutionary changes that predetermined that the final outcome would be beyond the scope of this limited economic understanding. The changes to the character of financial plumbing almost guaranteed a period of asset inflation since the need of the system to acquire and circulate "money" in all its new forms absolutely required as much. Some people denote such a system as a Ponzi scheme.

In 2012 as the economics profession wrestles with the incongruity of this limited framework measured against reality, therein lies the hope of real progress. The breakdown in the ability of the economists to manage the real economy inside the limited capacity of the equation of exchange should, at some point, lead to a growing desire for competing paradigms of understanding - especially those that demonstrate that there really is no distinction between macro and micro. The real distinction is the character of intermediation between the real economy and the financial economy, where increasing interventions into both the quantity and character of M pushes intermediation further away from usefulness.

The markets of capitalism cannot function over the long run without successful intermediation, but intermediation as it currently exists of interbank money and ledger money cannot be successful as it is now construed. Something has to give. Politically, mainstream economics holds to the incompleteness of the old equation, but the free market of ideas may yet win as the desire for success in the face of repeated (and now admitted) failures eventually overcomes the stubborn and entrenched status quo.


Jeffrey Snider is the Chief Investment Strategist of Alhambra Investment Partners, a registered investment advisor. 

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