Rethinking Finance

Page 1

a publication by Rethinking Economics Norway


Expect more from economics

Rethinking Economics Norway is part of a global network for economists, students and others with an interest in economics, with the aim of renewing and enriching the economics profession by building on the diversity of economic perspectives and traditions that exist. We are working for a realistic economics education that builds on both a theoretical diversity and a critical approach to all theories and academic practices.

The Rethinking Finance Publication is based on the Rethinking Finance Conference that was held in Oslo, April 12-13 2018, at BI Norwegian Business School organised by Rethinking Economics Norway. It was a collaboration with Finance Watch, the Centre for Financial Regulation, and Young Scholars Initiative (YSI) with funding from Finansmarkedsfondet.

Centre for Financial Regulation at BI Norwegian Business School

The conference gathered 150 participants to explore the future of economics and finance 3


IN APRIL 2018, Rethinking Economics Norway — true to its goals of pushing the boundaries of public debate — facilitated it’s third major conference, Rethinking Finance, seeking to shed light on how the financial sector could serve for the betterment of our societies. Finance, and in particular the importance of money, banking and debt, is sorely lacking the attention it deserves in the core economics curriculum. Additionally, the public is unaware of the significant role the financial sector plays in their lives. This publication seeks to communicate some of the main themes and concepts that were touched on during the conference, and empower you, the reader, to understand more of what is going on in the sphere of money, banking and finance. THE DISCONNECT between the financial economy and the real economy has never been greater than at this point in history. During the past few decades, the growth of the financial industry has been unprecedented. A larger and larger proportion of the money supply is now given to speculative, financial purposes, rather than real investments that create wealth in the real economy. The fact that the financial economy is growing at a faster rate than the real economy, tells us that the finance industry primarily works to enrich itself, and that there is a deep division between the two spheres. 4

THIS DIVISION is one of the primary drivers of the financial crises that frequently destabilise the global economy, and the lives of people world-wide. These financial crises include the Latin American debt crisis in the late 1970s to early 1980s, the banking crises in Norway, Finland and Sweden in the early 1990s, the Asian Financial Crisis in 1997, the ‘dot-com’ crisis in 2000 01, and the Global Financial Crisis that followed the US real estate crisis in 2007 - 08. In Europe austerity was imposed, preventing national governments from utilising public spending to provide for the needs of its citizens, resulting in crushing poverty and despair. This has been a significant cause of the rise of the far-right movement across Europe. Ultimately, the financial sector has largely been a destabilising force in society. 10 YEARS HAVE PASSED since the Global Financial Crisis, however the mainstream economics education, practice and discourse has not significantly evolved. We need to understand the root causes of the problems we are creating as a society and how to address them. Money is power, financial markets are not self-regulatory, and the ‘free market’ is neither free nor a natural state. WE CAN move towards the society we want, but this requires a rethinking of money, banking and finance.


LIV ANNA LINDMAN: Studying MSc Environmental Economics at NMBU and boardmember of Rethinking Economics Norway

ABEL CRAWFORD: Engineer who is studying MSc Agroecology (Food Systems) & board member of Rethinking Economics NMBU

CONTENTS MARIE STORLIE: Studying MSc Economics at the University of Oslo and is a boardmember of Rethinking Economics Norway.

SUNNIVA MELLBYE: Freelance Graphic Designer & Illustrator. She has created the illustrations on the front page, p.8 , p. 24 and p. 46

The Age of Finance


Bankers to blame


The Financial Crisis & Norway


What is Money?


Money is Power


Why regulate the financial system?


Towards a theory of shadow money


Thinking like an ‘economist’


ISBN 978-82-691429-0-7 (Print) ISBN 978-82-691429-1-4 (Ebook) Rethinking Finance Publication published October 2018 Funded by Finansmarkedsfondet. 5

Ebba Boye at the Rethinking Finance Conference [Photo Samuel Berntzen]

The Age of


Why are we letting the financial sector command the direction of our society? AUTHOR EBBA BOYE ANY HISTORICAL PERIOD is characterized by a specific commodity or production process that forms the growth, production, distribution, wealth and social structure of society. Iron, coal, assembly line production and the internet are all examples of this. A number of researchers and economists are now claiming that the most important characteristic defining the period from 1970 until today is the increasing dominance of finance. RANA FOROOHAR, commentator for the Financial Times and author of the book “Makers and Takers.


The Rise of Finance and the Fall of American Business”, describes financialization as a trend in which the financial sector, and its mindset, dominates business as a whole. In a world where short term profitability in the stock market drives decisions in companies, we see cuts in costs, wages and real investments. Foroohar describes how money flows from the real economy – the economy in which we work and live our lives - to the global financial markets.

17 billion loan to buy up their own stocks and pay dividends in order to drive up the share price. This has become an increasingly common practice among companies. The largest US corporations spent USD 3.7 trillion on buying their own shares between 2005 and 2014.1 More and more money in the financial sector goes to the purchase and resale of existing securities such as stocks and bonds, rather than supplying new capital to the real economy.

AS AN EXAMPLE, she describes how Apple in 2013 took out a USD

THE DRIVING FORCES behind this process include the trend of paying

Financialization describes a process where the financial sector has grown too large, on the expense of the rest of society

FINANCIALIZATION EBBA BOYE is the leader of Rethinking Economics Norway and the main organizer of this event. She finished her MA in Economics at The New School for Social Research in 2017 and works as a writer and public speaker. She has an economics column in the newspaper Klassekampen.

Increasing debt is a strong driving force behind today´s economic growth, and it creates strong imbalances in our economies

senior executives with stock options. Thus, shareholders can ensure that corporate management has a selfinterest in maximizing share value. According to Tranøy, Jordfald og Løken (2007), Norwegian companies Statoil and Telenor experienced demands from US investors regarding stock options for the executive management when they applied for listing on the New York Stock Exchange.2 IN THE BOOK ´Political Economy of Instability´ (2017) (my translation), by Ingrid Hjertaker and Bent Sofus Tranøy3, the increasing debt in society is described as the “commodity” of the financial sector. It is the creation of new credit for governments, companies, households and the financial sector itself, which forms the basis for both the new financial products and the profits created. All debts have a counterparty in the form of an assets. My debt is your financial investment. INCREASING DEBT is a strong driving force behind today´s economic growth, and it creates strong imbalances in our economies. In the rich parts of the world, private debt increased on average from 50 per cent of revenues in 1950 to 170 per cent in 20064. Then the financial crisis hit, but global debt has continued to rise in its aftermath5. THE FINANCIAL SECTOR now dominates more and more of our everyday lives. Many of us no longer have a pension that secures us a guaranteed income at retirement age. Instead, it is the financial markets, and our personal investment choices, that determine what we are awarded after the end of work life.

primary commodity, namely debt. FINANCIALIZATION describes a process where the financial sector has grown too large, at the expense of the rest of society. It has gained the power to pressure companies into a system where there is no room for long term decision making and social considerations. The result is increased instability and economic stagnation. Part of the solution therefore must be to reduce the size of the financial sector through taxation and regulation. We now see increased interest in returning to a system dominated by small, local banks that secure local investments in the “real economy”. In Norway we have retained a significant portion of the local “Savings and Loans – banks” structure. Perhaps this will give us an advantage when we start shrinking the financial sector? 1 William Lazonick, (2005–2014). Cash Distributions to Shareholders. & Corporate Executive Pay (2006–2014) Research Update #2,” Academic-Industry Research Network, August 2015. 2 Bent Sofus Tranøy, Bård Jordfald og Espen Løken. (2007). Krevende eierskap – Statlig eierskap mellom finansiell styring og industrielle ambisjoner. Oslo: Fafo-rapport nr 20 3 Ingrid Hjertaker and Bent Sofus Tranøy. (2017). Ustabilitetens Politiske Økonomi Cappelen Damm, Oslo. 4 Carmen Reinhart and Kenneth Rogoff. (2013). This Time is Different. Eight Centuries of Financial Folly, New Jersey: Princeton University Press 5 Richard Dobb, Susan Lund, Jonathan Woetzel og Mina Mutafieva. (2015) «Debt and (not much) deleveraging», McKinsey Global Institute Report, februar 6 Turner, Adair. (2015) Between Debt and the Devil: Money, Credit, and Fixing Global Finance, Princeton University Press.

THROUGH SKY-HIGH profits and revolving doors between the financial sector and the regulators, the financial sector has grown gigantic. In the United States and Great Britain, the sector has tripled as a proportion of the economy from 1950 until 2000.6 There were huge losses during the financial crisis, but helped by low interest rates, the sector has retained good access to its 7



Bankers to blame

The banks and the private finance sector are to blame the for large scale deregulation that brought on the global financial crisis, the flawed economic policy responses and ultimately the rise of facist politics who are preying on hardship. AUTHOR ANN PETTIFOR


a Rethinking Economics conference in Oslo last week I pointed out that western politicians and economists are repeating policy errors of the 1930s. The pattern of a global financial crash, followed by austerity in Europe and the US, led in those years to the rise of populism, authoritarianism and ultimately fascism. The scale of economic and political failures and missteps led in turn to a catastrophic world war. TODAY that pattern – of a global financial crash, austerity and a rise in political populism and authoritarianism – is evident in both Europe and the US. And talk of war has risen to the top of the US political agenda. Why have we not learnt lessons from the past? THE “FOUNT AND MATRIX” (to quote Karl Polanyi)1 of the international financial system prior to its collapse in 1929, was the selfregulating market. The gold standard was the policy by which the private finance sector, backed by economists, central bankers and

policy-makers, sought to extend the domestic market system to the international sphere – beyond the reach of regulatory democracy. In the event, the 1929 stock market crash put an end to the delusional aspirations of Haute Finance: namely that financiers could detach their activities from democratic, accountable political oversight1. BETWEEN 1929 and 1931 the losses from the US stock market crash were estimated at USD 50bn. It was the worst economic failure in the history of the international economy. Within three years of the crash millions of Americans were unemployed, and farmers were caught between rising debts and deflating commodity prices. In Germany between 1930 and 1932, Heinrich Brüning, the Chancellor, with the tacit support of Social Democrats, imposed a savage austerity programme that led to high levels of unemployment and cuts in welfare programmes. This in turn led to the demise of social democracy, the rise of fascism and ultimately a global war.

THE QUESTION that arose during the Rethinking Economics debate was this: could bankers be blamed for the current period of financial crisis, austerity, political polarisation and the rise of fascism? Surely responsibility rests with politicians? I BOLDLY ASSERTED that bankers (meaning the private finance sector) can be blamed for the Great Financial Crisis and for the economic policies implemented after the crisis. After all, it was bankers (backed by mainstream economists) that lobbied most successfully (both in the UK, the US and the EU) for laissez faire in the 1960s and ‘70s: the deregulation of credit creation, and for the lifting of controls over interest rates and for cross-border capital mobility2. By bribing and intimidating the political class, most notably in the US, financiers achieved, and still enjoy, self-regulating, global markets in finance. AFTER THE Great Financial Crisis of 2007-9, it was the finance sector that lobbied politicians into bailing out the financial system. The system 9


was on the brink of collapse, with the very real threat that hundreds of millions of deposit-holders would not be able to withdraw funds from their banks in the event of systemic failure. Bailouts of individual banks (and other institutions including insurance companies) were both inevitable and, given the circumstances, right. After the Fed bailout, Wall St. bullied and blackmailed the US Congress and demanded a further USD 700 billion in bailout funds “to rescue Wall Street from its own chicanery and greed” to quote Matt Taibi. Taibi reports that at “one meeting to discuss the original bailout bill – at 11 a.m. on September 18th, 2008 – (Henry) Paulson (ex CEO of Goldman Sachs, and 74th US Secretary of the Treasury) actually told members of Congress that [USD] 5.5 trillion in wealth would disappear by 2 p.m. that day unless the government took immediate action, and that the world economy would collapse within 24 hours.”3 WHILE PAULSON SPOKE, and politicians deliberated, money markets froze, and stock markets fell like a stone. As Jeremy Warner explained4 in the London Independent newspaper on 26 September, 2008: the sector had “warned of economic catastrophe if the Administration failed to get its way.” Soon after, politicians agreed to the USD 700 billion bailout, and markets recovered. But bankers went further. Not only did they want to be bailed out; they also wanted the systemic nature of the global, self-regulating financial system of laissez faire to be sus-

” 10

Ann Pettifor at the Rethinking Finance Conference [Photo Samuel Berntzen] tained and maintained. After the devastation of the crisis, there was public and political resistance to “business as usual”. The US Congress’s Volcker ‘rule’ – that banks could not use depositors’ funds for speculative bets on their own account, was in the banks’ firing line. With time and large sums of money, Volcker’s and the Dodd-Frank regulatory reforms were to be unwound. According to Reuters5, the financial sector spent USD 2 billion on political activity from the beginning of 2015 to the end of 2016, including USD 1.2 billion in campaign contributions – more than twice the amount given by any other business sector, according to the study from

Americans for Financial Reform. That works out to USD 3.7 million per member of Congress and is the most ever tracked by the group, which analysed spending data going back to 1990. THE MOST NOTABLE SUCCESSES for the banks came as a new law was enacted: S.2155 – the Economic Growth, Regulatory Relief, and Consumer Protection Act. As the not-forprofit NGO Americans for Financial Reform point out6: “S. 2155 is a bank lobbyist’s dream: it contains over two dozen deregulatory gifts to the financial industry. These include provisions that roll back the

could bankers be blamed for the current period of financial crisis, austerity, political polarisation and the rise of fascism?


rules on some of the biggest banks in the country, increasing the risk of financial disaster and a public bailout. Other provisions would expose home buyers to financial exploitation and predatory lending, as well as enable racial discrimination in mortgage lending…. This bill is a victory for banks and their lobbyists over the interests of virtually everyone else.” I STAND BY the point made: the private finance sector can largely be blamed for both the de-regulation (‘liberalisation’), reckless greed and speculation that led to the Great Financial Crisis. They lobbied to ensure self-regulation of the system, and to thwart efforts to restructure the system (as opposed to tinkering at the margins) after the GFC. The austerity policies that were recommended by economists7 followed as governments tried (unsuccessfully) to reduce the volumes of public debt that had risen both because of falls in economic activity, and because

of the bailout of the private sector. Those in turn have led to a rise in populism, and to the renewed popularity of fascist parties in Europe. AS I WRITE, bankers continue to foment anger and resistance. FinReg Alert reports8 that the “biggest US banks made USD 2.5 billion from Trump’s Tax Law – in one quarter!”. After the law was passed, Gary D. Cohn, CEO of Goldman Sachs, resigned as adviser to President Trump. GLOBAL BANKERS and financiers (including those overseeing trilliondollar Asset Management Funds) can be blamed for the rise of populist and fascist political parties after the Great Financial Crisis. And given their determination to evade democratic, regulatory oversight and management of the global financial system, we can expect bankers and financiers to be responsible for the next catastrophic, economic failure.

1 Polanyi (1944) The Great Transformation. New York: Farrar & Rinehart. 2 Duncan Needham (2014). Monetary policy from devaluation to Thatcher, 1967-1982. Palgrave Macmillan UK 3 Taibbi, Matt (2013.01.04). Secret and Lies of the Bailout. The Rolling Stone. 4 Warner, Jeremy (2008.09.26). Jeremy Warner’s Outlook: Paulson’s USD 700bn bailout hangs in the balance. But even if it passes, will it save the system from meltdown? The Independent. 5 Schroeder, Peter (2017.03.08). Banks spent record amounts on lobbying in recent election. Reuters. 6 Americans for Financial Reform (AFR). S 2155 Talking points. 7 Chick, V., Pettifor, A. & Tily, G. (2010). The Economic Consequences of Mr Osborne: Fiscal consolidation: Lessons from a century of UK macroeconomic statistics. 8 Rapoport, Michael. (2018.0.17). The Biggest U.S. Banks Made $ 2.5 Billion from Tax Law –in One Quarter.

...we can expect bankers and financiers to be responsible for the next catastrophic, economic failure.

ANN PETTIFOR is a UK based analyst of the global financial system, director of Policy Research in Macroeconomics (PRIME), a network of economists concerned with Keynesian monetary theory and policies. Her books include The Production of Money (2017) and Just Money: How Society Can Break the Despotic Power of Finance (2014). Pettifor is known as one of the economists who predicted the financial crisis of 2008 in her book The Coming First World Debt Crisis (2006).



The Financial Crisis

& Norway

The global financial crisis led to a ten year period of stagnation in most parts of Europe. Why was Norway able to contain the impacts of the global financial crisis? AUTHOR BJØRN SKOGSTAD AAMO The International Financial Crisis, which started in 2007-08, led to a ten-year period of economic stagnation in most parts of Europe. Norway also felt the impact of the crisis. Economic growth picked up however, after one year of stagnation and continued in the following years. This article will discuss some of the reasons why Norway was able to contain the impacts of the crisis. A primary explanation is that Norway had a banking crisis of its own in 1991-93. Both the banking industry and the financial authorities learnt from that crisis in the 90s which minimised the suffering in Norway due to the Global Financial Crisis.


The International Financial Crisis was initiated by the collapse of the subprime mortgage markets in the US. Millions of Americans had obtained loans with low interest rates and no repayments. While house prices were increasing, refinancing was easy. When the market turned around, millions abandoned their loans and the banks were left with the houses. The banks further depressed housing prices when they released them for sale.


THE SUBPRIME MORTGAGESi were “packed and sold” as securities to investors all over the world, known as ABS (Asset Backed Securities), MBS (Mortgage Backed Securities) or CDO (Collateralized Debt Obligations). The number of new CDO contracts was around 100.000 annually until 2004-2005 and then exploded up to 500.000 CDO contracts annually in 2006 and 2007. Rating agencies approved of these instruments as increasing house prices had prevented direct losses. THE US INVESTMENT BANKS were highly exposed, both as traders and investors. Meanwhile, banks in most European countries were investing substantially in securitiesii based on sub-prime mortgages. Other financial institutions such as hedge funds, mutual funds and pension funds also bought large quantities of these securities as they were expected to give higher returns than many other types of securities. i Subprime mortgages: is a type of loan offered at a rate above prime to individuals who do not qualify for prime rate loans. ii Securities: a financial instrument issued by the government such as government bonds that pay an investor a positive rate of interest

While house prices were increasing, refinancing was easy. When the market turned around, millions abandoned their loan...

Figure 1: Nominal credit growth, during & after the Financial Crisis in Norway, Denmark, Sweden & the Eurozone (Source: BIS). WHEN HOUSE PRICES in the US started to fall in 2007, the markets that handled securities became particularly nervous. BNP-Parisbas had to liquidate funds which had been invested in sub-prime backed securities. The British bank, Northern Rock, could no longer fund itself in the securities market and was forced to request Government assistance. Only deposits up to 2000 pounds were covered by the UK deposit insurance scheme. As a result, customers became nervous and thousands queued up to withdraw their money from the bank. WHEN the fifth largest investment bank, Bear Stearns, was ‘rescued’ by US authorities, there was some sense of relief, that a crisis seemed to have been avoided. However, on September 15th, Lehman Brothers, the fourth largest investment bank, went bankrupt and the US authorities did not intervene. The bank was left to normal bankruptcy procedures managed by a private lawyer in New York. Financial markets all over the world were influenced, and in many markets normal bank-to-bank lending came to a standstill. Most banks depend on such loans for their liquidity supply. LEHMAN BROTHERS had substantial operations in more than 60 countries, not at least as a broker and lender in the securities markets. To illustrate, in Norway some 20 000 deals at the Stock Exchange were stopped following the Lehman Brothers’ bankruptcy. THE DAY AFTER the bankruptcy, September 16th, the Committee of European Banking Supervisors (CEBS) held a telephone-meeting. Our Belgian colleague, Peter Praet, expressed the general feeling when he stated: “There is no one in charge over there.” US Investment banks were only regulated by legislation for security firms

without being subject to banking regulation. Authorities in other countries were left to clean up the mess created by the downfall of Lehman Brothers. Banks in NorthAmerica and Europe suffered heavy losses both on the subprime based bonds and their relations with Lehman Brothers. The losses reduced the ability of banks to serve industry and society. SEVERAL MAJOR BANKS suffered significant losses which threatened their very existence, resulting in the need for government support or nationalisation. Banks in Greece, Portugal, Ireland, Spain and Cyprus in particular had significant problems which was exacerbated due to domestic issues, and requiring direct government assistance.


The crisis in the international financial market had a significant impact on the credit supply from European banks. With low levels of own funds, the losses in the security markets forced them to restrict credit, which resulted in both reduced private investments and private consumption. Because government funds were used to ‘bail-out’ various banks, this reduced the ability of governments to support other public activities. BASED ON FIGURES from Bank for International Settlements, the nominal credit growth is seen in Figure 1. The figure shows that nominal credit stagnated in the Eurozone from 2008 onwards, and in real terms there was a decline. Norway and Sweden continued on a healthy growth path, while credit grew somewhat in Denmark before it stagnated.



the strength of the German economy had inflated the value of the Euro more than what suited other countries

THERE WERE two primary reasons for the stagnation of credits in the Eurozone: Lack of own fundsiii. Banks need their own funds both to fulfil legal requirements and to gain confidence from those who offer liquidity. The capital requirements are a fraction, where own funds are the numerator and loans and credits are the main items of the denominator. As banks were unable to attract capital to increase or maintain the numerator, the only way to maintain the capital fraction was to keep the denominator low by restricting credit. Lack of liquidity. The markets for bonds and other liquid assets stagnated as private investors became hesitant. The European Central Bank became the main supplier of liquidity, through the programmes of quantitative easing, whereby the bank bought securities in the market.


In the EU, the decline in economic activity was most significant in the Eurozone countries. They had no flexibility in their currencies, and highly diverse economic developments. Germany had improved its competitiveiii Own funds: is the bank’s own capital. Other sources of the bank’s funding are ‘borrowed’ funds.

ness and was running a surplus in current accounts of some 6 – 8 per cent of GNP in the years 2006 - 2008. Spain, Portugal and Greece had deficits of some 10 to 15 per cent of GDP. THE STRENGTH of the German economy had inflated the value of the Euro more than what suited other countries. Other Eurozone countries had to maintain or improve their competitiveness by forcing prices and wages down by restricting economic demand. They paid a high price for the fixed exchange rates. THE EUROZONE suffered a recession with declining GDP for 15 months from Q2 2008 and then 18 months from Q4 2011. These countries lost their fiscal ability to manoeuvre, partly due to the support given to banks. The Sovereign Debt Crisis thus paved the way for The Great Recession, - the deepest recession since the 1920-ies and -30ies. This is illustrated by the figure below: NORWAY had a very mild recession with GDP bouncing back to the 2008 level in 2010. Sweden had a deeper recession but recovered strongly in 2010. The ECB has in recent years added substantial funds to the markets by buying bonds, which helped to get the Eurozone economies out of stagnation by 2017-18.


Index Q1 2008 = 100

100 98 96 94 92 90 88 mar. 08


sep. 08


Euro area

mar. 09


sep. 09

mar. 10


sep. 10


Figure 2. Development of GDP in the first years following the Financial Crisis of 2007-2008. (OECD Statistics). 14



THE WORLD BANK has developed a special method, “The Atlas Method” for comparing economic developments between countries. The method shows that the Gross National Income per capita (GNI) in the Eurozone stagnated from 36.800 current USD in 2007 to 37.500 USD in 2015. For Sweden it rose from 52.000 USD in 2007 to 57.800 in 2015. For Denmark from 55.700 in 2007 to 60.300 in 2015. The Norwegian GNI per capita was on top in 2007 with 78.400 USD and grew more than other European countries, reaching 93.600 current USD by 2015. The US stimulated its economy by fiscal and monetary measures. The GNI per capita grew from 48.600 USD in 2007 to 56.100 USD in 2015, according to the World Bank. (Figures based on the report published in 2017).


Norway suffered a severe banking crisis in the early 1990s. During that time, I closely monitored the developments of the banks. Becoming Director General of the Norwegian Financial Supervisory Authority (FSA - Finanstilsynet) in early 1993, after being Undersecretary in charge of economic affairs at the Prime Minister’s Office from late 1990. The losses of the three largest commercial banks were so big that all their own funds were used to cover them. The three banks had to be fully taken over by the Government in 1991-92. There were both macroeconomic and bank-industry reasons for the crisis. NORWAY had strict quantitative credit regulations throughout the post-war era. In the 1950s and 1960s, with low inflation, this system worked reasonably well. Creditors paid a positive real interest rate after tax, even though interest rates were very low. Credit flows were steered towards the housing and manufacturing industries, thus rebuilding Norway after the German occupation. Higher inflation put the system under pressure in

the 1970s and 1980s. With limited adjustments of the tax system, high wage inflation led to substantial increases in marginal taxes on net income. Because interest paid on loans was deducted before paying tax on net incomes, net interests were lower than the inflation, implying there were no real borrowing costs. The highest marginal tax rate was 66.4 per cent, implying that two-thirds of the interest due was paid by the public authorities. Average income earners had a marginal tax rate of 46.4 per cent. CREDIT MARKETS were deregulated in 1984, and credit and housing markets followed a typically boom and bust pattern. Bank credits exploded, growing 100 per cent in the three years 1984, -85, -86. House prices doubled from 1983 to 1987, and then halved from 1987 to 1992. Minister of Finance, Per Kleppe (Labour), proposed tax reforms to reduce the value of the deductible paid interest in 1979, while I was his Undersecretary. However, the proposal was rejected in Parliament by both the Conservative Party and the Socialist Left Party (SV). No tax reform was prepared until the right-wing Willoch-government had been replaced by the Harlem Brundtland Labour government in 1986. TAX REFORMS were announced in the parliamentary session 1986/87 by Minister of Finance, Gunnar Berge (I was also his Undersecretary), which were aimed at reducing the value of interest deductions. Combined with restrictive fiscal measures, this played a significant role in the turnaround of housing and property markets. Without these announcements, the turnaround might have come later and with similar or even greater consequences. TO AVOID THE BOOM AND BUST CYCLE, fiscal and tax measures should have been introduced prior to, or concurrently with, the relaxation of credit regulations.

Other Eurozone countries had to maintain or improve their competitiveness by forcing prices and wages down... they paid a high price for the fixed exchange rates



A robust deposit guarantee scheme was established and capitalised, covering deposits up to two million NOK

The final tax reform was politically anchored in both the Labour Party and the Conservative Party. It took full effect in 1992, with a 28 per cent tax on net business and net personal income, which then became the share of interest paid by the public. MOST OF THE TURNAROUND came from a change in consumer behaviour when people realised they had borrowed too much. People stopped buying cars, TVs and other items so that they could service their housing debt. Private consumption declined by four per cent from 1986 to 1989. THE BANKS did not prepare for a free credit market. They were used to choose borrowers from the queue and did not fully analyse the ability of people or companies to service and pay back the loans. AFTER YEARS of quantitative regulations, the focus of banks was on growth. – How to make present clients borrow more and attract new clients, including by expanding their network of bank-offices. The management of the second largest bank, Christiania Bank (Kredittkassen) made it their main aim to become the largest bank, by growing more than others. In the four years from 1983 to 1987, annual growth of credit in the bank was 37 per cent. THE BANKS were not able to increase their own funds in line with the growing credits and exposure. Instead they used subordinated debtiv, which was of little value when the crisis came, as such money could not cover the losses without harming relations with international lenders of great importance to Norwegian banks. Only moderate losses were recorded the first years, and mainly in some regional banks. In late 1990 and in 1991 it became obvious that the downturn created substantial losses for the larger commercial banks, mainly in commercial and industrial property. Although the housing market played a leading role in the boom and bust developments, only one fifth of bank losses came from residential property mortgages. Norwegians gave priority to servicing their housing debt. iv Subordinated debt: is a debt owed to an unsecured creditor that in the event of a liquidation can only be paid after the claims of secured creditors have been met.



Banks gained valuable experience from the crisis in the nineties and improved their credit handling processes and internal controls significantly. This development was encouraged by the FSA with projects on better credit procedures and new regulations requiring good internal control systems and organised internal audit systems. One important feature was that during the crisis, Norway did not give the banks the option of off-loading lossmaking credit assets in separate “Bad banks”. The banks’ staff and management were forced to deal with the lossmaking credits internally and learn from their mistakes. NEW CAPITAL REQUIREMENTS were set at the consolidatedv, sub-consolidated and solo level. Norwegian requirements were clearly higher than in other countries as well as international standards. The FSA required minimum 7 per cent core capitalvi by all banks, well above minimum requirements abroad. Hybrid capitalvii was only accepted when core capital was above seven per cent. BANKING SUPERVISION was substantially strengthened by increasing personnel levels within FSA, many with banking experience. The supervisors conducted regular audits in all large and medium sized banks. Specific capital requirements were added if risks in a bank were considered to be higher than average. A robust deposit guarantee scheme was established and capitalised, covering deposits up to two million NOK. The confidence of the public in the banking system was thus strengthened. THE BANKING CRISIS and the period of public ownership developed a more cautious attitude. Norwegian banks in general did not buy sub-prime based bonds and consequently, did not experience the resulting losses. Absence of US and UK banks in Norway reduced the direct sale of such bonds. v Consolidation: “many to one”, happens when combining, or bundling, multiple loans into a single loan. vi Core capital: is the minimum amount of capital that a savings bank must have in order to meet regulations, consisting of equity capital and declared reserves. vii Hybrid capital: is a form of loan that falls between secure debt and equity, typically with terms and conditions.

Photo: The entrance to Norges Bank, Norway’s Central Bank [FROM MARKETSLANT.COM] MANY EUROPEAN BANKS had substantial losses on Icelandic bank bonds when the financial crisis hit these banks in late 2008. By 2004, Icelandic banks had given loans at the same size as the GNP of Iceland. By extending branches and subsidiaries to nearly twenty other countries, their total credits expanded to nine times the Icelandic GNP in a few years. The expansion was financed by selling bonds to European banks with slightly better dividends than other bonds. Only Norwegian banks did not buy them. This was influenced by the sceptical view of the Norwegian FSA on the Icelandic banks, which became generally known when the FSA denied the Icelandic bank, Kaupthing the right to buy 25 per cent of the shares in Storebrand, the largest Norwegian insurance company. BOTH FSA AND NORGES BANK (the Central Bank) developed their macro-economic surveillance of the financial markets. A close tri-partite cooperation with the Ministry of Finance was developed. When the International Financial Crisis struck in the autumn of 2008, the authorities were able to cooperate closely and make quick decisions. A barter arrangement whereby covered bonds secured in housing could be exchanged by the Central Bank for

short-term government bonds was of great importance to improve liquidity. A state Finance Fund was set up to help banks with low ratios of own funds. This strengthened general stability and gave flexibility for banks who had to obtain own funds from the market. Only a few banks did however need assistance from the Fund. THE ROBUSTNESS of the Norwegian banking system compared to other European countries was of key importance for the better economic performance of Norway. Strong public finances, helped by incomes from oil and gas, was also valuable, as the Government could stimulate the economy by increasing government spending. While unemployment levels in the Eurozone more than doubled and passed ten per cent of the work force, it was kept clearly below 4 per cent in Norway also in the years following the Financial Crisis.

BJØRN SKOGSTAD AAMO was leader for The Financial Supervisory Authority of Norway from 1993 to 2011. He was deputy minister of finance from 1973-79 and 198689. He is the former president of The Financial Action Task Force (FATF) and has held leadership positions in EFTA and Distriktenes utbyggingsfond. He is now Professor II Emeritus at the University of Agder. In 2016 he published a book on financial crises, called Læring fra kriser (“Learning from crisis”).


Photo by Sharon McCutcheon on Unsplash

What is Money? It is difficult to define what ‘money’ is, because the term ‘money’ can refer to different things in different contexts. AUTHOR ROHAN GREY THE STANDARD ECONOMICS NARRATIVE defines money as something that serves three functions: 1) a unit of account; 2) a medium of exchange; and 3) a store of value. However, even this simple description already conflates two distinct ideas – money-as-measurement (similar to the inch or the kilogram) and money-as-object, such as a coin, a paper note. THE FIRST CONCEPT of money-as-measurement is inherently abstract. You cannot ‘hold’, or ‘possess’ an inch or a kilogram, you can only hold things that are a certain number of inches long, or that weigh a certain number of kilograms. Of course, as Jimmy Carter will tell you, that does not mean the question of whether to measure things in inches or centimeters, in kilograms or pounds, is an apolitical one. The choice of a society’s measurement system reflects the values of that society, whether it is derived from King Henry’s armspan, the temperature of the human body, or a fixed number of atoms of a common basic element. 18

MONETARY MEASUREMENT in particular is nearly always understood in relation to prices of actual goods and services. In other words, we understand the difference between $2 and $20,000 partly because we know that a bottle of water today costs around $2, while a car costs around $20,000. However, unlike meters or kilograms, monetary prices are not scientifically determined, but instead reflect political decisions about how we structure the economy. The fact that a car costs 10,000 times as much as a bottle of water does not mean that it is objectively 10,000 more valuable, in the way that a kilogram is objectively 1000 times the length of a metre. MOREOVER, there is no guarantee that present-day prices will remain stable. Depending on the circumstances – say, a persistent drought, or new regulations that prohibit an old car from being driven on public roads – the relative prices of goods and services we use as referents when thinking about monetary values may change significantly. Furthermore, due to macroeco-


the government must spend into circulation more money than it later removes via taxation... in order for the nongovernment sector to run a budget surplus

nomic phenomena like inflation (a persistent rise in the general price level), the scale of monetary measurement in daily life can also change significantly, even as relative prices of goods remain constant – think, for example, of people in Victorian England paying for things with tuppence and sixpence that we might pay 5 or 10 pounds for today. BY CONTRAST, the idea of money-as-an-object is inherently concrete. We measure prices of things ‘in dollars’, but a ‘dollar’ itself is a thing that can be possessed and/or exchanged. This is true even in the digital age, when the ‘dollars’ in question are usually intangible accounting entries on a spreadsheet, or cryptographically secured files stored in a digital wallet. AT THE SAME TIME, we must be careful to distinguish between things-which-are-money, that is, objects that exist as or were created to be money, and things with ‘moneyness,’ that is, objects that exhibit functional properties of money, regardless of how they came to exist. Everyone will likely agree that a dollar coin is money, for example, but not everyone is likely to consider seashells, or cigarettes, or corporate gift certificates, or your local bar tab as ‘money’, even though each one has functioned as money at certain times and places in history. Ultimately, while we may intentionally create certain objects to function as money, any object can function as money, regardless of initial purpose, provided we collectively agree to treat it as such. OF COURSE, you cannot have ‘a dollar coin’ without first creating the idea of ‘dollars’ in general, and you can’t have a ‘cigarette money’ without people knowing how much tobacco exactly constitutes one cigarette. So from a logical perspective, money-as-measurement precedes money-as-object. In other words, you cannot have a money-thing

without first specifying what unit of account the ‘moneything’ is denominated in. CONVERSELY, once you establish a monetary unit-of-account, it is possible to engage in economic transactions denominated in that unit of account, even when you don’t possess any actual ‘money-things’ themselves, provided others are willing to extend you credit. Contrary to the standard economics textbook stories, the vast majority of monetary activity does not involve on-thespot, instantaneous transactions of a good in exchange for a ‘money-thing.’ Rather, most economic transactions have a temporal dimension – they involve a relationship between actors that endures over time, even if that time is as short as the difference between sitting down at a restaurant to eat a meal, and paying the check at the end. Sometimes, even on-the-spot transactions can transform into credit/debt transactions, if there is a payment processing issue, a defect in the good purchased, or if the good/service turns out to be something other than what was advertised at the point of sale. IN OTHER WORDS, most economic transactions involve people buying goods and services on credit, and settling their debts later. Furthermore, there are many kinds of social activities that we don’t think of as ‘voluntary exchange’ that involve creating and/or extinguishing monetary debts – when governments impose taxes, fees, fines, for example, or when people borrow money, or when someone accidentally damages someone’s property or hits them with their car. In previous centuries, individuals could even buy ‘indulgences’ from the Catholic Church, which absolved them in advance for sins they intended to commit later, reflecting the inherently close relationship between ‘monetary debts’ and ‘moral debts’ that endures to this day and is reflected in our common law approach to personal damages and compensation.

not everyone is likely to consider seashells, or cigarettes, or corporate gift certificates, or your local bar tab as ‘money’ 19


Although we don’t often think of government currency as ‘debt’, it is, in fact, a liability of the government...

USUALLY, we don’t use our own credit, but rather rely on the credit extended to us by our bank, or another third-party. For those third-parties, the ‘credit’ they extend to us represents their ‘debt’. Their financial liability is our financial asset. In other words, when I send you $20 from my bank account to your bank account, I am telling the bank to cancel its $20 IOU to me (by reducing the balance of my bank account), and to issue a new $20 IOU to you (by marking up your bank account). THE MOST BASIC and widespread form of third-party IOU that we use to make payments is, of course, government currency itself. Although we don’t often think of government currency as ‘debt’, it is, in fact, a liability of the government, both in an accounting sense, and in the real sense that the government is required to accept its currency as payment for any taxes, fees, fines, court-judgments, or any other obligations it imposes on its subjects, even if that currency isn’t legal tender for private debts (although most government currencies are that too). IN THAT SENSE, we can think of government money as a transferable tax-credit. If a public authority wants to prevent people from parking in a disabled parking spot, but only sets the fine at $50, it is going to have a hard time stopping a millionaire from parking there with impunity, because the millionaire can easily “pay” any fees that they incur. Thus, from the point of view of law enforcement, or a government seeking to influence social behavior, money can serve as a ‘get-out-of-jail-free’ card for whoever possesses it. THE INHERENTLY LEGAL NATURE of both government currency, and private IOUs created via contractual debts, means that monetary design, and more deeply, monetary value are questions of law. In particular, governments that issue currency are making a legal promise that the holder of that currency can obtain debt-relief equivalent to the face value of the obligation. A 100 Krona bill means 100 Krona of debt-relief. This promise is very different to the idea of promising that currency must maintain a stable value in terms of its ability to purchase goods and services. Indeed, contrary to the standard economics narrative, government currency explicitly does not promise to be a ‘stable store of value’. Instead, governments going back centuries have argued 20

that it is their sovereign perogative not to defend a stable purchasing power for their currency, so long as they honor its nominal face-value. In other words, a promise to pay 100 Krona tomorrow is just that – a promise to pay 100 Krona. If prices in the broader economy change between now and then, well, too bad for the rest of us. CONVERSELY, the fact that any object can have ‘moneyness’ - if private actors agree to accept it in payment or settlement of debts with each other - means that there is no single definition of money, nor is there a single instrument whose quantity determines all monetary activity. Depending on how ‘liquid’ different assets are, that is, how easily we can sell them, or pledge them as collateral in a temporary loan to obtain money (like pawning goods at a pawn shop), any asset can be used to increase the ‘supply’ of money in circulation. Often, as with the case of housing in 2008, these dynamics can cause systemic instability as financial activity expands and contracts independently of any one single actor or decision-maker. SO IF ANY ASSET CAN BE MONEY, why is currency in particular so valuable? The short answer is that certain kinds of obligations, such as taxes, can only be paid in government currency. And as the saying goes, there are only two certain things in life: death and taxes. The fact we are all likely to incur tax burdens at some point in our lives means that tax-credits have a stable demand across time and place. SOMEWHAT COUNTER-INTUITIVELY, in order for everyone to earn and accumulate tax-credit dollars, the government must spend into circulation more money than it later removes via taxation. In other words, the government must run a budget deficit in order for the non-government sector to run a budget surplus. FURTHERMORE, because the money to pay taxes must first be ‘spent into circulation’, as a matter of basic logic, taxes do not ‘fund’ spending in the general sense. Rather, the levying of taxes is what generates a demand for government money in the first place, so that when governments do want to spend money into existence, people are willing to give the government their labor, or their goods, in order to acquire it. In that sense, taxes anchor and drive the value of government currency, but they are

Photo by Thought Catalog on Unsplash not its source – rather, governments create money simply by entering keystrokes on a computer, or by signing new spending bills authorizing new deficits. SOMETIMES, GOVERNMENTS CHOOSE to issue other forms of financial instruments in addition to regular currency, such as government securities (also known as treasury debt). When these instruments are issued instead of newly issued currency to finance a budget deficit, we colloquially call this ‘borrowing’. We call it as such because we are used to think of people issuing debt in order to obtain something they don’t already have. But because money itself is a debt of the government, it makes no sense to think of issuing government securities as ‘borrowing’ in the conventional sense. Functionally, it is like issuing an a $10 IOU that promises to pay … a $10 IOU. OF COURSE, SOMETIMES GOVERNMENTS, or their central banks, will choose to pay a positive rate of interest on various kinds of government instruments, including government securities, and central bank reserves. This can be confusing for some people, as it appears that we are paying private ‘lenders’ interest as compensation

for lending the government funds it otherwise would not have. However, central banks, who are statutorily responsible for implementing monetary policy, in fact have the power to determine the interest rate paid not only on government debt, but also central bank debt, such as the settlement balances (or reserves) that banks hold in their accounts at the central bank. Today, most central banks around the world pay interest-on-reserves, just like treasury departments pay interest-on-government-securities. We call the former “monetary policy” and the latter “government borrowing”, but they are functionally the same, and are done for similar purposes of influencing interest rates in the economy more broadly. SO IF WE DON’T NEED to issue treasury securities in order to finance spending, why do it at all? Well, treasury securities circulate in different ways, and serve different financial purposes, than other forms of government monetary instruments, such as coins, notes, or central bank reserves. Big financial investors and pension funds who may not be able or willing to store hundreds of billions of dollars in physical cash, prefer to store their money in safe, interest-earning securities rather than

Because the money to pay taxes must first be ‘spent into circulation’... taxes do not ‘fund’ spending in the general sense. 21


In a way, banks can be said to function as franchisees of the government

risk storing them at a bank whose government-backed deposit insurance may only cover a few hundred thousand dollars per account. Indeed, some large investors are legally prohibited from holding their clients’ ‘cash’ in bank accounts due to the fact that doing so would expose them to the risk of the underlying bank collapsing. OF COURSE, it is difficult to pay for groceries, or even to pay taxes, using treasury securities. Thus, when investors want to move their funds back into cash or bank deposits, they simply sell the securities in the money markets, or in the last instance sell them to the government’s central bank. In this way, government securities accounts function like a savings account – it’s not easy to make payments from it, but it is easy to transfer funds into your checking account on demand. IN ADDITION to issuing its own monetary IOUs, the government can also influence the ‘moneyness’ of other actors’ IOUs via the degree of support or recognition they choose to extend to them. The most obvious example of this is in the case of commercial banks, whose IOUs – bank deposits – are typically insured by the government (up to a certain amount per account), and can be used by individuals to make tax payments directly, without needing to first obtain government currency (the bank and the government typically settle up on their own afterwards). IN A WAY, BANKS can be said to function as franchisees of the government, extending the government’s full faith and credit to individuals by proxy, in a sort of publicprivate partnership arrangement. From an accounting perspective, an individual gives its IOU (the loan) to the bank, who accepts it in exchange for the bank’s own IOU

(a deposit), which in turn is guaranteed to be convertible into the government’s IOU (currency). Effectively, therefore, banking involves a form of credit-laundering, whereby an individual’s IOU, which does not have a particular high degree of moneyness, is converted, via the bank, into an IOU with the highest degree of moneyness – that of the government itself. AT THE SAME TIME, commercial banks engage in a range of activities with other financial institutions, including investment banks, mutual funds, hedge funds, and insurance companies. These activities generally lead entanglement between institutions, and between the liabilities issued by those institutions, aided by creative lawyering and contractual arrangements. CONSEQUENTLY, when thinking about what money is and how it works, we must look at the legal architecture not only of commercial banks, but of all financially significant institutions (including individuals like us!), and all of the various financial products and instruments that we produce. MONEY IS THUS NOT MERELY A THING, or a unit of measurement, but an ecosystem. It is a layer of social infrastructure, a language, and a source of power. Understanding money provides us with a framework for understanding the economy more broadly, and hopefully, illuminates new ways of changing it for the betterment of all of us.

ROHAN GREY is a lawyer and president of Modern Money Network,a student-driven, non-profit organization dedicated to promoting public understanding of money and finance. He is also a research fellow at the Global Institute for Sustainable Prosperity, a director of the National Jobs for All Network, and a doctoral fellow at Cornell Law School, where his research focus on the law of money in the internet society


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Money is

power Sovereign governments have the power to create money. Policies can be enacted to address public debt and deficits, as well as distributional unfairness. What are the consequences for sovereign nations of giving up their constitutional right to print their own money? AUTHOR JESPER JESPERSEN


Money is power! We know it much too well from our personal experience. Especially when living in societies where the means of production is protected by private property rights. Money is the instrument of transaction used in modern societies to purchase goods and services and to acquire wealth. AT THE MICRO LEVEL, money is the generally accepted means of payment. When money is used as the means of payment, in the form of notes, coins or credit cards, the deal is complete. This is a rather practical legal arrangement, - especially when the money instrument has a wide-range circulation. Hence, the positive argument for creating a monetary unioni. FROM HERE the naïve micro-economic question follows: Why not just set-up a single currency for the entire world economy, and one global central bank? For a die-hard neoclassical economist, who views money from a micro perspective, this is the appropriate question to ask. Neoclassical theory views money as simply a means of transaction with no real impact: also known i Single currency for a group of countries with a federal central bank with a monopolized right to ‘print’ money

as the ‘Money is a veil’- argument. Following this argument, ‘one currency’ has only one kind of real effect: reduced transaction costs, - so the wider the monetary union, the better. (This was the main argument for creating the European monetary union, but the reasoning would also apply to a global level.) IN FACT, money hardly appears in neoclassical (or new-classical) economics textbooks. For more than a century, the insignificance of money has been part of the neoclassical heritage: the ‘Neutrality of Money’ii,1see for instance Patinkin2. It is argued that if money has an impact, it is due to people being irrational or acting out of ignorance: so-called ‘money illusion’. But according to neoclassical theory, such irrational behaviour will not last long: People will quickly learn their lesson, - that money is simply a veil. For instance, in the widely used ii And it is not only in neoclassical textbooks ‘that money is neutral’, see for instance Whitta-Jacobsen & Birch Sørensen1. This statement was also one of the favourite arguments used by prominent economists (and politicians) arguing in favour of giving up the Danish Krone and to adapt the euro: less transaction costs and a German rate of interest. Fortunately, the people and common sense in general overruled the neoclassical arguments, when the question was set to be decided on by a Danish (2000) and Swedish (2003) referendum.



in the widely used General Equilibrium models.., neither money, nor a financial sector, is appearing at all. Why? Because obviously ‘money has no real impact’

General Equilibrium models (GE-models) or the DSGEmodels, neither money, nor a financial sector, is appearing at all. Why? Because obviously ‘money has no real impact’! NO WONDER the dean of the London School of Economics (LSE) got into difficulties answering Queen Elisabeth in May 2009, when she visited the university and asked: “How could it [the global financial crisis] happen?” Because according to the General Equilibrium models – it could not happen! In fact, no conventional neoclassical macro-economist cares much about what happens in the financial sector. Their main concern is advocating for labour market reforms to reduce structural unemployment caused by lack of labour flexibility and a too generous welfare system, and to recommend a balanced public-sector budget. WHY ARE neoclassical economists so focused on a balanced public-sector budget? The economists know that public sector expenditures are powerful. Governments can by public money direct the market economic system away from the private sector general equilibrium solution with full employment. According to the model this a ‘Pareto-optimal’ meaning that no one can get an improved economic outcome without reducing the utility of someone else. Any policy intervention has a negative impact at the market economic outcome due to its dislocation effect of economic resources. So, any budget deficit will disturb, in fact prevent, that the defined and model-designed optimum is realized. Instead they have constructed a vision of a perfect-market economic system directed by private business and households. They assume that these rational private market actors are undertaking individually optimal decisions, arriving at a Pareto-optimal solution through the perfect market system. IN ADDITION, neoclassical economists consider public debt as an economic burden on future generations, who has to pay back the accumulating debt at a later stage. They do not see the cause of the deficit as a consequence of the private sector imbalances and self-inflicted unemployment due to lack of effective demand, see below. Hence, it is important to secure ‘neutrality of the public 26

sector’ by the requirement of a balanced budget preferably written into the constitution.iii WITHIN WELL-FUNCTIONING and competitive marketplaces, individuals can make their own free choices without any paternalistic interference from government. Therefore, the recommendation in all cases is to de-regulate the market system: Leave it to the individuals and to the market forces to direct the economic evolvement, - and money will have no impact. SO, AT THE THEORETICAL BOTTOM LINE of neoclassical economic thinking is a ‘no trust in political intervention’ to correct the private market economy. Because, politicians are like any other agent self-optimizing only thinking of his/her own carrier, and not caring for the ‘common good’ or ‘society as a whole’). Which is also the argument behind an independent central bank – independent of the self-optimizing politicians.iv

MONETARY UNCONVENTIONAL WISDOM MONEY AS A MEANS OF PAYMENT In economic terms, money is the ultimate power, because, as Clower3 forcefully stated, ‘money buys goods’. In a market economy you can get everything if you pay the price – and have the money. If you do not have the ultimate liquidity, in other words, the amount of money (means of payment), you must ask for credit. Credit means that you at a later stage return the agreed amount of money. And if not, you are in default and risk to be ‘bankrupt’. Keynes revolutionized monetary theory when he introduced the concept of uncertainty to macroeconomics: The micro-economic, i.e. behavioural consequences of individuals (and governments) not knowing the future, have macroeconomic impact. iii As a (misunderstood) consequence of the current economic crisis in Europe the EU has decided to require/recommending that the member-states write into their constitution a clause of ‘balanced public sector budget’. iv Listening to neoclassical macro-economists I have always been puzzled by their lack of consistency, when they consider all economic agents and politicians as self-optimizing individuals; but when it comes to themselves they only care for the common good and not taking advantage of their personal positions as central bank governors, professors at prestigious universities or just policy advisors – why are they not considered as self-optimizing agents?


Figure 1: In a closed economy, private saving surplus must by book-keeping identity be equal to the public sector deficit. In other words, a public sector surplus would have to be financed by private saving deficit, or private debt if you like (adapted from Jespersens “The Euro – why it failed” (2016)

To possess money means in modern societies having the ultimate, undisputed and reasonably secure (in real terms) purchasing power. Money is needed to undertake transactions. In fact, the gross domestic product, GDP, is defined as the aggregate value of transactions which create money income (wage and profit)v. ‘Money makes the world go around’ as we know. Surely, you can buy goods and services (and capital assets, see below) ‘on credit’, but only if you can get either a bank guarantee or a bank loan. Even more importantly, firms waiting to sell their output need to fund current production either by retained profit, or more often by the use of bank credit (i.e. money), essentially to cover the costs of resources as well as the wages of workers and sub-contractors. As such, they have a time gap before they receive the expected revenue in ‘cash.’ There will always be a time lag between when the production begins (costs are incurred) and the firms receive the (somewhat uncertain) revenue – therefore credit and finance is of crucial importance in a monetary production economy.vi4 MONEY AS A STORE OF WEALTH Money is a store of wealth. This is empirically a trivial statement; but it had to wait until Keynes5, to be explained by – once again – uncertainty. It is exactly because of ‘we simply do not know the future’ 6 that money is an essential part of any portfolio choice model: the financial asset with less uncertainty attached (under v There are few exceptions, but not relevant here. vi These aspects of monetary theory are especially emphasized by Monetary Circuit Theory, see among other, Graziani4.

normal social and political conditions)vii. Hence, money is a ‘rational’ store of wealth when uncertainty prevails. MONEY CREATION - CENTRAL BANK LIABILITIES. If money is power, then the right to supply money makes the issuer powerful. The demarcation of what items can serve as money is changing through time as can be read in histories of money, among other: Keynes5. Money is defined by legislation and practice of means of payment. Political power (essentially government) can legally define, what is legal tender. This definition of the means of payment can be more or less wide ranging. A narrow definition limits the use of a ‘legal tender’ to payment of taxes, i.e. transactions with the government. A wider definition defines specific financial assets as ultimate payment, the acceptance of which, cannot be denied. THE CONVENTIONAL VIEW on money supply is to consider central bank notes (and coins) as the ultimate means of payment, which can be used everywhere within the national jurisdiction.viii This view leads directly to the argument that the money supply is controlled by the central bank. While the gold standard was the core of the law regulating the activity of the central bank, there was a close relationship between the amount of gold and the number of notes in circulation. This link was definitively broken in 1931. Firstly, by the British government vii I am not considering for instance, Zimbabwe or Venezuela. viii To support the position of central bank notes as the ultimate means of payment any attempt to counterfeiting was capital punishment or in modern times long sentences.

Why are neoclassical economists so focused on a balanced public-sector budget? 27

Figure 2: The Financial Sector - The money flows in the public and private sectors (adapted from Jespersens “Introduksjon til Makroøkonomi” (2018) and shortly after by most Western countriesix. Two major changes followed from this institutional change in the 1930s of breaking the link between gold and the national currency: 1. the amount of central bank money became open ended, and 2. the exchange rate between the different national currencies became flexible. Both changes were substantial; but the neoclassical macroeconomic literature was unprepared and unhelpful for this new institutional situation, where government via the central bank could print money on demand and the exchange rate became at least partly determined by market forces (and therefore speculation). ON TOP OF THESE CHANGES came an increase in the use of direct interbank clearing of cheques drawn on ordinary costumers’ deposit accounts in private banks after the war. Cheques became means of payments within the private sector, and increasingly they were ix The only major exception was the US, which in principle kept the fixed convertibility of dollar notes into gold until 1971.

“ 28

accepted by government for payment of tax.x During the 1980s came the electronic revolution and with that the introduction of credit (or debit) cards. Two kinds of uncertainty emerged when payment with credit cards became the common practice: 1. Was there ‘money on the account’? (if not, the card would, in principle, be blocked), and 2. Was the private bank able to honour the amount drawn in the deposit account? (a matter of liquidity and/or solvency) The problem of bank solvency was (partly) solved by a mandatory requirement for all private banks issuing credit cards to be member of the depositors’ guarantee insurance organized by the government. In EU the amount guaranteed is € 100.000 (in Norway it is still 2 million NOK, but under pressure to conform to EU standard) – deposits beyond this amount ran the risk/uncertainty of the bank going bust.

x But, quite often in cases where the amount of money written at the cheque was not trivial, a telephone call was undertaken to the private bank to secure that the amount was present at the account.

more than ninety percent of economic transactions are undertaken by the use of private bank deposits... [which] are created by private bank loans


Unemployment is caused by structural private savings in excess of private real investment. To close this gap... the public sector must take action.

MONEY CREATION PRIVATE BANK LOANS CREATE DEPOSITS Today, more than ninety percent of economic transactions are undertaken by the use of private banks deposits which circulate as means of payment via credit card, mobile-pay or similar payment vehicles. Where do these deposits come from? The simple answer is they are created by private bank loans. Each time a loan is underwritten by a customer, the amount is credited to the borrower’s debtor account in the very same bank. Pop! - the amount of means of payment is increased by an equal amount. WHEN THE DEPOSITS are used for a (final) payment, the amount of money is credited another deposit account, either in the very same bank or more likely in another bank; but the amount of money is, anyhow, not changed by this transaction. If the deposits leave the issuing bank, there will temporary emerge a liquidity ‘drain’, which at the end of the day can be filled by interbank loans (or lending via the central bank). In fact, the interbank market plays a very important systemic role by levelling the liquidity flows between banks day-byday. Excess liquidity is hereby channelled to banks with a deficit of deposits, usually at a rate of interest set by the central bank. AS LONG AS the interbank market functions smoothly, there is hardly any limit to the amount of money, which private banks can create ‘out of thin air’. It all depends on the demand for credit by firms and households, and banks’ attitude (and risk assessment) to providing such loans. As Hyman Minsky7 convincingly has explained, the banking sector (as a whole) is historically characterized by waves of optimism, which at a certain stage collapse into a credit crunch followed by a financial crisis.


THE FOLLOWING SECTION analyses monetary phenomena within a closed society to clarify the basic arguments. Nevertheless, the analysis would also be applicable to an economy with import and export of goods and services, flexible exchange rate and international capital control, like Great Britain in the 1930s and during the

Bretton Woods era (where exchange rates were adjustable). xi IF WE TAKE THE VIEW expressed by Abba Lerner in his Functional Finance 8 published in the 40s (ideas re-launched by Randall Wray in 2012 under the name of Modern Monetary Theory9), the private and public sector financial imbalances must be analysed simultaneously. In stylized form, the public-sector budget balance has to be by accounting identities an exact mirror picture of the private sector excess savings. xiiAn even more important macroeconomic identity is: savings equal real investment (within a closed society or with nations that have a balanced current foreign account). Hence, it is the interplay between private sector real investment and financial savings which determine the level of employment if all production is conducted in the private sector. Keynes’s10 major contribution to macroeconomic theory was his demonstration that this ‘equilibrium’ between private real investment and financial saving could in principle occur at any level of (un)employment. In a closed society there is no self-adjusting mechanism within the private sector to secure full employment.xiii Falling nominal wages mean falling prices and/or falling effective demand. UNEMPLOYMENT is caused by structural private savings in excess of private real investment. To close this gap of excess private savings, the public sector must take action. For instance, they could increase public real inxi Next section with be on international money with special emphasis on the European monetary union. xii Public debt as a percentage of GDP fell in UK steadily from approximately 200 percent of GDP just after the 2nd world war to less than 50 percent in the early 1970s. This development was mainly driven by a GDP in current prices (due to real growth and rising inflation) which grew much faster than the public debt; In some countries e.g. Scandinavia there was even a public sector surplus for many years due to a deficit of private sector savings – caused by, among other things, a private housing boom. xiii The only economic professor at Cambridge University at that time was A.C. Pigou. He made a desperate attempt the introduce a self-adjustment mechanism: real balance effect (later Pigoueffect). The argument was that the real value of central bank money increases when wages and prices are reduced. He overlooked that already in the 1930s private bank deposits were the dominant part of the monetary circulation, see for instance, Keynes5.



So, the real financial challenge is to find the right mix between new issues of government bonds and of central bank money.

The Hoover Dam, an icon of Franklin D. Roosevelt’s New Deal, [Photo by Koushik Chowdavarapu on Unsplash] vestment (or initiate other forms of expansionary fiscal policy). By running a public-sector deficit, excess private savings can be saturated by public bonds. Hence, public real investment has a triple effect: 1. reduces unemployment; 2. saturates private excess savings with secure financial assets (no crowding out); and 3. increases the real capital stock (infrastructure, innovation, education, durable energy supply to the benefit future generations). ACCORDINGLY, the private structural excess savings could therefore equally well be described as an excess demand for external financial asset (at full employment). In a closed economy, this means that if the government creates more effective demand, output and employment, the public-sector deficit can automatically be financed by private excess savings without necessarily making the rate of interest increase. SO, THE REAL FINANCIAL CHALLENGE is to find the right mix between new issues of government bonds and of central bank money. This mix of bonds and central bank money will, of course, make an impact on the rate of interest dependent on how the private sector’s liquidity preference develops. If the private sector’s liquidity preference is unchanged, government can manipulate the rate of interest by changing the proportion of 30

government debt to the stock of central bank money, which will have an impact on private real investment. In fact, this is nothing new. The monetary policy which central banks, in broadly speaking all civilized countries, have undertaken in the aftermath of the financial crisis, under the name of Quantitative Easing, was to lower the long-term rate of interest. To what extent this policy has been a success, is not evaluated here. Suffice to say, the long-term rate of interest has never(!) been as low as it had been in the US, UK and euro-zone as when this monetary policy of QE has been undertaken – without, one should add, causing consumer price inflation. THE STOCK of central bank money has increased rapidly without causing wage or consumer price inflation. So, the classical quantity theory of money (QTM) and prices has obviously been discredited. It is equally obvious that the QE-policy has caused an asset price inflation which might have implications for future financial stability. FORTUNATELY, it is less disputed that the QE-policy, and the low rate of interest, have had a positive effect by reducing the private sector structural excess savings. This positive development has happened via several channels, of which two shall be mentioned here: The first one is the impact of lower rate of interest on the


speed of wealth accumulation in private pension funds, which reduces private passive savings. Secondly, a lower rate of (long term) interest will have an expansionary effect on private real investment. How strong these two effects are, will depend on circumstances; but they will, in any case, bring the labour market closer to full employment, and at the same time be a relief of the public sector budget.

TWO HISTORICAL EXAMPLES OF MANAGED AND MIS-MANAGED MONETARY POLICY AND FISCAL FUNCTIONALISM. NEW DEAL IN THE 1930S FRANKLIN D. ROOSEVELT took office in March 1933 and presented immediately a ‘New Deal’ to restore the American economy. Government involvement and regulation was increased in all sectors: banking, labour market, public investment, business support, agriculture, social policy and the gold content of the dollar. All these initiatives were presented by the President as part of his ‘fireside chats’ and summed up the following way “I hope you can see from this elemental recital of what the Government is doing there is nothing complex, or radical, in the process” 11. ROOSEVELT WAS RIGHT. He was making this successful policy out of intuition and common sense for two straight forward reasons: 1. The economists of his time assumed a self-adjusting private sector. This was obviously wrong, as were the policy recommendations accepted by the Hoover administration that aimed for a balanced public budget which actually aggravated and deepened the recession. 2. All sectors suffered from lack of purchasing power due to broken banks and a broken market mechanism. On top of these Hoover-failures, Roosevelt had some positive experiences from his time setting up public investment while he was the Governor

of New York State, although it was on a much smaller scale. WHAT THE AMERICANS COULD SEE was an economy that started to grow by 8 to 10 percent each year except for the year 1937/38. Unemployment fell steadily, but it was not until 1943 it had fallen back where it was in 192912. Why did it take such a long time? An important part of the answer is because the American economy had got stuck in a total collapse of gross private capital formation from USD 16 bill. to USD 4 bill. in 1932. The government could only partly fill in this gap by increasing public expenditure to USD bill13. Recovery had to wait for a restoration in business confidence (and the war). ALL WAY THROUGH HIS TIME IN OFFICE, Roosevelt faced difficulties in defending the growing public debt. He had to wait for Keynes arguments; but even Keynes had severe difficulties to convince the British politician of the constructive impact that public deficit and debt would have to re-balance the macroeconomic system and to reduce unemployment. This is still the current situation – public sector deficit and debt are considered as two macroeconomic imbalances which can be addressed separate from the private sector. It is even argued that a smaller public sector would be a relief and expansionary to the private sector, because ‘supply creates its own demand!’ (when of course it is the opposite which is true.) Otherwise, the call for austerity policy could only be seen as a cynical attempt to maintain unemployment much longer than needed. THE EUROPEAN MONETARY UNION IN 21ST CENTURY Looking at the European Monetary Union, it is striking that on average, decade by decade, the growth rate in GDP within the euro-zone has been the lowest ever

Roosevelt (..) presented immediately a ‘New Deal’ to restore the American economy. Government involvement and regulation was increased in all sectors 31



This is a sad story of intellectual and academic desertion, - and political defeat. I am worried that one has to wait for another Roosevelt, or a so-called populistic revolt by the people...

Photo by Sara Kurfess on Unsplash since the since the Second World War. Growth trends have been reduced and the euro-zone has performed more poorly than the non-euro countries, - not to speak of the US. Many refined arguments have been offered by the euro-monetarists, see Jespersen14. Among these arguments labour market inflexibility and persistent public-sector debt and deficit are ranking high. Forgotten are the first 25 years of the after-war period, where unemployment was around 1 percent and public debt ratio was constantly falling resulting in hardly any public deficit. THE DEVELOPMENT in nearly all European countries has, of course, changed considerably. The major change is that the private sector has swung into a position of excess financial saving, mainly due to a reduced level of real investment in most (but not all countries). The fall in real private investment could be counterbalanced by either an expansionary monetary or fiscal policy designed specifically for each country, due to each the country having various business structures, institutions, and political preferences. But the euro-zone countries 32

have given up the monetary sovereignty through their membership in EMU. They can no longer: 1. issue their own currency; 2. set their own short-term rate of interest and 3. manipulate the exchange rate. And there is not much help to get from the European Central Bank. It is under the obligation of the EU-Treaty to secure a stable development of the average of consumer prices all over the euro-zone. This requirement causes a diverging development, because the rate of interest will be too high for countries in recession, and too low for booming countries. Exactly the same counts for the common euro-exchange rate. In addition to this centralized monetary policy, within the EU-Treaty, EU-governments are banned from financing the budget deficit via printed money or lending from private banks. SO, FISCAL POLICY UNDER EMU must be financed via the bond market, which should not be a problem as long as excess private savings are there to absorb public securities by an equal amount. When the euro-monetarists and the Bruxelles-elite realized that there was no real


limit to fiscal expansion during a recession, they became nervous because that would run counter to the political priority of a balanced, – and even better: reduced – public sector. Thus, to limit the potential fiscal policy, the Growth and Stability Pact was written into the EU Treaty in 1997. According to this pact, no EU-member country was allowed to run a budget deficit above 3 percent of GDP. If it still happened, for instance due to a collapse of private investments, government should make plans – and get them approved by the EU-Commission - of how to reduce the public-sector deficit by austerity measures in the middle of a recession! However, when the recession hit in 2009, a number of EU member-states undertook expansionary fiscal policy by increasing the structural public-sector budget deficit to match the hugely increased private structural surplus. This expansionary policy had the positive effect of breaking the downward spiralling of the GDP, and for a short while, the macroeconomic development was supported by macroeconomic theory and policy which made Robert Skidelsky conclude: ‘Keynes: the Return of the Master’15. BUT, THIS OPTIMISM DID NOT LAST LONG, as the consequences of public deficits were very unevenly distributed among the euro-countries. Countries which also suffered from balance of payments deficits had to borrow abroad. Such was the case for the Southern European countries, whereas the Northern European countries, especially Germany, had a massive balance of payments surplus. So, Greece, Spain, Portugal, and later Italy, all had to go begging to borrow money from Berlin, Frankfurt and Bruxelles, as they were prevented from

issuing money themselves. The borrowing conditions were tough, and seemingly straight out of the monetarist textbook: increased public savings and labour market reforms. This demanded policies that initially deepened and later prolonged the economic crises in the Southern euro-countries. The effects then spread to the entire euro-zone, where all countries had an excessive public budget deficit according to the EU-Treaty. THE BERLIN/FRANKFURT/BRUXELLES AXIS had to realize that the Stability Pact was not restrictive enough to prevent financial instability, and it proved a challenge to the idea of the common currency as an integrating instrument. To prevent high uncertainty to unravel again, a Fiscal Compact was forced upon the euro-zone members and accepted by the other governments of the EU-countries (except Great Britain and the CzechRepublic). The countries were asked to amend their national legislation, or even constitution, in such a way, that no government, not even during a recession, should be allowed to undertake an expansionary fiscal policy of more than ½ percent of GDP. IT IS NO WONDER that most European countries have been stagnating for more than a decade. The only expansionary effect has come from the European Central Bank. The bank lowered the euro-area rate of interest and initiated a substantial QE-program. The latter became a relief to the debt-burdened euro-countries and created a boost for the exporting sectors by lowering the euro/dollar exchange rate.

It is no wonder that most European countries have been stagnating for more than a decade 33

JESPER JESPERSEN is professor of economics at the Department of Society and Globalisation at the Roskilde University, Denmark, where he has been teaching and conducting research since 1996. Previously he taught international economics at the Copenhagen Business School. His research field is Post Keynesian Macroeconomics.


How can it be that unrealistic macroeconomic theories repeat themselves, after they were discarded by Keynes more than 70 years ago? It applies to monetary, financial, fiscal and labour market theories. One may question how it can be that hardly any conventional economist has objected to the ‘soundness’ of the Stability Pact or the Fiscal Compact although Europe has had such a poor economic performance? How can it be that politicians, either blue or red, have renounced on a number of national policy instruments without having any influence on how these policies are undertaken at the federal level? It creates the impression as though politicians are scared of being made accountable of the macroeconomic development and be in opposition to the crunching international financial markets, - and has accepted that the latter has been implemented into national law by parliament in a number of EU countries, among others by the social democratic led Danish government in 2012 – even when the economic recession was at its deepest. THIS IS A SAD STORY of intellectual and academic desertion, - and political defeat. I am worried that one has to wait for another Roosevelt, or a so-called populistic revolt by the people, which seems to be under its way in Italy. In some way it makes no sense to wait for another Keynes – one is enough; his theories will be reawakened when the political climate is ripe to set a political agenda that gives priority to ‘full employment and a fair distribution of income and wealth’. But still I am wondering, like Keynes did, why it is so difficult to explain to one’s academic colleagues that: 1. The private sector is not self-adjusting, 2. When there is an excess financial saving in the private sector it will cause unemployment, 3. Government may reduce this unemployment by a matching/mirroring budget deficit (which, in fact, is selffinancing) that will disappear when the private sector turns around and starts to run a financial savings deficit. There are, of course, many strategies to reduce excess savings and unemployment within the private sec34

tor: low rate of interest, redistribution of income and wealth from rich to poor, investment subsidies, reduced (tax) incentives to private savings (old age pension is heavily subsidized especially for the rich people) or a reduced number of working hours per week16. 1 Whitta-Jacobsen, H.J. & P.B.Sørensen (2005), Intermediate Macroeconomics, New York: McGrawHill (p.62) 2 Patinkin, D. (1987), Neutrality of Money, in The New Palgrave: A Dictionary of Economics, edited by J. Eatwell, M. Milgate, and P. Newman, London New York Tokyo: Macmillan Stockton Press Maruzen. 3 Clower, R. W. 1967. A Reconsideration of the Microfoundations of Monetary Theory, Chapter 14 in Clower. R. W. 1969. Monetary Theory, Harmondsworth: Penguin book 4 Graziani, A. (2003), The Monetary Theory of Production, Cambridge: Cambridge University Press 5 Keynes, J.M. (1930), Treatise on Money, vol. 1 & 2, London: Macmillan 6 Keynes, J.M. (1937), The General Theory of Employment, Quarterly Journal of Economics, 51, 209-23 7 Minsky, H. P. (1982), Can ‘It’ happen Again? Essays on Instability and Finance, Armonk, New York: M.E. Sharpe 8 Lerner, A. (1944), The Economics of Control, New York: Macmillan 9 Wray, L. Randall (2015), Modern Money Theory: A Primer on Macroeconomics for Sovereign Monetary Systems, (Second edition) London: Palgrave/Macmillan 10 Keynes, J.M. (1936), The General Theory of Employment, Interest and Money. London: Macmillan 11 Rauchway, E. (2008), The Great Depression & The New Deal, Oxford: Oxford University Press (p.57) 12 Rauchway, E. (2008), The Great Depression & The New Deal, Oxford: Oxford University Press (p.5) 13 Lewis 1960 (p. 113) 14 Jespersen, J. (2016), The Euro: why it failed, London: Palgrave/Macmillan 15 Skidelsky, R. (2009), Keynes: The Return of the Master, London: Allen Lane 16 Keynes, J.M. (1931), ‘Economic Possibilities of our Grandchildren’ in Essays in Persuasion, London: Macmillan

Expect more from economics



Photo by Freddie-Collins on Unsplash

Why regulate the

financial system? This article considers four main approaches to regulating the finance industry as well as considering issues that are unaddressed by these four main approaches AUTHOR SHEILA DOW


may seem remarkable that we should still be asking whether the financial sector should have special regulation, so soon after the latest financial crisis and with the prospect of another one. Yet the debate continues, and indeed new post-crisis bank regulation is currently being rolled back in the US. So the argument for regulation still needs to be made. We will go back to first principles in order to consider why the financial sector needs special regulation, beyond normal company regulation (see further Dow1, Kregel and Tonveronachi2). How these principles are applied depends on the context, which, in finance, is always evolving. We will focus on the modern state of money and finance to consider issues surrounding the type of regulation that is needed. 36

WE MUST ALSO BEAR IN MIND the goals set for the monetary authorities when considering financial regulation. Before the crisis, the authorities focused primarily on targeting inflation. But since then, the authorities have been forced to prioritise dealing with the financial instability of the crisis and the economic stagnation which resulted from austerity fiscal policy. Monetary authorities still aim to promote monetary stability by controlling inflation. Additionally, they, formally and or informally, also target financial stability (e.g. the degree of volatility in asset prices, and financial conditions more generally) and economic stability (which is the primary goal set for Norway’s central bank).


As far as finance is concerned it is argued on the basis of historical study that financial instability in the past has actually been caused by state interference..

HOW WE DISCUSS FINANCIAL REGULATION depends on how we understand the way in which the financial sector operates and how it fits in with general economic processes. We will explore in particular four different approaches which vary in the extent to which they see governments intervening in finance: the neo-Austrian approach, the mainstream New Keynesian approach, the Sovereign Money approach and the Post-Keynesian approach.


This approach advocates for as little government involvement in finance as possible, relying instead on market forces. The general approach is based on the idea that individuals in the market have better knowledge to guide their decisions than the state does. So according to Hayek, the role of the state is limited to ensuring that markets operate competitively: “If man is not to do more harm than good in his efforts to improve the social order, he will have to learn that ... where essential complexity of an organised kind prevails, he cannot acquire the full knowledge which would make mastery of the events possible. He will therefore have to use what knowledge he can achieve, not to shape the results as a craftsman shapes his handiwork, but rather to cultivate a growth by providing the appropriate environment, as the gardener does for his plants”3 NEO-AUSTRIANS see state supply of money as a source of monetary instability, inflation being seen as the byproduct of politically-motivated increases in the money supply. They therefore argue for money to be supplied only by the banks in the form of deposits whose value would vary with the value of the banks’ assets. Competition would then determine which bank’s deposits were the most appealing to hold as money. There would no longer be any need for a central bank. AS FAR AS FINANCE IS CONCERNED, it is argued on the basis of historical study that financial instability in the past has actually been caused by state interference. In terms of the recent crisis, the argument is that the state’s support of the banks created moral hazard: it encouraged banks to take undue risks. If instead banks were

allowed to fail if they invested unwisely, their customers would withdraw their deposits when they sensed trouble ahead. In other words, the market would be a much more effective discipline on bank behaviour than any regulation 4.


The New Keynesian approach is what we might call the current mainstream approach to financial regulation, in that it is the one which has dominated the theoretical literature and much of the policy debate. The previouslydominant mainstream approaches (Monetarism, then New Classicism) had assumed, like the neo-Austrian approach, that efficient market forces would ensure financial stability. Indeed, because past and current mainstream approaches use models which focus on equilibrium, stability is built into them as the natural place for economies to settle. Also, like the neo-Austrian approach, mainstream approaches have continued to adopt a monetarist view of inflation: that it is caused by changes in the supply of money. BUT THE New Keynesian approach argues that in practice markets do not work perfectly, so that regulation is needed to ensure financial stability. In particular, they challenge the view, both of neo-Austrians and of the previous mainstream, that individuals have perfect knowledge for making the best market decisions. One consequence is that banks may ration credit, in the absence of full knowledge about borrowers’ riskiness. More significantly for them, in the run-up to the latest crisis, banks were unable to assess properly the riskiness of the complicated structured market products which ultimately proved to be highly risky. Critically for this approach, it is in principle possible to measure the riskiness of any asset, given full information. So, one aim of regulation is to enhance information availability, for example addressing the factors that lead credit-rating agencies to distort their ratings. A FURTHER AIM OF REGULATION, as with the neoAustrian approach, is to remove incentives to take on undue risk, notably the promise of central bank liquidity support. The New Keynesian approach to regulation has thus focused on dealing with bank failure. There has 37


Since monetary and financial instability are associated with credit cycles, the for the state to take over from the banks the supply of money.

been a push, for example, for banks to issue contingent convertible (‘coco’) bonds which would in times of crisis convert debt into equity. This reflects the mainstream view that, because they are continually priced in competitive markets, equity is more efficient than debt (especially illiquid bank loans, but also bonds). Further along these lines, were banks to fail, they should be bailed in rather than bailed out, i.e. the risk of failure should be priced in to their liabilities. Such elements are seen to be desirable features of the resolution mechanisms (or ‘living wills’) advocated for banks, enhancing in turn the knowledge of risk on the part of depositors. THERE HAS BEEN GROWING AWARENESS of network effects, whereby risks associated with one institution or asset can spread to others; these effects are a form of externality with respect to decision-making by any one institution. This is a further form of market imperfection for which New Keynesians have advocated regulatory reforms following the crisis. But Calomiris offers a critique of reforms which have been adopted, as departing from New Keynesian principles, the first of which, for him, is that: “Financial regulation should focus exclusively on bona fide objectives that relate to the performance of the financial sector, grounded in core economic concepts of externalities and information costs and supported by evidence that shows that the costs of regulation are justified by demonstrable benefits” 5


The third, Sovereign Money (or Positive Money), approach shares with the New Keynesian approach the view that bank behaviour, influenced by moral hazard, is the root cause of the financial crises (rather than the state, in the case of the neo-Austrian approach). Society’s money is mostly in the form of bank deposits, so that deposits are continuously recycled through the banks as payments are settled. This gives the banks the freedom to expand credit at will, with increased money the consequence. Rather than the money supply being controlled by the central bank, it is controlled by the banks: it is endogenous. Since monetary and financial instability are associated (as in the recent crisis) with credit cycles, the cure for both is for the state to take over from the banks the supply of money. 38

ADOPTING A MONETARY THEORY OF INFLATION, it is argued that state control of the money supply would allow direct control of inflation. Also, it is argued that the banks would no longer be able to cause financial instability. Having lost the power to create money, and the state support that historically has gone with that, banks would have to accept market discipline like other financial institutions. The Sovereign Money argument for the state to establish a monopoly over money would eliminate banking as we know it, without further need for regulation, or even deposit insurance6. Like for the neo-Austrians, bank liabilities would then vary in value along with the value of banks’ assets. THIS PROPOSAL has much in common with proposals current in the 1930s (prompted similarly by a financial crisis) for what was called full reserve banking7 . Banks would be required to back their deposits hundred percent by reserves with the central bank. There were several variants of these proposals, but the basic principles were the same. In many cases, the vehicle for getting new money into the economy was via fiscal expenditure. In some cases, the system would allow for a negative rate of interest imposed by the state as a means of discouraging hoarding of money. In the case of Sovereign Money, the state would issue money rather than the banks, but the banks would administer it, and the payments system. However, the central bank would also coordinate with government by tying money supply to both fiscal policy and to allocating resources to facilitate and direct bank lending in pursuit of social and environmental goals, as well as economic goals. The functions of the central bank are thus envisaged to be much broader than has recently been the case.


Post Keynesians share with the Sovereign Money approach this broader role for the monetary authorities, and also the view that the money supply is endogenously determined by the banks. But otherwise the analysis of the financial sector is very different8. SINCE the Post-Keynesian approach is the one which I advocate, I aim in what follows to explain why the other approaches are unsatisfactory from a Post-Keynesian point of view.


Photo by Mr. TT on Unsplash THE INTER-CONNECTEDNESS OF ECONOMIC SPHERES THE POST-KEYNESIAN approach differs from the others, not just in terms of its theory of money and finance, and the policy proposals which follow, but also in terms of their basis in the way in which the economy is understood. In particular, the first three approaches involve conceptual separations: notably a separation between the state and the private sector, a separation between money and other assets, and a separation between money and finance on the one hand and the real economy on the other. Since Post Keynesians focus instead on interconnectedness, the three goals of monetary stability, financial stability and economic stability are seen as interconnected, and therefore all the business of the monetary authorities. Monetary stability is the least important, since a stable economy and stable financial conditions are the main ingredients of low inflation, the money supply being endogenous9. THE STATE AND THE PRIVATE SECTOR are intertwined, not least in terms of the market for sovereign debt and thus the implementation of monetary policy. More fundamentally, the state provides an institutional, legal and knowledge foundation for the private sector; indeed, the state has evolved along with markets to meet society’s needs. This is clear from the history of banking. As banking evolved, it became clear that banks operating at the micro, firm level, did not normally address the macro level. A central bank instead could see the macro consequences of banks’ actions and either attempt to

moderate these actions or act to moderate the consequences. Thus, confidence in the system as a whole was provided by the central bank providing a lender-of-lastresort facility, so that the liquidity problems of one bank would not spread throughout the system, or indeed so that problems for the banking system as a whole would not cause a crisis. There was an implicit deal (a ‘social contract’) between the central bank and the banks that support would be guaranteed as long as banks accepted restrictive regulation and supervision to limit the need for support. MANAGING UNCERTAINTY AND RISK WHEN THIS SYSTEM worked well, the banks were able to supply society with a stable money asset in the form of bank deposits. Occasionally this kind of system could emerge without a state-run central bank, as in Scotland in the eighteenth century, when the older banks acted like a central bank towards the newer banks which threatened confidence in the system as a whole. Thus state-like institutions can evolve within the private sector if the state does not meet a need. The neo-Austrian approach focuses on financial markets at the micro level, such that any bank failure can be dealt with by transferring deposits to sound banks. If in fact there is scope for systemic bank failures, then market discipline is insufficient, and, without emergence of a private sector central bank, the system will collapse, leaving society without money. 39


Money has the capacity both to enable real activity and to constrain it.

THIS NEED FOR A SAFE MONEY asset is central to the Post Keynesian theory of money and banking. In contrast with the neo-Austrian and New Keynesian approaches, Post Keynesians emphasise the importance of the understanding that most of our knowledge is uncertain. This means that in general it is not possible to calculate the riskiness of any asset; rather than being concealed, as in the New Keynesian approach, such measures are unknowable. For Post Keynesians, it is unwarranted to rely on market pricing for financial stability under uncertainty. FURTHER, where neo-Austrians and proponents of Sovereign Money envisage individuals making their own decisions about how to value their bank deposits, Post Keynesians argue that the ensuing uncertainty would make these deposits unsuitable as money. More generally, as Minsky10 argued, the unavailability of true risk measures means that market valuations rely heavily on conventional judgements and are thus subject to wild swings. Since upward swings encourage increased leveraging (i.e. exposure to risk of asset price collapse), the outcome is financial instability as judgements about risks go into reverse and fire-sales of assets make price falls even worse. This was Minsky’s Financial Instability Hypothesis. SOCIETY NEEDS A SAFE ASSET to hold in times of crisis, or even of increased uncertainty about the value of other assets. Money thus acts as a store of value, a necessary feature of a means of payment. It also acts as a unit of account, which provides a secure foundation for debt and labour contracts. But, while state-issued money normally performs these functions best, the financial sector is adept at providing near-moneys, particularly when the state attempts to control the supply of its own money. The state can attempt to separate its money from rivals by requiring taxes to be paid in it. But the state cannot enforce a separation between its money and other assets, as presumed by the Sovereign Money approach. Financial history demonstrates the ways in which the financial sector generates assets which are close moneysubstitutes, bank deposits being a notable case in point. But these near-monies are highly problematic if unregulated.


REAL ECONOMY EFFECTS THE THIRD SEPARATION which Post Keynesians avoid is between money and finance on the one hand and the real economy on the other. In the New Keynesian approach in particular, the two only connect when there is a market imperfection, e.g. credit for real investment projects is rationed because of concealed information about risk. In the Post Keynesian approach, the interconnections are fundamental. Money has the capacity both to enable real activity and to constrain it. It enables by providing a safe asset as the basis for contracts and as a refuge from uncertainty. But by the same token it constrains by providing an alternative to positive expenditure decisions when uncertainty is high. Then effective demand is reduced, creating unemployment. In particular, Keynes argued that the short-termism of financial markets diverted finance from productive investment, with obvious real effects. Finally, the financial sector also has real effects when it promotes inequality of income and wealth. FOR KEYNES, the aim of policy (e.g. on monetary reform) should be the efficient promotion of individual liberty and social justice: ‘The outstanding faults of the economic society in which we live are its failure to provide for full employment and its arbitrary and inequitable distribution of wealth and incomes’11. Keynes thus saw central banking as operating within a wider remit than the narrow inflation-targeting version of monetary stability. Central banks rather were to work side-by-side with government in pursuing their goals. His approach indicates an enhanced role for regulation, given the financial sector’s capacity to provide near-money assets and its inherent tendency to be unstable and to promote a maldistribution of income and wealth. THE POST KEYNESIAN APPROACH to regulation is not to separate the state from the private sector, the former possibly with a monopoly on money supply and the latter relied upon to promote social welfare through competitive markets. Rather it is to accept the intertwined nature of public sector and private sector banking, to promote a mutually-supportive relationship between the two, to regulate particularly closely the provision of money-assets to ensure their safety, and to be alert to ongoing needs for new regulation as the financial environment evolves.


Photo by Lucas Favre on Unsplash IN THE WAKE OF THE 2007-08 CRISIS MANY OF THE CHANGES which have been discussed and even introduced in the wake of the crisis appear to follow these principles. New microprudential regulation aims to ensure more prudent bank behaviour, e.g. imposing minimum capital ratios, leverage ratios and liquidity ratios. But now there is also a much greater recognition of systemic risk which cannot be addressed at the level of individual banks. Macroprudential regulations have thus been introduced, including stress tests to identify individual banks’ vulnerability to adverse developments at the market level12. FUNCTIONAL SEPARATION between retail and investment banking is a further measure, designed to focus central bank support only on those institutions which supply society’s money. In fact, many of the other regulatory reforms too have been driven by the continuance of the ‘too-big-to-fail’ problem (that failure of a big bank would pose an unacceptable systemic risk). From a New Keynesian point of view, it is this major market imperfection which justifies continued regulatory intervention in the financial sector. There is now a greater appreciation in the mainstream policy literature of systemic risk, and of uncertainty. But the full significance of uncertainty for systemic risk which is central to the Post Keynesian approach to financial regulation is absent.


One of the changes discussed but not implemented is a global tax on financial transactions, building on the original idea for a Tobin tax. As an added cost, such a tax would reduce the efficiency of the financial sector; such ‘sand in the wheels’ would be welcome from a PostKeynesian perspective in that the sector would become less efficient in creating instability. Further, particularly if the revenues were used for redistributive purposes, the tax would increase the (Keynesian) efficiency to promote social justice. This is typical of the Post-Keynesian focus on efficiency with respect to social goals, rather than market efficiency, as the goal; it justifies introducing other constraints on markets, such as segmenting the financial sector through regulation, and capital controls, for example. INCREASED CAPITAL REQUIREMENTS have been a continuing thread in the regulation discourse, relying on the mainstream notion of measurable risk of portfolios. There is debate as to the effectiveness of raising banks’ capital ratios. And it should not be forgotten that the recent crisis was fuelled by the strategies the banks had adopted in the face of increased capital requirements – securitisation of loans to get them off the balance sheet, diversion of attention, from lending to business, towards trading in securities and derivatives of various sorts. But what is perhaps most worrying is that blanket applica41


Photo by Icons 8 Team on Unsplash tion of these minimum ratios to different types of financial institutions. In particular savings banks, co-operative banks and credit unions have struggled to meet new regulatory requirements more suited to large banks. And yet they were a notable source of stability throughout the crisis, providing support for the economic activities of their borrowers and depositors. These banks require to be segmented from the rest of the financial system regarding regulation – but also regarding the possibility of fiscal support. IN THE MEANTIME, shadow banking which, by definition, is not covered by regulation, has expanded apace as a major source of credit, consequently increasing systemic risk. The clear implication is that regulation needs to keep up, and continue to keep up, to encompass shadow banking as it evolves. The Financial Stability Board is addressing the monitoring of shadow banking, which is a first step, but regulatory action is urgently required. Such regulation will be challenging, not least given the nimbleness of the financial sector, but that is not an adequate argument for no regulation.


The credit-creating development which has sparked most controversy recently regarding financial regulation is the emergence of digital currencies, or cryptocurrencies (see Weber for an excellent account)13. While different payment vehicles, like credit cards and PayPal, had already offered alternatives to payment by cash or cheque, digital currencies also offer an alternative payments mechanism which is totally detached from 42

the conventional central-bank-centred system. These new currencies are emerging at an accelerating rate as a means also of raising credit. Are digital currencies examples of near moneys which threaten state control over money, and with it state earnings of seignoragei? IN FACT, they barely fulfill the three functions of money. Payment procedures are cumbersome (Bitcoin had to create a new ‘fork’, or spin-off, which would be less cumbersome for payments for goods and services), the value of each currency is highly unstable (even where the supply is fixed), and the unit-of-account function is impeded by the multiple valuations on different sites. Rather these currencies seem to be acting primarily as a vehicle for speculation. The proliferation of currencies, with new coin offerings (around 160 already in the first quarter of 2018) and forking from existing currencies, adds to the range of possible money assets, but also to the uncertainty surrounding their value. Further, these values tend to be correlated, creating a potentially fragile bubble within digital currencies. INTERESTINGLY, there are attempts at pseudo-central bank regulation, such as the limit to Bitcoin supply and the way in which bitFlyer closes client’s positions when they lose half their original margin. But the prospect of i Seigniorage: profit made by a government by issuing currency, especially the difference between the face value of coins and their production costs. (Oxford, 2018) https://en.oxforddictionaries. com/definition/seigniorage


“ currencies also offer an alternative payments mechanism which is totally detached from the conventional central-bank-centred system.

this type of control extending to an ever-expanding array of currencies is hard to imagine, implying the need for regulation. In the meantime, derivatives markets have developed around currencies, exposing the overall structure to even more systemic risk. THE PHILOSOPHY behind the first such currency, Bitcoin, is neo-Austrian. Society would provide its own money, independent of the state, founded on incentivised competition to validate transactions (the core feature of the new, distributed ledger, technology underpinning digital currencies). But the knowledge requirements for participants to value each currency is enormous. This is compounded by the need for individuals to be able to assess in each case the risk of fraud. This would all impose impossible demands on the general public, were digital currencies to be the only form of money.


But what if the state were to issue their own digital currency (see e.g. Engert and Fung 2017)14? There has been detailed analysis by central banks of the merits of the distributed ledger technology used by digital currencies. But it is not clear how great the benefit would be, and indeed digital currencies are already relying on it less. But whether using this technology or not, central banks could establish digital currency accounts for the general public, through which payments would be routed, sidestepping the commercial banks. This idea holds much in common with the Sovereign Money proposal. BUT THE STATE CANNOT ENFORCE a monopoly of money; inevitably other near-money assets would emerge to satisfy the need for a safe asset, including digital currencies, potentially earning a return. (The scope for a negative rate of interest is regarded as one of the attractions of a central bank digital currency.) The demand for such assets would rise when a rise in uncertainty provoked a rise in liquidity preference. If the supply of the central bank currency were restricted, or even just inflexible, it could not address discrete fluctuations in liquidity preference. IF THE IDEA IS to remove credit-creating power from the banks by diverting money holdings to central bank accounts, the scope for financial instability would rise rather than fall. First, the central bank would no longer provide liquidity support in cases of deposit withdrawals, just as for other financial institutions at present.

Bank liabilities would then need to become marketable, such that they would only perform money functions poorly. And that would be the only recourse for increased liquidity preference other than the liabilities of even less regulated institutions offering attractive (yet potentially unsustainable) returns. Second, the demand for credit would also be diverted elsewhere fuelling the growth of shadow banking. The opportunity to direct bank credit to socially-useful investment via new central bank currency would be welcome. But increased attention would need to be paid to the level and composition of credit creation elsewhere. THE ALTERNATIVE Post-Keynesian policy of segmenting retail banking would take account of financial innovation leading to new providers of money assets and creators of credit. The aim therefore is to ensure that the payment and credit functions of banking within any institution are regulated in order to ensure the functionality of the system. Thus, for example, if fintech companies are performing these traditional banking functions, they should be regulated accordingly; their other functions need to be segmented off and made subject to regulation appropriate to those functions.


WE HAVE REVIEWED very different approaches to financial regulation. The three approaches other than the Post-Keynesian approach, all show excessive faith in the capacity of the market to ensure its own stability. Far too much reliance is placed on the price mechanism and the presumed ability to identify true measures of risk. The dominant, New Keynesian, approach sees the economy as inherently stable, but thrown off course by market imperfections. It is natural then to focus regulation on reducing those imperfections. The other two of the three differ primarily over whether money, as a separable asset, should be provided solely by the market, or solely by the state. THE POST-KEYNESIAN VIEW is that each of these approaches is over-simplistic in assuming that conceptual separations used in their theoretical analysis are fully reflected in the real world. They ignore the fundamental interconnectedness between the state and the market, between assets arrayed along a liquidity spectrum and between money, finance and the real economy and society, and ignore the pervasive influence of fundamental uncertainty. 43


POST-KEYNESIAN REGULATORY PROPOSALS have included the reintroduction of the notion of institutional segmentation within the financial sector which was eroded from the 1970s, in particular between retail and investment banking. This would involve a return to the traditional deal between central banks and providers of money assets, whereby the former provides liquidity support to the latter in exchange for observing regulation designed to ensure the stable value of deposits. Rather than focusing on the potential for bank failure, this approach focuses on positive measures to ensure successfully sound banking. For the state to take on a monopoly over the provision of money would instead prevent these newly-stable banks from providing society’s money and the credit to finance real activity. Along these lines, there should also be regulatory segmentation between commercial banks and cooperative banks, given their very different culture and practices. But more generally, concentrating on monetary reform, either in the form of no state money or only state money, distracts from the urgent attention which needs to be paid to regulating the rest of the financial sector. For Post Keynesians, the financial sector is inherently unstable; regulation can never eradicate that instability, but it can moderate it. While the other approaches focus on the high degree of leveraging banks currently enjoy, because their liabilities are money, they fail to address the extent of leverage elsewhere in the system; this leverage is all the more dangerous because of the multiple, opaque, uses made of the same collateral. The answer then is two-fold. First regulation should be addressed at making sure that the financial sector can provide both a safe money asset and credit to finance real investment. Second it needs to be focused on widening the regulatory net to try to moderate the instability building up elsewhere in the system.

1 Dow, S C (1996) ‘Why the Banking System Should be Regulated’, Economic Journal, 104 (436): 698-707 2 Kregel, J and M Tonveronachi (2014) ‘Fundamental Principles of Financial Regulation and Supervision’, FESSUD Working Paper Series, no. 29. 3 Hayek, F A (1975) ‘Full Employment at any Price’, Hobart Paper, 45. London: IEA. (p.42) 4 Dowd, K (2009) Lessons from the Financial Crisis: A Libertarian Perspective. Libertarian Alliance, Online. 5 Calomiris, C W (2017) Reforming Financial Regulation after Dodd-Frank. New York: Manhatten Institute. (p.61) 6 Jackson, A and B Dyson (2012) Modernising Money. London: Positive Money. 7 Dow, S C (2016) ‘The Political Economy of Monetary Reform’, Cambridge Journal of Economics, 40 (5): 1363–76. 8 Fontana, G and M Sawyer (2016) ‘Full reserve banking: more “cranks” than “brave heretics”, Cambridge Journal of Economics, 40 (5): 1333–50. 9 Dow, S C (2017) ‘Central Banking in the 21th Century’, Cambridge Journal of Economics, 41 (6): 1539-57. 10 Minsky, H P (1986) Stabilizing an Unstable Economy. New Haven: Yale University Press. 11 Keynes, J M (1936) The General Theory of Employment, Interest and Money. London: Macmillan. (p.372) 12 Aikman, D, A G Haldane, M Hinterschweiger and S Kapadia (2018) ‘Rethinking financial stability’, Bank of England Staff Working Paper No. 712. 13 Weber, B (2016) ‘Bitcoin and the legitimacy crisis of money’, Cambridge Journal of Economics, 40: 17–41. 14 Engert, W and B Fung (2017) ‘Central Bank Digital Currency: Motivations and Implications’, Bank of Canada Staff Working Paper 2017-16.

SHEILA DOW is Emeritus Professor of Economics at the University of Stirling and Adjunct Professor of Economics, University of Victoria, Canada. She has worked previously as an economist with the Bank of England and the Government of Manitoba and as an advisor on monetary policy to the UK Treasury Select Committee. She has published in the areas of methodology, the history of economic thought, money and banking and regional finance. Recent books include Economic Methodology: An Inquiry (2002), A History of Scottish Economic Thought (2006) and Foundations for New Economic Thinking: a collection of essays (2012)





Towards a theory of

shadow money

Struggles over shadow money today echo 19th century struggles over bank deposits. AUTHORS DANIELA GABOR AND JAKOB VESTERGAARD THIS ARTICLE WAS FIRST PUBLISHED APRIL 2016 AT INETECONOMICS.ORG

MONEY, James Buchan once noted, “is diabolically hard to write about.” It has been described as a promise to pay, a social relation, frozen desire, memory, and fiction. Less daunted, Hyman Minsky was interested by promises of unknown and changing properties. “Shadow” promises would have fascinated him. Indeed, Perry Mehrling, Zoltan Pozsar, and others argue that in shadow banking, money begins where bank deposits end. Their insights are the starting point for the first paper of our Institute for New Economic Thinking project on shadow money. The footprint of shadow money, we argue,* extends well beyond opaque shadow banking, reaching into government bond markets and regulated banks. It radically changes central banking and the state’s relationship to money-issuing institutions. 46

MINSKY FAMOUSLY QUIPPED that everyone can create new money; the problem is to get it accepted as such by others. General acceptability relies on the strength of promises to exchange for proper money, money that settles debts. Banks’ special role in money creation, Victoria Chick reminds us, was sealed by states’ commitment that bank deposits would convert into state money (cash) at par. This social contract of convertibility materialized in bank regulation, lender of last resort, and deposit guarantees. But even money-proper is not the same for everyone. Central banks create the money in which banks pay each other, while private banks create money for households and firms. Money is hierarchical, and moneyness is a question of immediate convertibility without loss of value (at par exchange, on demand).


Using a money hierarchy lens, we define shadow money as repurchase agreements (repos), promises to pay backed by tradable collateral.

USING A MONEY HIERARCHY LENS, we define shadow money as repurchase agreements (repos), promises to pay backed by tradable collateral. It is the presence of collateral that confers shadow money its distinctiveness. Our approach advances the debate in several ways. FIRST, IT ALLOWS US to establish a clear picture of modern money hierarchies. Repos are nearest to moneyproper, stronger in their moneyness claims than other short-term shadow liabilities. Repos rose in money hierarchies as finance sidestepped the state, developing its own convertibility rules over the past 20 years. To convert shadow money into settlement money in case of default, repo lenders sell collateral. An intricate collateral valuation regime, consisting of haircuts, mark-to-market, and margin calls, maintains collateral’s exchange rate into (central) bank money. SECOND, we put banks at the center of shadow-money creation. The growing shadow-money literature, however original in its insights, downplays banks’ activities in the shadows because its empirical terrain is U.S. shadow banking with its institutional peculiarities. There, hedge funds issue shadow money to institutional cash pools via the balance sheet of securities dealers. In Europe or China, it’s also banks issuing shadow money to other banks to fund capital market activities. LCH Clearnet SA, a pure shadow bank, offers a glimpse into this world. Like a bank, it backs money issuance with central bank (Banque de France) money. Unlike a bank, LCH Clearnet only issues shadow money. THIRD, we explore the critical role of the state beyond simple guarantor of convertibility. Like bank money, shadow money relies on sovereign structures of authority and credit worthiness. Shadow money is mostly issued against government bond collateral, because liquid securities make repo convertibility easier and cheaper. The legal right to re-use (re-hypothecate) collateral allows various (shadow) banks to issue shadow money against the same government bond, which becomes akin to a base asset with “velocity.” Limits to velocity place demands on the state to issue debt, not because it needs cash but because shadow money issuers need collateral. WITH FINANCE MINISTRIES unresponsive to such demands, we note two points in the historical development of shadow money in the early 2000s. In the United

States, persuasive lobbying exploited concerns that U.S. Treasury debt would fall to dangerously low levels to relax regulation on repos collateralized with asset and mortgage-backed securities. In Europe, the ECB used the mechanics of monetary policy implementation to the same end. When it lent reserves to banks via repos, the ECB used its collateral valuation practices to generate base-asset privileges for “periphery” government bonds, treating these as perfect substitutes for German government bonds, with the explicit intention of powering market liquidity. FOURTH, we introduce fundamental uncertainty in modern money creation. What makes repos money - at par exchange between “cash” and collateral – is what makes finance more fragile in a Minskyan sense. Knightian uncertainty bites harder and faster because convertibility depends on collateral-market liquidity. THE COLLATERAL VALUATION regime that makes repos increasingly acceptable ties securities-market liquidity into appetite for leverage. Here, Keynes’ concerns with the social benefits of private liquidity become relevant. Keynes voiced strong doubts about the idea of “the more liquidity the better” in stock markets (concerns now routinely voiced by central banks for securities markets). Liquid markets become more fragile, he argued, by giving investors the “illusion” that they can exit before prices turn against them. This is a crucial insight for crises of shadow money. A PROMISE backed by tradable collateral remains acceptable as long as lenders trust that collateral can be converted into settlement money at the agreed exchange rate. The need for liquidity may become systemic once collateral falls in market value, as repo issuers must provide additional collateral or cash to maintain at par. If forced to sell assets, collateral prices sink lower, creating a liquidity spiral. Converting shadow money is akin to climbing a ladder that is gradually sinking: The faster one climbs, the more it sinks. NOTE THAT SOVEREIGN COLLATERAL does not always stop the sinking, outside the liquid world of U.S. Treasuries. Rather, states can be dragged down with their shadow-money issuing institutions. As Bank of England showed, when LCH Clearnet tightened the terms on which it would hold shadow money backed with Irish 47


The bigger task that follows from our analysis, is to define the social contract between the three key institutions involved in shadow money: the state (..), the central bank, and private finance.

and Portuguese sovereign collateral, it made the sovereign debt crisis worse. Europe had its crisis of shadow money, less visible than the Lehman Brothers demise, but no less painful. “Whatever it takes” was a promise to save the “shadow” euro with a credible commitment to support sovereign collateral values. SHADOW MONEY also constrains the macroeconomic policy options available to the state. That’s because what makes shadow liabilities money also greatly complicates its stabilization: it requires a radical re-think of many powerful ideas about money and central banking. The first point, persuasively made by Perry Mehrling, and more recently by Bank of England, is that central banks need a (well-designed) framework to backstop markets, not only institutions. Collateralized debt relationships can withstand a systemic need for liquidity if holders of shadow money are confident that collateral values will not drop sharply, forcing margin calls and fire sales. Yet such overt interventions raise serious moral hazard issues. LESS WELL UNDERSTOOD is that central banks need to rethink lender of last resort. Their collateral framework can perversely destabilize shadow money. Central banks cannot mitigate convertibility risk for shadow money when they use the same fragile convertibility practices. Rather, central banks should lend unsecured or without seeking to preserve collateral parity.

WE SUGGEST that the state, as base-asset issuer, becomes a de facto shadow central bank. Its fiscal policy stance and debt management matter for the pace of (shadow) credit expansion and for financial stability. Yet, unlike the central bank, the state has no means to stabilize shadow money or protect itself from its fragility. It has to rely on its central bank, caught in turn between independence and shadow money (in)stability, which may require direct interventions in government bond markets. THE BIGGER TASK that follows from our analysis, is to define the social contract between the three key institutions involved in shadow money: the state as base collateral issuer, the central bank, and private finance. In the new FSB or Basel III provisions, we are witnessing a struggle over shadow money with many echoes from the long struggle over bank money. The more radical options, such as disentangling sovereign collateral from shadow money, were never contemplated in regulatory circles. Even a partial disentanglement has proven difficult because states depend on repo markets to support liquidity in government bond markets. Our next step, then, will be to map how the crisis has altered the contours of the state’s relation to the shadow money supply, comparing the cases of the U.S., the Eurozone, and China.

DANIELA GABOR is associate professor in economics at UWE Bristol. She holds a PhD in banking and finance from the University of Stirling (2009). Since then, she has published on central banking in crisis, on the governance of global banks and the IMF, and on shadow banking and repo markets. Her latest publication is a co-edited book with Charles Goodhart, Jakob Vestegaard, and Ismail Erturk entitled Central Banking at a Crossroads (Anthem Press, 2014). She blogs at and Helicopter Money.



Thinking like an


A reflection from an economics student and attendee of the Rethinking Finance Conference in Oslo. What the public and many students consider constitutes an economics education covers, is rather far from the reality. AUTHOR BENEDIKT GOODMAN What is the economy? What is money? Who creates ‘money’ and how? What are the interlinks and dynamics between business, citizens, government and regulators? What are the implications of debt? What is the relationship between governments, central banks and banks? How does money and capital flow within the banking and financial industry? What is the relevance of the finance industry? THESE ARE CORE QUESTIONS that many students want answered when enrolling in the study of economics. It seems natural that such questions are a core part of an education that claims to make you an expert on ‘the economy’. And yes, once you start the first year there might be some interesting questions posed in the introductory lectures. In many of the courses offered in the first semester, it seems as though ‘economics’ is actually the study of the economy, and you get some time to explore parts of the institutions and mechanisms that currently shape the world around us.

BUT BY THE TIME you reach the second semester, something changes. The institutions that shape our economy, and the discussions about «how things actually work», take a backseat to rational agents, optimisation puzzles and the operation of linear economic models. From here on, most courses in economics are merely subsequent presentations of the neoclassical reductive methodi. The real world is put aside in order to focus on complicated idealised models and imaginary markets. «Thinking like an economist» they call it. AS AN ECONOMICS STUDENT, I am worried that I do not learn about some of the most important and complex characteristics of the international economy. I also find that professors that teach macroeconomics in my faculty are not sufficiently informed about the implications of global finance (debt, money and banking) as it works today and the consequences of the increasing share of the financial economy relative to

the ‘real economy’. I ALSO WORRY, that we are sometimes taught things that are empirically incorrect. A good example is how we are told in macroeconomics that banks are only intermediaries of money, turning savings into investments, and that only the central bank can create money. It took an external lecturer, in what is an elective class to many students, to teach us about endogenous money supply. Nonetheless, for the rest of the course we were still going back to models where investments require prior savings. Thus, most students who take classes in macroeconomics will take away a misunderstood impression of how an integral part of the economy works. HOWEVER, the rest of society expects this sort of knowledge - about money flows and money creation - to be a key area of expertise for economists. When people figure out that the emperor is nearly naked it 49


Illustration by Knut Løvås (first published in Klassekampen)



The real world is put aside in order to focus on complicated idealised models and imaginary markets. ‘Thinking like an economist’ they call it.

creates a problem for the entire discipline. An infamous example could be found in «The Queen’s question» to the economists at LSE during the 2008 crisis. CONFERENCES like Rethinking Finance have a role to play, addressing the topics not taught in the core education of economics. By providing a platform for conversations about the real-world economy we are providing crucial knowledge for future economists. How money is created, how the financial and banking sectors are regulated, and the challenges posed in the blurry area of shadow banking, are all important questions to answer, in order to understand contemporary economic issues.

IN THE YEARS running up to the 2008 crash, most mainstream economists relied fully upon the neoclassical reductionist equilibrium models to ‘understand’ what was going on. Models that do not serve any tangible explanation of financial instability. If they had been exposed to frameworks and theories outside the neoclassical box, for example Minsky’s financial instability hypothesis, they would have had more tools to better predict and explain the course of events that took place.

dominant view in economics through a bottom-up approach at economics departments world-wide, and tries to change what it means to think like an economist. With a bit of luck, and a lot of hard work, the hope is that a diversity of ideas and perspectives will be included in the core economics curriculum, making the discipline a better servant to society as a whole. i Reductive reasoning stems from latin, Reductio ad absurdum. The litteral translation is “reduction to absurdity”

EXPOSURE TO IDEAS currently omitted from the curriculum could be vital for the economist of the 21st century. Student initiatives like Rethinking Economics challenges the

BENEDIKT GOODMAN is the coordinator of Rethinking Economics NMBU and part of the team who organised this conference. He is currently studying a BA in Economics at NMBU, and a very active advocate for student democracy, with a particular interest in changing in the economics curriculum at NMBU, Norwegian University of Life Sciences


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