Morgan Ricks’s Money Problem is unusual in that it presents the creation of money by banks in simple but detailed terms that should be easily understood by the general public while at the same time presenting a novel perspective and recommendations that will challenge professional economists. While I do not agree with all of his conclusions, Ricks explores all of the main alternatives and critics of his proposal in a straightforward, illuminating and readable fashion.
Ricks’s central proposition is that the primary risk to financial and macroeconomic stability comes from financial panics, by which he means the equivalent of runs on banks. Bank runs reflected the rush by depositors to withdraw their funds before their bank ran out of cash, thus forcing the bank to sell its assets under fire sale conditions. Financial panics in the form of bank runs were eliminated by deposit insurance established in 1933 (Federal Deposit Insurance Corporation) but the equivalent potential now exists in the shadow-banking sector financed by “money equivalent,” short-term debt. This was what the U.S. experienced following the bankruptcy of Lehman Brothers in September 2008 when non-bank financial institutions that relied on rolling over short-term debt for their financial stability faced the inability to retain such financing.
“Ben Bernanke expresses a similar point in a slightly different way. In his analysis of the recent crisis, Bernanke distinguishes between what he calls “triggers” and “vulnerabilities.” The triggers of the crisis consisted of developments in the U.S. housing and mortgage markets. (“Some Reflections on the Crisis and the Policy Response,” remarks at the Russell Sage Foundation and the Century Foundation Conference on Rethinking Finance, New York, April 13, 2012.) Bernanke argues that these triggers alone can’t explain the magnitude of the accompanying economic downturn…. “Any theory of the crisis that ties its magnitude to the size of the housing bust,” he says, “must also explain why the fall of dot-com stock prices just a few years earlier, which destroyed as much or more paper wealth—more than $8 trillion—resulted in a relatively short and mild recession and no major financial instability…. One of the biggest vulnerabilities, he contends, was the financial sector’s heavy reliance on ‘short-term wholesale funding.”
Ricks’s argument for the importance of panics (runs) as a source of serious recessions is convincing, but his demotion of the importance of debt crisis and asset bubble bursts is less so. He does not deny, however, that these and other factors might also be important in explaining the particular responses of economies to individual financial shocks and reviews such competing theories as Austrian Business Cycle Theory, Keynesian Aggregate Demand Theory, Neoclassical real shocks Theory, Market Monetarism, and Debt Cycle Theories.
Ricks proposes to extend deposit guarantees to all bank deposits, including time and savings deposits, without limits, as well as to all bank liabilities of less than one-year maturity in order to eliminate the basis for runs. The government would charge for this guarantee with the equivalent of risk based insurance premiums to minimize the risks of moral hazard (excessive risk taking by banks when their source of funding is guaranteed). Nonbanks (the existing shadow banking sector) would not be allowed to issue money or cash equivalent liabilities (deposits or short-term debt). Thus the incentive for depositors and short-term lenders to withdraw funding if their bank’s soundness came into question (bank runs) would be eliminated.
Ricks builds his proposal around an unusual way of viewing the process of creating money. Fractional reserve banking, by which banks hold loans and other assets against depos its with the bank (plus a modest balance of cash reserves with the central bank), allows most of what we treat as money to be created by banks rather than by the central bank. This “public private partnership” allows money to be created against a much broader range of assets than would be appropriate or easy for the central bank on its own.
Central banks generally create money by purchasing government debt in the market. But the stock of such debt may not be sufficient for creating the amount of money demanded by the public. If the central bank were forced to buy privately issued debt or even to extend loans to private companies or individuals, it would face several daunting challenges. It would need to develop the capacity to evaluate the credit worthiness of such borrowers and would need to put in place credible safeguards against abuse in the form of favoritism toward one borrower over another. The practice in some countries of central banks lending to state-owned companies (often through state owned development banks) has not generally ended well. By allowing banks to create money, the range of counterpart assets can be greatly expanded by subcontracting to commercial banks the development of credit evaluation capacity and competitively provided loans. Banks lend money by creating deposit balances for the borrower.
Viewed in this way, the design of bank and financial sector regulations should be motivated by the goal of providing the supply of money (deposits and short-term debt) needed by the economy in such a way that banks are run-proof but without creating the moral hazard of excessive risk taking that such guarantees normally create. Following Milton Friedman and others, Ricks convincingly argues that the “moneyness” of short-term debt (he chooses a cut-off of one year) justifies including it in the definition of the broad money aggregate targeted by the central bank.
Ricks “defines banking as the business model under which portfolios of financial assets (typically credit assets) are funded largely with short-term debt that is rolled over continuously.” He maintains that while pruential portfolio regulations would still be needed for banks, nonbanks would no longer need regulation of their risk taking other than “requiring all entities that are not member banks to finance their operations in the capital markets and not the money markets.” He argues, “that once the monetary-financial system has been made panic-proof, other forms of stability-oriented financial regulations could be dramatically scaled back.” The aggregate amount of “broad” money that could be issued by the banking system would reflect monetary policy decisions and would be enforced by the use of tradeable entitlements to issue deposits and short-term debt in a cap and trade system.
Traditionally the potential but temporary illiquidity of a bank with fractional reserves was address by the central bank’s role as a “lender of last resort.” This was the primary purpose for establishing the Federal Reserve System in the U.S. in 1913. And bank soundness was “assured” by imposing capital and asset quality and concentration regulations, in conjunction with the provision of deposit insurance. Ricks argues that these subsidize and do not fully overcome the distortion to risk pricing and thus risk taking avoided by his risk-based fees levied in exchange for a full government guarantee of all bank monetary liabilities. This is at least debatable.
Ricks also argues that regulatory structures that rely on investor (depositor) regulation of bank risk taking are misplaced (e.g., limiting deposit insurance coverage to modest amounts). Bank depositors and short-term lenders, he argues, do not invest much if anything in evaluating the soundness of their counterparts (banks) and thus do not provide effective market discipline of bank risk taking. They trust their bank until they don’t, at which point they run. The best indicator that their bank is no longer sound is when others lose confidence in it and start withdrawing their funds.
Ricks’s commercial banks exist to broaden the assets against which money is created. He defends his proposals against others that would also make banks run-proof while reducing or eliminating many of the regulations currently in place. For most narrow banking proposals, especially the Chicago Plan of 100 percent reserves, all assets acquired in creating money are held by the central bank. See for example my: “Changing direction on bank regulation” Cayman Financial Review, April 2015. In the Chicago Plan, commercial banks exist to outsource the management of the payment system (the transfers of deposit balances between deposit holders). Government regulation, beyond the 100 percent reserves, would be almost nonexistent. Ricks rejects this approach (as well as large increases in required capital) on the grounds that the market might not contain sufficient assets appropriate for purchase by the central bank to provide for its money growth target. However, this problem is avoided by limited monetary financing of government spending as discussed in my “A modest proposal: Helicopter money and pension reform,” Cayman Financial Review, May 2016 . Moreover, the appropriate (optimal) growth in the nominal money supply depends on the desired and targeted rate of inflation. Milton Friedman argued that the optimal rate of inflation was the modest deflation likely to result from keeping nominal M2 constant (real M2 would grow at the rate of deflation).
This book is well written and thought provoking but not always right, in my view. That does not keep it from providing a solid basis for a serious discussion of better monetary arrangements and the regulations appropriate to them.