A money view of SDRs In a market economy, when you need something, you go out and buy it. Liquidity is no different, in that respect at least. If it is market liquidity that you need, you go to a dealer, who stands ready to buy what you are selling. You pay for the convenience, though—the dealer is getting more for the same asset than you are. If it is funding liquidity that you need, you go to your bank, who stands ready to lend. You pay for the convenience, though—the bank is paying less for its funds than you are. Stick with funding liquidity for a moment. A bank is well suited to provide such liquidity, since a bank's liabilities are money, and it can create them at will. If the need for funding liquidity is systemic, the bank that can provide it must be the one whose liabilities are interbank money—the central bank. And if the need for liquidity is international? The country that issues the world's reserve money can create more of it, and that might be enough to stave off the crisis. Might some other asset do the job? The eurozone crisis has sparked fears of a global need for liquidity. Domenico Lombardi and Sarah Puritz Milsom propose that a new allocation of special drawing rights could increase eurozone countries' ability to backstop the peripheral sovereign debt that still constrains their banks' ability to raise funds. Do SDRs provide international liquidity? Can the IMF serve as a bank, creating more money to meet the world's need for liquidity? The SDR is a reserve asset, in fact a reserve asset only for the top of hierarchy of money, as they can be held only by central banks. The SDR is opaquely defined as "a potential claim on the freely usable currencies of the IMF member countries". This linguistic muddle reflects the bureaucratic muddle that surrounded the SDR's creation. "Paper gold" or credit money, went the debate, and in the end the SDR is neither. Gold—outside money—is distinguished by its aggregate stock's independence of short-term liquidity needs. Credit—inside money—is highly responsive to short-term liquidity needs arising from ordinary banking business. The SDR, for its part, is created with the consent of 85% of the votes of IMF members, so it has neither the indifference of gold nor the responsiveness of credit. In that they are a purely financial concoction, SDRs are arguably more like credit than they are like gold. But credit money is a claim on the issuer, and SDRs are carefully described as potential claims, and not claims on the IMF, but rather claims on the "freely usable currencies of the IMF member countries". In practice, this means that the IMF acts as a broker in the market for SDRs, matching buyers and sellers. But it does not—can not—act as a dealer by buying and selling on its own account. What happens, then, when a seller cannot be matched with a buyer? The IMF can, in theory, assign the transaction to a member central bank, who would be obligated to provide national currency for the SDRs. This is in sharp distinction to a bank, which must allow its own balance sheet to fluctuate in size in the handling of payments. SDRs could back the extension of guarantees of eurozone sovereign debt to European banks. But the eurozone's funding needs are surely in the hundreds of billions of euros, if not into the trillions. If those guarantees were called upon, it would be euros, not SDRs, that would have to be paid to make whole the private holders of sovereign debt. The SDRs would have to be sold. The IMF would be powerless to assign them in sufficient size to generate the needed euros. The IMF, this is to say, is no bank. Because it cannot, in practice, make liquid the market for SDRs, a new allocation would turn a funding liquidity crisis on the part of European banks into a market liquidity crisis on the part of central banks. Rather than eurozone banks being unable to borrow, the Eurosystem would have no way to sell a trillion euros' worth of SDRs. Such a crisis unlikely to come about, I hasten to add. Market participants and central bankers will look through the proposal and see that it creates no new liquidity.
From a money view perspective, the central issue is settlement of TARGET balances between national central banks within the Eurozone, and the key is to understand TARGET balances as a kind of interbank correspondent balance. What I want to suggest is that the ECB's Long Term Refinance Operation can help settle the troublesome TARGET balance overhang. From time immemorial, banks have used correspondent balances as a way of economizing on reserve holding, as well as on the cost of reserve transfers. Suppose that, over the course of a year, the payments between Bank A and Bank B net out. Then there is no need for daily transfer of scarce reserves; daily net flow can simply be added to or subtracted from the outstanding correspondent balance. Fundamentally, that is what TARGET balances between National Central Banks are all about. Sinn and Wollmershaeuser, in their recent paper glossed by Martin Wolf here, express concern that TARGET balances are not being used as correspondent balances but rather as a political tool, to fund capital transfers within the Eurozone. And they call for Europe to adopt the U.S. rules for running a monetary union (p. 29), most importantly the U.S. practice of periodic settlement of outstanding balances. The chart below shows how those rules have played out in the U.S., both in normal times and during crisis. Before the financial crisis of 2007, interdistrict balances were small, and were settled annually in April by transfer of assets from deficit districts to surplus districts. During the crisis, however, interdistrict balances were much larger (almost as large as the TARGET balances), and April settlement did not eliminate the balances. Why not? According to U.S. rules, district banks need only settle the average balance over the last year, not the full amount outstanding at the moment of settlement. (You can see the April 2010 jump clearly.) By contrast, here is Sinn and Wollmershaeuser's chart of the TARGET balances from their paper (Figure 2): What I want to suggest now is that the ECB Long Term Refinancing Operation has the effect of providing deficit National Central Banks with assets that they can use to settle TARGET balances over time, so that the future TARGET chart for Europe can look more like the current interdistrict chart for the U.S. To make all this clear, it will help to remind ourselves how correspondent balances work. For concreteness, suppose that over the first half of the year the flow of net payments is from Bank A to Bank B, eventually totalling 100, while over the second half of the year the flow of net payments is the other way, also eventually totalling 100. That means that Bank A is, on average, borrowing 50 from Bank B. It follows that symmetry in the payments system, and hence minimum total credit exposure, can be achieved by Bank A transferring to Bank B an asset worth 50, accepting as payment a deposit at Bank B. (If Bank A and Bank B were not equally creditworthy, that fact could be reflected by an initial asset transfer of either more or less than 50.) That eliminates the average borrowing, and opens the door for pure correspondent banking. At the start of the year, A has a deposit at B worth 50. Over the first few months, A settles net payments by drawing down that deposit, hitting zero at 3 months and then going into overdraft. By mid-year, A has a liability to B worth 50. But then the net flow of payments reverses, and by end-year A has a deposit of 50 again. Each Bank spends half the year in debt to the other, with maximal exposure of 50. That's the theory but in practice, of course, no one knows in advance what the average over the next year will be. The Fed's way of handling that uncertainty is to adjust the amount of the asset transfer based on the average borrowing over the last year. Banks that have been in surplus exactly as much as they have been in deficit pay nothing at the settlement, even if they are currently in deficit. But Banks that have been in deficit on average have to settle the average deficit over the last year, which might be more and might be less than current deficit. When a deficit bank settles, its balance sheet shrinks by the amount of the settlement--both assets and liabilities shrink, as it uses an asset to pay off a liability. When a surplus bank settles, its balance sheet stays the same--it just swaps a settlement account asset for some other acceptable financial asset. The problem facing the Eurosystem of Central Banks is ultimately a problem of whether the deficit central banks have acceptable assets with which to settle their TARGET liabilities. My point is simply that the LTROs, or at least some of them, can serve such purpose, if not immediately then over time. And there are 489 billion Euro of LTROs, with more to come, a number quite comparable to the 450 billion Euro German balance that worries Sinn and Wollmershaeuser. The market has responded favorably to the first round LTROs, with most commenters seeing LTRO as a kind of backdoor QE, providing a profitable carry trade for banks which buy sovereign debt with cheap ECB funds. Be that as it may, a money view perspective puts primary emphasis instead on the "survival constraint", i.e. the requirement to settle net payments at the clearing. As the crisis unfolded, the buildup of TARGET balances between national central banks was the mechanism that allowed private banks to meet their own survival constraints. But ultimately NCBs are also banks, and as such face their own survival constraints. As the crisis proceeded, balances built up and the NCB survival constraints became more and more binding. What the LTROs do is to provide a way to settle some of those balances, so relaxing the survival constraint for a bit. We haven't seen much actual settlement yet, although TARGET balances at the Bundesbank were down by 32 billion Euro in December. But the important thing for financial markets is of course much more the prospect of future settlement than the actual fact of current settlement. And that prospect looks a lot more rosy today than it did a month ago. Maybe the market sees what Money View sees?
The title is the same as that of Maury Obstfeld's Ely Lecture, delivered Jan 6 at the AEA meetings in Chicago. Yours truly was at the meetings mainly to deliver a paper on "Three Principles for Market-Based Credit Regulation", about which more in a later post. And for most of the rest of the time I was locked in a hotel room interviewing candidates for an assistant professor slot at Barnard College (which gave me a good overview of the current state of macroeconomics, again fodder for a later post). But I did manage to get to the Ely Lecture, and boy am I glad that I did. The text for the lecture is not on-line yet, so I am writing from memory and some sketchy notes, caveat emptor. [UPDATE: Obstfeld sent me a copy of a Dec 2011 lecture which is along the same lines as his Ely lecture, and more emphatic about the importance of gross positions.] The empirical context of the lecture was financial globalization. The question was whether financial flows are now so efficient that the current account between countries is of no more importance than the current account between states within a country (which we don't even measure). Obstfeld's answer, "No", implies that the current account still matters. But why does it matter? Obstfeld makes a big point that the current account represents an intertemporal trade, where the deficit country obtains current tradeable goods in trade for future tradeable goods. Borrowing from the future in this way may be perfectly fine, but it may also be an "important indicator of potential macro and financial stresses". The stress he has in mind comes from the fact that, at some future point, the deficit country is going to have to come up with the promised tradeable goods, which means running a current account surplus. So far so orthodox, you say, and I agree. What made the lecture worthy of notice is the very large amount of attention paid, in the pages between the setup and the payoff, to the gross flows, of both goods and financial assets, that lie behind the net flow measured in the current account. Obstfeld seems to be moving in the direction of the Money View, but not yet all the way. Just so, consider his distinction between "intratemporal" and "intertemporal" trade. He emphasizes that most of the gross trade of goods is intratemporal, which is to say the outflow of one kind of current good and the inflow of another kind of current good. Only the net flow is intertemporal, the inflow of current goods against the promise of future outflow, and that is the potential indicator of stress. Shifting attention to the capital account, he makes the same distinction between gross financial flows ("intratemporal") and net financial flows ("intertemporal"). Again, the net flow is the main potential indicator of stress, but now maybe not the only one. A good part of the talk was concerned with the cumulative gross flow and the possibility that valuation changes in net asset balances could be a source of fragility. Such valuation changes are, Obstfeld emphasized, quite large, often swamping the net flow. Indeed one of the reasons that the U.S. has been able to continue running large current account deficits is that valuation changes have been large and in the opposite direction. In effect the US has been borrowing without incurring debt--nice work if you can get it! The worry is apparently that valuation changes might possibly move in the same direction as the net flow, but empirically valuation changes seem mostly to be transitory. Conclusion, valuation changes of gross positions can pose temporary problems, and also temporary solutions (as in the US), but in the long run the action is in net flows. Good stuff, but here is my money view quibble, maybe more than a quibble. First, intertemporal trade arises not only from net flows, but also from gross flows. The United States, viewed as a bank (following Kindleberger), borrows short and lends long. Even if net borrowing were zero (so no intertemporal exposure according to Obstfeld), this maturity mismatch creates a potential vulnerability. We are promising near-future goods to our creditors, while accepting promises for distant-future goods from our debtors. Gross flows involve intertemporal trade just as much, and maybe more (given volume) than net flows. [BTW, the same could be said about gross flows of goods, as for example when outflow of current services is matched with inflow of long-lived capital goods.] Second, the money view would go even further. The vulnerability is perhaps not so much about intertemporal mismatch as it is about liquidity exposure. The balance sheet of a bank like the U.S. involves systematic exposure to a "survival constraint". If creditors all demand their money at the same time, the reserve outflow can become impossible to sustain--that's a bank run. The point is that creditors don't want current goods, they want money. The current reserve status of the dollar may hide this fact, but it remains behind the scenes in the gross balance sheet exposures. At one level, neither of these points change the answer to the question of Obstfeld's title. The current account does still matter. But other things matter too, and maybe more. A current account deficit is neither a sufficient nor a necessary condition for vulnerability. In the brave new world of financial globalization, gross flows also matter, and so do gross stocks (liabilities and assets both). Indeed, in the short run where we all live, gross flows and gross stocks may well sometimes be all that matters.
When I started this blog, almost exactly one year ago today, my thought was to provide commentary on the financial events of the day, using the Financial Times as my primary source of information about those events. I felt, as Mr Skinner writes in his letter today, that the public does not know much about banking. He recommends starting from the text "Where Does Money Come From?", which seems to me fine advice. But the hard thing, as always, is applying such textbook knowledge to the real world events of the day; that's what I was determined to do in the blog. I started from a distinct point of view, what I call the "money view", that I had distilled from my reading of past economic thinkers--especially Minsky, Copeland, Hawtrey, and (late) Hicks. But I was also keenly aware that their thinking was for their own times, and that new thinking would be needed for the new world of today. (Modern finance was the most obvious lacuna.) The challenge I posed myself was to attempt such new thinking, in real time and in public, using the blog. The money view is certainly not a majority perspective, and never has been, at least among academics. (Practitioners, especially central bank practitioners, are another story; think Goodhart and Borio, for example.) But neither is the money view necessarily heterodox, at least as heterodoxy is catalogued by the Economist: neo-chartalist, market monetarist, and Austrian. All banking is a swap of IOUs, so the neo-chartalists are correct to remind us that all the Fed can do is swap assets. (The Fed is, after all, a bank.) It does not follow, however, that such swaps have no real effects. When a bank swaps its IOU with me, the bank gets an illiquid asset and I get purchasing power that I didn't have before. The same goes for the Fed, when it swaps its own IOUs with banks. Base money--a liability of the Fed--is better money than bank money (M1) or shadow bank money, so the market monetarists are certainly correct to remind us that Fed swaps have real effects. It does not follow, however, that sufficient swapping can stabilize nominal GDP. The quantity equation is an identity, and neither velocity nor the money multiplier is necessarily a constant (nor even a stable function). In a capital-using economy, illiquidity is a fact of life, so the Austrians are correct to remind us of the limits of central bank legerdemain. It does not follow, however, that there is nothing to fear from private bank legerdemain. What Hawtrey called the inherent instability of credit (and Minsky formulated as the Financial Instability Hypothesis) can certainly be exacerbated by unwise central bank policy, but central banks are also bankers' banks, not just instruments of state power. The real institutional alternative to the Fed is not some idealized world of free banking but rather private central banking, i.e. J.P. Morgan. Notwithstanding these critical comments, it is important to emphasize that each of these heterodox schools exist, and persist, because it is organized around some essentially correct insight about how the banking system works. Further, the reason the Economist is writing about them is not the internet, but rather the ongoing financial crisis. The internet is just a technology that makes these insights more easily available. The public does not know much about banking, but not until the crisis did the public realize that their ignorance was potentially life-threatening. The problem is that, so far as I can see, each of the heterodox schools has part of the truth, not the whole thing. The same could be said about the orthodoxy against which the heterodox schools define themselves (and of course also about the money view itself). We don't therefore want to choose which school to belong to; rather we want to determine which of these correct insights provides the most useful explanatory frame for whatever issue is currently at hand. Today it might be one; tomorrow it might be another. That is what the debate is about, or should be anyway. Thinking in real time and in public about the financial events of the day has absorbed a lot more of the past year than I thought it would. Looking back, I find that it was worth it. I know more today than I did a year ago; that's what matters.