Tuesday, December 24, 2013

How Important Is Shadow Banking?

During the great Williamson internet debate on purportedly deflationary quantitative easing, Nick Rowe mentioned in passing that he didn't understand Izabella Kaminska.   Scott Sumner wrote a post about how macroeconomists have views so different that they are in effect speaking different languages.   He linked to Nick's remark, using Kaminska as an example of someone doing macro that he doesn't understand.  

How was Kaminska relevant?   She has also argued that quantitative easing is deflationary, though not for the same reasons as Williamson.   It rather has to do with the Fed purchasing safe collateral, which interferes with the operation of the shadow banking system.   

Market Monetarists frame quantitative easing as a means of increasing the growth path of nominal GDP.     I think it is fair to say that all Market Monetarists believe that the level of nominal GDP could reach any target without there being a shadow banking system.   And further, that the real economy could survive without a shadow bank system.

On the other hand, I suspect there is more controversy as to whether the shadow banking system adds any value.   I, at least, suspect that it is at best a work around various undesirable banking regulations.   An appropriate deregulation of banking would result in the end of shadow banking and an enhancement of social welfare.  At worst, shadow banking is a net loss to the economy.

Of course, there are many people whose private interests are closely tied to shadow banking.   Kaminska covers them, and I think she may be too influenced by their special pleading.

Still, I think there is a fundamental intellectual error, very common among noneconomists.    It is the distinction between the nominal and the real.    A high level of nominal GDP (or price level) may imply a large nominal credit sector, but is  quite consistent with a small real credit sector.    Failure to make this distinction is sometimes called the money illusion.  That is the significance of Scott Sumner's claim that Zimbabwe proves that it is always possible for a central bank to generate inflation.   More to the point, it is always possible for a central bank to generate a higher level of nominal GDP.   Having a shadow banking system operating as it did in 2006 might be necessary for a full recovery of the real incomes of shadow bankers, but it is not necessary to return nominal GDP to the growth path of the Great Moderation.

Suppose all payments were made with sacks of gold coins.   The nominal interest rate on the coins is zero (and there are heavy storage costs.)   The government has a national debt and funds part of it with treasury bills.    Financial firms and other large businesses begin to hold treasury bills rather than sacks of gold.   The bills coming due every week or so provide extra cash receipts to cover needed expenditures.  

From the point of view of the firms holding the bills, they are saving a bit on their storage costs.   They earn interest on the T-bills rather than nothing on the sacks of gold.   Assuming the government has a modest national debt and is fiscally responsible, there is little credit risk.   And since the bills are claims to gold, the real risk is approximately the same as holding the sacks of gold.

From the point of view of society, the reduction in the demand for gold results in a slightly higher price level and some transitional inflation.   Some resources that would have been used to mine gold instead produce other consumer and capital goods.   And some of the gold that made up the coins now provides services in circuitry, dentistry, and as lovely jewelry.  

The government  will also benefit by funding the national debt at a slightly lower interest rate.   This will allow for slightly more government services or, better yet, lower taxes.   Since all plausible taxes distort, this further enhances welfare.

Private and social benefits.     Of course, those who are unable to economize on their cash balances suffer a capital loss due to the transitory inflation.   It isn't all benefit and no cost.

The benefits of using Treasury bills as a substitute for money is greatly enhanced by the development of a secondary market.   Rather than only purchasing new issues and waiting until the bills mature, cash balances can be used to purchase the T-bills and when cash is needed, the T-bills can be sold.   Of course, each firm using this technique bears transactions costs--they hire traders who are soon picking maturities and even buying and selling to try to profit from slight moves in the prices of the T-bills.   There is a bid-ask spread, which represents the transactions costs for those making the market.    These costs are traded off against the cost of storing the gold coins and the opportunity cost of the interest foregone.

But the private benefits and the social benefits are at least loosely aligned.

Suppose that a sudden massive loss in trust in the market makers causes the use of Treasury bills as money substitute to be much less attractive.    The traders on the secondary market would face disaster.     Instead of constant transactions as payments are received and then used to purchase T-bills and then sales of T-bills to fund purchases, there would be little activity.   The market makers would obviously suffer.  Some of those who had been managing their employers cash balances could even be laid off!

However, there would also be adverse macroeconomic consequences.   The demand for gold coins would expand.  If wages, and perhaps other prices, were sticky, then the increase in the demand for gold coins would result in lower output and employment.   And while a sufficiently lower price level would result in an adequate real quantity of gold coins, the increase in the real burden of private debt would be disruptive.   This would include a higher real government debt.  Not only must the government fund a higher real debt, it must do so without being able to sell T-bills as a substitute for money.  This would require a reduction in the provision of government services or higher distortionary taxes.

The private disaster faced by those trading the T-bills would be matched by a social disaster.   What can be done to recover confidence in the traders, allow them regain their livelihoods, and at the same time, allow aggregate demand and real output to recover?   The recovery of prices would alleviate the pressure on private debtors as well as reverse the increase in real government debt.

Leaving aside the gold, the trading off of interest and transactions costs was worked out by Tobin years ago.   Something that all monetary economists learn early on.

Now, suppose that rather than sacks of gold coins, government-issued paper currency is used as money.   Because a variety of denominations can be issued, including very large denominations, storage costs are insignificant.  Instead, it is simply a matter of trading off transactions costs and interest.   Otherwise, the logic of holding T-bills rather than paper currency is little different from sacks of gold coins from the private perspective.  

But the social point of view is much different.   The paper money is cheap to print and has no other use than money.   The ability to reduce balances of paper currency by trading T-bills provides no social benefit.   If the quantity of paper currency is assumed to track that of the gold coins, then there would be real capital losses due to inflation for those who cannot economize on their holdings of paper currency.  

But that is not necessary.   Instead, the quantity of currency can be reduced to maintain its purchasing power.   In other words, as the demand to hold paper currency falls, the central bank/treasury can reduce the quantity of paper currency   To do so, the central bank would make open market sales.   Alternatively, the treasury funds more of the national debt with T- bills and less with paper currency.

Once these adjustments are made, then there are no social benefits at all.   The firms using T-bills as a money substitute have employees to manage their trades.   There are firms making markets in the T-bills.   While all of these transactions costs are offset by private benefits--reduction in interest forgone, there are no social benefits at all.   All those financial traders are being pulled away from the production of useful goods and services.   There are no savings on the national debt.   Rather than funding it at zero interest with currency, it is necessary to pay interest on the T-bills.   This implies fewer government services or somewhat higher distortionary taxation.

Now, let us suppose that there is a loss of confidence in the market makers and there is much less willingness to use T-bills as a money substitute.   The demand for paper currency rises.   If the quantity remained fixed, or grew too little, the various social calamities described above would still occur.  However, it is possible to increase to the quantity of paper money as much as needed.   The central bank purchases T-bills.   The T-bills no longer held as money substitutes are now being held by the central bank.   Those who would have held the T-bills are instead holding paper currency.   

Unfortunately for those who traded the T-bills, they still suffer a private calamity.    And all of those now holding currency can look back at the interest they had earned when they could trust the T-bill traders.   A journalist who had been covering them might be quite focused on their private disaster.   Open market purchases?  What good will that do them?    The T-bills that they would have been trading over and over would just sit idle at the central bank (or be destroyed by the treasury.)

But there is more liquidity than before.   And if the quantity of money rises to meet the demand, there is no need for a reduction in spending on output or prices. Further, social costs are reduced.  The government is funding more of the national debt with zero-interest currency.   There is no need to mine the paper money out of the ground or pull it out of alternative uses like jewelry.   And, all of those T-bill traders can find some more productive work.

Of course, in the real world, bank deposits play the role of paper currency for most purposes.   And a loss in confidence in those trading T-bills was not a major factor in 2008.   The demand for T-bills has expanded greatly.   It was rather the more exotic money market instruments cooked up in an effort to enhance the yield earned by those managing cash balances that flopped.    But there is no gold standard.    It is not at all clear that shifting business from the conventional banking system to the shadow banking system provides any social benefit.    On the contrary, it is quite possible that shifting back the other way was on net beneficial.   But just not to those in the shadow banking industry.


  1. Good post Bill.

    In a way, the non-payment of interest on currency is like an implicit subsidy to all forms of banking, whether shadow or not. I need to think about this one some more.

    1. I agree that I could of told my story about sacks of gold and fractional reserve banking. One of Buchanan's last papers was an argument for 100% reserve banking on that basis. We aren't economizing on gold, but rather on fiat money. What is the social benefit?

      But I don't look at it that way. I favor private money.

  2. Some interesting ideas there. A couple of points.

    Shadow banking as "a work around various undesirable banking regulations." I'd say shadow banking is largely about avoiding bank regulations, although whether they're undesirable or not is another matter. Shadow banking prior to the crisis largely involved converting traditional banking assets into marketable securities, with the result that the risk could be held on investment bank trading books with substantially lower capital requirements. This had the joint effect of leading to an explosion in credit combined with worsening (effective) capital ratios.

    You note that a loss of confidence in the trading of T-bills was not a major factor in 2008, but of course what we did have was a loss in confidence in money (in the form of unsecured bank deposits). So we had almost the opposite position to the one you're describing, with the preference for bills over money driving the TED spread to record levels.

    Incidentally, I don't understand what Kaminska is saying either, but most of the safe asset shortage arguments I have seen don't stack up. High grade collateral certainly plays a role in shadow banking and there is definitely a current shortage, but what it does not do is facilitate the supply of credit to the non-financial sector. (My own post on this: http://monetaryreflections.blogspot.co.uk/2013/09/collateral-shortages-and-availability.html)

    1. "At worst, a net loss to the economy."

      I don't agree that the result of shifting from conventional to shadow banking is an "explosion" of credit. The larger effect is that ultimate lenders earn higher returns and bear more risk.

      For every borrower there is a lender.

      I realize that TED spreads rose, but the Federal Funds rate remained stable and the volume was little effected, or so I recollect.

      Do you really believe that the demand for transactions balances was falling during the crisis?

      Regardless, I agree that there was a large increase in the demand for Treasury bills in late 2008.

    2. No, I was just thinking of money as being bank deposits generally. I wouldn’t have expected demand for transactions balances to have fallen, but I don’t think it would have risen either, would it? But it does raise an interesting point. Does your analysis of a loss in confidence in the bill market require money to be understood specifically as transaction balances, rather than more generally as bank deposits?

  3. Good stuff, Bill. This is a very clear post. Hard to find anything I disagree with.

  4. "Nick Rowe mentioned in passing that he didn't understand Izabella Kaminska." One of the "safe asset" (created by shadow banks) arguments is similar to Nick's "the economy demands bubbles" meme. Specifically, although the economy wants a bubble, the public doesn't want to invest in one. The solution is to create safe assets or a "safe bubble". If true, this would increase social welfare. One example of why this could be true is given in this example (http://monetaryrealism.com/the-economy-almost-certainly-needs-bubbles/#comment-73590); note from the Z1 that most assets are financial assets, and it would be impossible to have bubble assets amounting to 4.5x GDP without them. (BTW this is not the same as the other "safe asset" meme, related to collateral that Nick Edmonds mentioned. There are so many safe asset memes that it's hard to keep track!) The poster child for the GFC is AAA paper defaulting at 10X junk bond rates and/or falling to 10c/$.