Money (37 page)

The main case against persisting with the Basel strategy of conventional warfare rests on nothing more complicated than its existing track record, however. The innovations of the late 1990s and 2000s proved that the financial sector is infinitely inventive at devising ways to circumvent such tax-based regulation. Even worse, the aftermath of the crisis demonstrated that the effects of these conventional weapons may even be perverse: requiring banks to raise capital
ratios following the crash exacerbated the credit crunch, restricting banks’ ability to make loans at precisely the time when companies facing falling demand have a need for credit lines. John Kay, one of the U.K.’s most respected regulatory economists, has put it bluntly: “[t]he belief that more complex versions of the Basel rules would be more effective in future represents the triumph of hope over experience.”
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To continue with the conventional approach would be to risk a regulatory Verdun, with more and more resources committed to the battle, for less and less return.

The regulators have therefore embarked on a fundamental reassessment of strategy; one which recognises that the root problem lies not with the bankers themselves, but with the structure of institutions in which they operate. “Financial stability,” warned Daniel Tarullo—the leading authority on bank regulation on the Board of Governors of the Federal Reserve—in June 2012, “is, in important ways, endogenous to the financial system, or at least the kind of financial system that has developed in recent decades.”
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Moral hazard is hard-wired into the system. This is why attempting to mitigate it by tinkering with capital ratios or liquidity requirements would be a Sisyphean task. So long as the nature of banking is to lend long-term by borrowing short-term, and take credit risk whilst promising none, the boulder of moral hazard would forever be tumbling back to the bottom of the hill just as the regulators think they have it fixed. What is needed is reform targeted at the fundamental structure of the banking system, rather than at the behaviour of the bankers within it. The war on financial instability requires not conventional tactics, but a counter-insurgency strategy.

When the excesses of the 1920s ended in the crash of 1929 and the Great Depression that followed, there was a similar depth of soul-searching over the institutional structure of the banking system in the U.S. Then as now, the unwarranted enjoyment of sovereign support by activities inessential to the provision of money to the public was identified as a major cause of the problem. In 1933, the Glass-Steagall Banking Act therefore established a rigid separation of firms permitted to engage in securities dealing, or investment banking, from
those permitted to engage in deposit-taking, lending, and payments services to companies and individuals, or commercial banking. And the McFadden Act of 1927 placed effective restrictions on the size of banks by prohibiting National Banks from opening branches outside their home state. Both restrictions lasted right into the 1990s.
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And it is notable that it was the relaxation of these structural constraints on the activities and size of banks that contributed to the unmanageable size of the problem that was exposed by the 2007–8 crash. It was when the mid-century interlude of strict structural regulation ended that the age of “too big to fail” definitively arrived.
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Since the crisis, this historical experience has constituted the default framework for the flurry of legislative activity aimed at changing the structure of the banking sector itself. In early 2009, President Obama appointed an Economic Recovery Advisory Board, chaired by ex-Chairman of the Federal Reserve Paul Volcker, to make proposals on thoroughgoing reform of the financial sector. On the other side of the Atlantic, the newly elected coalition government of the U.K. appointed an Independent Commission on Banking under the leadership of the eminent Oxford economist Sir John Vickers, in June 2010. Both groups recommended a new segregation of banking activities. There were differences of nuance—Volcker chose to distinguish client-oriented and proprietary trading, whilst Vickers drew the line between banks’ activities in retail and wholesale markets; and Volcker recommended that segregated activities be done in legally separate companies, whereas Vickers thought “ring-fencing” them within existing conglomerates would be enough—but the underlying philosophy was the same. Let Wall Street and City traders gamble as much as they like on their own tab, was the spirit of both sets of recommendations, so long as sovereign support is henceforth statutorily available only to strictly regulated institutions.

There appears, therefore, to be a rare international consensus on the counter-insurgency tactics of choice. But there remains a problem. “Tactics without strategy,” runs the famous maxim of the great Chinese military thinker Sun Tzu, “is the noise before
defeat.” What exactly is the objective of these structural reforms? At first glance, the answer would seem to be simple: “financial stability.” It is financial stability that the new institutions established since the crisis are charged with maintaining.
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It is financial stability that the newly chastened central banks acknowledge they must aim at, in addition to the overly simplistic objective of low and stable inflation (and perhaps low unemployment) that was their single-minded goal before. Above all, it is financial stability that is the stated goal of all the new legislation.
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Yet for all the sound and fury, there remains a deafening silence when it comes to the obvious question this raises: what exactly is financial stability?

It is a question to which neither of the dominant intellectual frameworks for contemporary economic policy-making are equipped to provide a sensible answer. As the Governor of the Bank of England has pointed out, modern, orthodox macroeconomics “lacks an account of financial intermediation, so money, credit, and banking play no meaningful role.”
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So as one of the founding members of the Bank of England’s Monetary Policy Committee has lamented, it “excludes everything relevant to the pursuit of financial stability.”
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But neither does the modern theory of finance, with its blind spot for money’s macroeconomic role, supply any new and specialised theory of financial stability to slake the thirst of the expectant reformers. “For all the attention paid to financial stability analysis in the last few years,” Governor Daniel Tarullo of the U.S. Federal Reserve dolefully concluded in October 2012, “it is still—relatively speaking—a fledgling enterprise.”
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The root of the failure in both cases, as we discovered, is the conventional understanding of money. Stuck in its Looking-Glass world, the policy-makers are flying blind. Can the alternative traditions of monetary scepticism help instead?

The global financial crisis has raised the stakes in the debate over regulatory reform. As a result, there is an openness to unorthodox ideas that has not been seen for decades. Fortunately, there is also
a rich seam of such ideas to be mined, if we look beyond the last fifty years of economics and finance. Some contemporary thinkers have already begun to float more adventurous proposals. Robert and Edward Skidelsky advocate a hearts and minds campaign—arguing that nothing short of ethical reconstruction is necessary to enable people to answer for themselves the fundamental question of
How Much Is Enough
and thereby free themselves from the militant insatiability intrinsic to monetary society.
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The philosopher Michael Sandel hints instead at the Soviet strategy. He suggests counter-insurgency by cantonment—reforms to make sure that there remain some things that money can’t buy.
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For others, nothing less than the Spartan solution will do. According to U.S. congressman Ron Paul, for example, the way to solve the intrinsic problems of our current monetary system is simple:
End the Fed
.
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The most important thing the unconventional tradition provides, however, is not any one particular proposal. It is the alternative understanding of money not as a thing, but as a social technology. The world, we have to admit, is an uncertain place. King Solomon’s biblical warning that “the race is not to the swift, nor the battle to the strong, neither yet bread to the wise, nor yet riches to men of understanding, nor yet favour to men of skill” might sound defeatist—but few would dispute his fundamental point that “time and chance happeneth to them all.”
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It is as true of the field of economic activity, as in every other, that there is a certain amount of inescapable risk in the world. Money is, on the unconventional view, a system for deciding how this risk is shared out. In the jargon of economists, genuine economic risk—uncertainty about whether the harvest will be plentiful or poor, or whether next month’s meticulously planned product launch works or it doesn’t—is “exogenous”: it is essentially beyond our control. Financial risk, by contrast, is “endogenous”: we decide, through the design of the monetary system, how those unpredictable economic gains or losses get shared around the community. Money answers the question of who bears which risks under what circumstances. Of course, money is not the only system for organising society that can answer this question. The redistributive engine of the
Western welfare state, in which social rights rather than economic value determine who gets what, is an obvious example of an alternative. But the way that money organises the distribution of economic risk in society—by making a simultaneous promise of stability and freedom—has made it epidemically successful throughout history. It is a brave promise.

For money issued directly by the sovereign, we have seen that the promise works because the sovereign, by definition, has political authority. A sovereign’s authority is in turn a function of its legitimacy. That’s why, when governments lose their citizens’ confidence it becomes much easier for private moneys to circulate, as the example of Argentina’s private and provincial currencies showed. In monetary society, how the sovereign can best preserve its legitimacy is therefore a critical question. It becomes all the more pressing because money’s promise of stability means that debt crises are bound to arise—and the sceptical tradition has understood since ancient times that a critical prerequisite for the sustainability of monetary society is therefore the safety valve of a variable monetary standard. So long as citizens permit the sovereign a discretionary power to recalibrate the financial distribution of risks by adjusting the monetary standard when it becomes unfair, sovereign money can work. This is why the conventional understanding of money as a physical thing is so dangerous. Whereas with physical concepts it is essential that the standard we use to measure and manipulate them should be an immutable or even a natural constant, with the social concept of value exactly the opposite is true. If money is to generate a just society then it is essential not that the standard of economic value is irrevocably fixed, but that, as Solon showed, it is unflinchingly responsive to the demands of democratic politics.

So much for sovereign money. In the modern world, nearly all the money in circulation is not issued by the sovereign any more: it is issued by banks. So how do banks pull off money’s promise to deliver both stability and freedom? The answer—according to the theory, at least—is that banks achieve “liquidity transformation”: they “transform” their liquid, short-term deposit liabilities into illiquid,
long-term loans. But the notion of “liquidity transformation” is, quite literally, a euphemism.
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Nothing is actually transformed at all. Banks’ liabilities remain short-term and of fixed nominal value, and their assets remain long-term and of uncertain nominal value, and never the twain shall meet. Instead, banks give the impression of achieving a transformation by artfully synchronising the payments in and out of their balance sheets. No matter how artfully this is done, though, there is always the possibility that people will lose confidence in a bank’s ability to do it. That is the problem that plagues every private issuer of money—and even did for the great international bankers’ money of the sixteenth century in the end. The international shadow banking sector and its horrified regulators relearned the lesson in the early 2000s: private money that sustains itself purely on its own resources works in good times but not in bad. So the only way to make bank money work sustainably is by piggybacking off the sovereign and its authority—that is, by striking a Great Monetary Settlement. For three centuries, this has seemed like a reasonable solution. But the crisis has exposed the fact that the distribution of risks that today’s system of bank-based money dispenses has become intolerably unjust.

Such is the alternative understanding of money that our unauthorised biography has described, and the interpretation of what is wrong with the banking system that it implies. Global banking’s current structure generates an unjust distribution of risks, where losses are socialised—taxpayers are on the hook for bail-outs—while gains are private—the banks and their investors alone reap any profits. So how can the situation best be fixed? Two extreme options help frame an answer. The first would be to privatise all the risks—to restructure the banking system so that investors bear all potential costs, as well as all the profits. The other would be the opposite: to redesign the system so that the financial system socialises all risks. Taxpayers keep all the downside risk—but now they get the upside too.

The first option is a modern version of the Scotsman’s strategy—John Law’s revolutionary idea for a structural fix for money. The core principle of Law’s plan was the transfer of risk from the sovereign to
his subjects, by the creation of what was, in effect, sovereign equity in the form of shares in his conglomerate System. Law’s hope had been that these uncertain claims on the revenues of the French economy would come to replace the fixed claims represented by banknotes,
billets
, and other sovereign debt securities. The moribund economic culture of the rentier state would be abolished for ever, and there would be no more debt crises—since there would be no more fixed obligations to get out of kilter with uncertain tax receipts. Two birds would be killed with one stone.