Money & Finance Archives – Page 4 of 5

Where Does Profit Come from in the Payments Industry?

“Don’t be seduced into thinking that that which does not make a profit is without value.”
Arthur Miller

The recent development in the payments industry, namely the rise of Fintech companies, has created an opportunity to revisit the economics of payment system and the puzzling nature of profit in this industry. Major banks, credit card companies, and financial institutions have long controlled payments, but their dominance looks increasingly shaky. The latest merger amongst Tech companies, for instance, came in the first week of February 2020, when Worldline agreed to buy Ingenico for $7.8bn, forming the largest European payments company in a sector dominated by US-based giants. While these events are shaping the future of money and the payment system, we still do not have a full understanding of a puzzle at the center of the payment system. The issue is that the source of profit is very limited in the payment system as the spread that the providers charge is literally equal to zero. This fixed price, called par, is the price of converting bank deposits to currency. The continuity of the payment system, nevertheless, fully depends on the ability of these firms to keep this parity condition. Demystifying this paradox is key to understanding the future of the payments system that is ruled by non-banks. The issue is that unlike banks, who earn profit by supplying liquidity and the payment system together, non-banks’ profitability from facilitating payments mostly depends on their size and market power. In other words, non-bank institutions can relish higher profits only if they can process lots of payments. The idea is that consolidations increase profitability by reducing high fixed costs- the required technology investments- and freeing-up financial resources. These funds can then be reinvested in better technology to extend their advantage over smaller rivals. This strategy might be unsustainable when the economy is slowing down and there are fewer transactions. In these circumstances, keeping the par fixed becomes an art rather than a technicality. Banks have been successful in providing payment systems during the financial crisis since they offer other profitable financial services that keep them in business. In addition, they explicitly receive central banks’ liquidity backstop.

Traditionally, the banking system provides payment services by being prepared to trade currency for deposits and vice versa, at a fixed price par. However, when we try to understand the economics of banks’ function as providers of payment systems, we quickly face a puzzle. The question is how banks manage to make markets in currency and deposits at a fixed price and a zero spread. In other words, what incentivizes banks to provide this crucial service. Typically, what enables the banks to offer payment systems, despite its negligible earnings, is their complementary and profitable role of being dealers in liquidity. Banks are in additional business, the business of bearing liquidity risk by issuing demand liabilities and investing the funds at term, and this business is highly profitable. They cannot change the price of deposits in terms of currency. Still, they can expand and contract the number of deposits because deposits are their own liability, and they can expand and contract the quantity of currency because of their access to the discount window at the Fed.

This two-tier monetary system, with the central bank serving as the banker to commercial banks, is the essence of the account-based payment system and creates flexibility for the banks. This flexibility enables banks to provide payment systems despite the fact the price is fixed, and their profit from this function is negligible. It also differentiates banks, who are dealers in the money market, from other kinds of dealers such as security dealers. Security dealers’ ability to establish very long positions in securities and cash is limited due to their restricted access to funding liquidity. The profit that these dealers earn comes from setting an asking price that is higher than the bid price. This profit is called inside spread. Banks, on the other hand, make an inside spread that is equal to zero when providing payment since currency and deposits trade at par. However, they are not constrained by the number of deposits or currency they can create. In other words, although they have less flexibility in price, they have more flexibility in quantity. This flexibility comes from banks’ direct access to the central banks’ liquidity facilities. Their exclusive access to the central banks’ liquidity facilities also ensures the finality of payments, where payment is deemed to be final and irrevocable so that individuals and businesses can make payments in full confidence.

The Fintech revolution that is changing the payment ecosystem is making it evident that the next generation payment methods are to bypass banks and credit cards. The most recent trend in the payment system that is generating a change in the market structure is the mergers and acquisitions of the non-bank companies with strengths in different parts of the payments value chain. Despite these developments, we still do not have a clear picture of how these non-banks tech companies who are shaping the future of money can deal with a mystery at the heart of the monetary system; The issue that the source of profit is very limited in the payment system as the spread that the providers charge is literally equal to zero. The continuity of the payment system, on the other hand, fully depends on the ability of these firms to keep this parity condition. This paradox reflects the hybrid nature of the payment system that is masked by a fixed price called par. This hybridity is between account-based money (bank deposits) and currency (central bank reserve).

Elham Saeidinezhad is lecturer in Economics at UCLA. Before joining the Economics Department at UCLA, she was a research economist in International Finance and Macroeconomics research group at Milken Institute, Santa Monica, where she investigated the post-crisis structural changes in the capital market as a result of macroprudential regulations. Before that, she was a postdoctoral fellow at INET, working closely with Prof. Perry Mehrling and studying his “Money View”. Elham obtained her Ph.D. from the University of Sheffield, UK, in empirical Macroeconomics in 2013. You may contact Elham via the Young Scholars Directory

Is the Recent Buyback Spree Creating Liquidity Problems for the Dealers?

“You are a side effect,” Van Houten continued, “of an evolutionary process that cares little for individual lives. You are a failed experiment in mutation.”
― John Green, The Fault in Our Stars

By Elham Saeidinezhad | The anxieties about large financial corporations’ debt-funded payouts—aka “stock buybacks”—are reemerging a decade after the financial crisis. Companies on the S&P 500 have poured more than $5.3 trillion into repurchasing their own shares since 2010. The root cause of most concerns is that stock buybacks do not contribute to the productive capacities of the firm. Indeed, these distributions to stockholders disrupt the growth dynamic that links the productivity and pay of the labor force. Besides, these payments that come on top of dividends could weaken the firms’ credit quality.

These analyses, however, fail to appreciate the cascade effect that will hurt the dealers’ liquidity positions due to higher stock prices. Understanding this side effect has become even more significant as the share of major financial corporations, including JPMorgan, is trading at records, and are getting very expensive. That high-class problem should concern dealers who are providing market liquidity for these stocks and establishing short positions in the process. Dealers charge a fee to handle trades between the buyers and sellers of securities. Higher stock prices make it more expensive for short selling dealers to settle the positions by repurchasing securities on the open market. If stocks become too high-priced, it might reduce dealers’ ability and willingness to provide market liquidity to the system. This chain of events that threatens the state of market liquidity is missing from the standard analysis of share buybacks.

At the very heart of the discussion about share buybacks lay the question of how companies should use their cash. In a buyback, a company uses its cash to buy its own existing shares and becomes the biggest demander of its own stock. Firms usually repurchase their own stocks when they have surplus cash flow or earnings, which exceed those needed to finance positive net present value investment opportunities. The primary beneficiaries of these operations are shareholders who receive extra cash payments on top of dividends. The critical feature of stock buybacks is that it can be a self-fulfilling prophecy for the stock price. Since each remaining share gets a more significant piece of the profit and value, the companies bid up the share values and boost their own stock prices. The artificially high stock prices can create liquidity and settlement problems for the dealers who are creating a market for the stocks and have established short positions in the process.

Short selling is used by market makers to provide market liquidity in response to unanticipated demand or to hedge the risk of a long position in the same security or a related security. On the settlement date, when the contract expires, the dealer must closeout—or settle—the position by returning the borrowed security to the stock lender, typically by purchasing securities on the open market. If the prices become too high, they will not have enough capital to secure their short sales. At this point, whoever clears their trade will force them to liquidate. If they continue losing money, dealers face severe liquidity problems, and they may go bankrupt. The result would be an illiquid market. To sum up, in recent years, buybacks by public firms have become an essential technique for distributing earnings to shareholders. Not surprisingly, this trend has started a heated debate amongst the critiques. The problem, however, is that most analyses have failed to capture the effect of these operations on dealers’ market-making capacity, and the state of market liquidity when share prices become too high.

Is Transiting to SOFR Affecting Firms’ Survival and Liquidity Constraints?

“Without reflection, we go blindly on our way, creating more unintended consequences, and failing to achieve anything useful.”
Margaret J. Wheatley

In 2017, after a manipulation scandal, the former FCA Chief Executive Andrew Bailey called for replacing LIBOR and had made clear that the publication of LIBOR is not guaranteed beyond 2021. A new rate created by the Fed—known as the secured overnight financing rate, or SOFR- seems to pull ahead in the race to replace LIBOR. However, finding a substitute has been a very challenging task for banks, regulators, and investors. The primary worries about the transition away from the LIBOR have been whether the replacement is going to reflect the risks from short-term lending and will be supported by a liquid market that behaves predictably. Most of these concerns are rooted in the future. However, a less examined yet more immediate result of this structural change might be the current instabilities in the market for short-term borrowing. In other words, this transition to SOFR creates daily fluctuations in market prices for derivatives such as futures that are mark-to-market and in the process affects firms’ funding and liquidity requirements. This side effect might be one of the underlying causes of a challenge that the Fed is currently facing, which is understanding the turbulences in the repo market.

This shift to the post-Libor financial market has important implications for the prices of the futures contracts and firms’ liquidity constraints. Futures are derivatives that take or hedge a position on the general level of interest rates. They are also “Mark-to-Market,” which means that, whenever the futures prices change, daily payments must be made. The collateral underlying the futures contract, as well as the futures contract itself, are both marked to market every day and requires daily cash payments. LIBOR, or London Interbank Offer Rate, is used as a reference for setting the interest rate on approximately $200 trillion of financial contracts ranging from home mortgages to corporate loans. However, about $190 trillion of the $200 trillion in financial deals linked to LIBOR are in the futures market. As a result, during this transition period, the price of these contracts swings daily, as the market perceives what the future value of alternative rate to be. In process, these fluctuations in prices generate cash flows that affect liquidity and funding positions of a variety of firms that use futures contracts, including hedge funds that use them to speculate on Federal Reserve policy changes and banks that use them to protect themselves against interest-rate hikes when they lend money.

To sum up, the shift from LIBOR to SOFR not only is changing market structure but also generating cash flow consequences that are putting extra pressure on money market rates. While banks and exchanges are expanding a market for secondary financial products tied to the SOFR, they are using futures to hedge investors from losing money or protecting borrowers from an unexpectedly rise on their payments. In doing so, they make futures prices swing. These fluctuations in prices generate cash flows that affect liquidity positions of firms that invest in futures contracts. Money markets, such as the repo, secure the short-term funding that is required by these firms to meet their cash flow commitments. In the process of easing worries, banks are consistently changing the market price of the futures, generating new payment requirements, and putting pressure on short-term funding market. To evaluate the effects of this transition better, we might have to switch our framework from the traditional “Finance View” to “Money View.” The reason is that the former view emphasizes the role of future cash flows on current asset prices while the latter framework studies the impact of today’s cash flow requirements on the firm’s survival constraints.

When it comes to sovereign debt, what is the real concern? Level or Liquidity?

“What can be added to the happiness of a man who is in health, out of debt, and has a clear conscience?”
Adam Smith

By Elham Saeidinezhad | The anxieties around the European debt crisis (often also referred to as eurozone crisis) seem to be a thing of the past. Eurozone sovereigns have secured record-high order books for their new government bond issues. However, emerging balance-sheet constraints have limited the primary dealers’ ability to stay in the market and might support the view that sovereign bond liquidity is diminishing. The standard models of sovereign default identify the origins of a sovereign debt crisis to be bad “fundamentals,” such as high debt levels and expectations. These models ignore the critical features of market structures, such as liquidity and primary dealers, that underlie these fundamentals. Primary dealers – the banks appointed by national debt agencies to help them borrow from investors- act as market makers in government bond auctions. These primary dealers provide market liquidity and set the price of government bonds. Most recently, however, primary dealers are leaving Europe’s bond markets due to increased pressure on their balance-sheets. These exits could decrease sovereign bonds’ liquidity and increase the cost of borrowing for the governments. It can sow the seeds of the next financial crisis in the process. Put it differently, primary dealers’ decision to exit from this market might be acting as a warning sign of a new crisis in the making.

Standard economic theories emphasize the role of bad fundamentals such as high debt levels in creating expectations of government default and reaching to a bad-equilibrium. The sentiment is that the sovereign debt crisis is a self-fulfilling catastrophe in nature that is caused by market expectations of default on sovereign debt. In other words, governments can be subjected to the same dynamics of fickle expectations that create run on the banks and destabilize banks. This is particularly true when a government borrows from the capital market over whom it has relatively little influence. Mathematically, this implies that high debt levels lead to “multiple equilibria” in which the debt level might not be sustainable. Therefore, there will not be a crisis as long as the economy reaches a good equilibrium where no default is expected, and the interest rate is the risk-free rate. The problem with these models is that they put so much weight on the role of expectations and fundamentals while entirely abstract from specific market characteristics and constituencies such as market liquidity and dealers.

Primary dealers use their balance-sheets to determine bond prices and the cost of borrowing for the governments. In doing so, they create market liquidity for the bonds. Primary dealers buy government bonds directly from a government’s debt management office and help governments raise money from investors by pricing and selling debt. They typically are also entrusted with maintaining secondary trading activity, which entails holding some of those bonds on their balance sheets for a period. In Europe, several billion euros of European government bonds are sold every week to primary dealers through auctions, which they then sell on. However, tighter regulations, such as MiFID II, since the financial crisis has made primary dealing less profitable because of the extra capital that banks now must hold against possible losses. Also, the European Central Bank’s €2.6tn quantitative easing program has meant national central banks absorbed large volumes of debt and lowered the supply of the bonds. These factors lead the number of primary dealers in 11 EU countries to be the lowest since Afme began collecting data in 2006.

This decision by the dealers to exit the market can increase the cost of borrowing for the governments and decrease sovereign bonds’ liquidity. As a result, regardless of the type of equilibrium the economy is at, and what the debt level is, the dealers’ decision to leave the market could reduce governments’ capacity to repay or refinance their debt without the support of third parties like the European Central Bank (ECB) or the International Monetary Fund (IMF). Economics models that study the sovereign debt crisis abstracts from the role of primary dealers in government bonds. Therefore, it should hardly be surprising to see that these models would not be able to warn us about a future crisis that is rooted in the diminished liquidity in the sovereign debt market.

Currency manipulation accusation against China not just “wrong now”, but fundamentally flawed

By Alexander Beunder. Investigative journalist. Platform Authentieke Journalistiek, the Netherlands.

Now that the dust has settled around the latest U.S.-China trade war spat, here’s something the Trump regime may want to evaluate before the next round: the fact that many economists and analysts refused to side with Trump and Mnuchin when they accused China of “currency manipulation”.

Initially, the story of Chinese currency manipulation was echoed around the world, when the Chinese yuan dropped 1,4% to the dollar on Monday, August 5. After US president Donald Trump responded by tweet that China was guilty of “currency manipulation”, the Wall Street Journal and others described how Beijing was “weaponizing the yuan”. China was obviously responding, some analysts said, to new import tariffs on Chinese products which Trump had announced a week before. The press paid even more attention to the story because of the diplomatic drama around it, as US Treasury secretary Steven Mnuchin rushed to officially declare China a “Currency Manipulator” and said to bring the matter to the International Monetary Fund (IMF).

It’s an accusation Trump (but before him, Obama) has been repeating for years. China’s central bank is supposedly keeping the value of the yuan to the dollar artificially low – by buying and holding on to dollar reserves – to make its exports cheap for the rest of the world. This creates an “unfair competitive advantage”, in the words of Mnuchin. Thanks to its cunning currency manipulation scheme, the argument goes, China enjoys a persistent trade surplus – exporting more than importing – while the U.S. suffers a trade deficit, hurting businesses and workers.

But fact-checking Trump’s statements has become a healthy habit among journalists. Several analyses quoted economists who disagreed with the latest accusations by Trump and Mnuchin. As The New York Times business correspondent Alexandra Stevenson noted, “many economists believe [China’s] currency should be weakening versus the dollar”, due to slow growth and the trade war with the U.S.. Another source, U.S.-economist Dean Baker, noted the 1,4% drop was large but “not that unusual” and can happen “without government intervention”. Even the annual review of China’s economic policies by the IMF, released after Monday’s accusations, concluded there is no sign of currency manipulation.

Still, several established correspondents agreed that the accusation was valid in the past. “China kept its currency weak a decade ago”, Stevenson wrote, but the yuan has now “strengthened to a level widely believed to be close to fair value”. Her colleague Eduardo Porter at The New York Times shared a similar view in an article which headlined, “Trump Isn’t Wrong on China Currency Manipulation, Just Late”. Bloomberg correspondent Noah Smith drew the same conclusion, noting China enjoyed a large trade surplus in the 2000s, but the “the country’s current account deficit has largely vanished”, after a peak in 2007.

Flawed economics

However, there may be something more fundamentally wrong with the currency manipulation accusation, and not just with the recent application of it by Trump and Mnuchin.

New York-based economist Anwar Shaikh and London-based economist Isabella Weber have been arguing for several years that the whole currency manipulation argument is based on flawed economics. Shaikh, an economics professor at the New School of Social Research in New York, and Weber, a lecturer in economics at Goldsmiths, University of London, published a working paper on the topic last year titled “Debunking the Currency Manipulation Argument”.

If they’re right, even the belief that China was guilty of currency manipulation a decade ago becomes questionable.

To understand what’s wrong with the currency manipulation argument we have to go back to the underlying trade theories, Shaikh and Weber explain. As currency manipulation can not be observed directly, economists look at other economic phenomena which, according to standard trade theory, are indicators of currency manipulation. A persistent trade surplus is the most important indicator because, according to standard trade theory, free trade would automatically eliminate trade imbalances. Hence, wherever a persistent trade surplus exists, it must be the result of currency manipulation, the argument goes.

The Chinese trade surplus, always positive since 1994, has been the central pillar of the currency manipulation argument, Shaikh and Weber note. Not just for academic economists; the U.S. Treasury uses persistent trade surpluses as official, legal criteria to determine whether a country is guilty of currency manipulation to gain an “unfair competitive advantage”.

But the proof is in the pudding, in this case, standard economic trade theory. If the theory is incorrect – which it is, according to Shaikh and Weber – the whole narrative collapses.

What’s wrong with the trade theory? The theory goes back to a famous model of the British economist David Ricardo (1772-1823), Shaikh and Weber explain. In Ricardo’s model and modernized versions of it, free trade ensures that, over time, no trading partner would enjoy a trade surplus or suffer a trade deficit. Imagine a country which would initially be more competitive in, let’s say, all sectors. Free trade would result in high exports and low imports (a trade surplus) attracting a massive inflow of money from foreign buyers. Such an inflow of money creates domestic inflation or an increase in the exchange rate, damaging competitiveness and eliminating the trade surplus. In a weaker, deficit country the opposite would happen: an outflow of money creates domestic deflation or a drop in the exchange rate, boosting competitiveness and exports and eliminating the trade deficit.

But the theory is fundamentally wrong, Shaikh and Weber argue. The “natural” result of a world in which trading partners enjoy different levels of competitiveness is not balanced trade. The “natural” result of free trade in such a world, they argue, is imbalance – trading partners with persistent trade surpluses and deficits.

Relying on classical economists like Adam Smith (1723 – 1790) and Roy Harrod (1900 – 1978), Shaikh and Weber present their alternative trade theory: in their version, the magical price or exchange-rate movements which would equilibrate trade in Ricardian models won’t happen. For instance, in a surplus country, large inflows of money due to excessive exports will not create domestic inflation or a rise in the exchange rate, because there’s something else that these flows of money do: move back to where they came from. Any oversupply of money a surplus country would receive would initially be saved in local banks and decrease the domestic interest rate. This would push capital towards other countries where it enjoys higher returns – indeed, to the deficit countries where the interest rate has increased due to an outflow of money.

Hence, a likely outcome of free trade is that surplus countries become creditors, and deficit countries become borrowers, and there are no automatic price or exchange-rate movements which would balance trade accounts.

This is, Shaikh and Weber note, an accurate description of the financial relation between the US and China, as China has become the largest creditor of the US. The only peculiarity, they explain, is that China’s public central bank is doing the lending (buying dollar assets) because Chinese capital controls prevent private investors from fulfilling this role. But these operations “might only mimic what would be the outcome of free capital and trade flows”, Shaikh and Weber explain. To label these monetary operations as the main instrument of a cunning currency manipulation scheme, as Mnuchin and others do, is unwarranted in their view.

So, if Shaikh and Weber are right, global imbalances in trade are simply natural outcomes of the free market, not of government interference. And if that’s the case, the currency manipulation arguments holds no water, as “we cannot infer from trade imbalances and from China’s purchase of reserves that the currency has been manipulated”.

No, Shaikh and Weber can’t exclude the possibility that China has intervened in the value of the yuan for purposes of competitiveness. Their main point is that the conventional criteria used by academics and the US Treasury to determine this – trade surpluses and deficits – tell us very little.

Perhaps more importantly, their message is to look at free trade itself to understand the roots of the trade deficit of the US and trade surplus of China. The real reason is surprisingly simple: “It is the lower costs in China that drive its trade surplus”, Shaikh and Weber conclude. It’s not Chinese currency manipulation which, as Trump complained in 2015, “makes it impossible for our companies to compete”. It’s simply Chinese competitiveness. It’s an argument which may be harder to swallow for those convinced of the everlasting power and competitiveness of the US economy.

Politics, not economic science

However convincing their debunking of the economic evidence may be, Shaikh and Weber are well aware that in the political arena the economic evidence plays a secondary role. U.S. presidents like Trump repeat the accusation of currency manipulation because of politics, not economic science, they note.

It’s been a “general pattern” in US foreign policy for some time, Shaikh and Weber write, to accuse trading partners of currency manipulation when they are running a trade surplus with the US, typically followed by the “demand that they enter into bilateral negotiations on a wide array of market liberalization policies”. Booming economies like Korea, Taiwan, Hongkong and Singapore faced the same accusation of currency manipulation in the late eighties and nineties, Shaikh and Weber note. China has repeatedly been accused of currency manipulation by the US Treasury since the nineties, Weber adds by email, with increased intensity “since the rapid expansion of the US-China trade imbalance following China’s accession to the WTO in 2001”.

So the return of the currency manipulation argument today, at a time when the US and China are fighting over the terms of a new trade treaty, is not surprising. But it is alarming, Weber says, as the unfounded accusation “is another step towards escalating the trade war”.

This article was also published by Rethinking Economics.

Why Inflation Targeting?

By Juan Ianni. Why does mainstream economics recommend the application of Inflation Targeting (IT) regimes? Is it because of its sophistication? Are there other ways of addressing inflation? Perhaps a historical analysis of the roots of what is now the dominant stabilization regime can shed light on these questions.

Although the concept “financialization” is still up to debate, some economists like Chesnais (2001) argue that, since 1970, capitalism has mutated toward a “financialized” model of accumulation. According to Fine (2013), financialization is the derivation of the use of money as a credit other than the use of money as capital. Other authors believe that financialization is the determining structure of other (political, social, economic) structures. Long story short, this would mean that changes in social relationships produce new economic (and non-economic) structures, which replicate the mode of production (or “the dominant structure”). But what does that mean?

The French school of regulation can answer that question. According to the theory they developed, every accumulation pattern (for instance, “financialized” capitalism) needs a mode of regulation. The latter consist of a set of institutions (or policies), which enable social and economic reproduction by solving conflicts (inherent to every accumulation pattern) between agents of the society. Therefore, institutions will appear, disappear and relate in a non-random way, structuring a certain institutional configuration related to the accumulation pattern.

Boyer and Saillard are two of the most influential theorist of the French school of regulation. In one of their articles (Boyer and Saillard, 2005), they identify five core conflicts between agents in every accumulation pattern. Nevertheless, two are enough to understand the emergence of Inflation Targeting regimes: the “wage-labor nexus” and the “valorization of wealth”. While the first conflict refers to the dispute over the economic surplus between the worker and the capitalist, the latter refers to the prevailing mode of accumulation and valorization of wealth.

In their opinion, financialized capitalism is characterized for having the “valorization of wealth” as the central conflict to solve (or stabilize) within a particular set of institutions. In the contrary, the “wage-labor nexus” is the “adjustment” conflict. This means that accumulation will no longer be led by an equal distribution of the production surplus between workers and entrepreneurs. On the contrary, financialized capitalism will ensure a way for wealth to be valued related to credit (and not capital), no matter how damaging that could be to workers.

With the gestation of financialized capitalism (along with its respective institutional configuration process) and the centrality of the “valorisation of wealth” conflict, the New Macroeconomic Consensus was established as a theoretical paradigm. In order to legitimize and deepen this institutional configuration, it propiated the emergence and propagation of Inflation Targeting regimes as a conceptual apparatus regarding anti-inflationary policy-mix.

As these regimes consider inflation as an exclusive consequence of an excess in aggregate demand, contractive monetary policies are “always needed”. In the case of IT, they must constantly ensure a positive real interest rate, which fits perfectly with the need of a way to value wealth. What is more, it decreases inflation by incrementing unemployment, which shows how the “wage-labour nexus” is the adjustment conflict.

However, it is well known that inflation is a multi-faceted problem. Empirical research shows that in addition to an excess in aggregate demand, inflation can be the consequence of the distributive conflict, international prices, inflationary inertia, etc. The way IT address this phenomena (setting a high real interest rate, increasing unemployment, and letting the exchange rate float) shows how it is the perfect piece for the financialized capitalism puzzle. However, since the existence of very close interconnections between the international monetary systems and the national financial markets (what Chesnais call the “financial globalization”), IT’s effectiveness has lowered.

In addition, when the main cause of inflation is not related to an excess in aggregate demand, IT’s efficiency falls. Vera (2014) argues that using IT demands a strong reliance on the unemployment channel (that is to say, to stop inflation, unemployment needs to increase), which has adverse side effects on both employment and income distribution.

Given these drawbacks, some economic schools have developed other tools to tackle inflation, which may be both more efficient and effective. To that end, a different policy mix in which real exchange rate targeting is combined with income distribution targeting can be structured. In this case, the nominal exchange rate could be set to sustain a balanced external sector, whilst income policies could preserve a more equitable distribution of income. Consequently, a low level of inflation is sustained while the “disciplinary effect” of unemployment is avoided.

In conclusion, Inflation Targeting is not the mainstream policy instrument because of its results or theoretical coherence; after all, it has needless consequences regarding employment and income distribution. The main cause of IT’s popularity is that it assures the reproduction of an institutional configuration related to the “dominant structure”: financialized capitalism. Explaining this process, in addition to noting alternative stabilization regimes, should motivate the design and application of economic policies more consistent with increasing employment and a more equitable income distribution.

About the Author: Juan Ianni just completed a bachelor’s degree in Economics, and has a an interest in political economy and macroeconomics. He is currently studying alternative political schemes to tackle inflation, which is a big challenge for his home country, Argentina.

Central Banks and the Folk Tales of Money

By Pierre Ortlieb.

On June 10th, 2018, Swiss voters participated in a referendum on the very nature of money creation in their small alpine republic. The so-called “Vollgeld Initiative,” or “sovereign money initiative,” on their ballots would have required Swiss commercial banks to fully back their “demand deposits” in central bank money, effectively stripping private banks of their power to create money through loans in the current fractional reserve banking system.

In the build-up to this poll, the Swiss National Bank (SNB) tailored their statements on credit creation based on their audience: when speaking to the public, the SNB chose to promulgate an outdated “loanable funds” model of money creation, while it adopted an endogenous theory of credit creation when speaking to market participants. This served to mollify both audiences, reassuring them of the ability and sophistication of the SNB. Yet the contradicting stories offered by the SNB are part of a broader trend that has emerged as central banks have expended tremendous effort on trying to communicate their operations, with different banks offering different explanations for how money is
created. This risks damaging public trust in money far more than any referendum could.

***

At the SNB annual General Shareholders Meeting in April 2018, Governor Thomas Jordan was verbally confronted by two members of the audience who demanded Jordan explain how money is created – Jordan’s understanding of credit, they argued, was flawed and antiquated. Faced with this line of questioning, Jordan rebutted that banks use sight deposits from other customers to create loans and credit. The audience members pushed back in disagreement, but Jordan did not waver.

On the surface, Jordan’s claim on money creation is an explanation one would find in most economics textbooks. In this common story, banks act as mere intermediaries in a credit creation process that transforms savings into productive investment.

However, only months earlier, Governor Jordan told a different story in a speech delivered to the Zürich Macroeconomics Association. Facing an audience of economists and market professionals, Jordan had embraced a portrayal of money creation that is more modern but starkly opposed to the more folk-theoretical, or “textbook” view. Jordan described how “deposits at commercial banks” are created: In the present-day financial system, when a bank creates a loan, “an individual bank increases deposits in the banking system and hence also the overall money supply.” This is the antithesis of the folk theory offered to the public, presenting a glaring contradiction. Yet the SNB’s duplicity is part of a broader trend: central banks are unable to provide a unified message on credit creation, both internally and among themselves.

For instance, in 2014, the Bank of England published a short, plainly-written paper that described in detail how commercial banks create money essentially out of nothing, by issuing loans to their customers. The Bank author’s noted that “the reality of how money is created today differs from the description found in some economics textbooks,” and sought to correct what they perceived as a popular misinterpretation of the credit creation process. Norges Bank, Norway’s monetary authority, has made a similar push to clarify that credit creation is driven by commercial banks, rather than by printing presses in the basement of the central bank. Nonetheless, other central banks, such as the Bundesbank, have gone to great lengths to stress that monetary authorities have strict control the money supply. As economist Rüdiger Dornbusch notes, the German saving public “have been brought up to trust in the simple quantity theory” of money, “and they are not ready to believe in a new institution and new operating instructions.”

***

While this debate over the mechanics of money creation may seem arcane, it has crucial implication for central bank legitimacy. During normal times, trust in money is built through commonplace uses of money; money works best when it can be taken for granted. As the sociologist Benjamin Braun notes, a central bank’s legitimacy depends in part on it acting in line with a dominant, textbook theory of money that is familiar to its constituents.

Yet this is no longer the case. Since the financial crisis, this trust has been shaken, as exemplified by Switzerland’s referendum on sovereign money in June 2018. Faced with political pressures and uncertain macroeconomic environments, some central banks have had to be much more proactive about their communications, and much more frank about the murky nature of money. As quantitative easing has stoked public fears of price instability, monetary authorities including the Bank of England have sought to clarify who really produces money. In this sense, taking steps to inform the public on the real source of money – bank loans – is a worthwhile step, as it provides constraints on what a central bank can be reasonably expected to do, and reduces informational asymmetries between technical experts and lay citizens.

On the other hand, a number of central banks have taken the dangerous approach of simply tailoring their message based on their audience: when speaking to technical experts, say one thing, and when speaking to the public, say another. The janus-faced SNB is a case in point. This rhetorical duplicity is important as it allows central banks to both assuage popular concerns over the stability of money, by fostering the illusion that they maintain control over price stability and monetary conditions, while similarly soothing markets with the impression that they possess a nuanced and empirically accurate framework of how credit creation works. For both audiences, this produces a sense of institutional commitment which sustains both public and market trust in money under conditions of uncertainty.

Yet this newfound duplicity in central bank communications is perilous, and risks further undermining public trust in money should they not succeed in straddling this fine line. Continuing to play into folk theories of money as these drift further and further away from the reality of credit creation will inevitably have unsettling ramifications. For example, it might lead to the election of politicians keen to exploit and pressure central banks, or the production of crises in the form of bank runs.

Germany’s far-right Alternative für Deutschland, for instance, was founded and achieved its initial popularity as a party opposed to the allegedly inflationary policies of the European Central Bank, which failed to adequately communicate the purpose of its expansionary post-crisis monetary program. Once a central bank’s strategies and the public’s understanding of money become discordant, they lose the ability to assure their constituents of the continued functioning of money, placing their own standing at risk.

Central banks would be better off engaging in a clear, concise, and careful communications program to inform the public of how credit actually works, even if they might not really want to know how the sausage gets made. Otherwise, they risk further shaking public trust in critical monetary institutions.

About the Author: Pierre Ortlieb is a graduate student, writer, and researcher based in London. He is interested in political economy and central banks, and currently works at a public investment think tank (the views expressed herein do not represent those of his employer).

The Shortage of Money: A Fallacious Problem

Whether they are implemented in Latin America (1970-90s), in the UK (under Thatcher) or in Greece (since 2012), austerity measures are all justified by the fact that “there is not enough money.” People are told that “there is no alternative,” and that the state needs to implement structural adjustment programs—usually including across-the-board spending cuts—to restore investors’ confidence and to hope for a better future.

What if this shortage of money could be overcome? What if this problem was ultimately the wrong one? What if we could have money for everything we needed?

In her latest book, The Production of Money: how to break the power of Bankers, Ann Pettifor argues that:

YES the society can afford everything that it needs,
YES we are able to ensure enough money for education, healthcare, sustainable development and the well-being of our communities,
YES we can discard money shortage, contrary to the human or physical (land and resources) ones.

However, one condition needs to be fulfilled: our monetary system should be well-regulated and managed.

To understand how and why, Ann Pettifor takes us back to basics. She starts by defining money as a “social construct based primarily and ultimately on trust”. One of the reasons why we use money in the first place is because we know that others will accept it in the future; it is the means “not for which we use to exchange goods and services, but by which we undertake this exchange” (Law). Your 100-dollar bill would be worthless if others didn’t accept it. The value of money depends on the “acceptance” of money, i.e. on the trust you and others have in money.

Contrary to popular belief, 95% of (broad) money (i.e. cash and coins + bank deposits) is created by private banks and not by the central bank. When a bank makes a loan to a firm, it creates simultaneously a deposit account from which the firm withdraws the loan. Money is therefore created “out of thin air” when the account of the borrower is credited—i.e. when loans are made. This has two implications:

When money is created, so is debt. This debt needs to be repaid. Ann Pettifor uses the example of a credit card which allows you to purchase goods and services today. The spending (= purchasing power) on a credit card “is created out of thin air”. You will ultimately need to pay back the amount spent plus a pre-agreed interest rate. Money is therefore a promise of a future productive value.
The money supply depends on private borrowers and their demand for loans. Central banks influence (but do not control) the money supply by increasing or decreasing the cost of borrowing with their policy interest rate. Money creation is therefore a bottom-up process rather than a top-down one.

Does this mean that we should create as much money as people want loans? Of course not. According to Ann Pettifor, there are constraints that make unlimited borrowing impossible: inflation (and deflation). Indeed, if money is not channeled toward productive purposes, the claim associated to it might not be reimbursed. In other words, the promise of a future productive value might not be fulfilled. When there is too much money “chasing too few goods and services”, reflecting over-confidence in the economy, it results in inflation, eroding the value of assets (such as pensions). Similarly, when there is not enough borrowing (either because borrowers need to repay their debts, as it has been the case in Japan and the US right after the last recession, or because the cost of borrowing is effectively too high), reflecting distrust in the ability to repay debt, deflation steps in.

Therefore, as money can be created “out of thin air”, there is no reason to have a shortage of money as long as it is channeled towards productive purposes. An unlimited amount of money can be created for projects that will ultimately result in the production of value, which will allow the repayment of debt. However, the author does not define what “value” or “productive purposes” are, which in my opinion is the main drawback of the book.

Although Pettifor does give some hints by opposing “productive purposes” to “speculative” ones and by associating “value” to the notion of “income, employment and sustainability”, her approach is rather imprecise and in this sense disappointing. To her credit, defining value is a difficult task, especially if we want to define what is valuable to the society as a whole. Pinning down the definition of value is, in my opinion, ultimately a political debate. If one considers that democracies reflect “collective preferences”, it can be said that societies decide through elections on what is most valuable to them at a given point in time.

Unfortunately, the current monetary system does neither enable nor guarantee that money and credit are used for productive purposes. It is characterized by “easy” and “dear” money; the former refers to unregulated and easy access to borrowing, while the latter conveys the idea of expensive borrowing, i.e. with loans charged at high interest rate. The issue with this system is that (1) with unregulated borrowing, money will be used for unproductive purposes, (2) with high interests, debtors will meet difficulties reimbursing their loans.

Such a system is harmful to society. In the words of Ann Pettifor:

“If rates of interest are too high, debtors have to raise the funds of debt repayment by increasing rates of profits, and by the further extraction of value. These pressures to increase income at exponential rates for the repayment of debt implies that both labor and the land (defined broadly) must be exploited at ever-rising rates. Those who labor by hand or brain work harder and longer to repay rising, real levels of mortgage or credit card debt. It is no accident therefore that the deregulation of finance led to the deregulation of working hours.”

A sound financial and monetary system would precisely have opposite features, with “tight but cheap credit” (Keynes), in which loans are regulated but cheap. “Tight credit” would ensure the soundness and creditworthiness of loans, while “cheap credit”, secures the affordability and thus the repayment of loans.

Hence, Ann Pettifor makes a remarkable argument by providing an in-depth but accessible insight into the workings of the monetary system and the debates surrounding it. Both economists and non-economists should give it a read.

It is indeed quite astonishing that money, ever-present in our lives, is so poorly understood; even by many economic experts themselves. According to Ann Pettifor, this incomprehension stems from the deliberate efforts of the financial sector to “obscure its activities” in order to maintain its omnipotence. The Production of Money aims at addressing this “crisis of ignorance” by providing an intelligible and comprehensive overview of money in the hope of empowering people against finance’s grip over society.

By Céline Tcheng
Disclaimer: views are my own.

About the Author

Céline grew up between Paris, China and Singapore. After graduating in a Master’s degree in Economics and Public Policy, she now works for a public policy institution in France. In her free time, she coordinates INET (Institute for New Economic Thinking) YSI (Young Scholars Initiative)’s Financial Stability Working Group and performs with her dance crew “Slash Art”. Her main interests are: macroprudential policy, financial stability, monetary policy. Follow her on Twitter: @celine_tcheng