Money (36 page)

The conventional wisdom assumed that the innovations of the late 1990s and early 2000s were transferring the role of banks in the creation of credit, but not in the creation of money, to the credit markets. It was an easy enough assumption to make. The global mutual fund industry had, after all, existed for decades to collect savings and select creditworthy borrowers for them. The new arrangements had just increased its size and scope. The business of maintaining synchronisation between payments on long-term assets and short-term liabilities—the management of liquidity risk, the thing that allows bank liabilities to be money—that, it was assumed, remained the unique preserve of banking. After all, only banks have charters from the sovereign, and only sovereigns can make credit into money. Right?

It was a story that would have seemed horribly naïve to anyone familiar with the history of the Monetary Maquis. Small-scale curiosities like community currencies show that private money can exist without any help from the sovereign. The episode of the Irish bank dispute and the precocious success of the sixteenth-century merchant bankers in manufacturing private money demonstrate that scale is not necessarily an obstacle. History proves that the power to issue money is an irresistable lure. If sovereigns allow it, whether
by commission or omission, private issuers will take full advantage. The decade before the crisis was no exception to this general rule. To the student of the Monetary Maquis, the only real question would have been how the new arrangements on the credit markets could be pulling it off. The key to issuing money is the ability to make the magic promise of both stability and freedom. The sovereign can do it because it has authority. Community currency clubs are able to do it because they share an ideology. Under the Great Monetary Settlement, banks were able to do it because they combined creditworthiness with the endorsement of the sovereign. But how could it be done outside the regulated banking system in the wide world of the modern credit markets? How could the ability to create and manage private bilateral credit outside the regulated banking sector be transformed into what had been the Holy Grail of private bankers since at least the time of Nicolas Oresme: the ability to create private transferable credit—private money—without the annoying constraints imposed by the policies of sovereigns and their assorted central banks and regulators?

The answer turned out to be surprisingly simple. It was to make everything surprisingly complicated. With a chain between borrower and end-investor involving seven legal entities in several jurisdictions issuing seven different securities rather than one issuer in one jurisdiction issuing one bond, a sleight of hand could be achieved. Somewhere along the long line of intermediaries, the critical issue of the synchronisation of payments could be conveniently fudged. The traditional credit market transaction, between end-investor and borrower via the medium of a bond, had been stolidly transparent on the matter of liquidity. Buy a three-year bond, and one’s money was tied up for three years; buy a ten-year bond, and see it tied up for ten. Of course, if one wanted one’s money back sooner, one could try to sell one’s bond before it matured—and in normal market conditions, one would be able to. But there was nothing in the prospectus to guarantee this surrogate source of liquidity. There was a clear and simple link between the liquidity terms bought by the end-investor and the liquidity terms promised by the borrower. Like a manual
transmission gearbox in a car, there was a simple, mechanical connection between what you chose and what you got.

The new style of credit market transaction was different. The end-investor could buy a share in a money market mutual fund that promised conversion to cash on demand—the credit market equivalent of a bank’s demand deposit. The borrower, meanwhile, could promise a bond that repaid in ten years. The awkward liquidity mismatch between the two could then be systematically obfuscated somewhere along the long chain of counterparties. Like a car with automatic transmission, few were equipped to understand exactly what was going on inside the box, even if the ability to shift gears without any actual effort from the driver is, when one thinks about it, rather remarkable. As for consulting the owner’s manual, that would have done no good at all. The theory behind the new arrangements didn’t concern itself with anything so trivial as money. And in any case: since it all seemed to work, who cared?

As with the demise of the Great Monetary Settlement, it was only when it was too late that the truth of the matter was discovered. The decades of specialisation and the division of labour had led in the financial sector to something much more revolutionary—and less innocent—than they had in other industries. The displacement of traditional banks by a disaggregated network of specialist firms linked together by complex supply chains, had not just been about greater efficiency, more choice, and better value, as it had in the car or mobile-phone industries. It had been about the reanimation of the Monetary Maquis: the discovery of a miraculous new means of creating private money outside the control of government. The result, by 2008, was nothing less than a parallel monetary universe: a vast, unregulated, “shadow” banking system organised internationally within the credit markets, alongside the regulated banking systems of nation states. In the U.S. alone, the balance sheet of the shadow banking system stood at around U.S.$25 trillion on the eve of the crash—more than twice the size of the traditional banking system.
³⁰
In Europe, where securities markets, like automatic gearboxes, have always been less popular, the new “Army of Shadows” was less numerous—accounting for a mere EUR 9.5 trillion.
³¹

It was only in the teeth of the crisis that these magnitudes began to be grasped and the true size of the challenge facing the world’s central banks and sovereigns became clear. Not only was the Great Monetary Settlement in tatters, and the traditional, regulated banking sector rapidly swallowing up billions of dollars in credit support, but there was a gigantic and previously unaccounted for shadow banking sector as well. The failure of this monstrous parasite would kill its host: it could no more be allowed than the collapse of the traditional banks themselves. Liquidity and credit support would have to be extended to it as well.
³²
The result was the bizarre sight of the U.S. Treasury providing credit support to an insurance company, and an expansion of central-bank balance sheets on an unimagined scale, as they absorbed the liquidity risk that banks and shadow banks had proved unable to manage alone. In the six weeks between 10 September and 22 October 2008, the balance sheet of the Federal Reserve doubled and the Bank of England’s more than tripled.
³³
The European Central Bank was initially a more reluctant saviour—but in time it too found itself having to backstop the broken promise of liquidity transformation made by both the traditional and the shadow banking sectors.
³⁴
Analysts expressed horror at this expansion of the money supply, warning of the imminent approach of hyperinflation, the collapse of the U.S. dollar, and the eruption of currency wars. But these lurid fantasies started from a mistaken premise. The news of what had really been happening was only beginning to leak out. The money had been there all along—it had just been hiding in the shadows.

With this coup d’état exposed, attention turned to the sovereigns’ response. The U.S.$25 trillion question, it seemed, was whether the regulators have the firepower to bring the system back under control. In the next chapter we will discover the answer.

The Great Monetary Settlement has become a one-way bet for banks, and the Monetary Maquis has been busy on a scale unparalleled in history. The last four decades, it seems, have seen monetary society burst its political bonds as never before. It is therefore no surprise that counter-insurgency is the order of the day. What might seem a little more improbable is that the global headquarters of the regulatory rapid-reaction force should be a provincial town in north-west Switzerland. The primary international forum for the co-ordination of financial regulation is the Basel Committee on Banking Supervision, based at the Bank for International Settlements—the so-called central bankers’ bank. When the crisis struck, Basel was therefore the first port of call for defining a new regulatory response. It was in Basel, after all, that the most important conventional regulatory weapons to mitigate moral hazard had been designed: rules requiring banks to keep a specified quantity of cash or highly liquid securities in their portfolios to reduce the chance of needing to borrow from the central bank, and others requiring banks to maintain a buffer of equity capital sufficiently large that they would not fail in the first place.
¹
But over the course of the twentieth century, the size of the protective capital buffers maintained by U.S. and U.K. banks
had been allowed to fall by a factor of five.
²
The proportion of cash and highly liquid securities in their portfolios has fallen by the same amount in only the last fifty years.
³
Basel’s diagnosis was that there was nothing wrong with these tried-and-tested weapons per se, but that more firepower was needed. In December 2010, a new directive requiring banks to hold more capital and more liquid assets in their portfolios was therefore agreed.
⁴

The picturesque Swiss town of Basel: the unlikely headquarters of the world’s monetary counter-insurgency operations.

(
illustration credit 15.1
)

Requiring increased holdings of equity capital and liquid assets acts as a tax on risky activities. Make it more costly for banks to gamble and limit the tables at which they can play, the basic argument runs, and a healthy equilibrium can be restored. On this view, the regulatory challenge is a schematic one, familiar from any industry which generates private benefits but also social costs. A chemical manufacturing plant, for example, might generate profits for its shareholders and salaries for its employees, but also waste products detrimental to the local environment. If the factory isn’t made to bear the costs of this pollution, it will enjoy a free ride, and therefore
produce more than is economically justified. The solution is to impose a tax that ensures the polluter pays the full economic cost of its production.
⁵

Many in the regulatory establishment are, however, sceptical that the deep problems revealed by the crisis can really be met successfully by conventional warfare of this sort. The pollution caused by the banking sector, they warn, is not like the pollution caused by a chemical factory, for two reasons. The first is simply the scale of the problem: the potential social costs of operating the monetary system as currently configured are simply too large to be discouraged through the tax system. Recovering the direct fiscal costs of liquidity and credit support might just about be plausible via a levy on the banks—albeit one that would wipe out most of their profits.
⁶
But the full bill for the financial instability that came home to roost after 2007 includes the costs of lost GDP, of mass unemployment, and lost capacity. These run into the tens of trillions of dollars: they are, practically speaking, uninsurably large.
⁷
If we stick to conventional warfare, in other words, victory would require an atom bomb so large it would destroy the Earth.

The second reason that taxation will not work, its critics argue, is that the networked nature of the banking system means that the activities of individual banks also generate emergent risks at the level of the system as a whole. So unlike in the case of the polluting chemical factory, an extra tax to discourage activities that generate systemic risks is in theory required. But the system is international—and there exists no multilateral political authority with the legitimacy to levy it.
⁸
Victory, if we stick to conventional warfare, would require a well-resourced and capable United Nations Army.