Morgan Ricks is a law professor at Vanderbilt University, former senior policy advisor and financial restructuring expert at the US Department of Treasury where he focused primarily on financial stability issues and capital market policy in response to the financial crisis. Morgan joins David on the podcast to discuss the ideas expressed in his book, “The Money Problem: Rethinking Financial Regulation,” and the implications it has for economic policy. Read the full episode transcript Note: While transcripts are lightly edited, they are not rigorously proofed for accuracy. If you notice an error, please reach out to [email protected] David Beckworth: Morgan, welcome to the show. Morgan Ricks: Thanks for having me. Beckworth: I'm glad to have you on. I've read your book and as
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Morgan Ricks is a law professor at Vanderbilt University, former senior policy advisor and financial restructuring expert at the US Department of Treasury where he focused primarily on financial stability issues and capital market policy in response to the financial crisis. Morgan joins David on the podcast to discuss the ideas expressed in his book, “The Money Problem: Rethinking Financial Regulation,” and the implications it has for economic policy.
Read the full episode transcript
Note: While transcripts are lightly edited, they are not rigorously proofed for accuracy. If you notice an error, please reach out to [email protected].
David Beckworth: Morgan, welcome to the show.
Morgan Ricks: Thanks for having me.
Beckworth: I'm glad to have you on. I've read your book and as you know I wrote a review of it, it's a really fascinating book and I encourage all the listeners to get a hold of a copy. Now I want to begin because this book is really chock full of interesting ideas and finance and monetary economics. A great review of the literature and there're some new things I didn't know I learned in reading your book as well. So, how did you get into this book? What experience was behind it? And what motivated you to do it?
Ricks: Yeah, I got interested during the financial crisis in this set of issues. A lot of people I watched with a mix of horror and fascination and in 2007 and 2008 as the financial system really melted down and I was at the time sitting on a trading desk at Citadel, a big Chicago hedge fund and as the crisis unfolded in particular in the later stages, I decided to make a move into public policy. And so in early 2009, I joined the Geithner Treasury on a small team there that was focused on... They were called the Crisis Response Team originally. So, it was run by a guy named Lee Sacks and a guy named Matt K. Baker and they hired me as the first team member and then we built out a team and so we were focused there in 2009 on financial stabilization policy and then we started to turn our attention to... In the later part of 2009 more to thinking about financial reform.
Ricks: There was a separate team within Treasury that was spearheading the drafting efforts for Dodd-Frank, we started to get more involved with that and that was when I started down the path that led to this book. I suppose it was probably around 2010 that I... maybe the early part of 2010 that things started to click in the sense that I had a thesis that I was really driving toward, but it took a number of years for it to reach fruition into this book.
Beckworth: You wrote some papers before the book, they were the early seed of the book, is that right?
Ricks: Yeah, that's right. In fact, I wrote... Even when I was in Treasury, in late 2009, early 2010, I wrote an internal memo that when I look back on it was a really crude precursor to some of the ideas of the book and we circulated it around Treasury and Geithner took a look at it and told me it was wacky. And then we basically threw it in the trash. So, when I left Treasury I kind of resurrected that set of ideas and I think he was right it was a wacky set of ideas then but it needed a lot more development and so I wrote a few academic papers in 2010 and 2011. By 2012, I realized that the topic needed for me to do it the right way it needed to be in a book form.
Beckworth: Okay, so has Tim Geithner come back and read your book and changed his mind?
Ricks: I haven't heard anything from him on it yet.
Ricks: I did send him an email when it was out, but I'm not aware of whether he's read it.
Beckworth: We'll take his silence as an approval of the book. Okay. Let's begin with a quick summary of your book. There's a lot to go through but if you could summarize the arguments upfront and then we'll kind of walk our way through them piece by piece. What is it that you see as the key problem, the key cause of the crisis and what should be done about it?
2008 Financial Crisis
Ricks: Yeah. So the book at its core is really a pretty old fashioned idea. So my core argument is that financial instability is mostly about private sector money creation. And I say this is old fashioned because I think if you had said that to, say, Milton Friedman, would have said it was self-evident. But most experts today at least in the field of financial regulation, don't tend to see it this way and the actual path of financial regulatory reform has been mostly occupied with other things. So, I'm arguing that we should consider doing things very differently. And one of the big conceptual hurdles and a major theme of the book is that, the nature of money and what constitutes money has evolved very rapidly in recent decades. So, it used to be when we thought about private sector money creation and the textbook description of money creation its deposits, where before that it was of course circulating bank notes that banks issued.
Ricks: But now, as Gary Gordon and others have described in detail, we have what's come to be known as the shadow banking system. That term gets used in a lot of different ways and some of those ways I think are less or more useful than others. I use it to refer in a pretty narrow sense to a very specific business model that involves issuing a lot of short term debt that's rolled over continuously. And so part of the argument in the book is that we have this rapid growth in various forms of private money in recent decades and that in a very real sense, these instruments are monetary in the sense of their deposit substitutes. The holders of these instrument think of them as cash and refer to them as cash or cash equivalents. And so in a very real sense shadow banking creates money and I documented the book that these markets are huge and they're pervasive. And I argue among other things that they are unstable and that this instability presents a uniquely grave threat to the broader economy.
Ricks: So like I said, in a sense that's all kind of old fashioned, although actually each of those components is quite controversial. Much of the book is concerned with what does it mean to say these instruments are monetary? That's a controversial topic. Is this funding model really unstable and what does it mean to say it's unstable? That turns out to be controversial. And is this instability really dangerous to the broader economy that's also unstable? And so the first part of the book is concerned with all those questions and then the second or third parts of the book are, "Okay, if I'm right about that, what do we do about it?" And here I'm also pretty old fashioned. So, I really like our US system of insured depository institutions insured banking that we've had since 1933 as amended a few times since then. And we can get into the details later if you want to, but the most controversial part of the book is my argument that we really haven't given sufficient attention to entry restriction into money creation. So, entry restriction has been around as a key part of banking law, really since the emergence of fractional reserve banking.
Ricks: And in the US and England at least, we pretty much always restricted entry into the creation of monetary instruments understood as banknotes or later deposits. My argument is that, well, the nature of money has changed the nature of our entry restriction needs to change. So, I'm advocating or suggesting at least that we think about imposing a generalized prohibition on private sector money creation outside the charter banking system, which means prohibiting a very specific funding model. And I argue not only is this feasible, it's actually a lot more feasible than a lot of other things we're trying to do in financial regulation. In fact, if we did this I arguably could stop trying to do a bunch of other things. So, that's really what the books about. You could say it's a book about shadow banking or about short term wholesale funding or about private money creation. Those to me are all ways of saying essentially the same thing.
Beckworth: Okay, the first part of that message that you have in your book is about money, what is money? You give a chapter titled taking money seriously and that really resonated with me, because like many people I too was under the impression or took the view that when we think of money it's M1, M2 and then the recession comes along Gary Gordon as you mentioned opened my eyes that we got to take all forms of money seriously. So, the M2 measure would be more of retail money assets and what you're pointing towards these institutional money assets. They're also very important. And you mentioned in your book that textbooks, principles of macro textbooks, money and banking textbooks. You mentioned some of the better known ones. They still look at money kind of the old fashioned way. Is that right?
What is Money?
Ricks: Yeah, I think that's right. And it's understandable certainly from a pedagogical perspective to describe deposit creation and to limit your view to deposit specifically but the problem is that we now have all these deposit substitutes that are really as you point out institutional money. So, I'm talking about things like overnight repurchase agreements and asset back commercial paper as well as euro dollars as well as securities lending, collateral obligations, variable rate demand notes and auction rate securities. There's a whole proliferation of these types of instruments that are really serving from their holders perspective as monetary assets, right? It's part of their cash reserve. They're not thinking of this as an investment security, they're thinking of it as a form of cash. And so I think we haven't certainly from a textbook perspective, the textbooks haven't caught up to institutional reality here. But there's a conceptual hurdle to get over which is what do we mean when we say that these instruments have monetary attributes.
Beckworth: Yeah. I'm still waiting for this first textbook to do that. I started teaching my undergrads soon after the crisis emerged in effort Gordon's work, what is money? We got to think of it more broadly than normal. So that's why your book is really refreshing to see that that chapter is really clear. And in fact, I plan to use in future classes that I teach when this money question comes up. Now, you are clear to distinguish between what you call near money assets or cash equivalents and the ultimate medium of exchange, which is actual currency or the dollar. But you point out that these near money equivalents, they still satisfy money demand. So, they're effectively functioning as a transaction asset, at least a potential one. Now, how do you define them in terms of maturity because you make a point in the book, there are safe assets in general, such as long term treasuries, short term treasuries and you draw a line in the sand in terms of what really is a near money asset.
Ricks: Yeah. So, this idea of safe assets has become really prominent in the literature in recent years and that term gets used in different ways, but I think usually it's used as a synonym for AAA credit assets, which would include say a 10 year Treasury bond. So, I argue that that is an excessively capacious understanding of what constitutes money and that moneyness really is something that arises at the short end of the yield curve. And the distinction is sort of obvious. High quality short term debt both has very little credit risk, but also very little interest rate risk and so it fluctuates very little in value in relation to the medium of exchange and therefore serves essentially as a substitute for the medium of exchange. I choose a year cut off, there's no magic to a year. It is the traditional dividing line between the money market and the capital market. I think that term money market isn't a misnomer and some people have argued that it is a misnomer we shouldn't refer to short term debt as money. But the one year maturity cut off is pretty traditional within the financial markets.
Ricks: It's also financial regulators and their new liquidity regulations have selected the one year maturity cut off as being significant. So, I'm not alone in that. Others have chosen different cut offs. So, the accountants for purposes of accounting, the relevant maturity cut off or something to be a cash equivalent is three months. So, a longer term security would have to be classified as an investment security for accounting purposes but if the maturity is three months or less it's classifiable along with deposits on your balance sheet. Why do I pick a year part? Yes, it's the traditional financial market cut off, but more importantly Jeremy Stein at Harvard along with Sam Hansen and Robin Greenwood, those are three economists at Harvard, have done a lot of work on analyzing the Treasury yield curve and they document that yields get really puzzlingly low on treasuries at the short end of the curve and their focus is on six months and less.
Ricks: But they show that there's this kind of moneyness premium, they refer to it as a moneyness premium or a convenience yield, in the sense that short term Treasury yields are a lot lower than one would predict based on an extrapolation of the longer term yield curve. So creditors or holders of these claims are paying extra for them in a sense. And they must be getting something out of that and Jeremy and his colleagues, his co-authors described that as moneyness. And they document that phenomenon and show it kind of at the six month and less maturity. I'm picking a year because it's traditional and because it's a bit outside of that six months. There's no magic to a year but I think it's kind of about right.
Beckworth: Well, that's where Treasury bills end, right, at a year?
Ricks: Yeah, that's right. And I would... It's funny when you look more detail at the way various way this issue gets treated in various domains. So, securities lawyers use a nine month maturity cut off. If it's in within nine months, you're generally exempt from certain registration requirements under the securities laws. Keynes, if you go back and read the general theory, he suggests the maturity cut off of three months. He says within three months, we can treat it as money outside of three months we can treat it as a bond. So, there's some range in here between zero and a year, that's probably about right.
Beckworth: I've read your book and I read that chapter on taking money seriously. It was fascinating because I've been working on an informed measure of the money supply. So the Center for Financial Stability, they have constructed some Divisia measures at the money supply and they're broader than the traditional simple some M2 you'd get from the Federal Reserve. And the informed measure includes some of these assets you've mentioned and they also include Treasury bills with a stop at Treasury bill. So, their definition is entirely consistent with yours. And I've done some work with a co-author Josh Henrickson, where we empirically look at what happens when they're just shocked to M2, verses M3, M4 and also M1 these different measures. And if you include the Great Recession period, the only one that produces reasonable results in terms of standard monetary theory, so responses in the price level, short term effects and real output, enforce the only one that gives the best measure. So, I thought it's striking that you're making the case for this definition of where money gets cut off and empirically seems to be supported by this Divisia M4 measure.
Beckworth: And I would encourage people to take a look at it. If you go to the Center for Financial Stability's website, they actually have graphs, you can download that data. And what's fascinating is you see a clear break in the series during the crisis. So, if you look at M2, you might think, "Oh, everything's fine," but M4 clearly has a collapse. And it's grow back past its peak, but never fully has recovered back up to the trend growth path. There's kind of a permanent reduction GDP, there has been this permanent reduction in the growth path. So, it speaks I think a lot to the point you're making in your chapter. I think that's why it resonated so much with what I was thinking.
Ricks: Yeah, I did come across the Divisia stuff in my research and ended up for some reason not really pursuing it, but I'll have to take another look.
Beckworth: Yeah. Well, it's consistent what you're doing. But let's move on in your book to the part where you talk about money creation and you get into how money is actually created. So, why don't we talk about that and then maybe segue into what problem is there when the private sector makes... You make an argument that there was a market failure in the money creation business. So, tell us about that.
How Money is Created
Ricks: Yeah. Well, in some ways this will all be quite familiar. So, the funding model, that issue here, whether it's deposits or whether it's these cash equivalents, it always consists of rolling a lot of the stuff over continuously and using these instruments to fund longer term financial assets, using also kind of fractional reserve of cash to meet redemptions in the ordinary course. And so it's a law of large numbers business model. That's the standard textbook treatment. I do think that there's a coordination game involved here. So this is for those... I know a lot of your listeners are economists and are very familiar with modern banking theory.
Ricks: For those who aren't, there's a very famous contribution to the banking literature by Diamond and Dybvig from the early 1980s, where they argued that banking involves a coordination game with a good equilibrium and a bad equilibrium and that runs on banking institutions have a self-fulfilling dimension. Not everyone accepts that banks do have a self-fulfilling dimension, but I think they do. I think that the way to the evidence points in that direction. And because there's a bad equilibrium and there's a self-fulfilling dimension, we can think of that as being a classic market failure.
Beckworth: Okay. And you suggest that there's no market solution to this, is that right?
Ricks: Well, I don't think there is. I'm open to the idea there might be but it doesn't seem to have materialized at least not on a broad scale.
Beckworth: Now, I have to turn around there. What about the idea of a suspension clause?
Ricks: A suspension clause in the instrument, so a contractual agreement?
Beckworth: Yeah, that says ahead of time. Look, if this bank run does occur, we're going to suspend convertibility between deposits and physical cash.
Ricks: Yeah. I am-
Beckworth: Is that workable? I guess.
Ricks: I'm aware there's a literature on that, that I looked at some time ago and then there may be some historical precedent for it in Scotland and in England, maybe in the United States, I don't really recall. So, I'm open to the idea that could work. I think one of the things that Gordon has argued and he Hugh Rockoff I think has a version of this argument in relation to the Depression is that suspension undermines the monetary nature of these instruments. So, Gordon says when suspension of comfortability happens, he's not referring to contractual suspension, he was referring to government imposed suspensions, but that once suspensions of convertibility have happened historically these claims on bank ceased to be money in any meaningful sense. And Rockoff had a paper that I looked at some time ago that argued that the quality of the money stock decline and the great depression as a consequence of suspensions. So, you're likely to see these claims ceased to trade at par, they'll cease to serve a meaningful monetary function for their holders. It's not obvious to me that a suspension clause would deal effectively with the knock on consequences of run.
Ricks: So, if an institution didn't want to suspend it, it would seek to liquidate its asset portfolio in order to prevent redemptions, which it might want to do for reputational reasons. And if that happens on a broad scale, you end up with disruptions in the financial markets. I think not withstanding a suspension clause but I'm open to the argument that could be workable.
Beckworth: Yeah. Well, it is hard to think through what would it have meant for the bank run of 2007/2008. I'm not sure I know that answer. How would they have had a suspension clause in place in the shadow banking system? Well, let's move on a bit to your discussion on banking, you have a chapter banking in theory and reality. And you go through the standard models for why banking exists and as a consequence why maybe money exists. And you mentioned too, you mentioned the commitment device model for banking as well as the information asymmetry model for banking. And you argue that they both have interesting things to say but they're incomplete. They don't really get at the heart of what is money. The role banks have in creating money. So, can you speak to that?
Commitment Device Model of Banking
Ricks: Yeah. So, there's a number of theories about why this funding model exists, why does certain institutions use demandable debt or very short term debt funding? And one of them is this commitment device model that's associated with Charlie Calomiris and others and it's really interesting. In their model, this funding model is used as a kind of way of solving an agency problem. It's essentially a way of keeping the management team honest and preventing them from absconding with the firm's assets. I find this interesting, but it's really essentially a non-monetary model of banking, in the sense that... And they're explicit about this in their paper, they say that liquidity demand is absent in their model. And it can be maybe seen as a byproduct of this solution to this agency problem. So, the monetary function of banking kind of arrives incidentally or as a byproduct here. As an intuitive matter, I'm not sure how plausible that is.
Beckworth: And that seems completely backwards.
Ricks: To me it does. If you think of banks first and foremost as monetary institutions, it's weird to think of that as being a byproduct of a solution to an agency problem. The other question about those models as a reason I think is, how do they connect up the right side and the left side of the balance sheet. So, this funding model is really heavily associated with financial asset portfolios, credit portfolios in particular and explaining why that particular asset profile raises these agency problems or which short term debt is a good solution, that connection has never been obvious to me. So while I find this models interesting, they don't for me at least get me very far.
Beckworth: No, I agree with you on that commitment device mode. I do want to point out an interesting, maybe an example where it seems to shed some light. But again, it doesn't get at this question of what is money and how the banks play a role in it? And that is the tequila crisis in Mexico 1994, ‘95 I think Calomiris has written about that where... My understanding, I may be wrong, but my understanding was that the government of Mexico basically guaranteed all bank deposits and then once the crisis hit, people realize they didn't have the resources to do that and so they said, "Oh, goodness," so they actually started looking at balance sheets, the health of banks and this kind of discipline story kicks in and what you found is that banks that were sound deposits flowed to them out of banks that weren't sound and the good banks survived the bad ones did not.
Beckworth: But I think your bigger point is that it really doesn't answer this money question. So, let's move to the next one. The information asymmetry model. I think probably a lot of our listeners have heard of this from Gary Gordon. What are your thoughts on that?
Information Asymmetry Model of Banking
Ricks: So, I think for me this was a really powerful set of ideas and the basic idea here is that the financial markets produce certain kinds of claims for which research is not really rewarded that much. The point of them is to be insensitive to information and this allows investors I think in the original version of their model, the idea is that there were informed traders and noise traders and the noise traders would be taken advantage of by the informed traders. And so the noise traders will prefer to hold instruments with respect to which the production of information is not rewarded and that way that could be not taken advantage of. I find this to be really powerful. I think it's a really interesting way of thinking about things like securitization, the production of safe assets, which we referred to earlier, AAA bonds. In other words, it's a way of understanding capital structure generally. At least for me, I find it helpful to think about that way.
Ricks: I'm not sure it gets... For me, at least it doesn't necessarily get to what's distinctive about banking, because information insensitivity I think can apply to long term debt as much as it can to short term debt. And yet, as we just talked about a moment ago, this moneyness property really seems to be a distinctive attribute of the short end of the curve. And I'm not sure that the information asymmetry models give us a good way of thinking about that. And so while I think they're powerful, they don't fully illuminate the banking business model to me.
Beckworth: Okay. So, moving on from those you also talked about in this chapter that the right definition of what a panic is. And you focus particularly on this idea of short term runnable debt panic. And you stress like an equity crisis in 1987 or maybe 2001 doesn't really measure up because it's focused on equity. So, tell us more about this idea. You this mentioned earlier, the primary threat that comes from the financial system is our bank runs. Is that right?
Why FinReg Policy Should Focus on Bank Runs
Ricks: That's what I think. Bank runs understood to include shadow bank runs. Right? So, what's the unraveling of this of type of funding model that we've been talking about it is what in my view, we should be far and away most concerned about when we do financial stability regulation and financial stability policy. So, for me, here I'll sound just like Gary Gordon and Bernanke has made a similar point. Bernanke says... He defines a panic in one of his speeches as widespread withdrawals of short term funding to a set of financial institutions. And that's all I mean by a panic. It's a run on the bank, it's not sales in the secondary market per se. So, an equity market disruption is not in and of itself, a panic. A panic is widespread redemptions of the financial sector short term debt. So, that's pretty much... I think that's pretty standard and old fashioned. Anna Schwartz has this paper that I haven't looked at in a while, but I think it was called “Real and Pseudo Financial Crises.”
Ricks: And what she equates runs on banks with real crises and she says all this other stuff burst bubbles and corrections in the stock market and whatnot, she refers to as pseudo crises and I agree with her definition, except that I'm not sure she would treat a shadow bank run as a... Or shadow banking panic as real crisis whereas I would.
Beckworth: So, your explanation for the Great Recession, at least what triggered it is a massive bank run on the shadow banking system. And you discuss in your book some of the other ideas given for the Great Recession, everything from the debt-fueled housing boom collapse, to Austrian theory, to the Monetarist discussion, but that's your understanding of what happened is primarily a financial crisis driven by this bank run, is that right?
Ricks: Yeah, that's what I think the main thing was. And that's not to say that there weren't multiple elements. And so, one of the things that's really interested me since the crisis is the sheer diversity of explanations for what it was that happened by experts. And there's a lot of diversity, but I think... My view is not really unorthodox, it may in fact be the dominant view. I think it's pretty clearly the view of Ben Bernanke as expressed in his recent book, which is that the financial crisis proper was a major source of damage to a major source of the Great Recession.
Beckworth: So your claim is that it was a bank run that caused the crisis. And so the follow up question is why we had so long of a slump or slow recovery. Rockoff and Reinhart would say, well, empirically, whenever you have a recession associated with bank runs or severe financial crisis, they just take time. They take time to unwind all the imbalances and to get balance sheets back in order. Do you have an explanation for why a banking crisis that caused the recession would take so long to recover?
Ricks: Yeah, I'm not sure I have a satisfactory one. This is a topic on which I would certainly defer to macro economists who have thought about this for a long time and studied in detail. A number of prominent economists argue that this debt overhang is a big part of the story. So, over-leverages household balance sheets or over-leveraged balance sheets in general throughout the economy create a drag that's an impediment to recovery. I think there's... I don't see any reason why there wouldn't be some truth to it. As I read through this, the literature here I was sort of intrigued by the idea that maybe the economy just doesn't have any automatic tendency to revert back to pre-crisis trend. So, this kind of multiple equilibrium notion that is present in Keynes and that others after him. I found James Tobin to be really interesting on this question of whether the economy has natural adjustment mechanisms to return it back to the pre-crisis path. I'm not sure that's the right answer, but it seems to me to be a plausible explanation for the lack of return to the pre-crisis trajectory.
Beckworth: Yeah, it was interesting reading your book, you brought out the multiple equilibrium story. Basically, there's multiple equilibrium. We could be in a better one, we're stuck in the low growth equilibrium. You mentioned Keynes, Tobin, I'd also throw in there maybe a current version of that is Roger Farmer from UCLA. He's a big advocate of that right now.
Ricks: Yeah, I read his book, which is an accessible version of his theories and I'm kind of fascinated by it. I think I sighed him in a footnote there in that section. But I just want to emphasize for me, that's more of a review of literature and theories I don't necessarily have any strong attachment to it and I don't know that I am qualified to have a strong opinion on the question of failure to recover, why we fail to recover from sharp acute macroeconomic disasters that are caused by the financial system. I'm not really qualified to answer. What I do think is important though and what I do believe, is that the financial crisis itself was a major driver of the recession.
Beckworth: It was the spark, right?
Ricks: Yeah, I think... I don't know. You could call... What was the spark, you might say the spark was a bubble in housing prices, you can take the chain of causation back as far as you want to. So, I don't like to think of it as a spark, I think of the panic itself as kind of the dagger in the gut, right? That's what really was the source of the damage. Another way of thinking about it is where would the economy have gone and the absence of the panic if everything else had played out the same way in terms of the conduct of monetary policy, in terms of the path of asset prices, including housing prices and household balance sheets, et cetera. And so I suppose my argument is that in the absence of the shadow banking panic, we would have had a much milder recession.
Beckworth: I don't know the answer this question, but I wonder what happened in Australia to its shadow banking system if they had it to a large extent, because they also had the big expansion of household debt, housing prices exploded and they never had the Great Recession. They were fortunate in that they had the ability to low interest rates before hitting zero lower bound. They also had support from fiscal policy. So, it would be interesting to see what happened there. So, I think that did good counterfactual, I suspect they must not have had the same type of bank run that we did.
Ricks: So I'm not as familiar with the Australia experience. Well, one thing that I find is interesting to look at or thought provoking in the US experience, is to think about the timing of the macro contraction. Housing prices started to fall in late 2006. They started to fall really in earnest in the early part of 2007 and by the time the Lehman event, which is when the severe panic struck, that story of housing price correction was already about two thirds played out and we were still at that point in a very mild recession, right? The peak to trough contraction was about 20%. We were about 20% of the way from peak to trough in terms of a macro contraction. And then there's this massive acceleration and the pace of contraction that happens immediately after the acute phase of the financial crisis. And so to me, the timing of these events is suggestive of an independent role for the panic in terms of causing a contraction.
Beckworth: Yeah, I agree with the point you make about housing already been almost completely done at least two thirds of it, you mentioned done. And by the time things really turned sour in 2008, housing had been contracting for a while if you look at the housing sector data, employment, income and all the sectors related to housing had been going down and the rest of the economy actually had been fairing not so bad. Actually you see some employment growth even through early 2008 outside of the housing related sector. So, we were weathering that recession well enough. So, I guess your point is, had this bank run not occurred, this may have just been an ordinary garden variety recession, not the Great Recession. And my views, I have a slightly different view at that point and I think the Fed may have made things worse, so I won't go there. I will mention this though, in terms of going back to your observation about the slow recovery, the multiple equilibrium story of Keynes, Tobin, Roger Farmer, it's a story of a coordination failure, right? That for whatever reasons, there's increased liquidity, people are highly risk averse, no one wants to be the first one to put their foot forward and maybe invest in a new plan, create jobs.
Beckworth: And so the question comes, well, what is something that can coordinate all of these actors and catalyze them to get going and in my mind, from that macroeconomic policy comes in, maybe temporarily raising the inflation rate, so people don't want to hold on to these liquid assets as much, some kind of spark that's going to take the efforts of a coordinated macro policy response, which I think we did not have or have enough of after 2009.
Ricks: Yeah, I don't disagree with that although again, I can't imagine that people really care what I think about-
Beckworth: As you said, there's a diversity of views and-
Ricks: ... but I do think irrespective of how we answer that question, there is reason enough to think that we'd all be better off if we get aboard avoid these kind of severe shocks to begin with.
Beckworth: Oh, absolutely.
Ricks: That's really my key point in that chapter.
Beckworth: And I think where we definitely agree is on this observation that you can't have a huge collapse in the money supply as measured by M4 and expect nothing to happen. When you have a huge drop like that in the money supply, something is going to happen. So, I think that's a reality that we all have to deal with. Let's look at potential solutions now and let's talk about a few others before we get to yours. Let's talk about one of the ones that has seemed to become more popular and that's narrow banking. So, what is narrow banking and what are the challenges you see with it?
What is Narrow Banking?
Ricks: So, people use that term in slightly different ways, but when I talk about narrow banking I am referring to taking your chartered banking institutions and requiring them to hold extremely safe assets. So, in the original and purest version of narrow banking, which is 100% reserve banking, which of course was advocated by Irving Fisher and Henry Simons and later by Milton Friedman. The idea is that a bank could hold nothing but base money. And so a bank essentially become just a pass through vehicle, private sector money creation then just goes away and money creation is a public monopoly. And then so of course, under the later versions of narrow banking, they liberalized it somewhat. So, I think the idea as Bob Layton and others described it in the late 80s, was to have banks be allowed to own Treasury bills at least. So, the basic idea is let's do massive restrictions on portfolios to the very, very safest stuff. So that set of ideas has been around for a long time and it's always run up I think against two problems.
Ricks: And the first problem is what I'm sure we'll talk about a little while, which is this problem of regulatory arbitrage or how do you prevent deposit substitutes from arising outside of your chartered banking system and essentially recreating the problem that you were trying to solve? And that's a problem that... It's interesting Henry Simons became... He was one of the guys who really spearheaded 100% reserve banking and was a leading thinker, an advocate of this in the 1930s, but he sort of ended up souring on it or becoming disillusioned because he didn't think you could solve this regulatory arbitrage problem. Irving Fisher thought he could solve and Milton Friedman thought there was a solution by paying interest to the 100% reserve banks. But essentially, this has always been a problem that proponents have had to confront. I actually think this problem is solvable in the sense I'm advocating entry restriction into creating monetary instruments. So, I clearly think it's possible to do it as a regulatory matter, but what I think is the big problem with narrow banking is the second problem, which is what I've called fiscal monetary entanglement.
Ricks: So, if you're going to restrict the banking system, to say Treasury bills and you need to make sure you have enough Treasury bills to accommodate the desired money supply. We're assuming for this purpose that we solve the regulatory arbitrage problem, where we don't have private sector money creation happening outside the banking system. Well, then at that point the banking system and the Federal Reserve are your only money creators. And if you're restricting them to holdings of treasuries and you got to make sure you have enough treasuries outstanding to accommodate the economy's need for transaction balances. So, to put it another way, a narrow banking system would not be consistent with a long term balanced fiscal budget because there wouldn't be any treasuries outstanding and so you couldn't have you a functioning banking system in the absence of those treasuries.
Ricks: So, it requires a certain structure of government debt. I happen to think there are good reasons to just divorce these two things and to have a monetary system that's compatible with a variety of fiscal environments, including a balanced budget. As far-fetched as a balanced budget may seem today, it wasn't that long ago in 2000 the Fed was very concerned about the rapid pay down of the government debt. They were concerned that they were going to run out of enough government debt even to accommodate the base money supply. Just the Fed's balance sheet. And they were giving serious consideration to what other assets they would have to buy if there weren't enough treasuries outstanding. So to me, there are good reasons to want to divorce, have a separation between fiscal and monetary and you can't do that under narrow banking.
Beckworth: Yeah, that was fascinating. I hadn't considered that point you've made, that if you go to 100% reserve back and you're going to be entangled in fiscal monetary policy. And I guess what's interesting is a lot of people who advocate that are more free market leaning types and I wonder if they think through the implications of that.
Ricks: Well, it's interesting, they all do in one way or another. Actually, Simons I don't know if he did, but Irving Fisher has this great passage where he basically says, "What if some fine day you bought all the Treasury debt and its outstanding? You bought it all and you still need more. What are you going to do now?" And his solution was, well, you just cut taxes. And in other words create more debt to accommodate your money balances. And Milton Friedman has this passage that he puts in a footnote of his program for monetary stability where he essentially goes through the same thing and he says he's not really satisfied with any of the potential solutions. He said you could either have the central bank start buying things other than treasuries or you can produce more debt to finance deficits. And he says neither of those answers is particularly appealing, but then he doesn't pursue the idea very much. Bob Layton addresses this point briefly toward the end of his book. So, narrow banking proponents have at least acknowledge the point but I don't think they've ever addressed it satisfactorily.
Ricks: This is a... It's not really just a hypothetical problem and as I mentioned we faced this issue in 2000. At least perceived it to be happening until of course we had the recession and tax cuts that resulted in an upward trajectory of government debt again and we stopped having to worry about it. But even in the late 19 century, one of the big flaws of the national banking system was that it required that national bank notes be collateralized by US Treasury bonds. Well, there just weren't enough Treasury bonds to satisfy money demand. And so the idea of creating a uniform national currency ran up against this problem of requiring that it'd be secured by Treasury debt. So, it's actually a recurring problem in monetary history.
Beckworth: Yeah, I was going to mention that episode. It's fascinating. They actually changed the law I believe to accommodate more money supply growth, because there wasn't enough national debt. Let's move on to capital requirements and probably our listeners are familiar with this one. This one's received a lot of coverage, but you make an argument that they can actually... Well, to some extent they're good, they can also be counterproductive. Why?
Capital Requirements: the Good and the Bad
Ricks: Well, it's actually for similar reason the narrow banking. So let's suppose we have a world where we have one set of money creation firms, let's suppose we solve this regulatory arbitrage problem so there's no money creation outside of our charter banking system. Once you impose capital requirements on the system, you're crowding out money creation by the system right? For any given asset portfolio of the banking system an increase in the amount of capital financing results and assume that the only types of financing available are capital or equity financing on the one hand and what I call money claim or monetary financing on the other hand, every dollar of capital financing or equity financing results holding assets constant results in a reduction of your monetary liabilities. So, you can't... If you're if you want the system to help you create money or to engage in money creation, you've got to have capital requirements that are lenient enough to accommodate the desired money supply. So, I'm not against capital requirements, I think you actually need them, but we can't make them arbitrarily high.
Ricks: The other thing about capital requirements there's two other brief points I'll make about capital requirements, which first is if you've decided to panic for the problem, which is what I argue in the book, capital requirements are a very indirect way of dealing with that problem. And there are a way that's hard to generalize and apply and generalize fashion across the financial system. So, I think that's one of the difficulties of capital regulation. Another difficulty is the capital regulation in a world with derivatives is just irreducibly complex. I think this point doesn't get enough attention in the literature on capital, there seems to be an assumption that we can make capital regulation simple. You have a set of assets, you take a percentage of that, you require that the equity capital, but of course losses can arise from instruments that are not reflected as assets on the balance sheet, particularly in a world with derivatives. And it's just extremely hard to calibrate capital regulation in a world with derivatives. So, I'm not against capital regulation, but I think we rely on it way too heavily to do too much heavy lifting and modern financial stability regulation.
Beckworth: Well, the third proposal is taking that idea capital requirements to the limit, you have complete equity finance banking. So, you talked about... You call it floating price money. Once you mentioned that briefly and then what challenges do you see with that?
Ricks: Yeah, this kind of idea has been floated over the years a number of times, why don't banks just look more like mutual funds and the claims on banks would fluctuate in price. There seems to be demand in the economy for assets that have a stable value in nominal terms. And I think that as money demand and I don't think we can assume it away. So, I'm not that attracted to the idea that we should just get rid of these fixed value claims.
Beckworth: Yeah, I absolutely agree to that view. I'm going to read from your book here, what John Cochrane, you mentioned John Cochrane. He has a proposal along these lines. He says with today's technology you can buy a cup of coffee by swiping a card or tapping a cell phone. So in $2.50 cents of an S&P 500 fund in crediting the coffee seller $2.50 cents mortgage backed security fun. Quarterly liquidity no longer requires people hold a large inventory fixed value pay demand, enhance run prone securities. Of course, the flip side of that is... And then David Andolfatto who I had on the show before we talked about this issue a little bit too, he has a great analogy.
Beckworth: He says basically your ATM becomes a Las Vegas slot machine and who wants that? When I go by ATM, I don't want to... One day I have $1,000 in my account, next day I got $800 in the account. I think you're absolutely right there is this... For whatever reason we have this demand for fixed value nominal short term securities. Maybe it's a sticky price world we live in that we want... And historically, that's what's evolved. If you go back to the free banking episodes, what naturally emerged was this demand for if fixed value short term debt, not equity backed financing.
Ricks: Yeah, I essentially take for granted that there's demand for that stuff. And our monetary system, we should be thinking about how to accommodate that demand.
Beckworth: All right, let's move to your solution now. We have about 10 minutes left. So, let's talk about your solution, how you are going to solve all the problems of the financial world.
Ideal Policy Solution as a Containment Strategy
Ricks: Well, I don't know about all of them, but I do think that this is a problem that we can make a lot of progress on. And so as I alluded to at the beginning, I like the insured banking system that we've had for a long time. It's not perfect. We certainly haven't managed it perfectly, but the basic structure of it is that we're going to have this chartered set of financial institutions that are in the business of having monetary liabilities. We confine their asset portfolios to the safer end of the credit spectrum. We don't say it has to be treasuries but we do say you can't hold stocks, you got to have a diversified portfolio, you can't hold junk bonds and what have you. We require some equity financing as a loss of the option layer and then we wrap the monetary liabilities with a federal guarantee for which we charge a fee.
Ricks: And that basic structure to me has a really sound internal logic and I like it, but as I mentioned earlier the controversial part of... So, I would build on the logic of existing system but the controversial part of this is building on the logic of entry restriction. So, we currently say as a matter of federal law 12 USC section 3782, you're not allowed to have deposit liabilities unless you have a banking charter. So, that's how entry restriction works. It's a generalized prohibition on everyone who's not a bank. So, a banking charter confers an exemption from that probation. And so my suggestion in the book is that money is changed all this other stuff, what we've learned is that we need a much more functional definition of what constitutes a monetary instrument, not just a deposit. The term deposit is defined in the law and circular fashion. A deposit is defined as a claim on a bank and a bank is defined as an entity that has deposit liability.
Ricks: So, it's perfectly circular. We need a functional definition of what constitutes a monetary instrument, which in practice always means various kinds of very short term debt issued by the financial sector. And so my suggestion in the book is that we should think much harder about restricting entry into this funding model. The strategy when I say restricting entry, saying the only chartered banks are entitled to use large quantities or short term debt rolled over continuously to finance a portfolio of financial assets. And so that will be a generalized provision. It presents a lot of questions, right? How do you enforce it? How do you specify what constitutes a monetary instrument in a way that can't be easily gamed or arbitrage by the financial system? And I have a whole chapter essentially, mostly devoted to that very question.
Ricks: I actually wrote down an appendix to one of the chapters, the entry restriction provision. In other words, I wrote statutory text and said this is how I would do it, here are the problems that presents and I think it's a lot more feasible than a lot of other things we're trying to do. But to me, that's the first step of financial regulation. Is entry restriction into money creation and in the absence of doing that, our financial regulatory problems are going to remain intractable.
Beckworth: Well, you mentioned in the piece in your book that the shadow banking system effectively already is backed by the government. It was during the crisis, you mentioned the large scale interventions done by the government. Let me just quote page 99 of your book, you put “the scale of these policy measures were staggering, at as peak the Federal Reserve extended about one trillion of liquidity through an arsenal of emergency lending programs. The FDIC issued over one trillion in guarantees, the Treasury Department supplied 0.3 trillion in equity capital infusions and three trillion dollars of rescues of the money market mutual funds.” So, there effectively is something in place and I think what you're arguing is let's make it cleaner, official, more efficient. Is that right?
Ricks: Yeah, this is to take a phrase from geopolitics, I'm advocating a containment strategy for moral hazard. We're backing this stuff, whether we want to or not, we have to back it. The fact that we're backing it creates all sorts of bad incentive effects and the too big to fail problem is one manifestation of this problem. And so I'd like to say, only a certain set of institutions are allowed to have this funding model and they're required to live under a very carefully circumscribed institutional environment. And we aren't going to back their monetary liabilities, we're not going to pretend that we're not going to. This is an insurance type of a system where we're saying the money supply is in fact sovereign. There's no constructive ambiguity at work. But I do think this is a containment strategy in the sense that we would at least arguably be able to withdraw implicit support for much of the rest of the financial system.
Beckworth: All right. Well, our guest today has been Morgan Ricks. Morgan, thank you for being on the show.
Ricks: Thank you David.