The world's financial authorities have rightly been doing whatever it takes to limit the fallout of one of the worst pandemics ever. Central banks — particularly the US Federal Reserve — have devised unprecedented measures and pledged trillions of dollars to support lending. Their efforts have eased panic, stabilized markets and kept at least some money flowing to people and businesses.
Yet this episode, much like the last crisis in 2008, raises a troubling question: Why is the financial system so fragile that, whenever something big and unexpected happens, the world must rely on officials' heroic efforts to rescue an ever-widening array of markets and institutions?
When the economy gets back on the path to recovery, it's worth considering whether a more permanent fix is needed.
The system's vulnerability stems from a defining element of banking. On one side of their balance sheets, banks issue short-term debt such as deposits — promises that people can access their money immediately or on short notice. On the other side, they put most of the money into longer-term investments such as loans. Generally, this works fine: Banks keep enough cash on hand to facilitate their customers' needs, and their lending helps fuel economic growth. But at any given moment, banks have the cash to pay only a fraction of their depositors. So at the slightest sign of distress, people have a strong incentive to get their money out first — triggering "runs" that can devastate the financial system and the economy.
Central banks exist to address this vulnerability. The Fed stands ready to lend banks as much cash as they need to meet withdrawals in an emergency — as long as they have assets to pledge as collateral. This lender-of-last-resort function — alongside federal deposit insurance — is designed to alter depositors' incentives. If they're confident that they can get their money, there's no need for a run in the first place.
For much of the 20th Century, from the New Deal on, this arrangement operated smoothly. The issuance of runnable liabilities — in this case deposits — was limited to chartered banks, which invested primarily in straightforward mortgage and commercial loans. The central bank had a reasonable grasp of how much short-term debt it was backing, and what collateral stood behind it. No systemic runs occurred, even during the rash of savings-and-loan failures of the 1980s and 1990s.
As often happens, though, a long period of calm created the conditions for its own undoing. Beginning in the 1980s, officials allowed a parallel, "shadow" banking system to emerge, largely outside the Fed's purview. Money market mutual funds, for example, competed with bank deposits by offering shares that could be redeemed on demand for $1 (and paid higher interest). The funds invested shareholders' cash in other short-term obligations, such as commercial paper and "repo," which entailed making loans — typically overnight — against the collateral of securities. Other non-bank financial institutions — including broker-dealers, hedge funds and various conduits — used such financing to build large holdings of securities backed by assets such as commercial, auto, credit-card and mortgage loans. Specialized finance companies, as well as banks, originated the loans.
All this innovation vastly expanded the financial system's dependence on short-term debt, issued by entities not subject to the safeguards that apply to deposit-taking banks — such as capital requirements, federal insurance and explicit access to emergency loans from the Fed. By 2007, the gross amount of three major types of non-deposit short-term obligations in the US — money market shares, commercial paper and repo — had risen to $8.8 trillion, or 60% of the country's annual economic output. That was up from about $50 billion, or 5% of GDP, in 1970.
The transformation fueled a credit boom: In the US, total credit to companies and households increased nearly 70% from 1980 to 2007. Unfortunately, it also left the system more vulnerable to runs. If a single link broke — if people pulled cash from money market funds, or if repo malfunctioned — the whole supply chain of credit could fall apart.
That's precisely what happened during the subprime-mortgage bust of 2008. Fear of defaults led repo lenders to demand extra collateral and refuse some securities entirely. "Fire sales" of securities that could no longer be financed sent prices plunging, aggravating losses and spreading distress. Investors fled money market funds, which in turn starved the commercial paper market and deprived companies of financing for their day-to-day operations.
To prevent a complete breakdown, the Fed had no choice but to go where it had never gone before. Officials scrambled to create myriad programs — and put up hundreds of billions of dollars — to support vast swaths of the non-bank financial system, including repo, money market funds and commercial paper. But central bankers faced a crucial limitation: There wasn't enough collateral to lend against. The short-term debt had been used to finance assets and activities that went far beyond simple mortgage and commercial lending — including derivatives and hard-to-value structured investments. To avoid losses, central banks had to apply "haircuts": A $100 asset might support only $50 in emergency lending, or none at all. Try as they might, they couldn't lend enough to prop up everything. The result was a severe credit crunch that exacerbated an already deep recession.
After the crisis, legislators and regulators around the world introduced measures to strengthen the banking system. But they did little to address the proliferation of run-prone debt. To the contrary, in some cases the added scrutiny of banks — necessary as it was — has helped push activity into the shadows. Nonbanks now dominate mortgage lending in the US, and have fueled a rapid and precarious expansion in subprime corporate debt. Among advanced economies at the end of 2018, the assets of nonbank financial institutions that rely on short-term funding amounted to an estimated $41 trillion, or 89% of GDP. That's up from about $27 trillion — 77% of GDP — in 2010, when many of the post-crisis reforms were adopted.
The result: This time around, as the battle to contain a global pandemic thrusts the economy into a deep recession, the financial fallout has compelled the Fed to expand its emergency lending to a breathtaking scale. In a matter of weeks, it has far exceeded the reach of 2008, committing potentially trillions of dollars to backstop everything from municipalities to junk-rated corporate borrowers. It has pledged to lend directly to companies if banks and capital markets pull back. It has gone global, creating swap lines to help foreign central banks backstop short-term dollar-denominated borrowing abroad, effectively becoming the lender of last resort to much of the planet.
No doubt, the Fed has done the right thing in the moment. Without its intervention, the economic damage would be much worse. But the need for such extraordinary measures reveals a deeper problem: Government has all but lost control over the creation of money. In good times, it allows financial institutions the freedom to create all manner of money-like instruments. In bad times, central banks must support those instruments, lest the financial system collapse. This implicit backstop establishes a dangerous incentive, encouraging institutions to fund ever more long-term investments with what amounts to federally subsidized short-term debt. Profitable as this may be, it renders the system ever more vulnerable to devastating runs.
Somehow, the government must reassert its authority over money. But how, exactly?
It's a question that economists have long pondered. One solution, known as the Chicago Plan, would ban private money creation completely. Originally championed in the New Deal era by prominent academics such as Henry Simons of the University of Chicago and Irving Fisher of Yale, it would require financial institutions to hold 100% safe, liquid assets (such as government securities or reserve deposits at the central bank) against all short-term debt (such as deposits). Longer-term investments would have to be financed with long-term debt or shareholder equity.
This would eliminate the risk of runs, because cash would always be available to cover all short-term liabilities. Research suggests it would also smooth out the boom-bust cycles that emerge when financial institutions create excessive amounts of money. Some worry, though, that it would be a step too far, requiring a radical and costly reorganization of the financial system, and erasing some of the benefits that arise when the private sector assumes the role of connecting short-term savers with longer-term borrowers.
A less extreme approach would be to restore the government's control over the private issuance of money. One version — proposed by Morgan Ricks, a professor at Vanderbilt Law School who worked at the Treasury Department during the 2008 crisis and as a hedge-fund trader before that — would limit the issuance of short-term debt to specially licensed banks, restrict investment of the proceeds to central-bank-approved assets and charge a fee for access to emergency loans.
Another — from Mervyn King, a former governor of the Bank of England and now a Bloomberg Opinion columnist — would limit the issuance of short-term debt to the amount of collateral that institutions pledged in advance to the central bank (minus haircuts, which could be as high as 100% for undesirable assets). Both would allow the central bank to safely guarantee all short-term debt, by ensuring that institutions had ample assets to back it.
Even these proposals are widely seen as radical. But that's a matter of perspective. What's actually the aberration? A system in which the government maintains some control over the creation of money, or one in which it must repeatedly devise unprecedented measures to backstop forms of money over which it has no control?
The larger and more desperate those measures become, the more a major redesign will start to make sense.
Disclaimer: This article first appeared on Bloomberg.com, and is published by special syndication arrangement.