GF: Let’s get right to it. What is money?
AW: Money is something you can use to buy things — goods, services and assets — and pay debts and taxes. In the dictionary sense, money is legal tender that stores and other counterparties are required to accept. In a more practical sense, it’s constantly changing. Money can be any medium that you can use to purchase things.
GF: Are U.S. Treasuries a form of money?
AW: I would say they are a form of “quasi-money.” Short-term Treasuries are very close to immediately available cash, but long-term Treasuries are not, because they carry with them significant price fluctuations. You can have a whole range of intermediate assets that, when times are good, act a lot like money. When times are bad they don’t. Mortgage-backed securities came to be viewed as near-Treasuries because of the implicit guarantee of Fannie Mae and Freddie Mac. The higher the degree of confidence in the liquidity and price stability of the medium, the closer the asset is to “money.”
When interest rates are zero, Treasuries become more like money because there is not much opportunity cost for holding Treasuries versus other bonds. Of course, this changes when interest rates go up. In a zero interest rate environment we often use Treasuries as a medium for large transactions. We don’t do this with small transactions because it would be akin to giving a $100 bill to a cab driver for a $10 fare.
GF: So do I take it that the debt limit confrontation was even more dangerous than perceived at the time because Treasuries are at the foundation of the monetary system?
AW: Exactly. Up until the debt limit, short-term Treasuries were effectively money. They were similar to a demand deposit in that the FDIC guarantee backstops demand deposits and the Treasury guarantee underpins the Treasury market. However, if the debt limit were to expire, we would effectively no longer have a Treasury guarantee. One assumes that if the FDIC were to run out of money there would be an automatic appropriation to meet FDIC obligations. Not necessarily so with Treasuries.
GF: These distinctions didn’t seem apparent during the government shutdown/debt limit confrontation.
AW: You weren’t looking. Treasuries are the collateral that secures certain obligations such as those in the repo market. If these securities came due during the Congressional standoff, even if we assumed that the debt limit would be raised, we couldn’t be sure that it would be raised on a timely basis. Some market participants wouldn’t accept short-dated Treasuries. Instead, they would substitute longer maturity Treasuries — with the idea that the debt limit would eventually be raised and long-term rates would go down, providing a lower price risk.
This uncertainty surrounding short-term Treasuries was one reason why we saw short-term interest rates spike during the debt limit conflict. Had we really let the debt limit lapse we would have seen huge disruptions in financial markets because Treasuries are the currency of financial markets and without them many transactions would not have gone forward or would have been aborted.
GF: In some of your earlier work, you suggested that eliminating ceilings on the interest rates that banks could pay helped liberate the system from Fed-induced credit market shocks but also made the system more vulnerable to problems of inflation and private credit default. Despite all of the regulations placed on banks, it seems like the fundamental credit creation process is largely unchanged. Is there an inherent flaw in the system?
AW: To understand these issues, you have to begin from the premise that the financial system is naturally prone to excess. Credit has to grow for the economy to grow. If we buy Treasuries as part of our savings plan, there are goods and services that we don’t buy. This phenomenon is what is called Keynes’ paradox of saving. Saving directs income away from the economic system; credit directs it back. For the individual, it’s perfectly logical to save for yourself and future generations. But in the aggregate, if everyone saves and no one spends, the economy doesn’t move. For an economy to grow, you need to have income plus credit.
It is also critical to distinguish here between financial and nonfinancial credit. Financial credit (more than half of total credit at its peak in terms of flow) refers to loans made between financial institutions, whereas nonfinancial credit refers to loans extended for the purpose of generating GDP — to households, businesses and governments. When we talk about the importance of credit growth for economic growth, we are really talking about nonfinancial credit growth.
The basic flaw in the system is that if government is doing the borrowing it tends to overspend, and if the private sector is doing the borrowing it is likely to over-borrow relative to its credit capacity.
GF: Are you saying that crises are inevitable?
AW: We will have crises no matter who is doing the spending because both public and private spending tend toward excess. In principle, public overspending is easier to remedy because the government can raise taxes or cut spending. Private overspending — which includes overinvesting — takes longer to deal with. For the private system, the constraint on the nonfinancial sector is default — or maybe a more inclusive term would be insolvency. The constraint for financial institutions is usually a crisis of liquidity — where assets and/or markets cease to trade.
GF: Can you clarify the distinction between insolvency and a crisis of liquidity?
AW: Sure. A company may be sound in accounting terms but doesn’t have the cash available to meet its obligations — hence it is insolvent. A liquidity crisis is when payments are disrupted, as was the case during the financial crisis when most markets stopped trading. In the case of a liquidity crisis, businesses and financial institutions, and in extreme cases, households, hold assets that they cannot turn into cash.
GF: While there have been a lot of efforts to constrain banks’ role in financial crises, it doesn’t seem that we have addressed the underlying problem.
AW: As I said earlier, the financial system is prone to excess. The question is how to manage credit demands and crises when they occur. Credit crunches that arose under the old regulatory structure that existed until the early 1980s may have been easier to manage because regulations could be changed, and they were. Also, interest rates could be lowered and both bank reserve and leverage ratios could be adjusted. But under the current regulatory structure, when credit crises arise because private entities unexpectedly go bankrupt, it is more challenging to manage their behavior, increase liquidity to the system, or offset balance sheet losses in the private sector. We may, and I emphasize may, have limited the tendency of banks toward excessive leverage, but we haven’t changed the behavior of the system. Financial excesses will continue to occur.
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