There’s been a few articles about how some assets are very much like money lately. Greg Ip had a good one in the Economist. vimothy points out Caballero and Gorton have been spouting something like MMR for a long time. Delong points out we need more safe assets and the market is screaming at us to borrow more. (Update: How did I forget David Beckworth on this? Here is his take. I’ll have more on his take in Part II)
They are missing something massively important from their analysis of money – the existence of money-like securities and instruments which are widely used in the financial world. They miss an important finance technology which makes these money like instruments all the more important and dangerous – the repo market.
It’s not just the fact these securities or equities exist. Rather, it’s the fact the repo market exists, and that it’s become very common to use stocks in transactions. What this does is take asset – which in the past were clearly not money and rather part of the Saving/Investment relationship and make them far more liquid, and therefore closer to money.
The statement by Minsky about money “anyone can create money, the problem is getting someone else to accept it” takes on a slightly different aspect when you think about the relative ease of monetizing financial assets today. The repo market has taken securities which in the past were illiquid and not able to be used as money and transformed them into something which is almost money.
It’s hard to understand why we think MMR has something important to add to the discussion until you recognize we’re able to shift between money and the instruments of saving and investment far easier today than we were 20 years ago.
Our last two recessions have been financial sector related recessions. In 2001, the internet bubble popped and our economy shut off. And we should always remember the crisis in 2008 triggered when the repo market stopped dead and forced Lehman into bankruptcy.
Gary Gorton has been talking about the repo market for the last several years, but I don’t think it has pierced the consciousness of most people who think about money. Here is a quote from Slapped in the Face by the Invisible Hand: Banking and the Panic of 2007:
“Creation of informationally-insensitive debt is the function of the banking system. In the regulated bank sector this corresponds to insured demand deposits. The characteristics of demand deposits are: (1) demand deposits have no fixed maturity; they can be exchanged for cash at par on demand; (2) they are senior claims; (3) they are claims on a portfolio; (4) they can be used in transactions. This form of debt is created by depository institutions and by money market mutual funds that offer checking.Shadow banking combines repo with securitization (or other forms of informationally-insensitive debt) to accomplish the same function for firms. Senior tranches of securitized debt and commercial paper (not discussed here) are also quite informationally-insensitive. The shadow banking system, the combination of repo and securitized debt, is a kind of bank, as follows: (1) repo has a short maturity; it is typically overnight and can be withdrawn (not rolled over) on demand; (2) it is senior in that the collateral is senior, but also senior in the sense that there may be a haircut on the collateral (this is discussed below); (3) repo collateral is backed by a portfolio if the collateral is securitization-based debt; (4) the collateral can be used in other transactions, i.e., it can be rehypothecated. Repo is discussed further below.”
Back in the old days of 1985, if you held bonds or stocks, the major way to translate those instruments into money for yourself was to sell them.
Today, this is no longer the case. Today, it’s much easier to get money from your investments, and you don’t even have to sell them. You can repo them out, and get money short term (or if you do it every day for an extended period, long term) for those assets.
Modern bonds and securitized assets have been designed to make them easy to use in the repo market. I do recommend reading a several Gorton papers to get a full view of what he thinks is happening with the repo market and banking.
Using Equity to Purchase Equity
It’s become vastly more common for firms to use equity of their company to purchase other companies. This is what happened in the late 1990’s. Firms used their recently issued equity as money to purchase other firms. There was little or no debt involved in that crisis. The crash wasn’t caused by there being too much debt in the system.
But the end result was recession – and it was a horrible recession. As far as I can tell, the economy just stopped.
S – I + (S-I)
We’ve been talking a ton about our seemingly simple equation S = I + (S-I), and showing the importance of private sector S and I. But it hasn’t been clear to people why we’re doing this and sometimes, they entirely disagree with our assessment of the importance of this equation.
The presence of the repo market and utilization of equity as money makes this equation central to our understanding of the economy.
As Minsky said “Anyone can create money – the problem is getting it accepted”. We’ve created a system where there are at least two huge ways to create money outside of the “traditional” horizontal and vertical money creation channels.
The repo market can take private sector financial assets and translate them into money for individuals for people very quickly. It’s entirely possible to take securitized assets, existing bonds or even stocks and go and get them repo’ed out for short term money.
The usage of equity to purchase other firms makes equity into a form of money entirely outside of the realm of what we consider horizontal or vertical money. The equity of a firm is simply what others will accept for that equity.
In the past, the money creation process was pretty slow moving – getting a loan from a bank was a lengthy and time consuming process. Using equity to buy another firm wasn’t common enough to be a problem.
This is no longer the case at all. It’s entirely possible to get money from an asset without selling it, and without what most people would consider borrowing. Using equity to buy other firms is very common.
Repos as a Glance
Let’s look at a repo and see how they work.
A repo is a trade where you get money for an asset, with a promise to repay that money plus some interest at a future date. The lender takes possession of the asset as collateral, but ownership does not shift unless the borrower does not repay the loan.
There are two important terms to know when talking about repos: haircut and repo rate.
The haircut is the amount of discount the lender gives the asset before they allow the borrower to post it as collateral. Let’s say you have a bond worth 100. The lender might say “I’ll only let you borrow 80 for it.” That 20% is the haircut on the asset.
The haircut is there to give the borrower an incentive to pay back the loan.
The repo rate is the amount of interest paid on the loan for the duration. The lender might say “I’ll let you borrow 80, and you owe me 88 when you pay me back.” The repo rate would be 10% for this instrument.
The haircut also determines how much money is “allowed” to be borrowed against the asset. As the haircut goes up, the amount of borrowing allowed goes down. This became important in the crisis of 2008, when the system raised haircuts on nearly every asset in the world, and the system found itself short roughly $3t in cash.
Low borrowing rates for good assets
Something even more important is you can borrow money against good assets for very low amounts. If you have high quality debt, the repo rates were and are very low.
Essentially, this becomes something close to free money. You have an asset, plus cash whenever you want it. For example, repo rates right now on U.S. government debt is 19bps. That’s .19% per year in interest payments. Free money any time you need it.
Also, it’s good to remember the problems in 2001 had nothing to do with debt, but rather happened because the prices of some equities fell dramatically. There wasn’t a debt overhang which froze the worlds markets. Rather, the ability of companies to purchase other firms and real world assets with their equity as collateral fell dramatically.
Summary for Part I
All of this points to something interesting and even profound. We have taken some assets allowed them to be translated to money through financial techniques. I argue the widespread awareness of these techniques makes those assets far more “money-like” than they had been even 30 years ago.