Monetary Realism

Understanding The Modern Monetary System…

Private Money is inherently unstable

Because people cannot trust they will get full face value for this money. It’s a huge problem, and is part of the contract design of private money.

I wrote a few posts over the summer about money and money-like instruments, and Cardiff was part of that conversation. Part of the reason I wrote these posts is to help myself understand how private money uses collateral to enhance it’s acceptability.

Cardiff Garcia has been pushing on similar ideas over at the FT, and Gary Gorton understands the problem better than anyone in the world. Cardiff interviews Gary over at the FT, and it’s a must read if you are thinking about money.

The Chicago Plan is an attempt to deal with this contract design flaw of privately created money. By eliminating collateral default risk, money-like instruments will retain their moneyness. Gorton has another solution in mind for achieving the same (or extremely similar) result.

(Update: here is a choice exchange:

And you write that only the government can create this kind of safe collateral, that bank runs are a risk whenever privately created collateral (eg the AAA-rated tranches of private-label MBS in the last crisis) is used to back bank debt. Why is that?

As I mentioned above, the private sector cannot create riskless collateral. This is because the backing assets are longer-term than the bank money; the backing assets are claims on real output. An inherent feature of a market economy is that private money is useful over shorter time intervals than the backing collateral. This “maturity transformation” is not a choice, but inherent in the economy.


The value of claims on real output can change dramatically in a short amount of time. It almost seems like private money is an American exercise option claim on a long term asset with some haircut as the strike price. )

Here is an excerpt from the interview, but go on MR geeks, go read the entire thing:

The concept of money, and specifically how short-term bank debt acts as money, plays a big role in your book. What does it mean for this money to “trade at par”, and why does it matter for the stability of the banking system?

It is easiest to think of the case where the money does not trade at par. An example of this situation is the American Free Banking Era prior to Civil War. At that time, each bank issued its own money backed by loans or state bonds. When used in transaction at some distance from the issuing bank, the money traded at a discount. My ten dollar bill, issued by a bank in New Haven,Connecticut would only be worth maybe $9.50 in New York City. But, no one knew for sure what the discount really should be and we would have to argue over this. Transacting in this way is difficult. So, creating private money with the feature that a ten dollar bill—or a check for ten dollars—would always be accepted as worth ten dollars would make money more efficient. This would require backing that was more credible.

But, even if society can get to the point where the money is accepted at face value, there is still the danger that people or firms lose confidence—they come to question the backing assets and ask for their cash. Privately-produced money is inherently vulnerable in this way.

Okay, and what’s the equivalent of how this works in the shadow banking system now?

Prior to the recent financial crisis a variety of different types of bonds were used as collateral. Some collateral was government debt but a variety of different privately-produced asset classes were also used. The collateral was acceptable because it was above suspicion, but the moneyness varied. In the modern system not all repo of the same maturity trades with the same overnight interest rate, for example. The overnight rate depends on the collateral. In other words, repo money is not all of the same quality but varies by collateral. This is similar to the different discounts in the Free Banking Era.

During the crisis, when suspicions arose about asset-backed securities of various types, market participants tried to re-create moneyness by shortening the maturities of repo and CP, and with haircuts. Some types of collateral also become unacceptable


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9 Responses

  1. jt26 says

    I think all Mike is saying is:
    – credit = money (or at least that’s what Cullen always says)
    – asset “claim on output, i.e. with some future cash flows” credit
    – therefore, asset money, to the extent the market perceives it has future cash flows and how risky they are
    The tricky part is for assets that don’t have cash flows, and in this case has no strict equivalency to credit. They may have moneyness via equivalency (e.g. a house could be rented, in principle, although banks generally lend on ability to pay, but my guess is at least with reverse mortgages, if you have no income they will gladly lend on that basis implicitly).

    • jt26 says

      sorry, html deleted some symbols:
      “- asset “claim on output, i.e. with some future cash flows” .is approx. equivalent to. credit
      – therefore, asset .is approx. equivalent to. money, …”

  2. Greg says

    Would love to see a lot more people explore this topic. To me this is the core of our current issues.

    Most of who have been following this crisis the last four years at places like “Monetary Realism”, “Center of the Universe”, “Naked Capitalism”, “Mike Norman”, “New Econ Perspectives”, “Money Illusion” are pretty well versed in the general frameworks of our money/econ models. We all pretty much can recite the differences in Monetarists, Neo Chartalists and MRists views of things.

    Using an analogy I can understand well, we are like a group of early doctors who understand the physical relationship of our bodies organs (what connects to what) and their names but we place differing values on their heirarchy. Some think the brain is most important, others the heart or the blood. (Still some are screaming from the sideline “Their is no heirarchy , its the organism that matters and its ALL part of the organism!!”) But we have a few differing models about how it all fits together and functions optimally as a sentient being.

    We here all know that our money system essentially has two types of money; credit money, privately generated endogenously via loan demand and govt fiat money, exogenously generated when the govt makes a purchase or a transfer.
    We’ve lived with varying combinations of the two in our history as a country and we are currently at the end of (I hope) a period where an over reliance on private credit money has reached its logical conclusion……too much debt in the system and not enough incomes to service it as those who control incomes have kept it for themselves and starved those who have accumulated the highest debt to income ratios. It seems obvious to me that this current system would end here since it must be its goal to get here. Dont banks want to increase their loan levels every month? Dont they need to? Since the collateral is what backs the loans doesnt the collateral have to rise continuously in value (also known as rising prices, called by many inflation) to support this?

    This takes me a slightly different direction but I cant stop thinking about an original issue in the early MR/MMT separation. Many did not like the notion of state money as it was described by Wray or Mosler. I think it was mostly a quibble about the degree to which the state money theory applied to our money system today but there was also an aversion to the whole idea that a govt via force of taxation can determine our money thing. This doesnt sit well with a lot of liberty loving Americans who think we use the US dollar cuz we like it and its the best. I remember some not liking Warrens mostly innocuous claim that “The govt creates money for the purpose of moving resources from the private sector to the public sector” It was pointed out by many that anyone can create money (must get it accepted) and that the govts money must compete and win to reach the top of the hierarchy. Okay, even if we grant that as true (the extent of truth still being determined) the point of fact/logic about Warrens quote remains.
    Let me rephrase his quote in a different way. If you were to decide to create your own money, why would you do it? If you are at all sane the only reason you would do it is to get something real for it from someone else i.e. to move real resources form someone elses sector to your sector. I certainly wouldnt make my own money to save “Greggies” in my own account. I dont need to save Greggies. I want to pass my Greggies to someone else and get a massage or pound of steak or flight to Columbus. If not for that, Ill just barter.

    So the purpose of banks issuing money is to get something real in return…… the collateral. Banks want the stuff too it seems to me as a point of logic. There is no other reason for them to create the money they do It sure seems to me that when push comes to shove the banks are eager to blow THIS money system up, keep the stuff they have (that we havent paid for) and start over. They get to sell the stuff in the “new” currency and start it all again. This is why its inherently unstable, they have the position to benefit form the instability.

  3. Fed Up says

    “Private Money is inherently unstable”

    Is the short version that demand deposits are defaultable?

  4. beowulf says

    Yeah, Mike perhaps if you could spell out what “private money” and “money-like instruments” are, we’d all be on the same page.
    “It is easiest to think of the case where the money does not trade at par… creating private money with the feature that a ten dollar bill—or a check for ten dollars—would always be accepted as worth ten dollars would make money more efficient. This would require backing that was more credible.”

    It begs the question, wouldn’t it would be even more efficient for the backer (inevitably, the US Government) to cut out the middleman and just create the money itself? Or, at the very least, it could capture a greater share of seigniorage income via the tax system.

  5. wh10 says

    This stuff sends me in loops.

    Why do you say it this way – “private money uses collateral to enhance it’s acceptability.”

    What do you mean by ‘private money?’ In a repo, existing money (dollars) is borrowed in exchange for collateral (e.g. bonds), with the trade reversed soon thereafter. The collateral is provided to insure the lender against default. But it’s not the money that isn’t acceptable. The money is being lent. It’s the creditworthiness of the borrower that is questionable, which necessitates the collateral.

    • Michael Sankowski says

      It’s not easy, so don’t think this is something everyone else understands. 1/2 the reason I write these posts is to help make it clear in my own mind.

      The transaction depends on the quality of the collateral. If a bum had U.S. treasurys as collateral, his/her credit isn’t an issue. The collateral is there to make the exchange of cash (or possibly other assets) less risky.

      Think about repos as what you did as a kid – the old “trade and trade back” transaction.

      With government money, the cash part is at 100% value all the time, while the other part of the transaction has a chance of less than 100% value. That other side is “private money”.

      Repo transactions rely on exchanging something which is very much like money for actual money. But the “very much like money” part has a chance of being worth much less very quickly – even though it is being considered as money. This kind of dive in value just cannot happen to real money.

      The valuations of this collateral aren’t 100% accurate, and can change. Banks are involved in both traditional lending and repo style lending. So think about this line from the interview.

      “The run resulted in about $1.2 trillion being withdrawn from dealer banks, which then had to sell assets causing bond prices to plummet. Plunging bond prices caused losses for many firms, many of which failed. The failures were observed, but not the cause. So, the popular narratives focused on bad greedy bankers and other superficial explanations.”

      The impairment of repo collateral became a bank run as banks needed to sell assets to meet capital requirements.

      In a real private money world, repo transactions would have a chance of default – and corresponding haircuts from both sides.

      • wh10 says

        Thanks, Mike.

        So it sounds like you are saying that the “private money” *is* the collateral, the stuff that “is very much like money.” That’s why I am confused when you write “– “private money uses collateral to enhance it’s acceptability,” because I read that as “collateral uses collateral to enhance it’s acceptability.”

        • wh10 says

          The other confusing thing is, as MR likes to say, cash *is* private money if you think of it as created by private banks. But maybe is it better to think of it as public money? I am curious to better understand Gorton’s story about the different banks and why their money wasn’t accepted at face value.