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