Thursday, November 5, 2015

The Decentralization of Money and Its Consequences

A decent while ago, I wrote a series of posts on the basics of money and banking that mostly focused on traditional banking and monetary policy. This post, on the other hand, will go further in detail and consists of three sections:
1. Shadow Banking
2. The Decentralization of Money
3. The Consequences of the Decentralization of Money

But before I get into anything else, I'll first speak a little bit more about how our current financial system operates outside of traditional banking. Basically, what I termed as money in my first post about money is the primary form of money for most households. However, the primary form of money as used by the entire financial/economic system is actually much larger than the total amount of bank deposits. Of course, it depends on what you consider money since many very intelligent, knowledgeable people would simply consider this form of money as a "very liquid assets", but I'll be treating these "very liquid assets" as money because (in today's financial system) they are money.

Shadow Banking
Anyways, firms that hold assets like treasury bills/bonds, mortgage backed securities (MBS) or asset-backed commercial paper (ABCP) or other securities that include the securitization of things like credit card loans or student debt or corporate debt or various forms of equity or whatever else can be can used as collateral in a transaction called a "Repurchase Agreement" (repo). So what exactly is a "Repurchase Agreement"? A repo is just an agreement where person A sells an asset today at price P with the agreement to buy it back at some time T (after today) at a certain price Q. The time-adjusted relative price differential is known as the "repo rate" and can be thought of as an interest rate on the repurchase agreement. If the repo seller defaults on their obligation (fail to repurchase), person B can choose to either keep the asset or to liquidate the asset for cash at market price.

Anyways, the important points aren't about the details of repo transactions, but instead about how capital assets can be used as a mechanism to acquire on-demand financing and, for many transactions, capital assets are basically as good as money because they're used as collateral to acquire cash. Now someone could make the claim that they're used primarily to acquire some form of traditional bank credit, but they could just as well be used to acquire some "bank deposits" in a money market fund (MMF).

So for there to be a widely used repo market for capital assets, there must also be a liquid market for capital assets. So in order to have a liquid market for capital assets, we must also have market-makers. These market makers are willing to buy and sell capital assets from anyone at the market price, which means that they generally have some kind of an inventory--and in order to be able to buy or sell capital assets, they must be able to acquire the funds to make the purchase/sale. So these market makers make the market by using their existing inventory as a means to acquire financing via the repo market. In other words, the entire capital asset market functions off the repo market.

Keep in mind that MMFs, hedge funds, investment banks, and all other similar types of firms are outside of the traditional banking system, but these firms are still critical parts of the American financial system. Basically, all of these institutions are effectively "shadow banks". Typical banks fund regular loans by issuing deposits. Shadow banks fund capital market lending via money-market funding.

Decentralization of Money:
As I briefly discussed earlier, shadow banking effectively creates capital assets via the creation of "deposits" in MMFs or some equivalent that can be converted into reserves held at the Federal Reserve or bank deposits, and thus anything else, at 1:1 par on demand. In other words, when you get some firm issuing ABCP to fund productive investment which is then bought by a MMF which issues "deposits" to buy various ABCPs from other firms as well, and then packages these ABCPs into an ABS, which is then sold to some hedge fund, what we end up having is a form of money creation.

For the financial system as a whole, the money created here was by the MMF that issued "deposits" to buy ABCP (or some other asset like a normal loan or whatever), which was then packaged into an ABS and sold to a hedge fund. However, if that hedge fund were to get rid of that ABS to some other firm that wanted an asset which could provide a return, that capital asset (ABS in this case) can be turned into cash at any given point to meet cash flows due to the existence of a repo market. So as we can see, these capital assets function as cash for much of the productive (and some parts of the financial) economy.

Basically, distinguishing between money for different groups or types of firms becomes very difficult. Hell, even talking about what money is becomes difficult and virtually any firm or company in our financial system can basically issue money at will, even though it's not a "traditional" "bank". So what does this do? For a person who isn't very well-versed in finance, it certainly does confound them, but other than that, all it tells us is that the money issuance by the financial system and private sector is far more decentralized than it has been in probably about 100 years (before World War I).

Anyways, when money becomes this decentralized, it becomes difficult to even distinguish what money is or what it gets used for. So what this has produced is a few discontents who feel that this decentralization in the issuance of money has transferred power from "the people". In other words, we've created a new set of discontents because we have a financial system that's become far more decentralized over the past 70 years, and particularly the last 30-40 since the USSR had sustained financial pressure and eventually broke.

Consequences of the Decentralization of Money:
Due to the drastic amount of decentralization in money and banking we've had over the past 30-40 years and technological shifts we've seen in our lives, what we end up with is a system where it's very easy for virtually anyone to get financing to do basically anything. Of course, the costs of the financing aren't free and can vary depending on the person, but that's besides the point.

Not only is it firms in, or related to, the financial sector that have really benefited in their access to financing, but it's also others who now have access to credit ranging from credit cards to online sources of financing (like Lending Club). What this massive decentralization of finance has basically created a massive financial system that operates under such lenient conditions that haven't existed until really the days before the creation of the Federal Reserve.

The most obvious direct consequence is that the federal government has a very small role in the operation of the financial system, which has meant more decentralization across the board for the entire country. Over the past 25 years, the nationalist sentiment in the US stemming from the Cold War has slowly started to dissipate while internal divisions between states are becoming far more prominent than they've been over the past 80 years and probably back to a time before World War I. Note: I'd say we have less government intervention than the financial system than we did during World War I and certainly less than we did during the interwar years, even though taxes have gone up (taxes are a terrible way to measure the centralization of an economic system, and particularly a financial system).

So there's this idea that it was the banks who created this crisis that's being pushed by certain political movements--primarily the left which consists of most Democrats--which isn't correct for reasons I'll discuss in another post (not that there isn't an issue with the banking system, but it's not a lack of government control). Anyways, the political impacts are that we'll end up seeing a divide that's very similar to what basically existed in the 19th century United States where the political divide literally takes the line along the banks with one side being for a greater centralization and control of money/banking and the other side being for less control of money/banking.
Note #2: There's a difference between control over the financial system and breaking down the big banks. Those are two completely different things and completely different issues. I do suspect the cartel formed by the big banks will be broken, but that will come from both sides--albeit from two completely different angles. One side (probably Democrats) will be for "regulation" while the other side (probably Republicans) will push something more akin to "free banking". But in reality, what I've described has already started to happen.