The Price of Liquidity: Financial and Fiscal Reform

In my last post (below and in FT Alphaville Long Room), I attributed a number of economic ills, including bubbles and sovereign crisis, to a lack of appropriate risk-free assets available to savers. This structural deficit has allowed an outsized banking system to step in and indulge savers’ aversion to risk by creating money far in excess of transactional demand. With money used as an open-ended savings vehicle, instead of just as a medium of exchange, its velocity is prone to violent fluctuation whenever sentiment changes, which threatens its very soundness.

Recall that the demand to save describes a willingness to postpone consumption. Yet rather than concede purchasing power (liquidity), savers have been encouraged to hoard it on deposit. Policymakers have expressed little concern about this luxury for the reason that money can be created ex nihilo in what appears a costless manner. This is an illusion: liquidity comes at a premium, which is currently paid for by the public in a variety of ways, some visible and others less so.

What I did not query was whether savers’ demand for risk-free assets is even compatible with those functions required for capital financing. Maximal risk-aversion by way of hoarding would stifle investment, because for any diversion of productivity from consumers’ goods into capital to take place without depressing levels of consumption, goods must be free to circulate. If savers are not simply to hoard goods, are they not obliged to assume financial risk?

The current arrangement would suggest otherwise. The banking system induces savers to hold money in preference to goods, which correspondingly are able to circulate over the course of capital formation. The “successes” of banking are remarkable: savers earn interest, take no financial risk and concede no liquidity, while borrowers are issued with newly-created money with which to go about their business. Everyone’s a winner, or so it seems. Dig beneath the surface and you find a temporary, fragile truce rather than economic victory; with superabundant bank money callable on demand, variation in the demand to consume that is not accommodated by a change in output will rapidly disturb prices. Volatility in the demand for money driven by shifts in liquidity preference is endemic to a financial system that requires money to be hoarded, which risks no less than the soundness of money as a medium of exchange.

Furthermore, we have only recently glimpsed at how many fiscal degrees of freedom can be lost in patching up the system. The triumvirate of liquidity, interest and zero risk that is offered to savers acts as an unacceptable drag on public finances, and seems to be premised on ignoring that risk is introduced whenever capital is being financed. Policymakers are beginning to understand the weakness of this system, although, perhaps not unreasonably -given their role in the said system- their attention is being drawn towards efforts to bolster banks rather than reform the system.

Calls for tighter limits on bank lending, more prudent solvency regulations and insurance schemes each might have some success in reducing the incidence of bank failure and consequent calls on informal state guarantees. But if the desired outcome is reached through discouragement of enterprise, through deterrence of risk-taking, then it will be a hollow victory. It is true that with the financial capacity of society set in relation to savings, squandering finance into doomed projects is socially very wasteful. Under any circumstance, finance will have to be rationed; the best that can be hoped for is that it is allocated on the basis of productivity.

Although private banks are certainly not as interested as policymakers in maximising national productivity, the practice of charging interest on loans may lead one to expect the bulk of finance to be directed towards those able to invest it most productively. Unfortunately, this is stymied by perversions in banks’ inventives, not least of which being those stemming from the public guarantee. Some risks are liable to grow when insured, especially when such growth is handsomely rewarded. And so it was with the banks, who set about taking on increasingly reckless business for many years. The banking crisis is all the more remarkable for being so poorly predicted, especially given the degree of understanding about the powerful moral hazards at play.

Replacing poor incentives would certainly be a step in the direction of more efficient financial allocation. However, as long as the public guarantee remains intact (if dormant) and limited liability enshrined in commercial law, banks would be fools not to return to recklessness once they are out of the media and political glare. Those that exercise caution will be punished by their shareholders and staff when the going is so palpably good.

Leaving such facts aside, I suppose the most we can expect from these reforms is a redistribution of finance towards where it can be put to better use.  Yet even a perfectly operating banking system would represent a major systemic risk if it continued along the lines of today. The liquidity premium would perhaps no longer feature quite so visibly in the national accounts, but it would be paid all the same, and still by the public.

There is always a price for liquidity. Indeed if it fetched no price, there would be no saving, and thence no investment. Presently savers can earn an undeserved return by retaining liquidity, which defeats any willingness on their part to sell it. To tackle this, one must ask what savers should buy and hold in return for liquidity. Naturally, unless they are adequately compensated, savers would be loth to hold anything that injures their ability to consume in the future; they would want an instrument that entitles them to receive money at a given date in the future. In current parlance, and given savers’ risk-aversion, this sounds very much like the trusty government bond. However, as was noted in my previous post, the availability of government bonds is set not by savers’ demand, but by fiscal policy. Moreover, lending to the government passes on to it the problem of financial allocation, unless the state is to undertake all enterprise in its own name.

So if the rightful issuer of savings instruments is neither the government nor the banking system, then it must rest with entrepreneurs themselves. Of course it was doubt about the quality of individual borrowers that fostered the emergence of banks, entities able on the basis of their gilded reputation to borrow savings and subsequently lend. I should say that there is absolutely nothing suspect about the service of credit insurance sold by banks.

It is another feature of banking that interests me here – the risk-mitigation techniques that they pioneered, and in particular the practice of taking security over the assets of borrowers. In most cases, banks will only advance a fraction of the value of such assets, which may lead one to wonder why it is that individuals admitted on the basis of their portfolio of assets would opt to borrow instead of selling. Part of the reason is that the main asset at the disposal of would-be borrowers is future rental streams pertaining to privately-owned plots of land. Our social contract is in many respects asocial because it discriminates among its own citizenry -arbitrarily- as to whether or not they are obliged to pay rent. In short, based on historical accident, there are some who are required to pay rent and there are others, in contrast, who are allowed to use resources freely. This is a  matter given the full backing of the law, which of course is what lenders rely on when they accept mortgages as collateral.

Leaving any polemic to one side, this state of affairs has concentrated a large share of natural assets in the hands of a minority of landowners. Control over land and other resources is typically an important facet of productive enterprise, so it is not surprising that borrowing is typically more attractive than asset sale to producers. Unsurprisingly, therefore, landowners enjoy a distinct advantage over the landless in obtaining credit and thence creating capital.

A more civilised social contract would surely insist that everybody compete for the use of scarce resources by paying market rent; the converse logic of this would insist also that everybody would go on to receive an equal share of rent collected. These streams of future rent, taxed and disbursed -and thus secured under universal contract- would constitute assets equally enjoyed by all. The justice of such a proposal is rather obvious, since property rights that attach rightfully to what is actually produced (i.e. wealth) should not extend over what is not produced (land and other scarce resources).

Less obvious is that this would make available to savers a risk-free asset class: future rental receivables. By the same token, all citizens would have the ability to obtain liquidity immediately by marketing a unit of future rent (or whatever fraction thereof that is satisfactory to savers) that is payable at a specified date in the future. A process of discounting, as the supply and demand of receivables of differing maturities are exchanged via a public clearing system, would reveal the prevailing rate of interest over a given term schedule (i.e. the natural yield curve).

This fiscal reform would economise on the use of money, no longer demanded by savers or hoarded in case of emergency, but demanded only by consumers on demand. Since it offers holders no utility in and of itself, any given stock of money could function effectively as a medium of exchange, whatever the volume of commerce. This would make ad hoc and de facto monetary policy that is currently devolved to self-interested banks entirely redundant. Indeed, the banking system would be usurped by libertarian money markets, in which rental receivables are exchangeable for others with differing maturities as well as for money. Gone would be any requirement for public subsidy as well as erratic and arbitrary changes in the supply (and velocity) of broad money.

Currency would become entirely subject to democratic management, including as to how its supply ought to vary with overall output (if at all): either nominal price or income stability could be targeted by additions or subtractions to the quantity of rent disbursed. (For what it is worth, I believe that aiming for stability in the price of a basket of goods is altogether preferable to holding the supply of currency constant, mainly because the former has the advantage of avoiding deflation as the economy grows. However, the issue of how, when and by how much the supply of money should alter remains open to debate, especially given the influence such changes might have on pricing and production.)

This fiscal reform -the taxation and redistribution of rent- would thrust productivity firmly into the driving seat, insofar as higher productivity raises the threshold of capital cost affordability facing potential entrepreneurs – in paying rent (bid to secure use of scarce resources); in paying interest (bid to secure capital finance); and in paying wages (bid to secure labour). Moreover, nobody would any longer be distracted by useless and harmful speculation over the price of scarce resources, removing the prospect of debilitating bubbles hijacking economic policy.

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