British House of Lords inquiry into the Bank of England’s performance is a confusing array of contrary notions
On November 27, 2023, the Economic Affairs Committee of the British House of Lords completed…
This is Part 2 of the series I started earlier this week in – An MMT-Green New Deal and the financial markets – Part 1 (September 2, 2019). In the first part, I discussed Chapter 12 in John Maynard Keynes’ General Theory, published in 1936, where he outlined how the growth of financial markets was distorting investment choices and biasing them towards speculative wealth-shuffling exercises, which had the potential to destabilise prosperity generated by the real economy (production, employment, etc). His insights were very prescient given what has transpired since he wrote. He was dealing with what we would now consider to be a tiny problem given the expansion of the financial markets over the last three decades. In this part, I am briefly outlining what I think an MMT-Green New Deal agenda would encompass in the field of financial market changes. The MMT association is that such an understanding opens us up to appreciate a plethora of policy options that a strict sound finance regime rejects or neglects to mention. That policy proposals and reform agenda I outline here reflects my MMT understanding but also, importantly, my value set – what I think are important parameters for a futuristic progressive society. So we always have to separate the understanding part from the values part (although that is sometimes difficult to do). The point is that a person with a different value set who shared the MMT understanding could come up with a totally different agenda to deal with climate issues and the need for societal restructuring. You can see all the elements of my thinking on this topic under the category – Green New Deal – which also contains a long history (now) of relevant commentary. Most of my writing on the topic are about the societal aspects of the GND transformation rather than the specific climate issues. That is obviously because I am not a climate scientist. But as I signalled in Part 1, I am about to announce a coalition (in the coming week I hope) which does include climate science expertise to broaden the capacity of the MMT-GND agenda.
In its April 2006, Global Financial Stability Report, the IMF represented the orthodox position that the deregulation of financial markets was delivering massive benefits both in terms of efficient channelling of savings to best-practice ends and financial stability.
There was a plethora of academic papers all singing from the same hymn sheet.
Chapter II of that IMF report, entitled “The Influence of Credit Derivative and Structured Credit Markets on Financial Stability”, starts with this statement:
There is growing recognition that the dispersion of credit risk by banks to a broader and more diverse group of investors, rather than warehousing such risk on their balance sheets, has helped to make the banking and overall financial system more resilient … Over the last decade, new investors have entered the credit markets, including the credit risk transfer markets. These new participants, with differing risk management and investment objectives (including other banks seeking portfolio diversification), help to mitigate and absorb shocks to the financial system, which in the past affected primarily a few systemically important financial intermediaries. The improved resilience may be seen in fewer bank failures and more consistent credit provision. Consequently, the commercial banks, a core segment of the financial system, may be less vulnerable today to credit or economic shocks. At the same time, the transition from bank-dominated to more market-based financial systems presents new challenges and vulnerabilities. These new vulnerabilities need to be understood and considered in order to form a balanced assessment of the influence of credit derivative markets.
A few paragraphs later we read:
While the credit derivative markets raise some supervisory concerns, the information they provide is very useful for supervision
and market surveillance. First, by enhancing the transparency of the market’s collective view of credit risk, similar to bond markets before them, credit derivatives provide valuable information about broad credit conditions, and increasingly set the marginal price of credit. Therefore, such activity improves market discipline. Second, supervisors and other public authorities also may be able to use such market-based information to detect deteriorating credit quality, and to better monitor regulated institutions and other market participants. Finally, with the broadening of the product base (e.g., the development of mortgage and other asset-backed derivative instruments), these markets may also provide an early warning mechanism about economic stress in sectors beyond banking (e.g., the household sector).
So two hallmarks of a functional financial system – efficiency and stability.
This was the line increasingly pushed by the financial market lobby groups as the neoliberal era unfolded. It was also the line presented by the mainstream macroeconomists in the lead up to the GFC.
For example, the likes of Larry Summers, who is now busily trying to reinvent himself as some sort of wise man of economics, was prominent in pushing this viewpoint.
I discussed this sort of involvement in this blog post – Being shamed and disgraced is not enough (December 18, 2009).
Remember, Summers, Robert Rubin and Alan Greenspan were cast by the Time Magazine on February 15, 1999, as “The Committee to Save the World”. This was in relation to their resistance to regulating the Over-the-Counter derivatives market and the way they derailed the work of Brooksley Born, who was the head of the US federal Commodity Futures Trading Commission.
She resigned that position on June 1, 1999, after the US Congress legislated to prevent the Commission regulating derivatives trading.
The US Frontline Program ran a story – The Warning – which was a retrospective examination of the period.
Brooksley Born was asked in the program, who she was “trying to protect”.
We’re trying to protect the money of the American public.
Her warnings of the danger of these unregulated markets “made her the enemy of a very, very large number of people” and finally, a legislature, captured by those same people, acted in violation of the best interests of the public to outlaw regulation, ending her ambition to reduce risk and provide greater safety for the savings of ordinary people.
And as a result of the lack of regulation and oversight, these markets grew quickly.
We also have the situation where because of excess risk-taking in financial markets (wealth shuffling casino behaviour), participants in the real economy (firms, etc) have to insure themselves against loss (hedge) arising from, say, exchange rate and/or interest rate risk.
That insurance, in turn, provides profit opportunities to the financial markets, when if they had not forced the need for insurance onto the real economy, there would have been losers to match the winners in the financial sector.
It becomes a self-fulfilling situation. The financial markets create excessive risk, and then offer derivative products and market expansion to exposed parties separate to the transactions hedging opportunities, which then expands the reach of the financial markets even further and elevates the risk.
We have dramatic developments in derivative markets in foreign exchange, local currency debt markets, which trade risk – Keynes’ ‘Pass the Parcel’ game (see An MMT-Green New Deal and the financial markets – Part 1 (September 2, 2019).
Many of these products (for example, forward contracts) are not traded in regulated exchanges but rather are bought and sold as over-the-counter (OTC) transactions.
The Triennial Central Bank Survey of foreign exchange and OTC derivatives markets in 2016 provides data to track the developments in the OTC markets.
The two broad derivatives markets relate to foreign exchange trading and interest rates (local bonds) and since 1995, these markets have grown in volume by 429 per cent and 1,773 per cent respectively.
Overall (and recognising the exchange rate derivatives are around twice the volume), the overall OTC derivatives market has grown by 500 per cent. The following graph shows this history (using BIS Outstanding OTC derivatives datasets).
You can see that the trading slowed marginally during the crisis, but has since regained pace.
And as I demonstrated in Part 1, there is a disconnect between real GDP growth, which is an (imperfect) measure of overall material well-being and the growth of the financial markets.
This was brought into relief by a study by working paper published in 2009 by WIFO (Austrian Institute for Economic Research) – A General Financial Transaction Tax: A Short Cut of the Pros, the Cons and a Proposal.
The following graph (reproduced Figure 1 in that publication) shows the explosion of global financial flows and derivative markets over spot markets (although the lines are a little hard to distinguish)
1. “The volume of financial transactions in the global economy is 73.5 times higher than nominal world GDP, in 1990 this ratio amounted to “only” 15.3. Spot transactions of stocks, bonds and foreign exchange have expanded roughly in tandem with nominal world GDP. Hence, the overall increase in financial trading is exclusively due to the spectacular boom of the derivatives markets …”
2. “Futures and options trading on exchanges has expanded much stronger since 2000 than OTC transactions (the latter are the exclusive domain of professionals). In 2007, transaction volume of exchange-traded derivatives was 42.1 times higher than world GDP, the respective ratio of OTC transactions was 23.5% …”
In other words, most of the financial flows comprise wealth-shuffling speculation transactions which have nothing to do with the facilitation of trade in real goods and services across national boundaries.
This is the point that John Maynard Keynes understood well back in the 1930s. It was also the point of departure for Brooksley Born in her failed quest to regulate this growth before it turned nasty.
And turn nasty it did in 2008.
And the world is still not recovered from the bust and the legacy costs remain and will make the next crash even worse.
So as part of a Green New Deal, which must aim to build a society based on equity and stability this paradigm of relatively unfettered financial excess has to end.
Most of the financial sector could be shut down with very little long-term damage to the rest of us.
What a progressive agenda needs to accomplish in the field of finance is the elimination of the divergence between speculation and the real fundamentals of the economy.
That divergence has elevated the risk of bubbles impacting negatively on the real economy and created a massive industry which has no productive role to play in the allocation of resources to useful ends.
Even basic commodities such as food have become objects of speculative profit-seeking, which in many situations, has denied people access to that food while making profits for the speculating investment institutions.
That paradigm has to end.
The question then is how that will happen.
What approaches should progressives take to bring speculative behaviour in financial markets into line with the real economy?
A popular progressive approach around the time the GFC was to advocate a global financial tax, sometimes called a Robin Hood tax.
This follows the idea that Keynes introduced in Chapter 12 of the General Theory (which I considered in part 1) that policy makers had to make it harder (more costly) for people to engage in these unproductive and potentially destabilising and destructive activities.
James Tobin built on the idea in the 1972 (then 1978) when he proposed a tax on foreign exchange and share transactions.
Tobin’s idea is the one people most associate with this sort of tax.
He first proposed it during a lecture at Princeton University in 1972 which was subsequently published in J. Tobin (1972) The New Economics: One Decade Older, Princeton University Press, 88-93.
It was later developed in his Presidential Address to the Eastern Economic Association in 1978 which was published as J. Tobin (1978) ‘A proposal for international monetary reform’, Eastern Economic Journal, 4.
I discussed the idea in detail in these blogs:
1. A global financial tax? (November 9, 2009).
2. Robin Hood was a thief not a saviour (April 1, 2010).
3. Progressives should move on from a reliance on ‘Robin Hood’ taxes (September 4, 2017).
My basic criticism of this proposals are:
1. It is usually constructed in the context of governments needed extra funding and that it would be better to tax the financial companies to reduce some of the incentive they have for accumulating large stocks of wealth and trading financial products across borders.
Clearly, an MMT understanding rejects that foundational premise outright.
2. That a market-based solution – imposing a tax which affects the margin generated by transactions – will moderate behaviour.
In general, progressives seems to have been lured into this ‘market-style’ thinking. Everything has to be moderated through the price mechanism. This is a neoliberal framing.
Markets are constantly being corrupted by the wealthy and ‘rigged’ in their favour.
3. If the financial sector is largely unnecessary and potentially destructive why would we want to moderate its behaviour a little through a tax that is likely to be largely ineffective anyway?
A non-neoliberal framing is to reject the market logic and use regulate and the legislative capacity of the state to make illegal activities and functions that we deem to be unnecessary to the well-being of the people and which may potentially undermine our prosperity.
This is also my perspective on eliminating carbon-intensive industries – better to regulate them out of existence than try to play smart with carbon taxes or trading schemes.
In the short-term, though, a financial tax might be part of an adjustment period as the sector is downsized and eliminated.
Eliminating these sorts of activity will force most non-bank financial institutions out of business.
It will also significantly alter the scope for the commercial banks, which come under the aegis of the central banking acts.
The essential framing is to recognise, first, that commercial banks have a public as well as a private dimension.
Banks should operate to provide credit to clients after fully appraising their credit-worthiness. As part of that process, they seek funding through deposits and other means.
Many of the ‘other means’ involve participation in risky wholesale, global funding markets.
The only way these activities can be ‘safe’, meaning that the depositors funds are protected from market fluctuations, is for the currency-issuing government to offer insurance guarantees.
In addition, the central bank always has to ensure there are sufficient reserves in the system through loans and asset swaps, to maintain financial stability.
These essential government roles render commercial banking ‘public’ activities. The profit-seeking are the ‘private’ aspect.
The challenge then for a progressive government is, in the context of these public inputs into the security of the financial system, is to ensure that the banks do not adopt a ‘privatise the gains, socialise the losses’ mentality, which is sometimes referred to as the ‘too big to fail’ problem.
To satisfy that need, the government has to limit the behaviour of the banks on what we call the ‘asset’ side of their operations, rather than the ‘liability’ side.
Imposing reserve requirements on bank lending is an example of ‘liability-side’ regulation. As we saw in the period after deregulation, it is very hard to maintain discipline through these types of measures.
Asset-side regulations include:
1. Constraining what assets the banks can hold. For example, the geographic domain of the banking system would be defined by the currency area. Banks would be prohibited from creating assets through off-shore lending activity.
2. Ensuring all assets originated in the banks are kept on their balance sheets – so eliminating practices such as mortgage securitisation. This would eliminate the ‘Pass the Parcel’ mentality where the banks create assets they consider too risky to hold against their own capital and push onto (unsuspecting) buyers.
This would also eliminate the trend in the 1980s for commercial (deposit-taking) banks to set up subsidiary (finance) companies that were beyond the scope of prudential regulation and could shuffle assets for the head office bank at will.
3. The corollary of (2) is that banks would not be allowed to trade in the so-called secondary markets – buying and selling assets as speculative instruments. Speculative behaviour would be prohibited. This would reduce profit-seeking opportunity by the banks but ensure risk-analysis was more appropriately engaged.
4. Forcing minimum and meaningful capital requirements onto the banks – to ensure that probably losses are fully born by the shareholders of the bank rather than the public through government bailouts.
5. All financial instruments that are akin to credit default insurance would be prohibited. The government would be the only provider of financial security for the banking system under strict controls.
At some point, once we understand the impact of these changes and more on the limiting the scope of private banks, the question would arise as to whether a better way forward is possible.
The obvious preferred model is to bring all the risk and stability requirements wholly within the public sector – that is, national the retail banking system.
Then the publicly-owned financial institutions would be subjected to tight controls on management to ensure they functioned to provide credit where it was demanded and maintain an orderly payments system.
Overall, this new commercial banking environment would place specific obligations on the central bank.
Under a tight asset-side regulation model, the central bank’s role with respect to private banks would be to fund them on demand to avoid disruption of the payments system.
It becomes a relatively simple activity – ensure there are sufficient reserves in the system available at whatever short-term interest rate is being maintained by monetary policy.
This would eliminate any need for interbank borrowing, where the private banks trade government funds to cover open payment positions. If the central bank simply ensured all funds were available at all times then the banks would take that option.
Given the preferred MMT monetary policy setting is to allow excess reserves and maintain zero short-term interest rates, this function becomes straightforward.
Further, as the preferred MMT position is for governments to avoid issuing any debt to the non-government sector, any interest-rate maintenance above zero would be accomplished by the central bank offering an appropriate return on excess reserves each day.
In 2009, Warren Mosler outlined this type of model in the context of the US – Proposals for the Banking System, Treasury, Fed, and FDIC.
However, the asset-side regulation model generalises to any currency system and is the only way to ensure long-term financial stability.
Other reforms which would be suggested for the financial markets:
1. No speculative trading in any food products (with exceptions):
2. The use of capital controls on across border transactions:
I will return to this theme in a future blog post.
That analysis will cover transition arrangements as a Green New Deal scales down unproductive and destabilising activities in the financial markets.
Essentially, lawmakers must adopt the principle that activities will be regulated to ensure they meet the purpose of advancing the well-being of humanity rather than lining the pockets of a few.
And if such regulation is fraught, then legislation will render such activities that do not advance that criterion, illegal
That is enough for today!
(c) Copyright 2019 William Mitchell. All Rights Reserved.