FT Alphaville has picked up on my friend James Sweeney's latest, and since James cites the latest writings by other friends Zoltan Pozsar, Manmohan Singh, as well as my own most recent, the piece reads like a discussant's comments on a shadow banking symposium. (Further discussion here.) As one of the putative participants of that symposium, I am roused to respond.
One of the things that made me a bit cautious about Sweeney, when I first read his stuff, was his fixation on measuring the quantity of money. I had taken to heart Fischer Black's dictum, in his first published article in 1970, that in a world of uncontrolled banking:
"it would not be possible to give any reasonable definition of the quantity of money. The payments mechanism in such a world would be very efficient, but money in the usual sense would not exist. Thus neither the quantity theory of money nor the liquidity preference theory of money would be applicable."
Coming from this point of view, Sweeney's work looks a bit like an attempt to revive the quantity theory of money by expanding the definition of money to include shadow money. The collapse of this shadow supply of money, he says, is the monetary shock that caused the crisis, and the expansion of the public supply of money is the policy response that put a floor on the crisis. So far, so MV=PY.
Now back in 1970 Fischer was thinking about the world of his friend Jack Treynor's CAPM, a world of risky equity securities and short term riskfree bank deposits, in which those wealthholders with the greatest tolerance for risk increase their exposure by borrowing (from banks) while those with the least tolerance for risk decrease their exposure by lending (to banks). For Fischer, the important consequence of this way of thinking was that asset prices, not only the price of risk but also the risk free rate, reflect the balance at any moment between the bulls and the bears, not the actions of the central bank. I call this the "finance view".
Sweeney's world, by contrast to Fischer's, is a world of risky and safe debt, which is to say a world of shadow banking. Safe debt is more or less a perfect substitute for a bank deposit, since at any moment it can be used as collateral to obtain a bank deposit. Risky debt is a less perfect substitute, because its price is less stable and also (because of that), the haircut for use as collateral is a lot higher and more volatile.
As I say, I worried about Sweeney, until I saw the connection between his world and Fischer's. The connection is this. Risky debt is just safe debt plus an interest rate swap and a credit default swap. Fischer himself emphasized this in an unpublished paper from 1970:
“Thus a long term corporate bond could actually be sold to three separate persons. One would supply the money for the bond; one would bear the interest rate risk; and one would bear the risk of default. The last two would not have to put up any capital for the bonds, although they might have to post some sort of collateral.”
Fischer's dream in 1970 is our current reality. What Sweeney measures as the quantity of shadow money is not so much the quantity of money as money is traditionally understood; rather it is the monetary value of available collateral.
From this point of view, my most recent paper can be thought of as an attempt to see the shadow banking system through the eyes of Fischer Black. What is important, from that point of view, is not so much the balance between the risk tolerant and the risk intolerant, but rather the balance between two kinds of financial intermediaries that I call the Capital Funding Bank and the Asset Manager. In accounting terms their balance sheets are mirror images, but it is the movement of prices--the prices of risk as well as the riskfree rate--that make these two types of agents happy to hold those balance sheets at any moment.
Where I depart from Fischer of 1970 is my emphasis, following the Money View, on the dealers that stand in between the Capital Funding Bank and the Asset Manager. I emphasize two types, the Global Money Dealer who trades in money and the Derivatives Dealer who trades in risk.
In emphasizing the role of these dealers as market makers, I provide a way of understanding the role of the central bank in the modern market-based credit system. Backstopping both of these kinds of dealers, the central bank serves fundamentally as dealer of last resort. Abstracting from market makers, as Fischer did, means abstracting from the reason for a central bank. Bringing market makers back in, as I do, means also bringing the central bank back in.