The question of how to regulate and control an unstable banking and financial system was broadly already at stake in the period from 1929 to 1930, particularly when analysing the causes of that ongoing 1929 financial crisis and intervening in the various financial improprieties and scandals of the day. See Figure 5.3. The 1934 – 1935 banking and financial reforms only partially addressed these needs. If the economists of that time developed the necessary theories, history would prove that no long-term regulation was possible without the type of statistical basis that ultimately emerged as a result of the Bretton Woods Accord, at war's end. Only the war changed matters, as well as the victory of the USA and dollar domination. Things have changed again, but no new theory has been set up.

Monetary regulation and follow-up

FIGURE 5.3 Monetary regulation and follow-up


We were reminded above that such classical analyses have traditionally been grounded in the thinking of centralized monetary and banking set-ups – institutional organizations and their networks that are equipped and mandated to enable monopolistic control over the right to issue money and lend capital. Following the historically more recent outburst of modem money in its novel expanding forms and functionality, the meaningful role of these institutions has come into question, and thus requires broad reform and redesign.

Considering what is known about changes in the nature of diverse financial instruments used to clear primary transactional exchanges, and the very real expanding role for such new instruments (including associated refinancing within a parallel “shadow banking” sector active in refinancing), virtually no sense of surprise is justified when looking at prevailing trends and projections. Central banks can access the most comprehensive data in this regard. Yet, due to their internal set-up under present conditions, central banks are ill-equipped to meaningfully determine true monetary velocity in the external financial sector and overall economy. Today, with the disintermediation of financing throughout our economy, and the limited jurisdiction of legal systems in this regard, available data can only provide a general picture of assets and liabilities held by holding agents (administration, financial institutions, households, enterprises). Analogous to representing asset values in the absence of linkage to measurements of mobile monetary flow, such data provides insight into concepts of limited relevance and thus a window only into the past.

In an overall context, and particularly when considering both monetary injections made since 2007 and the very weak evolution of GDP (for the already developed industrialized nations) during the intervening period, it is clear that monetary velocity is slowing to a concerning degree when not supported by non-conventional monetary policies. It is as if masses of expanding and available real (currency) and virtual (derivative instruments) money are frozen with government help – that is, in the form of savings instruments. This includes pension plans, life insurance policies and tax exemption mechanisms (no withholding tax); all designed to favour the issuance of sovereign debt and the maintenance of low interest rate policies that artificially subsidize disposable income. It may also be considered that today's increasingly draconian “prudential policies” are also pushing many existing banking institutions to use their equity ratio requirements in the direction of supporting sovereign debt – a practice that will significantly enhance overall systemic risk.

At the end of 2009, M3 was 1.6 trillion euros for France, only a fraction of the nation's 12.5 trillion euros net worth that represents the difference between 32.5 trillion euros in assets and 20 trillion euros in liabilities. 6.8 trillion euros comprised the French financial sector assets (consisting of shares, instruments and mutual funds), thereby distinguishing M3 only by the solvency of the issuers – financial organizations (MFIs and monetary institutions) on the one hand and enterprises on the other. Despite a l-to-4 ratio in both categories, M3 represents mostly liquid financial instruments that are destined to be assimilated into currency. Economic agents can easily change their asset allocation between each category, and that fact alone has resulted in a near total loss of meaning for the M3 designation; which also includes pensions, as well as instruments deposited at or by banks (that by definition remain the property of their owner while not being shown on the books). These financial subsectors and instrument categories were not tracked closely as the 2007-2008 financial crises erupted in the USA.

Central bankers did try to follow up on the appearance of new types of monetary representation and financial instruments, in part by creating new categories with which to represent them (M2 for small short-term deposits, M3 to add for savings, etc.). In doing so, central bankers and regulators rapidly encountered a vexing issue: nothing can prevent an agent from purchasing M2 assets in lieu of real money. Some economists are stating that in applying Goodhart's law,[1] only publication of the money supply index will induce behaviour that seeks to escape from constraints that the supply index is tied to. Using this discovery,[2] since 2000 the FED has no longer provided information on M2 targets, and in 2006 ceased publishing M3 data. Three years prior to that point, the FED had already abandoned issuing M3 data as an internal tool for assessing monetary policy. Professor Congton[3] from International Money Research has provided an interesting but partial analysis of the FED's decision. This occurred when the FED directly confronted the difficulty of precisely measuring aggregates and their impact – including the dynamics of the monetary system associated with migration away from simple script money to complex financial instruments and savings mechanisms, new forms of which continue to emerge today.

Viewed retrospectively, fiduciary money was a simple and easy category of monetary data to describe and measure. Script money was already more complicated, and presented a wider field for research – while still remaining within defined boundaries set by financial institutions and subject to regulation. In contrast, the ongoing transition to an entirely new generation of derivative financial instruments presents significant uncertainties for our economic system.

Alongside the disappearance of significant currency exchange restrictions (other than those involving China), the advent of globalization and the concurrent loss of financial institutions' respective monopolies served to markedly transform the global financial environment. Within this new economic universe, electronic systems obviate the “delivery and transfer” of currency, and the clearing of transactions can be executed via an additional set of secondary or even tertiary transaction derivatives. Such financial engineering creativity has liberated currency exchange, with the resulting flux in monetary velocity varying in accordance with the mood of brokers (who are engaged in appraising the environment). In the absence of regulatory constraints, financial agents are free to operate with stocks and other financial instruments, in part by opportunistically tracking the accumulation of sovereign debts and trade deficits.

Many research papers tried to overtake the limitations set by the classical aggregates and definition of banks or non-bank financial institutions, but were unable to break their walls. Either they consider the non-bank financial intermediaries and focus on balance sheets, and try then to discover by empirical observation a link between values, rates and liquidity, or they focus on explaining bubbles caused by excess liquidity provided by excess resources or collateral values. They fail to be conclusive as they cannot provide a global image of the money transformation inside their classical analytical system or they lose most of the interconnectivity with the global economy, not considering that most exchanges are made outside of it directly between enterprises that may or may not be considered financial.[4]

Despite the correct reasoning of all these papers triggered by the 2007 financial crisis and the wide enquiry led by the Commission on the cause of the financial crisis,[5] it is now generally accepted that agencies and international financial institutions cannot wisely ground the policies they would be in charge of conducting if they had determined as a target more than the financial stability. With only stability in sight they favour imposed stabilizing regulation instead of economic development through monetary policies to favour velocity.

At the centre of surveillance protocols set up in its 2010-2011 81st annual report, and after considering an epidemic of balance sheet mismatches and potentially deleterious international financial system interconnectivity, the BIS concludes: “The recent financial crisis highlighted shortcomings in policy makers' ability to measure systemic risk gaps, and are evident in both analytical frameworks and the available financial firm-level and aggregate data that policy makers and market participants use in making decisions. These gaps hinder market participants in pricing and managing risk, and policy makers in monitoring and responding to vulnerabilities. This experience should prompt improvements in macro-surveillance and data collection.”[6]

  • [1] Goodhart's law (chief economist at the Bank of England in 1975) says that, as soon as an economic or social indicator becomes a goal for policies, it loses all its potential informative value.
  • [2] Between 1975 and 2000, the FED reached its objective for M2 growth in only 11 years out of an expected 26.
  • [3] Tim Congton, British economist, member of the shadow monetary policy committee and author of Keynes, the Keynesians and Monetarism as well as author of the article “A decision following Federal reserve decision to discontinue publication of M3 data".
  • [4] Shin, H.-S. and Tobias, A., Liquidity, monetary policy and financial cycles. Economics & Finance Vol. 14, Federal Reserve Bank of New York, Jan/Feb 2008. Extract: "Our findings suggest a need to rehabilitate balance sheet quantities as a relevant measure in the conduct of monetary policy, but with one twist. Rather than reaffirming the conventional monetarist identification of the money stock as an indicator of liquidity our analysis assigns this role to the stock of collateralized borrowings.” On a parallel topic, also from Shin: “Procyclality and monetary aggregates”, February 2011 and "Monetary aggregates and the central financial stability model", March 2012.
  • [5] With US Congress. Already quoted.
  • [6] BIS 2010/2012 81st annual report. The 2011/2012 82nd report emphasized the dependency of the entire system on US$ credit lent to the rest of the world, and which “has tended to grow much faster than credit to US residents – a gap that has widened substantially, following the crisis".
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