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Bond MarketCentral Banks And Crises

Central Banks And Crises

This article is a wrapping up of a sequence of articles on the topic of “central banks as banks,” which is expected to form a chapter in my book on banking. This version of the text is a brainstorming exercise — I expect that it would require a massive re-write to get into a book. I am presenting it in this format since it was a topic that came up in comments on earlier articles, and I also want to finish the train of thought starting in my online articles. It is breezy, and it relies on discussions that appeared in my earlier book Recessions: Volume I. I am going to suggest that readers spend their bookstore gift cards buying that book rather than repeating too much from it; my banking manuscript is going to have to be more stand alone. I also am relying on stream-of-consciousness assertions, and would need to backfill references once the text is closer to finalised.

Happy New Year!

If things are going well, the role of the central bank within the banking system of a developed country is largely invisible. The wholesale payments system just works, and there are no serious worries about the private banks that are the core of the financial system. Instead, most commentators just worry about central bankers’ abilities to centrally plan the capitalist economy by nudging a policy rate up and down and making cryptic statements about the economic future. (Of course, those of a hard money bent are continuously predicting calamities since nobody is adopting their demand that the currency be pegged to whatever collectible they favour.)

During a crisis, the role of the central bank in the banking system comes back into focus. Given the trauma of the Financial Crisis of 2008, we might have a generation of central bankers and central bank watchers who are more attuned to crisis management. However, stability breeds complacency, and we should expect the importance of crisis management to fade as youngsters move up and push their agendas.

The Inevitability of Financial Crises

Crises driven by finance are part and parcel of industrial capitalism. My thinking largely follows the story of Hyman Minsky, who in turn followed Keynes. I will just outline the structure of the argument without offering references. From my own writings, this would be covered in Recessions: Volume I, while Hyman Minsky has a lot of readable material on this topic.

If we look at the Kalecki Profit Equation (link to primer), we see that (net) investment is a source of aggregate profit to the business sector. We need to keep in mind that cash flows tend to be circular — wages are paid out as an expense, but unless those wages are saved, the cash flows return to another business as revenue. For investment, they are a cash flow out of firms (or households if they invest in housing) that is not an expense (depreciation will eventually occur) but they create revenue for the firms providing the investment goods.

The justification for fixed investments is the expectation of profit, while the act of investing itself generates aggregate profits. This creates a self-reinforcing feedback loop (“positive feedback loop” if you are an audio engineer). Although profits can be used to finance investment, in the real world, a lot of investment is done by companies speculating about future profits. This implies that the investment needs to be financed by debt (since equity financing is too expensive for any but the most risk averse).

This creates the tendency for capitalist economies to “melt up” — an investment-driven profit boom. We can capture this effect in classical (1950s era) investment accelerator models. The problem is that this feedback loop works until it doesn’t. Sooner or later, businesses and households pile on too many dubious investments, and lenders develop cold feet. At which point, the process goes into reverse.

Everything I have written so far is just a consequence of how industrial capitalism works. We then need to ask what the financial system is doing while all this is going on.

Financial Instability

If one reads financial commentary, it would appear that the entire purpose of the financial system is to gamble on literally everything. In fact, that is just the world view of most financial market participants. This outlook is self-reinforcing, but believe it or not, the credit markets do finance activity in the real economy. The credit markets are split between the formal banking sector and non-bank finance — or the “shadow banking sector” if you want it to sound cool.

The fundamental problem with capitalist finance is that there is an overwhelming bias to hold short-dated instruments with a low perceived credit risk, while fixed investment cannot naturally be financed by such instruments. (The closest we get is trade receivable financing.) The financial sector needs to do some magic to bridge this mismatch. The traditional banking model notoriously does this with deposits being used to finance loans. The shadow banking sector achieves this by issuing short-dated instruments that are allegedly safe and used to finance positions in long-dated credit assets. To the extent that the shadow banking sector is safe, it relies on lines of credit backstops from the formal banks — and they have the implicit backstop of the central bank.


Although Hyman Minsky thought of himself as following Keynes, his writings are certainly easier for a lot of us to follow. Although parts of his Financial Instability Hypothesis are catchy and get a lot of attention (Ponzi Units!), I think you also need to pay attention to his description of institutional changes in finance. (For example, see “Central Banking and Money Market Changes” in the collection Can “It” Happen Again: Essays on Instability and Finance.) The key is that the financial system is not static: its structure changes over time in response to regulatory action, and market forces that pushes for “innovations” (that coincidentally wiggle out of said regulations). The views here are mine, and may at this point be only tangentially related to what Minsky meant, but he would be a source to turn to if you want a reference.

The short version of the idea is as follows. Given the maturity mismatch between the overall mix of lenders and borrowers, in order to generate growth, we need financial intermediaries to bridge the gap. However, such a mismatch can lead to a financial crisis, which will result in the classic behaviour of putting in reforms that will prevent a repeat of the exact same crisis (horse, barn door, etc.). A crisis tends to cull some of the more imprudent credit market participants, and so we would probably avoid a repeat of the same crisis even if nothing is changed. However, industrial capitalism (generally) needs credit growth for incomes to grow, and so there is pressure to find “innovative” “safe” ways to bridge the maturity gap. (The innovation invariably is finding structures that are economically equivalent to debt, and they are “safe” because they are so “innovative” that the people dealing in them are unaware of the credit risks.)

The real kicker is that “stability is destabilising.” New financial practices are often put into place with good safety margins — the novelty of the instrument allows greater credit spreads to be charged, covering potential losses. Meanwhile, credit standards are tight in the aftermath of a previous financial crisis, so there is no need for the new instruments to offer too much embedded leverage. These safety margins validate the new financial practice as safe. (And in the sense of realised losses being less than what was priced into the instrument, they are safe.)

And if one has ever run into finance professors in the wild, one discovers that the answer they almost invariably prescribe to a situation where there is a “safe” profit to be made: put more leverage on that sucker. Firms loosen lending standards, allowing more leverage against assets. At the macro level, this increases leverage allows a greater price for the asset being levered. Once again this validates the decision to loosen lending standards.

I do not recall Minsky using these words exactly, but there is a Darwinian selection at work: stodgy financial firms that do not loosen lending standards will lose market share to those that do. This is ensures that the funding mix will move towards aggressive intermediaries — even if other lenders hold the line on standards. (That is, this shift does even not require participants’ attitudes to change, their weighting will shift anyway. Entities loosening standards turbo-charges this.)

Of course, the loosening of standards dooms itself. Since the core problem is lending short-term against long-term assets, the formal banks are likely have been drawn in somehow. In the Financial Crisis of 2008, the formal banks in many developed countries mainly kept the garbage off their regulated balance sheets — they just ended up involved with “bankruptcy remote” (lol) off balance sheet vehicles. (If the formal banks have not been drawn in, the central bank is free to let the speculative bubble to melt down — not matter what the market capitalisation of the bubble is. One of the problems that the financial press has is that people conflate “market capitalisation” with actual cash flows. Every major sporting event sees the collapse of the market value of losing bets — yet this has no effect on the macroeconomy. Although the equity market might be useful as an indicator, very little money is raised by equity issuance, so the equity market could be shut down for a considerable time and firms could continue to function. This is unlike the credit markets, where debt needs to be rolled almost continuously.) The formal banks can only survive if they can draw on financing from the central bank — which is exactly why people are willing to lend to them in the first place.

Can This Be Stopped?

A standard reaction to the previous argument is outrage — typically at bankers, financial capitalism, or “socialist” central bankers (depending upon ideological sympathies). I view financial crises to be one of the inevitable side effects of industrial capitalism, like pollution and idiotic advertising. It is easy to prevent the last crisis — the problem is that the best and brightest in finance will just end up with a new way of generating a crisis.

Many free marketeers who are unhappy with banks are angry at the “welfare state for bankers.” Although it is unwelcome seeing bankers being bailed at by the government, pretending that non-bank finance can survive a major crisis without a central bank bailout is wishful thinking. The non-bank financial sector has a straightforward selective pressure: credit risk ends up in the hands of the participants least able to understand the magnitude of the risks they are running. Sooner or later, that is an unstable edifice — and will take out the real economy if intervention does not occur. Politicians are not going to let their economies be wiped out to defend some abstract notion of “free market capitalism” when they are being inundated with calls by panicky “free market capitalists.”

On the other hand, hoping that regulators will save the day also requires a hefty dose of wishful thinking. Although behaviour might be more discreet in the aftermath of a crisis, sooner or later the free market dogmatism embedded in neoclassical models will result in regulatory capture of the regulators. In the Financial Crisis, central bankers were too busy patting themselves on the back about achieving “the Great Moderation” to even be aware of what was happening in the shadow banking sector. However, even if they had paid attention, there is no reason to believe they would have been anything other than cheerleaders, arguing that the gaussian copula models scientifically proved that a financial crisis was impossible.

The elites in a capitalist society are not going to favour crippling growth by refusing to allow financial practices that appear to be safe. Although one can point to periods of stodgy, conservative financial behaviour, the last one — the 1950s — required The Great Depression, World War II, and Communists Under The Bed — as backstory. Even then, behaviour loosened up by the mid-1960s.

Concluding Remarks

We have been through some major financial upheavals, and warning about financial crises is possibly still somewhat “edgy.” (The underlying reason why it will always appear to be novel is that the neoclassical framework has no satisfactory way to model a financial crisis.) The problem is — if everyone is prepared for a financial crisis, one will not happen. You need somebody taking really stupid risks with a whole lot of money to derail mature capitalist economies. At the end of the day, all the central bank needs to do is lend against any instrument that can fog a mirror to get the core of the banking system functioning again.

An entirely plausible scenario is that we could stumble along for a couple decades with only mid-level scandals and financial stupidities, while financial crisis bugs repeatedly proclaim the onset of the next crisis (invariably in the second half of the next year). That is, they will end up looking like aged cranks who proclaimed the next wave of inflation every year from 1984-2020. (For those who might think that is not so bad, ask yourself: how old were you — or your parents — in 1984?) At which point, things might be relaxed enough for everybody to break out their Minsky quotes once again.

In my view, the best that you can hope for is that the central bank has some cynical senior people who are somewhat aware of what monkey business the financial sector is up to, and do not assume that markets tend to stable equilibria if regulators remove pesky “imperfections.” They might spot problems early enough that the damage from over-exuberance can be contained. Having this market expertise probably requires the central bank to be continuously involved in lending against private securities as a means of creating the monetary base — as opposed to just plopping its balance sheet into central government securities that allow it to ignore private credit (the problem with neoclassical thinking from 1945-2008).


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