Liquidity Changes Everything

Much has changed in the institutional organization of money markets since Fall 2012 when INET filmed my course “Economics of Money and Banking”, but what strikes me most is how well the fundamental analytical structure has held up.  The two ideas that I identify as central to the “money view”—the importance of the daily settlement constraint in the payments system, and of the market-making activity of the dealer complex—continue to provide essential analytical entry points for understanding how the system works, even as regulation and innovation have changed how these fundamental ideas play out in detail.

Most obviously, whereas in 2012 I focused attention primarily on unsecured money markets (the Fed Funds market domestically and the Eurodollar market internationally), today the activity of secured markets is more central (repo markets and FX swap markets mainly).   In the MOOC I do treat both secured markets, but if I was doing it today I would give them more central emphasis.

Related, in 2012 I treated Covered Interest Parity as an empirical fact enforced by riskless arbitrage, and focused my attention on explaining persistent violation of Uncovered Interest Parity (as well as the Expectations Hypothesis of the term structure) as a consequence of the profit-seeking activity of dealers in foreign exchange markets.  Today, however, Covered Interest Parity also fails persistently.  But the reason for that failure,  according to BIS economists, is broadly consistent with money view thinking.

More generally, in 2012 I was excessively anchored to Stigum’s largely domestic account of dollar money markets, because that is where I started when I first began to develop the course.  Today I would emphasize instead the dollar as global money, both means of payment and means of funding, not just in Europe but now increasingly in the Global South as well.  In this regard, one of the most important developments of the decade since the global financial crisis has been the ability of private non-financial firms in emerging market countries to tap global capital markets directly for their dollar funding needs.

One way to understand these recent developments is as yet another step on the winding road toward establishing a global dollar system.  Here is Kindleberger in 1987:

The model for the world should be the integrated financial market of a single country, with one money, free movements of capital at long and short term, the quantity theory of money employed on trend, but free discounting in periods of trouble.  Such a world will be full of ambiguity, paradox, uncertainty and problems.  Such it seems to me is the human condition.

One way to understand developments in the thirty years since Kindleberger wrote is as a gradual and imperfect implementation of more or less this model, along with plenty of the “ambiguity, paradox, uncertainty and problems” that he warned us about.  The point is that financial globalization and its discontents have grown up together, and one consequence of the global financial crisis was to bring the voice of discontent much more prominently to the fore.

That seems to be the material basis for the popular attention now being garnered in the Global North by such movements as MMT, Positive Money, and Vollgeld (not to mention the soul-searching within the central banking community itself, as Paul Tucker).  The financial crisis let the genie out of the bottle—central banks put a floor on the crisis by taking a substantial portion of the financial market onto their own balance sheet.  And that inevitably raises the political question, “Why those particular financial assets and not the ones I myself issue?”

In the Global South, by contrast, the voice of discontent has been prominently at the fore for much longer.  The challenge of managing one’s interface with the global system is unavoidable in these countries, and that challenge definitely focuses the mind.  The settlement constraint is a very real thing, and also very dollar thing.  In these countries typically financial markets are too thin to absorb very substantial imbalances, which means that most of the adjustment comes through price, meaning exchange rates and domestic interest rates, and through public balance sheets rather than private.   Put bluntly, the “market” has its own way of managing imbalance between cash inflows and outflows, on current and capital account, and if you don’t like it then you are bound to find other ways of managing it.  The search continues.

It is fair to say that in 2012 I paid essentially no attention to these political economic questions, neither in the Global North nor in the Global South, not so much because I judged them to be unimportant, but rather because I had started with Stigum and was more focused on understanding how the system worked, in appropriate technical detail.  I started with US money markets, which is to say with the domestic payment system and domestic clearing, and then built up from that an understanding of the role of the dealer complex in dollar funding markets.  To the extent that I paid attention to offshore money markets, it was more or less from the perspective of a U.S. based institution viewing offshore money markets merely as a possibly attractive alternative to onshore money markets.

If I were doing the MOOC today, I would take a much more global approach, as I do for example in my paper on the global swap network, and would extend that analysis from the C6 and the Global North to include also the bilateral swap agreements and regional financial arrangements of the Global South.  And I would take a much more political economic approach, emphasizing the persistent contestation of the alchemy of money, along the following lines:

  1. The monetary-financial system is inherently hybrid, both public and private, each dimension with its own source of power
  2. The points at which these two dimensions meet are under persistent contestation, which is to say inherently political, and inherently in need of management
  3. A central issue of contestation is elasticity versus discipline, elasticity for me and discipline for you, alchemy of banking and money funding for me, austerity and borrowing/payment for you.

So far as I can see, that’s the world we live in and have to make sense of, and that’s the world whose gyrations we are impelled to manage to the best of our abilities.  It’s a daunting task, to be sure, but I have to assume that we are capable of it, if only we focus our energies there.

In Fall 2012, INET filmed my bricks-and-mortar course and in Fall 2013 we launched the first iteration of the online course on the Coursera platform.  The result surprised everyone, including me.  This little course, designed for upper level economics majors at Columbia University, turned out to capture the imagination of a much broader audience.

I take the lesson that the world I describe in the course is the world not only of those who trade the money markets, i.e. the target audience that Stigum had in mind, but in fact of all of us.  Not just Americans, but everyone lives in the global dollar system.  The financial crisis put us on notice how important this system is, as the vital foundational infrastructure of the global system of production and exchange.

Not just students but also practitioners, not just economists but also historians, lawyers, and anthropologists have taken the MOOC as the beginning of their own intellectual journey, building it out in ways that make sense for their own lives and disciplines.  It has been a wondrous thing to watch, and it’s not over.  Liquidity changes everything, and the change is yet under way.