Arnold Kling  

Monetary Institutions

My Fantasy Testimony... What Samuelson Said About Infl...

Mencius Moldbug sent an email asking me to comment on this post, and we have been corresponding back and forth. I should say that monetary theory gives me a headache.

Let us think of real investment in terms of a fruit tree. I spend resources planting a fruit tree today, but I won't be able to harvest any fruit for several years. Suppose I don't have all the resources I need today, so I need to borrow.

One way to borrow is to borrow short term and then roll over my debt until enough years have passed and I have sold enough fruit to pay off the loan. Each time I roll over the debt, I do not necessarily need to use the same lender. I can trust that the market will always provide a lender who will roll over the debt at the prevailing short-term interest rate, adjusted for whatever risk is associated with my fruit tree investment.

In this simple example, what would constitute a financial crisis? Could there be a liquidity squeeze? I think we need a more elaborate model to create a crisis or a liquidity squeeze, but I'm not sure.

Why would a bank come into the picture? A bank might say to the fruit tree entrepreneur, "Look, every time you roll over your debt, you are going to have to pay a fee to have your project evaluated by new lenders. Why don't you just make a long-term commitment to roll over your debt with me?"

The entrepreneur says, "That sounds good. But if I commit to you, then what stops you from charging me a huge monopoly interest rate when I roll over my loan?"

The bank says, "OK, we'll lock in the interest rate for 15 years. That will be our guarantee that we won't exploit our monopoly power." The bank in turn relies on short-term debt, rolled over frequently.

Thus, what Moldbug calls Maturity Transformation (MT) is born. What the market supplies--short term debt frequently rolled over--is transformed by the bank into a long term loan. Moldbug writes as if MT is some sort of original sin of a fiat monetary system,. However, I have not introduced fiat money at all. I just said that it costs resources to evaluate a project, and to economize on having to evaluate a project every time the debt rolls over, a bank comes in and offers long-term lending. Maybe this MT increases the risk of financial crises. I'm not sure. But I do think we need a theory of how long-term lending emerges in order to say anything about monetary institutions.

Comments and Sharing

COMMENTS (69 to date)
MattYoung writes:

Another way to say that, the yield cure has nothing to do with the type of money you have, the yield curve represent the yield of the various goods producers over the various terms.

In a barter economy, one needs to measure the yield over various terms with a basket of good that most of your agents have a value relationship to. That virtual basket of goods definition becomes the proxy for fiat money.

Thomas Dinsmore writes:

It's not self evident that a theory of long-term lending must be derived analytically from a theory of short-term lending. Businesses need short-term capital and long-term capital, and investors have a mix of short and long term goals.

Mencius Moldbug writes:


Thanks for the link! I believe history shows it's much better to have a headache than not to think at all. Wherever you find honest and thoughtful people, you'll find headaches.

I wouldn't say maturity transformation (fractional-reserve banking is a special case of MT) is an original sin of fiat currency. You can practice MT on a gold standard - the Bank of England did it from 1694 to 1931. Of course the BoE was a GSE from day one, and its power to default without being liquidated, effectively making its notes legal tender, was amply demonstrated during the Bank Restriction of the Napoleonic wars. (William Graham Sumner's History of American Currency (1876) remains a fun read.)

But MT is an extremely dangerous practice on a metallic standard, or any other monetary system in which the monetary base is quantitatively restricted. MT is wildly unstable without a lender of last resort. When MT flips to the "off" side of its dual equilibrium, and private MT lenders abandon a market, the LLR needs to step in to plug the leak. That means it needs cash - possibly infinite amounts of cash.

MT is basically a way for the government to manipulate long-term interest rates, in the downward direction of course. In an MT market, the quantity of current bank liabilities (MZM) considerably exceeds the amount of actual money in the world (M0). By about a factor of 10!

It requires no imagination to see what would happen if M0 was restricted to a constant, to physical gold, etc. But because the Fed has (in Dr. Ben's immortal words) "a technology called a printing press," the present crisis is the mere ghost of a shadow of the apocalyptic hyperdeflation that would ensue.

In fact, I largely agree with those (such as Barry Eichengreen) who claim that the Great Depression was the result of the gold standard - which simply could not cope with the tremendous credit expansion of WWI. Saving it would have required returning to gold at a much higher price (devaluing). Instead the democracies tried to restore the old parity. The resulting ratio of paper gold claims to actual gold was astronomical and beyond the reach of all the old tricks. In the US, the final crisis was a run on the dollar.

Mencius Moldbug writes:

Anyway, let's get back to the fruit-tree example, which is an excellent one.

Let's make the terms of the loan explicit, and say it takes 3 years for the tree to produce fruit. Because the yield curve slopes upward, FruitCo is borrowing in the market for 30-day loans.

The missing side of this example is the situation from the lender's point of view.

In my view, MT will not exist in a free market, because no rational lender will make this loan. Rather, FruitCo will have to issue a 3-year bond and pay the higher long-term rate.

Suppose you are the lender. You lend money to FruitCo for 30 days. That means you are signing a contract in which you pay FruitCo X dollars now, and in 30 days FruitCo pays you X+q dollars.

And where will FruitCo get these X+q dollars? Not from fruit, that's for sure! Oh, no. It will have to find another lender, who loans it the money to pay you back. If you choose to roll over, of course, this lender is you. But if you're sure you're going to roll over, why not lend at 60 days, not 30 days? The yield will be higher.

Thus the success of your transaction, as the lender, depends not just on the proper growth and nourishment of FruitCo's tree. It depends on the presence of other lenders like you in the loan market. You will sometimes see this referred to as "liquidity."

FruitCo is what might be called an internal maturity transformer. It borrows short for a long-term project which it conducts itself. The picture clarifies somewhat if we separate FruitCo into two accounting units, FruitFarm and FruitBank. FruitFarm issues a 3-year bond to FruitBank, which buys it with your 30-day loan. This is profitable for FruitBank, because the yield curve slopes upward.

In this structure we can see how the loan is collateralized. Let's assume that the fruit tree is a good one, and the "hold-to-maturity value" (thanks, Professor Bernanke!) of the 3-year bond is all it's cut out to be.

So you, as a lender, have an additional reason to participate: FruitBank is solvent. The fact that the market price of its assets exceeds the market price of its liabilities makes your loan a safe one. Even if, when the 30 days are up, FruitBank can't find a new lender, it can always sell FruitFarm's bond and you'll get all your money back.

But this is not true! Once again, we're ignoring collective effects in the loan market. If the supply of lenders willing to fund 3-year projects with 30-day loans dries up, the FruitFarm bond will decrease in price.

Maturity transformation, by converting 30-day lenders into 3-year lenders, has increased the supply of 3-year loans. Thus, it has reduced the yield on 3-year bonds, and increased their price. Turn MT off in the fruit-financing market, initiate crunch mode, and the interest rate goes through the roof. And the bond price drops. And FruitBank, quite likely, becomes insolvent. Is all this starting to sound a little bit familiar?

This is what Professor Bernanke is missing in his "hold-to-maturity" pricing. The price of a loan depends on two factors: interest rates, and he is assuming an MT-on long-term interest rate. Whereas if you actually had to match 30-year borrowers with 30-year lenders, the interest rate would be much higher. Making the price of the loan much lower. Making the banks much more insolvent...

The reason that lenders and borrowers in today's market generally ignore this effect is not that they're stupid, but that they assume a financial market with a "lender of last resort." The basic problem with the LLR model is that the LLR needs to (a) control interest rates, (b) have an infinite stash of money, and (c) worst of all, verify that FruitFarm's fruit tree is a good one.

Given (c) especially, the LLR might as well just be making the loan itself. And the only reason it doesn't, I think, is that it would look fishy. Thus MT becomes essentially a surreptitious way for the government to print money and lend it - which, IMHO, is just weird.

Mencius Moldbug writes:

The acute reader may notice an unjustified assertion in the above: that the yield curve slopes upward. Ie, higher-maturity loans will carry higher interest rates.

This tends to be true in practice. As an Austrian, though, I find it more interesting that it's true in theory.

The fact that the natural yield curve slopes upward is pretty much the essential observation of Austrian capital theory. (Gigantic reams of Hayek, especially, can be condensed into this sentence. Also, when Mises uses the phrase "more roundabout means of production," a really
horrific Germanism, this is what he's talking about.)

On the borrower's side, we can expect higher demand for long than short loans, because (a) intuitively, there are basically no productive investments that can convert X dollars into X+q dollars in one second, one minute, one hour or one day, and (b) more rigorously, every short-term opportunity for productive use of capital is also a long-term opportunity (just repeat the productive process), whereas the converse is not the case.

Eg: if your fruit tree takes 3 years to produce, you need a 3-year loan to finance it. If your fruit tree takes 1 year to produce, you can get a 3-year loan and do three trees in a row, or you can get a 1-year loan. In a world that contains 3-year trees, there exists demand for 3-year loans that cannot be satisfied by 1-year loans.

On the lender's side, the natural yield curve slopes upward because, at the same rate, lenders would always rather lend short than long. Long lenders give up the option of getting their money back instantly. And an option can never have negative value.

Ergo, demand for long-term loans being higher and supply being lower, price must be higher.

Aesthetically, what I dislike most about MT is the way in which it jams this elegant natural price signal, by introducing a supply of short-term loans into the market for long-term loans. As a result, we really don't know what a 2038 dollar is worth in 2008 dollars.

A simple way to see this is to imagine that an asteroid will hit the earth and destroy it in 2030. There is no escape. In this world, what should the price of a 2038 dollar be in 2008 dollars? Pretty much zero. But in our world, people could continue taking out 30-year mortgages as usual. Again, this is just weird - it should, at the very least, produce a headache.

David writes:

Mencius, there is one aspect of your argument that confuses me. What makes the market for debt so much different than other markets?

For example: I need to eat every day for the rest of my life, call that 80 years of food. The consequences of a month without food are at least as bad for me as FruitCo's month without debt is for them. So theoretically I should be signing a contract for 80 years of food. But in reality, I keep a week or two of food at home, and can trust that two weeks from now, there will be people with food on hand who want to sell it at a price I can afford - the market works.

What makes the market for debt different? Is it just that we don't have as much practice with it in the markets, or the governmental intervention? Why can't FruitCo trust that in a month there will still be people who want to lend money at a price they can afford?

Libra writes:


Is the fundamental problem of the financial system really maturity transformation, or is it the bank run equilibrium?

Imagine I have $1 in the bank, and the bank holds a variety of long term debt. If 10% of the bank's loans go default, the first person to the bank gets a whole dollar, but the people who show up late might get nothing. Thus everyone runs to the bank, and the crisis becomes self-fulfilling.

On the other hand, imagine I own a share in mutual fund that holds long term debt. The shares are relatively liquid, and thus I can hold the shares short term while earning the yield of longer term interest rates. If 10% of that debt goes bad, then everyone's shares will be devalued 10% instantly. There is no incentive to sell immediately, as the loss is already factored into the price. Thus no bank run happens.

It seems that this second example is pretty close to maturity transformation, but would not have bank runs, and thus the overall system would be sound.

Arnold Kling writes:

I want to try to separate out two types of risk. One I will call pure liquidity risk. That is, a bunch of people said to the bank, "Here's my deposit. I will come back in three years when I'm ready to retire." But then they come back in a month and say, "Oops, just kidding. Apple just came out with a personal jetpack, and I want one now. So I'm taking my money back today."

The other I will call pure investment risk. You plant the fruit tree, but maybe before it bears much fruit, a disease comes along that greatly reduces the value of fruit trees.

The current crisis with mortgage securities strikes me as like the banks have loans backed by a lot of diseased fruit trees. Nobody knows quite who is holding what in terms of the diseased fruit tree collateral. Nobody wants to lend to any bank or insurance company that might be insolvent because of its diseased fruit tree loans. As a result, a lot of lending dries up, perhaps even to the point where companies with good investments cannot get funding.

I attribute the problem to a failure of the system to take into account the risk of fruit tree disease. Everybody thought they were less exposed than they were to that risk.

My guess is that if you eliminated maturity transformation you probably would not have gotten into this situation. However, you might also have stopped a lot of productive economic transactions from taking place. I am not convinced that maturity transformation is inherently wrong. I think that handling investment risk is a challenge.

On the one hand, it's too much work for investors to evaluate the riskiness of the underlying projects, so they rely on banks. This gives banks the privilege of gambling with other people's money. On the other hand, it's pretty hard to repress that sort of intermediation and equally hard to accept the consequences when banks fail.

If we take the view that government is going to protect individual depositors, then it is up to government to come up with sensible regulations of banks in order to protect taxpayers. I think that what broke down here was that regulations wound up encouraging too much of what I call Method B lending. That party got really good in 2004 and 2005, and instead of taking away the punch bowl, the regulators told the banks (as well as Freddie and Fannie) to keep drinking.

Mencius Moldbug writes:


The demand for food is extremely predictable, because (as Tony Soprano says) everyone's gotta eat. The demand for loans isn't, because it is always more profitable to hold cash than to make a bad loan.

If the government prohibited "hoarding" of money and required everyone to lend, you might have a bit of a point. And such things have been tried... it's no coincidence that in the Austrian fantasy world, there's a lot more hoarding.

tobbic writes:

I would say that the common theme in discussion is a model which assumes it's possible to make money by pooling risky investments. This business model works fine if these risks are uncorrelated but if they due to some circumstance suddenly become correlated it collapses (realization of the systemic risk).

So a basic model for risk pooling is the insurance business. You make X amount of, say, fire insurance contracts with X people. If you assume the fire department works as it should, under normal circumstances is quite safe to assume that the the probabilities that the X ppl's houses get burned are independent. Thus, because of law of large numbers you only tiny percentage of ppl will burn their houses down and you can make money.

However, this business model fails if risks become correlated.

Mortgage market and the subprime mess:
Mortgage backed securities pooled together mortgages. If there is no housing bubble, everything goes fine (tiny fraction of the loans default). If there is a housing bubble and it bursts, a lot of the loans default & value of the mortgages takes a dive. So because of the bubble the value of the mortgages comprising the MBSs were correlated and thus the failure.

Banks & MT:
one borrows short and lends long. This works fine as long as there is enough lenders in the short term market. The assumption is that if one lender doesn't want to lend you short you can find somebody who will. In circumstances where lender behavior is not independent (e.g. a run), this model fails. For instance, a bank run when depositors find out that bank is holding toxic MBSs and is insolvent.

Mencius Moldbug writes:


That's a good question. The answer is that your mutual fund is not really a maturity transformer in the classic sense, because it does not have constant-dollar obligations to its shareholders. Ie: its obligation to you is equity, not debt. There is no sense in which a mutual fund can become insolvent - it does not borrow.

So the situation is really as if the participants in the mutual fund held the instruments directly.

This does not avoid the risk of an MT collapse. You don't need financial intermediaries to engage in maturity transformation. All you need is a large group of people whose avarice exceeds their wisdom, such that they invest at term T when they really want the money at term U, U being less than T. You'll see the same effect of crowding in and crowding out. Rational investors will avoid this entire herd.

A good analogy for MT is the market manipulation problem in commodities. With a sufficiently large sum of money, you can create paper profits by bidding up any commodity. But you have not actually rung the cash register until you get out, as well as in. (This is called the "burying-the-corpse" problem.)

In MT, the commodity in question is not cotton or gold or pork bellies, but future money. The situation is the same: you have bid up prices (bid down interest rates) by introducing spurious demand into the market.

By some perversity of nature, our financial system already has the perfect instrument for maturity-matched retail debt investors: the CD. If bullion is too risque' for you, I recommend them highly... :-)

winterspeak writes:

ARNOLD: You ask a good question, and you have isolated the right two kinds of risk.

1. Liquidity risk: will there be other people willing to lend at the moment I need to borrow?

2. Solvency risk: will the fruit trees bear fruit?

The problem is that with banks, these two risks create a positive feedback loop. If you actually had to borrow for 3 years, no MT, no rolling over, it might cost you 10%. But, in an MT world, it might just cost you 5%.

So, on the banks balance sheet, the asset side has $100M, which is the price at 5% interest rates. If MT turns off, the interest rate on those assets goes from 5% to 10%. The value of those assets now falls from $100M to, say, $50M to reflect this higher cost of financing. This is like someone paying $500K for a house with 20% down, but $1M for a house with 10% down. Same house, but the value has changed because the financing costs have changed.

The bank now has a $50M hole on the left side of its balance sheet. If the Equity on the right side of the sheet is

We WANT banks to assess solvency risk: are the fruit trees good or diseased?

Unfortunately, in an MT system, they need to work on both solvency risk AND liquidity risk, and it is impossible to model liquidity risk because bank runs are spontaneous and unstable. They cannot be modeled. No risk manager will use a scenario where there is a generalized bank run. It cannot be done.

So, to have banks CONTINUE to assess solvency risk, and not worry about liquidity risk, we eliminate liquidity risk by eliminating the mechanism that enables it: MT.

The alternative is that you keep MT, keep solvency risk, and keep liquidity risk. Then, when a bank run happens, the Government just lends to everyone: businesses, banks, you name it, directly. Which is what is happening now.


Mencius Moldbug writes:


I like your diseased-fruit-tree analogy. I would put the problem slightly differently, though: MT is a piece of financial engineering which is highly sensitive to fruit tree diseases.

In fact, it is nonresistant to even the rumor of fruit tree diseases. In a bank run, it doesn't matter whether people are getting out for good reasons or bad reasons, Apple jetpacks, actual fruit tree diseases, or false rumors, maliciously spread by evil Communists, of fruit tree diseases. The rational investor joins the run - as soon as possible.

My favorite analogy is to the Tacoma Narrows Bridge. The TNB was a piece of bad structural engineering. It swayed oddly in light winds, but was perfectly functional otherwise. It was brought down by high winds. The US loan market was a piece of bad financial engineering. It was brought down by method B, aka diseased fruit trees. On this, we agree.

But if you say, "high winds caused the TNB collapse," you are missing an important element of the disaster. High winds were the proximate cause of the TNB disaster. Bad structural engineering was the ultimate cause. For obvious reasons, people tend to focus on the latter.

This is what stability is: resistance to unforeseen problems. In a stable financial system, the result of diseased fruit trees is that some people who have lent money to fruit farmers don't get all of it back. In an unstable financial system, the result is a total intergalactic thermonuclear supernova implosion of the universe. What MT explains is not the bad mortgages, but the way in which they managed to cause this bizarre collapse.

It should be noted, also, that these events could not have happened in a classical, fully-insured MT system. Banking with printing-press insurance is perfectly stable. The problem is that the financial geniuses who created the "shadow banking system" forgot that if you're going to lend long and borrow short, you need to have Big Brother on your team. Via the too-big-to-fail theory, they sort of thought they did have BB on their team, but the death of Lehman put an end to that theory. I suppose that in this sense, the people yammering about "free-market fundamentalists" may have some semblance of a point.

floccina writes:

Mencius Moldbug I lean with you but it think this, where Jeffrey Rogers Hummel makes a case for fractional reserve banking, is worth a listen:

Mencius Moldbug writes:


My guess is that if you eliminated maturity transformation you probably would not have gotten into this situation. However, you might also have stopped a lot of productive economic transactions from taking place. I am not convinced that maturity transformation is inherently wrong.

By "productive economic transactions" I presume you mean in the usual sense of welfare economics. This is your specialty and not mine, so I can't argue. We Austrians are obscurantist to the hilt - we don't believe in models or aggregates at all, not even GDP or the CPI. I can't really have any opinion on what MT does to GDP, or whether this is "productive" or otherwise. It's like asking a Muslim which is tastier, a pork chop or a Shenandoah ham.

However, I do have two observations on the subject. One is that, especially with modern, near-frictionless computerized finance, you cannot do MT without a lender of last resort. I believe this is an uncontroversial statement. I would argue that the "good" equilibrium of MT is not an equilibrium at all, but even if it is, it is far too unstable to hold up a bridge.

Two is that the LLR's function is equivalent to that of an LFR - ie, a lender of first resort, which is what USG is rapidly turning into.

Consider a classical deposit bank. It takes deposits at zero term, makes mortgage loans, and is protected by USG. We can duplicate this more or less precisely by creating two new entities: A, a giro, narrow or 100% reserve bank which stores its deposits (quelle horreur!) in the vault, and B, a mortgage broker which borrows long from USG to make its mortgages. B is only allowed to make as many mortgages as A has cash in the vault. There is no reason for this constraint, but we'll put it in anyway.

Both A and B are maturity-matched. A's deposits are risk-free. USG is exposed to the risk of B's mortgages. Everyone involved in this system has precisely the same banking experience, and there is no unstable dual equilibrium.

Moreover, this design is blatantly superior in a number of regards. We can break the spurious and unnecessary connection between A's deposit base and B's mortgage volume. USG can set the mortgage rate to whatever it wants - an especially low rate, perhaps, for disadvantaged peoples and Friends of Angelo.

So, basically, if you believe that MT is economically productive, you believe it's economically productive for the government to print money and lend it out. Which may well be the case. The only question is why you prefer that this be done indirectly in a dangerous and unstable way, rather than openly, directly and stably.

Mencius Moldbug writes:


You're right in a general sense, but there is a qualitative distinction between the two kinds of pooling: one involves an intrinsic dual equilibrium which creates its own correlation. The other is merely exposed to external unknown correlations, aka black swans.

9/11 is your classical black swan. There is no way 9/11, or a similar event, is not going to have a correlated effect on the financial markets. This is what stress testing is for. But the market should not be generating its own intrinsic instabilities, and it should damp extrinsic ones rather than magnifying them.

winterspeak writes:

MENCIUS: To build on your point, a non-insured MT system is so unstable it doesn't even need a rumor to collapse. Sunspots will do it.

I also agree that people are too focused on mortgages. MT style financial collapses seem to happen every 5-10 years, as they did with S&L, Asian Debt, Russian ruble default, peso crises, etc. etc. Every credit crises is the same: a credit bubble followed by a bank run. Bank runs must have MT to be a problem.

I see a lot of activity around stopping bad mortgages. I see nothing around stopping whatever the new bank run will be in 2012 or whenever.

Mencius Moldbug writes:

I think Hummel is a member of the same free-banking school as, say, Lawrence White.

One basic error in the Rothbard-De Soto model of fractional-reserve banking (again, a special case of MT) is their belief that FRB is in some sense unethical, a point that stems ultimately from Rothbard's rather strange model of contract law. The free bankers have decisively and in my view effectively challenged this.

But what they've failed to show is that FRB is prudent, stable and safe. They've invented a number of financial gimmicks which they claim enable FRB without a central bank. I put this in the general category of perpetual-motion devices. For example, an "option clause" which allows banks to suspend redemption cannot force the notes of suspended banks to trade at par, and in an efficient market they will never recover from this discounted state.

floccina writes:

When I look at fancy bank lobbies and the number of employees that they have, I have to question whether they increase productivity in net.
I presume that when people say that banks increase productivity, that mean that they do it by providing capital at a lower interest rate (presumably by creating the equivalent to forced saving and investing).
Am I right anyone?

Mencius Moldbug writes:


Sunspots will indeed do it. The so-called equilibrium is just not stable.

We don't usually think of deposits as negotiable securities, but in an efficient market they are. These notes cannot trade above par, and if the bank is maturity-transformed there is a chance of a bank run in which they will be worth less than par. Even if this chance is epsilon, the notes will be discounted by epsilon. But this is like a pencil balancing on its point, which is always epsilon away from stability. The epsilons are self-reinforcing, and turn into deltas...

winterspeak writes:

Mencius: A side point I've been thinking about (and I think Arnold is struggling with too).

You can have MT with a fiat currency, or a hard currency.

You cannot really have FRB without MT. It just doesn't make sense, unless you're borrowing long to lend short.

I don't think you can have FRB without fiat currency, otherwise the bank is just lending out it's own scrip.

Do I have this straight?


Mencius Moldbug writes:


I would put it a little more directly: FRB is a case of MT. You can't have FRB without MT for the same reason that you can't have a sheep that's not a mammal.

Another way to state your conclusion is to say that the reason the Austrians are right about narrow banking is that the natural interest rate at a term of 0 is 0. There are no actual productive endeavors which can be financed at a term of one hour, one minute, one second or one nanosecond. Therefore, just keeping the money in the vault is the only game in town.

As for FRB without fiat, you are right but only in the most elastic sense of the word "fiat." Banking in the 18th and 19th centuries, at least in the Anglo-American world (I think Hamburg was the last full-reserve monetary system) was nominally on a specie standard, but it used several tricks to work effectively as fiat. For example, if the State accepts bank notes in payment of tax or other obligations, it can easily allow banks to suspend redemption while still accepting gold at par with paper. Gresham's law will operate and gold will disappear, of course. But many subtleties can be applied.

So, basically, if you're looking for a sharp line between a redemption standard and a fiat currency, there isn't one. The sharp line is between narrow, 100%-reserve banking and MT.

winterspeak writes:


Yes, that makes sense.

You need MT for FRB to happen.

I was arguing for no-MT on Megan McArdle's blog, and was accused of wanting to go back to the gold standard. I pointed out that you can have no-MT *without* going onto a gold standard. I think this is still right. The US could change to a no-MT system, and not go back to the gold standard (indeed, they would need to print a boat load of dollars to ameliorate all the monetary contraction that MT-off would trigger). You've made this point many times.

As for FRB without fiat, we are agreed -- the bank needs to pay in some flavor of their own scrip, which, once it's sufficiently close to the official currency, becomes fiat.


Libra writes:

The answer is that your mutual fund is not really a maturity transformer in the classic sense, because it does not have constant-dollar obligations to its shareholders. Ie: its obligation to you is equity, not debt.

Ok, but by that definition many money market funds are not maturity transformers either. And isn't that where the crisis is occurring?

Also, is there a hard line distinction between equity and debt? It seems you have a continuum based on the details of the particular contract. At one end of the continuum you have actual Federal Reserve Notes, then you have safe deposit slips, then loans, then convertible notes, then preferred stock, then common stock.

One could say that the mistake is maturity transformation. One could also say that the mistake is that everyone treated money market funds as currency deposits rather than equity in a fund of loans. That led them to believe there was no risk, and so $1 in a fund traded as if it was a $1 federal reserve note. This in turn led to a bubble analogous to your commodity bubble example ( actually a bit different, in a commodity bubble the price goes up and up as the underlying asset remains the same, in the money market bubble, the price stays the same as the underlying asset (home loans) deteriorates. But the effect is the same).

It's also analogous to the internet bubble. Instead of the bubble being in shares of internet stocks, the bubble is in shares of money market funds. The trouble is that there is an enormous amount of money in these funds, and an enormous number of balance sheets and loan contracts count on these shares being risk free.

When it turns out the shares in the money market funds are not risk free - (too many mortgages default and the fund breaks the buck) - then people run away from them. A whole class of assets are not as safe as people thought. The bubble in these assets implodes, and people are lot less wealthy than they thought. Even worse, people have no idea which investments are safe. Companies now can't borrow to meet payroll, workers get laid off, and you have a full scale implosion. A money market share bubble is far worse than a dot com stock bubble, simply because the extent of it is far greater, not because there is a difference in kind.

My point is that while you and the Austrians see the general problem as being MT, it seems to me that the general problem is that people will stupidly invest in bubbles. The object of the bubble could be a bank note in a fractional reserve bank, it could be a share in a money market fund, a house, a share of, or the Nikkei. And not only will individuals invest in bubbles, everyone in society might systematically invest in bubbles. If the investment is big enough - like the money market bubble of 2008 or the bank note bubble of 1929 - the pop could destroy everything.

And while MT is pernicious because people think they are investing in one thing ( a safe deposit) they are really buying another ( a share in a risky bond fund), that could be said of a lot of other investments. When people buy a share in a Nikkei index fund, they think they are buying shares in companies. Except most Nikkei companies don't pay dividends. So in reality, they are buying a baseball card with the stats of the company. Like a baseball card, the shares are only worth what other people will pay for it. It could be $50 trillion or it could be nothing. This is systematic delusion on a multi-trillion dollar scale too. You don't need MT to get systematic fraud and delusion.

winterspeak writes:


money market funds *are* maturity transformers. The cash in them is essentially 0 term -- you can take it out whenever you want. And people expect $1 in a money market fund to stay at $1 (otherwise the term "breaking the buck" would not make sense). They also buy commercial paper, which as 30-90 day duration, and hence have transformed maturity.

Equity/debt distinctions have become extremely slippery as of late, but this is true no matter what you think of MT.

And while you are right, people invest in stupid things, there is a critical difference between an ASSET bubble, and a CREDIT bubble.

The Internet bubble was an ASSET bubble. People poured equity into internet companies, either via VCs or through buying the stock. The bubble went up, popped, and anyone involved in an internet company had some pretty lean years. But the broader economy was not effected, and it had no impact on the currency.

A CREDIT bubble occurs when an entity, an MT entity, prints too much money, which then causes the price of something to rise. Credit bubbles are fueled by credit, and MTer can extend more and more credit as the price of an asset rises (because their rising asset prices show them as having healthier balance sheets). When the price action turns around, the cycle goes in reverse. The problem is, that this time the bubble has been in CREDIT, ie. the money supply itself, and every business uses money to conduct transactions. Also, when MT turns off (you have a bank run) balance sheets collapse to stable "hold to maturity, MT-off" pricing, which means they need to reign in credit even more.

ASSET bubbles are not contagious, CREDIT bubbles are extremely contagious. I don't much care of a sector debauches itself, but I do care if a sector debauches the currency. People will always make mistakes, but a system should be able to contain those mistakes, not blow up and take everything else down with it.

People do stupid things, which is all the reason not to give them weapons of mass destruction ie. MT. A baseball card bubble is fine, so long as it's all finances through equity. A baseball card bubble that's an expression of a credit bubble though is a different animal altogether.


Mencius Moldbug writes:

These are good questions. The precise line between an asset bubble and a credit bubble is a fascinating question, and it's not one that I've thought about much. Or at least, not enough.

I'd say the difference between a simple asset bubble and a credit bubble is the existence of a tier of mandated payments, ie liabilities, and the construction of a financial model which breaks if these liabilities are not renewed. You don't have an MT crisis if you don't have a rollover dependency.

Libra is right that there are a lot of very junior instruments that smell a little like credit and a little like debt. But the fundamental distinction between mandated and discretionary payments, stocks and bonds/notes, is pretty sharp IMHO. Things that seem to blur the line are just combinations of the two in a single security - I think. Feel free to try to convince me otherwise.

Winter is right that the entity which promises to pay these liabilities can be speculating in anything. In the '20s, for example, deposits were taken to speculate in equities. So we have the formula for a credit bubble: an asset bubble on one end, a structure of rollover-dependent liabilities on the other.

Again, you can have an asset bubble in any security or commodity. Add buyers to the market, and the price goes up. In an MT bubble, the asset bubble is a bubble in future money. (In this case, that future money is collateralized by house prices, which of course are part of the bubble too.) But it could be cotton, or Honus Wagner baseball cards, or whatever.

The structure is unstable because the asset bubble will pop as soon as the noteholders refuse to roll over. And then they have an incentive to depart the building as soon as possible, because the corpse needs to be buried and not all of it will be. Ie, when the asset bubble pops, not all the liability holders can be made whole, because falling asset prices render the intermediary insolvent. The result: FAIL.

Winter is also right about money-market funds. They are certainly maturity transformers, if on an oddly short timeframe. The stretch between zero-maturity and 1-month or 3-month maturity is, in financial terms, small. Certainly small enough that it's very hard to break the buck on a money-market fund. It's really into the "Bobby and Dwight" range.

I'd say there are two basic problems with the CP market these days. One is this small-time, Bobby-and-Dwight MT. This could easily be rectified by USG as follows: (1) convert all MMFs to present FRNs, (2) hold all the CP to maturity, (3) redeem it. This solution is completely portfolio-neutral for everyone, including even USG.

There is just one leetle problem with this solution: it leaves the entire US economy in a smoking heap of rubble. "Other than that, Mrs. Lincoln, how did you enjoy the show?"

The second problem is that most CP is not used for the original purpose of the CP market, so-called "real bills" to finance receivables. Rather, it is used by America's largest companies for financing needs that are genuinely long-term. Precisely like Arnold's FruitCo example. Real bills used to be described as "self-liquidating," ie, like a note for a shipload of wool payable in Venice, or something like that. What makes them "real" is simply that they are not dependent on a continuous stream of rollover's, like Arnold's fruit tree.

(Note that I am not endorsing the "real bills doctrine" here - any more than I'm endorsing Bobby and Dwight, who were doing pretty much the same thing.)

Libra writes:


I don't think there is a difference in kind between an asset bubble and a credit bubble. If I own a share in Alcoa Aluminum, it is valuable because it pays me a sustained flow of dividends. If I own a share of a money market fund, it is valuable because it will return me principle plus interest. If Alcoa makes bad investments, profits drop, the dividend drops, and the price of my shares drop. If the money market fund makes bad investments, it will have to return its investors less than $1 per share ( this is what happened to Reserve Primary Fund, for instance).

The difference is more one of degree, and of expectation of risk. When money market funds turn out to be much more risky than previously thought, that is devastating, because there is a ton of money in those funds. And if the error in degree is big enough, it becomes a systematic crisis. Ordinarily, the price of a share of a bond or a stock will depends on what people are willing to pay for the cash flow. But if the crisis is big enough, both the buyer's capacity to pay and the expected cash flow depend on the pricing of the asset in question. This is circular, and everything freezes up.

So for instance, say a whole bunch of money market funds invested in bad loans. The share price has fallen below $1. But what is the proper share price? I personally have some money to invest. Perhaps I would like to buy the shares ( which is a right to remaining principal plus interest) at $.70 on the dollar. That's how much I value the expected cash flows. Except there is a problem. I work for a VC backed startup, and all our money is in money market funds. So if those funds sell at $.70 on the dollar, my startup has just lost a bunch of money. Which means I'm going to get pay cut. Now I can only afford to pay $.50 on the dollar. Of course, that means even more of a pay cut ... etc. etc. That's the systematic crisis, and it doesn't rely on MT. The systematic crisis occurs when the bubble is so big that the collapse of the bubble effects the wealth of those who would in normal circumstances buy up the devalued shares at a discount.

That said, I think my conclusion ends up being somewhat similar to yours. People do stupid thing. Most people are crappy investors. People should not be required to invest in interest paying funds just to prevent themselves from losing money via inflation. They will invest that money poorly, and will need to be bailed out. The Fed should have a zero-monetary inflation policy. Companies should be able to keep their money in plain old Federal Reserve Notes ( or even mold). Most people should have an asset allocation that's probably something like 50% cash, 25% bond funds, and 25% dividend paying stocks.

Mencius is correct in pointing out that our current banking system with FDIC insurance is identical to having everyone put their money in the safe deposit box, and then having the government print money to make loans. I agree that it would be better if this was formalized.

My only point of contention is that I don't think this would end systematic crises. Over time, people's asset allocation would slip so that 90% of it was in bond funds and stocks. The managers of these funds would then figure out clever ways to defraud the investors ("Dividends? Ah, those don't matter any more, it's the new economy! Stock buybacks that pay for the options of our engineers are just as good as dividends!"). Then the crisis strikes again.

The Snob writes:

I propose another bet. Right now this is like two kids in a dorm room at 3am arguing over whether the US would be better off with a parliamentary system of government.

If Moldbug is right, I'd like him to state what the world might look like in 12-24 months, so we can watch and see if it happens.

If this crisis is really so terrible, then it ought to be sufficient to trigger something beyond a typical proportional recession unwinding.

If within 12-24 months the banking system continues to function, and commercial paper is back on the move, and unemployment is below 10%, then I propose that his MT thesis be put to rest.

Mencius Moldbug writes:


The qualitative difference is that Alcoa Aluminum does not actually owe you dividends. It has not contractually obligated itself to any payment. Its only obligation to its shareholders is, if it performs some action beneficial to them (such as paying a dividend), to benefit each share equally.

Your money-market fund, on the other hand, has promised to (a) return your money whenever you ask for it, and committed to (b) some fixed formula for the money that will be paid.

This is a qualitative, boolean distinction between the two classes of investment. I don't see any way to construct an intermediate. An obligation may be in money, cotton, houses, or any other object or instrument, but an obligation is an obligation and a non-obligation is a non-obligation.

This distinction is promoted to the distinction of credit bubbles and asset bubbles, because credit bubbles have an obligation layer whereas asset bubbles need not. An asset bubble is inevitably part of any credit bubble, but it is certainly possible to have naked asset bubbles which are not credit bubbles.

Libra writes:


The precise line between an asset bubble and a credit bubble is a fascinating question, and it's not one that I've thought about much.

It seems pretty fine indeed. For instance, I couldn't even determine from this New York Times article if the investors in the money market fund in question own a contract to redeem dollars or if they own shares. At any rate, the fund did not seem to have a problem converting from MT debt into shares. The line was gray. The problem seems to be that the investors lost a lot of money on what they thought was a risk free, good as FRN's investment. That's why I don't think MT is the core problem with money market funds, but rather systematic bad investments and misperception of risk.

I think we are all in agreement on the fact there is a credit bubble. I think I'm just putting the emphasis on "bubble" rather than "credit" or "MT". At any rate, the solution seems to be the same. You can let the bubble collapse, leaving the economy in pile of rubble. Or you can convert the credit into the one bubble that never pops - money (Federal Reserve Notes).

This could easily be rectified by USG as follows: (1) convert all MMFs to present FRNs, (2) hold all the CP to maturity, (3) redeem it. This solution is completely portfolio-neutral for everyone, including even USG. There is just one leetle problem with this solution: it leaves the entire US economy in a smoking heap of rubble.

I thought this is basically the Moldbug solution you described in your blog post?

The second problem is that most CP is not used for the original purpose of the CP market, so-called "real bills" to finance receivables. Rather, it is used by America's largest companies for financing needs that are genuinely long-term.

That's more troubling. I was unaware of extent that this problem exists ( and if you happen to have any links I'd love to read them, I really don't know much at all about the CP markets).

Whether it's a straight up credit bubble or an MT bubble, it's likely that many of those long term investments will not be profitable if companies have to pay interest rates according to people's current preferences for credit risk. What would the solution for this be? Bail the companies out? Have the government print money to subsidize the loans, and then gradually turn off the spigot? Let the loans go bad, and accept the consequences?

Mencius Moldbug writes:


The problem with your kind suggestion is that I don't have a prediction of the result which is independent of government action. If USG decides to reflate and does so decisively, we will reflate. If not, we won't. (If we had a financial system that was technically capable of it, which we don't, it might be fun to try and roll all transactions back to, say, September 2007. They at least tried this at the end of the original Tulipomania.)

Ie: from the perspective of economic theory, future events could be anywhere along the range from hyperdeflation to hyperinflation. The setting on this knob is the outcome of Washington process. I am not in Washington and I have no idea what the process is, and even if I did I certainly wouldn't bet on it.

Mencius Moldbug writes:

It seems pretty fine indeed. For instance, I couldn't even determine from this New York Times article if the investors in the money market fund in question own a contract to redeem dollars or if they own shares.

I'm not saying it's fine in practice! I'm just saying it's fine in theory.

All I actually know about money market funds is all I know from the perspective of a retail investor: they are sort of like bank accounts, except earning a higher rate, but subject to all kinds of funny restrictions.

I am not particularly concerned about the actual details of these contracts in actual corporate law. A securities lawyer is one thing I am not, and I feel it's acceptable at the economic layer to gloss over this point. The point is, you put money in, there is no real risk, and you can take it out any time. Whatever you call it, that's basically deposit banking.

I thought this is basically the Moldbug solution you described in your blog post?

Ha. No. It is except for one point: I wouldn't redeem instantly. I'd convert CP loans to, say, 5-year bonds. They were expected to work this way, via rollovers, and an economic administrator should always strive to work precisely but invisibly. If your goal is to make everyone's life basically what it was before the crisis, this is the sort of way to do it.

Redeeming instantly on all CP notes would destroy the long-term projects in process that were financed by the CP. This is simply an act of economic masochism. Indiscriminate vandalism.

What will probably happen, of course, is that the CP purchased by the Fed will be rolled over for an indefinite period of time, most likely becoming infinite. The acquired paper will turn into, more or less, consols: rollover permanently guaranteed. With guaranteed liquidity, this is more or less what CP is.

Mencius Moldbug writes:

By "fine" I mean, as should be obvious, precise - a boolean, not a floating point. Since this is exactly the opposite of Libra's usage in the quote above, it is obviously confusing.

winterspeak writes:

Libra: I hear what you are saying, and I agree that people can speculate in anything, and they can create instruments that let them speculate in anything.

That said, I still think there are material differences between asset bubbles and credit bubbles.

In a credit bubble, the bubble is create by an (unsustainable) increase in money supply through debt. The money supply increase by excessive lending, as under the FRB system, banks can (and do) create money out of nothing. In commercial banking they are (sort of) limited by reserve requirements, although they routinely get around these with SIVs and other off balance sheet vehicles. In investment banking (the shadow banking system) there were no reserve requirements, and we saw much greater use of debt and leverage.

This debt, which is a key part of credit bubbles, is term transformed, and so subject to bank runs (aka a "liquidity crises" or "failure to roll over short term deposits to cover long term loans").

When credit bubbles pop, money supply shrinks (as credit is written off) and that's why we end up in a broader deflationary macro environment. That is exactly what we are seeing here. It is accompanied by a bank run, which is the "liquidity crises" we read about in the news.

By contrast, asset bubbles are not fueled by debt, and so are not subject to a liquidity crises. There was no bank run, or liquidity issue, or failure to roll over short term deposits to fund long term debt when the internet bubble popped. Internet stocks were fueled by equity, not debt, and the difference is real.

Money market funds "breaking the buck" were such a problem because people actually thought they were putting cash in the bank. Now that the Fed has extended FDIC protection to them, the two are equivalent, but it should be clear that money market funds, by themselves, cannot exist in the wild.

You ask if we're making a distinction without a difference. Let me put it this way: in a no-MT world, we would not have bank runs, liquidity crises, or credit bubbles. But we *would* still have asset bubbles. Suppose a new technology sector became hot, venture capitalists began to fund start-ups in the area, some went public, people rushed into their shares, more went public etc. etc. This would be a classic asset bubble, and MT, or lack thereof, would have no impact on it. *BUT* we would not see the sort of widespread liquidity problems, non-traded assets, and discussion of inflation/deflation that we're having today. I think this is a meaningful difference, worth a distinction.

Mencius Moldbug writes:


I pretty much second Winter's comment. Basically, think of it as like the difference between a fission bomb and a thermonuclear bomb. The thermonuclear bomb contains a fission bomb, but it is a qualitatively distinct class of design.

The analogy follows even to the explosion: the fission bomb of diseased fruit trees ignited the fusion secondary of the maturity-transformed, but unprotected, shadow banking sector.

Moreover, the explosion is magnified. Notice, for example, how the losses in the current crisis greatly exceed the actual losses in the actual mortgage market - ie, the disparity between what "method B" loans will pay out at, and their face payment.

This is because the current price of future payments is dependent on two values: the default risk, and the interest rate. The default risk has changed moderately, but the interest rate has changed tremendously. It is now basically random.

This calamity is not due to diseased fruit trees. It is due to the presence of a large cylinder of liquid tritium placed directly adjacent to the diseased fruit trees. The resulting nasty surprise is the credit-bubble structure I described earlier.

Libra writes:

By "fine" I mean, as should be obvious, precise - a boolean, not a floating point.

Maybe you should go edit the wikitionary entry:-)? That's the usage I've commonly heard.

Winterspeak and Mencius-

The point is, you put money in, there is no real risk, and you can take it out any time. Whatever you call it, that's basically deposit banking.

Let me put it this way. There is a demand for risk free place to put money that has on demand withdrawals. Currently that demand is met roughly in three ways:

1) holding actual green bills
2) buying shares in fund that holds many low risk bonds and trades at high volume.
3) having a deposit in a bank that's practicing MT

Most savers put most of their money in 2) and 3).

Mencius's original post argued that the problem was that people were putting their money in 3). I'm arguing that even if everyone had their money in 2) we still would have had the financial crisis.

The systematic financial crisis arises when the following events unfold. First, everyone has large amounts of money tied up in funds they think are risk free. Second, the perception of risk free is so great, they trade as if they were FRN's, people use them to calculate net worth, ability to pay loans, etc, and so their existence is essentially factored into the money supply. Third, they find out these assets are actually very risky. And fourth, no one can price these assets anymore, because anyone who might buy these assets on the cheap, has their own wealth tied up in the risky assets.

The only way to prevent the crises is for people to keep their near risk-free savings in actual green backs, or a bond fund that actual does invest only in very low risk loans. However, I think the second option is unworkable in practice, as most people are bad at judging risk. So in the end, the only way to prevent crises is that people should hold what they believe to be risk free deposits as actual risk free deposits ( ie 100% reserve, FRN deposits).

Are we in general agreement, or are we far apart?

It seems the big difference is that you both think that if we just found a way to end MT, we could prevent financial crises. I think that as long as the average Joe - ( or even the average CFO or pension fund manager ) - keeps the majority of their savings in anything other than 100% reserve cash deposits (whether it be bond funds, stocks, etc), they are going to get scammed in a systematic way.

Libra writes:

This is because the current price of future payments is dependent on two values: the default risk, and the interest rate. The default risk has changed moderately, but the interest rate has changed tremendously. It is now basically random.

I agree with this. To add a fifth step to my scenario above, when people find out their bond mutual funds are systematically more risky than previously thought, the reallocate money into FRN notes. This dries up credit, and raises interest rates. Businesses that depended on these low interest rates are now in trouble, and the crisis escalates.

Mencius Moldbug writes:


The only place in which I disagree with your interpretation is that I'd replace "risk-free" with "zero-maturity." The ratio between MZM and M0, for example, is extremely telling.

Almost all of the CP which is now frozen, for example, is not in the slightest sense risky. Many of the MBS which are frozen are probably obviously fine. But these CP, MBS, etc, nonetheless refuse to trade at prices which imply their actual default risk, ie, the notorious "hold-to-maturity pricing." The missing variable is the MT phase, which anywhere outside the MT-on condition requires users of the formula to use a rate much higher than the rate on risk-free Treasuries.

It is this risk amplifier which is distinct about the MT situation. I say: you can't remove risk, even asset-bubble risk. But at least remove risk amplifiers.

As for your comments about how the world should work, I offer the following fact: have you ever noticed that when you read, say, Jane Austen, the characters tend to say "I have two hundred pounds a year," or the like? Not, of course, that they have anything so humble as a job?

The old aristocracy, and in consequence basically all serious money in the 19th century, lived off a quaint device which still exists. Both centuries refer to this humble, but extremely effective, widget as the "annuity." Another related instrument, even cooler in some ways, is the "tontine." Tontines, alas, are a thing of the past - the regulated era did not admit them.

An annuity or a tontine has excellent lending properties for maturity-matched financial intermediaries, because its option structure is a function of the human lifecycle. Sort of like the amount of food people eat.

WIth these classic retirement structures, actuarial techniques can predict the terms of appropriate financing quite effectively. Voluntary early withdrawal is quite rare, and very unlikely to be triggered in some kind of feedback loop by intrinsic effects. And the pool of retirement savings on which they draw is, in general, the largest money pool in the world.

So put it this way: if you didn't have MT, would you invent it? And if the answer is "no," why stick with it?

Libra writes:

So put it this way: if you didn't have MT, would you invent it? And if the answer is "no," why stick with it?

No, I would not. I would like to get rid of MT, I'm just not sure that getting rid of it would the panacea you seem to think it would be.

I think the basic problem that it's not the old aristocracy that's investing anymore. We have a mismanaged USGov telling pension funds to invest in the bonds that Moody's marks as grade A. We have Average Joe signing up for the default mutual fund as part of his 401k package. Your average Joe can't tell the difference between a good investment and the South Sea Company.

As evidence of this, just think about the fact that 95% of investors in the stock market don't realize that the ultimate point of a stock is to pay dividends. Most books on financial planning tells young adults to put 70% of their savings in the stock market. This is despite that the S&P dividend ratio has been below 2% for the past decade. Mark Cuban has called the entire thing a scam, and until shareholders start demanding dividends, I think he's right.

Even more of a scam is the Nikkei, which has a dividend yield of under 1%. That's a ten trillion dollar market, in what are effectively baseball cards!

The serious money of the early 1900's would not have put up with this. I was browsing the NYTimes archive, and found an article from the 1920's about how shareholders in a certain car company were calling a special shareholder meeting to demand higher dividends. Stuff like that doesn't seem to happen anymore. Can you imagine investors in Dell storming down to Austin, insisting on a 5% dividend yield?

I think the problem is that there is just too much dumb money in the market. Putting money in the stock market, or even buying a maturity matched bond, doesn't magically make money. You have be somewhat smart your investment decisions. If the investment decisions are being made via government regulation or by your average Joe listening to a Charles Schwab ad, then you are going to have a lot of bad investments. The return for the average investor might very well be quite negative. That's why I'm suggesting that it's possible that the only solution for the average Joe is to just keep the money in a 100% deposit. Of course, not even that is safe. Over time, the bank might stealthily turn that 100% deposit into an 80% reserve, then 60%, etc etc. And thus it begins again.

Mencius Moldbug writes:


I agree with your essential point that dumb money is a cause of asset bubbles.

In fact this is pretty much a tautology: a bubble is a sort of pattern on a chart, in which asset prices fluctuate in a way that looks silly. This usually has a sort of sawtooth pattern. Typically the sawtooth is due to a market becoming gradually ever more wrong, then suddenly becoming right. Perhaps sometimes it's the opposite, but righteousness tends to come on in a flash, whereas wrongtiousness builds up gradually over the ages.

If you allow markets to display aggregate stupidity - for instance, stupid regulation is a trivial cause of aggregate stupidity - you can make them print more or less any chart.

However, one of the nice things about traditional types of investments - annuity, tontine, CD, etc - is that they do not involve personal money management on the part of the investor. At most, this involves selecting a financial provider. It is the provider who has to think, not the retail investor.

On dividends, while I agree that the absence of dividends in today's market is atrocious, this does not actually prove that the profit rate of the actual enterprise is that low. Google has never paid any dividends, but its search monopoly is absurdly profitable. The question is whether you believe figures for retained earnings. The nice thing about a real dividend, obviously, is that it involves no credulity whatsoever, but it is certainly not impossible that retained earnings are real.

Financial professionals of a century ago would certainly be shocked by the relative absence of dividends. They would also be appalled to discover the omnipresence of what they called "watered stock." Modern accountants know this "water," of course, as the wholly benign "goodwill." Such is the decline of American capitalism, once the wonder of the world.

enderv writes:

Nice discussion, so I will throw my 0.02 (PYC)
We can not get rid of MT. Ultimately, it was the act of men (and, at that time, much freeer market) that created MT - and even if we banned it today by a fiat, it would come back, because it offers the hope of money for no money - which is something that is evolutionary in-built (not the money, but rose tinted view of the world. Indeed, if we weren't as a species overoptimistic, we would never moved out of the jungle to a savannah). Maybe not tomorrow, maybe not in a year, but it would be back in time (short of man dissappearing from the universe)

The best we can achieve here is to let the alternatives flourish.

I don't know about US, but in UK a lot of people live with 0% interest (or effectively) current accounts. So, how about letting a pure clearing institutions, which are not banks, but can move electronic money from X to Y. You pay for the transfers (it could be relatively trivial sum, as you'd go with volume), receive 0 interest, and your cash would be 100% safe - as the insitution would not invest it anywhere, just hold it in its virtual vault.

Should you want to receive an interest, you have to accept a risk that you won't get something (or, indeed, anything) back (but, on the other hand, receive interest reflecting this). Whether the institution you lend your money to is a classical, without any MT, or with MT - well, who cares, as long as you know it? It's your money, and you can do whatever you want with it. It's your money, do whatever you want with it.
Most people have current accounts not because they want to earn the pitiful monthly interest (which even if reasonable is trivial on most average current account balances) - but because that's about the only way how to reasonable handle their finance.

Right now we're mixing two functions we require in one, and suffering the consequences.

That said, I think that if there was a long period of people getting always at least 1 dollar for dollar put in (into the investment bank), they would want them to merge... so we would again be back to square one :).

JKH writes:


A very interesting original post and discussion here.

As a USG staffer said at one of the various emergency bail-out meetings:

“This would be analytically interesting if it wasn’t happening to us.”

So it is with MT.

I think the MT framework requires additional analytical decomposition.

No complete proposal here, but some rough ideas:

Pure maturity transformation is one element in a complex set of risk transformations that may apply to single or group financial asset combinations.

There are at least two other risks that should be separated within the meaning implied here by ‘maturity transformation’.

The first is interest rate risk. It is quite possible to construct MT where exposure to interest rate changes is minimized. This is done by using 30 day funding for example to finance a 5 year loan whose interest rate resets every 30 days according to the rate set on the 30 day funding rollover. The entire Libor loan market is built on this mechanism. One partitions the yield curve into two components in this way. The first corresponds to the pure (i.e. “risk free” benchmark) interest rate expectations component. The “other” is the curve without pure interest rate expectations.

(The “risk free” rate is worthy of a longer discussion in itself. It is risk free only in a very constrained way, even in theory, particular in relation to interest rate risk. It is a core bastardization within academic theory.)

The ‘other’ above is still greater than the applicable MT yield curve. This can be split once again into two more components. One corresponds to the MT curve for the reference “risk-free” rate – e.g. the Treasury curve – a relatively small spread perhaps, but non-zero. The other corresponds to the MT curve for the net credit risk embedded in the transaction. This final curve is the true MT yield curve for the credit in question.

Another aspect that requires fleshing out, as you’ve noted, is the analytical decomposition of intersections and non-intersections of redeemable money, fractional reserves, and MT. Redeemable, 100 per cent reserves reflect MT-off for reserves. But FRB doesn’t preclude MT-off for non-reserves. MT-off still requires liquidity and solvency protection. Credit risk still exists, and both liquidity and solvency are required to repay an MT-off depositor when the “matched” asset fails.

This is all very quick and sloppy, possibly with errors - insufficient time today unfortunately.

Mencius Moldbug writes:


Thanks - of course, we've discussed this in the past. I don't really expect you to have sufficient time for anything today! But you (or anyone else) can always email moldbug @ gmail...

MT with the short interest rate resetting is not, I think, a major distinction, because it is still effectively negotiating a new loan every 30 days etc. The real solvency-liquidity (solvquidity?) risk is the fall in price of the 5-year bond, ie, rise in the 5-year rate, as MT turns off.

The fall in price of long-term notes as the result of a liquidity crunch is not generally seen as an interest rate rise (or, more precisely, a steepening of the yield curve) largely because the tools to measure it in the normal way don't exist. For one, since there is plenty of default risk as well in these troubled assets, you'd need a risk-free, MT-off interest rate. This price signal simply does not exist.

I do believe that Treasuries are genuinely risk-free, because I believe that the incentive to print before defaulting - while not formal - is rational, strong, and stable. However, there is all kinds of maturity-transformed and official demand in this market, so it cannot produce the number we'd really like to know - the genuine demand among private holders of 2008 dollars to exchange them for 2013, 2018, 2028 or 2038 dollars.

As for your last paragraph, the thoughts are slightly too compressed for me to evaluate! I will agree with your premise, however, that much fleshing-out is necessary.

Mencius Moldbug writes:


Although it seems to be the product of independent thinking, your view - that depository institutions should be one thing, and lending another - is pretty much the Austrian orthodoxy. This would be unusual if both you and the Austrians are wrong, but it is less surprising if both of you are right :-)

floccina writes:

Libra I love this description that you made

people buy a share in a Nikkei index fund, they think they are buying shares in companies. Except most Nikkei companies don't pay dividends. So in reality, they are buying a baseball card with the stats of the company. Like a baseball card, the shares are only worth what other people will pay for it. It could be $50 trillion or it could be nothing. This is systematic delusion on a multi-trillion dollar scale too. You don't need MT to get systematic fraud and delusion.

I have been telling people for years that investing in stocks is all about dividends and potential future dividends anything else gambling but everyone wants to get rich owning the next Microsoft or flipping houses or buying lottery tickets.

Amen to this also:

People do stupid thing. Most people are crappy investors. People should not be required to invest in interest paying funds just to prevent themselves from losing money via inflation. They will invest that money poorly, and will need to be bailed out. The Fed should have a zero-monetary inflation policy. Companies should be able to keep their money in plain old Federal Reserve Notes ( or even mold). Most people should have an asset allocation that's probably something like 50% cash, 25% bond funds, and 25% dividend paying stocks.

Right now the wealth wants to go from the foolish to the prudent but the foolish are the majority of voters and so the government is trying to prevent it.

BTW IMO with VTI yielding only 2% public companies should not be borrowing money, instead they should be selling more shares.

winterspeak writes:

Good discussion here:

LIBRA: You and I are in agreement about stupid decisions (which are unavoidable) being a cause of bubbles and all manner of misallocation.

That said, I don't think stocks not paying dividends is a problem, and I still think CREDIT is more important in CREDIT BUBBLE than BUBBLE. We can't do away with bubbles, but we can do away with CREDIT bubbles (while keeping CREDIT -- which is an important and useful part of the economy!)

In your examples of 1, 2, and 3, 3 is essentially the same as 1 because of FDIC insurance. People may do 2 thinking it is the same as 1 and 3, but in fact it is not -- when MT turns off this becomes obvious.

JKH: To moldbug's point, separating a floating interest rate does not save you from the bank run problem.

And you are correct, maturity matched deposits still have credit risk -- banks need to separate good risks from bad etc. -- but they do NOT have liquidity risk (ie. are subject to bank runs). The word "liquidity" is tossed around in lots of different forms, but I'm using it in this context to mean: can I roll over short term deposits to pay long term debt, or am I in a bank run situation.


Isegoria writes:

As Libra points out, most of these "maturity transformation" issues disappear when you move away from an old-fashioned bank, which makes explicit promises of r% interest and withdrawals on demand, and move to a bond fund, which makes no promises about what yields it can deliver — and which doesn't have to unwind its investments just because shareholders want to sell their shares.

Certainly bad debt can lead a money market fund to break the buck, and that can cause a liquidity crunch for investors who considered it cash-equivalent, but there's no incentive for a run on the money market fund; shares just lose value, and no new shares are issued until the share price creeps back up to $1.00.

Further, any "maturity transformation" is pretty painless, as those who have cash now can buy shares, and those who want cash now can sell shares. There's no angst about "fraud" from promising on-demand withdrawals while only holding fractional reserves.

Isegoria writes:

Libra wrote:

Except most Nikkei companies don't pay dividends. So in reality, they are buying a baseball card with the stats of the company. Like a baseball card, the shares are only worth what other people will pay for it. It could be $50 trillion or it could be nothing. This is systematic delusion on a multi-trillion dollar scale too.
It's disingenuous — or at least misguided — to claim that a stock is "only worth what other people will pay for it," because it pays no dividends — implying that it's inherently worthless and just a piece of paper.

Granted, mature companies probably don't need to hold on to cash, but growing companies probably do. If a company has good (positive-NPV) ways to invest internally, then investors should prefer to see the company invest internally rather than hand out a dividend.

And dividends are not the only way to give money back to investors. Stock buy-backs are not some crazy scheme to manipulate the market. They let a mature company give cash to investors who want cash, while increasing the value of the equity of investors who want equity.

winterspeak writes:

Isegoria: When you say "bond fund" do you mean a long term bond fund (which people think of as a safe form of equity) or a money market fund (which people think of as a checking account)?

Many bond funds *are* MT, as are money market funds, because they take term 0 deposits and do NOT make term 0 loans -- they make term >0 loans.

That means they have all the issues we've been discussing here.

Equity funds do *not* have these issues. True cash deposits do not have these issues. CDs do not have these issues.

Bad debt *can* cause a money market fund to "break the buck" -- which seemed to happen with Lehman CP at Reserve Primary, but it was not bad debt that caused the Fed to extend FDIC coverage to all money market funds, that was to stop old fashioned back runs. Any term transformer is subject to bank runs -- liquidity risk -- which non term transformers simply do not have.


JKH writes:

Moldbug, Winterspeak –

My point regarding risk decomposition was not to deny the incidence of MT risk, but to highlight embedded pricing components that are unrelated to pure MT risk. E.g. the credit spread for a 5 year loan that prices according to 3 month Libor is very different from the credit spread of a 5 year fixed rate loan. Both have the same MT risk when funded by 3 month Libor, but very different credit spreads. The second spread incorporates the price of interest rate risk. So we need to be careful about this when attributing the true cost of MT.

Isegoria writes:

Winterspeak, what I said applies to any fund -- long-term bond, short-term money market, whatever -- because the key point is that a fund doesn't have depositors who can withdraw their funds on demand; it has investors who can sell their shares on the open market.

The fund might buy 30-year mortgages or 30-day commercial paper, but there's no real issue with maturity transformation, because no one's pulling out their investment early -- not even to buy a cool, new Apple iJetPack. If investors want to liquidate their investment, they sell it on the open market -- maybe at a slight discount, maybe not -- and the fund loses none of its quasi-deposits.

With no notion of first-come, first-served, a fund's in no danger of a run; its shares simply drop in value when its assets drop in value. It's comparatively stable, since no one has an incentive to make matters worse for other investors in order to save their own skin.

guyson writes:

Hmmmmm... I have a question:

If borrowing short and lending long is essentially unstable, why did so many people lend to these unstable institutions? In particular, why did anyone lend to the so called shadow banks, who didn't have any of the government guarantees (i.e. FDIC, discount window, etc.) that non-shadow banks had?

Ajay writes:

Sigh, I commented on Mencius's original post about a big misconception that he has but he clearly does not read the comments on his own blog, while obviously reading the comments here obsessively, so I'll repeat what I said with a bit more detail. The fundamental problem with Mencius and his blog is that it's all off the cuff, so there's a lot of rambling and imprecision. One major imprecision is that he, and others here, label fractional-reserve banking (FRB) as maturity transformation (MT), which it's clearly not as there's no maturity date! One can make a trivial point about FRB deposits having 0 maturity, infinitely rolled over, but that's just debasing the meaning of MT to begin with. What's particularly confusing is that sometimes Mencius attacks real MT, other times FRB, so it's unclear which he really has a beef with, maybe both.

Let's start with basic concepts. MT is, as has been described, borrowing short to lend long. FRB is not MT, it is legalized counterfeiting, as Rothbard and the Austrians have long decried. When you "lend" normally, you give money to someone and are told you will not get it back till 3 years later. When you put money in a FRB bank, you're told the money is lent out AND that you can get it back at ANY time of your choosing. This inflates the money stock and devalues your deposit, the ultimate make-work/welfare program/scam for bankers! Now, any given bank has some percentage of its money coming in from deposits, the rest from MT (for Bank of America, it's about 2/3 deposits, 1/3 loans). When a bubble like the current real-estate one bursts, banks have to liquidate assets to meet reserve ratios, taking losses in the process as everybody else is selling too. As Libra and others have pointed out, this is inevitable as there are a lot of dumb investors out there- many working at banks as Taleb likes to point out- and they always find new ways to fuck up. This is a problem for MT normally but not catastrophic. It is however a huge problem under FRB as the money stock is slowly destroyed as bank assets are liquidated. Now prices fall even further as the money stock falls, touching off a vicious cycle, which is what central banks try to stabilize. Of course, they never step in on the way up, when the banks are in the process of levering up and increasing the money stock, the inevitable consequence of which is the current opposite: delevering. :)

FRB is the foundation of this unstable financial system, MT is merely the building on top. The building starts sagging and Mencius seems to be saying that the structure, MT, has a big problem, when the real problem is the foundation, FRB. I take any suggestion that MT must be abolished as stupid, you will never have a realistic economy full of perfectly maturity-matched loans and I don't see a reason to even try. The real problem is FRB, which has been tipped into unstable mode by the crisis du jour, of which there will be many more to come. The real solution is to switch to a more stable foundation of full-reserve banking or at the very least, FRB with much higher capital rations in the 30-90% range. I don't know why anyone would want to keep FRB, even with higher ratios, and allow banks to keep counterfeiting their money but that's a choice I'll leave to them. Now, I just need to actually find a full-reserve bank where I can put my money (and no, I'm not going to put it into something silly like gold). I personally favor commodity-backed currencies and I think they will probably be wide-spread soon enough.

Richard Boltuck writes:

Molberg's exposition is clever, but his conclusions are incorrect. If MT is magic, so is much that markets routinely accomplish, including the ability to facilitate multi-party exchanges (the non-coincidence of wants) through a common exchange medium, or scale economies achieved through collectively sufficient demand to drive down average costs.

Pooled short deposits, in effect, offer funds available for long term investment. If the mediation is transparent, and the terms of the deposit acceptance clear, then there is no fraud or deception. The law of large numbers permits this "magic" to make sense. One of Molberg's errors is confusing the basic regulatory requirement of capital sufficiency with his notion that a depositor is cheated if all deposits could not be simultaneously returned by a bank -- or by the entire banking system.

As others have noted, under normal conditions that persist for decades at a time, there is no pervasive "pressure" to start bank runs. But as Diamond-Dybvig have formalized in their model, the non-run equilibrium can become unstable given a sufficiently large perturbation, one that calls solvency into doubt (as the Lehman bankruptcy apparently did).

Still, not all Bagehot-like banking systems are government insured. Australia, for instance, does not insure its system, but rather places depositors ahead of unsecured creditors in the event of a bankruptcy. Result, less moral hazard in Australia, where banks are faring well through the current "global" crisis. One reason: depositors monitored how risky lending practices are at banks, which led to much more responsible mortgage design and origination down under (see ). How does Moldberg explain the stability of Australia's uninsured banking system? Australian depositors know that in the event of a bankruptcy, perhaps related to a run, they might only receive a partial return of their deposits; that is simply part of the deal, made worthwhile by the prospect of earning interest, and the relative safety of banks (compared to mattresses).

Where I agree with Moldberg is that FDIC does partially integrate the Federal government's balance sheet with those of "private" banks -- on the down side, anyway, socializing losses. But profits remain private, which in turn explains the casino-risk taking we observed through mid-2007 and the subsequent insolvencies.

Though MT is not responsible for the crisis, the paradox of explicit deposit and implicit "too-big-to-fail" insurance needs to be resolved going forward. Without insurance, Diamond-Dybvig runs cannot be stopped. With insurance, moral hazard leads to excessive risk, bad assets, and insolvency that puts banks under just as surely as a run. Insurance breaks the link between depositor prudence and bank lending practices, and provides banks with low-cost funding. As Moldberg observes, that funding is ultimately financed with tax revenue. Neither does regulation offer a promising solution, given the history of regulatory capture and politically motivated regulatory policies.

Many papers on SSRN address how to best design deposit insurance, based on historical experience and theory. All worth considering, but in the end, there may be a paradox here that requires more fundamental re-thinking regarding the design of private financial institutions going forward.

winterspeak writes:

guyson: that's a great question! I'm sure many people are asking that exact same thing right now.

ajay: you confuse me. You need MT for FRB to happen. FRB is a case of MT. You seem to be against FRB, but not MT. Are you making a chicken and egg argument?

richard: MT is not magic -- it's just a bad idea. And the law of large numbers does not hold in any system with positive feedback loops, as we are seeing.

i don't know about Australia. we'll see if there is a bank run there or not. now's certainly the time for natural experiments


Ajay writes:

winterspeak, not sure what was confusing about my simple nuts-and-bolts explanation, let me go a bit more basic. Maturity transformation is turning short-term loans into long-term loans. A loan means you give someone money and you don't get it back, no matter what, till the term ends. FRB, on the other hand, you give the money and you can take it out any time, which is what causes money stock inflation and the instability of the system. The trick that the FRB bankers play on you is that they try to represent it as a loan of zero time, or 0 maturity as I said before, that's rolled over infinitely, until you ask them to stop by taking your deposit out. This is not really MT as there is no term to the loan, it's zero! What it all comes down to is that when you make a real loan, the money is gone. You can't make a $1000 3-year loan to your friend and then decide the next day that you will buy a HDTV with the SAME money. It's gone for 3 years. With FRB, the bankers give you the illusion that you can both lend and use the money at THE SAME TIME. Now, the person who the FRB bank gave the money to and you can both bid on that new HDTV, inflating the price because the money stock has been inflated. This FRB scam works as long as times are going good and most of their loans are working. When they inevitably make mistakes, particularly when they fuel a bubble like the current one, it all comes crashing down like the world trade center.

winterspeak writes:

Ajay: I know what MT and FRB are.

I cannot see how you can conduct FRB without MT.

Are you saying that, when I deposit money in a bank, I'm not loaning it money?

Or, can you show me how a bank could conduct FRB in a no-MT system?

Ajay writes:

Sigh, you clearly don't know what they are. Despite my repeatedly pointing out that FRB is not just a case of MT, because a zero-term "loan" is fundamentally different than a finite-term loan, you do not seem to grasp this simple fact. There are two separate and fundamental constructs to our monetary system: fiat money and FRB. Each has its own problems but FRB is the fundamentally unstable one in our current system. It is possible for fiat money alone to be very unstable, if the printing presses run wild at the government's behest, but that's not the problem in this country at this time. As for your question, yes, a bank deposit is not a loan to the bank, because it is missing the fundamental feature of a loan, that the money is not accessible to you while it's loaned. Rather, a bank deposit is something else entirely. You're essentially telling the bank, "Go ahead and counterfeit my money by lending 90% out while simultaneously promising me that you will return 100% to me at the time of my choosing." All this does is create many more dollars chasing the same goods, ie massive inflation, and a fundamentally unstable banking system. Now, rather than bank losses being losses alone, they also destroy the money stock as the process works in reverse. Please read about how FRB works in more detail and how it is fundamentally different than loans/MT.

Richard Boltuck writes:

Winterspeak: "[MT is] just a bad idea."

Response: You wouldn't know it from the present crisis, since term mismatch is not responsible for causing it. Rather, as is generally recognized, imprudent long loans (bubble valued collateral, NINJA, etc. etc.) were securitized in ways that created products hard to value while real estate prices are still collapsing, leading to widespread insolvency, or suspected insolvency, in the banking (and shadow banking) sector. There were other compounding and complexifying factors, but there it is in a nutshell. (Of course, one may ask why the imprudent loans were made, and I've pointed here and elsewhere to a prime culprit in Federal insurance and inherently ineffective regulation).

But I readily agree that term mismatch leads to potential instability in banks' balance sheets given a big enough black swan shock. The question is, do we achieve better economic results preventing that possibility by prohibiting term mismatch, or by simply accepting the risk and getting on with life? Seems to me that's definitely an empirical question, not one that can be reasoned out a priori.

Mencius Moldbug writes:


Rothbard's model - fleshed out at great length in De Soto's Money, Bank Credit, and Economic Cycles - argues that the depository contract in FRB is a fraudulent variation of the warehouse-receipt contract in a 100%-reserve bank.

Indeed, this is its historical origin, both in our financial era and in others. But the history is of no importance. The contract is well-understood today - and even if it wasn't, a libertarian government has no business telling any two private parties what contracts they may or may not sign.

Moreover, the FRB contract can be modeled perfectly as a time deposit of term epsilon. Rothbard has no objection to time deposits, and nor does anyone else. Even if you have a problem with the number zero, if you reduce the term of the loan to one hour, one minute, one second, etc, you get an instrument that behaves exactly like an FRB deposit.

Furthermore, the phenomenon of an FRB bank run is not dependent on the term of the deposit contract being zero. Any maturity mismatch will do it. FRB is not a special case.

In summary: Rothbard was a titan, but not a god. I'm sure Mises and Rothbard themselves would have been the first two people to agree that Austrian economics is a way of thinking, rather than a cult. Infallibility can be left to the Pope.

winterspeak writes:

Ajay: I don't know why you are bringing fiat money into this. I asked how you could possible conduct FRB without MT. A person loans a dollar to a bank. The bank turns around and loans 9 dollars out. How is this possible without MT?

You claim that a "zero-term "loan" is fundamentally different than a finite-term loan". But I do not understand your reasoning.

"a bank deposit is not a loan to the bank, because it is missing the fundamental feature of a loan, that the money is not accessible to you while it's loaned."


But it is *not* accessible to me while it's loaned -- it's in the bank! Cash in my wallet is instantly accessible to me, cash in the bank I need to get before I can use.

I put $100 in a checking account. I no longer have it. I get the money out of the bank. Now I have it. Why is this not equivalent to a zero term loan (that keeps being rolled over)?

If your point is that on-demand deposits should *not* be loaned out, they should be essentially kept in a vault, I agree. But that certainly is not what's done today.

I'm no fan of FRB either, so you don't need to convince me of that. I just cannot see how you can have one without the other. Are you saying that you can get rid of FRB but somehow keep MT? I'm very curious as to how this would work. I am confident though that without MT you cannot have FRB.

Richard: Whenever you have a "credit crunch" or a "crisis of liquidity" it is caused by short term deposits no longer bring available to support long term loans. This is the definition of MT.

Mencius Moldbug writes:

Still, not all Bagehot-like banking systems are government insured. Australia, for instance, does not insure its system, but rather places depositors ahead of unsecured creditors in the event of a bankruptcy. [...] How does Moldberg explain the stability of Australia's uninsured banking system?

As the consequence of insurance that is informal, but politically assured. This is (or was until recently) the nature of a number of essential facilities, such as Treasury's protection of FDIC, the GSEs, etc, etc.

FDIC is a good case: at least assuming rational actors, if we learned suddenly that FDIC did not have an infinite line of credit, we would all go to the ATM right now. FDIC's own funds are sufficient for sporadic solvency failures due to malfeasance. In a true systemic bank run, it is inadequate by orders of magnitude.

Yet no bank run occurs. Why? Because depositors aren't stupid. They vote, and they know that the government will protect them. And this is how MZM can exceed M0 by a factor of 10. I don't know where to find the equivalent ratio for Australia, but I imagine it's comparable.

Basically, in the modern world, a retail depositor thinks of a bank as a safe place to deposit money. And he assumes that his government makes this safe, as with so many other things. And in practice, this is basically how it plays out - the required formal insurance tends to appear quite rapidly.

When the government issues a loan guarantee, it issues an option - a CDS, basically. This is dilutive, as the ratio of MZM to M0 shows. Pretending not to issue these options, but really issuing them anyway, is not an increase in transparency. If Australia really made it clear to its citizens that the deposits in its banks were not in any sense guaranteed, and the message was both true and believable, Australia's banks would vaporize overnight just like anyone else's.

But I readily agree that term mismatch leads to potential instability in banks' balance sheets given a big enough black swan shock. The question is, do we achieve better economic results preventing that possibility by prohibiting term mismatch, or by simply accepting the risk and getting on with life? Seems to me that's definitely an empirical question, not one that can be reasoned out a priori.

If we can agree that uninsured term mismatch is unstable, I don't think we disagree on any question except for this one.

On this one, see my earlier answer to Arnold in which I construct an equivalence between insured term mismatch and direct government lending. Again, if you believe it is economically productive for the government to provide insurance that allows banks to mismatch maturities, you must also believe it is economically productive for the government to simply print money and lend it out. This is a legitimate perspective, but not one that is often defended.

Mencius Moldbug writes:

JKH, no disagreement - although the contractual details of some of these resetting-rate loans, especially auction-rate securities, remain a bit of a mystery to me. Regardless, the MT risk involves a steepening of the yield curve rather than a change in its short end, as implied in these examples. Of course the latter may happen in a crisis as well.


If borrowing short and lending long is essentially unstable, why did so many people lend to these unstable institutions? In particular, why did anyone lend to the so called shadow banks, who didn't have any of the government guarantees (i.e. FDIC, discount window, etc.) that non-shadow banks had?

Because either (a) they thought the shadow banks were protected by informal political support ("too big to fail"), or (b) they didn't think about it at all, because they were used to working with models of the loan market that assumed lenders of last resort. I'm afraid (b) is probably the most common answer.

Ajay writes:

Wow, the ignorance shown by the responses of Mencius and winterspeak is mind-blowing. Let's start with Mencius. First, he mentions some irrelevant history, presumably to demonstrate he knows of what he speaks, before saying the history is unimportant. Then, he says the government shouldn't intervene although nobody's calling for government intervention: I specifically said that capital ratios should be left up to depositors and whatever ratio they're comfortable with. Then, he simply repeats the claim that deposits are zero-term loans, that I've already debunked. He is right that FRB is not a special case, it's a whole different scenario, as I stated earlier. The critical difference is that MT does not create money as FRB does and that banks have to plan for the possibility of some maturities not being rolled over under MT, while there is no way to plan for on-demand deposits as everybody can pull out at once. Finally, he says that Rothbard is no god, as though my analysis depends on Rothbard in any way. All I know about Rothbard is that he's against FRB and for full-reserve banking, I have never read his writings on either subject. Really, this shallow and evasive retort from Mencius made me lose what little respect I had for him.

As for winterspeak, let me reduce my explanation to the drooling neanderthal level as you and Mencius clearly don't understand even the simple prior explanations. Let's suppose that Arnold and Bryan live in a tropical village, where Don, the chief of the village, gives them each 1000 pooka shells (PS) to use as currency (total currency in circulation [M1]: 2000 PS). Russ comes along and borrows 200 PS each from Arnold and Bryan, saying he'll pay them back in 3 months, leaving them each with 800 PS. Then, Tyler comes along with some extra snails that he dug up and offers to sell them. Arnold and Bryan bid and the snails are sold to Arnold for 700 PS.

Now, suppose an alternate scenario where there's a bank instead. Again, after loaning 200 PS each to Russ, both Arnold and Bryan put their 800 PS in the bank and the bank turns around and loans them each 400 PS. Now, both Arnold and Bryan think they have 1200 PS, as they have 400 PS each from the bank loans in their pockets and think they have 800 PS sitting in the bank (M1: 2800 PS). This time when Tyler comes along with the same snails, they bid and Bryan buys them for 1000 PS, which he pays with the 400 PS on hand and 600 PS more that he pulls out of the bank (M1: 2800 PS). The price for Tyler's goods have inflated by almost half because of the increase in the money stock caused by FRB, which would have never happened if all Bryan had were his original 800 PS. Notice the critical difference between the actual loan made to Russ, from which the money will not come back for another 3 months and so cannot be used in the snail bidding, and the deposits in the bank which can be pulled out "on-demand." The bank can get away with this because both Arnold and Bryan did not withdraw their money at once: this is what an unstable system like FRB, really a Ponzi scheme, fundamentally relies on.

Continuing on with this banking scenario, now let's move on to the reverse delevering process, analogous to the current financial situation in the real world. The bank now has 200 PS on hand and proceeds to loan out 150 PS to Brad (M1: 2950 PS). Brad comes back the next day and says he had a hole in his pocket and he lost 100 PS in the swamp, which he cannot possibly pay back (M1: 2850 PS). Now the bank is worried. It has 1000 PS on deposit versus only 50 PS in reserves. Also, if all its assets and liabilities were unwound, it would only have 900 PS on hand to pay back 1000 PS deposited, leaving it insolvent. So, it decides to build back its reserves a bit to project confidence. The bank goes to Arnold and asks him for 200 PS back out of the 400 PS it lent him, as he happens not to have spent it yet (in the real world they liquidate assets but this is a close enough alternative to keep the example simple). Now, the bank has 250 PS in reserves and feels a bit safer about its day-to-day activities but M1 has now dropped to 2650 PS. Prices then proceed to drop as M1 has dropped: there are less pooka shells in circulation to buy stuff with.

Monetary inflation through FRB is prone to this reverse process of deflation when trouble hits, and I haven't even talked about the bank run contagion that happens when one bank's failure causes another to fail and then another, like a stack of dominoes. The alternative that I'd prefer is full-reserve banking. Want to make a loan? Put 30% of your money into a bond or some other instrument that has a real maturity, ie you cannot pull it out till the maturity date comes around. It is irrelevant whether the loan is used for MT or not, what matters is a finite maturity date. If some want to put their money in a FRB bank with capital ratios in the 10-90% range, be my guest. What matters is that depositors think about the money creation and inflationary effects of this decision and act accordingly. However, most people currently are completely ignorant of fractional-reserve banking; I suspect they would not put any money in FRB if they knew what was really going on. The current crisis offers a great opportunity for Austrians to make this case. The really difficult part is making the transition from FRB to higher capital ratios without undergoing massive short-term deflation. I suggested a possible solution for this in my original comment more than a week ago.

winterspeak writes:

Ajay: I've been perfectly civil about this, but you're being a jerk.

If you think having money in your wallet is the same as having money in a bank account, then we must simple agree to disagree. I just wish my bank would pay me interest on what's in my (accessible) wallet and hidden in my (inaccessible) couch.

Also, as you continue your crusade against FRB, I would offer that you consider all the non-FRB MTers out there. Getting rid of MT gets rid of all of these problems, including FRB; getting rid of FRB just gets rid of that one instance of MT, and leaves all the other standing. Why you're focused on the narrow solution to part of the problem, I don't know.

You keep talking about how FRB inflates the money supply. I know that. Do you understand how MT inflates the money supply? FRB is one instance of MT. You're focused on squares, and I'm asking you to focus instead on rectangles (which includes squares).

Anyway, I'm done.

Richard Boltuck writes:

winterspeak: "Richard: Whenever you have a "credit crunch" or a "crisis of liquidity" it is caused by short term deposits no longer bring available to support long term loans. This is the definition of MT."

Disagree. Suppose every 30 year bank loan were matched by a 30 year depository CD (sort of calls into question whether banks have any residual function in this hypothetical world). Now suppose the 30 year loans are imprudent in the sense I used the term in my prior comment: NINJA, based on bubble-valued collateral and assuming only continued increase in collateral value, and so on. Surprise, the loan goes bad. The bank is insolvent and cannot now service the 30 year CD. Why is that not a financial system crisis similar to the one we're in now?

Granted, term mismatch means that insolvency might be followed by a bank run, but the essence of the problem is not the bank run but the bad banking assets prior to the run. The bank run is then merely a symptom and not a cause of crisis, perhaps an amplifier, or perhaps, as some might suggest, a form of needed market discipline (discipline that is ineffective when risks at all banks are correlated). Moreover, even if deposit insurance stanches the run, the insolvency and crisis remain, since such banks are out of the business of generating new credit.

Consequently, it is incorrect to assert that any credit crunch must be caused by MT. Sometimes it can be caused by bad prior loans stinking up the balance sheet, and MT plays no first-order role.

Mencius Moldbug writes:

Suppose every 30 year bank loan were matched by a 30 year depository CD (sort of calls into question whether banks have any residual function in this hypothetical world).

Well, someone has to construct the CD!

Now suppose the 30 year loans are imprudent in the sense I used the term in my prior comment: NINJA, based on bubble-valued collateral and assuming only continued increase in collateral value, and so on. Surprise, the loan goes bad. The bank is insolvent and cannot now service the 30 year CD. Why is that not a financial system crisis similar to the one we're in now?

Because the result is merely that the CD owners take a haircut. Earning a lower rate, possibly even a negative rate, over their 30 years.

Moreover, this risk is the kind of risk that bankers know how to handle; it can be diversified, insured, etc, and basically spread out across the known universe. And further, since it is entirely private risk, none of this insurance needs to be a government function - which means the moral hazard is absent, and the NINJA loans are a good deal less likely to happen.

The bank run is then merely a symptom and not a cause of crisis, perhaps an amplifier

I think we are in a state of violent agreement, at least as regards the facts. "Amplifier" is exactly how I'd put it. See the Tacoma Narrows Bridge disaster - the analogy is precise. The bridge amplified the high winds.

There will always be shocks. What we need is a financial system that damps them, rather than amplifying them.

winterspeak writes:

Richard: As you say, if you make a 30 year loan with a 30 year CD, and the 30 year loan was imprudent, you would see a loss on the CD. If enough of these happen, the bank would be insolvent.

And this is certainly happening now to some degree in some banks. And I would also agree that that triggered the current bank run at those banks.

BUT the element that makes it so contagious is that bank runs reduce the value of long term assets. Long term assets have two prices, the bank run price and the non bank run price. Liquidity and Solvency become intrinsically linked.

MT turning off (a liquidity crises) is a systemic event that takes a few bad loans and makes them into a collapse of the financial system. People will always make bad loans, but a robust banking system should be able to survive it, and MT without FDIC insurance (aka the shadow banking system) is not robust. A solvency problem at one bank (caused by bad loans) becomes a solvency problem across the entire system because MT, at a systematic level, turns off.

An institute level bank run can be caused by insolvency. But a systemic bank run (credit crunch, liquidity crises etc.) can only be triggered by MT turning off.


JKH writes:

This excellent discussion has probably run its course for now, but it is far from satisfying as an end game. I hope it continues at some future point. In my view, there remain many highly tentative and questionable logical inferences drawn by the proponents of what might be called the strong form of the MT theory.

For example, I remain unconvinced that the following are not true:

a) Maturity transformation does not necessarily imply fractional reserve banking.
b) Fractional reserve banking does not necessarily imply maturity transformation.
c) Neither a liquidity crisis nor a solvency crisis necessarily implies the precondition of maturity transformation (Richard Boltuck describes why in a very eloquent way just above).
d) Declining asset prices are not always explained by bank runs.
e) And following from c) and d), there is no robust relationship between declining asset prices and MT.

So MT is an interesting and fundamental risk characteristic, but the argument that it is the sine qua non of banking risk fails as robust theory. The basic error in the theory is its assumption that liquidity risk and solvency are analytically inseparable. They are quite separable. As distinct risks, they can be integrated, and in combination, they can be differentiated. But they are not inseparable.

I’m similarly not persuaded by the popular application of physics theory to finance problems. The idea of the black swan does not require physics to be understood. Physics at best is an alternative paradigm for the explanation of financial risk, but it is not the true explanation.

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