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The theory of money entanglement (Part 2)

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DECEMBER 19, 2013 5:18 PM

By: Izabella Kaminska

GiveuntoCaesarwhatisCaesars

Followingonfromourpreviouspost(http://next.ft.com/content/5c17f057d440378e8f
b044eb2d68d72d),thereareanumberofreasonswhybankschoosetovoluntarilyfund
andcapitalisethemselveswhenthankstothepoweroftheirownseignioragethey
donthaveto.

First,fromabanksperspective,theonlyreasontheyissueunitsatallissothattheycan
eventuallycollectbetterformsofmoneyforthemselvesnotablybasemoney,collateral,
orscarcecommodities.Thisleadstosomeaccumulationofcapitalintheformof
shareholdersfunds.

Second,evenifthewiderbankingandmarketsystemishappytoacceptunfundedbank
unitsforsettlement,taxauthoritiesgenerallyarenot.AsfarbackasCaesarsdaythestate
woulddictatethetermsoftaxcollection.Qualifyingassetsmightincludeeverythingfrom
actualoutput(wheat,food,linenetc),booty(jewels,land,slaves,collateral)toofficial
coinageoftherealm(a.k.abasemoneythatwhichhasCaesarsownimageonit).
Privatelyissueduncollateralisedbankmoney,however,wasnotlikelytomakethecut
afactorthatseverelylimiteditsmassmarketappeal.

Yetitwasalsoafactorthatcouldbeeasilyresolved.Allbankshadtodowasofferto
transferanequalamountofcollateralorbasemoneytothegovernmentifandwhentheir
unitswereusedtopayoffgovernmentliabilities.

Thisresultedinastrongincentivefortheprivatemoneybankingsystemtoraisejust
enoughcapital(intheformofbasemoneyorothergovernmentacceptedcollateral)to
meetthesystemstaxobligations.
Overtime,thegovernmentprivatebankrelationshipevolvedtoonewherethestateeven
becamewillingtoacceptprivatemoneydirectlyontheprovisothatbankscouldprovethe
underlyingbasemoneyorcollateralwasheldintheirreserves.

Nowadays,thatrelationshipisevencloser.Thegovernmentviaitsagentthecentral
bankispreparedtoprovidetheprivatemoneysystemwiththebasemoneyitneedsto
meetitsliabilitiesforthesakeofsystemstability.Anditspreparedtoprovidethat
liquidityforaslongaspricestabilityforitsownunitscanbeguaranteed.

Withbasemoneytheoreticallyavailableontap,theresnoreasonforanyofthedifferent
unitstotradeatanythingotherthanthevalueofbasemoney.Itisinthiswaythatprivate
moneygetsalmostfullyentangledinthesystem.

Itsworthnotingthattheprovisionofthissortofunlimitedliquidityiswhatmodernfree
bankingenthusiastsdisagreewithsofervently.Intheirminds,theamountofbasemoney
orcollateralshouldbefixed,andbankswhichfallshortontheirliabilitiesshouldsimply
beallowedtofail.

Tous,thisignorestwoimportantfacts.Thefirstisthatbasemoneyisstillconstrained.Its
justthattheconstraintisdeterminedbyeconomicoutput(asindicatedbypricestability)
ratherthangoldorsomeotherarbitraryconstant.Thesecondisthatmodernmoney
entanglementhasahabitofturningwhatmightotherwisebeanisolatedbankfailureinto
asystemwidebankingcollapse.

Admittedly,manyoftheaboveobservationsaresomethingofagrossgeneralisation.There
arenaturallymanyexceptionstotherecountedpatternofevents.

Therearealsomanyotherreasonswhybankshavetendedtopartially,ifnotfully,fund
themselvesthroughouthistory,amongthem,usurylawsandothergovernmentmandates.

AninterestinghistoricalexampleinthiscapacityistheMedicibank(http://en.wikipedia.
org/wiki/Medici_Bank),apawningbusinesswhichmadeitsfinancialmarkbyfacilitating
moneytransfersformerchantsandtradersacrossrenaissanceEurope.

ThesystemtheMedicidevelopedexploitedthefactthatitwasnotonlyextremely
cumbersomeanddangerousfortraderstocarryheavycoinagewiththemtoforeignlands,
butalsoincrediblyexpensivetoconvertsuchcurrenciesintolocalequivalentsbecauseof
foreignmoneybansorcapitalcontrols.

WiththeMedicisystem,however,youcoulddeposityourcollateralathome,beissueda
Medicibillofexchange,thenpayforthegoodsatthedestinationpointviatheliquidation
ofthebillattheprevailinglocalcurrencyrate.

This,ofcourse,isnotdissimilartohowPaypalorBitcoinoperate.

JustlikePaypalunitsbutunlikeBitcoinunitsMedicibillswereissuedbyaspecific
entityandprudentlycollateralisedtoaccountfortheirownexchangeraterisk(thoughits
ontheexchangethattheymadetheirmoney).JustlikeBitcoinandunlikePaypalunits
theybecamemoneylikeintheirownright,bestowingtheMediciwiththeawesome
powerofseigniorage.

TheMedicisabilitytoexploitthatpowerinthemodernfreebankingsense,however,was
constrainedbyusurylawsoftheday.Thusmuchofitwasdirectedatlendingto
governments.

Sowhatsourpoint?

Well,mainly,thatmodernbankshavealwaysbeenfreetoissuecompetitivemoneyunits
andthattodayscentralbanksystemonlyformalisesapreexistingrelationshipwith
governmentthathasevolvedovertimetoenhanceratherthansuppresstheprivate
bankingsystem.

Thatsaid,tryasitmight,acentralbankcanonlyinfluencethesupplyandpriceofitsown
units.Ifitsunitshavebeenentangledwithcorruptedprivatemoney,otherassetscan
becomemoremoneylike(http://ftalphaville.ft.com/2013/12/17/1724982/therepomark
etasaformoffreebanking/?),leavingthecentralbankwithlittleornoinfluenceovera
freebankingsystemthatissuddenlychoosingtoprioritisedifferentformsofmoneythan
usual.

Consequently,tosumup:

Banksupholdthevalueoftheirunitsbymakingthemasuniversallyacceptableas
possible.Toensurethistheyofferholdersashareoftheincomethattheunits
generate,agreetoaccepteachothersunitsindiscriminately,getthestatetoaccept
themforsettlementaswell,andmakeitextremelyeasyandsafetotransferunits.*

Bankstendtoorganisetoholdjustenoughliquidcollateralorstatemoneybetween
themtoensurethata)thecredibilityoftheirprivateunitscanbeassuredona
collectivebasis,b)thesystemsliabilitiestothestatecanbemanaged,andc)the
valueoftheirunitsremainsstablerelativetothevalueofbasemoneyunits.
 Themoredigitisedmoneygets,themoredifficultitistodifferentiatethevarying
unitsandwhatreallybacksthem.Thisleadstotheproblemofmoneyentanglement,
whichnotonlymakesitdifficulttosegregatethedifferenttypesofprivatemoney
fromeachother,butalsoblursthelinesbetweenbasemoneyandprivatemoney
altogether.

Moneyentanglementisexacerbatedbycentralbankliquidity,whichcauseslotsof
varyingprivatemoneytypestoconvergetothevalueofabasemoneyunit.**

Theentanglementissueonlybecomesaproblemiflessprudentbankscreatemajor
capitalshortfalls,whichotherbanksaresuddenlynotpreparedtocover.Whenthis
happens,healthybankswilltrytodisassociatethemselvesfromtheentangledand
corruptedprivatemoneypoolbycollateralisingalltheirmoneyunits.

Asaresultofallthis,clearlydisentangledcollaterallikeTreasurydebtorgoldcan
becomemoremoneylikethanbasemoneyorprivatemoneyduringfinancialpanics.

*Thisishardlytheconventionalwaytothinkaboutbankequity,butagoodindicatorof
whetherbankshavemadetheirunitsextremelyappealingiswhethertheirlistedbank
stockistradinghigherthanbookvalue.UnlikeBitcoinwhichwearsitsappealinitsprice
relativetodifferenttypesofmoney,whendemandforprivatebankmoneyoutstrips
supply,itcouldbesaidthatanyadditionalvaluetobasemoneycanbecapturedby
publicshareholdersoremployeesinstead(vialargerdividendsorbonuses).Thisis
becauseabankhasnointerestinseeingitsunitsdivergefrombasemoneyevenonthe
upside.Somoredemandonlygivesabankanincentivetocreatemoreofitsownunits,
irrespectiveofwhethertheloansitismakingaresound.Itcausesittogetriskier.

**Inotherwordsbankspolicetheupperboundontheirownunitsbylendingmore.The
lowerbound,meanwhile,isguaranteedbythestatewhichstandsreadytoprovide
distressedbankswhoseunitsmightotherwisefallbelowthevalueofbasemoney
withthebasemoneytheyneedtoguaranteethatasaminimumvaluefortheirunits.

Relatedlinks:Therepomarketasaformoffreebanking(http://ftalphaville.ft.com/201
3/12/17/1724982/therepomarketasaformoffreebanking/?)FTAlphavilleFromthe
comments,negativeTbillratesofreturn(http://marginalrevolution.com/marginalrevolu
tion/2013/12/fromthecommentsnegativetbillratesofreturn.html?)Marginal
Revolution
Anewgoodcalledsecurity(http://next.ft.com/content/34c4189799f536b9b647b61e9
0144f7a)FTAlphaville
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COMMENTS (17)

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Ecoute Sauvage Dec 21, 2013

"Spukhafte Fernwirkung" (spooky action at a distance) was Einstein's term for entanglement. Since then, physicists
have managed to get their debits to equal their credits and even photograph the process:
http://medienportal.univie.ac.at/uniview/forschung/detailansicht/artikel/einsteins-spukhafte-
fernwirkung-erstmals-auf-kamera/
If double-entry book-keeping is now a lost art, couldn't we at least learn from the quantum theorists and try a step-
by-step reconstruction of basics like T-accounts? Perhaps this is too old-fashioned an approach.

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DavidBernier Dec 20, 2013

It's a thought-provoking piece by Izzy. When we think of all the complex portfolios in modern banking, valuation
becomes pretty complicated. I prefer to think in terms of "cash ow", i.e. the ebb and ow of units in various
accounts. As long as the bank is in the "safe zone", things are Ok. With offshore banking in the Caymans and so on,
news of drugs money laundering, this "ebb and ow" involves signicant data that the public likely won't see
properly accounted and disclosed in "ocial" bank documents. There's also political risk: Russian bonds just after
the 1917 October Revolution (debts to foreigners) were renegged upon. I read that some say Leo Wanta was hired
under the Reagan Administration to do "nancial warfare" on the USSR by cornering all the rubles, something like
that. So, as any person only knows so much, he/she will always face uncertainties with nance and the banks; this
applies to the banks themselves, who won't have much to do if the Mayan Doomday Prophecy is a year late and end
of world is on Saturday, December 21st 2013. I hope Izzy might continue her articles on money entanglement, and
all that.

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Dis-Enchanted Dec 20, 2013

Everything depends on "price stability"? Asset ination gets around that. With excess goods supplied in a globalized
world "price stability" is a given which allows unlimited increases in units? ? ?

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Cat in a box Dec 20, 2013

Of course since the nancial crisis most banks have been trading at less than book value.

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JulN Dec 20, 2013

@LeveragedTiger
Can't agree more...
But, well... I've almost given up on arguing.
What's worrying is the number of people who don't seem to see the problems...

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LeveragedTiger Dec 20, 2013

Izzy, please, please, please read an intro to the asset and liability matching of banks before posting an article about
anything regarding a bank's balance sheet again.

The level of disconnect between macro-level theorizing and banking practice is becoming too wide to stomach
anymore.

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Tom_ Dec 20, 2013

A very strange article.

What Izzy says is her main point is absolutely true. Banks have always been free to issue money, or what is often
called pseudo-money. Bank deposits, private banknotes, bills of exchange: these are all just promises by banks to
deliver currency or metal. The modern central bank is indeed a result of a long process of evolution of state support
for private banking.

Much of what she writes in her bullet points is also true, except one very silly statement, double-asterisked, that
banks "police the upper bound on their own units by lending more". No they don't. There is no possibility of bank
deposits rising above the value of currency. The highest value they could theoretically reach would be a like volume
of banknotes plus the cost of storing and securing them.

Other than that weird and silly one, Izzy's other conclusions aren't controversial or new. Indeed they're even a bit out
of date. Our modern system of private bank deposits that are interchangeable with state currency is no longer
troubled by individual bank failures. It's troubled by the rare systemic bank failures that the state is unable to
backstop, as in Cyprus, and less rare situations perilously close to that, as in all the bailed-out EU periphery states.

But Izzy arrives at these ordinary conclusions with the most bizarre and counter-factual of stories. She posits a
hypothetical banking system in which banks don't need to fund themselves, and portrays modern banks as having
evolved from such unfunded banks, which actually never existed. Early bank issues were promises to deliver metal
to specic parties, which evolved into transferable and varyingly accepted private banknotes. Valuation of these
depended on perceptions of the bank's creditworthiness. Banks that built a reputation for being adequately funded
and liquid could begin to issue in excess of their funding, so long as they met current redemption demand. In other
words, the evolution went the other way - from fully funded to partly funded. The Medicis are a great example of
what I mean. Their issuance evolved from fully funded to partly funded - that is, in the opposite direction from Izzy's
story.
But most bank failures have come about for more mundane reasons: they lost capital to defaults, or they funded
short, lent long and couldn't roll over funding.

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ChrisJCook Dec 20, 2013

@JulN

Money wasn't and isn't as important as credit, and the inconvenient truth of the methods and instruments which
pre-date modern nance capital are only now re-emerging.

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JulN Dec 20, 2013

I'd like to get the sources of the historical description of this post...

There weren't banks the way we know them in Caesar's time. Small bankers/money dealers. And there was no
"uncollateralised" private bank money. If private bank money there was, it was backed by the commodity money of
the time (even if ever it was on fractional reserves, which was very rare at that time).
After the fall or Rome, "banks" and bankers almost virtually disappeared until the 15th century.

As in other posts, there also seems to be a confusion between funding and collateralisation.

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ChrisJCook Dec 20, 2013

@ Justin Cormack

Firstly, I don't know you and therefore will not give you time to pay (credit) or lend money to you at interest (a P2P
loan).

But if an intermediary comes between you and me which I do trust then I will extend credit to them, and they extend
credit to you on agreed terms.

So the bank acts as a risk intermediary or trust intermediary, and (a) charges interest to you; (b) pays me interest;
(c) deducts default costs; (d) deducts operating costs.

Any remaining prot belongs to the shareholders.

Secondly, there is the matter of the way in which modern money is created as credit by central and private banks
and the way in which governments fund their expenditure through unnecessarily selling dated Treasury credit (stock
is credit, not debt) to private banks who create credit for the purpose.
There is no reason whatever why the Treasury could not create and issue whatever credit is necessary for public
spending with the management of issuance being by banking service providers under the supervision of a monetary
authority. There is not and never has been any reason why money is necessarily created by private or public banks
as intermediaries.

Having said that, in an age of direct instantaneous connections, there's no longer even a need for Treasury issuance.
Credit can now be provided directly Peer to Peer and Peer to Asset (via prepaid use value) within a mutual
guarantee agreement like a P & I Club, and I suspect it will not be long before that is precisely what happens.

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Veritas321 Dec 20, 2013

IK - banks will always nd themselves insolvent from time to time: it's what they do. In fact, if the government
insures banks, you only guarantee bigger and more disastrous blow-ups: moral hazard at play. Reinstate Glass-
Steagall, daily mark to market, no lending beyond collateral plus bank capital, across the board cash reserve
requirement, and full balance sheet disclosure: problem solved.

Banks play up the "world will end, tanks in the streets" whenever their interests are threatened. Ever see "Blazing
Saddles"? "Isn't anyone going to help that poor bank? Hush, Harriet! That's a sure way to start a bank run!"

Oh, baby, you are so entangled--and they are so dumb!

Banks are cheap, frankly -- it takes a storefront, capital, some contracts, but the important hard part: trust.

You call it entanglement, but there is a better political term for what much of the western world faces. When big
banks and governments collude, corporations swiftly get on board, and citizens nd themselves on the short end of
fascism.

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Justin Cormack Dec 19, 2013

@ChrisJCook not sure I quite follow, can you elaborate?

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Paul Bowman Dec 19, 2013

The idea of private money that seeks to maintain a one-to-one correspondance with base money extends quite
nicely to money funds, and hence shadow banking.

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bill40 Dec 19, 2013

The modern monetary system is run by a consolidated government (the Treasury and BoE are one and the same
thing). The central cannot control the money supply but can control interest rates indenitely. It is this control and
proteering that www.positivemoney.org wants returned to democratic control.

On the subject of Bitcoin don't write it off just yet. China can pass all the laws it likes but Bitcoin is the currency of
the Darknet so beyond control. The banks will nd a way to facilitate transfers if there is a prot to be made. They
will not trouble themselves to check whether the deals are legal or not, as past history proves.

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bankrupt greek Dec 19, 2013

Simon Johnson's "Big Banks and the Failure of Bankruptcy" (below) point to a gigantic "Gordian knot" , rather than
your modest "entaglement".

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ChrisJCook Dec 19, 2013

Banks are essentially in the business of guarantee provision or credit insurance, standing between lender and
depositor or trade seller and trade buyer, and guaranteeing the credit of the borrower or buyer.

The joke is that when private banks create the credit/ modern money with which they - completely unnecessarily
(this is the great scam of modern nance) - buy Treasury 'debt' (dated credit akin to Preference Shares in UK Plc in
fact) they are thereby guaranteeing the Treasury's credit.

You could not make it up: but they did, and the reality of the privatisation of the public credit (and its seigniorage)
has been clouded in accounting smoke and mirrors and chicanery ever since.

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petergeorge42 Dec 19, 2013

Is this about Bitcoin?

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