26 June 2011

Sketching Sustainable Future for Finance (2/3)

In Part 1 of this series of articles we described the main issues that need to be addressed when sketching a sustainable future for finance. Very briefly, these issues are:
* No control over money supply and debt, basically no reliable and suitable anchor for money – the problem which is amplified by the uncontrollable expansion of debt
* Too many assets in too few hands, i.e. (although I may sound like a socialist which I’m not) too much inequality
* Far too much volatility in interest rates
* Mechanisms that transfer assets from real economy to financial sector and risks from financial sector to public sector
* Measures (or quick-fix style of solutions) that artificially preserve imbalances and allow them to grow until they are far too big
* Too much complexity, obscurity and inconsistency in financial world
The following presents the result of a thought experiment the task of which was to come out with a sketch of monetary and financial system that were free of these issues while still fulfilling its very functions in our economy and in our society. Clearly, it’s only a sketch and there are many details to discuss and challenge. Yet we have to begin with some kind of vision.

There are at least six ingredients in the sustainable future for finance:
* Free money and a suitable anchor for the total money supply
* A revised structure of financial system
* Price of money that is linked to the fundamentals of real economy
* Understandable financial instruments the value of which could be assessed adequately
* Thoroughly revised functions of monetary authorities
* Financial literacy
These ingredients can also be thought as the major differences from the current monetary and financial system, or changes that are needed so badly. Sure, further explanations are unavoidable here. So, let’s look the ingredients one by one.

Free money and a suitable anchor for the total money supply

We have to get rid of an absurd-like situation where money supply is either collapsing whenever the total amount of loans outstanding is declining or there is no other choice than replacing the decrease in lending by the freshly “printed” money (the later means enormous growth in monetary base and in central banks’ balance sheets). In other words on principle money should not continue to be debt, save for rather small portion of it which results from the need to reward savers/investors for taking the risks of lending out their savings/capital and is directly backed by the value added that such lending is ought to generate. This means that on global level (and on the level of a well-balanced economy) money on asset side has to suffice for repaying all the outstanding liabilities on liability side.

Yet freeing money from debt is one thing but an important question still remains: how big should the total money supply be / what’s the total amount of money that should be available in an economy at a particular point in time if this cannot be defined by the amount of debt? In other words, we also need an anchor for money. This anchor has to be impossible to manipulate, and at the same time enable growth of real economy and improving life standards. In one of my earlier posts, Anchor/Base for Money Needed, I propose basing the total money supply to a Life Quality Index. Of course, what this index exactly is and how it is ought to be measured, is a subject for further far more detailed discussions. The idea is that we should recognise economic growth only if it adds to the quality of people’s lives, and that money supply should be anchored to the economic growth measured in this way.

Revised structure of financial system

Clearly, the current monetary and financial system is not designed for the principle of free money. Instead, it follows the logic of fractional reserve system which has to be abandoned when sustainability is concerned. However, it’s not enough to increase the reserve requirement to 100%. We still would have depositors’ money invested into too risky assets, too-big-to-fail institutions that benefit from state guarantees, deposit guarantee funds that have too little resources for fulfilling their obligations in a crisis situation. This makes a thorough revision of the structure of current financial system necessary.

The solution would be a monetary and financial system that consists of the following types of institutions:
* Savings banks / narrow banks – the banks where people could deposit their money they don’t want to risk in nominal terms (i.e. the deposits of these banks would be fully guaranteed by the deposit guarantee fund). These banks would keep all of their assets in cash or as deposits in central bank, and only provide payment services.
* Fund-type of financiers of various risk levels – the banks / financial institutions that would lend money to companies and households, and fund their activities via selling equity shares to private investors. Private investors could choose from various risk & revenue levels starting from relatively safe home loan and government bond funds up to the leveraged finance. Money invested via such financiers would not be guaranteed but the value of investments would change as the value of the fund changes.
* Loan servicers – the companies that would communicate with customers, choose an appropriate financier for them or (in case of large loan amounts) assist in composing a syndicated loan, collect payments and pass them through to fund-type of financers and their investors.
* Exchanges – quite in the same function as today; the idea is that households and non-financial companies would still have the possibility to invest directly and transparently into equity shares, bonds and all other traded instruments.
* Central banks (or whatever we call the monetary authorities) that would be responsible for the technical part of money supply and smooth operations of payment systems as well as for financial supervision.
* Insurers, incl. deposit guarantee fund

Note that only deposits in savings banks would be guaranteed by the deposit guarantee fund. Because of being risk-free, these deposits would earn no interest. The idea is just to have a safe place for certain part of people’s wealth (strategic reserve or so). Households and companies who are seeking higher returns could choose from fund-type of financiers of various risk levels or invest directly into equity and bonds of other companies. The reasons for replacing traditional lending function of banks with the fund-type of financiers are: cutting off the possibility of creating “fake money”, making investors aware and responsible for the risks accompanied with the lending activity (and thus limiting excessive lending), as well as limiting the potential obligations of deposit guarantee funds by separating banks’ risky activities from the saving bank function.

Price of money

Call it price of money, money cost, interest or fee for the use of money it shouldn’t make loan payments unpredictable and it shouldn’t be unsustainably high. The base for deriving correct price for money would not be some policy rate set by central bank but growth rate of real economy (in terms of life quality as discussed above). To that one would add a customer and deal specific risk premium. The main idea is that those who take risks of lending the money would later get back the same amount in real terms plus risk premium. It’s worth highlighting that as deposits in savings banks are not earning interest, they are slowly losing value as economy and money supply grow. This is to stimulate the circulation of money. Another important point is to avoid capitalising interests which would result in uncontrollable growth of debt (as it currently does). Defaults should be recognised and losses taken as they occur.

Understandable financial instruments

The possible range of financial instruments should be limited to those which have one-to-one connection with the underlying exposure. Furthermore, each of the qualifying instruments has to be understandable and its valuation in balance sheet transparent. This definition excludes sliced and diced products and their derivatives, derivative instruments that are used for pure speculation and do not have an underlying asset, basically more-less all of the so-called model business where valuations are derived by using internal valuation models. Alleged benefits of disqualified instruments are far too small compared to the obscurity, uncertainty and instability that they create.

Revised functions of monetary authorities

As a result of the above described reforms into the monetary and financial system, several of the current functions of monetary authorities would become redundant. Active monetary policy in terms of decisions on policy rates and money supply is no longer necessary, and should be replaced by a rather technical job of measuring the anchor for money and adjusting money supply accordingly, as well as providing base data necessary for deriving fair price of money. Financial institutions still need to be supervised, yet the nature of this supervision is about to change as the financial system and the subjects of supervision change.

Financial literacy

As people’s fortunes and misfortunes depend so much on financial literacy, high quality financial education needs to be made as accessible as is calculus. No financial advisor is a replacement for one’s own judgement when it comes to financial decisions. Besides helping to prevent inequalities growing even bigger, spreading financial literacy would also reduce chances for fraud by those who have become too greedy.


The next big question is how to move from point “A” where we currently are to point “B”, i.e. to a financial system that we just sketched. This will be the discussion topic next time.

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