Discussion Paper

No. 2012-34 | July 20, 2012
Register, Issue, Cap and Trade: A Proposal for Ending Current and Future Financial Crises
(Published in Special Issue Coping with Systemic Risk)

Abstract

A fundamental cause of the global financial crisis was excessive creation of short-term money-like liabilities (‘quasi-money’), notably in shadow banking holdings of sub-prime MBS and other US dollar structured credit instruments and in cross-border flow of capital to the uncompetitive Euro area periphery. This paper proposes a registration system for: (i) controlling quasi-money and resulting economic externalities and systemic risks; and (ii) supporting public sector monetary issue to counter collapse of private sector credit in the aftermath of crises. This policy would trigger a profound but also economically beneficial change in the business models of both banks and long-term investors.

Paper submitted to the special issue Coping with Systemic Risk


 

JEL Classification

G28 E44 G21

Cite As

Alistair Milne (2012). Register, Issue, Cap and Trade: A Proposal for Ending Current and Future Financial Crises. Economics Discussion Papers, No 2012-34, Kiel Institute for the World Economy. http://www.economics-ejournal.org/economics/discussionpapers/2012-34

Assessment



Comments and Questions


Neil Lancastle - Who pays adjustment costs?
July 27, 2012 - 16:11

I am not an expert in this field, so can only offer general comments.

Your paper reminded me of a proposal by Lynn Stout et al (UCLA, 2009) that the cheapest thing governments can do is to withdraw the legal backing for complex financial products: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1485518.

I ...[more]

... am concerned that a 'cap-and-trade' solution passes adjustment costs to the public sector, without necessarily reforming banking. The separation of retail and investment banking, withdrawing legal support, Pigovian transaction taxes, and stronger competition law to break up and diversify the banking sector, would seem (to me) to have fewer public costs. I guess, to answer that, these alternatives need to be costed.

I am also concerned about the moral hazard. TBTF institutions already benefit from historically low central bank rates, that are not always passed on to borrowers. Negative interest rates, even if the practical issues could be overcome, exacerbate this and adjustment costs get passed on to investors in developing countries (who had bought government debt to evade the worst of the private debt).

If central bank rates were higher, and TBTF were allowed to fail, then Chinese banks (who only earn 3% from their central bank) might be encouraged to invest directly in the UK economy, diversifying the sector.

In a more general sense, having argued that the money supply is determined by private actors, I was expecting to see more reference to post-Keynesian economics (Arestis, Sawyer, Graziani).

I hope these comments help and perhaps stimulate some discussion.


Alistair Milne - useful ´comment
September 05, 2012 - 15:32

These are useful and constructive comments, well worth taking on board. Some brief replies below
1. Your paper reminded me of a proposal by Lynn Stout et al (UCLA, 2009) that the cheapest thing governments can do is to withdraw the legal backing for complex financial products: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1485518.
ALISTAIR: I ...[more]

... was unaware of Lynn Stout's suggestion, will reference.

2. I am concerned that a 'cap-and-trade' solution passes adjustment costs to the public sector, without necessarily reforming banking. The separation of retail and investment banking, withdrawing legal support, Pigovian transaction taxes, and stronger competition law to break up and diversify the banking sector, would seem (to me) to have fewer public costs. I guess, to answer that, these alternatives need to be costed.

ALISTAIR: This comment is about the balance of costs v. benefits from "cap and trade". One response is already in the paper, cap and trade seems a less costly way of controlling maturity mismatch than the NSFR and LCR requirements of Basel III.

I do not currently comment on the broader issue of the costs and benefits of reform, especially the impact on the availability of credit to the private sector. This goes well beyond the subject matter of my paper (cap and trade is only one oa numer of possible proposals, including those those you mention, they are not alternatives, many could nd are being pursued together); but I think you are correct to identify cost v. benefits as a major issue and some brief reference to this wider debate is in order.

3. I am also concerned about the moral hazard. TBTF institutions already benefit from historically low central bank rates, that are not always passed on to borrowers. Negative interest rates, even if the practical issues could be overcome, exacerbate this and adjustment costs get passed on to investors in developing countries (who had bought government debt to evade the worst of the private debt).

ALISTAIR Again a pertinent comment, this time more about "issue" not cap and trade, and closely related to the second criticism of my proposals made by Charles Goodhart that this woudl undermine monetary disclipline.

Please see my reply to Charles for fuller response and discussion. I fully agree with him (and I think this is your point also) that monetary credibility is of great value and should not be undermined. I do not think that issue when combined with cap and trade does undermine monetary discipline. This needs to be made clearer in the article.


4. If central bank rates were higher, and TBTF were allowed to fail, then Chinese banks (who only earn 3% from their central bank) might be encouraged to invest directly in the UK economy, diversifying the sector.

ALISTAIR. I don't totally follow this point, but I think it is consistent with my general argument that investors, chinese banks or otehrwise, shoudl not be able to invest to an unlimited extent in short term bank liabilities, with the expectations that this is money and they will be protected from any losses as a result of bank failure. I think cap and trade woudl encourage more efficient diversification of teh economy. But I see no need to lengthen and arleady long article witha discussion of this point.

5. In a more general sense, having argued that the money supply is determined by private actors, I was expecting to see more reference to post-Keynesian economics (Arestis, Sawyer, Graziani).

ALISTAIR: I agree some references to this line of thinking is appropriate, although the point is a much older one and made by Tobin, Kaldor and various Austrian economists amongst others.,


Neil Lancastle - Thanks
September 11, 2012 - 11:56

I appreciate the reply, and the pointers given.

I agree with the author that debt deflation is the major concern. Certainly, this proposal improves on Basel III (NSFR, LCR) which is hopelessly uniform. It is, in principle, Pigovian, but like Charles Goodhart I worry about the opportunities ...[more]

... for regulatory arbitrage. For me, taxes seem simpler. To dissuade short-term capital, extend stamp duty to bonds (as Germany did). To dissuade capital flight, extend transaction taxes to currency. And so on. Of course, it's debatable.

The most interesting idea, to me, is using 'helicopter money' to deal with debt deflation. The Bank of England has £200 billion in QE assets....mostly long-term UK Gilts. I may be completely wrong, but it strikes me that these assets might be swapped for (and deflate) private debt. Overseas investors get lower-yielding public debt, but they have a stronger currency and you have dealt with Goodhart's concerns about inflation.


Charles Goodhart - commentary
August 22, 2012 - 11:43

see attached file


Alistair Milne - reply to Goodhart comments
September 05, 2012 - 15:08

Comments from Charles always deserve careful consideration.

I have two main takeaways from his comments

(1) the proposal will not work because intermediation can always take place outside of the controlled registered system

Here I disagree.

I think I have failed to communicate clearly enough ...[more]

... that this proposal is focussed on the control of maturity mismatch (like the related proposal of Jeremy Stein), not on the aggregate level of credit.

It does not matter if intermedation takes place off the register, (using "currency" as Charles puts it) because this off register intermediation would not involve maturity mismatch. This is true even if the unregistered contract is in the form of a deposit, under my proposal it could not be legally enforced.

So, as I argue in the paper, registration, cap and trade, can be an effective tool for controlling liquidity risk, better than the rather inflexible Basel III proposals which are fundamentally weakened because (unlike registration) they do not extend automatically to shadow banks.

(2) Charles's second main point is that my suggestion of "issue" i.e. direct money creation through the register is a serious loss of monetary discipline; it would amount to throwing away all the hard won gains of the world's central banks in establishing their anti-inflationary credibility.

much better according to Charles -- if we need to ease monetary conditions further -- to use "conventional" unorthodox monetary tools of credit easing, i.e. the central bank buying of private sector assets.

Here the issues are complex and I am on trickier ground.

I concede that the "issue" element of my proposals is a distinct argument from the main point I make about controlling liquidity risk and maturity mismatch. Such direct issue could be conducted without a register (eg as with the first world war Bradbury's could be used directly by government for purchase of goods and services, thus reducing the requirement to tax; or simply distributed to the population on per capita basis).

Another reason that this takes the reader away from the main argument of my paper is that the broad question of the effectivness or otherwise of various unconventional monetary policy tools (negative nominal interest rates, quantitative easing, credit easing, direct issue etc.) is a difficult and controversial one and certainly not one I want to enter into in this paper.

There are two reasons why I think issue still deserves a place here, but possibly with less emphasis than in the current draft.

(1) Register, cap and trade on its own is -- from a policy perspective -- rather shutting the stable door after the horse has bolted. It may well have been useful in 2005-2007 to prevent the build up of credit and maturity mismatch before the crisis; but now the problem is contraction of private sector credit and reduction of short term monetary liabilities (much as in the 1930s).

We do not know which of the many unorthodox tools, if any, will be effective. Pursuing registration of short term liabilities right now rather than in the future, is a practical way of implementing yet another form of unconventional monetary policy "issue" and also of keeping it clearly distinct from fiscal policy. We may yet need this additional tool.

(2) The second reason is that register cap and trade, because it offers a mechanism for controlling broad money growth as well as maturity mismatch, can help provide credibility to a monetary policy stance which claims to be expansionary today (in order to counter disinflation) but seeks to maintain the targeting of inflation in the future. This applies which ever form of unconventinal policy is adopted (negative intrerest rates, QE, CE or issue). Of course inflation targeting also provides some credibility, but additional credibiltiy is no bad thing.

To conclude, for the final assessment of my article, I suggest that the discusssion of issue be rewritten, to make clear the limited contribution of the article on this particular topic.

I can add I am not as some do advocating rapid inflation as a means of entirely wiping away private and government sector debt (although this may be unintentionally suggested by my current draft). Such a policy would be undesireable both on grounds of unfair distributional impact e.g. on pensioners with fixed nominal incomes and because of the damage to the credibiltiy of monetary policy. Rather I see "register, issue, cap and trade" as a potentially very useful combination, with cap and trade controlling expansion of short term funding and hence providing an appropriate discipline on issue or other forms of unconventional monetary policy.

I am however still arguing that some moderate inflation, perhaps at a higher level than targeted, through direct monetary issue via the register, may be necessary to prevent private sector debt overhang leading to a cumulative disinflation with falling output and prices. We have I think at present knife edge (unstable) macroeconomic equilbria which makes control problem for the authorities exceedingly difficult.

two final point for any readers who get this far in my reply.

(1) For London based readers, Charles and I will be debating my proposals at the London School of Economics Financial Regulation Seminar at 5.30pm on October 1st, 2012; the LSE website should provide details of venue etc.

(2) and yes, finally, I can say this was a lot of fun to write, doing research does not always have to be painful !

Alistair Milne


Anonymous - Reader Comment
September 05, 2012 - 13:06

See attached file


Alistair Milne - systemic risk in derivatives
September 05, 2012 - 14:14

this comment is not really relevant to my paper, so not sure why it is here at all.

All I can say is that if derivative holdings contribute as much as this other research suggests to systemic risk, then registration of derivative holdings is likely then to be ...[more]

... a useful tool to monitor this risk and may provide additional tools for controlling systemic risk e.g. if unregistered contracts are not legally enforceable.

But since my paper is about short term bank funding , not derivatives, this is a separate discussion.


Anonymous - Referee Report 1
February 05, 2013 - 17:01

See attached file


Alistair Milne - Revised Version
February 19, 2013 - 11:25

See attached file