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Symposium 2013

Proposal - The Art of Central Banking: A Proposal on Collateralization & Re-hypothecation

The Challenge

The global financial crisis has revealed regulatory failure in financial markets and demonstrated the urgent need for reform. In particular, it is now widely accepted that in addition to established m ...

The global financial crisis has revealed regulatory failure in financial markets and demonstrated the urgent need for reform. In particular, it is now widely accepted that in addition to established microprudential policies, macroprudential policies aimed at increasing the stability of the financial sector as a whole are imperative. But an active debate has emerged over what role the central bank should play with this augmented set of policies.

Summary: To avoid another crisis global monetary authorities should be focusing on expanding the collateral base with assets that have intrinsic value while limiting the ability to re-hypothecate paper assets which are nothing but third-party liabilities and which have no intrinsic value.

Central banks have been increasing reserves but the velocity of money has been declining. Unless the latter reverses course the global economy may be set on a path of dismal growth if not catastrophic collapse. Dismal real growth rates endanger employment, incomes, and the ability to meet inelastic obligations. We know that the epicenter of modern monetary theory and practice is credit and not so much money creation. The that extent then the focus should be on collateral and its velocity. If we first protect the system through defensive measures, and then empower it with greater ability to generate credit based on real assets, then we should see both higher collateral velocity as well as higher money velocity, both of which will become instrumental in capital creation which in turn leads to more jobs, higher incomes, greater stability, and lower inequality.

The defensive measures reflect actions that limit the re-hypothecation chain of paper assets as well as the kind of obscure paper assets accepted in that chain. By taking such measures we lower the risks of another crisis (where the value of IOUs is determined by subjective algorithms while they are not backed by real collateral i.e. they are nothing but third-party liabilities) and thus we better safeguard the global economy.

However, defensive measures represent only half of the work that is required. Expanding the collateral base with real hard assets empowers the ability of monetary institutions to create credit. Therefore, the focus should be on identifying dormant assets whose collateralization will speed up collateral velocity. As collateral base and velocity increase, balance sheets strengthen, and in turn credit expands which also increases the velocity of money. As credit and money velocity rise, investment and consumption increase which in turn become seeds of capital creation that can advance  the number of jobs created and uplift people through the mobility ladder.

Of course, such a proposal may be seen as antithetical to the latest attempts (which started on Sept. 23rd) to reignite the collateral base through repo agreements between the Fed, its primary dealers, and the expanded collateral chain which this time includes besides hedge funds, other broker dealers, and money market funds. However, I would suggest that it is complimentary. The latest attempt to increase collateral and money velocity is based on the notion of lending in the short term paper assets which in turn will be re-hypothecated a few times with the hope that in the process credit and loans will be extended, which in turn will create enough capital to cover the holes in the collateral base as well as create jobs and increase growth. However, the proposal above focuses on a long term permanent fix. Therefore, we need to distinguish between short term band-aids, medium term fixes, and long term cures.

The problem with the latest Fed attempt is the separation of the paper assets value from the fiscal imbalances of issuers. Moreover, such imbalances (or in general IOUs based on unhealthy balance sheets) are prone to tail risks which by any standard are fatter these days. Of course, we should recognize that a proposal similar to the one outlined above requires time, and thus the latest attempt by the Fed may be justified in terms of buying time for the short term. However, given the dangers implanted by an inverted credit pyramid where derivatives' notional value is in the hundreds of trillions of dollars, we should also safeguard the global economy by imparting a level of confidence regarding the soundness of our monetary system, in the medium term.

Therefore, the proposal for the medium term is to back up global fiat currencies that are used as international reserves with precious metals and possibly other commodities. As an example I would mention that according to the Fed's balance sheet there is enough gold at Fort Knox to back up required reserves four times over (Gold reserves at current prices are estimated at about $350 billion, while required M1 reserves are about $85 billion).  A  fractional reserve system whose currencies are partially backed up by hard assets will boost confidence, reduce uncertainties, and limit risks. Needless to say that as the basket of the commodity-backed currency expands, so does the trust level in the economy and thus the business environment improves substantially.

Finally, in the long-term global monetary authorities should agree for new (sometimes dormant) hard assets to be included in the collateral base as described above which will create a global monetary system based on sound money.

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