Tuesday, October 07, 2008

Struggling with Term Transformation

I'm glad to see that the Fed is now lending directly to businesses. In a world with maturity transformation plus FDIC, deposits are essentially kept under a mattress, and all loans are made directly by the Government. This credit crises is essentially a bank run on non-FDIC insured banks, and it's nice to see the US Fed (slowly) remove the ambiguity in the situation by taking over most of the world's financial system.

Given that the financial system has revealed itself to be one enormous Government Sponsored Enterprise, I'm amused to hear that the solution is "more regulation". I assume that that's the solution to FEMA as well.

Arnold Kling continues to struggle with the notion of "term transformation" or "maturity mismatch". This makes it very difficult to understand this, actually any, credit crunch or liquidity crises. Essentially, when an intermediary uses short term deposits to finance long term loans, it always runs the risk of a bank run, as those short term deposits can choose to withdraw their money at any time, and the intermediary cannot call in the long term loans to make up the short fall. This is your classic "bank run" and it has no solution. The Government can step in and simply guarantee some short term deposits, and add reserve requirements, but as we've seen in practice, during an actual bank run the Government will simply extend it's guarantee to all deposits, and the bank will use off balance sheet vehicles to get around reserve requirements. Better to simply put your money under the mattress and borrow directly from the Government (which is what is happening now) but it also might be nice to experiment with this thing called "banking".

Arnold reasonably becomes confused between three concepts: fiat money, fractional reserve banking, and maturity mismatching. He also asks for a "theory of how long-term lending emerges". I will clarify the first three, and offer the fourth.

Fiat money is essentially any medium of exchange that can be increased at will by the Government. The dollar is exhibit A. Ultimately, all fiat money will become debauched and valueless through inflation (monetary dilution).

Fractional reserve banking essentially gives banks the ability to increase the money supply by extending credit. So they have mini printing presses of their own, just like the Treasury. Fractional reserve banking means that a bank can make a loan without needing to have the money on hand. It can conjure the money out of thin air -- which is pretty cool. Note, that in a fiat money system, this now means the central bank has much less power over monetary expansion because there are so many new entities that can extend credit by using their own little printing presses. You get a credit bubble when banks print too much money using the fractional reserve system.

Finally, maturity mismatching means using short term deposits to make long term loans, a system which is intrinsically unstable and subject to bank runs.

You can maturity mismatch with any kind of currency. The bank will still be subject to runs, but the currency will not lose value. As the issue of the day seems to be an enormous bank run, maturity mismatching is the culprit at its heart.

As for Arnold's "theory of how long-term lending emerges", I would suggest that you have someone who wants to borrow money for a long period of time, and he finds someone to lend it to him.

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