Last week I attended a conference on Shadow Banking at Cass Business School. One of the things that struck me in the course of the two days was the disconnect between those who perceive the shadow banking system simply as a deconstructed banking system that we don't yet fully understand, and those who see it as the primary means by which money is hidden from view for the purposes of avoiding taxation. In his excellent presentation on tax havens, Ronen Palan commented that separation of fiscal and monetary policy meant that central banks didn't concern themselves with the social effects of shadow banking. In his words, they didn't "join the dots". This post is my attempt to join the dots.
But so far, as far as I can see, no-one is asking why the financial system needs safe assets in such quantities. What exactly is the driver behind such a desire for safety?
It is unfair to blame regulation alone for the increased demand for safe assets. All regulation has done is sharpen an existing need. Nor is it fair to say that the increased demand is solely due to risk aversion following the 2007/8 financial crisis. Investors were seeking safety as a primary objective long before that. In fact one of the key factors in the financial crisis was the failure of safe assets. Residential mortgage-backed securities, widely used in the shadow banking system as safe assets to back cash deposits, suddenly became unsafe as the extent of subprime defaults emerged: when BNP Paribas announced that it could not price mortgage-backed commercial paper following the failure of the Bear Sterns hedge funds in August 2007, institutional investors pulled their deposits and the ABCP funding market collapsed. Similarly, in 2008 the fall of Bear Sterns itself and later of Lehman caused runs on tri-party repo, a supposedly safe collateralised form of funding. Safety, it seems, was critical, and when safety was removed, so was the money.
This is vital to an understanding not only of the 2007/8 financial crisis, but of the shadow banking system and financial crises in general. It is often stated that the cause of the credit bubble and subsequent crash was "search for yield" - lots of hot money flowing around the world seeking a return. That is true, but it is not the whole story. The first, and most important thing, that the hot money flows were seeking was SAFETY. Investors were looking first of all to avoid loss. The search for yield was secondary.
Avoiding loss is the key driver of all depository activity, whether in the regulated banking system or outside it. Investors making cash deposits do not expect to take losses. This is as true of cash-rich corporations and high net worth individuals as it is of small retail depositors. The problem is that large deposits in the regulated banking system are not insured. So large-scale depositors look for liquid investments outside the regulated banking system that carry some form of guarantee or safe collateral backing. Short-term government debt is the best, but prior to the financial crisis property-backed private label assets were also regarded as good collateral. When those failed in the financial crisis, that left a crippling shortage of safe collateral. The temporary lifting of the FDIC insurance limit mitigated this by enabling insured bank deposit accounts to be used by wholesale depositors. But that limit has now been reimposed, and yet there still is no sufficient replacement for the private-label safe assets lost in the financial crisis and the sovereign ones lost in the Eurozone crisis.
The question is whether avoiding loss is a reasonable expectation for a wholesale depositor - or indeed for a retail one - and more importantly, whether governments should be expected to make good all losses suffered by depositors. Deposit insurance schemes explicitly commit government to making good the losses of small depositors. Some people suggest that only transaction accounts should receive such a guarantee, and that other small retail deposits should not be guaranteed: but deposit insurance helps to prevent retail depositor panics and bank runs, and there may also be good social reasons for protecting small savers from loss. But wholesale depositors are perhaps a different matter.
Typical losses suffered by depositors are default (where the depository institution is unable to return their money) and capital erosion due to negative real interest rates (where inflation is higher than the nominal rate of interest on the deposit). For retail depositors, the first of these is mitigated through deposit insurance and the second may be mitigated by indexed rates. Similarly, for wholesale depositors the first of these is mitigated through investing in safe assets and the second by investing in index-linked assets. But there is a third type of loss that both retail and wholesale depositors seek to avoid, and that is taxation. Retail depositors avoid taxation by putting funds into pensions and other forms of tax-free saving such as the UK's ISAs.* The equivalent for wholesale depositors is taking funds offshore and/or transforming them into assets that are more lightly taxed. That is what the shadow banking system does.
At present there is considerable concern around the world about tax avoidance. There are calls for closure of tax loopholes, elimination of tax avoidance schemes and clampdown on tax havens. This is driven by considerable public anger about what is seen as "unfair" behaviour by large corporations and rich individuals. The tax avoidance about which there is so much anger is perfectly legal and arises as a direct consequence of liberal tax regimes, open borders and free movement of capital. The question is therefore one of morality: is it "right" for wealthy individuals and large corporations to seek to avoid tax by perfectly legal means?
Tax campaigners have a point: wholesale depositors using the shadow banking system to avoid taxes while taking advantage of government guarantees on debt are looking to have their cake and eat it. But from the point of view of the wholesale depositors, avoiding taxes is perfectly reasonable. Retail depositors, after all, are able to save free of tax: why should not wholesale depositors? And since tax havens provide a legal means for them to do so, why should they not use them? I've outlined some practical reasons why governments might wish to offer retail depositors more loss protection than wholesale ones, but the moral case for this is still to be made, and until it is, in my view it is wrong to regard wholesale depositors as "immoral" for seeking the same loss protection as retail depositors.
So wholesale depositors seek to deprive government (legally) of tax income. But, by investing in government debt they are returning money to government even if they are not paying tax - money that can be productively used for investment in the real economy. Admittedly government has to pay interest on that debt, but that's the only cost, and it could be very low or even zero. So what is the problem? Why is tax avoidance such an issue, if government debt is the vehicle in which the "hidden" deposits are primarily invested? Surely an alternative to the difficult job of chasing tax avoiders all around the world would be simply for governments to issue more debt and encourage those tax avoiders to buy it? Admittedly, if government spent the money it raised from so much additional debt it would risk inflation, but it could always raise interest rates and/or increase taxes to choke it off. What's not to like?
Sadly this strategy falls foul of the problem I identified in my post "When governments become banks" and discussed further in "Safe assets and Triffin's dilemma". How do government assets remain safe? In the eyes of investors, government assets only remain safe if they can be guaranteed to be repaid in the future - which means, ideally, holding cash backing for them (risk-free) and/or running fiscal surpluses sufficient to meet all future debt service and refinancing obligations. Running persistent fiscal surpluses, unless accompanied by trade surpluses, destroys the private sector's ability to save, eventually wrecking both investment in the real economy and ordinary people's security. And cash backing for government debt prevents money raised through debt issuance from being invested productively in the economy. The consequence of large wholesale depositors' desire for safety is therefore progressive impoverishment of smaller depositors and indeed of the whole economy. This could be offset by taxation of wholesale deposits, but not if those wholesale deposits have been hidden somewhere they cannot be taxed.
Alternatively, government could simply ignore investors' demands for debt to be kept safe, and do whatever is necessary to meet the needs of their economies. After all, as I've pointed out before, sovereign currency-issuing governments don't actually have to issue debt at all. They do so in order to make it possible for the private sector to save in something other than currency. If large wholesale depositors abuse that facility, governments can simply refuse to make it available to them. But the problem is that issuing large amounts of debt without considering the effect on price and interest rates potentially impedes the ability of the government (via its central bank) to control inflation.
Really we need to reframe the whole issue. A sovereign currency-issuing government does not require debt in order to fund spending, and it does not require taxation either. Debt is a savings scheme. And taxation is a means of mopping up the excess of government spending over production, thus reducing the risk of inflation - the same job as interest rates do on the monetary policy side. The real issue is investment, not taxation.
It is unreasonable of wholesale depositors to withhold risky investment in potentially productive activities themselves AND refuse to allow government to do so. If private investors will not take risks, and the government cannot for fear of upsetting private investors, the economy is doomed to stagnation. So it seems to me that wholesale depositors have three choices:
- They can allow governments to meet their need for safe assets, but accept that governments will use the money raised from the additional debt to invest productively in the economy.
- They can invest their deposits productively themselves, taking risks in order to generate economic growth to the benefit of everyone including themselves - and perhaps governments might offer some tax incentives for this.
- They can allow government to invest productively on their behalf using money they return to government through taxation.
Or some combination of all three, of course. And on its side, government needs to consider the extent of loss protection it can or should reasonably offer to both wholesale and retail depositors. Current direction of policy appears to discriminate against wholesale depositors in favour of retail, while keeping the back door open for wholesale depositors to find less obvious ways of obtaining similar protection.
It is not acceptable for wholesale depositors to dictate terms to governments regarding the conduct of economic policy while withholding essential investment and expecting the sovereign to compensate them for losses. Nor is it necessary or desirable for government to encourage hoarding of unproductive assets by offering sovereign loss-protection insurance of one kind or another to all investors. For there to be a growing and productive society, someone has to take risks - and if the private sector will not, they should either be slapped in the face as Beckworth suggests, or government should take the risks instead. The quest for safety ultimately leads to economic death.
* Note that the existence of non-bank tax-free savings schemes for small depositors causes disintermediation, since ordinary retail bank and building society (thrift) deposits aren't eligible for tax relief. The consequences of this for the safety and stability of bank lending are not widely discussed.
Some Unpleasant Monetarist Arithmetic - Sargent & Wallace
Global Safe Assets - Gourinchas & Jeanne (BIS)
The Supply & Demand for Safe Assets - Gorton & Ordonez
The Changing Collateral Space - Singh
When governments become banks - Coppola Comment
Safe assets & Triffin's dilemma - Coppola Comment
Government debt isn't what you think it is - Coppola Comment
The return of negative repo rates - FT Alphaville (for disussion of taxation)
Resolving the safe asset shortage problem - Macro and Other Markets Musings
Collateral transformation - Alloway (Markit)