What should be done about the private money market? It is widely recognized that this market was at the center of the recent financial crisis. Indeed, very nearly the entire emergency response to the financial crisis was aimed at stabilizing this market. Yet recent and proposed reform measures have done little to address this market squarely.
It is important to be precise about terminology. The term “private money market” refers to the multi-trillion dollar market for short-term IOUs that are neither issued by nor guaranteed by the federal government. This market includes repurchase agreements (“repo”), asset-backed commercial paper (“ABCP”), uninsured deposit obligations, and so-called Eurodollar obligations of foreign banks. It also includes the “shares” of money market mutual funds. (Contrary to widespread belief, commercial paper issued by non-financial firms is only a tiny fraction of the private money market—on the order of 2%. That is to say, the private money market is dominated by financial issuers, not commercial or industrial ones.)
The recent crisis witnessed a massive run on the private money market (also called the “shadow banking system”). And the federal government responded with a massive intervention. But why intervene? What would have been so bad about widespread defaults by issuers of these instruments? In my recent article, Regulating Money Creation After the Crisis, published in the Harvard Business Law Review, I provide one possible answer. Specifically, I argue that the instruments of the private money market have important properties of money. Accordingly, widespread defaults on these instruments should be expected to generate adverse monetary consequences.
This argument echoes Milton Friedman’s and Anna Schwartz’s influential argument about the causes of the Great Depression. In their monumental Monetary History of the United States, they traced the origins of the Great Depression to a massive monetary contraction brought about by the collapse of the banking system. “[T]he [bank] failures,” they wrote, “were the mechanism through which a drastic decline was produced in the stock of money.” And the economic devastation that followed was “a tragic testimonial to the importance of monetary forces.”
Does the Friedman-Schwartz logic apply to the private money market? The argument is admittedly somewhat counterintuitive. Unlike bank demand deposits, most private money market instruments do not function as a “medium of exchange”—the sine qua non of “money.” Nevertheless, the article offers both theoretical support and empirical evidence for the “moneyness” of money market instruments. It also shows that money market instruments are in fact treated like demand deposit obligations—and differently from ordinary debt instruments—in a variety of legal, accounting, and market contexts. In other words, these instruments are widely acknowledged as having money-like attributes, in a way that ordinary (capital market) debt instruments are not.
This line of reasoning poses a problem for traditional financial regulation. Suppose for the moment that money market instruments do indeed serve an important monetary function. (The article argues that they do, in every sense that matters.) Suppose also that defaults on these instruments, like defaults on deposits, amount to a contraction in the money supply, with the attendant macroeconomic consequences that Friedman and Schwartz identified. If these consequences provide a sound economic justification for the extraordinary regulation of depository banks—not to mention the special support facilities to which depository banks have access—does that rationale not apply with equal force to issuers of private money market instruments? In other words, does our special regulatory system for depository firms rest on an arbitrary and formalistic distinction?
My paper argues that it does. More generally, it finds reasons to favor establishing money creation as a sovereign responsibility by means of a public-private partnership system—in effect, recognizing money creation as a public good. (This is just what modern bank regulation has done for decades.) Logically, this approach would entail disallowing access to money market financing by firms not meeting the applicable regulatory criteria—just as firms not licensed as banks are legally prohibited from issuing deposit liabilities.
Against this backdrop, the article reviews the Dodd-Frank Act’s approach to regulating money creation. It finds reasons to doubt that the new law will be conducive to stable conditions in the money market.
The full paper is available for download on the Harvard Business Law Review website here.