Do Collateral Chains Create Real Value?

Some of the keenest monetary thinkers out there, over at FT Alphaville — Izabella Kaminska, Cardiff Garcia, etc. (I’ll even throw in Tyler Durden at Zero Hedge, with qualifications) — have been pointing us for years towards the work of IMF Senior Economist Manmohan Singh on collateral chains in financial markets. He provides wonderfully cogent explanation of the shadow-banking system and how it creates “money” for the financial system.

Start here:

The other deleveraging: What economists need to know about the modern money creation process

In brief, banks create debt securities collateralized by other debt securities, which in turn are used to collateralize yet more debt securities. This creates an upside-down pyramid of debt securities, all balanced upon a very small amount of real collateral (ultimately, the real economy’s future ability to produce human-valuable surplus through real effort, skill, and knowledge, hence their future ability to pay off their loans plus interest to the financial system from that surplus).

Singh speaks in terms of the “velocity of collateral” when referring to the lengths of these collateral chains, and equates it to the “velocity of money” in the real economy. During the financial crisis these collateral chains shortened (and in individual cases evaporated), resulting in a huge decline in the financial system’s “money supply.”

Emphasis mine:

When market tensions rise – especially when the health of banks comes under a shadow – holders of pledged collateral may not want to onward pledge to other banks.

With fewer trusted counterparties in the market owing to elevated counterparty risk, this leads to stranded liquidity pools, incomplete markets, idle collateral and shorter collateral chains, missed trades and deleveraging.

 

In practical terms, the ratio of pledged-collateral (which is a measure of the credit thus created) to underlying assets falls as this onward pledging, or interconnectedness, of the banking system shrinks.

While acknowledging the excellence of Singh’s shadow-banking-mechanics explanation, I have to question his economic conclusions as embodied in the first bullet point, and the enthusiasm of the aforementioned monetary sages for those conclusions.

“Incomplete markets.” “Missed trades.” He’s claiming that shorter collateral chains result in inefficient allocation of financial capital.

I’ve got to ask (as Durden does, in a somewhat self-contradictory manner): Do those pyramids of collateralized debt securities actually result in more (and more sensible) lending to real-economy ventures? Absent such a massive pyramid, would real-economy borrowers be unable to get loans for promising projects? Is he suggesting that “savers’” money would never find its way to borrowers absent that labyrinthine pyramid?

Is Singh simply invoking the tired old money-multiplier/loanable-funds/savers-fund-borrowers silliness (but here on steroids) that has been so resoundingly discredited by so many over so many decades?

Yes:

Plainly this re-use of pledged collateral creates credit in a way that is analogous to the traditional money-creation process, i.e. the lending-deposit-relending process based on central bank reserves. Specifically in this analogy, the Indonesian bonds are like high-powered money, the haircut is like the reserve ratio, and the number of re-pledgings (the ‘length’ of the collateral chain) is like the money multiplier.

Given the appropriate disdain that Kaminska, Garcia, et. al. have for that incoherent model, I have to wonder why they give so much credence to identical economic conclusions — even if they are attached to an admirable understanding of the system mechanics.

In particular, I have to wonder why Garcia lavishes such gushing praise on a Credit Suisse paper whose lead-off bullet points begin with this a priori assertion:

• Liquid collateral is the lifeblood of the modern economy

And end with this:

• Don’t throw the baby, a highly evolved financial system, out with the bath water, a credit bubble and recession.

“Lifeblood”? Even if that were apt, you don’t make a body healthier by simply pumping more blood into it. To repeat my own analogy, finance is better understood as lubrication. You’ve gotta have enough, but if there’s too much, the shop-room floor gets very, very slippery. Ditto: bubbly bathwater.

Cue:

Adair Turner, Andrew Haldane, et. al. (2010):

There is no clear evidence that the growth in the scale and complexity of the financial system in the rich developed world over the last 20 to 30 years has driven increased growth or stability, and it is possible for financial activity to extract rents from the real economy rather than to deliver economy value.

And Paul Volcker (2009):

“I wish someone would give me one shred of neutral evidence that financial innovation has led to economic growth — one shred of evidence,” said Mr Volcker, who ran the Fed from 1979 to 1987 and is now chairman of President Obama’s Economic Recovery Advisory Board.

Mr Volcker said that the biggest innovation in the industry over the past 20 years had been the cash machine. He went on to attack the rise of complex products such as credit default swaps (CDS).

Cross-posted at Angry Bear.