The Coming Crisis: systemic stabilization and the investment state

18 May 2016

Andrew Baker - Honorary Research Fellow, SPERI, & Reader in Political Economy at Queen’s University of Belfast

Richard Murphy - Professor of Practice in International Political Economy, City University

A new ‘investment state’ is needed to provide stability in the new uncertain political economy of shadow money, financial instability and demand deficiency

We live in an era characterised by a confusing evolutionary dynamic relationship between financial innovation, the state and patterns of investment that we barely understand. At the core of this conundrum is the little understood issue of shadow money. Shadow money is a promise to pay backed by high grade collateral, usually government bonds, which means that government debt now plays a key role in the stabilisation of the financial system. We argue that this complex dynamic requires a new political bargain. We call this bargain the investment state, – a compact between the state and financial markets and between the stabilisation and investments arms of the state.

Understanding and anticipating the dynamics of any ‘coming crisis,’ must begin with an appreciation that we never really left the previous one behind. The collapse in asset values and dramatic evaporation of wealth of 2008 resulted in what, the Bank for International Settlements (BIS) call, a balance sheet recession. These are notoriously protracted affairs

Evidence of this can be found in the publicly-expressed worries of a diverse range of economists. The BIS worries about the paralysis of monetary policy caused by debt overhang and over indebted agents. Adair Turner, the UK’s former chair of the Financial Services Authority, has warned of the continuing problems of global deflation and disinflation, calling on authorities to start exploring overt monetary financing. Andy Haldane, the Bank of England’s chief economist has alluded to negative rates and the effective abolition of cash payments. Simon Wren-Lewis has made the case for a form of helicopter money. Lawrence Summers references secular stagnation and the need for greater combined monetary and fiscal stimulus. All are extraordinary suggestions for extraordinary times. Economic, policy and intellectual elites of a variety of stripes are deeply concerned and troubled.

The common thread is demand deficiency. As Yanis Varoufakis has noted there is a shortfall in investment, particularly in the things we need most such as environmentally friendly sustainable new technologies, infrastructure projects and research and development, all of which suffer from progressively shortening financial time horizons. The consequence is that investment in the very things that do most to generate productivity, growth and meaningful long term work, are at risk in an age of asset management.

Central to the conundrum we face, (although not obviously so) is the issue of shadow money. Daniela Gabor and Jakob Vestergaard, consider shadow money to be repurchase agreements issued by financial firms to fund capital market activities. Central banks create the money that banks use, while private banks create money for firms and households, but shadow money is created through repurchase agreements (repos), or promises to pay, between financial institutions backed by tradeable collateral (usually government bonds).

The shadow money system is complex, but its primary relevance for the theme of a coming crisis, is its pronounced ‘procyclicality’ and inherent fragility. The liquidity of financial institutions’ funding depends on their ability to settle obligations with immediacy – their ability to convert promises into sovereign state money on demand. If financial assets in their portfolio start to fall, institutions with repo liabilities, need to sell assets to raise cash. This can lead to fire sales of assets, but also downward liquidity spirals. The conversion of repo liabilities by their holders inadvertently exerts a downward pressure on their collateral valuation. Gabor and Vestergaard compare the conversion of repo claims to climbing a ladder that is sinking – the faster you climb, the faster it sinks.

Consequently, market liquidity has become the pivotal social institution in market based finance, but as Keynes noted the ‘illusion of liquidity’ means it is notoriously fickle and prone to sudden evaporations. Lehman Brothers and Bear Stearns experienced these processes when they lost access to repo funding in 2008, making it impossible to meet repayment demands on funding agreements.

Government bonds are the most favoured form of shadow money collateral because they are on the whole liquid and low risk. Government debt accordingly plays a crucial role in balance sheet expansion. Consequently, the expansion of market based financial systems actually places new demands on the state to issue debt, because financial institutions need that base asset to support credit expansion. However, in Europe shadow money vulnerabilities and liquidity problems spread to government bond markets. Ultimately, the European Central Bank had to stabilise shadow money collateral in Europe by intervening through quantitative easing (QE) and bond buying that put a floor under sovereign bond prices, also saving shadow euro money in the process.

One of the realities of the new financial world is that a system of credit claims built on base assets issued by the state, blurs the distinction between monetary and fiscal policy. It is increasingly difficult for policy makers to maintain the fiction that they can be institutionally separated. Central banks now face a tricky balancing act between stabilising the system of shadow money and maintaining base asset scarcity, or avoiding excessive government bond purchases.

Post-crash political economy is in a new age of uncertainty and instability. At the core of this instability and uncertainty is the system of shadow money. The state’s role in this system is already being forced to evolve by market dynamics. Economics is beginning to catch up. Party politics lags further behind.

The processes outlined here create an imperative for a new conception of the state. We think it is time to start thinking in terms of a new ‘investment state’ in which treasuries and central banks co-ordinate government bond issuance and debt management in the context of systemic instability and demand deficiency. This requires a new social contract, or political bargain between the state and financial market actors, in which financial markets are obliged to fund public investment projects in return for public backstopping of shadow monies. The investment state will need to perform this stabilization function, through the purchase of government bonds as base asset. In return market actors who benefit should have to buy the bonds of new public investment banks, sharing these purchases with the central bank, so the investment state can catalyse and crowd-in private investment to the technologies of the future.

The precise nature and terms of this new social contract, and how it should inform institutional design is central to the political economy of this new era of great uncertainty. Any coming crisis will spotlight the urgency of building a workable politics for the investment state and the new social bargains that will be needed to tie a variety of stake holders into its operation.

The Coming Crisis SPERI blog series: In next week’s blog – published on May 25th – Helen Thompson will consider the ‘surreal world’ of post-2008 financial markets.

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