Saturday, 2 October 2021

Economists overlook the obvious flaw in maturity transformation.


Short abstract.    Maturity transformation has the alleged advantage that it enables money / liquidity creation by private banks. It also has a big drawback, namely that's it leads to bank fragility, and hence to bank failures and disasters like the 2008 bank crisis. But central banks and governments can create any amount of money anytime. So why court disasters like the 2008 bank crisis. i.e. why not ban maturity transformation and just have central banks and governments do the money creation?

Longer abstract.   The “borrow short and lend long” practice that banks engage in (aka maturity transformation (MT)) has an alleged advantage namely that it enables money / liquidity creation by private banks (thus it's the basis of fractional reserve banking). The big DISADVANTAGE is that it renders banks vulnerable: it largely explains bank failures and was a big contributor to the 2008 bank crisis, which cost about thirty million people their jobs worldwide. So economists, regulators and politicians devote tens of thousands of hours and millions of dollars trying to work out the best compromise between the latter advantage and disadvantage.

Now the obvious point they overlook here is that governments and CENTRAL BANKS can very easily create and spend into the economy whatever amount of money is needed to bring about full employment, and all WITHOUT the latter risk! Indeed, governments and central banks have been doing just that on an unprecedented scale since the latter crisis. So why do we expose ourselves to the latter risk? There's no point. At least I've read more about banks, MT etc than 99.99% of the population, and don't remember seeing the latter obvious point being made.

Of course the above arguments against MT is not a comprehensive argument against MT. The purpose of this article was just to point out an example of failure to see the obvious.


Overlooking the obvious is a well-known human failing, but it’s worse with economists because they spend a fair amount of time trying to impress everyone with their amazingly sophisticated and complicated solutions to sundry problems – which almost ipso facto means overlooking the obvious.

Second, when anyone produces a simple solution to an economics problem, that tends to get rejected because it’s embarrassing to have to admit that the profession overlooked a simple solution for an extended period.

Anyway, moving on to maturity transformation (MT), MT is a phrase often used to describe what banks do, namely “borrow short and lend long”. While an alleged merit of MT is that it creates money/liquidity, a claim made here for example. In contrast, the big problem with MT is that it renders banks vulnerable. (as pointed out by Messers Diamond and Rajan in the abstract of their NBER working paper 7430.

To illustrate MT, the typical retail bank accepts deposits which are essentially short term loans to a bank, and lends to mortgagors and others.

The former loans / deposits are short term because the loan can be withdrawn by the lender / depositor instantaneously (or after two or three months in the case of a term account) . In contrast, mortgages typically last several years. And that makes banks vulnerable: if depositors withdraw their depositors faster than the bank can turn its loans and investments into cash, the bank is bust.

But there's a blindingly obvious way to create liquidity / money WITHOUT the above risk of bank failures and recessions which result in 30 million losing their jobs: have the government and central bank (“the state”) create money and spend it into the economy! Economists apparently haven't noticed that very obvious point.

Incidentally, some readers may be wondering whether the above conflation of “money” and “liquidity” is justified.

Well the third edition of the Oxford Dictionary of Economics starts its definition of liquidity thus.

“The property of assets of being easily turned into money rapidly and at a fairly predictable price....short dated securities such as Treasury bills are the main asset of this form.”

Indeed Treasury bills and government debt generally are actually used as money in the World's financial centres! Thus whether a very liquid asset is officially classified as money is near irrelevant: the reality is that it is actually likely to be used as money.

Of course the initial recipents of the new money under a “have the state” do the money creation would be a bit different to where private banks do the job. But the differences are less than might seem: where the state does the job, those who receive the money are free to lend it out, or use the extra money to pay interest on additional loans. So lending and borrowing, via banks and in other ways, do in fact rise where the state creates extra money.

Second, to the extent that “the state” system puts more money into the hands of a wide cross section of the population, its hard to see what's wrong with that.

Third, any democratically elected government has the right to concentrate a particular bout of stimulus on SPECIFIC items, say health and education. But what of it? Does any great harm come from that?

In that barring or curtailing the amount of money creation done by private banks DOES cut the amount of money creation by private banks, less private bank related activity there means less debt. In view of the moaning and groaning we get from the great and good about the allegedly excessive amount of debt, no great harm is done there either!

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