(Originally published here.)
One of the most basic functions of a financial system is that it allows people to smooth their consumption spending over time. The oldest example of this is probably when Josephadvised the Pharaoh to store the surplus from Egypt’s bumper crops in the expectation of future famine. Since then, private firms have developed a range of products to help households and businesses weather the vicissitudes of life. Unfortunately, some of these products don’t perform as advertised, which can cause extreme hardship and amplify economic cycles.
Fortunately, governments with their own currencies can offer many useful financial products at lower costs than traditional banks, insurers and asset managers. This is because, unlike other borrowers, governments never have to worry about running out of money. For better and for worse, they can always print what they need. While we already take advantage of this to some extent, we could do it even more.
Take money. The overwhelming majority of what we call “money” is really short-term debt produced by private firms. The value of this money is inherently unstable without government guarantees like deposit insurance and access to the lender of last resort. Unfortunately, as I’ve previously argued, these guarantees subsidize excessive risk-taking at taxpayer expense. One straightforward reform, which has been advocated by luminaries including Irving Fisher, Milton Friedman and James Tobin, would replace this quasi-private money with money created directly by the government.
Governments with their own currencies also have an edge over private firms when it comes to selling certain types of insurance (unemployment benefits), long-term savings vehicles (Treasury bonds), and annuities (Social Security). The reason is that the government’s borrowing costs generally fall relative to those of private firms when the economy contracts. Sovereigns therefore have an easier time meeting their obligations precisely when funds are needed most, unlike, say, American International Group Inc.
This also means that the value of long-term Treasuries (and Gilts, Japanese Government Bonds, etc.) generally rises when other investments, including stocks, commodities and real estate, are losing money. The private sector does sell financial assets and derivatives that do well when equities and commodities do badly. These instruments, however, generally offer a less attractive risk-return tradeoff than long-duration government bonds. Moreover, you can’t guarantee that the firm selling the insurance will be good for the money when you need it. This is why the Bank for International Settlements says that governments with their own currencies are the only entities capable of producing genuinely safe assets.
There are strong arguments that governments with their own currencies are currently failing to produce enough of these financial products to meet the demand, creating what many people call a “safe asset shortage.” At the same time, we also have a problem with too much private indebtedness, both in the financial and nonfinancial sectors of the economy. One neat solution would be a swap where the government issues new safe assets as the private sector reduces its leverage. (Another option, discussed last week, would be for the government to increase the size of its pension promises.)
Incidentally, the possibility of these debt exchanges suggests that the debate about the optimal ratio of public debt to national income needs to be thought of in a different perspective. For example, banks fund themselves in part by selling hundreds of billions of dollars of commercial paper to money-market mutual funds. These debts are implicitly guaranteed by the government. That makes them government liabilities even though they don’t appear in the usual debt-to-GDP ratio beloved by scaremongers.
Suppose the banks reduced their borrowing and relied more on equity to finance their lending. That would be desirable from the perspective of systemic risk. Yet it would also lead to a contraction in the supply of money because those short-term bank debts are treated as equivalent to cash. The government could easily offset this decline and prevent the money supply from shrinking by issuing more debt, just as it did during the worst of the crisis. That would cause the observed ratio of public debt to GDP to rise despite the fact that the real burden on taxpayers wouldn’t have changed. If anything, the reduced likelihood of a financial crisis would increase individuals’ net wealth.
Of course, there are plenty of things that the private financial system does better than the government. Some might be tempted to have the state decide which industries deserve investment and which don’t. That would be a mistake. It’s true that the markets often do a poor job allocating capital — just think of all the waste caused by the tech bubble and the housing bubble. Despite those orgies of excess, governments can almost always be relied on to do an even worse job. That’s why we’ve advocated for reforms that would help get the government out of the residential mortgage market, for example. The private sector is also more likely to make useful innovations. Would the government have created ATMs or mobile payments systems?
The private and public financial systems are useful complements to each other. Both perform necessary and useful functions. The private financial system expanded tremendously over the past three decades, probably more than was appropriate. Now that it’s contracting, it’s time for the government to step in and pick up the slack.
(Matthew C. Klein is a contributor to the Ticker. Follow him on Twitter.)