The aim of this conceptualization article is to formulate propositions about: (1) systemic faults in established money and financial systems, in particular the mechanisms that make for boom-and-bust cycles; and (2) the cognitive and action factors which limit the central banks capabilities to consistently and effectively to regulate or to limit these cycles. Drawing on earlier research (our own as well as that of others), this conceptualization is presented in Section 1. Section 2 identifies a new design and institutional arrangement, which would minimize the boom-and-bust predispositions in money and financial systems. This work builds on earlier research invested in “ the Chicago Plan ” (from the 1930s) in addition to our own research. Section 3 considers the expected political and ideological constraints on reforming financial systems. Previously operating constraints—including Neo-liberal erosion of New Deal banking arguments and reforms—make for formidable barriers. The paper concludes that reform is necessary—if boom-and-bust cycles on the scale of those since 1929 are to be effectively regulated; but it is suggested that such reform is politically and ideologically difficult if not impossible in the short-run.
This paper draws on earlier research (our own as well as that of others) on boom and bust cycles in financial markets. Section 1 identifies a few causes of such cycles and explains the limitations of central banks in consistently and effectively dealing with such cycles. Explanation is traced to the contradictory functions of money and the collective action problems of decentralized markets. Section 2, drawing on earlier work including that of “The Chicago Plan”, identifies a new system design and institutional arrangement which would minimize boom-and- bust predispositions in money and financial systems. Section 3 focuses on the political and ideological constraints on accomplishing such reform. In the conclusion, we stress the necessity of a new design (either the one sketched here or others), at the same time that any major reform will face substantial ideological institutions and political obstacles. In the meantime, it is argued, one should investigate and analyze new alternative system designs which would overcome the limitations of the established design.
In earlier work we argued that contemporary money and financial systems are systemically flawed―even with some of the reforms since 2007 such as the Dodd-Frank Act (2010); they are potentially highly unstable, prone, in particular, to repeated occurrences of boom-and-bust cycles [
As we have shown in a socio-economic systems model [
After a contraction phase of greater or lesser duration, market and/or government actors eventually may redefine the situation and initiate a process of expansion, which sooner or later leads to another (excessive) expansion or boom, etc.
Our socio-economic systems research implied the following:
Principle I: Contemporary money and financial systems are systemically unstable as a result of the lack of coordination―in this case, of the private decentralized money creation and money destruction mechanisms through credit decision-making. Each banking agent decides on the basis of its immediate demand and level of risk-readiness, indications of anticipated asset value increases, and the expectation that credit created will be repaid according to contractual agreements.
The systemic problem is that private, decentralized banks are enabled to create and destroy money―through making loans, on the one hand, and through retracting or reducing loans, on the other hand―without effective coordination of the aggregate macroeconomic and financial consequences for the entire socio-economic system resulting from the decentralized creation and destruction of money.1 The process tends to be self-amplifying in that the creation and allocation of money/credit to a sectoral development (housing, or technology development) can result in greater asset values, often reinforcing the mobilization of further credit and other financial resources. The self-amplifica- tion process is fed by credit demand of debtors or potential debtors and bank credit supply made available during the boom phase. In a word, there is a lack of market coordination in the money creation process.
The self-amplifying process continues until there are indications of potential problems, excessive risks, related discourses, judgments and prognoses of an increasing number of experts (serving in part as a self-fulfilling prophesy [
The lack of coordinated money creation and money destruction in the expansion/contraction cycle results in self-amplifying processes (vicious circles of positive feedback): in the expansive phase, a vicious circle of excessive money creation and value growth; and in the contraction phase, a vicious circle of excessive money contraction and asset value destruction.
Principle II: Constraints on the Central Bank's Regulation. It cannot reliably and effectively regulate the credit/money creation process (in the expansion phase) and the credit/money destruction process (in the contraction phase), because it is not cognitively and behaviorally designed to deal with “collective action problems”. It may, of course, regulate the interest rate, but this may or may not be responded to appropriately by those debtors or potential debtors and/or by the banks themselves. It is a very indirect influence on market behavior; there is simply no direct control over these unstable socio-economic processes. And while the banks theoretically might self-regulate (as claimed by neo-liberal ideology), the population of banks lack a cognitive framework to determine the appropriate level of money for each agent to create3―nor do they have an adequate institutional framework (for instance, with legal powers) to coordinate their responses in the aggregate whatever their cognitive bases―indeed, such an arrangement would be illegal in the USA and the EU. Still, what happens systemically depends on the aggregate consequences of the actions of banks. Of course, the banks observe what one another are doing―and obtain some degree of certainty in an uncertain, disorderly world through such observation and through mimicking one another, which is part of the problem.
A third principle refers to the contradictory purposes/functions of money which are not sufficiently taken into account in regulatory cognitive models and institutionalized strategies of correction [
Principle III: Contradictory functions of money make it difficult for a central bank to regulate consistently and effectively, for instance to maintain stable monetary value and to stimulate or enable money creation. The bank tends to be ambivalent and inconsistent in its regulatory actions.
The multiple functions of money are referred to in economics textbooks when money is discussed. What is typically not discussed is that the functions or purposes of money are contradictory [
Monetary value stability may be achieved at the expense of investment and growth; or, investment and growth may be achieved at the expense of unstable money values such as inflation. Or, attempts to deal with the use of money for speculation may hamstring consideration of encouraging capital formation and deployment.
On the basis of our research and that of others, we concluded that there are at least two fundamental problems to solve in developing a new design and institutional arrangement:
(1) Solve the coordination problem by having centralized, legally enforced money creation (regulation of the credit creation of individual banks and the aggregate effects), thus eliminating uncoordinated money creation and contraction as occurs in the existing banking system.
(2) Differentiate and regulate the contradictory functions or purposes of money, for instance, money as a medium of exchange; money as a store of value; money as capital, an instrument of investment and economic development; money utilized for speculative purposes, among other “functions.”
The lack of coordination in credit/money creation and credit/money destruction is a type of collective action problem (CAP). The behavioral phenomenon is well-known in the social sciences (CAPs entail “collective responses to possibilities of bonanza”, on the one hand, and collective responses to “fire-in-the theatre”, on the other; CAPs share characteristics with n-person prisoners’ dilemma game [
More generally, we suggest that the deep explanation of banking and financial crises lies in the key freedoms and power processes to create credit (that is, a form of money creation) which together with innovation capabilities tends to result in over-expansion and the generation of high risk prone and vulnerable systems. The key mechanisms of over-expansive credit-creation (e.g., through diverse and innovative forms of leveraging) but also of protective contraction (e.g., de-leveraging typically entails crowd-type behavior―imitation and diffusion of self-fulfilling beliefs), generate uncoordinated and destabilizing market behavior.
Following the 1929 Crash, proposals for new institutional design(s) of money and banking emerged. Among these, the Chicago Plan (1935)―much discussed and debated at the time but with limited influence on the reforms of the 1930s [
In sum, under a Chicago or similar institutional design, the Central Bank creates and puts into circulation money in the money and financial system through subsidies, tax reductions, and government expenditures as well as government loans with interest to commercial banks. As Van Egmond and De Vries [
Benes and Kumhof [
(1) Much better control of a major source of business cycle fluctuations, sudden increases and contractions of bank credit and of the supply of bank-created money.
(2) Complete elimination of bank runs.
(3) Dramatic reduction of the (net) public debt.
(4) Dramatic reduction of private debt, as money creation no longer requires simultaneous debt creation. Furthermore, output gains were found to approach 10 percent, and steady state inflation could drop to zero without posing problems for the conduct of monetary policy.
Here we focus on the multiple contradictory functions or purposes of money and suggest possible institutional arrangements for differentially regulating money functions. For example, Money I as a Medium of exchange, Money II as a store of value, Money III for the purpose of capital formation and financing project initiatives and development, and Money IV for purposes of speculation, which should be banned or highly constrained.
The diverse functionalities of money should be distinguished cognitively/ca- tegorically as well as institutionally. This corresponds to what Viviana Zelizer refers to as “earmarking” on the family and organizational level [
There will need to be institutional arrangements to assure sufficient money in circulation. Certain “Banks” would maintain current accounts―for households, businesses, etc.―payments are drawn on accounts and payments are made into them. There would need to be some buffering mechanisms to deal with time and balance issues. Mechanisms for expanding currency in circulation and/or its velocity would be required. The purpose and regulatory framework for this type of money is kept distinct from money in savings or money-as-capital (as today in the distinction between current and savings accounts).
The purpose of Money II is savings: either to keep for future use and/or earn interest. Savings can be placed in special “banks”, an institutional arrangement where depositors receive interest for their deposits, a rate decided by the central bank. Through setting the interest rate, the Sovereign can encourage savings or dis-savings. But pure savings banks would not loan money. Of course, the central bank’s payment of interest would be based on its budget resources and/or money creation.
The stability of money value is important both for money as a medium of exchange and as a store of value. Money as a unit of accounting―conveys information through a system of prices. Money expressed in prices enables comparisons of commodities in a complex system.
This “money” would be mediated through banks obtaining money for this purpose―the money would come from individuals, households, companies, municipalities wishing to earn more than they can earn through “savings associations” (Money II); these actors and the banks would be risk-takers; these investments would be secured to varying degrees by private and/or public insurance schemes, or by some degree of Sovereign guarantees. It would make sense to have specialized investment banks as earlier (“home loan”, “agriculture,” “international trade,” “venture capital investors”, etc.), whose levels of risk would likely vary considerably.
Financial capital may be “invested” in economic activities to facilitate the expanded production of goods and services by oneself or by others to whom one loans capital. Investing money to gain more money, the value of the original (level of) money is significantly―exponentially―greater than the value of the money that is not (available) to be exchanged in this way. For instance, just used for the purchase of commodities.
Financial capital in a “genuine market” for investment (stocks, shares, bonds, projects, etc.) is, of course, a productive power or force for development. Those who “specialize” (focus) on the accumulation and investment of financial capital play a crucial role in fueling economic growth that is essential to creating wealth.
The “sovereign” could supplement the capital of Money III banks with money creation for risk purposes. They would be in a position to precisely steer these developments, for instance, by creating money for Money III banks operating in priority areas, such as renewable energy, sustainable technology developments, medical research and development, etc. The money III creation legitimized by the state could be either in the form of subsidies and/or loans.
Of course, the policies and rules concerning Money III creation as well as provision of loans would need to be spelled out; there would be a distinct rule regime regulating type III money formation and disposition. This would not be arbitrary money creation (a la Argentina). Moreover, the Sovereign would be in a position to regulate the degree of risk-taking (from 100% to 0%).
For instance, with respect to stocks, bonds, and money exchange markets themselves―should be banned, if possible, or at least heavily penalized and/or taxed. In a world of electronic banking, increased systematic and effective constraints on “casino economy” practices should be feasible.6
The very rich have monetary resources with which to play speculative games. Moreover, they are in a better position than most to obtain credit―for their speculations―which doubly takes resources away from other, more essential uses. Cutting back on resources used in speculation would free these resources for productive uses. To the extent that advanced economies already put excessive resources into financial (and all-too-often speculative) dealings, and these resources are needed for innovation and development of such areas as alternative energy and transportation development, health care, etc.
As suggested in the article, banning may not be feasible. But constraints can be imposed. This is the point of the “Tobin Tax” and its several variants such as the financial transaction tax or the securities transaction tax.
Besides taxation and penalties, certain sectors should be excluded; other constraints could be that no borrowed money would be allowed (easy enough in the Chicago Plan since the Central Bank may specify and provide new money for appropriate investment sectors); time constraints against short-term transactions―not only a tax or penalty but time rules. In general, an elaborate policy regime is needed to constrain, if not partially eliminate, speculation (and the access of speculators to money resources).
Keynes proposed in 1936 a transaction tax to be levied on dealings on Wall Street, where he argued that excessive speculation by uninformed financial traders increased volatility. For Keynes (he was himself a speculator) the key issue was the proportion of “speculators” in the market, and his concern that, if left unchecked, these types of players would become too dominant! This is, in part, a correct assessment, in part because of the rapid accumulation of wealth; in part because Wall Street becomes a hot spot attracting others interested in speculating with some resources at their disposal including bank loans.
The original Tobin tax proposal (early 1970s) was intended to put a penalty on short-term financial round-trip excursions into another currency. His intent was “to dissuade speculators”. By the late 1990s, however, the term Tobin tax was being incorrectly used to describe all forms of short term transaction taxation, whether across currencies or not. Tobin’s method of “throwing sand in the wheels” was to suggest a tax on all spot conversions of one currency into another, proportional to the size of the transaction. In the development of his idea, Tobin was influenced by the earlier work of Keynes of general financial transaction taxes. Keynes proposed in 1936 that a transaction tax should be levied on dealings on Wall Street, where he argued that excessive speculation by uninformed financial traders increased volatility. For Keynes (who was himself a speculator) the key issue was the proportion of “speculators” in the market, and his concern that, if left unchecked, these types of players would become too dominant.
Repeated attempts to constrain and regulate the uses and abuses of bank powers of credit creation and allocation have only succeeded partially, in spite of a long history of trying; there was partial success in the 1930s with the establishment of a complex of bank and financial regulatory arrangements [
Part of the problem is that banks are not only serving important societal functions, which policymakers and multiple stakeholders support, but that many of them are also economically and politically powerful with their own private interests and substantial capacities to influence and manipulate policies and the architecture of regulation [
Neo-liberalism―the godfather of the high risk banking and financial system that led up to the 2007 Crash―was no emergent (or “invisible hand”) phenome- non. There were powerful, purposive agents who initiated and established it. During the early period of the Cold War, a movement led by business interests and associated intellectuals worked to create a better climate for business and the wealthy in the USA (indeed, the “cold war” provided a context for stressing the importance of capitalism and the business community) [
Neoliberal ideologues attacked “excessive regulation,” claiming that it was blocking innovation and economic growth. Many of the problems in the 1970s, for example, the phenomenon of stagflation, were blamed on government regulation and excessive government intervention. (All of this were taking place in the context of 1968, the Vietnam War, massive global demonstrations, and open radical movements in many countries.) This set the stage for the construction of new financial and regulatory conditions, the so-called New Financial Arrangements (NFA).9
In the period from the 1970s to the 2000s, the restructuring and transformation of the banking and financial system entailed, among other things, the removal or rewriting of the 1930 laws and policies and the introduction of new ones.
The growing ideology of neoliberalism, the range of technological innovations―some of them enabling avoidance of regulation―and, in general, the overall powers of the financial industry resulted in conditions where regulatory arrangements were increasingly inadequate to deal with the risky financial systems which emerged in the 1970s and afterwards. The neoliberal framework and its principles convinced regulators that agents in the financial markets were much more competent than themselves and were fully capable of dealing with any major risks and market instabilities. Regulators admired and trusted the industry’s technical skills displayed in quantitative risk models of financial agents and the industry, which enabled them to price and manage risk better than earlier and better than the regulators could ever manage [
… innovations … had already undermined New Deal restraints while others were apparently pushed through by administration officials with strong ties to financial institutions that would benefit (from the changes, our addition). Whatever the case, these changes allowed for greater leverage ratios (in some cases reaching 20 to 30 times capital), riskier practices, greater opacity, less oversight and regulation, consolidation of power in “too big to fail” financial institutions that operates across the financial services spectrum (combining commercial bank, investment banking and insurance and greater risk … No one captured the reigning sentiment better (or played a bigger role in the deregulation movement) than Chairman Greenspan: “Market participants usually have strong incentives to monitor and control the risks they assume in choosing to deal with particular counterparties … Private regulation generally is far better at constraining risk taking than is government regulation. In other words, the state would take a step back and let ‘free markets’ regulate themselves.” [
The overall deregulatory thrust launched during the 1970s and developing more or less “hegemonically” until 2007 facilitated, among other things, major increases in credit expansion and leverage extremes. Increased leverage, motivated by higher bank profits, significantly increased basic vulnerability to default at the same time. The very substantial profits were not used to reinforce banks’ capital base and solidity in a context of increasing stakes. The FRB under Greenspan operated more or less unconcerned with asset “price inflation” and focused instead on domestic US consumer price inflation which remained low largely due to cheap Chinese imports [
In general, during this period the normative climate was lax: macro-, meso-, and micro norms of prudence, and risk adversity were weakened or ignored. The general atmosphere became permissive and risk insensitive, embodoed in the attitude and policies of Alan Greenspan as Chairman of the US Federal Reserve Board, his statements and policies reinforcing the “lax climate”. For long periods, FRB policy was to maintain very low interest rates, basically interest-free loans if one corrected for inflation, and at the same time to step in to rescue those suffering major failures during the 1980 and 90s (in the period from 1986 to 1995 more than 1000 (of 3200+) savings and loans banks failed) and early the late 1990 and early 2000s (when the doc.com or tech bubble burst, the NASDAQ fell as much as 78%).10
In sum, interest-based power relations, hegemonic cognitive framework of neo-liberalism (along with substantial theoretical and practical expertise),11 pressure-group politics (with lobbyists, associations, think-tank pundits), and the systemic functional power of financial systems and agents; control over a strategic/key area in the contemporary world such as banking and finance makes for a high capacity to influence strategic decisions and policies as well as institutional designs (there is very limited countervailing power and expertise from the state as well as civil society and NGOs―under the influence of hegemonic neo- liberalism). Global finance had become the key actor and the prosperity itself of the 1990s for developd countries derived to a great extent from a global growth of public and private finance and credit, facilitated by substantial deregulation and justified by neo-liberal economic doctrine.
Given the continued powerful counterforces and constraints on redesigning and establishing new systems of money and finance―limited success in the 1930s and little success in the aftermath of the 2007 crisis at the same time the potentially highly unstable system continues to operate―it would be useful to discuss “what next”, “what is possible”? We see an immediate challenge, a need to systematically―with theoretical, empirical, and policy research―counter the ideology that markets are basically self-regulating and equilibrating. It is widely recognized that most markets of any complexity and/or with complex products are highly regulated: legal arrangements, effective judiciary processes, safety-of- product regulations, occupational safety and labor force regulations, capital markets and banking regulation, regulation against deception and fraud, etc. Capitalist markets need state regulation?in order to minimize market failures, market conflicts and movements disrupting markets and the economy as a whole [
In light of these considerations, a task force (or a network of taskforces) should consider some elaborated form of “embedded and regulated capitalism”, similar but not equal to the regime prevailing in post-Second World War decades, prior to many of the Neo-liberal reforms including the New Financial Arrangements (NFA). Moreover, such taskforce(s) should proactively prepare for the next serious crisis when reform packages, which has been thought out and formulated earlier can be introduced and discussed. The tasks force(s) would be encouraged to prepare a knowledge base and models, mobilizing expertise and publishing “plans” or reports―at this time there is already considerable knowledge production of alternatives such as the Chicago Plan. It is essential to involve not only multi-disciplinary researchers but policymakers and practitioners in these preparatory deliberations and analyses.12
The paper concludes that reform is necessary―if boom-and-bust cycles on the scale of those since 1929 are to be effectively regulated. One or more new alternative designs such as the Chicago Plan―or variants of it―should be developed into proposals for consideration whenever the opportunity for radical reform affords itself (for instance, a new crisis or the election of a reform government with a major mandate). However, in the short-run such reform is politically and ideologically difficult if not impossible. In the meantime, alternative system designs and institutional arrangements must be investigated and debated.
We are grateful to Helena Flam and Joc Pixley for their comments and suggestions on an earlier version of this article.
Burns, T.R. (2017) Boom and Bust Cycles in Financial Markets―Causes and Cures: Multiple Contradictory Functions of Money and Collective Action Problems. Theoretical Economics Letters, 7, 914-928. https://doi.org/10.4236/tel.2017.74062