Gorton's battle of light and dark money Money markets have a tendency to be misunderstood. As we've mentioned before, this is because most people believe them to represent a market for loanable funds, in which said funds are objectified and thus absolute. In reality, however, when you speak to central bankers, you realise they actually see money markets as more of an insurance market. You can read our explainer here. This is important because it impacts our understanding of liquidity shortages and surpluses. It's not so much a liquidity shortage as a shortage of private sector insurance that causes the problems. We bring this up because of a fascinating new paper about the development of opacity in US banking, by Gary Gorton, in which such misunderstandings are brought to light. Once you understand that money markets represent a private clearing system for bank-issued private money that runs parallel to state money, you understand why the banking sector depends on institutional opacity and the deliberate blurring of information. As we've noted before, a monetary system in which lots of different privately issued bank money is accepted indiscriminately by the public depends on the perception that the money-market clearing system works seamlessly to guarantee all claims, and that all claims are as good as another. The more the public becomes aware of banks" individual quirks and differences the less smoothly that system operates. In short, no actual "funds" are transferred from one bank to the other in the money markets. Rather, banks with surplus reserves of "state money" pledge that stock to deficit banks just in case those banks need to pay it out. Though by and large, they don't. All in all it's a bit like an honour system, in which members promise to be accountable for each other's behaviours and agree collectively that their issued units should trade at par with state money, because state-money reserves will always be offered up by someone in the network for the collective good of the system. Once we understand this, we begin to see the banking world quite differently. Most of all we realise that much of the money that circulates indiscriminately with state money in our system is just another form of bank liability (whether it's debt or equity). Gorton explains this very well: ...in this paper I look at U.S. financial history and show that the production of private money by banks optimally involves closing informative financial markets where bank liabilities (debt and equity) are traded. The efficient use of bank claims as money entails eliminating informative financial markets, so that banks are opaque and their monies consequently are accepted at par. The output of a bank is its debt which is used as money, whether demand deposits, private bank notes, sale and repurchase agreements, or other forms of short-term debt. For short-term bank debt to function efficiently as money it must trade at par, that is, it must be accepted at face value without any suspicion that it is worth less than its face value. And no information should become available to create suspicion. For this to be successful the banking system keeps secret the value of the backing for its debt. Banks, for example, lend predominantly to households and small businesses, entities for which there is little or no public information. Bank examiners check the banks" portfolios, but their assessments are also kept secret. Banks are inherently opaque institutions, which is why they are examined and regulated. Given the above, bank runs come about when undermining information leaks into the public domain. It is at these times that the fungibility of an entangled money system is compromised - usually by the behaviours of one or a few banks - and a third party, usually the government, becomes essential to fill the guarantee void. Gorton goes back to the US Civil War, however, to explain why it was not always so. Before the U.S. Civil War, the predominant form of bank liabilities used as money was private bank notes. The federal government did not issue paper currency at that time, but banks issued their own paper currencies. Bank notes traded at discounts from face value, revealing information about the issuing banks" backing assets. And, bank equity traded in information-revealing stock markets. Gradually, demand deposits (checking) grew significantly and after the Civil War the government imposed a tax on private bank notes, essentially forcing them out of existence. The transition from bank notes to demand deposits is instructive about the optimal form of banking and bank money. The transition involved closing informative bank note and stock markets in which bank liabilities traded, reducing the available information, so that demand deposits could more effectively function as money. The transition involved the creation of opaque banks. So what used to be a system that depended on open information and non-fungibility (different bank notes had different values, depending on bank equity valuation), turned into a clearing system which successfully harmonised the value of bank units, but came at the cost of transparency. That transformation quickly created the need for a clearer of last resort function: the central bank. As Gorton notes: During financial crises - bank runs - clearing houses assumed the role of a central bank. During a crisis, the clearing house managed the information environment, further suppressing information about member banks while at the same time producing information that it kept secret when the clearing house examined some banks during a crisis. The clearing house also issued new liabilities, which were the joint liabilities of the member banks. These two acts, suppressing bank- specific information and issuing joint liabilities, effectively joined the members into a single banking system. Rather than focusing on whether any specific bank was weak, the clearing house by these two acts, made the only relevant question one of whether the banking system was solvent. Gorton's conclusion is interesting in so much as he believes that today's attempts to bring transparency to the banking system in fact conflict with the fundamental nature of the modern banking system. For as long as we have a system of harmonised shared liabilities, we need the differences between individual issuers purposefully obscured. The only alternative is replacing them entirely with the liabilities of an institution which is inherently collective by nature - most notably the government. As he concludes: The same problems as in the 19th century have reemerged, and the Federal Reserve and the government have rediscovered the modern equivalents, overcoming stigma, introducing stress tests, and trying to suppress information-revealing markets. The financial crisis of 2007-2008 has led to widespread calls for "transparency." Some blame the crisis on a lack of transparency. But, banking is inherently opaque. Were it not opaque it could not be able to produce money. While Gorton doesn't say it directly, the implication is that the growth of the shadow banking sector as well as more government intervention is the system's reflexive response to the need for more obscurity. That is, we need more obscure forms of money so as to continue to blur the lines of shared liabilities successfully - at least if the current monetary set-up is to withstand. But Gorton also seems to be hinting somewhat strongly that if you don't like that, the only other alternative is a modern revival of the free banking system, in which the harmonised unit of account is given up entirely in favour of greater transparency. And there is, we'd say, some logic to this sort of thinking. It's easy to understand, for example, why during the 19th century, the harmonisation of the unit of account brought many benefits to trade and growth, since it made payment and settlement so much easier. In a manual world, a single unit of account cut down on paperwork, and more importantly helped to create a universal pricing framework, that was predictable and easy to understand. It was hugely beneficial for consumers, retailers and traders, as well as investors. However, in the modernised digital world, that sort of harmonisation is not necessarily needed anymore. Not only is the fixed-price regime becoming outdated as retailers turn increasingly to personalised and dynamic pricing systems, foreign exchange systems have grown sophisticated and liquid. So much so, in fact, that the idea of constant valuation and exchange for private monies at the touch of a button is not implausible. Sean Park of Anthemis, for example, has always predicted that the future will feature more currency issuers not less, foreseeing a world of millions of currencies in which values are continuously assessed with the help of a Star-Trek type "universal translator." Individuals may even become currency issuers in their own right. The upside of this sort of world would be the end of opacity, because inclusion would be dependent on the market's ability to assess all details related to one's solvency. The more open you are, the greater your purchasing power will be. Perhaps this is the reason why the value of personal data is growing in its own right? Perhaps personal data is becoming a competing unit of account? The downside, of course, is the privacy sacrifice that this would entail. We're talking, after all, about the need to throw open the books for constant market assessment. The details of individuals" private earnings capacity, debts, spending habits and more would need to be constantly available to all. It's clearly obvious that this level of transparency is not in the interests of everyone, since it makes everyone personally accountable for their own purchasing power. To date, many have been served far too well by the anonymous nature of the collective liability system of a universal money market, which has in a way been able to socialise away the information holes across member participants, or to society at large by means of government (largely to the benefit of those falling short or not playing by the rules). When you think of it that way, you realise that an anonymous money framework such as the dollar system by definition depends on a collective function that can continue to obscure and socialise liabilities in this way. A feature Bitcoin notably does not have. Which means we either continue to obscure and socialise financial information for the sake of retaining a truly fungible and anonymous bearer currency system - i.e. we allow the government to replace the private banking system's money creation function - or we opt for the sort of transparency and personal accountability that kills the anonymous function of cash entirely. It's hard to see a third way. (Though, we can't help but think that the latter system would not be as forgiving to human errors or mistakes and would perhaps unfairly punish those who had "financially sinned" unwittingly or accidentally early in their lives, and in so doing affected their credit rating for life. Consequently, to work, the system would need some form of embedded jubilee or rolling forgiveness system. The former dark system, on the other hand, would instead offer a form of perpetual salvation from "financial sin" by means of the redistributive socialist function of the government guarantee. It does indeed get very biblical.) Related links: Space opera, beyond finance edition - FT Alphaville Bitcoinmania - FT Alphaville The Development of Opacity in U.S. Banking - NBER