Younger and Menand Explain How We Got the Modern Banking System

That's right. Everyone got really into Finn Red. No. So this is basically a follow up from the episode we did with Josh Younger, one of our favorite guests, in which he was talking about the origins of the repo market, and we decided that we needed to talk more about it, and we wanted to bring in Josh's research partner, Love Men,

and yeah, that's right. And so we have this sort of sprawling financial system, you know there, as you mentioned, there's a repo, there's euro dollars, there's crypto stable coins, PayPal, Venmo, all of these things that have sort of like some banking like qualities but aren't really banks. And so the frame after that great episode with Josh I guess that was in October is basically like, how did we get here?

How did we get in this position where we have all these sort of various bank entities that aren't traditional banks that in somewhere or another, the FED is responsible for regulating or backstopping, right, And I think there's a lot about the financial system that we tend to take for granted. But there's a reason that all of these different things exist, for better or worse, and they do

come with, you know, advantages and drawbacks. So that's really the theme of this particular episode, talking about how we got here and why and what it means now. So please enjoy it. Thank you everyone for coming to a very special live recording of the All Thoughts podcast. I'm Tracy Alloway and I'm Joe Wasn't so I am very pleased to say that to day we have Josh Younger,

one of our favorite Odd Thoughts guests. We also have his research partner, Love Men and he is an associate professor of law at Columbia also the author of The FED Unbound. And one of the reasons we wanted to hold this live event is because we recorded an episode with Josh Younger earlier this month, I believe, where we talked about the origins of the shadow banking system, specifically

the repo market. And one of the themes that emerged from that discussion is that even if you think the shadow banking market has a lot of issues and problems today, the reason those issues and problems exist sort of stems from these decisions that were made many, many decades ago, conscious decisions by regulators, notably the FED, that combined to create the shadow banking market as we know it today. Right, even if you're not interested in shadow shadow banking market,

shadow banking market is interested in you basically. So yeah, I'm really excited about this. Um plenty to learn, plenty to sort of look through history to sort of understand where we are now, plenty of finnregg and financial stability issues always popping up. So let's go for it. It's a good time to talk about financial stability. Good time. Just one note before we begin, I think our producer already walked you through some of the housekeeping, but we

are taking questions from the audience. Please write them down on your index cards and they will be put into the magic box that we have on stage. Alright, So, without further ado up, Love, why don't we start with you? I mean, researching the evolution of modern banking. How did you get into that? And why? So it's really a

product in my biography in some sense. I graduated from college in the midst of the global financial crisis and the and it's aftermath, the Great Recession, and I, in a in a weird turn of events, got a job at the Federal Reserve Bank for New York. So I was I was thrown into an economy that was in turmoil, UH, financially induced turmoil. And so I was naturally very curious about that. And then suddenly I had a job that gave me an opportunity to UH to learn about that

problem and and to confront it UH directly. And so I got to work on the first ce CAR, the first stress test, and developed that. And I also got to UM. I was seconded to the Financial Stability over s ACOUNTIL. I got to work on UM preparing the first Financial Stability Report for the United States. UH. And then you know, once you find a problem that is interesting to you, you know, I guess my personality. I've

just continued sort of chewing at that ever since. UH and and and in part because I don't think that we've solved the solved the problems from two thousand and eight, and I think that the consequences of two thousand and eight are are extremely momentous across a number of dimensions of society, many problems that we're experiencing today, political, economic, social, Two thousand and eight was a was a major shift in how we address those problems. In nature of those

problems made a lot of them worse. And I think that monetary and financial stability, what we lost for that one moment is a key social good that we need to do a better job of preserving and protecting over time. So one of the do in um, Josh, you know, in terms of like, okay, we had you on recently, we talked about the nineteen fifties, What is it about

the history? Why is it important to take a historical lens to think about some of these problems and to think about, Okay, what does an optimal financial regulation system look like? Why is like the historical lens is sort of useful approach for that. Yeah. So I have, in many ways the opposite story to live. So I was trying as a physicist. I got my PhD two thousand nine, UM, and so when the financial crisis was raising, I had

no idea what was going on. I mean, I was entirely focused on I was using a telescope in Hawaii like a collecting other physicists or to blame for the financial crisis. So at least your blameless, right, I'm not

going to take a view on that. But um, so I think when you're a physicist, like you're turning to figure out what the rules are that the input um in a sense, and so they're taking you know, I just try to post to figure out how the world works, because it works a certain way and that's not up to me, but it's interesting to figure out what like what that is. Um. Financial markets are opposite of that, which is we get to set the rules to achieve

an outcome. And so you know, as I went into the industry and and uh sort of got deeper into the really fundamental questions of market structure. First you have to get your sea legs because I didn't know like what bond math was, for example, and then these things so you figure out like yields up, prices down. I got that right, um. But after you do that, you start to think about why the system operates the way

that it does. And and because it's a construct because it's a set of choices that we don't necessarily like all the aspects of where it ended up. Raises the question as to why we made those choices in the

first place. Is this just a function of markets, um, you know, having their own mind um and going their own way, or is this really a set of conscious decisions where maybe we don't love some aspects of the system, um, but it was set up to solve other problems, right, And so the history tells you that, it tells you

what the intent was, and that's important. One to just understand why things are the way they are because to a to a new observer, they seem a little odd sometimes, but but also to think about the limits of what you can do to fix it, because because the the entrenched interests that are created by that process are really important. So why don't we talk about one of the rule making episodes or one of the like conscious decisions that

was made that reverberates to today. And Josh, this is something we spoke about with you on the episode the nineteen fifties and one of the outcomes of that particular era was the repo market as we know it today. But love you have also talked about how the FED chair at the time, William Martin, made a big decision about breaking with traditional banking and shifting the system into something and part of that involved the role of primary dealers in the repo market. But talked to us about

that that break and why it matters today. William Martin is one of the most consequential twentieth century figures and played a huge role in creating the world as we know today. Things that we take for granted, like the repo market, the eurodollar market and their centrality and how our financial system works, how our economy works. These were projects of William Martin, and they were things that he tried to construct and bring about. UH. And he was

not painting on a blank canvas. UH. He was UM. He was actively trying to re engineer a system that had been set up in the wake of the Great Depression, the New Deal banking system UM. And that system was constructed around a separation between banking and other financial and commercial activity. And banking was a franchise business UH. And the point of the business was monetary to issue deposit it's deposits with the primary form of money still are

the primary form of money in the economy. When there's more deposits, you get inflationary pressures. When they're seward deposits, you get disinflationary pressures. This was the banking franchise banks. We're going to do this subject to a bunch of regulations. Other things we're gonna happen outside of banks. UM. William Martin in an effort to solve a series of problems, one of which you talked about with Josh previously, UH is keen to UH break down some of these borders.

So the birth of the repo market is a way to allow broker dealer firms who had been pushed out of the banking business to UH find a way to fund themselves like banks UM by copying the business model of banks. UH. And so they're legally barred by the New Deal banking laws from maintaining deposits because there's a provision in the Banking Act of three that says that

only a bank can take deposits. UH. So they create a structure that mimics UH deposit UH and Martin is instrumental in facilitating this, allowing this to happen, providing a

backstop for it. UM in the fifties. And this is really the birth moment of the shadow banking system, UH, the idea that we're not going to have a money supply that's entirely provided by either the government in the form of cash or the banking system in the form of deposits, where the deposits are the sort of the big the big event, and the cash is a small side. So there's actually room in this system for non bank money,

other forms of private money, UH, namely repo. And this starts UH in earnest in the fifties, and and everything else that sort of comes along, and I think we'll get to it. The eurodollar markets, UH, money market, mutual funds, commercial paper of very short duration UH. Stable coins are a sort of variation on this same theme. And all of these UM are more or less viable based on a sort of in more relationship that they can develop

with with the central bank. You know, if you have a central bank back stop, you can you can make a viable money alternative. If you don't have access to the central bank, you really you can't get very big. You can't you can't do that UM. And so Martin's key role was to UH was to re arctact the system and make it clear that the FED would provide backstops for various time types of non bank money UM too. In particular that become the dominant the repo market and

then the euroinour market. So use this word border, which I think is interesting, and you describe, okay, the expanding border. And there's all these sort of like non bank shadow bank type entities that issue deposit like instruments even if they're not technically bank deposits, uh nearly defined. What is accomplished by this? What is sort of for either of you? What is it? What do we get from having the benefits from having more of these entities that can issue

deposit like money. Isn't having this relationship with the Federal Reserve outside of like the sort of normal banking system. Well, so I'll let Josh sort of get into the details on on RIPO and the treasury markets in particular, but

just sort of at a high level. The banking system is heavily regulated under the New Deal banking law framework, and so there are lots of requirements on banks and UM there's an effort to direct the sorts of assets that banks invest in, so they are expanding the money supply.

Where is the privilege of that going Who gets access to that UM money issued based credit that monetary financing, And there's lots of rules the government has put in place on who who benefits, and there's lots of restrictions on the design of the banking system. So at this time we have something that looks a lot more like a unit banking system. It's very uh decentralized. There's thousands and thousands of banks UM. There's limits on how big banks can be. There's limits on how much banks can

pay their depositors. This is rg Q, which exists from the thirties until the early a these. And so the incentive to create non bank money is an incentive to have some UM to direct the benefits of monetary financing in some other way not subject to all of these constraints. Uh. And so there's just large rents or surplus to extract from being able to expand the money supply outside of

all these constraints. And so that's the impetus that everybody that's always leading people to try to create private forms of money is to do it without the without all the costs. And this is exactly what goes on with stable coins as well. So I think the treasure mark is a great example. So, like, what do we want

from the treasury market, Well, the investors want liquidity. Um. That means dealers that can expand and contract their balance sheets and take on a lot of leverage, because a low margin business means lots of liquid it means low transaction costs. But like you still have to pay the rent um and and so you need to take on

more leverage to make than a profitable business. And so that that doesn't work in a traditional banking framework, in part because it shouldn't work in a traditional banking favorite in certain ways, like banks are providing this incredibly central social service of making money, uh, and so like they're held to a higher standard in a sense, and so um, you know, dealers get access to money like financing, even if it's not strictly money in the classic sense, and

that gives the market liquidity depth and in particular low transaction costs. That's what we're really talking about, right, I don't want to pay a lot to trade by treasuries, and I want to do it in arbitrary size. Um, So for the treasury that beans lower yields liquidity premium. Right, liquidity premium means I'm going to pay more because this thing has liquidity value, and that's just a lower overall cost of debt service um. So all of these things

are are valuable. And then you rewrap all of that in the context of having a lot of elasticity, meaning if there's a shock like in for example, people need to monetize their treasures, if everyone needs to sell at the same time, there has to be new money to provide the proceeds of those sales um. Because those bonds are held outside of the banking system. When they come into the banking system, that gets turned into bank as

sets and that means they're funded with new money. And so then the holders of those bonds now hold money in the classic sense, and so that elasticity is not easy to provide um within the context of traditional banking. And so you know, the shadow banks in a sense like augment the money supply as needed under stress in a very desirable way. But it comes to costs and that that's that's the issue. It's it's a means to an end. It's not a generic good. Just to put

a finer point on what happened in the fifties. Uh, the Federal Reserve is providing the elasticity for the treasury market coming out of the forties. And so if there is the need for balancing capacity, if you want liquidity in the market, where's that Where's that elasticity coming to the Federal reserves balance sheet? Can the banking system take that roll over? Given the regulations in the banking system, the liquidity that the amount that of elasticity that they

can provide is going to be much less. What if we turn to broker dealers and provide them with a similar ability. Oh, they're not sust all of these restrictions on their bountary capacity. They're going to be able to mimic the elasticity at the Federal reserve balance sheet was able to provide um. But now we don't have the

Federal Reserve directly in the market anymore. And that's that's how this all gets going in the mid fifties, Josh, could you maybe talk a little bit about the birth of the euro dollar market, because this is also something that happens by deliberate policy choice. And I feel like nowadays a lot of people talk about the euro dollar market like it's some mysterious like shadow pot of synthetic dollar deposits just floating around. But why did it happen?

Why does it exist? There's kind of two euro dollar markets in the beginning. Um, there's the original euro dollar market, which is a communist creation. So uh in the in the late forties. Yet it wasn't expecting to hear that. Yeah, and so that one of the most important capital markets is a communist invention, which is in the late forties. People usually when they tell this history, they point to the Suis incident where the US froze Soviet assets and they said, oh, I don't want to take that risk

of the U s sezing my my assets. But actually goes back a lot further, even before the Korean War. Um, there's declassified CIA documents that track the flow of dollars from Soviet accunts in New York into Europe. Uh, and y Europe. It's because in Europe you could have the deposits denominating currencies other than the local currency. That wasn't true in the US. So you can get a dollar depositent Paris, get a dollar depositent Belgium, and so in the late forties, the CIA is reporting a list of

six or seven banks have taken communist dollars um. The problem with that is it's not scalable. But there's a lot of problems with that, But like they're it's not scalable in the sense that what are you gonna do with these dollar liabilities? You need assets to match the liabilities. And so they were used primarily for East West trade finance, so trade in dollars from from the Communist block to the West UM. For a lot of reasons, the Soviet Union didn't want a lot of that because they wanted

to be independent UM, and so they restricted it. And so like there was a very small market in the beginning. The key development is in ninety four when the UK liberalizes convertibility and I can exchange my sterling for dollars on shore among banks and specifically in the forward market.

And the key there is now I can hedge it, right, so now I can take a dollar deposit, I can hedge it back to sterling, put those sterling into the local market, and maybe there's an arbitrage and it turns out much like today, people didn't know how to price

effex forwards, and an arbitrage free framework. And so like the the the FX forward market of the of the mid fifties had a large cross currency basis, meaning it wasn't priced it precisely the interest rate differential, wasn't price perfectly fair to take free money borrowing dollars in your dollar market going to the f X forward market, swapped them for sterling on a forward basis and just buy local bills in the UK. And and so then the market starts to grow because now there's something I can

actually do. It's still narrow. There's a lot of like echoes of stable coins in this right, it's a specific application. We said stable coins three times, so I'm just gonna say, okay, it's like nineteen minutes in stable coins have mentioned three times. What are we talking so much about stable coin? And what is it specifically in the context here? You know, you're talking about, Okay, this whole like all these non deposit deposits that exist sort of an arbitrage purpose is capables,

Like how does stable coins fit into this? In your your dollars are a great example where you create a product for very narrow purpose. So initially it's like sanctions of Asian by communist block countries, and like, that's obviously not gonna grow. We try that. It's not a great business model again for a lot of reasons. So like

that stays relatively small UM. But but once you find a use case, in this case cross border interest rate arbitrage, which is still narrow but bigger, the market starts to grow and then and then you eventually get to the big, big event. Right, so after twenty years you get to something really massive, But over time that product starts as

a seed. In the case of stable coins, it's the lack of access to traditional banking among large cryptocurrency exchanges, and so stable coins are a way to transfer dollar equivalents into a new ecosystem. UM, you're you're a dollars were way to transfer or create dollars. In case UM, which you could say of algo stable coins as well, it's way to create new money UM in the new ecosystem that is native to the new ecosystem. In this

case it's European trade finance UM. And as global trade increases, and specifically intra European trade increases, there is demand for dollars is the currency of trade UM, and now you have a new market, and so that I think the interest here for stable coins is we're kind of at the beginning of that narrative that we're in where there's one bank taking major ear dollar deposits for the purposes

of cross border arbitrage. And the question is what's the next phase in that, and what are the what is required of the market and regulators to get to those next phases where there's real exponential growth, and will we do that and do we want so leve One of the things we've been discussing is how how the FED basically seded some money creation powers. And I feel like nowadays one of the criticisms that you hear about central banks.

And maybe this is because I spent too much time on Twitter, as we all do, but you know, there's a perception on Twitter that the FED controls everything, and you know, all markets are artificially manipulated by the central bank. And so I guess my question is does the FED control too little or too much or the wrong things? Like how would you view that? It's a it's a hard question to answer at the sort of level of abstraction. Um I would say that in some senses the FED

controls too little UM. The FED was designed two UM manage the money supply, the bank issued money supply. We have an outsourcing system. We don't have a money supply that's issue directly in bulk by the government. UM. But we have a central authority, the Federal Reserve, whose job it is to manage the size and composition of bank

balance sheets and the rate of expansion. And there's a specific mandate they want to UH ensure that that expansion continues sufficient with the economy operating at its full capacity over the long term, which is what Section two A is about. And the FED has a much harder time doing its job keeping the money supply expanding at a rate consistent with the economy's full capacity potential over the long term. UM. When a lot of the money UH

in the system, that's critical to the system's functioning. UM. If it disapplines, you get huge disinflationary deflationary pressures. Is exactly what happened in two thou and eight UM. If

that's being issued outside of the banking system. Because the FED has all these tools that allow it to monitor and adjust the size and position of bank balance sheets, and it has many fewer tools with respect to broker deal or balance sheets um and certainly with respect to the balance sheets of foreign financial institutions UM that are issuing lots of your dollars or stable coin issuers UH.

And so the more of the money supply that is outside of the mut of the fed's tools, the more it's going to be um uh over relying on tools like emergency lending, which it can then repurpose. And so there's a discount window that's built into the Federal Reserve Act for the banking system. That's one of the key tools that's built in so that they can manage the bank money supply. But then they create all these ad hoc facilities. They're basically air sets discount windows for all

the other shadow moneys that have come along. And you see them roll out those facilities, and you see them roll them out again because you need those discount windows. That's like, that's one of the only mechanisms we have now to ensure the monetary stability that the FED is there to do. Otherwise you fail on the section to it, you get monetary shrinkage, which is which causes recession and depression. So in that sense, the FED doesn't have nearly nearly

enough control. Um. But then in another sense, um, you know, it's too involved, because in order to make up for the lack of ex anti tools, it becomes ex post extremely involved in financial markets in ways that I think even FED policymakers are sometimes uncomfortable with. And so you have a much much larger balance sheet that's a product of of not being able to control the money supply

in in ordinary traditional ex anti ways. Uh that that Congress at least designed the institution to carry out its task, you know, and you you've written about this, but I wanna following up on this point. I mean one of the things that people is like, oh, the FED is there to fight inflation because politicians can't be trusted because if it weren't for the FED, they would just spend and maybe ramp up spending before every election, etcetera. So

we need this independent FED. And your argument is that just really not about that that actually like the deeper history of the FED. Your story is like, that's a myth, that that's why the FED exists more or less, Yes, I mean, the FED almost exists for the opposite reason. So we set up the privately owned, investor owned banking system we outsourced. We didn't do green backs. This is the this is the direct money issue. During the Civil War, we we moved away from green backs. We created the

National Banking System in eighteen sixty three. That was to prevent over issue by politicians UH. The idea that we just don't want to have the government issue and all of the money supply. We need to outsource that some of the money is going to have to be lent into circulation. We don't want the government to be doing that, lending itself having to evaluate credits. This could lead to

corruption and problems. So we set up the National Paining System, and then fifty years later we create the FED because what we discover is that the national banking system is prone to break downs under issue of money and it needs UH an institution to avoid those kedowns UH basically to avoid deflation, UH, to avoid contraction, and to ensure that the money supply UH grows over time consistent with

the ability of the economy to grow. And so the FED doesn't actually get its section to a UH mandate until nine seventy seven. It has a mandate under what's called the Employment Act of ninety six, which is to pursue maximum employment, maximum purchasing power. But that's that's a mandate that applies to the whole federal government. This is born of Kansian thinking. Uh, following the Second World War, it gets Section two A and I thine seventy seven.

And the concern of Congress when writing that is about high unemployment in the nineteen seventies. Uh, you know, you you would think that their concern was the high inflation rate, but they were concerned this is the highest unemployment since the nineteen thirties, and the FED was was not providing enough growth in the money supply. And uh, what's amazing is that it's just three three years after this that you get the vocal shock and changes our whole way

of thinking about what the FED is for. And then the vulgar FED success or perceived success and taming a decade of inflation that various politicians and government officials tried to address and we're understood to have failed. Leads to a whole reconceptualization of what the purpose of the FED is and what a central bank, what role central bankser performed in an economy. So, just on this note, like I realized we're kind of having an abstract conversation about

the purpose of the FED. But can you can you maybe draw a direct line between that conceptualization of what the FED should be doing or could be doing, to what happened in for instance, two thousand eight, Like, can you connect those two events? Yes, So two thousand and eight is the FED confronting it's need to perform its fundamental purpose, which is to prevent monetary contraction, the core or of its men, the whole reason it was created,

the reason it's for it's key modifications. Seven. It's all about do not allow for a monetary system breakdown to cause a terrible recession. That's the FEED is there to prevent that from happening. Uh. And they're now they're facing this monetary system breakdown and uh it's a product of this whole shadow banking system that they had been involved in developing over the years. It turns out to be unbelievably fragile, UM and need an enormous amount of central

bank support in ways that they had not anticipated. And uh, and ultimately they don't keep all the balls in the air. Um. The Lemon Brothers ball falls, and we have a whole conversation about UM you know, whether there were other ways to keep that ball in the air and what the right response to that was. But the reality is when you have shooge chunks of the money supply collapsing like that, you get a very acute recession. And that's exactly what

we have UM. And so the FED does a sort of you know, in the period maybe a B B plus job. I mean, I'm rucking sort of give it a great because it's sort of like, in some ways they failed completely and in other ways they succeeded. They avoided a much worse crisis. But the Great Recession is fundamentally the product of monetary system breakdown that was a complete own goal. From a social design perspective, we didn't need. It's like the electricity grid turning off for two months.

Imagine what would happen if the electricity grid is sort of shut down for six weeks UM you'd have a huge drop in gdp UH. And the monetary system is like the electricity grid for the financial system, and if you turn it off, you can have an activity just

sort of grinds to a halt. And and the Fed's job is to keep the lights on, and they didn't totally nail it, so, Josh, you know, with each of these crisis and the two big ones obviously that we've experienced recently two thousand and eight, and then all the activity, the flurry of activity and spring two thousand twenty when COVID hit, you know, obviously there's all these sort of de facto discount windows that open up for the non

banking sector. But then there's also like seems to be this legal fight that emerges in terms of like, well, what tools are really available under the law? Is there any real limit to what the FED can justify to itself? Like are there actually hard constraints on what the FED can do? Where is it always sure to either one of you? Or is it always the sort of like the only constraint is the creativity of the lawyers. This is an invitation to make fun of lawyers. I think, yeah, well,

that's fraught for many reasons. But I think the answer that question is the answer to any question related to the legal constraints on a public institution, which is that any public institution can quote unquote get away with whatever they can justify. The question is like, is there a long history of doing it? Um, that's not enough on its own, but like it helps, right, So the fen's

been doing repost since nineteen seventeen, that's a long time. Um. You know it's been doing f X operations since then, since the sixties. That's also a long time. And so, like, you know, the was like the open and notorious doctrine I guess you call it. Is it called the doctor and I'm not really sure. Basically, if you walk into somebody's house, set up shop and never leave and they never kick you out, of call anyone, it's your house. Um, And so you know someone who tried to do that, Yeah,

usually doesn't work. But for real property, that's like a real adverse possession, yes, which which shouldn't necessarily apply to like administrative practices, but like the principle of the thing sort of applies to some extent. I'm kind of avoiding your question in the sense that like the answer is yes and now, um. But but ultimately you have to be answerable to the public. And so you know, I think that's on Congress in a sense to say we don't like what you did, Um, you can't do it anymore.

I'm going to write that down. We're all going to vote on it and the President's going to sign it. Now it's a rule. UM and they've done that in the past. UM And and for example, in also nearly fifties, there's a voluntary credit restraint program in UH around the Korean War, and basically the Congress removed ability to do that and they brought it back later. But like there've been examples of powers being moved by Congressional action, and

that's ultimately to another in the remedy. Right, it's not that people sue the Fed, it's that Congress passes. Is also a great example Dive Frank Act Section thirteen three, which is one of the core authorities that the FED

leans on. In two thousand and eight, Congress makes significant modifications because it wasn't pleased with certain ways in which Congress use thirteen three in two thousands and its specifically Congress made thirteen three launch to support UM the rescue of bear Stearns and UH to a I G. And the modifications in say that thirteen three lending has to be through facilities with broad based eligibility UM, and the FED can't make loans to save a particular specific failing

financial company. And so just recently we had seen that mechanism at work, though, I would say in general, the government is full of administrative agencies that exercise delegated authority from Congress pursuantto enabling statutes, and the ordinary mechanism for checking that exercise of authority by those agencies is the

courts is the judicial process. So so so what the e PA decides to regulate air pollution, uh, they often get sued and then they have to go and explain why the statute authorizes them to regulate air pollution in that way. And then there's a bunch of judges who you know, are either convinced or not convinced, and they apply various doctrines and that process. The FED is subject to very little of that, for variety of reasons we can get into.

And so, unlike many agencies that were familiar with, the FED tends to be the final interpreter of its own enabling statute. UH. And so it's the FED General Council's Office that sort of decides what Section fourteen means because there's basically no cases where a judge has ever been involved, So we haven't developed a bunch of precedents, and it's uh not sort of come about that anybody has sued the FED for a variety of reasons, uh, and gotten

a judge involved in the issue. And that's why the sort of main players that are constraining what the FED can do are its own General Council's office and then Congress Um, which can intervene. It must be nice to be able to be the arbiter of your own your own powers. Um. I'm going to reluctantly fast forward to two and you know, we've been talking a lot about

this on the podcast. There's been a lot of air being taken out of the sort of most frothy parts of the market, and there's been a lot of talk about the FED raising rates until something breaks. But the standard opinion seems to be that the financial system is safer than it was in two thousand eight. You don't have the build up of leverage that you had back then. Is that right? I'd love to hear from both of you, like where are the pockets of vulnerabilities right now? And

should we be worried about financial stability? So the interesting answers there's some like idiosyncratic source of leverage that no one talks about. And I'm going to tell you right now and then we'll have the answer. But I'm not going to do that because I tried, Yeah, well I can't do that. I should say no, I'm not going to do that. But but I think an interesting case studies.

So I hated to rewind to that. But two eight is a credit crisis that is deflationaring in the sense that the money that was created to fund new loans is now not money good because the loans are bad. When the loans go bad, the money goes away, and you have deflation. Um in we have a big much bigger economics. Then we head into thousan Nate and by lots of measures. And yes it was short lived. Yes it was like quote unquote V shaped or whatever. Maybe it's sort of a check mark shape because we kept

going up. But like the that wasn't obvious at the time. Um, but we don't have a credit crisis, Like nobody's really worried about the underlying stability of the banking system in a meaningful way at any particular point in that. Now we do stress tests, we make sure we're but it's more about checking your answer than it is about coming up with a new one. And so like that's a success in that it's not a credit crisis, it's a

liquidity crisis. Central banks are designed to deal with liquidity crisis. So um, now you could ask the question, should there be that much liquidity in the market in general? That's ultimately the question of shadow banking, is there's more liquidity than necessarily is sustainable. And if the FEDS going to or central banks in general are going to backstop liquidity, like they should have some limit to what they're willing

to do. Um. If you think about the current environment, you know, just this the simple fact of rising rates doesn't seem with some idiots and credit cases left the side, like the global economy and for the US economy, um is problematic in much more boring ways. Meaning it used to be really cheap to our money, it's not so cheap anymore. And like that's not a financial system meltdown

kind of thing. Um Because now you know, that's a sanguine look and that's like classic like you know, final word on the like it's not going to go well, I make that prediction, but like the I think that the problem is different, and there's this tendency to say, you know, there's this stressor that's applying pressure to the system, and the system is vulnerable, and this crack is going to open, and it's all going to spread wide, and we're going to find out that what we didn't know

is the only thing that matters. And and I think we should open ourselves up with the possibility that this is kind of just a rate cycle, and that there's no obvious source of monetary and stability UM and that it's still gonna be painful at times because it's more expensive our money, but it's gonna be about that real economy stuff as opposed to like the mechanical or the plumbing or the financial your side of things, love did did Josh just jinx us into a major credit crisis?

I'm going to hazard the other position, the other side of this um UH. It's certainly the case that we've made a lot of improvements UH since two thousand and eight, but we still have a fundamentally unstable monetary financial system. It's just inherently fragile. The run risk is lurking constantly. And that's because repo market, the your dollar market, repo issuers and your dollar issuers are not in fact banks.

There is no deposit insurance, so you can have repo insurance, and so there's enormous incentives that are just always hanging over to run. You can think of a of a cash provider in a repo or a euro dollar depositor as picking up pennies. Um, they're getting paid more interest than if they're in a bank deposit, and then good times, great, pick up those pennies in front of the steam roller.

But then all that has to happen is a change in expectations about the future uh any concern and there's just an incentive for the cash providers and your dollar depositors to just go back to a regular bank deposit or t bill um, you know, to to get out. And so Ben Bernanke I think it was his famous comment about the subprime mortgage issue. He thought that that was contained. He was like, this is too small to

cause a crisis. But the lesson in some sense of two thousand and eight is that if you have an inherently fragile monetary system, it doesn't have to be huge losses. It just has to be sufficient uncertainty about the distribution of those losses to cause all of the shadow money

people to try to rush into the good money. And I would say that right now, where we're looking at is balance sheets of of shadow banks that are under pressure from a frustrate rises because they have a lot of dead instruments that become less valuable when interest rates

go up. And so the more pressure the assets side of financial institutions UH that are issuing money instruments, the more pressure that that is under, the higher the likelihood that there will be a moment where everybody looks down and says, wait a second, I don't know if this guy is UH is such a good bet anymore. Let me just move my money to JP Morgan Chase. And that's what happened in two thousand and eight some sense. Alright, we're forty minutes in and we'll get to audience questions

in a second. But there's one since I want to bring it up. You know, Tracy mentioned like, well, nothing is broken yet, but one thing has broken and it's the crypto market or there was a pretty big break there. But here's the thing. People hate bailouts. So thank god, nothing so far knock on wood with the FTX story has like caused any sort of financial institution to need to bail out what should be done so that never in my life do I have to hear about a

crypto company getting built out. What would you like to go first? Either one of you is how do we

avoid that risk forever? So the crypto ecosystem is I think eager for And if they're not eager for it, they should be uh some official sector recognition that will allow ordinary financial institutions to hold and trade and deal in cryptocurrencies, because right now what they have is a whole little world that just exists on the internet, is completely divorced from any economic activity in the real world.

It's like the apopiosis of finance. The purpose of finance is to help us allocate real resources in the real world, and here's crypto and they're doing it, except they're not allocating any resources in the real there's no there's no connect The only point of connection between the crypto world, the only significant point of connection with crypto world right now and real economy is stable coins, which is the bridge.

It's how you get in and out. And so the stable coin issues actually have real dollar assets, they're the only ones um. And so the way you avoid ever having a crypto bailout is you keep it that way, you don't have the actual economy ever become reliant or exposed to the value of these tokens, and you don't end up with massive stable coin issuers that you know are issuing stable coins that people use to buy real

goods and services. If the only use of a stable point is to buy a token with no value, then you know, it's just not it's not a real risk. But if people are using stable coins to buy actual stuff, then it becomes part of the money supply, And if all those stable coins disappear, you could get contractionary pressures that have to be counteracted by some official sector action and doesn't have necessarily be a bailout, but a bailout

is often the most efficient means. You know, UH, it would have been easier to have bailed out leaving brothers than to try to get the money supply expanding through other UH central bank actions. So I think it's um, Like, I completely agree with that. I mean, maybe I'm exposed to be supposed to Twitter flame by saying that, but like, I mean, I think the sorry you're not on Twitter, there's another Jeosh Younger on Twitter who's not him, not me, Um,

very very much, but there's probably more than one fairness. Um, but I think that the thing that money is supposed to do something for you, right, So that's kind of along the lines of less argument, which is like it has some real economy purpose and so like, ultimately bank deposits are good and good money in the sense that I can guess by goods and services, but there's an underlying transfer of federal reserve liabilities behind that, like banks

interact with them between each other in federal reserve money, and so and then and and that bank deposits value in the sense that I can go to the bank and get paper money and then in principle pay my taxes with it, right, because that's definitely use of government issue money. Is that, oh, the government a hundred dollars, I take my hundred dollars, I give it to the government. I don't go to jail. Much better outcome. And so like the question is in crypto, like where's that convertibility?

And so this is where the your dollar analogy comes up, which is like building up an infrastructure that guaranteed that convertibility in the way that let the market scale was a lot of work and took a long time, and it involved the direct involvement of the Federal Reserve at many steps and all the other central banks. And so you know, the crypto ecosystem is similarly offshore, involving many

different regulatory authorities. Um. And if I can't take my bitcoin, turn it into a tether, turned it into a dollar, turn it into a paper dollar, and give it to the treasury to pay my taxes, like, if that chain is not guaranteed, it's hard to see how it scales, um and so like to last point, you just don't do anything, and you're gonna end up not necessarily with crypto exchanges being like iron clad, because probably won't get that either. But it won't have like a real economy impact.

It won't be a major component of the monetary system. It won't be a major component of the financial systematic can be segmented off. You know, the the FTX stuff like is mostly about crypto um and there's real economy complications. But like you and there's really like bad outcomes for lots of people, and I don't want to diminish that at all, But like the banking system will survive, should we take some audience questions? So We have some really good ones. I have to say about half of them

are about crypto. But this is where we did them buy a card? Yeah, they are. They're good crypto questions. It's not like would you buy bitcoin? But but okay, when you hold the magic box, you're gonna get that to that one on on this convertibility point, um, here's

one question. So do you think that some of the shadow banking solutions or other types of solutions could reach the retail level through payment solution companies such as PayPal, so that, for instance, you could have repoat availability for your average person on the street. And this person didn't mention this, but I'll just tack this on central bank digital currencies. I mean, one of the use cases for those is this idea that people could potentially have access

to the FED directly in some way. You do have that right, that's a money market fund. So the money market fund gives you direct access. Fore, it gives you direct access to FEDS balanchie the reverse repot facilities and money market fund asset almost exclusively. And so like that functionality exists, and people are utilizing at the government money market fund complex, which is this like risk free component of money market funds, multi trillion dollar business, so so

it's happening. I think with central bank digital currencies, the question is what problem we're trying to solve. That's what everyone starts with when they talk about CBDCs. They say like, well, what are we trying to solve? And I think, like a center bank digital currency has two like unique aspects. One is it is a digital asset blockchain or not uh, and the other is it is not a bank, it's

the central bank. So if we want a central bank digital currency available to retail investors because wholesale has access to the central bank's balance sheet. Um, the questions, do retail investors have a have serious concerns about the stability of commercial banks that would warrant a different counterparty right there? Their counterparty is currently a commercial bank. They'd rather be

the central bank. And you only do that if you really don't think that commercial bank is gonna be good for the convertibility and everything about the way bank depositor price tells you people are perfectly comfortable with with the ability to the banking system to deliver on their promise of convertibility. So then it's a question of the settlement cycle and the payment system. And one of the things that I think is really interesting about the the discussion

of payments. Anyone who's like talk to me is probably brought up the statistic at some point. But the FED does a survey, They say, have you used a check hasher or another non bank financial media in the past year, so Casher's paid loans, all that kind of stuff, um, and people say yes or no. It's multively small fraction people, but it's it's non trivial. And then they say, do you have a bank account? And so of people who

use a check casher also have a bank account. So this is about the payment system for those folks, and that's why the financial inclusion bit of CBDC. I think the question is can the backing system solve that through a better payment system of faster settlement cycle. Is it really about access to central bank money or is it access to faster payments? And that's why segmenting the problem is useful because then you can look at the technology and say this piece is useful, this piece is not.

So the banking system has been telling us that they're going to solve the unbanked under banked problem since the nineteen eighties when Congress had a hearing and UH and the Fed actually said, don't worry, the bank banking system is going to address this. Will will will get that number of unbanked down to the level of other advanced economies, which, by the way, is plus other advanced economies are banked.

And we have actually made a lot of progress in the last ten years UM for reasons having to do with technology making it cheaper to offer bank accounts, but we still have around five of households unbanked, which is millions of people. And so I do think that's one reason why central bank money UH, public option for central bank money could be appealing. Obviously agree with Josh that there's not a safety stability deficiency for bank account money.

Of course, that's because the public stands behind that through deposit insurance and the discount window UH. And so the government has given a franchise for the banking system to create that safe money. And so fundamentally, the question should we have a CBDC is a question about do we want to re engineer or change that arrangement and change the nature of the banking franchise and and and and introduce a public option that competes with the banking franchise.

Do we think that will lead to a solution of the on bank problem that's more robust, uh, a solution to the payments problem. The banking industry has spent decades um not investing in fast payments because banks have an interest in the float and in having additional time to prevent fraud, which because of federal law, generally they have

to absorb those costs. And so whereas other advanced countries have had real time growth settlement, real time payments the retail level for decades, uh, here we are in two and it's it's patches here and there in the u S where you can move your money quickly. And this is part of the reason why you end up with the stable coins. In some sense, stable coin issues make this argument it's going to be more efficient transaction. So I think there's a question on those sort of bread

and butter dimensions. Would a public option for bank accoun out money improve the private options that exist? And then there's the larger question about the shadow bank money. What's a major reason why you have repo market, what's a major reason why you have money funds? Because ft I C insurance caps out at two fifty dollars, and there's actually a deficiency in the nature of the bank franchise. We don't actually have this level of safety that we

would want. And so there's large corporations that have very large balances. Maybe they want to have a five hundred million dollar cash balance, and there may be not so comfortable about having that all in one bank, and do we need to fix that? And maybe should Apple be able to just hold a billion dollar cash balance at the federals or that's nondefaultable. Why not make non defaultable money more widely available? And that's I think that's sort

of the the pro case. Or central bank digital currency, not necessarily like on the blockchain, uh, not token eye, central bank digital currency, but just what you know, fed accounts for all, which is something that I've been in favor up for many years now. So I don't know if you guys knew that that that I was for that. But by the way, future episode we should do one, just like why there's no instant payments in the US. I think that would do really well and just like

some of the yeah, that's a good future episode. Can you um you know you've written about like the sort of coevolution or the different evolution. So we talked about, Okay, the FED having to like come up with all these new mechanisms um to deal with the growth of deposit

like things outside of the banking system. Can you compare that, like, what does it look like for the other major central banks and their evolution E, C, B, B, O, J. Have they also roughly had to do the same thing, or is because there is not as similar like sort of as big offshore market for some of these other currencies,

has it not been pressing up an issue? So Josh might be deeper on this than I am, But generally the dollar based shadow banking system is vastly larger than for other currencies, and there's a variety of reasons for this.

One has to do with exactly what we were talking about, the stance of US policymakers, in particular Treasury Department and the Federal Reserve in the latter half of the twentie century to actually facilitate its growth um and to allow for the sort of impairment of the bank franchise, not just to allow to nurture it. Another has to do with the fact that in a lot of other countries, the currency that everybody wants to be in as dollars.

And so for US where we just we just use dollars here, but in a lot of other countries there are there is the presence of multiple currencies. The other currency is dollars and UH and so in European countries, the sort of shadow banking problem that they have is the creation of dollar deposits, which then they have to manage. As Josh pointed out, one way to have managed that is just to prohibit institutions in your country from issuing

deposits denominated in another currency. If you don't, if you allow it, you're gonna want to regulate it because if these liabilities build up, you the central bank um you know of Japan or UH in the UK, you can't create dollars. And so now you have a run in your economy amongst your institutions, and you call up the federal Reserve and ask for a swap line. You need to phone a friend or you're gonna lose your economy

and you can't carry out your mandate. And so I would say that's that's been the big shadow banking problem. And I do think that in a lot of these jurisdictions. The Euro dollars are are issued by banks, but they're often issued by other types of financial companies, which we would consider sort of traditional shadow banks for here, so UH, you know in Asia life insurance companies, they're of various

companies engaged in short term don a liability creation. And how did the Bank of Japan deal with that in when it when it ran it borrowed over three hundred billion dollars from the FED to online. I think that it's all part of the plan basically, which is that in the in the fifties and sixties, the goal was to cement and entrenched UH and grow the dollar system because it offered all of these benefits. This is exorbitant privilege. This is the idea that I borrowed my own currency.

There's also the currency of global trade, and so like the first generation of your dollars, this is a benefit to other countries as well, right, because there's the idea of a global currency. So of all trade happens in the same currency, I can finance it in that currency. I can deposit the proceeds of my trade in that currency, and now I'm sort of all in all in the family kind of thing. And so the first generation of your dollars is primarily deposits of central banks. So central

banks are the seed for the modern euro dollar market. Uh, they are the depositors. Um. So they're making a choice to park their funds added your dollar issue or and not in T bills or other sorts of dollar denominated assets. Is because they see value in that system for themselves. And and the FED goes one step further and says like you need to find a friend, call me right,

which is here's some swap lines. It's two start with Switzerland, move on to the b I S and the Bank of England, and and grow that that network which sort of connects all central banks into one globalized dollar system. So you can do open market operations in the your dollar market. Because ultimately the chain leads back to the issuer of dollars, which is which is the Federal Reserve.

I think you guys have paramariland on recently. I was going to say, we've come full circle to our previous limber. You know, has a book about Charlie Kinda Burger, uh, and the and the point that Charlie Kindle Burger makes uh and that Paramariland makes is that the huge network effects and money, and so it's much more efficient if we're all on the same sort of currency. And so the construction of the euro dollar market, which is apparently in stale market in a lot of ways UH is

also it's a more efficient market. And so for all of the other countries that have different currencies, if they can get dollar funding, it's going to be cheaper, it's gonna be better for their businesses. And so this system was built up over decades too because of its superiority

on certain efficiency dimensions. When pots Namors never really worked out was how to keep it stable in a business cycle downturn, and also various governance and distributional issues which are sort of shoved under the rug and are really significant in terms of who wins and who loses in terms of adopting what is a currency issued by the United States and what that means for businesses in the

United States UH and also businesses in other countries. UM, we are running out of time, so I'm gonna ask one more audience question, and I would encourage you all to to seek out Josh and Love after this because we will be having drinks um over there, but in the meantime, h This question is from Yakov, who is on Twitter at Yakov, and the question is what does pal fantasize about doing? What is poal fantasize about doing

if he wasn't constrained by the dual mandate. I'm going to rephrase this slightly and say, like, if the FED could start over today when it comes to designing the financial system, what do you think it would do differently? And since there's another question that's very similar to this, I'll just add what would you do different you know, it's like someone else basically like, well the one the

one changed you'd like to see. I'm not I actually don't have a can answer that question, in part because like, for all of its issues, like chatter, banking has yielded great benefits to the United States, and so like is it too much to pay the boatman? I'm not sure, um, But I think that the key is it takes a crisis to figure out how to fix it, and so like, in some sense, the hypothetical is if you knew all the things that could go wrong, would you just build

in systems that can handle it? Um. The other version of this is to say, Look, you know the money supply should be issued by banks and investments are for investors, and you know there should be some lubrication into the system. But the continuum of money is sort of too diffuse in a sense, like it's hard to see where one ends and the other begins, and and so you know, either drawing very clear lines, not necessarily at bank deposits, but like being very explicitly behind certain forms of and

not others in advance. UM. Again with some policy goal in mind. In this case, probably the global dollar system is worth preserving UM in lots of ways, and so that kind of force it would be useful. What would I do? UM? Maybe I should have pretended like I didn't remember that that part of the question. Um. You know that that the the old Lombard Street logic I think applies really strongly, which is a lend against good collateral at a penalty rate. UM. So liquidity should never

be the reason why the financial system goes down. UM. Now that means making sure you're comfortable with what people are doing the providers of that liquidity are doing with the proceeds of it. UM. So like data collection, transparency to regulators, not necessarily to the public, but certainly transparently to regulators and the public where it's useful and beneficial and in the public interest. I think that's all really important.

And part of the big problem with with markets structured with this continuum of money is transparency is very hard to achieve um and so policymakers don't really know what they're looking at. They don't have all the information. And we tend to sort of put together a data collection

program that solves the last crisis. So we're getting really good at the treasury market now, and I'm not convinced that's going to be the next big thing that breaks, you know, And we have to avoid this tendency to kind of like investigate the thing after it goes wrong and then have all the information about it. But the next thing is not is not on a rator. So I mean, I'm gonna take a stronger position against the

shadow banking system. I would say that the the benefits tend to be very overstated and to often be articulated and stated by members of the financial sector who tend

to reap a lot of those benefits. And on the other side of the ledger, I think the costs tend to be under a appreciated the full range of costs of the shadow banking system, and so you know, there's one way of thinking about the euro dollar system as you know, a form of Dutch disease that has had all sorts of bad UH consequences within the US economy.

Although that's not my main reason to be concerned about it, I do think that those issues should be looked at much more closely than policymakers seem to have looked at them so far. There's such a focus on stability for the system, but there's huge political economy effects of having a system like this, and what you have is sort of an open ended government backstop for financial sector risk taking. And you know, I don't get great comfort in the

sort of invocation of the badget rule. Uh. Walter Badgett's second half of the nineteenth century vision for how society should be structured is not one that I think many of us would find appealing today. This was a monetary financial system for an imperial power in a highly liberalized economy in the second half of the nineteenth century, and I think that there's uh a real concern that we should have about a system that is as unstructured as the one we have where the public sector is um

so frequently on the back foot. And I think that the solution isn't as hard as it sometimes seems, and that the history that Josh has done such a good job of elucidating on the other podcast about the fifties and we talked a little bit about eurodollars, shows that the public sector actually has huge control over whether you have an inherently unstable system or a stable system. And we just sort of we have experience of this in other areas, and so think about other areas of financial

regulation with the speck to the regulatory perimeter. The reasons securities regulation works is that we have a functional definition of a security, and anything that comes within the functional definition as supposed to a formalistic definition, you can't dress it up as something else and then not comply with securities regulation. Anything like it's covered by the functional definition of security is subject to the same set of rules. UH.

Insurance regulation works like this. You know, if you call it an insurance document, obviously you have to follow the insurance regulation rules. UM, but there's an incentive if you could maybe dress it up as something else. There's so many ways to dress up an insurance agreement and not call it insurance. UM. If you could dress it up as something else and not be covered by the insurance rules, the insurance rules are going to fall apart. And this

is true for mortgages. UH. There's so many areas of regulation, and financial regulation in particular. The fundamental problem we've had in money and banking going back forever is that we have not had a functional definition that had has been UH in force. And Josh is right there there's a spectrum, but you can pick ninety day you know, ninety day maturity.

Any instrument that matures in ninety days or less is a banking instrument that has to be UM issued by an entity that is subject to the same sort of coherent body of banking regulations. And that would just sort of regularized, rationalized, normalized, put some logic on on a system that has become very ad hoc and unpredictable in a way that I think is on that not in the in the public interest. And are there challenges like preserving the benefits of Parian Marylyn Charlie Kendall Burger's UM

you know, international finance system with low frictions. Yeah, we've got to figure out some ways to preserve the benefits. But I think there are ways to preserve the benefits. Uh, And the costs of doing nothing are large, and we could be facing the consequences, uh, you know, in more on that order of months and as opposed to years. Shall we leave it there. Yeah, I was gonna say, we could talk for hours on this, but let's leave it there. So many future episodes. I know a ton

of ideas here. Um, Josh Younger and love Men, and thank you so much. Fantastic discussion. Really great to have you here. Thank you to the audience for coming into the Bloomberg Offices to actually listen to this. Thank you for your excellent questions. Sorry we couldn't get to more of them. Thank you everyone. So that was our live recording with Josh Younger and Love Men, and thank you to everyone who came to Bloomberg's offices to you actually

watch and listen and engage in that conversation. Thank you as well to our producers Carmen Rodriguez and Dash Bennett. I'm Tracy Alloway. You can follow me on Twitter at Tracy Alloway. And I'm Joe wisntal. You can follow me on Twitter at the Stalwart, follow Carmen on Twitter at Carmen armand follow Dash on Twitter at Dash but oh, and follow Levi Menon on Twitter at lev men And. And we're probably gonna do several more of these, or hopefully we plan and tend to do several more of

these three. So keep a listen on the podcast, follow us on Twitter so that you know about the next one, and YouTube can join in person, and odd lots listeners, Tracy and I are going to be doing an A M A Ask Me Anything episode where you can ask us questions, send us a voice memo, state your name, where you're from, and one question. Put it in an email to odd Lots at Bloomberg dot net, and we will give you our answers. Thanks for listening to