The Bank-Centered View of the Money Market Part II: Re-Evaluating the Real Bills Approach to Macro-Prudential Regulation

Abstract

This paper argues that an early 20th century central banker, had he been alive at the turn of the 21st century, would have predicted the 2007-08 crisis and its severity. This paper is Part II of a series which contends that early 20th century banking theory is a valuable framework for understanding the relationship between banks, financial markets, and the central bank. This paper builds on Part I which explained that because a social norm supports the circulation of bank deposits as money, deposits are a network good and this makes possible monetary finance, or the expansion of the money supply as a source of funds for banks to lend.This paper first analyses the British model of monetary finance, the structured interaction of banks, the money market, and the central bank that formed its core, and the means by which this structure made possible the origination of safe, privately-issued assets. Then, the analysis turns to the macroeconomic implications of monetary finance: in order to protect the monetary social norm, both financial instability and inflation must be avoided. The real bills principle addressed the former by proscribing monetary finance of long-term assets and the latter by requiring careful monitoring and control of the growth of money market instruments that were not real bills.Thus, the modern integration of money and capital markets is seen through traditional banking theory to be a recipe for financial instability, because it undermines the ability of banks and the money market to be joined together in the production of safe privately-issued assets. This theory indicates that restabilizing the financial system will require structural reform and that only after such reform has been implemented can we expect macro-prudential regulation to succeed.