We have let finance to those who know about it. We should, though, discuss the details of the financial fabric around us and push it into political agenda.
It will be ten years after Lehman went bust this fall. There are many thoughts about this. One of my reocurring ones is: Do we know what happened? And with that I don’t mean “we”, the ones who are interested in repos, liquidity coverage ratios, financial-stability-currency-swap kind of nerds, but normal people, who have not as a job to read research or finance related literature on a frequent basis.
Gladly, I am involved in the process to create educational material on “Ten years after the crash” for age groups upper middle and high school. We try to come up with engaging, maybe playful, but definitely thoughtful educational methods to be used in schools. We have an activity that will draw students in, engage in such an abstract topic as economics in their daily lives. Like, “What could you buy with one Euro, or with ten? And what with a stock that is worth ten Euro?” or, we talk about bank bailout packages and try to build reference for what building a local soccer field or repairs in their schools would cost. We offer newspaper articles for discussion in reference to our constitutional law and how house evictions could be seen under such a perspective.
This work is very engaging. I constantly have to boil down, think again and discuss how we perceive reality. And that is what I mean by saying: Do we know what happened?
We have for example an activity that intends to explain what a bank-insolvency is. We draw up how balance sheets work, how maybe a student in school has a deposit account and their parents a mortgage on their home. And then we explain what happens to that bank if loan repayments are missed. Now, at this point our activity focusses on losses on equity of the bank and it thus becoming insolvent. And this is what happened essentially in Germany, where Commerzbank after trying to buy Dresdner Bank had a terrible cough and just with the help of government intervention could bolster its capital cushion enough to remain solvent.
I wasn’t part of the team planning this activity, that I now like very much. It tries to explain in very hands-on ways what a bank-insolvency is.
I, on the other hand, had thought of the crisis differently: I had looked only at a couple of months earlier than the Commerzbank incident. I had in my thoughts of what happened in the financial crisis only looked at the funding crisis that crushed Lehman. I had only taken the angle of a liquidity crisis. I had heard Perry Mehrling speak, read Minsky and used their writing, as well as, “the run on repo” as lecture material. Thus, in the activity we have on solvency of a bank, I was a little uneasy. Does it really explain what happened? Should we rather focus on the solvency or the liquidity aspect of the crisis?
And now I am extremely glad that I made myself write this up. Because it made me google and find a wonderful article by the excellent Noah Smith who asked exactly this question. 2008: Liquidity crisis, or solvency crisis?
He’s quoting Steve Williamson with words that I couldn’t possibly shorten, thus excuse the long quote:
One [the liquidity crisis] view is that the fragility is inherent to financial systems. This view is framed in some versions of the Diamond-Dybvig model, in which the maturity mismatch and illiquidity inherent in banking imply that bank panics are possible. An alternative [the solvency crisis] view is that the fragility is induced…a too-big-to-fail financial institution understands that it is too-big-to-fail, and therefore takes on too much risk, relative to what is socially optimal…This high level of risk could be reflected, for example, in a high-aggregate-risk asset portfolio, or in a maturity mismatch between assets an liabilities…[I]t is possible that Lehman Brothers could have taken corrective action…to ward off failure, if it had correctly anticipated that a bailout would not occur.
Noah then concludes by writing, that he himself is undecided whether 2008 was a liquidity or a solvency crisis. But the distinction is fundamentally important because of the policy implications they carry. While the solvency perspective holds the “Moral Hazard” explanation for us and leads to stability mechanisms that focus on monitoring and bailing out (fiscal policy), the liquidity perspective focusses on deposit insurance and, yes, liquidity ratios — thus also monitoring, lender/dealer of last resort facilities by central banks (monetary policy).
The article is quite complex. I just spent an hour and a half diving into the theoretical papers Noah quotes. On the Diamond-Dybvig model, or on herding, here or at the FED. And I ponder how much I actually know about what happened in 2008 and how much I just learned through writing this down.
Following this short theoretical excursion, I would like to share two thoughts about how this distinction is important to a democratic, political public. Namely, I argue that increasing plurality of perspectives as in ways to make sense of “reality” adds democratic steadfastness as it offers positions to take and argue for instead of a “there is no alternative”-narrative. Second, on a broader but also more concrete note, I argue that major changes in monetary and fiscal policy personnel need to be much stronger publicly controlled.
An argument about current politics and a public discontent with it is that levels of complexity in our current world aren’t addressed thoroughly enough. This obviously becomes apparent in topics of the financial or euro crisis, crisis management or resulting monetary policy like QE.
With this in mind, I pose the question of: How much would it be good for a democratic society to understand the details of what happened in the last financial crisis, that still has its effects with rising rents, unemployment, pension losses and the still ongoing greek disaster. Does it matter to this public whether to look at the crisis in terms of a liquidity or solvency perspective?
Would we, with adding an activity to our banking crisis material that covers a liquidity crisis perspective, add to the perceived over-complexity of finance that must as a consequence have the reaction of “fuck it, too complex, don’t give me more perspectives, let Mario decide”?
Like, warding off any more complexity?
I don’t think so. I think opening up new perspectives to a situation, discussing them or just simply trying to understand them would add exactly to our democratic process what we are missing at the moment. Understanding the issues of liquidity is much harder than understanding solvency. We all know what happens when we individually run out of money in the bank. But with a growing financial industry it makes sense to pursue understanding of what a funding crisis is. Because as Perry Mehrling would put it: Liquidity kills quick.
Also, the implied “moral hazard” in the solvency perspective always left me somewhat puzzled. It seems to come down to “greedy” bankers so much, to the “nature” of human beings to be rapacious. This is countered by the systemic explanations like those of herding or Minsky’s inherent financial instability. If the naturalistic assumption humans just individually being ex ante greedy holds, we should wonder if there is any path out of thus created financial instability at all. A systematic perspective on the other hand doesn’t offer quick policy responses like raising capital buffers, but it may offer long term approaches to financial stability, targeting the inherent asset-liability mismatch of every financial agent who is interwoven into the financial fabric.
Perry’s Money View with his elasticity-discipline-approach (which is by the way super useful for explaining current surges in equity, private equity, real estate and even “crypto”) actually suggests embracing both perspectives as being true descriptions of “reality” and the swinging pendulum between scarcity of (ultimate) money and elasticity of (derivative) credit makes for two perceptions — solvency vs. liquidity — on the same issue.
A political debate on the two perspectives and their implications touches basic questions of “how we treat each other” (see moral hazard) or “what role the law should play in human interaction” (see policy). Teaching a plurality of ideas, embracing the controversy, even opposites, strengthens democratic steadfastness by bringing the fresh wind of new vocabulary to describe one’s reality.
Monetary policy and financial regulation should be carried out and decided on by highly trained people who can still feel emotions and not act as robots catering to “the market”. But for that to happen the above mentioned democratic public needs the tools and the knowledge to control these experts.
Next year Mario Draghi is set to leave the top post at the ECB. In Germany’s last year federal elections the conservative Bundesbank chief’s nomination to his replacement wasn’t among the topics discussed by political parties. Installing the hardliner Weidmann as the Eurozone’s top financial regulator and central banker wasn’t part of this democratic process. A shame.
Also, this week Germany’s freshly baked Minister of Finance Olaf Scholz made a statement that fits into my reasoning. For reference, Scholz is now replacing his eight-year-predecessor Wolfgang Schäuble who is famous for his anti-european and Germany-first agenda during the euro-crisis. Also, he is the politician who during a time of record low interest rates and a record high infrastructure investment backlog, is proud of the “black zero”, indicating a happiness for a balanced federal budget with no added government deficit.
Scholz now this week stepped in front of international press and said he will stick to the “black zero” and: “A German finance minister is a German finance minister, the party affiliation plays no role there”. Mr Scholz should ask himself whether his voters voted for the obscure role of “a German finance minister” or for the social-democratic party he is part of. With his SPD on the brink of being a relevant party the party-head should take democratic decision making seriously and not pursue the same agenda his conservative predecessor propagated. Because there are alternatives. Teaching about them could make them gain traction.
And here is finally where I make full circle back to the activity about solvency, on how Commerzbank was rescued. This understanding in a general public is important. Offering alternative perspectives will always add to democratic decision making strength. Getting a feel of what happened in the crisis into the public remains a target for all of us who’s job it is to teach and think about finance. Deciding on the steps to be taken should be a democratic process that necessarily has a bunch of alternatives to choose from. An explanation that focusses on solvency and one that focusses on liquidity. And best: One on hearding, too. Financial Society is the name of our time and educational material that captures our core interlinkings democratizes knowledge to re-power, bottom-up.