The State as Financial Intermediary

Article excerpt

Start with two stylized facts about the modern state in advanced industrialized countries. One, the state's credit tends to be the best credit, better than that of business, households, or any (other) financial intermediary; better in the sense that the state borrows at the lowest rate. Two, the state's money tends to be the best money, better than bank deposits, credit cards (household), or trade credit (business); better in the sense that the state's money is a more universally acceptable means of payment. What is the reason behind these two facts?

One view is that these two facts are actually one fact, in that both follow from the state's power to label certain instruments (the state's own issue) as legal tender money, which power makes the state's money trivially the best money. Further, since state debt is just a promise to pay the legal tender money issued by the state itself, there is no possibility of default, and hence state is also the best credit. There is something to this argument, but I am not convinced that things work like that except in extraordinary circumstances such as during wartime.

A second view, the argument for which is sketched below, is that, at least in normal times, what makes one credit better than another, and one money better than another, involves a commercial, rather than a political, calculation. From this point of view, the two facts are different facts--related facts to be sure--but different. Let's look at money first.

Monetary systems are always structured hierarchically. Consider the gold standard system. There is a clear hierarchy from gold (the ultimate means of payment) to national currency, to bank deposits or notes, to other securities. The various layers of this hierarchy are knit together by a particular class of financial intermediary that we may call market-makers. Market-makers seek profits by taking a long position in some less liquid asset and a short position in a more liquid asset, a spanning operation that exposes them to liquidity risk. It is the willingness of market-makers to span in this way that keeps the layers of the hierarchy in contact with one another, and thus makes it possible for end-users to view the assets in the different layers as substitutes.

Just so, banks have loan assets (long position) and deposit liabilities (short position). They can be viewed as market-makers in their own deposits insofar as they undertake to maintain those deposits at par with currency. Indeed, the market-making function is essential to the profitability of the liquidity spanning strategy since it is the superior moneyness of deposit liabilities, relative to loan assets, that makes it possible for banks to borrow cheaper than they lend. In this sense, it is possible to view bank profits as payment for bearing liquidity risk. Banks manage that risk in part by holding currency reserves. More important than the reserve itself, however, is the ability to replenish the reserve by borrowing from other banks (the Fed Funds market) and ultimately from the central bank (the discount window).

A central bank is also a market-maker but at a higher level in the system, and with a different objective from the profit-maximizing banks lower down. A central bank holds discounts and securities as assets (long position) and issues currency as its own liability (short position). It can be viewed as a market-maker in its own currency insofar as it undertakes to maintain that currency at par with gold, the international money. Under the gold standard, central banks held supplies of gold as a hedge against the liquidity risk involved in this spanning strategy. To some extent, they were able to rely on borrowing from other central banks when they needed to replenish their reserve, but there was no super-central bank with the ability to create more international money. Instead, ultimately, the central bank relied on its ability to sell some of its assets in order to absorb any excess currency issue. …