Money can be used to purchase things now or saved to purchase things later. If individuals want to save their money to purchase things in the not too distant future, they can invest in what are known as cash equivalents. These include savings accounts at banks or money market mutual funds. Cash equivalents pay a little bit of interest while also having price stability in that the value of deposits varies little from day-to-day.
Money Is Debt Backed By Debt
Gary Gorton, Professor of Finance at Yale, points out that one reason cash equivalents have stable prices is they are debt instruments backed by debt.
A bank savings account is a liability of the bank. It is a form of debt that can be redeemed on demand by the depositor. That is why checking and savings accounts are called demand deposits Those demand deposits are backed by assets that the bank holds including loans and bonds. Bank loans are debt owed by borrowers. Bonds are debt owed by governments and corporations. So a bank savings account is a debt obligation of the bank that is backed by assets that are also debt in the form of bonds and loans.
A money market mutual fund is a vehicle that invests in short-term debt including government notes, commercial paper, and repurchase agreements. Commercial paper is an unsecured debt issued by corporations. Repurchase agreements are a form of short-term borrowing secured by collateral, usually Treasury bonds, which of course are also debt.
When individuals store money at a bank or money market fund, they don’t typically research what is backing the deposit. They assume that bankers and money market mutual fund managers conduct due diligence on the loans they make directly or when they buy commercial paper and bonds, or enter into repurchase agreements.
No Questions Asked Trading
Gary Gorton and other academics refer to this type of trading as “no questions asked.” Trillions of dollars of cash equivalent instruments and short-term debt are traded daily by institutions and individuals. Participants in these money markets assume they will be repaid and that the collateral is good so they don’t need to ask many questions. Not questioning the value of collateral or the creditworthiness of the issuer allows trading to proceed more smoothly. There is more liquidity because transactions are not delayed due to a need to conduct additional analysis. It is similar to how individuals assume that the currency they receive when selling goods or services is not counterfeit. It would be too time-consuming to verify that every dollar bill we receive is authentic and not fake.
What Causes a Financial Crisis
Most of the time money market trading proceeds smoothly. Problems arise when market participants start to doubt the value of what is backing a cash equivalent instrument. If individuals or institutions are concerned about the value of collateral or whether they will be repaid then they exit the market and don’t trade.
When trading is curtailed because money market mutual fund and other traders are less willing to purchase short-term debt instruments then companies who were funding their daily operations by issuing that debt run short on cash. They are forced to sell assets to cover operating expenses. Forced selling and an unwillingness by market participants to trade and lend can lead to a full-blown financial crisis as asset prices fall, liquidity dries up and corporations collapse. That is exactly what happened during the Great Financial Crisis.
Such crises require governments and central banks to step in as the lender of last resort by providing loans and guarantees to market participants. Eventually, government and central bank actions calm markets and restore confidence so that market participants are again willing to trade. The cycle begins again.
We see then that most money, such as currency, bank deposits, money market mutual funds, and repurchase agreements, is really short-term debt, often backed by other debt. As a result, money is subject to runs when investors lose confidence and don’t want to own it. That can lead to financial crises. In Episode 285 of Money For the Rest of Us we explore what individuals can do to protect themselves from these types of financial panics.
Topics covered in this episode include:
- How counterfeiting currency works.
- Why most money is debt backed by debt.
- How a loss of confidence in money leads to bank runs and other financial crises.
- How demand for U.S. Treasuries as collateral is keeping interest rates low even though the U.S. federal budget deficit is growing.
- Why the Federal Reserve is considering capping interest rate yields on U.S. Treasuries and what are the risks of doing so.
- What can individuals do to protect themselves against a financial crisis caused by runs on banks and financial securities.
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