Tuesday, October 11, 2011 26 Comments

Professor Krugman on maturity transformation

There's always time for a short lecture on UR's favorite topic. It's important to remember that Paul Krugman is an idiot, but he's not a fool:
Like a lot of people, my insights draw heavily on Diamond-Dybvig, one of those papers that just opens your mind to a wider reality. What DD argue is that there is a tension between the needs of individual savers — who want ready access to their funds in case a sudden need arises — and the requirements of productive investment, which requires sustained commitment of resources.

Banks can largely resolve this tension, by offering deposits that can be withdrawn on demand, yet investing most of the funds thus raised in long-term, illiquid projects.
I face a similar tension between going to Reno every weekend, and buying strained carrots to feed my one-year-old. The Fed could largely resolve this tension, by printing fat stacks of benjamins for me to blow on coke and whores before I hit the Safeway for some Gerber. I note also that the policy would create demand - a favorite consequence of Professor Krugman's.

Just as the entire purpose of a monetary system is to decide who gets to go to Reno and who has to scrimp and save for strained carrots, the entire purpose of an interest-rate market - as well understood when Professor Krugman was eating strained carrots - is to match the supply and demand of loanable funds and eligible borrowers at every duration.

If you convert loanable funds of one duration into loanable funds of another duration, either by wholesome George Bailey banking or by synthesizing collateralized instruments (a category which logically includes nominally zero-term demand deposits), you are taking this elegant market signal, the yield curve, and raping it in the ass. You will give it AIDS. It will give you AIDS back. This will become known as the "business cycle" - a sort of historical quartan ague. Though no one understands it, it exists.

And both Wall Street and Main Street will exhibit a pattern of unending financial crises for all of modern Anglo-American history - from Walter Bagehot to Secretary Geithner. I'm sure this couldn't be due to a defective, archaic banking system which wasn't even redesigned for the 20th century, let alone the 21st.

Indeed, as Bagehot's Wiki - not cattily - notes:
Bagehot’s observations on finance remain relevant and cited by central bankers, most recently in the wake of the global financial crisis that began in 2007.
Indeed. I could hardly put it better myself. I've proposed before that classic Lombard Street banking, borrowing short and lending long, should be forever known as a "Bagehot scheme." Isn't it fascinating that while so many other 19th-century English institutions - like slavery, the gallows, and impressment of sailors - have met their demise, this one continues merrily on? Talk about a barbaric relic!

Professor Krugman is unintentionally wonderful on this point:
The problem, of course, is the vulnerability of such a system to self-fulfilling panics: if people believe that a bank will fail, everyone will in fact want to withdraw funds at the same time — and because the bank’s assets are illiquid, trying to meet those demands through fire sales can in fact cause the bank to fail.
Actually, Professor Krugman, the Diamond-Dybvig model is not a true multiple equilibrium. The maturity-matched model - in which long-duration asset prices are much lower - is the only free-market equilibrium.

If you can fix asset prices, of course - whatever. But in a free market, the value of a synthetic asset is always epsilon less than the value of the equivalent real asset. By definition the synthetic asset can default, whereas the real asset can't. (In a George Bailey bank, for instance, your demand deposits are loans to the bank collateralized by the bank's portfolio of burned-out Section 8 New Deal ghetto towers.)

No perfect system of collateralization can be constructed. Epsilon exists. As free markets become frictionless, epsilon becomes tradable. The bank run happens automatically. Intervention is required to prevent it:
This then leads to the need for policy: deposit insurance and/or lender of last resort facilities to head off bank runs, and bank regulation to reduce the moral hazard from these explicit or implicit guarantees.
Unless the lent asset is USG shares - ie, dollars. USG can issue and lend as many USG shares as it wants. By engaging in this practice, it can lower interest rates to zero across the duration curve. Indeed, it is in the process of doing so. In theory, Google could just as easily operate a Bagehot scheme in GOOG shares. They are neither idiots nor fools, so they don't.

In the end state of this pernicious practice, there are no "private" banks at all. There is just one big bank: the government. Congratulations, Professor Krugman! You've reinvented the Soviet Union. Could you get a second Nobel for this mighty discovery? When the zero bound is hit across the curve, there is no lending even at zero interest rates, and capitalism is officially flatlined. Instead of infinite stimulation, this is the point of infinite stagnation. All economic organization becomes the task of the government. Soy Cuba! Yo, Cuba!

A "lender of last resort facility" is a crucial piece of machinery in the Bagehot scheme. In all cases, "loan guarantees" can be modeled simply as loans. If A guarantees B's loan to C, what is really happening is that B lends to A, and A to C. A in this case being our friend, tha USG. Or more specifically, the Fed.

So, when you "deposit" dollars "in" a bank, not only are you really lending them to the bank - you're really lending them to the Fed. Moreover, when a bank lends you dollars, you are really borrowing from the Fed. Yo, Cuba! Never in the history of Bagehot schemes has this been more clear. Fortunately, at least we're not on a gold standard, under which no Bagehot scheme can survive (USG being a perfect credit risk for USG equity, and nothing else). Naturally, this is Professor Krugman's most devastating argument against the gold standard.

What I love - what really illustrates the difference between an idiot and a fool - is the bizarre overall thrust of the Professor's argument, which clashes so baldly with the rest of his political idiocy. Graphite-cooled plutonium reactors, Professor Krugman tells us, are essential, because they generate electricity. How else can you generate electricity?

(Obviously, if we did not synthesize loanable funds at 30-year duration, no one would invest in 30-year mortgages, because no one saves money with the intent to spend it 30 years later. Thus, the price of a 30-year dollar would be a present nickel. And we will all be zillionaires when we retire, because each of our 2011 nickels will buy a 2041 dollar. Hey, wait...)

But graphite-cooled plutonium reactors also have a tendency to burn when they melt down, contaminating half the Ukraine. We need electricity, though! So we'll just have to cover the Ukraine with plastic sheeting, which teams of Mexicans in bunny suits can wipe down every time there's another Chernobyl. As an added benefit, this will create demand and stimulate the Mexican economy. Also, tomatoes can be grown under the sheeting.

No fool could come up with this. But an idiot could. Also, one lovely benefit of this dangerous brush with reality is that we have the opportunity to hear the Professor's rare, shy and beautiful libertarian side - the prothonotary warbler of the liberal conscience. Regulation, you see, is hard:
So, are you going to ban fractional reserve strategies by money market funds? Are you going to ban repo? Auction rate securities? Where does it stop?
Professor! I know! I know! Hey, look at me! "Yes," "yes," "yes," and "a long way farther on."
They have an oddly antiquated notion of what money and finance are about, one that misses the “virtualness” of the modern world. They still think of money as being pieces of green paper, rather than what it mostly is now, zeroes and ones in some server somewhere. They still think of banks as being those big marble buildings, in a world in which most banking is a lot more abstract than that.

This is, after all, the 21st century. Things have moved on a bit.
No, actually. They haven't. They should, though.

Now, to be fair, Professor Krugman is a fool but not an idiot. If there are any Austrians left who can't understand that fractional reserve is a special case of maturity transformation, and they prefer to consult living professors, they can ask Philipp Bagus. If they prefer the idol himself:
For the activity of the banks as negotiators of credit the golden rule holds, that an organic connection must be created between the credit transactions and the debit transactions. The credit that the bank grants must correspond quantitatively and qualitatively to the credit that it takes up. More exactly expressed, "The date on which the bank's obligations fall due must not precede the date on which its corresponding claims can be realized."
In other words, a healthy bank - virtual or marble-pillared - expects to meet all its obligations from cashflow, without new borrowing to pay off old loans. Well, knock me over with a feather. If that's not simplistic, I don't know what is. That's what accounting should be - simplistic.

The genius of Professor Krugman is that he goes so near the truth that he makes it obvious even to his commenters - who typically are both idiots and fools, but several of whom spontaneously exhibit the same insight themselves:
Why can't we regulate or even ban the maturity mismatch? Savers would have to make the maturity choice themselves and it would be transparent. Currently, the savers don't understand the huge run risks that the banks have by funding with demand deposits and lending long. It's hiding the risk.
And almost cogently:
I'm not a hard-money crazy, but I have wondered if there's a weaker version of hard money that makes sense: forcing duration matching. Is borrowing short-lending long actually a required service? What if the bank only lent long money borrowed long such that the assets and liabilities matched in duration?

It'd still be fractional reserve banking, but it would not be subject to bank runs. While we're on the subject of hard-money feasibility, can you comment on this variant?
Somehow I don't expect an answer.


Anonymous The Reluctant Apostate said...

Correction on an ancillary issue:
The V.I. Lenin Nuclear Power Station consisted of four RBMK reactors, which are graphite-moderated, not graphite-cooled. Like most nuclear reactors around the world, it was light water-cooled.

October 11, 2011 at 11:28 AM  
Blogger Alrenous said...

All I hear about Krugman is how he's wrong again this time. I know why progressives read him. Why does anyone else?
Ditto Yglesias. Guys, we've established the pattern. You don't need to beat it to death.

That said I'm always happy to hear more about Bagehot schemes.

Also interesting to me is that you can approach communism without actually reaching it. The Bagehot scheme actually is communism. The Fed in fact has the power to command all debt.
But it doesn't choose to do so. It's exercising less than half its communist mandate, I estimate.

"They have an oddly antiquated notion of what money and finance are about, one that misses the “virtualness” of the modern world."

The fatal flaw of all progressives. We don't have to argue about this. Just don't prevent me from opening a non-fractional reserve, non-Fed backed bank, using its own bank notes. (I'd use osmium, because I'm bored with gold.) If Krugman is right, I fail. If I'm not...well, we see why he might want to head this one off at the pass, because the Fed fails. So, unsurprisingly, opening an osmium-backed bank is basically illegal, though I don't think it's been specifically outlawed.

October 11, 2011 at 11:37 AM  
Blogger Gabe Ruth said...

I think this does a good job illustrating the wisdom of the West's version of socialism vs. the Soviet one. It was important to be THE hegemon before embarking on this process for reals (to make sure there were no alternatives), and it was also important to discredit anyone who would be willing to make an argument with such child-like simplicity (because it is unanswerable; the circularity of the needs driving the current system is surreal). Mind control was an expensive tactic, but I think you could say it has paid off, while providing an endless supply of distractions and angry, scared people as a bonus.

One thing that is sort of ironic: the success of the progressive project ensures there will be no progress in any sense; the apostates are so not because they believe their way leads to progress, but because they believe regression is possible. Some optimistic ones think progress would be a pleasant side effect of a return to sanity.

Those comments were priceless, the stuff of fairy tales.

October 11, 2011 at 12:59 PM  
Anonymous josh said...

"The Fed in fact has the power to command all debt.
But it doesn't choose to do so. It's exercising less than half its communist mandate, I estimate."

No, its pretty much whole hog, or at least as close to state communism as the Soviet Union. The planner of the USSR also had a dual mandate; allocate capitol in an efficient manner based on "scientific" algorithms, and follow the commands of the central committee when it came to favored/disfavored groups or projects. They had some personal discretion, but hid behind formulas and "the law". The bankers also paid themselves handsomely for the trouble of handing out right to build permits. Does any of this sound familiar?


October 11, 2011 at 1:13 PM  
Anonymous Anonymous said...

Since people put their money in banks to "protect" their money and government ultimately provides property rights, it's not surprising that banks appear to be just an administrative arm of the government.

A real "private" bank would have to be a sovereign government over its piece of territory. So there can't really be a "private" bank separate from government.

What Mencius wants with a "private" bank is really just a more efficient arm of the government that more effectively punishes its administrators for their mistakes.

October 11, 2011 at 4:07 PM  
Anonymous Anonymous said...

Maturity transformation exists prior to anyone depositing money in a bank.

There can be no saving without government.

Saving presupposes possession i.e. property rights.

Government upholds property rights that wouldn’t exist in the absence of law enforcement.

When you possess something there is a cost to defending your right to possess that thing.

October 11, 2011 at 4:08 PM  
Anonymous Anonymous said...

Even before people put money in banks, there is maturity transformation going on with people simply holding their money in their wallets or under their mattresses.

Money taken in by the government maintains the existence of the entity that provides the property rights that ensure the money in wallets, under mattresses, etc., is there some time in the future indefinitely. There is significant maturity transformation going on at this fundamental level as the money taken in tends to be taxes on income, capital gains, value added, sales, etc. i.e. taxes on economic activity, labor while the money that comes out in the future (the property rights that get protected into the future) didn't have to pay for its preservation (like it would have to for property insurance).

October 11, 2011 at 4:09 PM  
Anonymous josh said...


October 11, 2011 at 4:33 PM  
Anonymous Anonymous said...

Blogger isn't allowing longer comments to go through for some reason.

The order should be:

4:08 PM
4:09 PM
4:07 PM

October 11, 2011 at 4:36 PM  
Anonymous Anonymous said...

so business cycle = mutual butthex


October 11, 2011 at 6:29 PM  
Blogger Independent Accountant said...

This post made me laugh. I suggested MSFT do what you suggested GOOG do 25 years ago!


October 11, 2011 at 6:36 PM  
Blogger nazgulnarsil said...

um...I'm with winterspeak on this one. Bank's don't lend deposits. *They use deposits to cover epsilon*. No one actually needs to have the rest of the money. The bank types it into your account in recognition of the fact that a piece of paper that says you'll pay X dollars a year for Y years is itself a type of money. Banks do the accounting of translating between these future dollars and today dollars. They estimate epsilon. When they do a bad job of estimating epsilon the market bites them.

October 11, 2011 at 9:21 PM  
Blogger Aaron Davies said...

The V.I. Lenin Nuclear Power Station consisted of four RBMK reactors[...]

wait, the official name of Chernobyl was "Lenin"?!? I had no idea! not surprised it's not publicized tho...

October 11, 2011 at 9:29 PM  
Anonymous Clyde Frog said...

Come on over, and do the Twist

Transforming illiquid long maturity assets since October 2011

October 12, 2011 at 3:40 AM  
Anonymous Thrasymachus said...

The Whiggish Protestantism you analyze has a big element of magical thinking. One of Jesus's themes was how believing something, if the faith was strong enough, made it true. "Don't be afraid, just believe." And how if your fate is great enough, you can move this mountain.

This fractional reserve banking system depends a great deal on the faith and trust of the depositor. This idea of believing things and making them true is also deeply embedded in all kinds of things in liberal culture.

October 12, 2011 at 9:31 AM  
Blogger TGGP said...

The guy who just won the Nobel had a talk here that discussed "narrow banking", and Diamond-Dybvig vs Karaken-Wallace (deposit insurance is pure good int he former, pure bad in the latter). But he doesn't discuss an alternative to maturity transformation, since Diamond-Dybvig simply defines a "bank" to be something engaged in maturity transformation.

When I hear of most mechanism design I just think "fatal conceit". But I don't think I'd entirely identify with the perspective Sargent associates with "free banking", since he conflates it with the "real bills doctrine" even when there is still a central bank. Most of the free banking proponents I'm aware of reject the RBD and often blame it for the Fed's terrible behavior during the Great Depression (Douglas Irwin and Richard Timberlake have both used that to explain why the "gold standard" wasn't to blame at that time).

October 12, 2011 at 10:16 PM  
Blogger Motley Fool said...

"No perfect system of collateralization can be constructed."

This is actually incorrect. One has been constructed, or I should rather say reconstructed by Prof. A. E. Fekete.

The short and long of it is that commercial and investment banks should be separated, as they once were, and that the type of assets a commercial bank may be possess must be restricted to only two things : specie and bills that mature into specie.

Modern day bank runs, on 'solvent' banks, only became possible when banks were allowed too (forced rather) to use government bonds as collateral.


October 13, 2011 at 11:00 AM  
Anonymous Fake Herzog said...

I sent this post to famous market monetarist Scott Sumner and his reply was as follows:

What’s his [Mencius] view on the Canadian banking system, which has never had a crisis? (at least in the past 100 years)

Inquiring minds want to know...

October 13, 2011 at 11:32 AM  
Blogger TGGP said...

Mencius often cites the Austrian position that logic trumps empiricism, so historical evidence is worthless to him. Aaron Haspel, who has been on the UR blogroll since the beginning, had some thoughts on the Austrian/Objectivist prophecy of inevitable collapse here.

October 13, 2011 at 6:47 PM  
Blogger Alrenous said...

"Since today's economists (except of course the Austrian School) have abandoned the the apparently unfashionable concept of causality in favor of the reassuringly autistic positivism of pure statistical correlation, it has escaped their attention that when you stop shooting heroin, you feel awful."

October 14, 2011 at 6:06 AM  
Blogger death maiden said...

krugman is as much to blame for the liquidity trap as MM is for obstreperous niggers on the overpass (hey ... ?)

there are lots of assertions here that aren't provocative but are just blowing smoke up the reactobag. suppressing the yield curve in treasuries doesn't have anything to do with "govt organization" of shit. it's monetary policy, not fiscal, and it's neutral. the goal is lower the risk-free rate and flood the banks with cash -- both spurs to lending. that it's completely ineffectual -- pushing on a string -- is described in the papers for which krugman won his nobel

and as someone above pointed out -- banks don't lend deposits, and reserve ratios have shit to do with why money gets lent or doesn't

October 14, 2011 at 11:11 AM  
Blogger death maiden said...

the truth is, galbraithian sovietization of US banks -- forcing them to lend -- would be an improvement, a logical step, which is why it won't happen

October 14, 2011 at 11:34 AM  
Anonymous josh said...


Search for Mencius on interfluidity. MM admits your latter point btw.

October 14, 2011 at 3:51 PM  
Anonymous zanon said...

moldbug is like the bourbons. he remember nothing and forget nothing.

pity he read an austrian text back when a little boy, and then never bother to figure out double entry bookkeeping.

of course, krugman is equally clueless, but even more convinced of infallibility.

banks do not lend out deposit. there is no "loanable fund" market. DD model is not applicable to US system as US is not on gold standard.

here, for those want clue, is what happen if, under DD, everyone want to withdraw money from Bank A and move to Bank B.

Bank A reduce person account, and Bank B increase person account by same amount.

Bank A reduce its reserve account (held at Fed) and Bank B increase it reserve account (held at Fed) all by same amount.

So, just number change on spreadsheet.

Then, at end of day, Bank A look at balance held at Fed. Say is below regulatory requirement. Then, Bank A overnight interbank market which is setup for such situation, and borrow what it needs from a bank with surplus reserve, promising to pay back when rooster crow.

Bank B has such surplus, and left to bank A until sunup. The rate bank B charge to bank A is called "federal fund rate" and it is what Bernanke the Beard target. This overnight, interbank lending is how the rate is actually set, so everything is totally normal here.

Now, suppose bank B (and no other banks) have surplus. Bank A go to discount window at Fed and Fed lends the money overnight. Sun come up, money return.

so, as you see, it is no problem is people all want to move money from bank A to bank B because it all connected and B just lend back to A as regulator require.

in canada, for examples, reserve requirement is zero, so here bank go into overdraft at reserve account and settle back to zero. In US, bank go into intraday overdraft too, but have some positive number to settle at.

bank do not maturity mismatch. they just clear check, and extend credit by expanding both side of balance sheet.

interbank connection via reserve account at Fed is what makes this possible for bank, but not possible for person

October 20, 2011 at 1:18 PM  
Blogger Motley Fool said...


I enjoyed your comment tremendously. I'm curious where it disappeared too.

I do think that there should be a divide between commercial and investment banking, so that maturity transformation problems are at least public knowledge.

Your Ps. comment was hilarious for being true, though I wouldn't quite say they are wrong on everything. xD

October 22, 2011 at 2:03 PM  
Anonymous Anonymous said...

Newest HBD term: MAMB

Give it a thumbs up:


October 24, 2011 at 1:14 PM  

Post a Comment

Subscribe to Post Comments [Atom]

<< Home