Larry White on Stablecoins, Money Market Funds, and the History of Free Banking

Larry White is a professor of economics at George Mason University and is a returning guest to the show. He rejoins Macro Musings to talk about stablecoins, the history of free banking, and money market funds reform. Specifically, David and Larry also discuss the critiques levied against stablecoins, their impact on the banking system, and why stablecoins could be considered the new version of money market mutual funds.

Read the full episode transcript:

Note: While transcripts are lightly edited, they are not rigorously proofed for accuracy. If you notice an error, please reach out to [email protected]

David Beckworth: Our guest today is Larry White. Larry is a professor of economics at George Mason University. And he joins us today to discuss stablecoins, the history of free banking, and money market funds reform. Larry, welcome to the show.

Larry White: Thanks, David. Good to be here.

Beckworth: As listeners may know, Larry is a returning guest. Now, Larry, did we ever get you a nominal GDP targeting coffee mug?

White: Yes, I have one.

Beckworth: Okay. Very well. So Larry drinks from that mug every morning.

White: Only tea.

Beckworth: Only tea. Drinks tea from the ... We'll call it the nominal GDP targeting tea mug in Larry's case, but like other guests, he is a part of the privileged elite group that has one. And I encourage our listeners to go back and check out that episode. It's a great conversation from a few years ago. We'll make that available on the show page. But Larry, I have you on because there's a lot of interesting conversations going on right now about stablecoins. And you had an article you recently posted online titled, *Should We Fear Stablecoins?* So a lot of people are talking about that. We'll come back and mention some specifically, but tell us what is a stablecoin? Just to start things off.

What is a Stablecoin?

White: Stablecoins are an asset available in cryptocurrency space. They come in several forms and various brands, but the ones people are talking about, the ones that some Federal Reserve officials are worried about, like Tether, USDC, True US dollar, are dollar denominated, tokenized IOUs. By tokenized I mean, they can be traded on cryptocurrency exchanges. They're issued on Ethereum and other blockchains. They're bought and sold on crypto exchanges. So they're mostly used by crypto traders who, when they sell, say Bitcoin, don't necessarily want to be paid in bank account dollars because that's a hassle, that sends you through the whole know your customer rigamarole. It involves time and hassle to move the money into your bank account, and then when you want to buy some other cryptocurrency, back out of the bank account.

White: So it avoids those delays. It's more seamless. And so that's how they're used. They're used by crypto traders in large volumes to avoid the hassles involved in wire payments. You can think of it as a different payment rail for crypto traders to use outside the ordinary payment rails that go through commercial banks and central banks. There are about $110 billion in stablecoins in circulation. So that gives you an idea of the size. Daily transactions are running in the neighborhood of 10 to 20 billion per day. So it's big.

Beckworth: It's big, but it seems like the conversations, the concerns expressed by many is disproportionate to the dollar size of stablecoins going on. Is the concern about where it could get to in size? Because this $110 billion doesn't seem extremely large relative to, say, the U.S banking system.

White: No, that's right. I think the concern has been not so much about the size per se, but about stablecoins and these alternative payment rails being used more widely by ordinary consumers. So competing with the ordinary banking system for ordinary retail payments, it was the announcement by Facebook that they were going to issue something initially called Libra, now called Diem, which was to be, it hasn't happened, a kind of stablecoin useful at the retail level that really got the attention of some central bankers and got them worried about payments moving beyond their control.

Beckworth: Yeah. So I'm still left wondering though, how consequential this will be. I mean, you mentioned that right now it's being used by cryptocurrency traders, and that's it, right?

White: Pretty much. There are some activity in what's called decentralized finance or DeFi that involves stablecoins with smaller level investors, but that's still pretty young.

Beckworth: Let me ask it this way, do you think it is possible for stablecoins to grow beyond the cryptocurrency world so that you and I, for example, could go out and get a meal together and pay with a stablecoin?

White: I don't see that becoming in our advantage or being a cheap way to make payments in the near future. The coin called USDC has though been advertising themselves as a payment service for businesses that want to make overseas payments more conveniently and more privately than by using wire transfers. So there is some possibility of it spreading to that market.

Beckworth: You mentioned in your essay that stablecoins probably will continue to grow overseas no matter what happens here. So another part of me says, this is just like talking about shadow banking system or offshore dollar markets. There's not a whole lot U.S regulators can do anyways with that.

White: They can make life less convenient for U.S residents. Sure.

Beckworth: Less convenient. Okay. For residents. But it wouldn't be able to rein in, I guess, stablecoins based on the dollar overseas, correct?

White: That's right.

Beckworth: Okay. So some of the people who have been talking about this, I'm just going to run down a list some notables. You alluded to them earlier, but Governor Lael Brainard had his speech on May 24th. And you mentioned this quite a bit in your article.

White: Yeah. My article is pretty much a critique of her speech.

Beckworth: To respond to her speech. It's kind of like the good old days of blogging when you take an article and you take it paragraph by paragraph and show why you disagree with it.

White: Is that not in fashion anymore? I mean, that's still what I do.

Beckworth: That's still what you do. Okay. Very nice. And we'll provide a link to that for our listeners. It's a very, I think, useful article because it provides, I think, a fuller picture of what a stablecoin is and a different perspective on the issue. So we have Governor Lael Brainard in May 24th of this year, then recently there was some hearings in the Senate, Senator Elizabeth Warren on June 9th, got into the discussion of stablecoins and compared it to Wildcat banking and notes from back during that period.

Beckworth: More recently, Gary Gorton and Jeffery Zhang have a paper that came out in July titled, *Taming Wildcat Stablecoins.* So the name of that paper itself is alluding to the “Wildcat banking” during the free banking period in the United States. And we'll come back to the history in a bit.  And I think both of us agree that most of these folks who invoke this history really are getting their history wrong. But let's put that to the side for the time being. A question I have is, why is this receiving so much attention now? Why are all these politicians, central bankers, academics, getting worked up and excited about stablecoins now?

Why are Stablecoins and CBDCs Presently in Vogue?

White: That's a good question. As I suggested earlier, there has been some concern about the Facebook plan to launch a stablecoin, but the volume of stablecoins in circulation has grown. That may be part of the reason, but it also seems to be linked to the debate over central bank digital currency. So some people have said, not without reason, that stablecoins do everything a central bank digital currency is supposed to do, but they do it more efficiently and without involving the federal government or the federal taxpayer. And so, often the criticism of stablecoins has been joined to a plea that, "Well, once we get rid of stablecoins, we can provide central bank digital currency to give the same kind of easy transaction system."

White: And I believe Jerome Powell said, "We wouldn't need stablecoins if we had a central bank digital currency", which says to me that he doesn't appreciate just exactly what stablecoins are useful for. They're used by people who don't want to use the legacy banking system and payment rails. But you're right about this association with free banking and free banking with Wildcat banking. So the message by Lael Brainard and by Gorton and Zhang, is boo for stablecoins and hurray for central bank digital currency.

Beckworth: Yeah. And we'll come back, as I mentioned, to the history, but there's a strong case to be made that they're making some false comparisons there. But I want to go back to this point you just made about central bank digital currency maybe being part of the reason why people are getting so interested in stablecoins. And I've interviewed several people on the show before. I had Augustine Karstens recently, the BIS came out with the reports. I know you were a big fan of that particular episode, Larry. But we talked about central bank digital currency. And I ask them this question that I'll ask you, why are we talking about central bank digital currency so much?

Beckworth: So let's take it to that level. Is this a case of central banks responding to the demand for something like a central bank digital currency? Or is this kind of the field of dreams, “build and they will come” and use a central bank digital currency? Where do you see the forces coming from, that have pushed this interest in central bank digital currency?

White: If I were going to give a psychological explanation, I would say it's, central bankers have a fear of missing out on the latest payment technology. And they seem to overlook that they're not really up to speed on providing retail payments. That's not their strong suit. That's not their advantage. It's not what they're accustomed to doing. Central banks provide wholesale payments, clearing and settlement. They have a few thousand customers. They don't have millions of customers. And at least in the form of a central bank digital, so-called currency, where it's really an account balance, not a currency, where everybody has an account balance on the Fed's books, I don't think they realize what that would entail. I don't think they would realize exactly what they're taking on. Now, sometimes they say, "Well, we'll farm that, the retail part out to commercial banks." And then you're left wondering, "Well, what are you doing that's any different from what you're doing now?” Because then you're only handling the interbank part of it.

Central bankers have a fear of missing out on the latest payment technology. And they seem to overlook that they're not really up to speed on providing retail payments. That's not their strong suit. That's not their advantage. It's not what they're accustomed to doing.

Beckworth: Right. You're back to where you started. So that is a question I've had too. And I want to come back to that in a minute. But let me read to you an exchange between Senator Elizabeth Warren and Lev Menand, who's a professor of law at Columbia. Now, Lev Menand is a friend of the show. He's been on here before, had some great things to discuss regarding the Fed’s facilities last year during the pandemic. But he's going to take the opposite side of you, Larry. But I'm going to read the exchange here, kind of get our conversation going a little bit more on why exactly we need stablecoins. So here's Senator Warren during this hearing on June 9th in the Senate. And she says, "Most people are holding Bitcoin as a speculative investment, a way to make money rather than a substitute for money as a way to buy this week's groceries or to pay their babysitter."

White: Fair enough.

Beckworth: And she goes on to say, "Now, the crypto industry knows about this problem. So they've come up with so-called stablecoins. And I think we've heard a couple of references to that already today. This is the kind of cryptocurrency that claims to be pegged to the value of a fixed asset like the dollar. Professor Menand, are these so-called stablecoins as safe or reliable and stable as, say, a digital dollar that is issued by the Federal Reserve?" So here's his answer where I want to run this by you. And so Lev says, "No, no, Senator, certainly not. They're much riskier. They are dangerous to both their users and as they grow to the broader financial system.”

Beckworth: “So whereas Bitcoin is something we really haven't seen before, stablecoins are. They're the devil we know just wearing new clothes. They're teched up versions of money market mutual funds in certain respects. They're type of deposit substitute, and deposit substitutes are very unstable because people who issue them don't have bank charters, they don't have deposit insurance, they don't have access to the Fed's discount window. And if people lose confidence in stablecoins there’s a good chance they'll dump them en masse and a sort of classic run dynamic and lead to no financial instability reasons.” So that's the story Lev is sharing here. And I want to use that to kind of flesh this out. So Larry, should we be worried about stablecoins creating all these problems? Are stablecoins just a worst version of a money market fund which we saw had issues in 2020 and 2008?

The Potential Problems with Stablecoins

White: Well, I think we need to distinguish between whether you as an individual, should put your money in stablecoins, and then whether there are some systemic risk created by stablecoins. So people have a point when they say that stablecoins are runnable. They are, they’re debt claims. But runnable doesn't necessarily mean run prone. This worry about runs on stablecoins are hypothetical, that is, we haven't really seen one happen in the way that it's being discussed. There was an incident a few years ago where Tether lost like 12% of its value briefly, and then it bounced back. So it didn't collapse from a heavy withdrawal. So stablecoin issuers are issuing debt claims or quasi debt claims. I think it's probably more accurate not to think of them as operating like a bank, where you bring any small amount you'd like to the counter and you can get cash for it, but rather like central banks operating peg systems.

I think it's probably more accurate not to think of them as operating like a bank, where you bring any small amount you'd like to the counter and you can get cash for it, but rather like central banks operating peg systems.

White: They keep the value close to a dollar, not by making lots of redemptions every day, but by themselves intervening in the market when they see the price going below a dollar or above a dollar. Now, as issuers of that claims, they are rather thinly capitalized. And so I think that is a reason to be concerned if you're a crypto trader and you have $10 million to park somewhere, then you want to shop around for a credible stablecoin. And I believe crypto traders are doing that. And we've been seeing in the last few months especially stablecoin issuers providing more transparency and more of accounting attestations as to what their assets are. And some making a selling point, "We are more regulated than the other ones. We are hooked up with regulated institutions in the way that the other coins aren't."

White: So that kind of competition on credibility dimensions, non-price dimensions, because none of them pay interest, but rather on, "You can believe us that we won't let the value drop", I think that's beginning to go on and I think we need to leave it to the market to determine what's the most effective way to make a stablecoin credible to its users. But at least at present when you and I don't have stablecoins and have no reason to have stablecoins, I don't see there being a big systemic risk. There have been stablecoins that have failed, not anything of the size that Tether and the biggest ones have, but smaller ones that have failed maintain their peg. And there haven't been any spillover effects. People took their money and moved it to somewhere more credible. So an individual stablecoin can fail without the system crumbling.

White: So it's a big leap from saying, there could be a run, to saying, a run is inevitable, to saying that, if there is a run, the whole system crashes. That's a very different proposition and I think it's completely hypothetical and I think not justified. So one thing about stablecoin users is, as I've said, they are people who don't want to use the regular banking system. And so they're going to be reluctant to cash out in a way that will shrink the portfolio of the issuer, that is demand U.S dollars in a bank account in exchange for their stablecoin units. Instead, they're going to sell them on the exchange. And that's not exactly like a run because it doesn't diminish the assets of the stablecoin issuer. But if the price begins to drop, the stablecoin issuer can liquidate its assets, enough of them to destroy stablecoin units, shrink the money supply, in other words, to bring the exchange value back up to a dollar.

White: And that's been what they've been up to as far as I can understand it. So I think there is a disciplinary mechanism that constrains stablecoin issuers from over issuing. And I think market forces are in the process of bringing us greater balance sheet transparency and credibility. What we haven't seen yet, and this sort of brings us back to the comparison to the free banking period, is an emphasis on the ability to absorb asset losses by having adequate capital as the stablecoin issuers that have told us both the value of their assets and of their liabilities have revealed that they have capital of less than 1%. And even though the assets are pretty safe, their money market fund assets, commercial paper, Treasury bills, there could be a drop in their value that would make life difficult, if enough of the holders decided that it was time to cash out. Like I said, that's a hypothetical. But one way to reassure people is to hold more capital.

Beckworth: Right. So just to recap, the concern about stablecoins presenting some kind of systemic risk for the U.S financial system really isn't founded because one, its size is still relatively small, and that means you and I aren't using it. It's not something that's being widely used, either wholesale or retail, it's much smaller, for example, relative to the size of money market funds, which they're often compared to.

Beckworth: So there's just isn't the chance now for that to happen. You also just said that there are disciplinary forces the market's imposing upon them, which should make them more honest. So maybe the most charitable rating then of these concerns is, like we talked about earlier, some kind of future concern that if these stablecoins grow to the size of the money market fund industry, then maybe we would start worrying then. But your point is that there are ways to address this. Fund with more capital. And some of these firms may have the incentive to do that, to kind of make the market feel comfortable and…

White: To stand out from the pack. Yeah.

Beckworth: Yeah. So it's a selling point they could use. So I think we can set aside for now the question of systemic risk, but let's move on to a different critique of stablecoins. And this comes from Governor Lael Brainard. I'm going to quote a little paragraph, one that you cite in your paper. And she says, "Giving network externalities associated with achieving scale and payments, there is a risk that the widespread use of private monies for consumer payments could fragment parts of the U.S payment system.” So the concern here is not about systemic runs, but somehow a breakdown or just some kind of disconnection between one person using bank accounts, one person using stablecoin money." How do you respond to that?

Concerns of Fragmenting the U.S. Payment System

White: Well, I think it's a little silly. First, she's blurring together scale economies and network economies. Those are not the same thing. Scale economies are at the level of the firm and network economies are at the level of the standard. They're network economies when it pays to be on the same standard as more other people. And stablecoins don't change the standard, they're denominated in U.S dollars.

White: So they don't fragment the system in that way any more than your ability to use a debit card issued by JP Morgan Chase or Citibank or Bank of America, fragments the payment system. Those are just different issuers of dollar denominated payment media. And so stablecoins, even if they came down to the consumer level, as Brainard mentioned, they would just be another dollar denominated payment medium. So I don't see any fragmentation there being a reason to be concerned. She seems to be jumping to people paying with Bitcoin, which would be a different medium of account, a different monetary unit.

Stablecoins, even if they came down to the consumer level, as Brainard mentioned, they would just be another dollar denominated payment medium. So I don't see any fragmentation there being a reason to be concerned.

Beckworth: Yeah. So you mentioned this, that really there's no difference between a stablecoin and your bank balance.

White: In terms of the money they're denominated.

Beckworth: Yeah. They're denominated in dollars. They're both digital money. Effectively, it's a Bank of America dollar that I'm using with my debit card versus a stablecoin dollar. They're both ultimately… and they promise to be redeemable in the unit of account, the dollar. So I'm trying to think of the argument. They might say, "Well, but the Bank of America is backed up by the FDIC. It's regulated." All these things. So people will feel more comfortable using a Bank of America dollar than a stablecoin dollar. But I think you could flip the argument on them and say, "Well, a stablecoin dollar is effectively 100% reserve banking, right?

White: Well, I wouldn't say that.

Beckworth: You wouldn't say that. Okay.

White: When people say 100% reserve banking, they mean 100% reserves, not 100% assets against liabilities. So that means 100% cash. And stablecoin issuers do not hold 100% cash. They want to earn some interest. So like any ordinary bank, they have a fractional cash reserve, but they have assets more than enough to buy back their liabilities. And so they're solvent.

Beckworth: They're solvent…  let me put it this way then, is the asset side of a stablecoin’s balance sheet. Is this a consistent, more shorter term liquid assets and, say, a bank, because a bank will often they'll go long, invest in a mortgage or something, a higher yielding security to have that net interest margin. Is it the same business model here or is it less so? Less of a spread therefore, less susceptible to some of these concerns?

White: No, the stablecoin issuers don't make mortgages. They don't make business loans. They hold money market instruments. So as I said before, certificates of deposit, treasuries, commercial paper. And some people have been critical of their balance sheet accounting for not digging into that category and telling us, "Well, who's this commercial paper being issued by and how safe is it?" And so on and so forth. But they are short term liquid assets.

White: So the part that isn't cash can be readily liquidated for cash if the need arises. They're more like, and this comparison has been made by some of their critics, they're more like money market mutual fund portfolios. The money market part of the description means the assets are shorter than one year. And that's what seems to be the case on the balance sheets that we've seen of stablecoin issuers, so that there isn't much interest rate risk. And they're supposed to be AAA rated or above. We're not quite so sure about all the assets on the stablecoin balance sheets in regard to rating, but something that it would be easy to liquidate, to shrink the balance sheet when necessary.

Beckworth: Okay. Let me ask a cynical question here. Since we're talking about banks, what about big banks? They may strongly object to stablecoins for their business reasons. They want to keep out the competition. Do you think there's any pressure, any kind of backdoor influence on some of these objections coming from big banks?

White: Well, I'm not privy to those conversations, but it's an interesting question. I think we should look at any position papers or white papers or statements made by the research departments of the major banks, whether they've taken a stand on this. I know some of them are pretty favorable towards central bank digital currency, so it wouldn't surprise me if they were negative on stablecoins.

Beckworth: Yeah. So it would be interesting to see how this plays out for them. As you mentioned earlier, some central bank officials have said, "Look, we're going to farm out the retail central bank digital currency to the banks." They'll continue to do that, and the central banks will keep the wholesale funding. But it'd be interesting to know what big banks think about stablecoins. Could it be something they could do themselves or would it be competition for them?

The Stablecoin Impact on the Domestic and International Banking System

White: Isn't it something they could do themselves? Well, that's a good question. Would their regulators let them? I suppose they could do it. A bank holding company could have a subsidiary that would be a stablecoin issuer. I'm not sure a regular commercial bank could do it on their balance sheet.

Beckworth: On their balance sheet, yeah. That would present a number of problems, it would seem.

White: The Comptroller of the Currency has all these rules about what kind of liabilities you can issue.

Beckworth: Okay. So, Larry, one thing we mentioned earlier is the possibility of stablecoins emerging overseas. So even if the U.S cracked down on stablecoins, that we're based out of the U.S, made life difficult for users here, it could still flourish overseas somewhere.

White: Some of them are headquartered overseas. Tether is in Hong Kong.

Beckworth: Okay. So it seems to me, this is just, again, another form of what I would call global shadow banking or the global dollar market. And there's several implications flow from that. The first one is that, this would just further expand the reach, the dollar. It would add to the weight of global dollar dominance that exists already.

Beckworth: And I've made the argument many places, many times before, is one of the reasons the U.S government in the U.S and in HOLC has lower interest rate cost is because there's this demand for dollar denominated assets around the world. And stablecoins may just add to that. It may be another way to get demand for dollars around the world satiated. And that indirectly creates seigniorage flowing back into the U.S. Some of it goes to the private sector, some of it goes to maybe firms in Hong Kong who issue dollar liabilities, but some of it will also flow into the U.S Treasury. So that would be a win for the U.S running big budget deficits while we continue to finance them.

White: Yeah. I think that's right. So I think the Fed has been thankfully lenient toward U.S banks operating in offshore markets. And as you say, that generates more dollar banking around the world, and their rebounds toward the global common acceptance of the dollar as a payment medium. And so that's in the interest of the U.S citizens to have a currency that people around the world want to get. And stablecoins can play a role in making dollar balances available to people around the world whose banking systems won't let them have dollar bank accounts, or whose central banks won't let them deal in dollars, because it all takes place online and it's difficult for them to police it. So in the dollarization that's going on now in Venezuela and in Lebanon, the payment system, Zelle, which is made by a consortium of U.S banks has been operating in Venezuela.

I think the Fed has been thankfully lenient toward U.S banks operating in offshore markets. And as you say, that generates more dollar banking around the world, and their rebounds toward the global common acceptance of the dollar as a payment medium. And so that's in the interest of the U.S citizens to have a currency that people around the world want to get.

White: And I don't know to what extent there's been use of stablecoins, denominated in dollars. But potentially, like I said, there's not that much retail use of stablecoins, but potentially it's another vehicle by which people around the world can hold dollar denominated balances. And so, now we are talking about network economies, and it makes it more useful for all of us who use dollars, the more widely we can spend them, the more people around the world there are who will accept them.

Beckworth: Absolutely. No, I'm a big fan of dollar dominance, as listeners of the show will know, but there is a critique of this view. So I've had my friend Lev Menand, I'm going to bring him up again. So Lev, shout out to you. You're helping make this show, buddy. But he makes, I think, a valid argument, raises a concern, I think, that's reasonable.

Beckworth: And that is because you have all these shadow dollar sources around the world, whether it's money market funds overseas, whether it's Euro dollars, whether it's stablecoins, whatever the next iteration of this shadow banking, shadow dollars may take, is that it's runnable. And so we saw last year, for example, that the Federal Reserve stepped in, and whether it had to… I think it had to. I'm going to be supportive. I think it had to step in and open up the spigots for central banks around the world. So they opened up the dollar swap facilities with major central banks around the world. It also opened up a repo facility, allowed foreign governments to trade treasury securities for dollars, but it basically bailed out this global dollar funding market overseas. And so Lev would say, "Well, this isn't right. We shouldn't be having a central bank bailing out all these dollar markets."

White: When you say bail out, you mean they acted as a global lender of last resort to dollar denominated…

Beckworth: Yes. They backstop the markets through the other central banks-

White: Did they lend at a penalty rate?

Beckworth: I believe they did.

White: Well, that's classical central banking theory then. If they didn't, if they're subsidizing and creating more hazard, then I'm against that.

Beckworth: Okay. Well, fair enough. You've heard it straight from the mouth of Larry White. He supports the dollar liquidity facilities as long as they are charged at a penalty rate. And I believe they are. I believe the Fed ... I'll have to double check that.

White: Well, look, I'm not saying I support it, because I don't support having an activist central bank or even a central bank at all if I had my druthers.

Beckworth: Sure. But given the world we live in and given the alternative of like a massive run on dollar funding-

White: I can understand why the Fed would want to avoid that.

Beckworth: Yeah. Very understandable. So let's move then into the history question that we touched on earlier, because one of the arguments made by these individuals, so Gorton and Zhang, Governor Brainard, and of course, Senator Elizabeth Warren, they all invoke the free banking period in the United States as what a disaster stablecoins could become. So Larry, tell us why this comparison is not the right one to make. Do that first, and then secondly, please explain to me why this history is invoked so often. Why do people want to continue to draw upon it?

Responding to Historical Critiques Invoked Against Stablecoins

White: This is an extremely common trope, as the English professors say. My dissertation was on the 19th century debates over whether to have free banking and central banking. And even back in the 19th century, people debating in England would use the United States as an example of what to avoid. “You don't want to have a free banking because you'll get Wildcat banking and panics and runs and all kinds of disasters.” But there are two mistakes there. One is that, what the United States had in the 19th century was not an unregulated banking system. It was in fact, a banking system that was made much weaker by poorly conceived regulations at the state level. The federal government wasn't involved until the civil war. So before the civil war is the so-called free banking period. It was called free banking because various states, a little more than half of them before the war, passed laws that made entry into the banking industry freer.

White: Instead of having to petition the state legislature to get a charter, you just had to meet the requirements of the law, which involved having a minimum capital, but here's the more important thing, holding collateral in a form that the state dictated. And many states used it as a way of selling state debt. So if you want a bank charter and you want to issue bank notes, you have to agree to buy a certain amount of state issued bonds, and they have to be in proportion to the amount of bank notes you want to issue.  Sometimes it was 110% collateralization. Sometimes it was only 100%. But it was a restriction that meant that the bank's portfolios were not very well diversified. They were too heavily invested in state government bonds. And there was another restriction that came with it. It would vary from state to state. And there was no freedom to branch. Nobody could branch across state lines because no state would recognize charters from other states.

White: And in some states, you couldn't even branch outside a single office, so-called unit bank states. And that made banks very poorly diversified because you can't lend to lots of industries if you're only in one town under 19th century technology. So you had a system that was very artificially hampered in its capitalization, in its diversification. And you had these bank notes that kind of had the stamp of approval of the state government, and that made it easier for fly-by-night operations to get bank notes into circulation until the states figured out what they were doing wrong. But some states had very successful experiences with these liberal chartering laws. And some had very terrible experiences like Wisconsin and Minnesota. In Minnesota, they said to a bank, "You can collateralize your bank notes with any state bonds. You don't have to be Minnesota bonds. And you have to have a dollars worth of bonds to issue a dollars worth of bank notes." So the bank said, "Well, what's the cheapest bonds we can buy to back our $1 bank notes?" Turned out to be Missouri.

White: Missouri bonds were trading at a deep discount because it's on the eve of the civil war and there's a lot of risk that Missouri is not going to pay back its bonds during the war. And so they overloaded. They had like… more than half of their assets were Missouri state bonds. And when the war broke out or threatened to break out, the price of Missouri bonds plummeted even more, and it wiped out two thirds or three quarters of the banks in Minnesota. So that was an example of legal restrictions causing the banking system to fail, not Laissez Faire causing the banking system to fail by any means. So the U.S before the civil war is a terrible example of an unregulated banking system. It's a heavily and poorly regulated, perversely regulated banking system. Whereas, if you want a picture of what an unregulated banking system looks like, you should go elsewhere. You should look at Canada, our neighbor to the north. Very similar economy, mostly agricultural.

White: Of course, most of it was located within a few miles of the border. Still is, but no bond collateral restrictions and no branching restrictions. And Canadian banks were run free. Well, that's putting it too strongly. Not run prone. There were a few failures, but there were no panics. The failure of a badly run bank would not spill over into suspicion toward the well-run banks. So banks had established different portfolios and different reputations. In a place like Canada, the reputation that bankers had in the 19th century was not that they were wild risk-takers, but that they were too conservative. That was the main complaint. The old joke was they won't lend you money unless you don't need it. But they were very conservative because they had to be conservative to attract deposits in competition with other conservative banks in an environment where they didn't have deposit insurance. But what they did have was a lot of capital.

White: And U.S banks before deposit insurance, typically had 20% capital. Of course, after deposit insurance, they hold as little as they can get away with. The system I've written the most about is the Scottish banking system in the 19th century. And in the debate over whether to have central banking or free banking in England, that was the example used by the people in favor of greater freedom of banking of letting banks branch, letting banks capitalize as much as they would like so that they can diversify and not be failure prone. So to think that any bank, anytime, anywhere, without deposit insurance is on the verge of collapsing because of bank runs, it just betrays a terrible ignorance of the scope of banking history. But that's the kind of slight of hand that's being performed by Governor Brainard and Senator Warren, and regrettably, because he knows better, by Gary Gorton and his coauthor Jeffery Zhang. I know Gorton knows better because he reviewed my dissertation when it came out as a book. He wrote an essay review in the Journal of Monetary Economics, and it was fairly even handed.

To think that any bank, anytime, anywhere, without deposit insurance is on the verge of collapsing because of bank runs, it just betrays a terrible ignorance of the scope of banking history.

White: So he understood the argument and he knew that free banking succeeded in Scotland. And presumably he knew that it succeeded in other places, Canada, Sweden, Switzerland. So it's just a misconception that unregulated banking means Wildcat banking and runs and panics. That's not what the historical record shows. The relatively less regulated banking systems were more stable than systems that were perversely regulated like the U.S and like the English banking system, where there was a limit on the number of investors a bank could have. So the banks were chronically under capitalized. So don't confuse what was called free banking in the U.S for minimally regulated banking. That's the first mistake. And don't ignore successful less regulated banking systems like Canada, Scotland, Sweden, Switzerland. That's the second mistake I see in this literature.

Beckworth: Well, that's a great review of this issue. And I think it's worth pointing out, Larry, that this is fairly well understood in the literature. You pick up any kind of economic history journal article on this issue, they understand this more nuanced point. They take this seriously. I remember in grad school reading articles on this as part of one of my classes, and they highlight, for example, in the case of the U.S that some states did really well, some did poorly, and it was tied to how well the institution of banking was set up.

White: Yeah. There's a large literature, Hugh Rockoff was a pioneer in this, and Rolnick and Weber had several articles about it. And the puzzle was, why was so-called free banking successful in New York and some other states and led to bad results, either fly-by-night banking, so-called Wildcat banking, in a couple of states.

Beckworth: Yeah. So I'll encourage listeners to check it out.

White: And so they were teasing out how the regulations inadvertently caused these poor results, where there were poor results.

Beckworth: Yeah. So this is a good history here, and there's another question and we don't have time to get into, but it's the whole question of why was the U.S so messed up in its banking laws in those cases where things did turn out badly? And why was Canada so much more successful in the design of banking? And I know there's been work done pointing towards federalism playing a big role in that, and people wanting to protect their profits in their hometown.

White: Yeah. Rent seeking by local banks.

Beckworth: Yeah. Rent seeking by local banks. But that's another discussion for another time. So one more thing, Larry, I want to bring up about this discussion and something you bring up in your article is that even if we look at the best case of unregulated banking, bank notes during this period, it's still not the right comparison. You say stablecoins really aren't bank notes in the sense that they were issued back during this time, is that right?

White: Well, they are debt claims and they do circulate, but they're not like bank notes in the sense that they're not half of the banking system’s liability, is the way bank notes were, and they're not handled by ordinary people as an everyday medium of exchange. They're pretty much limited to specialized traders.

Beckworth: Okay. So that goes back to the earlier points where you were saying about the limited use of stablecoins. So Larry, all of this discussion about stablecoins, we've been kind of circling around this other topic, money market mutual funds, which are very similar. I've heard one person say, stablecoins are the children or the offspring of money market funds. That your grandparent's stablecoin was a money market fund came out of the 1970s. So we had some challenges with money market funds, which is, I think, one of the reasons that people getting worried or nervous about stablecoins. And this is just another version of a money market fund. Look what happened in 2008. Look what happened in March 2020. So how would you respond to those concerns?

Stablecoins as the New Money Market Mutual Funds

White: That's a good question. And you're right. Gorton and Zhang make that argument. They say Tether, especially they think is very much like a money market mutual fund. They leave out the word mutual, which I guess has become the trend, but I think it's important because it emphasizes that they issue shares, which are equity claims. They are not banks, they don't issue debt claims. They don't intermediate debt into debt. They intermediate equity into debt. But Gorton and Zhang want to make that comparison because they think that money market mutual funds are also susceptible to runs. And their piece of evidence on that is, as what you mentioned, they run on a single money market fund. I shouldn't say run on a single fund. Collapse of a single fund due to a run. There were heavy withdrawals from other funds but they all survived.

White: So the one that failed was called the reserve primary fund. And I've written about this on the Alt-M blog because it was a puzzle to me. I had learned from Hugh McCulloch in particular, that mutual funds are not susceptible to runs because there is no me first problem. There's no problem of the claims exceeding the value of the assets because the value of the assets is scaled down by losses. So too are the claims, because the claims are defined not as $10 but as one nth of the entire portfolio. So as portfolio strengthens in value, so do the claims. That's what makes it a mutual fund. So how could there have been a run on a money market mutual fund? So I had to dig into that, and two long Alt-M blog essays. So what happened to the reserve primary fund was that they held some Lehman Brothers paper. And when Lehman Brothers failed, this was a shock. And the Lehman Brothers' paper was marked down 20%. I guess that's some kind of conventional rule. But Lehman Brothers paper was about 1% of their assets.

White: So now instead of having 100 cents on the dollar, they now have 99.8 cents per dollar of claims. Well, why didn't they mark the claims down? It was an accounting convention among many money market mutual funds to, instead of having the share price vary and a fixed number of shares, that's the traditional structure, to have a fixed share price of $1 to make it look more like a bank account, I guess, to make it more natural to write checks on it, and let the number of shares vary as the portfolio varies. And that works fine in the upward direction, but the funds were somehow reluctant or maybe this was part of the contract, I'm not sure. They were reluctant to withdraw shares when the value of the portfolio fell below 100 cents on the dollar. So that's known as breaking the buck. And reserve primary after a day and a half, did break the buck. But in the meantime, they had assets that were worth 99.8 cents and claims that were worth a dollar. And the shareholders said, "Well, there isn't enough to go around."

White: So the big shareholders, quite rationally, got out while the getting was good and they got a dollar on their shares until the withdrawals were so heavy that the bank that was processing these payments said, "No more." Now, why hadn't this happened before? Well there hadn't been a shock like the Lehman Brothers failure, but more importantly, other money market mutual funds, when they had suffered similar shocks, or shocks that meant that they had negative equity, had gotten an infusion of equity from their parent companies. And so it was kind of an implicit part of the arrangement that they were backstopped by the parent company. They would inject capital as necessary to keep the share price from going below a dollar. A reserve primary didn't do that. And so for a while, it was rational for the shareholders to liquidate their shares. When the redemption stopped, there were some people left inside the fund and they closed down the whole operation and liquidated it.

White: So they sold off all the assets. The shareholders ended up getting about 99 cents on the dollar. So it wasn't a big haircut that they ended up taking. But if they had either broken the buck immediately or injected capital, then there wouldn't have been a run, but they delayed. So that's the one example. Gary Gorton by the way, was on Jim Cramer's Mad Money show last week. I don't know if you saw that?

White: [He was] talking about his paper. And Jim Cramer asked him, I wrote this down. Jim Cramer said, "When I think of Tether and what they may or may not own, they seem a likely one to break the buck if things turn bad for Bitcoin." So Cramer seemed to think that Tether invests in Bitcoin, that's part of their asset portfolio. And if the price goes down, they're in trouble. And it may be that they used to do that. There have been allegations that they used to print Tethers and buy Bitcoin to try to prop up the price of Bitcoin. But according to the statement, they were required to furnish for the New York regulators, they now have non crypto assets backing their dollar liabilities one for one. So Tether is owned by a parent company and the parent company may invest in Bitcoin, but on Tether's balance sheet, there's no Bitcoin according to these accounting statements. So a drop in the price of Bitcoin doesn't affect the solvency of Tether.

White: So the message I'm getting here is that money market mutual funds are not inherently failure prone provided they mark their claims to market immediately or inject capital as necessary. They didn't have to do that in 2008, because there was a practice allowed by the regulators, or encouraged even, called penny rounding. So if you were at 99.8 cents, well, we round that up to a dollar, and you can go on claiming that the shares are worth a dollar without reducing the number of shares. And the shareholders saw that that was not sustainable.

The message I'm getting here is that money market mutual funds are not inherently failure prone provided they mark their claims to market immediately or inject capital as necessary.

Beckworth: Now, Larry, there were a number of reforms that came out of that crisis in 2008, the SEC, FSOC, they came in and made prime money market funds use these floating net asset values to doing exactly what you suggested would be important. So that was helpful for prime money market funds. It was a nice first step. But they also proposed and initiated some other reforms that you and many others were worried about.  And these spheres came to fruition last year in March of 2020, but they imposed this 30% minimum liquidity ratio. And if it was breached, then the funds could restrict redemptions, and they call these redemption gates. And my understanding is, this itself creates fear because you know that this redemption gate might be imposed, you better be the first one in to get your funds out. Is that right?

The Imposition of Redemption Gates

White: Yeah, that's right. So what happened in 2020 was there were large withdrawals from money market mutual funds and from ETFs, where investors were, because of the coronavirus, began worrying about corporate defaults. And so they were worried about the default risk on the assets that the commercial paper and commercial IOUs that money market mutual funds held. So they were moving out of private debt and into Treasury bonds. These weren't runs based on worry about the insolvency. Well, so I guess these withdrawals were due to a concern about what the defaults by corporations might do to the solvency of mutual funds. But if a fund promptly adjusts the net asset value, then there's no reason to beat the crowd if the value of your share goes down, as soon as the asset falls in value due to defaults or what else, and it's too late for you to withdraw.

White: Anyway, a mutual fund that only issues equity shares and doesn't have fixed dollar shares can't become insolvent because the total claims can exceed the total assets. And you can still have this $1 share price if you have a provision. And I believe some European funds now have these provisions, that the fund can subtract shares from your account. It's the equivalent of marking down the floating net asset value. So if you had $500 worth of shares and it goes down to 490, we can either mark each share down from 50 cents to 49 cents, or we can subtract 10 of your shares at a dollar each, same thing. So when these withdrawals happen, then the mutual funds started selling off their more liquid assets, and then investors began to worry that the gates were being approached. So they could if they stayed in the fund, be stuck, not allowed to withdraw or not allowed to withdraw without paying some kind of a fee.

White: So that's what at least in part, prompted to the continued outflows, not just they're concerned about losses to defaults by corporate borrowers. So the Federal Reserve stepped in to provide funding, that is to buy up the assets that the mutual funds were selling, but not so much because they were having solvency runs, but because of this liquidity threshold. If any fund actually imposed gates or started imposing fees on withdrawals, they could imagine what would happen at other funds that were in a similar situation. So it seems to me, putting in the gates made things worse rather than better. And the more elegant solution is either floating net asset value or eliminating penny rounding, and allow a contractual share reduction mechanism that has the same effect as a floating net asset value.

It seems to me, putting in the gates made things worse rather than better. And the more elegant solution is either floating net asset value or eliminating penny rounding, and allow a contractual share reduction mechanism that has the same effect as a floating net asset value.

Beckworth: Yeah. I'll mention that there's been a number of proposals since this time last year when we had this run on money market funds in March 2020. There's been the president's working group, December 2020, so end of last year. They had 10 reforms. The FSB had a paper come out just in June of this year. And the Brookings Institute had a paper come out this month in July on ways to reform them.

Beckworth: A lot of them have similar suggestions. And I'm going to run just three of them by you. One of them you alluded to earlier. So I'm not going to go through all 10, for example, from the president's working group. But one of the first ones that always comes up is just some kind of capital buffer. And you mentioned that the money market funds had, before 2008, an implicit understanding of the equities put into the company by their parent company if push came to shove. So that's one of their proposed reforms. What do you think of that? Should money market funds fund with some portion of capital? Because you often hear this said, money market funds are banks without capital. So how do you respond to that?

Responding to Suggestions for Reform

White: Yeah. Money market funds are not banks, because they don't issue debt claims, they issue equity claims. So if you take out penny rounding and compel honest accounting, you have to either have a floating net asset value or share subtraction from accounts. But if you do that, you don't need a capital buffer because it's all funded by equity. It's all capital. They have no liabilities, only capital. So that distinction between shares and debt claims ought to be clear. So it's a problem if you try to maintain the fiction that the share price is a dollar, and either can't be adjusted downward or shares can't be subtracted, especially in an environment where mutual funds are no longer earning much interest. You can't count on the accruing interest to outweigh any capital losses when there isn't much interest income.

Beckworth: Okay. Fair enough. The other two suggestions I'm going to bring up here, and again, there's 10, and I encourage listeners to go look at all of them, but one would be to establish a minimum balance at risk. So this would say your ability to get redemptions will be delayed a certain amount of time on a certain percent of your assets. So if there is this panic period, and those who would try to redeem first will bear most of those first losses.

Beckworth: So you couldn't redeem a certain fraction of your assets. That's the minimum balance of risk. And then finally swing pricing. The idea behind swing pricing is that the increased transaction costs during these panic periods would be passed on to the investors trying to redeem their funds. So they effectively would be taking a hit during this period. So any thoughts on those two proposals that seem to be pretty popular.

White: It sounds to me like both of those proposals make money market mutual funds a less attractive investment vehicle. And so they're going to shrink the money market mutual fund industry for the sake of saving it, which seems kind of perverse. Now, contractual option clauses can be a good idea. So we have examples from the free banking period in Scotland, of banks that in order to prevent other banks from attacking them with embarrassing large redemptions, put a clause in their notes that said, "We will repay the bearer on demand 10 pounds or at the option of the bank directors, six months from today with interest." So they could invoke this clause if another bank was trying to embarrass them, but they didn't invoke it against ordinary customers. One, because it's bad for business, and two, because it costs them interest to do so.

It sounds to me like both of those proposals make money market mutual funds a less attractive investment vehicle. And so they're going to shrink the money market mutual fund industry for the sake of saving it, which seems kind of perverse.

White: So it was an incentive compatible clause. So that was a clever contractual design. I do not trust regulators to come up with clever contractual designs. Firms have to do it and then test them in the marketplace, and then we find out which of these clever contractual designs actually make the customers better off and are accepted by the customers who say, "Well, I like that because it means other people can't empty out the bank or the mutual fund ahead of me, leaving me holding the bag and getting less than 100 cents on the dollar." That's the test that these designs have to pass before they'll be used by any firm that has to attract customers. And that's the test that they ought to have to pass. So imposing them from the top down seems to me that the regulators are confusing the job of making sure the accounting is honest and prosecuting fraud, with the job of being entrepreneurs designing contracts.

Beckworth: Okay. Well, with that, our time is up. Our guest today has been Larry White. Larry, thank you so much for coming on the show.

White: Oh, my pleasure.

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