Daniela Gabor on Financial Globalization, Capital Controls, and the Critical Macrofinance Framework

Daniela Gabor is a professor of economics and macrofinance at the University of West England at Bristol, where she works on shadow banking, capital markets, and transnational banking. Daniela is also a returning guest to the podcast, and she has a new paper out on the burgeoning field of critical macrofinance and how it sheds light on the past great financial crisis (2007-2009) and the present COVID-19 crisis. She re-joins Macro Musings to discuss this paper and how it can offer important insight into the current global economic environment.

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:  Daniela, welcome back to the show.

Daniela Gabor: Hi David. Thank you for inviting me again. A pleasure.

David:  Oh, it's great to get you back on. Now on our previous show, and I encourage listeners to go back and listen if they haven't already. But on the previous show, we talked about safe assets shortages, the possibility of a safe asset for the Eurozone, a truly safe asset there; shadow banking, money, repos, very fun conversation. And you were very excited about this. And if people follow you on Twitter, they'll know that you're very engaged in this area. And today we'll touch on some of those again, but we'll do it through the lens of the COVID-19 crisis in this paper you have. So I'm happy to get you back on. I'm just curious though, Daniela, how are you doing over there in the UK? How are you holding up during this crisis?

Daniela: We're okay. We're hoping to get the lockdown lifted as we have less casualties. It's a very long process marked by a lot of institutional incapacity, but I'm sure you know about that.

David:  Everywhere. Right. Right. I think there is a lack of capacity, both the public health side, as well as the economic side. I think no one really planned for this properly, but few foresaw it happening as well. And hopefully, that does get better soon. I'm just wondering over there though, in the UK, I don't have a sense of what's happening. Are universities going to open up their facilities? There's still going to be online learning? What's it like where you work?

Daniela: I am locked out of my office for a good while I suppose. We are talking about the going back in September and depending on whether we get the second wave or not, and it's a digital first approach or an online first approach, and with some face to face interaction. So still a lot of disruption in the university system here.

David:  Okay. Well, very similar to what we have here. People are hopeful that schools will open up again, both for professors, students, and as a parent myself. I have children too. Hopefully things will be better, safer. We can get back to some sense of normalcy in our education system.              

David:  Well today, though, we want to talk about what's happened this crisis and use your critical macrofinance framework to examine it. And I want to get into your paper because your paper has a nice summary of this field. And this field, as I understand it, brings together a number of different views and synthesizes a nice systematic way to think about macroeconomic financial issues from a global perspective. Before we jump into that though, I just want to walk with you through what's happened, some of the big contours of the crisis and get your take on what's happened. Whether the policy responses were appropriate or not, and maybe some lessons learned already this far into the event.

David: So let me start with going back to March. So in March, one of the big things that happened Daniela, as you know, is the treasury market nearly tumbled. It nearly imploded. This supposedly safe haven market. The market of markets had real problems, not because the US government couldn't finance its deficits, but because of plumbing, technical issues, having a hard time clearing, and the Fed had to step in, in a major way, and started buying a trillion dollars daily in repo. Did QE again, over a trillion dollars. Some of the bank regs were relaxed, so broker dealer balance sheets could open up. But it's a pretty surprising development to see the treasury market of all markets have such challenges. Were you surprised or did you see this coming?

Daniela: To be honest, I was surprised. If your listeners recall the conversation we had around safe assets, a couple of years back, the reason the safe asset literature assumption that at least one country, the country that sits at the top of the global hierarchy, dominated by the US dollar, would be able to issue a safe asset by definition, simply because during crisis and crisis of market based finance, financial institutions run to the safest asset in the world, that's perceived to be the safest asset, which is a public asset issued by the US Treasury.

Daniela: So I was quite surprised to see that nothing is really safe. My understanding of that particular moment was that highly leveraged financial institutions, hedge funds in particular, were having to meet margin calls and these sort of dynamics of the plumbing threatened the US Treasury market in a similar way in which the dynamics of the European plumbing, the repo markets in Europe, threatened and disrupted quite significantly government bond markets of several large countries during the 2009, up to 2012, European sovereign debt crisis.

David:  Yeah, so it's pretty surprising. I think all of us were surprised. I think the Federal Reserve was surprised and stepped in so aggressively because it was so worried and shocked by what happened. Last week's episode, I had Darrell Duffie on and he has a paper where he walks through what he thinks are some proposals to reform the treasury market. And particularly, he wants to see more central clearing in the treasury market. So he mentions a lot of the inter-dealer trades are already done with central clearing facilities, but he wants to extend it to all the counterparties, including the hedge funds you mentioned, as well as pension companies, life insurance companies, anyone who's in that market for treasuries. He thinks it would be more effective to have some kind of central clearing mechanism so that you avoid these technical issues. I mean, the treasury market is, like you said, key. Your hierarchy, we'll come back to. I mean, it's central, right? You got to have that market working for the other ones to function. But what do you think about that? You think there's a place for using more central clearing in the treasury market, or do you see any challenges in taking that approach?

Central Clearing Usage in the Treasury Market

Daniela: Thank you, that's a really interesting question. I'm not quite sure that I have a straightforward yes or no answer. And in the paper that you're going that we're going to discuss in this paper on critical macrofinance, I make reference to the question of introducing CCPs in the US financial system. I mean, we already have some form of a CCP there, but the question to my mind is how does the move towards central clearing, how would it really interact with the conduct of monetary policy and with the transmission mechanism? And does it create new types of systemic actors that we don't understand very well? The Financial Stability Board has a work stream on CCPs. It thinks of them as global systemic financial institutions. In Europe, several CCPs have direct access to central banks. Yet, I think through this critical macrofinance lens, we need to think more carefully about the systemic implications of concentrating a lot of the repo market on the balance sheet of one or two systemic actors.

I think through this critical macrofinance lens, we need to think more carefully about the systemic implications of concentrating a lot of the repo market on the balance sheet of one or two systemic actors.

David:  Now, that's a good point. And that's something that I brought up with Darrell too. And I think that's also critique, Daniela, of the derivative swap CCPs. Out of the last crisis, there was a big move to take these swaps and put them on the central clearing facilities, which makes it more transparent. You can see what's going on. It's easier for regulators to get in there, but it concentrates all this risk on one note in the financial system or several notes, depending how many central clearing facilities you have. So there's tradeoffs, right?

Daniela: There are tradeoffs. There is a real interesting paper by Taylor Spears where he discusses how the move towards CCPs in the derivatives market creates very interesting and sometimes puzzling dynamics of collateral valuation. The interaction between collateral valuation and derivatives pricing is I think understudied and we don't understand it very well. And what is also important is that its subjects more and more financial institutions to what Marshall and Steigerwald called the time critical liquidity, the idea that you have to deliver a particular type of collateral in a particular currency within the space of minutes or hours or days. So within a very short time period, and we don't understand the time critical liquidity and the management of that time critical liquidity very well either.

David:  Yeah. Well, I appreciate your humility and your sense of caution before we take this big leap and it's something pretty radically different for the Treasury market. And I think in the past, you've expressed concern of the existing framework. It's not that you don't question it, right? You're fairly critical of the whole repo financing framework. Is that fair?

Daniela: I would say that we have moved towards a repo financing framework within a broader evolutionary change in global finance, towards what I call... Not me, but what several others call market-based finance or financial systems organized around securities markets, repo and derivative markets. And more recently, ETFs. And the question that I have there is if we move towards market-based finance, do we have to think about the marginal institutional changes like the production of central clearing? Or do we have to think seriously about structural change? Are we happy with the system that we have? Does it produce the sort of private credit creation that works for the real economy or does it produce systemic vulnerabilities and does it skew the balance of political powers towards private finance in ways which to my mind raise significant questions of democratic accountability of the credit allocation? And of course, of providing backstops to private finance through the balance sheet of both central banks or mainly central banks, but also the Treasury or fiscal authorities.

David:  Those are all great points. I think important ones, the democratic accountability, backstopping. There's questions of equity here. It's a convoluted mess, to be honest, when I look at this. But let me go back to March. So one way you could summarize what happened is that the broker dealer balance sheets couldn't handle the sudden demand for liquidating all these treasuries.

David:  As Darrell Duffie says, he goes, look, the growth in the amount of public debt the US Treasury supply has grown so much and broker dealer balance sheets didn't keep up with that. They couldn't keep up with that, all the new regulations. So you came to this point, there was this tension, this breaking point in March, and there's two ways you can look at that. You could say, oh, there's too much US debt on one hand. Or alternatively, you can say there's something wrong with the plumbing that we're relying on broker dealer balance sheets, and it's not where it should be. And I think you would probably come down more on the side of the there's something wrong with the system, the plumbing that needs to be refined. Is that right?

Daniela: Yeah, I'm sort of reminded with a smile of the arguments about shortages of safe assets that we had pre-COVID. And it's interesting that the shortage of safe assets can very quickly morph into arguments that are excessive safe assets in the system, right? So I'm not quite sure that we have the analytical tools to ascribe the problem to an excessive issuance of public debt. I think it's much more interesting to my mind to think analytically through the structures of the system and whether those structures are creating systemic vulnerabilities that we cannot get away from.

David:  Yeah, no. And I think that's a great point and one that I want to stress here is that just because there's technical problems in the market for safe assets doesn't mean the broader demand isn't there. It still is, the fact that 10 year Treasury yields are still really, really low. I was looking at the ECB's yield curve, much of it is still negative, below 0%, right? There's still a huge demand. And despite the fact that the Fed has bought up so much, the US deficits have gone up so much, we still have low inflation, low interest rates. That all to me screams there's still this safe asset shortage and we shouldn't miss the forest for the trees here. We shouldn't confuse a technical problem. We saw in March, we saw some of it last year in the repo market, and confuse that with the broader demand.

David:  So I'm very sympathetic to your thoughts there. Let me move on to something else that the Fed did. So the Fed really stepped up to the plate and made a big effort to relieve the pressures in the treasury market. And we'll have to figure out ways to maybe improve it, so it doesn't happen next time. But I think that that was part of a broader attempt to address liquidity concerns. So intervene at the repos, treasuries, did QE, but it also opened up its facilities from 2008. So the primary dealer credit facility, the commercial paper facility, the money market funding liquidity facility, all these facilities to kind of backstop or help out the shadow banking area, where you spend a lot of your time. And my understanding of it is that what the Fed's doing there is what it does for traditional banks, like the discount window.

David:  But shadow banking, and normally can't reach into shadow banking, but under 13(3) of the Federal Reserve Act, it's able to do so in a crisis that stepped in and it helped out. And one of the other facilities that it brought back is this dollar swap lines and it also introduced of course this new repo facility, this foreign international monetary authorities, this FIMA facility. But what I see, though, is this shadow banking tension, again, this issue that came up in 2008. And I'm wondering, what were you thinking when the Fed had opened up all these facilities again? What thoughts crossed your mind?

Shadow Banking and the Fed's Recent Facilities 

Daniela: Well, I for one was in a sense... I had been wondering, and there was some speculation before the COVID crisis. There was some speculation of what would happen in the dollar dominated global financial system, if there was suddenly a tightening of financing conditions in dollar markets, both onshore and offshore under a Donald Trump presidency, because there was a potential scenario under which Trump would say, “Well, I don’t think I would like to see the Fed providing unlimited liquidity to official counter parties in Europe, for example, or in Canada. I don't like this idea of backstopping the entire global financial system through official swaps.” And the Fed actions in that sense, the Fed acted very quickly. It acted to prop up the dollar financial system, and that was a necessary step.

Daniela: In the paper, I talk about the importance of thinking about the Americanization of both the global financial system and of national financial systems, where you have the same kind of plumbing of securities markets that you have in the US, you have it reproduced in various other jurisdictions. And I also talk about the structural power of the US, which is something that comes from the international political economy literature. And to preserve the structural power of the US, you have to preserve the dominant position of the US dollar. And the Federal Reserve did exactly that by saying central banks come to me, I will provide you with dollar liquidity. It effectively made sure that it replaced the private dollar financing markets with what we call, in Europe, the bazooka of central banks, who were able to produce the liquidity in their own currency in an unlimited way.

David:  Yeah, that's interesting. You raised the point about Donald Trump potentially getting involved in this. That's your concern, right? That Donald Trump might wake up on the wrong side of the bed one morning and say, hey, I don't like Germany or the ECB getting these dollar swap lines because they irritated me with something they said last week.

Daniela: It's ugly.

David:  That's your concern? Interesting. I think that's a fair concern with what we've seen. But it was interesting that, when I had Adam Tooze on the show, he also shared a similar concern, slightly different. His concern though is that it would be abused. So, like there was a Bloomberg article that Turkey was wanting to get access to the dollar swap lines. Turkey was wondering, why don't we have a dollar swap line with our central bank? And Adam Tooze was like, whew, kind of having a sigh of relief that president Trump didn't push for Turkey to get that dollar swap line. So, there's all kinds of room for mischief and problems with something as powerful as these dollar swap lines that the Federal Reserve has.

Daniela: Well, I'm not quite sure that I share Adam's concern, if that's a concern, about what is the geopolitics of official access to the Fed's balance sheet from abroad. I think it's very clear in some ways that the Fed didn't have a choice not to backstop the European financial system, because it's so deeply rooted and connected to the U.S. financial system.

Daniela: Turkey raises very interesting and very different kinds of geopolitical questions. But, in a sense, the fact that the Federal Reserve was prepared to at least offer a repo facility for countries who have portfolios of U.S. treasuries to be able to borrow from official financing lines to my mind suggests that there has been a hierarchy of official access. This is also interesting in terms of thinking through a critical macrofinance perspective about hierarchies of money and hierarchies of balance sheets or hierarchies of liabilities. It's an interesting question to think through, the hierarchies of official access, because it's one thing to swap your own currency that you as a central bank can produce without any limits for U.S. dollars. And it's another thing to be able to borrow against your portfolio of U.S. treasuries, U.S. dollars. It's a differentiated access and some are more privileged than others, for sure.

It's an interesting question to think through, the hierarchies of official access, because it's one thing to swap your own currency that you as a central bank can produce without any limits for U.S. dollars. And it's another thing to be able to borrow against your portfolio of U.S. treasuries, U.S. dollars. It's a differentiated access and some are more privileged than others.

David:  Yeah. Now, I may be getting ahead of myself here, this is really getting into your paper. But I want to raise this point you just alluded to. And that is, when the Fed reintroduced these dollar swap facilities, it introduced this repo facility for central banks as well. I mean, it really opened up its balance sheet to many, many other central banks out there. Right?

Daniela: Yep.

David:  And, as you mentioned, doing so further entrenched the power of the dollar. Right? The reach of the dollar, the incentive to maintain using the dollar, right? So, if I'm overseas, if I'm an insurance company overseas, if I'm a big institutional investor overseas, I now have seen these facilities used twice. And it should reassure me, right, that it's, push comes to shove, the Fed will be there. So, on the margin, at least, and I'm not making a real strong moral hazard story. What I am saying though is that it definitely reinforces the existing framework, the existing structure. And, maybe on the margin, makes you more comfortable doing deals, loans, financing in dollar terms. And one of the points I think you're you raising your paper, right, is this kind of structure, this influenced the U.S. has. Is that fair?

Daniela: Yes.

David:  Okay.

Daniela: I would say that, in a sense, I mean, I don't know how you want to proceed in terms of talking about the paper. But the paper argues or starts from this analytical observation that we, for the last 30 to 40 years, we live in a U.S. dominated financial globalization. And, because we live in this U.S. dominated financial globalization to my mind, the U.S. Federal Reserve is willing to help other countries de-risk, in this case, exchange rates, right? Because one of the reassuring facts for the kind of institutional investors you refer to is to know that the central bank of the country where you hold some local currency bonds is not going to expose you or is it going to do its best to de-risk the exchange rate in order to protect you from a depreciation that would eat into your local currency position.

David:  Yeah. So, let's go ahead and start your paper then. So, I'll mention its name again. It's titled, *Critical Macro Finance: A Theoretical Lens.* And you list four propositions. And you've touched on the first one, but I'll repeat it as well. So, proposition one, again, this is a framework for thinking about the global monetary financial system. But proposition one is, U.S. led financial capitalism has evolved around market based finance anchored in changing practices for producing liquidity. So, we've touched on this already, but maybe define for us what is U.S. led financial capitalism? And how has it evolved?

The Definition and Evolution of American Financial Capitalism

Daniela: Okay. So, when I think about financial capitalism or financial globalization, I think about financial systems that are globally interconnected on the balance sheet of global financial institutions that are systemically relevant, either global banks, or global asset managers, or global institutional investors. This market based financial system is increasingly organized around securities market with a very distinctive type of plumbing in derivatives and repo markets. Right?

David:  Yeah.

Daniela: And I'm arguing that it's U.S. led in the sense that the U.S. dollar is the most important funding currency. It's a dollar based global financial system. And it's evolved historically since the 1970s through processes of evolutionary changes in finance. And this is where the microfinance goes back to insights from Hyman Minsky, who argued that, in order to understand, or to approach analytically the effectiveness of monetary policy, for example, you have to start by looking at financial structure and changes in financial structure. And this is the starting analytical point of critical macro finance. So, if we look sort of in broad terms over the last 40 years, we have had an increasingly globalized financial system. And we have had, hand in hand with that, what I call an Americanization of a local financial system. That is an export of the U.S. model of financial capitalism with evolving liquidity practices first to Europe, and then to countries across the world.

I'm arguing that it's U.S. led in the sense that the U.S. dollar is the most important funding currency. It's a dollar based global financial system.

David:  Yeah. And you note in your paper, there's a literature from International Political Economy that has looked at this from a kind of a structural perspective that the structure of the world is set up to empower, to favor the U.S. But your approach, if I understand correctly, looks at this more from a kind of a gradual process that evolves, as you mentioned. How the demand for liquidity has evolved in conjunction with existing frameworks. Right? So, it's a more gradual process.

David:  And, I guess, just to expand on that, I mean, when I think of globalization, I mean, it's going to require financing. Right? So, you mentioned financial globalization. It's hard for me to imagine globalization, the opening up of trade, occurring without some kind of global medium of exchange, some kind of common financial framework to facilitate it. And it seems to me, if you're going to go down the path of globalization, it's almost inevitable there's going to be these needs for financing that emerge. And yes, financing might run ahead of the actual needs for trade at times. But I guess my question is this, it's easy to see someone paint a nefarious, oh, there's this plan to dominate the world, versus what's kind of naturally emerged. Or maybe there's a bit of both in there. What is your take?

Daniela: Well, let me start by noting that we hear very often these days that we live in the end of globalization as we know it. And I think that's a very pertinent and insightful observation when it comes to real globalization, that is the international trade in goods and services. There are clearly very serious tensions emerging in real globalization, for example, in the trade war between U.S. and China. But I don't see the same sort of impediments or obstacles in the reach of financial globalization. I think it's quite alive and well.

There are clearly very serious tensions emerging in real globalization, for example, in the trade war between U.S. and China. But I don't see the same sort of impediments or obstacles in the reach of financial globalization. I think it's quite alive and well.

Daniela: We have seen some attempts to reign it back, but I think they're quite feeble, when Donald Trump tried to prevent U.S. pension funds from including in their indexes some Chinese stocks. But overall, I would say that the COVID-19 crisis, although it requires a very significant intervention from the Federal Reserve and other central banks, has not in any way stopped financial globalization or forced it to sort of roll back.

Daniela: Now, in the critical microfinance framework, there are no normative implications, or maybe there are some, but we can come to those because it talks about political power. But there are no normative implications about the evil hegemon, in this case, the U.S. or the U.S. dollar. It just notes that, if you want to have, exactly as you put it, if you want to have a global finance, then you will have a country that will issue an international currency. And that country typically will have a private financial system that will go increasingly global. And it will try to create new spaces for extending its balance sheet, for extending its reach, and for creating new liquidity practices in order to finance its positions or its assets. So, I don't want this to be a conspiracy theory about the U.S. It's not. It's not that. It's simply a sort of, let's call it an observation about how global finance operates in contemporary times.

Daniela: You could probably make the same argument. Maybe you won't, but one could hear the same argument in 50 or a hundred years time if we have a new hegemon. It's private financial institutions will probably resolve to the same strategies in order to grow their balance sheet. In Minskian terms, it's a natural impulse of private finance to want to grow and to want to increase its profitability. And it does so by trying to move away from the kind of money or from the kind of liabilities that are guaranteed by the state, because these are expensive. So, you have evolving liquidity practices. You have changing plumbing. And the changing plumbing is really thinking through how the liabilities that are financing asset positions change over time in order to maximize profits and minimize regulation from the state.

David:  Well, it's very interesting. And I think that makes a lot of sense. So, here's a question I've been wrestling with. I've asked some previous guests who've been on recently this question. And I apologize to our listeners if you're getting sick of me asking this question.

David:  But Daniela, so one of the issues is the continued growth of the shadow dollar funding across the world. Right? And the Fed having to intervene with the dollar swap lines with its liquidity facilities is an attempt to deal with that, the run on the shadow banking. And, as you mentioned just now, there's this natural tendency to move away from the super safe money, safe assets, into these substitutes in the shadow banking system. Right? The frontier is constantly emerging, evolving, going forward.

David:  And so, the question is, is there a practical way for governments to deal with this? In other words, if the shadow banking system is always going to present financial risks to the global financial system to the U.S. financial system so that there might be runs on it like there were in 2008, and we know this current crisis wasn't caused by the financial system, but there were problems that came by as a byproduct of the COVID-19 crisis. But is there a way to strengthen the shadow banking system?

David:  I mean, one proposal I've heard from previous guests is to try to move as many money creating firms, shadow firms into the regulated space. Others have called for higher capital funding. I mean, but it seems really hard for me to imagine a global effort to reign in shadow banks because you have cross border issues. But I wonder what your thoughts are on this.

Strengthening the Shadow Banking System

Daniela: Yes. I think it's a fair point to say that it's not only you that has been struggling with this question, but all of us were interested in sort of the political dynamics of shadow banking and of global market based finance. And this reminds me of the research that I've done a while ago looking at the first wave of financial globalization at the end of the 19th century and beginning of the 20th century, where the U.S., I think, developed sort of endogenously a very similar system of shadow banking that more or less imploded in 1929. And it's fascinating, if you read... I cite in the paper that we are discussing, I cite a paper from 1907, that describes what Brunnermeier and Pedersen in 2009 described as liquidity spirals or the ways in which runs on the shadow banking system occur through this combination of market liquidity and funding liquidity pressures. In 1907, a woman in the U.S., or an academic in the U.S., already was able to describe a similar dynamic.

Daniela: So, that means that, in the system of financial globalization, we already had... her name is incidentally, Anna Youngman, and the paper is called *The Growth of Financial Banking*, in the Journal of Political Economy, a 1906 paper. And I recommend your listeners to have a read. It's fascinating how she basically describes margin calls on what were then the equivalent of repo instruments.

Daniela: But to go back to your question, when the shadow banking system in the U.S. imploded in 1929, we had a political willingness to try to think through what would it mean to reform the system? And how do you affect structural change? And I want to mention here a very important inquiry headed by the Pecora. And the Pecora inquiry documented the extent to which the shadow banking system is fundamentally exacerbating or amplifying cycles of liquidity and leverage. And, from there, we had the Roosevelt regulations that basically strangled both the repo market and the repo financiers in the U.S.

Daniela: So, I mean, you could go down the sort of straightforward route of profound structural change, but that is a very difficult political route. It requires political willingness to say, okay, the shadow banking system isn't only some nefarious hedge funds that have very large financing needs, and then whose margin calls during crisis may end up creating tensions, even in the U.S. treasury market. What you have, as has been shown a while ago, you have on the demand side institutional investors that represent or asset managers that represent private pension funds that represent private insurance companies. In the literature, this is called asset-based welfare. And it's the idea that, instead of collectively provisioning for the future through the state who gives us free health or public pension, we provision through financial markets.

Daniela: So, to basically reform the global shadow banking system or global market based finance, you need political willingness at the global level and in the U.S. in the first place to say, okay, we need a fundamental rethinking of the contract between the state and its citizens. And that is quite a difficult political challenge, I think. So, then we have second door, the kind of solutions that say, okay, regulate global asset managers like BlackRock as globally systemic financial institutions. Try to find their hidden leverage. Try to impose some form of sort of rules on securities financing transactions or on repo positions. We had all this after 2008, but they were watered down very quickly. And, in the paper, I argue that they were watered down very quickly, simply because there is a very complex entanglement between monetary policy, fiscal policy, and the plumbing of financial markets, and this complicated entanglement that Benjamin Brown argues confers infrastructural power to private finance makes it very difficult to arrive to meaningful regulatory reform.

To basically reform the global shadow banking system or global market based finance, you need political willingness at the global level and in the U.S. in the first place... And that is quite a difficult political challenge.

Daniela: To give you an example from Europe, because I know your listeners are very familiar with the U.S. situation, but to give you an example from Europe, the European Commission after the crisis in 2008 said, "Well, one of the problems we have in Europe, and this is what gave us the banking crisis and then the sovereign debt crisis, is that we have a lot of leverage that is built up in the system through the shadow banking market. So why don't we put a financial transactions tax not only on trading in secondary market in bonds or on derivatives, but let's put the financial transaction tax on the repo market."

Daniela: And within five minutes, the repo lobby in Europe said, "Well, the best strategy we have is to go to the Ministry of Finance or the Treasury of every member State of the European Union, and to ask them what happens to liquidity in your sovereign bond markets if you repress the repo market?" And that was a very effective political strategy to push back against attempts to regulate these new liquidity instruments that I described in the paper, because threatening a sovereign with a loss of liquidity is a very quick and effective way of preventing reform.

David:  Yeah, going back to Europe, so Europe is highly reliant on repo financing as well, is that correct?

Daniela: It is, yes. In nominal terms, it's comparable to the U.S. repo market, the European repo market is.

David:  And you mentioned in your paper that that wasn't always the case, that the Bundesbank in Germany, they were worried about going down this path, the Bank of England also, is that right?

Daniela: Yeah. So, in the paper I discussed this idea that what has powered financial globalization and the Americanization of national financial systems in the first place was the change in liquidity practices in the sovereign bond market. So what we had in the 1990s in Europe, just around the introduction of the Euro, was a pressure from both U.S. based financial institutions, but also from European private financial institutions, we had the pressure to liberalize or to create repo markets in the image of U.S. repo markets.

Daniela: And there was some resistance. For example, France very quickly accepted that, to create a legal regime around repo liabilities that ensured a legal ownership of collateral for the repo lender that the insured the margin calls would happen within a standardized legal framework. But the Bundesbank and the Bank of England initially resisted this push. The Bundesbank, in fact, was a pioneer in regulating repos because it had the reserve requirements on repo deposits, which made it much more expensive, so Deutsche Bank moved a lot of its repo activities from Frankfurt to London.

Daniela: And Bundesbank said, "I don't want to encourage the growth of the repo market or to deregulate the repo market, because I worry about encouraging short-term finance. And Germany for quite a while was very reluctant to think about short term finance because it viewed it as inherently speculative. And I worry about financial stability." And Bank of England more or less had the same concerns, because the memory of the [inaudible] led attack on the U.S. gilt market was very fresh, and they worry that if you allowed U.S. financial institutions in the gilt repo market, then there will be a multiplication of [inaudible] there.

Daniela: But this sort of resistance was quite short term in the U.K. because there was a sense that the U.K. could not make a claim to remain a global financial system if it didn't allow for these kind of liquidity practices, and in Germany because they were afraid that entering the Euro area with France, that France would basically get ahead of them and become safer for the Eurozone.

Daniela: So you had these competitive pressures that financial globalization does very well in creating, and these competitive pressures become very quickly political pressures for governments to accommodate the pressures of Americanizing financial systems. And we see that even now, for example, I discuss in the paper the G20 local currency bond market initiative, and if your listeners want to enjoy themselves with reading the technical documentation around that, there is always a very clear requirement to recreate money markets in emerging countries and basically everywhere, even beyond G20, to recreate money markets in developing countries in the image of the U.S. money markets.

David:  So if I step back from these observations Daniela, what I see is... And maybe I'm drawing false conclusions here, so bear with me. But what I see is that if we want to go down the path of globalization or increased trade, even with, as you mentioned, there's been some pullback during these past few years, but in general repo markets, or what I would say more generally, money markets are going to actively grow if you have globalization.

David:  So you gave the example of 19th century globalization, repo markets were very active back then, and then the Great Depression, World War II, those things kind of shut them down up until the early '90s, when they start coming back to life. And so you get really strong repo market activity, and as globalization spreads you see this re-emergence in the US and Europe. So I wonder is it inevitable if we want to go down the path of globalization, increased trade, or is there an alternative path?

Globalization and the Imposition of Capital Controls

Daniela: Well, I mean, nothing is inevitable because it is a political choice how one designs the system of credit creation in one's country. I think that, to me, is very clear. Also as a long-term reader of Keynes, and critical microfinance is very much anchored in some of the Keynesian insights, I can imagine a world where we re-nationalize financial systems and we put some more barriers in the way of free capital flows.

Daniela: So it is possible to think that you can... I think it's even possible to think that you have a real globalization proceeding alongside a much more national based financial system where you don't depend so much on, say, global institutional investors in order to issue local currency sovereign bonds, or in order to issue local currency corporate bonds. But this political choice has to somehow start from the countries that are at the top of the hierarchy, and here I want to make a real interesting observation and maybe ask you what your thoughts are on in it.

David:  Sure.

Daniela: In March, I coordinated with several other colleagues a letter to the Financial Times asking for... We were looking with dismay at the base of capital outflows from emerging countries, and we're thinking in the Keynesian tradition that what countries need to do in order to protect themselves against such an extreme shock to their capital account, was to bring back capital controls and to normalize capital controls. I mean, we already have this discourse of normalization of capital controls, say, after the global financial crisis. The IMF, even, is on board one way or another.

Daniela: But what was fascinating to me after we published this letter was how reluctant emerging countries have been to impose capital controls, even to think about debt restructuring. Their argument was that if we get debt restructuring now, or if we ask for debt restructuring now, given the multiple shocks that are coming both through financial channels and through legal channels, we might lose future market access to global finance. And this argument about not foreclosing access to global dollar markets in the future was weighed stronger in most emerging countries than the argument of let's try to protect our economies now from these very large capital outflows.

David: That is an interesting observation, Daniela. These countries don't want to impose capital controls. I have a few thoughts on that. First, I understand why they are reluctant. They're worried about, as you've mentioned, future capital flows coming in, and you're saying, "Well, what about the present? What about the pain imposed now?"

David:  I would think probably the best time to implement capital controls would be during the good times. So you're not doing it during a crisis where it's harder, or maybe it does send a bad signal. So maybe ideally you would set this up during normal times, and I think of the case of Chile. Now, I haven't looked there in a long time, but I recall Chile had some capital controls that weren't particularly onerous, but they were very useful. If you put your funds in Chile, you had to wait a year before you could pull them back out. There were certain limits. In my understanding, and again, this is probably dated, but Chile did relatively well compared to other Latin American countries. So there might be a place for something like that, but my suspicion is you got to do it when it's easier.

David:  If international investors are very agitated and worried and you come and do something, what appears radical, it might be more destabilized and they might pull their funds out. In other words, if the legislator in an emerging market starts talking about capital controls and it looks like it has teeth, the investors might want to pull what remaining funds they have in that country out. Whereas if you did it during a normal, peaceful, calm, non-crisis time, it might be better accepted. Does that seem reasonable?

Daniela: I think it's a very reasonable point, and it's one that institutional investors make to me on Twitter, that imposing capital controls during bad times or during times of significant capital outflows is not a particularly successful strategy. It doesn't signal very well or create confidence. However, I think the question that I want to go back to is, what do countries do then in a global dollar dominated market based financial system when the politics doesn't work for capital controls to be introduced?

Daniela: And that's what I argue in the paper, is that we are seeing a new institutional function for central banks, and for the state in general, and I call it the de-risking state. That is a state that de-risks systemic liabilities like repos or exchange ETFs, or exchange traded funds, in high income countries, and that de-risks exchange rates in emerging countries. In other words, it provides some form of hedging for global institutional investors in order to convince them to stay. You no longer raise interest rates, you just reduce the volatility and the exposure to volatility of exchange rates for institutional investors.

We are seeing a new institutional function for central banks, and for the state in general, and I call it the de-risking state. That is a state that de-risks systemic liabilities like repos or exchange ETFs, or exchange traded funds, in high income countries, and that de-risks exchange rates in emerging countries.

David:  Yeah, and this is your fourth proposition. So we probably need to get back to your other two propositions, but your fourth proposition is in this environment you need a de-risking state for these liabilities. But just one more thought on the capital controls, Daniela. So I do think the point I raised is a great, one, theoretically, but in practice it doesn't happen. This is where probably Game Theory is helpful. But the problem with saying, "Well, impose capital controls during good times." Well, that's hard to do too, because during good times you want all the money flowing into your country. And you don't want to put any barriers up.

David:  So when times are good, it's hard to make those tough changes. If I need to exercise and I need to eat better, it's hard to do that when I'm in decent health. When I get a heart attack, and they tell me to go do it's hard then too. So I understand there's no easy way around this. It kind of reminds me of one of the issues that I've been pushing for, and that is for initiating some kind of level target, like a nominal GDP level target, or price level target. You would want to, in theory, do that during the good times where it's easy to transition to it, but that doesn't seem to happen. And then during the bad times, it's also too hard because, well, we're in the middle of a crisis. So there's no easy fix.

David:  So something needs to be done, but it's not clear what's the best way to do it. All right, so we've talked about two of your four propositions. The first one, again, was U.S. led financial capitalism has evolved around market-based finance, anchored in changing practices for producing liquidity. We just touched on your last one, which is market-based finance requires the de-risking state for systemic liabilities and new asset classes. Your second one though, is global finances organized in interconnected hierarchical balance sheets increasingly subject to time critical liquidity. We've kind of touched on that, but go ahead and summarize point number two for us.

Heirarchal Balance Sheets and Time Critical Liquidity 

Daniela: Yes, thank you. This goes back to a taking a Minsky lens to understanding the co-evolution of private finance and the macro institutions of the state, and it thinks of debt as a balance sheet relationship. It's a social relation between the lender, for whom the debt is an asset, and the borrower who records the debt as a liability. If we think of market-based finance as interconnected balance sheets, what is special about market-based finance is the way in which it entangles assets and liabilities. And I gave the example in the paper with repos, because, in a sense, financial institutions, when they finance securities positions by creating repos, they use those very securities as collateral. And they are benefiting from changes in the market price of collaterals to margin calls, and that feeds into liquidity and leverage cycle. And what I also argue in the paper is that we have to think, not only to focus on repo liabilities, I tend to do that because I've spent a long time studying them and it's the part of the planning of the financial system that I guess I understand better, but what is fascinating to me is to look at the way in which balance sheets become increasingly interconnected through an ecosystem that creates liquid ETF shares out of equity and bond collateral, right?

David:  Yup.

Daniela: Then we have the same logic there of trying to innovate new types of liquid liabilities first through equities, but the bond ETFs to me are much more interesting, also because they illuminate the growing power of asset managers.

Daniela: And if you look at the dominance of the three largest managers in the ETF market, that I think it's very easy to tell that, but also thinking forward, in terms of conversations that we have in Europe. I am not quite sure that the US has advanced that much in that conversation on greening finance.

Daniela: And here, there is a lot to think through, in terms of what is going to happen next, what new systemic liabilities is private finance going to innovate? And I'm very much hoping that this critical macro finance research agenda will generate more interest and more research on understanding, systemically or in macroeconomic terms, the rise of the ETF ecosystem, right?

Daniela: So that's one way in which the balance sheets matter, in the sense of trying to think through how assets and liabilities becoming entangled through these evolving liquidity practices. And the second way in which balance sheets matter, I argue in the paper, is that they are hierarchical both within and across currencies. And they are hierarchical in this traditional hierarchy of money sense in which some liabilities on the balance sheet are stronger promises to pay than others, right?

Daniela: So a repo is a strong promise to pay because it has the collateral valuation system behind it. An ETF is a strong promise to pay in some ways, because it maintains par value between the ETF share price and the underlying portfolio of securities or of equities.

Daniela: And also, there is, and this is something that Zoltan Pozsar has written a lot about is to think, again, through evolutionary terms, how hierarchies are changing in the sense of the, particularly here, I'm thinking about the nexus between the US repo market and US dollar FX swap markets.

Daniela: And here, I was thinking through questions of the role of, and we will go back to this in proposition three, but the role of FX swaps as an instrument for leverage. There is some debate there that I think is interesting to explore and to think through the macroeconomic implications for that. Okay.

David:  All right. Very nice. Let's go to your last proposition in your paper in the time we have left, and that is, credit creation in global market based finance requires new forms of money.

New Forms of Money in Global Market Based Finance

Daniela: Yes. So I argue here that we typically think and debate credit creation through a lens that privileges banks as the money creators and thinks about credit creation through a bank loan. And what I ask in the paper, what does it mean if we think about credit creation through the bond market and what does it mean, in terms of thinking through, how do you create new systemic liabilities or new types of money in order to finance this credit creation through securities markets? Right?

Daniela: And what I argue there, that there is still a very critical role that traditional banks play because when they move from creating bank deposits to creating repo deposits in order to finance their securities positions, what they effectively do is they destroy bank money, right? Or they destroy bank deposits.

There is still a very critical role that traditional banks play because when they move from creating bank deposits to creating repo deposits in order to finance their securities positions, what they effectively do is they destroy bank money.

Daniela: And why does this matter? It matters because most macroeconomic papers, when they think about traditional measures of money, and you don't have to be a monetarist to think that the quantities matter, right?

David:  Right.

Daniela: It's interesting to think of them. But when we think about traditional measures of money, we can't really capture either monetary or credit activity very well because banks endogenous creation of repo deposits destroys bank deposits, right?

David:  Right.

Daniela: So there are some movements across the hierarchy of money that are very important to think through. And I argue there that one has to start thinking about the monetary power of collateral, that is the ability of collateral through repo markets to confer monetary power to certain types of liabilities, because it allows these liabilities to promise credibly to store value at par, okay?

Daniela: And I draw some consequences, or I raise some questions there that should be investigated further, in terms of how do we model growth, employment, income inequality, if the basic money indicators that we have need to be expanded or need to be enlarged to take into account more than financial structures, right?

David:  Yup.

Daniela: So for example, when you look at the DSG model that takes the unsecured interbank money market, the interest rate there as the indicator of liquidity in the system, is that the right indicator to choose when a lot of the money market activity is now concentrated in the repo market?

David:  Daniela, I really like what you've just said there, because I'm sympathetic to that point. As you know, there's some monetarist blood running through my veins. So I do think quantities matter, but I also acknowledge that it's difficult to measure properly, what is money? What is a transaction asset, when you think about all of these issues we've discussed.

David:  There's a center in New York City that attempts to measure money broadly. And it includes repos, commercial papers, and also treasury bills, and does a Divisia-informed measure. And what's interesting is during 2008, this broad measure of money actually contracted, reflecting the run on shadow banking during that time.

David:  Whereas if you looked at M2, which was backed up by FDIC, super safe, it's like a straight line that nothing happens. Now, come to the present crisis and what do we see? We actually see this series explode. It's growing really fast. A lot of the measures of money are growing really fast, but this measure that collapsed in 2008 is actually rapidly growing.

David:  And my first take on this was that it's due to the fact that the Federal Reserve is now backstopping shadow money, but maybe I'm wrong. Maybe there's some other story going on here, but my sense was maybe people were rushing into these assets. For example, money market funds, they now know the Fed is backstopping them. And so, they're relatively safe compared to other assets. But any thoughts on that?

Daniela: Exactly. That to me is that is the de-risking state in action.

David:  Okay.

Daniela: In the sense of preserving the monetary power of private and public collateral by direct intervention, this market maker of last resort interventions in securities markets, or in propping up money market funds, or other types of liabilities that we can think of as systemic liabilities. Right?

Daniela: And this is where I think that the Fed has done that very extensively. And what we see now is not only the Fed, but the European Central Bank has been much less hesitant than in the previous crisis to act as a market maker of last resort. And in Europe, we make this joke repeatedly about Lagarde promising to target spreads, that is the spreads of the sovereign bond yields to the German Bund.

David:  Well, Daniela, those are all very interesting points. Our time has come to an end today. Thank you so much for coming on the show. Our guest today has been Daniela Gabor. Daniela, thank you for coming back.

Daniela: A pleasure. Thank you, David.

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