An important podcast on shadow money & the boom and bust cycle

I recently came across a terrific Bloomberg On The Economy podcast with James Sweeney and Carl Lantz on “shadow money” — assets which are used as the equivalent of money during the snowball of the asset bubble / artificial boom.

The problem Sweeney and Lantz identify is that the stock of money expands and contracts across the boom and bust cycle in the domain of “shadow money” — leading to the differential distortions of the structure of relative prices and supplies across asset classes, and discoordination between planned levels of investment, savings, and consumption, as well as discoordination between economically sustainable streams of rival production processes.

Listen to the podcast or dowload here (mp3).  Listen for a discussion of Hayek toward the end of the conversation.  The podcast discusses ideas contained in their paper “Long Shadows:  Collateral Money, Asset Bubbles and Inflation” by Jonathan Wilmot, James Sweeney, Matthias Klein, and Carl Lantz (pdf).

Wilmot, Sweeney, Klein, and Lantz begin their paper with this quotation from Friedrich Hayek:

“There can be no doubt that besides the regular types of the circulating medium, such as coin, notes and bank deposits, which are generally recognised to be money or currency, and the quantity of which is regulated by some central authority or can at least be imagined to be so regulated, there exist still other forms of media of exchange which occasionally or permanently do the service of money.

Now while for certain practical purposes we are accustomed to distinguish these forms of media of exchange from money proper as being mere substitutes for money, it is clear that, other things equal, any increase or decrease of these money substitutes will have exactly the same effects as an increase or decrease of the quantity of money proper, and should therefore, for the purposes of theoretical analysis, be counted as money.”

Friedrich Hayek, Prices and Production 1931 – 1935.

They continue their quotation from Hayek in the middle of their paper:

“It is necessary to take account of certain forms of credit not connected with banks which help, as is commonly said, to economise money, or to do the work for which, if they did not exist, money in the narrower sense would be required.  The criterion by which we may distinguish these circulating credits from other forms which do not act as substitutes for money is that they give to somebody the means of purchasing goods [or securities] without at the same time diminishing the money spending power of somebody else. …. The characteristic peculiarity of these forms of credit is that they spring up without being subject to any central control, but once they have come into existence their convertibility into other forms of money must be possible if a collapse of credit is to be avoided.”

Wilmot, Sweeney, Klein, and Lantz then comment:

Hayek’s point is that the economy can create its own media of exchange in order to economize on the use of inside and outside money when there is significant demand for some type of money for use in purchasing assets. Of course, when assets can themselves serve as collateral, allowing for leveraged purchases, then they take on money-like properties. And when financial assets serve as collateral for borrowing to purchase yet more financial assets (buying on margin) this form of shadow money can become particularly potent in driving asset price overshoots and bubbles.

I also recommend the transcript of an “On The Money” podcast with Sweeney and Lantz from Jan. 5, 2010 on the same topic.

UPDATE — Ellen Brown of Global Research presents a summary of Sweeney and Lantz:

Along with the disappearance of the “shadow lenders,” there has been a dramatic decline in something called “shadow money.” The concept of shadow money was presented by two economists from Credit Suisse, James Sweeney and Carl Lantz, in a Bloomberg interview in May. As explained on DemandSideBlog, shadow money is money the market itself creates in order to finance a boom — “money” in the sense of a medium of exchange. In a boom there is not enough cash to go around, so collateral is used as near money or shadow money. Shadow money can include government bonds, private bonds, asset-backed securities, credit card debt (which can be incurred and paid off without drawing on the M1 money stock), and even real estate (when it is highly liquid and easily tradeable) . . .

Lantz and Sweeney calculate that at the peak of the boom there were six trillion dollars in the traditionally-defined money stock (or money supply). The private shadow stock accounted for $9.5 trillion, and government-based shadow money accounted for another $11 trillion. Thus the shadow money stock dwarfed the traditionally-defined money stock. This can be seen in the chart below provided by Tyler Durden. The blue strips at the bottom, called “outside money,” are dollars printed by the Federal Reserve. The red sections, called “inside money,” are money created as loans by the banks themselves. The green sections, called “public shadow money,” are money created by the government and the Fed as debt (or loans). The purple sections, called “private shadow money,” are the money created as private debt securities by the shadow lenders.

Lantz and Sweeney estimate the total drop in private shadow money (the purple blocks) during the current credit crisis at $3.6 trillion. This has been offset by an increase in public shadow money, both from the massive borrowing needed to finance the federal deficit and from the aggressive liquidity measures taken by the Fed in converting private securities into loans.  Those measures helped prevent an even worse drop in the commercial money supply than actually occurred, but they were not sufficient to eliminate the credit squeeze from lowered commercial lending, which continues to act as a tourniquet on the productive economy.


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Our task [as economists] is to show how only a market and a competition-determined price system can enable us from day to day to adjust a worldwide division of labor to ever-changing circumstances and to maintain that degree of productivity which we need in order to keep the population of the world alive. — F. A. Hayek

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