Financial Regulation Book Review 130 Harv. L. Rev. 1148

The Importance of “Money”


In a provocative new book, The Money Problem: Rethinking Financial Regulation, Professor Morgan Ricks argues that the government should reclaim control over money creation. Money, Ricks argues, is not just the cash in your pocket or the balance in your checking account. Instead, at least for purposes of financial stability policy, money is best equated with short-term debt. For most of the twentieth century, such debt was issued primarily by regulated commercial banks and insured by the Federal Deposit Insurance Corporation (FDIC), resulting in a fairly stable financial system. As a result of financial innovation, however, much of today’s short-term debt is issued in the far-less-regulated shadow banking system — a market-based system of intermediation that serves many of the same functions traditionally performed by banks. Runs by money claimants in the shadow banking system were central to the 2007–2009 financial crisis (Crisis). The Dodd-Frank Wall Street Reform and Consumer Protection Act and other post-Crisis reforms, however, have done relatively little to shut down this unauthorized money creation. That, in Ricks’s assessment, is a mistake.

The book provides a seemingly simple blueprint for reform: the government should allow only banks to issue demandable debt, it should heavily regulate and insure all such debt, and it should prohibit anyone else, other than the government, from issuing debt with a maturity of less than a year, thereby preventing private money creation (pp. 12–24). According to Ricks, this set of reforms would “panic-proof[]” the financial system and prevent the type of recessions that leave lasting scars on a country’s economic health (p. 3). Moreover, this approach is sufficiently certain to work that the government could roll back the myriad other financial regulations aimed at promoting stability. Even the Federal Reserve would be optional in the new landscape that Ricks envisions (p. 229). Regardless of whether one buys into his proposed reforms — and let me state at the outset, I don’t — the book makes a lasting contribution by demonstrating the importance of money, broadly construed, and the shortcomings inherent in the current academic and regulatory efforts to understand and address money claims.

A virtue of the book’s reform proposal is the way it brings to life the incredible oddity of money as a financial asset. According to Ricks, the best way to promote financial stability is to allow banks to fund themselves with debt from creditors who are indifferent to whether the bank fails or succeeds. No matter how large or sophisticated the creditor, so long as maturity of its claim is less than a year, Ricks does not want that creditor to undertake any due diligence, engage in any ongoing monitoring, or impose any discipline on the bank. Those roles would be left to the bank’s shareholders — who will often want the bank to assume more risk than is socially optimal — and the government.

At first blush, many might agree with then–Treasury Secretary Timothy Geithner, who described the author’s first iteration of the idea in 2009 as “wacky” (p. xi). In most financial markets, information generation and discipline are the types of activities that we want market actors, not government regulators, to undertake. In equity markets, for example, stability is often assumed to flow from efficiency and promoting private information generation is widely viewed as the optimal, even if imperfect, route to enhancing efficiency. In this frame, intentionally short-circuiting market-based information production by making a firm’s debt insensitive to any kind of information would seem like a recipe for disaster. And that’s before layering on the challenges posed by the contrary interests of the firm’s shareholders. Yet, Ricks argues thoughtfully, and at times quite persuasively, that this is the best way to achieve financial stability.

As Ricks shows, the assumptions that underlie corporate finance have only limited applicability when the financial asset in question enjoys some degree of moneyness. Moneyness alters the premium a holder will pay for a claim and the amount of due diligence the holder will undertake before acquiring the claim, rendering the efficiency-oriented assumptions underlying standard asset-pricing models largely inapplicable to money claims. At the same time, when short-term debt funds longer-term liabilities, a defining characteristic of banks and much of the shadow banking system, the institutions that result are inherently fragile. If money claimants withdraw their funds en masse, as they do in a run, the institution issuing those claims will be compelled to sell its relatively illiquid assets at discounted fire-sale prices, potentially rendering even a solvent institution insolvent. This fragility alters the incentives of money claimants, who now must worry about the behavior of their fellow claimants in addition to the health of the institution issuing their claim, setting the stage for financial panics and the deep recessions that often follow. Although these insights are not new, The Money Problem demonstrates in new light the importance of recognizing money as a type of financial claim that can be readily produced by private mechanisms, absent a prohibition, and one that poses unique public policy challenges. This is the book’s most important contribution and it alone justifies the undertaking, for author and reader alike.

Shifting from the author’s claim that money poses a distinct policy challenge to his proposed solution to that challenge reveals the limits of his analysis. His claim in the abstract is simple and appealing. Because money claims created in the shadow banking system are not insured like bank deposits, the shadow banking system is more prone to runs, which in turn inflict lasting damage on the economy. We should, accordingly, update and expand the banking system and prohibit any money creation outside of that system. The details of the proposal, however, reveal that he wants to significantly expand, not just update, traditional bank regulation. Ricks proposes a scheme of government control over money creation and short-term debt that is, to my knowledge, unprecedented in any advanced economy. According to Ricks, the government should significantly expand government-provided insurance to cover all bank deposits, no matter how large the deposit or how sophisticated the holder and irrespective of any systemic threat. The government should also limit the aggregate deposits that the system could create, control the terms pursuant to which banks accept deposits, and prohibit virtually all private debt with a maturity of less than a year — no more traditional money market mutual funds, sale and repurchase agreements (repos), or commercial paper (p. 226). Despite this significant expansion, Ricks contends that traditional bank regulatory tools will suffice to constrain bank risk taking and counteract the moral hazard and other distortions that the massive insurance scheme would induce.

The breadth of Ricks’s proposal allows almost countless angles of attack. Concerns could be raised on issues as diverse as operational challenges (e.g., could the government rely on market actors to provide elasticity when it is most needed?), desirability (e.g., how would the proposal impact the status of the U.S. dollar as the reserve currency?), and political feasibility (e.g., could the proposal overcome a significant challenge on both the domestic and international fronts?). As a result, any assessment of The Money Problem is likely to reveal as much about the person launching the critique as it does about the book’s strengths and shortcomings.

Rather than hiding from this fact, let me make my biases plain. Ricks and I agree on a number of key issues. We both see shadow banking as central to the Crisis. We agree that the shadow banking system grew outside the direct purview of prudential regulators, and that policymakers and other experts failed to appreciate its scope or significance prior to the Crisis. We further agree that the shadow banking system’s extensive reliance on short-term debt increases its fragility, and we are skeptical that the post-Crisis reforms adequately address these challenges. On other issues, our biases diverge. To grossly oversimplify, students of banking can be categorized into two groups — one that views banking crises as primarily the byproduct of coordination problems and a second that believes crises are triggered by information and the fundamentals that information conveys. Ricks provides an alternative to the classic coordination-based theory (pp. 52–77), and I have my own alternative account of the ways that information and information gaps contribute to fragility. We also both recognize that information and coordination problems typically interact to produce crises. Nonetheless, Ricks assumes that the challenge money poses is primarily a coordination game and that banks will not assume excess risk unless incentivized to do so by bad government policies even in the absence of creditor monitoring or discipline. In contrast, I see information as the critical factor distinguishing periods of stability from crises, and I view some private information production and the threat of creditor discipline as helpful in efforts to maintain stability.

For related reasons, we have different takes on the history of banking and bank regulation, leading to very different views on the capacity of any single government intervention to bring about lasting stability. Ricks believes this is possible. In his assessment, the key is ensuring that the scope of government control and the complementary prohibitions are sufficiently broad to shut down shadow banking and its kin. A very different lesson one could take from the growth of shadow banking and our collective blindness to it before the Crisis is that the exceptional dynamism of financial markets ensures that policymakers will never succeed in identifying and addressing all sources of systemic instability in advance. Shadow banks will reappear, in one form or another, and private money creation will emerge, whether driven by insufficient authorized money or the high cost of holding such money. A regulatory regime that does not anticipate such dynamism can itself inhibit the capacity of regulators to identify and respond to new threats. Taking the latter view leads me to favor a regulatory regime that is responsive rather than rigid and regulators who bring more humility than hubris to the challenge of identifying systemic risks.

These differences make me skeptical of Ricks’s proposal, but they also serve as a lens for illuminating valuable insights embedded in The Money Problem that can get lost in the author’s conviction regarding his proposed reforms. A concrete example of a reform measure that builds on the book’s insights while addressing these concerns would be to expand and clarify the situations wherein the government should serve as an “insurer of last resort” — providing broad guarantees to money claimants to prevent runs in situations that pose a systemic threat. This approach would provide many of the benefits of the book’s proposed scheme and would frequently be more effective than the lender-of-last-resort interventions often used in such circumstances while still allowing market discipline to deter idiosyncratic risk-taking outside of crisis periods.

This Book Review proceeds in four Parts. Part I provides context. It explains why the book deserves to be widely read and discussed, but also why the policy prescription that serves as its backbone ought to be, and probably will be, ignored. Parts II and III address why that reform proposal is both over- and underinclusive by situating the proposal in the literature on banking and money, respectively. Part IV expands the focal point by providing a very different reading of the history of financial panics and banking regulation, leading to a very different set of conclusions about how best to address the challenges that shadow banking poses.

* Professor of Law, Columbia Law School. I am grateful to Jeffrey Gordon, David Skeel, Scott Hemphill, Eric Hilt, and Patricia Mosser for helpful comments and conversations, Francesca Cocuzza and Catherine Walsh for exceptional research assistance, and the editors of the Harvard Law Review for thoughtful feedback throughout the editing process. I also wish to thank Morgan Ricks, whose thought-provoking book inspired this response and with whom I look forward to decades of ongoing debate.