Back in 2018, Steve invited Robert Hockett to come on to talk about shadow banking and explain its role in the 2008 financial crisis. We’re bringing back this interview because shadow banks are still around and people still have a hard time grasping exactly what they do. This is partly because many don’t understand what banks themselves actually do. The popular vision is that banks borrow and lend and that they make loans based on what they have in the vault; we MMTers know that they make loans based on profitability.
Banks are policed with a view to their liquidity risk, while shadow banks are behaving the same way, without the policing.
In order for us to unpack this issue, we need to know the meaning of “endogenous” and “exogenous” money. Bob defines endogenous as the credit-money generated by private banks and lending institutions, while exogenous is the sovereign element, created by the Fed or central bank. As in most cases, there’s always an element of public involvement in the private. This is usually overlooked. To better illustrate this, Bob uses the metaphor of franchising, where the Fed is the franchisor and the private financial institutions are the franchisees, charged with distributing a public resource which Bob defines as “the sovereign’s monetized full faith and credit.”
When the Fed recognizes a bank loan or loan extended by a financial institution, it is effectively turning a private liability into a public liability. But if it's not fully cognizant that it's meant to be exercising quality control, you can get a defective product. That certainly happened in the lead up to 2008.
In this interview, Bob points out that everyone operates under the false premise that there’s a shortage of capital. He also distinguishes between capital meant for productive use and that meant for speculation and gambling. The market for speculation - ie, the neverending quest for new ways to generate profit - leads to the creation of new and twisted kinds of financial instruments, such as the disastrous subprime mortgage packaging that led up the financial crisis.
Bob’s proposal to insulate us, the public, from the kind of harm that arises from speculative mania is to separate the two kinds of financial institutions. Those that actually extend primary credit to homebuyers, small businesses, producers of goods and services should be separated from those that create credit for speculation. In other words, one institution would not be able to perform both functions.
For a true solution, he suggests we look to the past, to the Reconstruction Finance Corporation of the 1930s and ‘40s:
The RFC in its day was by far the largest financial institution in the entire world. Its balance sheet dwarfed all of the combined balance sheets of the Wall Street institutions. It was by far the largest credit-generating institution, credit-extending institution in the world, and it extended loans as small as $20 or $30 to African American barbershops in certain Los Angeles neighborhoods to giant mega-million or even billion-dollar loans for large public infrastructure projects like the Hoover dam or what have you. And this institution was a public institution. It was a government institution.
After all, it’s our credit anyway, isn’t it?
Robert Hockett is the Edward Cornell Professor of Law at Cornell Law School, Visiting Professor of Finance at Georgetown University’s McDonough School of Business, and Senior Counsel at Westwood Capital, LLC. He specializes in the law, economics, and philosophy of money, finance, and enterprise organization in their theoretical and practical, their positive and normative, and their local, national, and transnational dimensions.
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