Conceptualizing

Financial Resilience

David Bieri

Political Space Economy Lab, University of Michigan | @space_economy

VT Ridenour Faculty Fellowship Conference

Arlington, VA

October 2014

The fluttering veil

“It is well that the people of the nation do not understand our banking and

monetary system, for if they did, I believe there would be a revolution by

tomorrow morning.”

Henry Ford (1922)

What are the questions?

• What is the relationship between resilience in the financial

sector and resilience in the real sector?

• If “financial resilience” is a policy target, what are the

corresponding policy instruments?

– How do “financial stability” and “macroprudential policy” relate to

financial resilience?

– What is the role of increased leverage, excessive liquidity and maturity

transformation, interconnectedness, and complexity?

• What are the appropriate units of analysis for financial

resilience?

– Sectors: Households, nonfinancial firms, government, financial sector

(banks and nonbank financial institutions)

– Scale: International, national, regional, local

Ideas, institutions and events

Ideas, institutions and events

• Ideas about the “nature of money” determine monetary

analysis:

– Historical representation of economy as system of circular flows

evolves with social imaginary.

– Common dichotomy across different economic paradigms: “real

sector” (production and consumption) and “monetary sector” (money,

credit and banking).

– Nature of real-monetary nexus as key distinction between schools of

economic thought.

• Institutions represent the socio-economic arrangements that

rest on and are influenced by specific ideas.

• Historical events give rise to new theoretical insights/ideas, in

turn re-shaping institutions.

“Sunspots” and the credit cycle

Sources: Jevons (1884); Wagemann (1930); Diamond and Dybvig (1983); Kiyotaki and Moore (1997)

Money matters

Economic paradigm Origins of

economic cycles

Real-monetary

sector

relationship

Nature of crises Spatial

consequences

Classics Real sector Neutral Resources Not considered

Marxism Real sector Non-neutral Over-

accumulation Urbanization

(Post) Keynesianism Both sectors Non-neutral Financial

instability Not considered

Neoclassical (RBC) Real sector (Super)neutral Exogenous

shocks Not considered

Monetarism Monetary sector Non-neutral Inflation Not considered

“New” urban economics, new

economic geography Real sector Neutral None Agglomeration

Source: Bieri (2014a)

Financial stability: A variety of concepts

• Different definitional scope:

– Systems definition: Financial stability = “well-functioning financial

system” (role for monetary policy?)

– Narrow definition: (Excess) volatility of specific observable financial

variable (asset price volatility, interest rate smoothness)

• Historical perspective:

– Volatility-based instability (ERM 1980s/1990s, 1987 crash, 1994 EME

bond markets, 1998 Russian default, 2001 Argentinean default,

2007/08 US subprime crisis).

– Stress-based instability (Default of individual institution. Credit-Anstalt

1931, Guardian National Bank 1933, Bankhaus Herstatt 1974, BCCI

1991, Barings 1995, LTCM 1998, recent institutional failures

[Northern Rock, Bear Stearns, Lehman Brothers, AIG]).

– Crisis-based instability triggered by both real and financial sector

imbalances.

Financial stability: A variety of concepts

• Traditional view: Financial regulation to minimize threats to

the banking system and the economy from defaults or credit

crunches (cf. Basel III, asset quality reviews, “stress tests”)

• Post-crisis “new normal”:

– Is stabilizing the banking sector enough to stabilize the whole financial

system? No: Fragility of market financing arrangements and nonbank

financial institutions (financial migration and “shadow banking”)!

– Central lesson: Defaults, credit crunches, and fire sales not just

across institutions but also across securities and assets.

– Mitigation of the leverage cycle plus a systemic regulator to combat

fire sales and their causes (cf. Basel III)

• Policy trade-off between monetary stability and financial

stability?

We’re all “macroprudentialists” now

Regulatory and supervisory arrangements “Macroprudential” “Microprudential”

Proximate objective Limit financial systems-

wide distress

Limit distress of individual

institutions

Ultimate objective Avoid output (GDP) cost Consumer protection

(investor/depositor)

Model of risk (In part) endogenous Exogenous

Common exposures across institutions

(correlations) Important Irrelevant

Calibration of prudential controls Systems-wide distress,

top-down

Individual institutions,

bottom-up

Proximate objective Limit financial systems-

wide distress

Limit distress of individual

institutions

Sources: Borio (2003), Bieri (2009)

Global monetary-financial governance

Source: Bieri (2009)

U.S. monetary-financial governance

Source: Bieri (2014b)

From stability to resilience

Scale/Sector Households Firms

(nonfinancial) Government

Financial

sector (Banks,

NBFIs)

International

National

Regional/local

“Capitalism is essentially a financial system, and the peculiar behavioral attributes of a capitalist

economy center around the impact of finance upon system behavior."

– Minsky (1967): Issues in Banking and Monetary Analysis,1967.

“To analyze how financial commitments affect the economy it is necessary to look at economic

units in terms of their cash flows. The cash flow approach looks at all units – be they

households, corporations, state and municipal governments, or even national governments –

as if they were banks.”

– Minsky (2008): Stabilizing and Unstable Economy, New York: McGraw-Hill.

A tale of two hierarchies

• Hierarchy of cities: Cities as “organisations”, positioned

within a spatial order of economic production.

• Hierarchy of money: All money is credit money and credit is

always and everywhere fundamentally hierarchical in nature.

Credit allocation as a core function of modern states.

Historical interaction between urban and monetary hierarchy

matters for distribution and evolution of economic activity

across space.

Trajectory of spatial development and advancement of the

monetary-financial system as joint historical process (Bieri

2013).

Nexus of hierarchies matters for financial resilience.

Hierarchy of cities

• Cities as “organisations” within a spatial order of economic

production

– Diversity in size and scope from differences in scale economies

relative to per-capita demand.

– Small number of large cities and large number of small cities

– Place in hierarchy is changing over time, depending on relative

specialisation

Source: Conzen (1975)

Phase 3: Secondary Growth Phase 2: Plowback Phase 1: Frontier

Urban hierarchy: Theories

• Path dependency vs. standard narrative

• Higher productivity occurs because

– large cities disproportionately attract both high- and lows-skilled

(“extreme-skill complementarity” of spatial sorting),

– large cities select more productive entrepreneurs and firms

– agglomeration economies (sunk cost, IRS)

• Urban efficiencies (“contrasts in agglomeration”) depend on

– Numbers (such as city or industry size),

– Nature of urban interactions (“The whys and wherefores of urban

diversification” Chinitz 1961; Jacobs 1969)

Urban hierarchy: Laws of motion

• Agglomeration economies differ in important ways

– localization economies attenuate rapidly across space

– industrial organization affects the benefits of agglomeration

• The microeconomic determinants of agglomeration

– 3 Marshallian transportation costs: “goods, people, ideas”

– Input-output linkages (input sharing, product shipping costs)

– Labor market pooling

– Knowledge spillovers

– Natural advantage (“first geography” vs. “second geography”)

• “Coagglomeration” matters

– General tendency of various industries to locate together,

– Clusters …

Hierarchy of money

• All money is credit money and credit is always and

everywhere fundamentally hierarchical in nature

– The modern monetary-financial system (MFS) is hierarchical in finance

and in power (“taxes drive money”, “lender/dealer of last resort”).

– MFS is a hybrid where public liabilities (“outside money”, a net asset

to the private sector) and private liabilities (“inside money”)

– Spatial relationship between financial variables and institutional

functions matters for urban development (e.g. interest rates or credit

intermediation)

– Hierarchy of money shifts across economic cycle through three

phases (hedge finance, speculative finance and Ponzi schemes)

– Money and credit fluctuate between states of discipline and states of

elasticity (cf. Mehrling 2012).

Hierarchy of money

• Hierarchy of money:

• Hierarchy of balance sheets:

Money Gold

Currency

Deposits

Credit Securities

Central Bank Banking System Private Sector

Assets Liabilities Assets Liabilities Assets Liabilities

Gold Currency Curreny Deposits Deposits Securities

Securities

Source: Adapted from Mehrling (2012)

Monetary hierarchy: Theories

• Two main approaches to monetary theory

• Money as a medium of exchange, unit of account and store

of value

– Money is a numéraire good, arising from portfolio preferences,

intermediation technologies and high-powered government money

– Monetary sector forms “veil” behind which “real economy” operates

• Money as a form of credit (“credit theory of money”)

– Promise to pay income at some future point.

– Debt claims to assured income flows provide liquidity which can be

bought or sold)

– Taxes-drive money view

Monetary hierarchy: Laws of motion

• Business cycles across different economic paradigms:

– Marxian: M – C – M’

– Keynesian: Y = C + I + G + (X-M)

– Monetarist: PY = MV (Quantity Theory)

– Flow of funds: sources of funds = uses of funds (endogenous

money)

• Re-theorising money and finance within economic

geography

– Taking history and institutions seriously

– Theorizing spatial aspects of the monetary-financial system

Case study: Detroit’s place in U.S.

monetary-financial history

• Stereotype of land-capital dynamics: Detroit’s rise and fall

within the U.S. urban hierarchy are largely driven by

successive stages of monetary-financial evolution that

enabled speculative real estate development.

• Prototype of financial instability: Institutional origins of

financial instability and banking-led crises in Michigan begin

in 1830s (Free Banking). Detroit is at the epicenter of 1933

banking crisis; municipal bankruptcy precedent in 2013.

• Archetype of frontier finance; As the financial frontier moves

across time and space, different “zones of exclusion” emerge

(mortgage speculation, large scale vacancies, financial

illiteracy, underbanked sections of the population).

“Money interest” vs. “Public interest”

Detroit is at the epicenter of cyclical instability driven by the

spatio-temporal evolution of the U.S. monetary-financial system

and its urban hierarchy (Bieri 2014a).

– “Proto-Central Banking” (1795 – 1815)

– “The Great Banking Experiment” (1816 – 1845)

– “The Great Banking Crash” (1933)

– “The Securitisation Bubble” (2000– ) and the post-crisis normal

Central tension between “money interest” and “public

interest” (cf. Mehrling 1997) as a key theme for the last two

centuries of Detroit’s economic history.

REFERENCES – I

Adrian, Tobias, and Hyun Song Shin. 2010. “The Changing Nature of Financial Intermediation and the Financial Crisis of 2007–09.” Annual

Review of Economics 2(1): 603–18.

Bieri, David S. 2009. “Financial Stability, the Basel Process and the New Geography of Regulation.” Cambridge Journal of Regions, Economy

and Society 2(2): 303-331.

Bieri, David S. 2013. “Form Follows Function: On the Relationship between Real Estate Finance and Urban Spatial Structure.” CriticalProductive

2(1): 7–18.

Bieri, David S. 2014a. Moonlights, Sunspots and Frontier Finance: The Historical Nexus between Money, Credit and Urban Form, Ann Arbor:

Political Space Economy Lab. http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2392673

Bieri, David S. 2014b. “Financial Stability Rearticulated: Institutional Reform, Post-Crisis Governance, and the New Regulatory Landscape in the

United States ,” in Iglesias-Rodrígues, P. (Ed.) Building Responsive and Responsible Regulators in the Aftermath of the Financial Crisis,

Cambridge, Intersentia Publishers.

Borio, Claudio E. V. 2013. “Towards a Macroprudential Framework for Financial Supervision and Regulation?” Working Paper No. 128, Basel:

Bank for International Settlements.

Chinitz, Benjamin. 1961. “Contrasts in Agglomeration: New York and Pittsburgh,” American Economic Review, 51(2): 279–289.

Conzen, Michael P. 1975. “Capital Flows and the Developing Urban Hierarchy: State Bank Capital in Wisconsin, 1854–1895” Economic

Geography 51(4): 321–338.

Copeland, Morris A. 1952. A Study of Moneyflows in the United States. Cambridge, MA: National Bureau of Economic Research.

Diamond, Douglas W. and Dybvig, Philip H. 1983. “Bank Runs, Deposit Insurance, and Liquidity,” Journal of Political Economy, 91(3): 401–419.

Jacobs, Jane. 1993. “Gradual Money and Cataclysmic Money” in The Death and Life of Great American Cities, New York: Random House; 380–

416.

Jevons, W Stanley. 1884. Investigations in Currency and Finance. London: MacMillan and Co.

Kiyotaki, Nobuhiro and Moore, John. 1997. “Credit Cycles,” Journal of Political Economy, 105(2): 211–248.

Lösch, August. 1940. Die räumliche Ordnung der Wirtschaft: Eine Untersuchung über Standort, Wirtschaftsgebiete und internationalen Handel .

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Lösch, August. 1954. The Economics of Location, New Haven: Yale University Press.

Mehrling, Perry G. 1997. The Money Interest and the Public Interest: American Monetary Thought, 1920–1970 , Cambridge, MA: Harvard

University Press.

REFERENCES – II

Mehrling, Perry G. 2011. The New Lombard Street: How the Fed Became the Dealer of Last Resort. Princeton University Press.

Mehrling, Perry G. 2012. “The Inherent Hierarchy of Money”, Mimeograph, Barnard College, Columbia University.

Minsky, Hyman P. 1967. “Financial Intermediation in the Money and Capital Markets,” in Pontecorvo, G., Shay, R. P. and Gailord Hart, A. (Eds.)

Issues in Banking and Monetary Analysis , New York: Holt, Rinehart and Winston: 33–56.

Minsky, Hyman P. 1992. “On the Non-Neutrality of Money,” Federal Reserve Bank of New York Quarterly Review 18(1): 77–82.

Minsky, Hyman P. 2008. Stabilizing an Unstable Economy. New York: McGraw Hill.

Pozsar, Zoltan, Tobias Adrian, Adam Ashcraft, and Hayley Boesky. 2013. “Shadow Banking.” Federal Reserve Bank of New York Economic

Policy Review 19(4): 1–17.

Wagemann, Ernst F. 1930. Economic Rhythm: A Theory of Business Cycles. 1st ed. New York, NY: McGraw Hill.