06 Nov Cash Is Not The Answer To Financial System Stability

There are a lot of theories being floated on how to effect financial system stability. Most involve separating money from finance.

Reverence for money or cash is evident in the Chicago School of economics and neoliberalism, where value theory is based on price. It also underlies theories that equate banks to Ponzi schemes. The definitive argument on why we must ring fence cash from risk is Morgan Ricks’ book, The Money Problem. Intriguingly, also, the Guardian recently proposed cleansing money to stop climate change.

This logic is exactly backwards. Why we have uncontrollable risk is not that we treat cash too casually but that we revere it too much. Our reverence blinds us to larger realities.

Risk is merely cash in the future tense. To try to separate cash from risk, we must live in the present tense perennially. We’ve already tried that. It’s called “shareholder value.”

A more effective solution would be to start using fundamental data to quantify future uncertainties and link that analysis to asset prices directly so that prices can reflect the risks that detract from value.

This sounds obvious, but it’s not how finance works. Finance uses synthetic data–traded prices–to arrive at a market price for risk, so that people can buy and sell it.

Such thinking is deeply embedded in our central beliefs about finance and economics since the 195os. This was the Arrow-Debreu model. It helped us think about how finance dovetails with economics, but it left risk dynamics out.

Financial theory says there will always be a buyer of risk for the right price. But our pricing system is emotional, not fundamental. When risk starts to spiral, there are no right prices and no takers.

Just as mid-20C economists strove to link market microstructure to the macro-economy, today we must link cash to credit market microstructure if we want to restore asset markets to health. And yes, this is the fastest path to redressing climate change, too.

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