Can It Happen Again?

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International Journal of Political Economy, vol. 40, no. 2, Summer 2011, pp. 63–80. © 2011 M.E. Sharpe, Inc. All rights reserved. ISSN 0891–1916/2011 $9.50 + 0.00. DOI 10.2753/IJP0891-1916400204

Sergio Rossi

Can It Happen Again? Structural Policies to Avert Further Systemic Crises Abstract: I elaborate on the structural causes of the global systemic crisis of 2007–9 to show that its ultimate origins lie in the still defective bookkeeping structure of national and international payment systems. As monetary circuit theory shows, banks are special, insofar as they can grant loans without the need to dispose of preexistent bank deposits. When the loans-generate-deposits causal chain occurs on the factor market, for firms to pay the wage bill, the money– output relation is not affected by banks’ intermediation. This relation is modified when banks exploit the loans-generate-deposits mechanism for any financial market transactions, whether for their clients or for their own sake. Financial liberalization and deregulation pushed banks to compete with nonbank financial institutions, for them to retain their market share, reducing both their markup on monetary policy rates of interest and the credit standard they used to apply to firms as well as households. In that process, banks have, therefore, become “financial supermarkets,” engaged first and foremost in investment banking, which is a misnomer, because, in fact, it has nothing to do with investment properly speaking: it is speculation on “global” financial markets, which are indeed far from providing any support to productive investment within the economic system. Keywords: bank money, financial crisis, payment systems, systemic risk The 2007–9 financial crisis is, in fact, a structural–systemic crisis, as its ultimate causes lie in the structure of the payment system at both the national and internaSergio Rossi is a professor of macroeconomics and monetary economics at the University of Fribourg, Switzerland. This paper was presented at the DIEF–DiSSE–Laboratorio Vicarelli international conference “Can It Happen Again? Sustainable Policies to Mitigate and Prevent Financial Crises,” University of Macerata, Italy, October 1–2, 2010. 63

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tional levels. A number of behavioral factors such as fraud and greed, predatory lending, and regulatory capture exacerbated the structural flaws of the payment system but did not originate the global crisis observed in the aftermath of Lehman Brothers’ collapse on September 15, 2008. This is the reason that all new regulations being discussed or implemented at the time of this writing—which focus and aim at affecting various agents’ behavior—miss the point, because neither the domestic payment system nor the international monetary regime is actually subject to a structural reform. Hence, in the absence of such a reform, another structural– systemic crisis can happen again. The fact that those banks, which survived after the crisis (with or without public support), continue their “business as usual” around the world is a sign that nothing has changed on structural grounds both within and between domestic payment systems. I show that the origins of the 2007–9 global crisis are structural and systemic and that structural policies are required to avert further systemic crises. These policies should be informed by a monetary circuit approach and focus on reforming the payment system at both the national and international levels. Unless these reforms are carried out, the so-called global economy will be prone to a series of other systemic crises, for no behavioral regulation can have an impact on the working of the economic system as a whole (which is more than the sum of its constituent parts; see Rossi 2010). Causes and Consequences of the 2007–9 Crisis: A Monetary–Structural Approach The 2007–9 financial crisis has been labeled a “subprime” crisis, a “credit crunch,” and a “Minsky moment.”1 The first label (over)emphasizes the fact that this crisis first affected the “securitization” of a number of mortgage loans to individuals whose payment record was problematic but, nevertheless, did not prevent banks as well as mortgage brokers in the United States from lending huge amounts of money to them. When the monetary policy rates of interest decided by the U.S. Federal Reserve began to rise at the end of June 2004, moving from 1.00 percent to 5.25 percent twenty-four months later, an increasing number of “subprime” (as well as “alternative-A” or “prime”) adjustable-rate mortgage holders began having serious problems in servicing their debts, triggering thereby the whole “securitization” chain into severe financial troubles, with the ensuing negative consequences for “global players” on “globalized” financial markets. This elicited a global “credit crunch,” because several banks both in the United States and elsewhere (particularly in Europe) had to reassess and to write down a considerable relevant part of their assets, owing to their direct or indirect involvement (through special purpose or structured investment vehicles) in the markets for asset-backed securities, collateralized debt obligations, and other structured products of financial engineering. As illiquidity and insolvency threatened banks’ and others’ (pension funds, insurance companies, and car manufacturers were also hit severely) balance sheets, credit lines to both

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banks and nonbank agents were cut back in a dramatic and unexpected way in the United States and elsewhere, thus channeling the deflationary pressures from the financial markets to the whole monetary production economy of a number of countries around the world. Economists, policymakers, regulators, supervisory authorities, financial market agents, and mass media have noted numerous factors to explain how such a global and abrupt crisis could originate in the United States and rapidly spread to several countries. These factors boil down to behavior (or lack of it) by a variety of agents and institutions having some role to play on “globalized” financial markets. In macroeconomics, however, the causes of the phenomena observed are deeper than their empirical evidence, which can only depict the superficial outcome of the underlying factors to be discovered by a logical–conceptual analysis of the working of the whole economic system (which no mathematical treatment will ever be able to accomplish).2 The first step toward understanding, and thereby curing, the ultimate causes of the 2007–9 global crisis, therefore, is to consider the economic system as a whole, and notably as a complex set of circuits within which money is pervasive for any kind of economic activities domestically as well as internationally (see Rossi 2007b and references cited therein). It is indeed neither by chance nor by negligence that the global crisis originated in the United States: as the country issuing the so-called (main) reserve currency, the United States—since the Bretton-Woods agreements were signed in 1944—has been enjoying what (using de Gaulle’s expression) has come to be known as the “exorbitant privilege” (see, e.g., Gourinchas and Rey 2007: 12) of paying its current account deficits “without tears” (Rueff 1963: 322). In fact, whenever a “key currency” country pays the rest of the world a given sum of local currency for any sort of imports from it, the relevant bank deposit cannot but remain recorded in the banking system that gave rise to it (see Table 1). This is the unavoidable result of the payments’ mechanics and does not depend on any agents’ behavior. As such, no regulation acting on behavior will ever be able to avoid the structural flaw originating this phenomenon; only a monetary–structural reform can eradicate it (see Cencini 2010 and Rossi 2009c, who expand on this in light of monetary circuit theory). Let us start from scratch (tabula rasa) to avoid the temptation to explain the formation of a bank deposit by a transfer of a preexistent bank deposit whose origin would remain indeed unexplained. Suppose that an agent residing in country A (United States) imports some items from country C (China) and therefore must pay a given resident for them in country C. In this case, the payer (in country A) has to obtain a loan from any local bank (or the national banking system as a whole, BSA) to pay the exporter who resides abroad (the payee who banks with the banking system of country C, BSC). When this occurs, the payer’s account (in BSA) is debited (that is, his debt to BSA increases by, say, y units of money A (MA)) and the payee’s account (in BSC) is credited analogously with a sum of z units of money C (MC); we therefore suppose that y MA = z MC. Of course, this is a final payment for both the payer and the payee, because, as a result of it, the “seller of a good or service, or


Table 1 The Result of an International Payment in the Current “Non-System” Banking system of importing country A (BSA) Assets Loan to the payer

Liabilities +y MA Deposit of BSC

+y MA

Banking system of exporting country C (BSC) Assets Official reserves (+y MA)

Liabilities +z MC Deposit of the payee

+z MC

another asset, receives something of equal value from the purchaser, which leaves the seller with no further claim on the buyer” (Goodhart 1989: 26). This, however, does not yet represent a final payment for the two countries concerned: the fact that the (net) exporting country (C) enters an amount of y MA in its reserves (recorded by the national banking system, BSC) confirms that this country still has a claim on the net importing country, A. Indeed, the importing country (A) does not suffer any loss of bank deposits (in BSA) as a result of the cross-border payment order carried out by the local banking system in the name of the payer (resident in country A). It is true that the relevant deposit entered on the liabilities side of BSA’s balance sheet is owned by a nonresident in country A (this is a deposit owed to a foreign banking system [BSC], through which the exporter is finally paid). Yet this deposit cannot be anywhere but in country A, whose banking system, to be sure, may still “circulate” it in any kind of economic transaction, including transactions that are purely speculative, as I explain later. In a nutshell, international payments in the current “nonsystem” (Williamson 1977: 73) do not give rise to the transfer of the relevant bank deposit from the payer country to the payee country; so the payee country would have no further claim on the payer country (defining, thus, a final payment between them as explained above). As Table 1 shows, in fact, when the banking system of the payer (BSA) informs the banking system of the payee (BSC)—that is, when BSA records a deposit in the name of BSC—the payee country is entitled to “monetize” this addition to its official reserves, crediting the exporter with an amount labeled in local currency. There is thus a “duplication” of the original deposit—which remains indeed in the payer country’s banking system—so that the payee country obtains just its “duplicate.” This duplicate has no purchasing power, as the object of it (a foreign output, produced in country A) remains in the payer country—which therefore does not pay for its (net) imports.3 As Rueff puts it, Entering the credit system of the creditor country, but remaining in the debtor country, the claims representing the deficit are thus doubled.

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This is so, because any deficit in the balance of payments of a country whose currency is returned to it—the United States and, in the sterling area, England—produces a duplication of the world’s credit base. In effect, the claims transferred for the settlement of the deficit are bought against the creation of money, by the banking system of the creditor country. The cash balances thus created are handed over to the debtor country. But at the same time, these claims against which the creditor country has created money are replaced on the market of the debtor country. Thus everything happens as if these currencies had never been exported in the first place. (1963: 323–24)4

We thus notice two important points for understanding the ultimate origins of the 2007–9 global financial crisis. First, within the international economy, national currencies are treated as objects of trade (whose “price,” the exchange rate, thus fluctuates according to demand and supply conditions) rather than being used in conformity with their nature of means (rather than objects) of payment.5 Second, key currency countries cannot but “recycle” on their local markets those bank deposits that their national banking systems generate, as a result of the payment mechanics indicated above. Elaborating on Table 1 allows us to explain that those deposits resulting from the cross-border payments carried out by the banking system of the debtor country (BSA) are available for domestic spending in any kind of markets. In particular, having to pay interest on all deposits, banks are induced to find suitable borrowers (so much so that competition among banks leads each of them to implement a variety of predatory lending practices) and, owing to financial deregulation and liberalization, to “off-load” the more risky of their loans into some sort of structured investment vehicle. These special vehicles have the purpose of securitizing these credits, to sell them on globalized financial markets—most of the time to unaware institutional investors (e.g., pension funds and insurance companies)—with the marks of complacency given by a handful of American rating agencies. As shown by the 2007–9 financial crisis, this chain of events turns into drama on a global scale, as those structured products that result from securitization are sold throughout the globe, affecting (or infecting, as they become “toxic”) a number of balance sheets of agents and institutions across the world, so much so that their total volume is a multiple of world output (as in the derivatives industry, which is thereby “several layers removed from any real economic activity of value creation” [Guttmann 2008: 9]). This international monetary disorder—which blurs the distinction between a promise of payment and a final payment between countries—originates thereby an increasing stock of financial capital every time key currency countries “pay” their current account deficit in foreign trade. This was first noted by the “Triffin dilemma,”6 which recalled that “having to supply other countries with dollars for their cross-border payments, the United States must run chronic balance-ofpayments deficits to maintain steady outflows of dollars to the rest of the world” (Guttmann 2008: 11). This huge amount of financial capital deposited in the U.S.


banking system, to which no output corresponds in the United States or the rest of the world7 therefore originates inflationary pressures within the domestic economic system in the form of (real and financial) asset “bubbles”—thus provoking “boomand-bust” cycles à la Minsky (1982).8 Banks’ Bookkeeping in Finance-Dominated Regimes Although the international monetary disorder indicated in the previous section originates in key currency countries only (i.e., those countries allowed to “pay” with a simple promise to pay internationally), there is also a domestic monetary disorder that concerns, and affects, every country around the world. All countries have indeed to date a domestic payment system. In this system, banks are special, as each of them can issue money in any payment with no need to dispose of preexistent bank deposits for this payment to be carried out finally. No other agents or institutions (apart from central banks, of course) have the same capacity; nonbank financial institutions need to have a preexistent bank deposit (either owned or borrowed from either a bank or the financial market) for them to carry out a payment on any kind of market.9 To be sure, the loans-make-deposits mechanism is exclusively the result of double-entry bookkeeping by banks. It is necessary for the existence of any monetary economies of production and exchange but not yet sufficient to avoid any mismatches between money and output as a result of banking. As the theory of monetary circuit explains, firms need to apply to banks for them to obtain credit lines for the whole amount of their production costs. When firms pay the wage bill to workers through the banking system, national income is formed as a bank deposit resulting from the relevant payments to the wage earners in the consumption goods as well as in the investment goods sectors. As Keynes (1936: 213–14) noted in this regard, wages are the sole macroeconomic cost of production, because labor is the sole true factor of production. Considering the set of firms as a whole, all costs of production are therefore wages, as interfirm purchases cancel out at the macroeconomic level (see Graziani 2003; Schmitt 1966). Now, if the loans-generate-deposits causal chain is crucial for the production of income in every national economy, the bookkeeping structure of domestic payment systems enables banks, and banks only, to exploit this causality for their clients or for their own sake—particularly in a variety of financial market transactions that have no income-generating properties (they are, so to speak, income-transferring operations in a zero-sum game for the whole economic system). Finance-dominated regimes10 are so because of this causality being put to practical use for banks (i.e., their managers and shareholders) to seek increasing financial rents from incomeproducing activities and to the detriment of society as a whole (see Forges Davanzati and Tortorella Esposito [2010] for a recent analysis of these rent-seeking forms of behavior, and Stellian [2010] for the resulting effects in light of monetary circuit theory). The loans-generate-deposits causal mechanism exploited for banks’ profit works as shown, in a stylized form, in Table 2.

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Table 2 The Result of Opening Credit Lines on the Interbank Market Bank A Assets Loan to bank B Deposits (into bank B) Securities (sold to bank B)

+x m.u Deposit of bank B +y m.u.

Liabilities +x m.u.

–y m.u. Bank B

Assets Deposits (into bank A) Securities (sold to bank A) Loan to bank A

Liabilities +x m.u. –x m.u. +y m.u. Deposit of bank A

+y m.u.

Note: m.u. = money units.

Suppose that bank A and bank B open a credit line reciprocally for a number of x and y units of money, respectively (x may be higher or lower than y or the figures may be equal). To acknowledge their debts, both banks issue and exchange the relevant number of securities between them. When they do this, the sum of bank deposits available in the banking system as a whole increases by x + y money units—without any increase in output, hence introducing a discrepancy in the money-to-output relationship, which is likely to induce some inflationary pressures in the economic system eventually. Indeed, when, say, bank A disposes of its deposit in bank B to purchase some assets on the financial market, this can increase the prices of these assets, thus allowing bank A (into whose balance sheet these assets are recorded) to further enhance its lending, as it complies with Basel-II like (pro-cyclical) agreements. The fact that bank B can do the same, disposing of its deposit in bank A, further exacerbates the (potentially destabilizing) forces at play on interbank and financial markets alike. In short, banks can exploit their loans-make-deposits causal mechanism to enhance their activities on financial markets, underestimating risk as well as encouraging asset bubbles and excessive leverage by banks (and nonbank financial institutions, including those of the so-called shadow banking system). This is so much so when all banks “move forward in step” (Keynes 1930: 23), that is, when each of them exploits the loans-make-deposits causality on financial markets so that, at the end of the day, it is impossible to detect any settlement problems on the interbank market, because, referring to our stylized example, x and y are equal in this case. Hence, there is no interbank debt to be settled, and banks are thus sure that no central bank money will be required for that purpose from any of them involved in these activities, which, as a result, neither monetary authorities nor financial market supervisors will investigate any further in this regard.11


To date, there is no endogenous (structural) limit for banks to engage in speculative activities even though they lack the funds to pay for the real or financial assets they buy in these transactions. This is so much so when banks become universal, that is, cover in-house the whole spectrum of financial activities, which deregulation, globalization, and computerization have greatly expanded and profoundly transformed. As Guttmann observes, “This triple push has changed our financial system from one that was tightly controlled, nationally organized, and centered on commercial banking (taking deposits, making loans) to one that is self-regulated, global in reach, and centered on investment banking (brokerage, dealing, and underwriting of securities)” (2008: 4). In fact, investment banking has nothing to do with investment properly speaking: from the point of view of the economy as a whole, it does not generate new income, but is merely a speculative activity aimed at transferring (preexistent) income to the benefit of banks and their managers or shareholders. It consists thus in rent-seeking operations on market fields that are several layers removed from any sort of productive investment—which is a macroeconomic operation as it affects, positively, the level of income in the economic system as a whole. These operations are, indeed, the result of the deep structural changes brought about by financialization in our monetary economies of production over the past thirty years or so (see Rochon and Rossi 2010: 8–12). In the prefinancialization era, banks were key in advancing initial finance to (nonfinancial) businesses, which spent it in paying out wages to their collaborators. As a result, firms were in debt to banks and wage earners had a credit on them in the form of bank deposits— whose purchasing power the households exerted on the market for produced goods and services, allowing thereby the set of firms to obtain final finance for them to reimburse the banks from which they obtained their credit lines for the opening of this monetary circuit (Graziani 2003). Figure 1, adapted from Seccareccia (2009: 2), illustrates the relevant circuit revolving around the key role played by (commercial) banks in that respect. Financialization changed this framework dramatically, to the detriment of wage earners, first, and of the whole economic system eventually. As Forges Davanzati and Tortorella Esposito (2010) explain, labor market deregulation has negative consequences on the purchasing power of wage earners, particularly so when this is associated with restrictive fiscal policies. Reducing public sector intervention and decentralizing wage bargaining increase the downward pressures on wages for at least two reasons. On the one hand, workers accept lower wages, because they fear unemployment and the related lower compensation by social security. On the other hand, their productivity increases, as they fear being dismissed, considering their reduced bargaining powers. All these phenomena combine to give rise to lower employment levels, which put pressure on wage earners to reduce their compensation claims. The possibility for wage earners to apply for, and rather easily obtain, consumer credit is an additional factor that explains how the labor market regime elicited by neoliberal economic policies had been operating for about three

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Figure 1. The Key Role of Banks in the Prefinancialization Era

decades before the 2007–9 financial crisis burst in the United States (for analytical elaboration on the unfolding of this crisis, see Stellian 2010). These structural changes moved wage earners from a creditor to a debtor position with respect to banks and reciprocally for nonfinancial businesses. As Seccareccia notes, “Instead of industry being the net borrower in relation to the banking sector, growing profits and retained earnings associated with a relatively weak business investment have slowly transformed (or “rentierized”) the non-financial business sector itself into a net lender that seeks profitable outlets that provide high financial returns for its internal funds” (2009: 3). Indeed, retained profits by nonfinancial firms are recycled on global financial markets rather than invested in new production processes. The result was a rapidly inflating asset bubble in the early 2000s on real estate properties and financial (structured) products, which in the end burst and ravaged the global economy. The role of banks has thereby changed owing to financialization and has become much more oriented to financial market activities for their own sake or their clients’ (i.e., principally (non)financial businesses and wealthy people). Figure 2 illustrates this schematically (Rochon and Rossi 2010: 11). In finance-dominated regimes, a large and increasing share of credit granted by banks is directed toward financing consumers’ demand rather than investment projects by nonfinancial firms, as these projects have been largely limited by financialization. This also explains the persistence of involuntary unemployment, because firms find it more profitable to lend their profits in financial markets rather than investing them in the production process (see Gnos 2009). Monetary circuits are thereby driven by financial markets and motives, rather than by labor markets and productive investment. The relation between banks and globalized financial markets has thus become instrumental in the working of any finance-dominated


Figure 2. The Altered Role of Banks in Finance-Dominated Regimes

regimes, and it dictates the pace and the path of economic growth as well as the short-term objectives of both financial and nonfinancial businesses today. As a matter of fact, owing to financial liberalization and deregulation, banks may and do have to compete with nonbank financial institutions on credit markets for them to try to keep their market share, reducing both their markup or spread on policy rates of interest and the credit standard they used to apply to firms and households. In such an environment, as Seccareccia notes, “banks have played a key role by being the primary providers of the financial raw materials that have gone into feeding, through securitization, the financial markets via the investment banks . . . with new, and ever more sophisticated, speculative derivatives—that are then sold in the financial markets, through hedge funds, etc., to the new corporate rentiers” (2009: 6). This key role played by banks would not have been possible were they obliged to structure their bookkeeping entries according to the fundamental distinction between income-generating and mere income-transferring operations on any kind of markets. I expand on this in the next section. A Monetary–Structural Reform of Banking Activities to Avert Further Systemic Crises Bank regulators and supervisory authorities should not waste time and effort trying to affect the behavior of financial market operators, introducing (or amending) all

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sorts of rules to distinguish among banks and nonbank financial institutions as well as between systemically important financial institutions (too big to fail, alone, or as a group) and all the rest. The most effective regulations are, in fact, those affecting the structures of the very system through which all these actors play their role in domestic and cross-border markets. As I have shown, the 2007–9 global financial crisis has its origin in the current structure of both national and international payment systems. If this analysis is correct, the solution to avert further systemic crises is plain: the banks’ bookkeeping must distinguish those payments that give rise to new income from all other payments, which merely transfer (preexistent) income from the payer to the payee. In light of the theory of the monetary circuit (see above), income-generating payments can only occur on the factor market when firms pay out wages to their workers through the credit lines that banks open to them. Logically, financial market transactions cannot generate a positive income in the economic system as a whole, as these transactions do not concern production but just the exchange of financial claims between any two market participants. Logic as well as conceptual thinking lead us thus to the conclusion that the regulatory changes needed to prevent any further systemic crises in finance-dominated regimes will have to affect the structure of contemporary payment systems at both the national and international levels. Let us focus in this article on the necessary reform in domestic payment systems, in light of the analysis I presented in the previous section, referring readers interested in the international payment system reform to Rossi (2009c) and Cencini (2010). Both reforms certainly require strong political will to be carried out, so much so that the appropriate momentum for their realization is vanishing, as a number of countries’ economies are, at the time of writing, apparently recovering from a sharp recession (which appears to be gone, according to some indicators that mainstream economists use as empirical evidence that the time for so-called exit strategies has come for governments around the world). Banks—that is, those financial market institutions that can make a payment without having preexisting (either owned or borrowed) bank deposits—will have to record their transactions in two separate bookkeeping departments analogous to the departments named issue and banking departments introduced by the 1844 Bank Act for the Bank of England to not impair monetary stability of the national economy under the gold-standard regime.12 As Bradley points out, “The division [in two departments, one for banking activities and the other for the issue of bank notes by the Bank of England] adopted in 1844 failed to fulfill its objectives because it was based on an exogenous conception of money” (2001: 3). Yet, considered in light of money endogeneity, as explained by monetary circuit theorists, the separation of banks—not just the central bank—into two functionally distinct bookkeeping departments remains relevant today. In particular, it allows the distinction, explicitly, between money emissions for income-producing payments and money emissions for all those payments that simply transfer a preexisting income in any kind of market. Reforming banks’ bookkeeping structure to introduce this distinction will


thus enable banks, as well as their supervisors, to know at any point in time the amount of income that banks’ clients deposit with them, beyond which no financial market operation will be allowed, as it would rely on a pure creation of money to which no income corresponds. Let us illustrate this monetary–structural reform referring to the stylized example above. Suppose that bank A has issued x units of money in payment for the wage bill of firm A and that bank B did the same for firm B but for a number of y money units. Income has thereby been formed for a total sum of x + y units of money within the whole economic system. Table 3 records the results of these money emissions in bank A’s and bank B’s books. Entry (1) shows the emission of money to the benefit of the relevant firm, which has to pay the wage bill to its wage earners, who are credited with a bank deposit by entry (1′). As soon as this payment is carried out by the bank, the latter transforms the monetary debit of the firm (entry 1) into a financial loan (entry 2′), on which interests will accrue daily, as this is standard practice in any bank. The balance of all these entries shows in the end that the firm has indeed a financial debt to the bank, which in turn is financially indebted to a firm’s wage earners. So far, the results are no different from today’s (single-department) banks’ bookkeeping, which in fact already records both firms’ financial debts and wage earners’ financial credits to the relevant bank. Now, whenever a given bank carries out any financial market transactions that do not generate new income for the whole economic system, the two-department structure of bank accounts will show the maximum amount (of income) that the bank will be able to spend for its own sake or for its clients’ without inducing financial instability. As Table 3 shows, bank A may either lend or dispose on financial markets of no more than x units of money income, as this is the total amount of purchasing power available in it. Bank B may for its part do the same, for a maximum amount of y units of money income. If any bank is lending or disposing of financial market transactions of a greater amount of money than it has in the form of deposits, it would have to record this transaction through its two accounting departments, that is to say, create ex nihilo in its issue department the number of money units to add to the money income available in its banking department, thus transparently breaking the related bookkeeping rules stemming from bank departmentalization. This would lead to an immediate sanction from banking supervisors, providing thereby the incentive for any bank to abide by these rules in any of its financial market transactions. If this is done, the entries recorded in Table 2 will not be possible, unless the relevant bank either owns or borrows the necessary (preexistent) deposits, which it will then spend on either interbank or financial markets for any income-transferring operations. In the latter case, bank A, for instance, will record the entries shown in Table 4. Entry (3′) records the fact that bank A sells some securities (in its trading book) to firm B’s workers (who have their relevant deposits with bank B). As a result of

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Table 3 The Results of the Payment of Wages through the Banks’ Two Departments Bank A Issue department (I) Assets

Liabilities

(1) Credit to firm A

+x m.u. Department II

+x m.u.

(2) Credit to firm A

–x m.u. Department II

–x m.u.

(*)

0

0

Bank A Banking department (II) Assets

Liabilities

(1’) Department I

+x m.u. Deposit of workers A

+x m.u.

(2’) Loan to firm A

+x m.u. Department I

+x m.u.

(*) Loan to firm A

x m.u. Deposit of workers A

x m.u.

Bank B Issue department (I) Assets

Liabilities

(1) Credit to firm B

+y m.u. Department II

+y m.u.

(2) Credit to firm B

–y m.u. Department II

–y m.u.

(*)

0

0

Bank B Banking department (II) Assets

Liabilities

(1’) Department I

+y m.u. Deposit of workers B

+y m.u.

(2’) Loan to firm B

+y m.u. Department I

+y m.u.

(*) Loan to firm B

y m.u. Deposit of workers B

y m.u.

(*) is the balance of those entries that are recorded in the relevant department.

this operation on the financial market, the property right on the deposit of y money units recorded with bank B moves from firm B’s workers to bank A, as testified by entry (3″). Entry (4′) is, by way of contrast, the record of another financial market transaction in which bank A disposes of its deposit with bank B to purchase some financial assets whose price is y. Entry (4″) records, therefore, the transfer of (the


Table 4 The Result of a Financial-Market Transaction in the Reformed BookKeeping Structure for Domestic Payments Bank A Banking department (II) Assets

Liabilities

(*) Loan to firm A (3’) Deposit (into bank B) Securities (sold to workers B) (4’) Deposit (into bank B) Financial assets (bought from a trader (a client of bank B)) (**) Loan to firm A Trading book (memory item): Securities (sold) Financial assets (bought)

x m.u. Deposit of workers A +y m.u. –y m.u. –y m.u. +y m.u.

x m.u.

x m.u. Deposit of workers A

x m.u.

–y m.u. +y m.u.

Bank B Banking department (II) Assets (*) Loan to firm B

(**) Loan to firm B

Liabilities y m.u. Deposit of workers B (3’’) Deposit of workers B Deposit of bank A (4’’) Deposit of bank A Deposit of trader y m.u. Deposit of trader

y m.u. –y m.u. +y m.u. –y m.u. +y m.u. y m.u.

(*) initial balance; (**) final balance.

property right on) the relevant deposit with bank B from bank A to the trader selling these assets to it. All in all, as the final balances show, in both bank A and bank B, the total sum of available deposits within the whole banking system (x + y) corresponds to the loans that banks provided to the nonfinancial business sector (firms A and B) for the latter to remunerate their workers in the labor market. As the object of both firms’ debt to the banking system is produced output, this ensures that the money–output relationship established on the factor market through the payment of wages (see above) is left unaffected by those financial market operations that banks may carry out for their clients or for their own sake. If all operations that any bank carries out on financial markets has to be recorded, as shown in Table 4, distinguishing between the issue and the banking department in its bookkeeping, then no bank will have an interest in off-loading any part of its loans into special purpose, or structured investment, vehicles. Appropriate structural reforms, therefore, have a positive influence on agents’ behavior, although the latter is not constrained at all by the former. Simply, what to date is a potentially destabi-

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lizing form of behavior will not be so anymore once the structural reform proposed above has been carried out. Individual freedom and financial stability will thus be preserved simultaneously, with a regulatory reform in banking that puts into practice the distinction (between money and credit) by which monetary circuit theory has been developed in the history of economic thought (see Rossi 2007: ch. 1). Conclusion Contrary to widely held beliefs, the ultimate origins of the 2007–9 huge financial crisis were not behavioral but structural. It is the book-entry structure of payment systems that, to date, puts financial stability at stake and generates boom-and-bust cycles à la Minsky (1982). This is particularly so for finance-dominated regimes, within which banks have the original responsibility of exploiting their loans-makedeposits feature to extract purely financial rents from monetary circuits that have no value-added properties for the whole economic system. Waiting for G-20 leaders to elaborate and agree on a structural reform for international payments—which is in the mutual interests of deficit and surplus countries, as indicated in this article—13 any country can dispose of the internal flaw that impedes financial stability on structural grounds. The required reform will have to avoid blurring the distinction between income-generating and income-transferring transactions as recorded by banks’ bookkeeping, considering that money endogeneity must be framed within an appropriate structure for domestic payment systems, in particular with respect to financial market transactions that are merely speculative, as they do not create value in the economic system as a whole. Notes 1. As Minsky (1982: 95) explains with his now famous financial instability hypothesis, a period of steady economic growth induces more risky forms of behavior of financial market operators, spurred also by financial innovations. The debt structure of the economic system becomes problematical, as agents reduce the security margin on debts in light of the apparent stability of that system. When the prevailing financial conditions worsen, the economic system becomes unstable, leading to a crisis. The phase when agents do have financial problems because of their overindebtedness has been labeled a “Minsky moment”: at this moment (forced) sales of financial assets provoke a sharp reduction of their prices, which aggravates the financial problems of (over)indebted agents, so that the whole system becomes progressively unstable, owing to a “debt-deflation” dynamics as noted by Fisher (1933). See Whalen (2008: 6) and Desmedt et al. (2010) for analytical elaboration on this point. 2. See Rossi (2010) for an analytical elaboration. 3. This is just another proof of the fact that the payment carried out by country A is merely promised rather than being final as indicated above. 4. U.S. current account deficits are thus explained by structural, rather than behavioral, factors. As Rueff and Hirsch observed metaphorically, “If I had an agreement with my tailor that whatever money I pay him returns to me the very same day as a loan, I would have no objection at all to ordering more suits from him” (Rueff and Hirsch 1965: 2). See also Bergsten (2009) in this respect.


5. The fact that national currencies are denatured in the international economy explains their exchange rate erratic fluctuations (see Rossi 2009d). 6. See Triffin (1963). More recently, this problem appeared in the so-called global imbalances (see Rossi 2009c). 7. As these bank deposits (such as y MA in Table 1) result from payments of (net) imports by the country considered, there is obviously no national output associated with them. There is also no foreign output to which these deposits can be associated, as the imported foreign output is already associated with a foreign bank deposit, namely, the deposit that stems from the payment of the production costs for this output (in the exporting country). This financial capital is therefore fictitious, which implies that “the market value of paper claims could be driven up without any parallel increases in the valuation of any tangible assets, through the use of credit, for the benefit of trading those claims profitably” (Guttmann 2008: 9). 8. This is so when monetary policy strategies focus mainly, if not exclusively, on targeting a rate of increase in consumer prices, neglecting or ignoring asset price inflation (see Rochon and Rossi 2010: 20). For a critique of inflation targeting regimes, see Rossi (2009b). Rossi (2009a) discusses the merits of flexible inflation targeters, such as the Swiss National Bank, whose monetary policy also considers the economic situation with respect to output and employment levels to steer policy rates of interest. 9. The so-called shadow banking system is therefore a misnomer, for none of its constituent parts (hedge funds, insurance companies, and so on) has the capacity to generate new bank deposits in the system as a whole (i.e., exploiting the loans-make-deposits causal chain noted by money endogeneity advocates; see Rossi 2007a and the references quoted therein). 10. This label, or equivalently “finance-led growth regimes,” defines the stage of capitalist development that is driven by finance (see Epstein 2005; Hein 2010). 11. See Rossi (2007: 71–78) for an explanation of interbank settlements in central bank money. See also Cordey and Rossi (2010) for a proposal aimed at improving on cross-border settlement processes to limit systemic risks for banks and nonbank financial institutions. The fact that interbank transactions on assets, as in the stylized example above, may occur “over the counter” rather than on formally structured markets (overseen by some clearing institution) adds to the systemic risks generated by these transactions to date. 12. The 1844 Bank Act stems from a long theoretical struggle between the Banking School (see Fullarton 1844; Tooke 1844) and the Currency School (see Ricardo 1824/1951). The latter school argued that the emission of bank notes by the Bank of England ought to be separated from its financial intermediation activities to distinguish money and credit in the central bank’s books, limiting money creation by the full metal backing of the notes issued by the bank. As Ricardo indicated, “The Bank of England performs two operations of banking, which are quite distinct, and have no necessary connection with each other: it issues a paper currency as a substitute for a metallic one; and it advances money in the way of loan, to merchants and others” (Ricardo 1824/1951: 276). Observing that these two operations have no necessary connection, Ricardo argued that they can be carried out by two separate bodies, “without the slightest loss of advantage, either to the country, or to the merchants who receive accommodation from such loans” (Ricardo 1824/1951: 276). 13. See Piffaretti and Rossi (2010) for an analytical elaboration on this.

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