Debt Obligations and the Need for Regulation

By Dan Kervick

Brad DeLong says he often wondered why Milton Friedman was willing to accept the need for government regulation in the world of money and banking, but not elsewhere:

In my rare coffees and phone calls with Milton Friedman, I found I could distract him whenever I was losing an argument by saying: “Why is it that the government needs to intervene and keep the flow of liquidity services provided to the economy growing along a smooth path? Why must there be a quantitative target achieved by government for the path of the liquidity services industry–commercial banking–when there must not be a quantitative target for kilowatt hours or freight-car loadings?”

DeLong reports that Friedman had no really good answer, but had a few undeveloped ideas:

He would chuckle and say it was a hard problem, but that he was confident that someday he or somebody else–maybe even me–would find a good, concise, convincing way of proving the point that a modern economy needed very heavy-handed government intervention in regulating the commercial banking industry but nowhere else. It was, he thought, something about the social waste of unnecessary bankruptcy, the catastrophic consequences of bank failures, debt deflation, and the fact that the price of liquidity services was intimately tied up with the units of account that we used to denominate our web of debt.

I think DeLong’s focus here on the concept of liquidity – roughly speaking, the ease with which some asset can be converted into cash at its current price, and the ease with which cash can be converted into something else of the seller’s choice – might be a little bit off the mark.   Rather, I believe the right concept to zero in on in connection with the monetary system and banking economy is the concept of a debt obligation, with an extra complication thrown in by the role of negotiable debt obligations.  The fact that these negotiable debt obligations are usually highly liquid is a third complicating factor that is important, but not really the heart of the matter.

We don’t live in either a barter economy or a spot transaction economy, and so a large percentage of our transactions involve a promise for future delivery on at least one side of the transaction. The promise might be for goods and services, or it might be for another kind of negotiable debt obligation like a bank deposit balance or a note.  Or it might be a promise for that peculiar modern form of non-interest-bearing, government-issued liability that is “debt” only in an honorific sense, i.e. the money issued by governments.

Debt obligations essentially involve a reference to the future.  And the future is (i) inherently hard to predict with any precision, and (ii) something about which people think with decreasing rationality the more remote it is, (iii) a mostly unknown space that people tend to fill up with fears, fantasies and wishes, and (iv) a place where surviving institutions will be run by groups of humans who are not the very same humans who made the contracts that then come to bind the former groups.  So transactions that make reference to the future are a very fertile ground for some terrible calculations based on wishful thinking, fraud, recklessness and primitive stupidity.

Yet our whole sophisticated, modern economy is based on interlacing and complex chains of promises extending deeply into this fraught and mysterious land of the future, and the ability of any one party to make good on the promises made by that party depends on the ability of numerous others to make good on the promises made to that party. So the vicissitudes of individual human irrationality and deceitfulness are knitted together into a fabric on which we all collectively depend. If individual miscalculations only affected that individual’s own life, there would be less cause for alarm. But they don’t; we’re all connected in the web of debt obligations.

The fact is that people acting alone aren’t all that bright, they aren’t all that far-seeing and they aren’t all that honest, so except for cases in which their transactions are constrained by factors that are facing them in the present moment, where all the relevant information is transparent to them and right in front of their eyes, and where the negative impacts of their own personal decisions aren’t easily offloaded to others, their actions need to be socially well-regulated on the basis of those somewhat wiser and more sober judgments coming from historical awareness and the chastisements of experience.

Cross-posted from Rugged Egalitarianism

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