In an additional effort to revive the ailing European economy, the ECB is now preparing to expand the money supply through the purchase of asset-backed securities. Although central banks have always been able to use their balance sheet for the transmission of monetary policy, the extent of its use by the Federal Reserve, the Bank of England, Bank of Japan and the Swiss National Bank since the global financial crisis demonstrates how their role has shifted from that of lender of last resort to that of dealer of last resort. Through buying securities, central banks can influence their price or, as in the example of the ECB, revive otherwise dried up capital markets. Moreover, it shows the increasingly important role of securities in the money creation process.
The securitization of assets, and more generally the ability to create tradable instruments from otherwise illiquid assets, has been key in developing deep and liquid financial markets for the important goal of recycling "old" capital into dynamical investments for innovations. Loans are converted into securities, which in turn can be used as collateral for further credit creation. Short-term securities have become money-like instruments, as large institutional investors prefer not to hold cash in bank deposits but rather instruments such as repurchase agreements or commercial paper. Dealers manage the conversion of deposits into securities and vice versa by taking on inventory and price risk. The banking crisis of 2008 was not a traditional bank-run on deposits, it was primarily a run on short-term securities. In contrast, traditional banks manage the conversion of deposits into currency by taking on liquidity risk. They create money through the creation of loans and deposits, which are claims on currency. Currency in turn is the creation and liability of the central bank. This whole edifice is often referred to as the "hierarchy of money", which is inherently fractional at all levels because money is always scarcer than credit. Under the Gold Standard, currency used to be convertible into gold. Nowadays, it is no longer convertible into anything other than itself and, from a balance sheet perspective, it is backed primarily by securities. Being at the top of the institutional hierarchy, central banks can use their ability to create money to support credit creation at institutions below. The irony of our times is that we combat excessive credit creation prior to the global financial crisis with more money and credit creation. However, from the perspective of the hierarchy of money, what counts as money and what counts as credit depends on your point of view: money at one level of the hierarchy is merely credit for the institution above.
This hierarchical perspective of money creation reveals two fundamental insights. First, as securities back currency, the hierarchy of money closes into a circle, illustrated by the graph depicting the hierarchy of money in the shape of an Ouroboros:
The "Inherent Hierarchy of Money" and its feedback loop
Securities are both (i) part of the fourth level of money, (ii) are credit of the third level, but (iii) can also be used again for money creation at the first level. This combined process of money and credit creation can continue in principle many times, creating securities of securities of ... Indeed, on the positive side, the use of securities as money of the first level provides the engine for full (and more than full) use of capital that would be otherwise unutilized. On the negative side however, this loop creates intrinsically the recurrent danger of instabilities and excessive credit. The second insight relates to what we call the "illusion of the perpetual money machine"; the implicit belief that value can be created through financial profits and debt rather than through productivity and innovation in the real economy. Securities are a store of value, representing fractions of firms and households. Their value is derived from the cash flows that these entities are expected to generate in the future. Because any financial instrument is just a derivative of the real economy, value can ultimately only be generated in the real economy and is the foundation of the value of securities, which in turn is increasingly the foundation of money creation.
Through buying private sector debt in the form of newly issued asset-backed securities, the ECB will directly facilitate credit creation for firms and households. In order to generate growth, these must be used for productive investments. If these loans are primarily used to finance real estate and consumer spending (the two largest categories of outstanding European asset-backed-securities) with immediate GDP growth but without facilitating innovation, all we can expect from them is the further fuelling of asset bubbles and debt.
Source of graph: "Inherent Hierarchy of Money" as clarified by Perry Mehrling, and our own interpretation within the Ouroboros representation to show how securities are recycled at the first level to stress the insight that the hierarchy of money is actually closing on itself.