Why do we suffer from recurring financial and banking crises? Since we are, once again, living through a new crisis, it is perhaps worth leaving the headlines behind and reflecting on the more structural reasons for recuring crises, and how this may change in the future.
A common narrative is that recurring financial crises are the fruit of a broad deregulation of the financial system beginning in the '80s.
It is certainly true that the frequency of financial crises has increased in recent decades, but financial crises have a long history going long before the period of liberalization and globalization that began in the 80s.
Another thesis is that crises are part of the capitalist process, the result of an investment process made difficult by inherent uncertainties, the irrationalism of "mass psychology", which lead to all kinds of exaggeration, speculative bubbles followed by crashes, etc.
This is all true and many financial crises are the result of speculative processes that lead to bubbles, but as we are seeing in the current banking crisis, bubbles are not necessary for a banking/financial crisis.
I would put that the main factor that leads to recurring financial crises is the confluence between money in its public and private senses.
We think of money as a mechanism serving three classical functions: stores of value, unit of account, and medium of exchange.
Let’s realize that there's an inherent tension between the functions of store of value and medium of exchange. If paper money and deposit at the central bank represents the ideal form of medium of exchange, it is not a very good means as a store of value because of the existence of inflation and the opportunity to earn interest.
This leads to the creation of a spectrum of money types, sacrificing its immediate use as an exchange medium in favor of a potential store of increasing value.
This is at the basis of the fractional banking system: your demand deposit is transformed by the bank into a credit operation, having a longer maturity.
Obviously, such a structure is potentially unstable, and so we have created a whole regulatory and insurance apparatus to deal with this instability.
But no apparatus will work all the time, either because of information asymmetries; regulatory capture; and the fact that no bank is immune to truly extreme scenarios – as we have seen in recent years with extreme monetary and fiscal stimuli due to the pandemic followed by the fastest monetary tightening in recent history.
Most of us think that what we have in the bank is money, but in fact it is a type of "private" money, in the sense that it represents a financial operation intermediated by a private entity, where the deposit has as partial backed by a credit operation.
There are other examples of private money, and the financial system also has the ability to create money endogenously: when a bank has decided to create a loan (an asset) it already has its backing automatically created by the deposit it makes (a liability). Only prudential rules and profitability incentives discipline the amount of credit or private money that the banking system can create at any given time.
One thing is true: all major global recessions have been accompanied by some collapse in the provision of private money. This is always the "weak link" that breaks.
Economists such as Milton Friedman and Irving Fisher after the Great Depression suggested versions of "full reserve banking", where 100% of bank deposits would be backed by public money, or reserves deposited with the central bank, treasury bills etc.
Despite the obvious attraction of the proposal with regard to financial stability, it has never been adopted in practice, since despite all the risks, the economy needs the intermediation of credit by banks, and only banks have access and incentives to analyze the information necessary to measure and price credit risk.
Thus, despite all the financial advances of recent decades, we still have maintained the same structure, where private money represents the greatest part of the money supply, and where in times of crisis the demand for public money explodes at the same rate as it implodes for private money.
But the idea of full reserve banking is coming back with the creation of CDBCs, or digital money issued by central banks.
Academics like Morgan Ricks (see his excellent book "The Money Problem") have advocated the creation of a digital dollar deposits held directly at the Federal Reserve. For him, we need to "democratize" what today only commercial banks have: access to the reserve account of the central bank.
There are many possible advantages in having digital currency, for financial inclusion and security, creating the possibility of focusing financial/fiscal aid directly on those who need it most.
Having public money with greater availability and functionality would effectively end the perennial risk of unstable demand for private money. Hard to imagine a bank run against the Fed...
But there still remains the problem of the functions of risk assessment and intermediation/money creation performed by the banking system, as the digital dollar would be backed by Treasury bonds, not loans to the private sector.
One answer to this problem is that there would be a natural accommodation in the allocation of resources, where the distinction between money, now only public, and investments with higher returns and risks, would be clear. Interest rates/spreads would equalize the demand and supply between money and investments. Mixed money, private in good times and public in bad, would cease to exist.
The problem with this thesis is that in times of stress we would still have the same phenomenon: falling demand for investments and high demand for money. We would not, in theory, have bank failures (these would effectively become managers of credit funds), but there would still be disintermediation and sudden fluctuations in demand between money and risk assets.
Now here I would like to launch a speculative idea: what could happen if to the blockchain behind the digital dollar (or Brazilian real) was added artificial intelligence capabilities?
If the blockchain is populated with a wide enough range of information (which can obviously be supplemented by other sources) we could imagine algorithms embedded in smart contracts making the intermediation between digital deposits and their uses in the private economy.
The liquidity and remuneration of contracts would be determined in real time in electronic markets that, at peaks of demand for lower risk, can " in extremis" resort to an automatic rediscount window managed by the central bank.
The blockchain framework would allow for instant and fully transparent access to the central bank of the entire financial system, since everything is "on chain." There would no longer be a need for individual and often late supervision of each bank or fund. All positions – including those of companies and consumers – would be available in real time, allowing changes in spreads/interest automatically to leave them in balance. The mythical walrasian auctioneer of general equilibrium theory would be incorporated in an algorithmic way.
Obviously, there's are lots of things to think about here, but in my view, I don't see an inherent problem in imagining this transformation: the technologies needed already exist or are emerging. There is still a lot of fog ahead, but on the horizon, we can already see the future of money.