Macro-financial governance process

The systemic financing of a large-scale transformation requires an initial balance sheet expansion, long-term funding, backstopping, and eventually a final contraction of the balance sheets in a monetary architecture.

Financing a politically desired large-scale transformation in any given monetary architecture requires a governance process that comprises four ideal-typical phases: initial expansion, long-term funding, backstopping, and final contraction.

1. Initial expansion: To begin financing a large-scale transformation, balance sheets in a monetary architecture must expand and create new credit money against loans or bonds. This ‘swap of IOUs’ is the quintessential balance sheet operation to create credit money. An initial expansion can be carried out between different types of public, private, or hybrid institutions capable of issuing credit money (central, commercial, or shadow banks) and different types of counterparties (households, firms, treasuries, OBFAs).

These multiple combinations for balance sheets to provide an initial expansion fully comprise the ‘triad’ framework’s options of treasury borrowing and central bank money creation, but are more comprehensive as they factor in all balance sheets in the monetary architecture, and are more precise, as they underline that money creation can be done not only by central banks, but also by banks and shadow banks; that central bank money creation and treasury borrowing are identical operations if they are each other’s counterparty in swapping IOUs; and that taxation does not actually entail an initial balance sheet expansion in the first place.

2. Long-term funding: After the initial expansion, the monetary architecture must ‘fund’ the investment project over a long-term horizon. This means that the initial balance sheet expansion has to be maintained in the system ceteris paribus while the actual instruments created change in between balance sheets. The short-term IOUs (credit money) have to be used for investments in physical capital stock while the long-term IOUs must be distributed to balance sheets that are willing and able to hold them over a long time horizon.

As different balance sheets are in charge of an initial expansion and long-term funding, the transition between both steps is a major challenge in the financing of a large-scale transformation. This involves making sure not only that the credit money created is used for the appropriate investment purposes but also that the long-term IOUs are not paid back too soon or have to be liquidated in a credit crunch.

How this funding problem is solved is vital for the success of a large-scale transformation but poorly understood both in the economic history literature on war and reconstruction finance, as well as in the debates on the Green Transition. Proposals for financing the Green Transition almost exclusively focus on the initial expansion but omit the question on how to fund the initial money creation over time. By keeping the question of systemic funding of a large-scale transition in a monetary architecture as a black box, it is left to the infamous invisible hand of the (financial) market to decide whether the funding of a large-scale transformation succeeds.

3. Backstopping: Backstopping is the insurance layer of a large-scale financing cycle: it supplies an implicit or sometimes explicit, credible promise that someone will provide liquidity or absorb losses if balance sheets can no longer fund or value the long-term IOUs issued during the expansion phase, held for the long term during the funding period, or to be paid back during the contraction phase. In functional terms, a backstop can involve central-bank lender-of-last-resort lending, government guarantees, deposit insurance, ‘bad banks’, or market-making commitments; what unites these mechanisms is their ability to convert fragile, long-dated claims into instruments that are as close to cash as necessary when panic threatens.

In an ideal financing cycle, backstops act merely as potential insurance mechanisms and are not actively involved in the financing process. But politically desired large-scale transformations push the boundaries of financial expansion and innovation, and may sometimes lead to the creation and mushrooming of potentially hazardous assets or hidden risk, resulting in pernicious, potentially systemic consequences like inflation, asset bubbles, and other financial dangers. These may threaten the integrity of the financing cycle and lead to a premature contraction of balance sheets and a failure of the sought policy goals. Whereas the private sector is normally well-equipped to deal with idiosyncratic risks emerging organically during any financing cycle, for systemic risks that appear during large-scale transformations policymakers must ensure backstops are in place, either via state balance sheets or OBFAs.

History offers numerous illustrations of how these backstops operate. The Bank of England’s rediscounting of Treasury bills during WWI, the creation of the FDIC in 1933 to stop US bank runs, the ECB’s 2012 Outright Monetary Transactions pledge that calmed peripheral sovereign-debt markets, and the UK government’s 2022 guarantee scheme for energy-trader margin loans all served as backstops that forestalled disorderly contraction and bought time for orderly adjustment. Importantly, in each case the promise of intervention was often more important than the actual volume deployed; credibility, not continuous activity, did the stabilising work. Backstop mechanisms are thus a crucial feature in any successful large-scale transformation.

4. Final contraction: As the initial expansion implies issuing IOUs today as promises to be repaid in the future, it seems a necessity that a financing cycle must end with a final contraction of the balance sheets and hence a reduction of the systemic funding volume in a monetary architecture. The ideal solution would be that the web of interlocking balance sheets contracts orderly as the outstanding loans and bonds are repaid and reverts back to the initial level of expansion.

However, orderly repayment is not the only scenario and arguably an historical exception rather than the rule. Unorderly defaults or the ‘bursting of a bubble’ are common after an initial expansion. A strategy with high opportunity costs was used after WWI with the decision to shift the debt burden to balance sheets of the defeated German Empire via reparation demands, followed by the attempt of the Weimar Republic to reduce the debt burden by means of a hyperinflation.

An alternative to orderly or disorderly contraction is to try to postpone phase 3 and keep the monetary architecture in the funding phase. This can be achieved by continuously rolling over existing debts without clear intentions to repay them—a common practice in sovereign debt markets to-date—or by creating a new balance sheet on which the debt gets parked and perpetually funded; an act that lies at the core of the Bank of England’s foundation in 1694.