Dr. Steffen Murau| steffenmurau.com

Financing Large-Scale Transformations

The Green Transition to net-zero carbon emissions is the greatest challenge of our age. We broadly know what technically needs to happen, but where should the money come from to pay for it? Financing large-scale transformations is a process that requires macro-financial governance, which involves manufacturing an initial balance sheet expansion, organizing long-term funding, stabilizing against financial crises, and facilitating an orderly final contraction.

How states are able to finance large-scale transformations is the topic of the OBFA-TRANSFORM project, an Emmy Noether research group entitled ‘The Political Economy of Financing Large-Scale Transformations. Off-Balance-Sheet Fiscal Agencies in Wars, Reconstruction, and the Green Transition’ (https://obfa-transform.eu).

Monetary architecture

Monetary architecture is a methodology to represent historically specific monetary and financial systems as a web of balance sheets that comprises different monetary and fiscal institutions and interlocks via different credit instruments.

The “grammar” of the monetary architecture approach has several building blocks. It starts with monetary jurisdictionas a legal category that is subdivided into segments: central banks, commercial banks, non-bank financial institutions (NBFIs), and a fiscal ecosystem, which is made up of treasuries and off-balance-sheet fiscal agencies (OBFAs). Each segment comprises different institutions that are represented as balance sheets and have a hierarchical relationship with each other. They interlock through the instruments they hold as assets and liabilities, which are denominated in differentunits of account. This adds up to a fully self-referential credit system in which each asset is another institution’s liability. What counts as money depends on a balance sheet’s relative position in the hierarchy and can change over time. Each institution has its own respective elasticity space for balance sheet expansion.

The monetary architecture framework can be used to represent past, present, or future institutional settings of the monetary and financial system. It provides the conceptual lens for the OBFA-TRANSFORM project to study the setup and the evolution of the monetary and financial system in the context of large-scale transformations.

Off-Balance-Sheet Fiscal Agencies

The guiding hypothesis of the OBFA-TRANSFORM project is that off-balance-sheet fiscal agencies (OBFAs)—hybrid public-private institutions which uniquely combine dimensions of monetary and fiscal policy—played a crucial role in past large-scale transformations and are best suited to do so again in the Green Transition.

OBFAs come in various guises—supranational development banks, national development banks, public deposit insurance schemes, government-sponsored enterprises etc.—and are a recurrent feature of financing politically desired large-scale transformations. This may explain why they were mobilized at historical junctures such as wars and reconstruction. Yet OBFAs’ role in financing past transformations is under-researched and not well understood. This project seeks to remedy that. On the one hand, OBFAs can use their own balance sheet to provide expansion, funding, and contraction by mobilizing elasticity space that treasuries do not have, while being backstopped by central banks. On the other hand, OBFAs can engage with other segments such as banks or non-bank financial institutions and align them with the macro-financial goal of financing large-scale transformations. This may entail contributing to triggering an initial expansion of the monetary architecture, ‘crowding in’ private balance sheets and organizing the allocation of credit instruments during the funding phase, and managing the contraction of balance sheets when the financing cycle comes to its end.

The project thus puts OBFAs centerstage and investigates how they were used historically to finance large-scale transformations, while at the same time making use of an up-to-date theory of modern credit money. The project is driven by three motivations: (1) historical case studies on war finance and reconstruction finance mostly fail to account for the role of OBFAs; (2) OBFAs seem to unlock new governance capacities useful in periods of large-scale transformation; and (3) insights into OBFAs can fruitfully inform our effort to decarbonize the global economy.

The triad of taxation, treasury borrowing, and central bank money creation

The literature that addresses how states finance large-scale transformations typically sketches out a ‘triad’ of ways to achieve this: taxation, treasury borrowing, and central bank money creation. While this framework dominates the literature, it often remains implicit in studies of war finance, reconstruction finance, and the Green Transition.

The triad framework suffers from three main shortcomings:

First, the triad lacks a theoretical conceptualisation of credit money. Taxation and treasury borrowing typically describe how a government can increase its cash flow which can then be used for investment through government expenditure. But this often follows the erroneous imagination of the loanable funds theory, which suggests that there is a defined quantity of ex ante financial resources that must be reallocated. While there is some merit to this view in commodity money systems, the opposite is true in a credit money system: New credit money is created ex nihilo when a financial institution gives a loan or purchases a bond from a counterparty. This implies that the monetary system has an inherent potential for expansion, which can be leveraged for financing a large-scale transformation. The money required can be created, it does not have to be redistributed.

Second, the triad lacks a systemic understanding. The volume of credit money needed for a large-scale transformation cannot be borne solely by public institutions like central banks or treasuries but the entire monetary and financial system must be harnessed. Credit money creation can be carried out both by public and private balance sheets such as commercial and shadow banks. Getting the system in tune to finance a large-scale transformation is always the same objective, but faces different challenges depending on the shape of the international monetary system—whether subject to national capital controls as in the post-WWII era or characterised by financial globalisation, offshore money creation, and shadow banking as in the present day.

Third, it ignores the procedural dimension. Financing a large-scale transformation is a long-term process that requires diligent macro-financial governance and coordination of different parts of the credit money system. Not only does the system have to create credit money today, it also has to put it to productive use over a long period of time, avoid an implosion of the credit network, and receive repayments later. Accounts that rightly emphasise the system’s unlimited capacity to create credit money ex nihilo but disregard its subsequent progression through and impact on the system miss the complex procedural dynamics at play in financing large-scale transformations.

Due to these three shortcomings, the triad misses out on the key role afforded to OBFAs in financing large-scale transformations. OBFAs are part of the wider monetary architecture and fulfil crucial functions in the overall financing process. Yet they are either overlooked, treated as outliers, or framed as part of established monetary and fiscal policy institutions. In fact, OBFAs break the confines of the triad. They complement fiscal and monetary agencies and mitigate stipulations for the conduct of their policies. Still, we lack a grounded understanding of the role OBFAs play in financing large-scale transformation as a systemic process. This gap is a problem of both historical empirical data, and of the theory of the monetary and financial system.

Three-Phase Financing Process

Financing a large-scale transformation in any given monetary architecture requires a process that comprises three ideal-typical phases: initial expansion, long-term funding, 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 paribuswhile 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. 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.

Case studies

The OBFA-TRANSFORM project will carry out case studies about three different types of large-scale transformations:



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Discussion Papers

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