demand deposits, fixed-value money-market funds, or overnight debt must be backed entirely by short-term Treasuries. Investors who want higher returns must bear price risk. Intermediaries must raise the vast bulk of their funds for risky investments from run-proof securities. For banks, that means mostly common equity, though some long-term or other non-runnable debt can exist as well. For [money-market?] funds, or in the absence of substantial equity, that means shares whose values float and, ideally, are tradable.
I suppose Murray Rothbard would have liked this.
My own aphorism about financial intermediation is that the nonfinancial sector wants to issue risky, long-term liabilities and to hold riskless, short-term assets, which the financial sector accommodates by doing the opposite. If that aphorism is correct, then Cochrane’s vision involves getting rid of financial intermediation.
I suspect that the optimal amount of financial intermediation is not zero. However, I suspect that it is not as much as we get in a world in which there is deposit insurance, too-big-to-fail guarantees, and tax advantages of leverage. Here, Cochrane’s tactical approach is interesting.
Pigouvian taxes provide a better structure for controlling debt than capital ratios or intensive discretionary supervision, as in stress tests. For each dollar of run-prone short-term debt issued, the bank or other intermediary must pay, say, five cents tax. Pigouvian taxes are more efficient than quantitative limits in addressing air pollution externalities, and that lesson applies to financial pollution. By taxing run-prone liabilities, those liabilities can continue to exist where and if they are truly economically important. Issuers will economize on them endogenously rather than play endless cat-and-mouse games with regulators.
The way I put it is that you cannot make financial institutions too regulated to fail. So instead of trying to make financial institutions harder to break, try to make them easier to fix. This means taking away the incentives to adopt unstable financial structures. Cochrane would go further and penalize unstable financial structures using taxes.
Meanwhile, Peter Wallison warns that the command-and-control approach to regulation has a logic of ever-widening jurisdiction.