Payment in a Cashless Society

Playing Monopoly using repos instead of money.

In the board game Monopoly, if you own property, you can pay for something even if you do not have any money. You mortgage your property, and the bank gives you money that you can use to make your payment.

Wall Street finance works like that, but without the bank. A dealer in government bonds has a ten-year bond in its inventory. It needs money. It “mortgages” the bond to a money market fund that has money, using a repurchase agreement. Under the terms of the agreement, the dealer will repurchase the bond next week at a slightly higher price. If for some reason the dealer cannot repurchase the bond, the money market fund keeps the bond.

The money market fund wants to earn a little interest, but it really, really does not want to own the bond. So the repo market requires dealers to be very reliable about honoring repurchase agreements.

In effect, the dealer has borrowed from the money market fund, using the bond as collateral. The slight price difference is the interest rate on the loan. That interest rate is known as the repo rate.

If Monopoly worked like that, you could use your properties to get repo loans. Suppose that you owned Short Line railroad, which cost you $200 when you bought it. Now you need money. Instead of mortgaging Short Line railroad to the bank for $100, you would borrow, say, $180 from another player and agree to repurchase it on your next turn for $180, plus $2 interest (say). If you don’t repay the loan, the other player gets to keep Short Line railroad.

On Wall Street, the money market fund will not lend the full value of the bond. If the bond is worth $100,000, the money market fund might only lend $99,000 in the repurchase agreement. The $1000 difference is called the “haircut.” The riskier the collateral, the greater the haircut.

In the Short Line railroad example, the haircut is $20, which is the difference between the $180 that the other player lends you and the $200 face value of Short Line railroad. In regular Monopoly, where you go to the bank for a loan, the haircut is $100, because when you mortgage Short Line railroad the bank only gives you $100 against the $200 face value.

The financial crisis of 2008 was manifested on Wall Street as a dramatic increase in haircuts. Securities dealers had been financing holdings of mortgage-backed securities using repo loans. Suddenly, these securities, which had been rated as nearly riskless, were downgraded as investors factored in significant probabilities of default. The haircuts became so large that the repo market in these mortgage securities essentially collapsed, threatening to bankrupt the large Wall Street dealers.

Repo loans in a cashless society

In a cashless society, the dollar is a unit of account. You measure your receipts and expenditures in dollars. A computer keeps track.

Every period, the computer calculates the difference between your receipts and expenditures during that period. A period might be 24 hours. Or it might be one second. Whatever we standardize on. Call each period a “turn.”

Suppose that during one turn you collect $200 in salary and just by chance the bank in which you own shares pays you a dividend of $50. So you have net receipts of $250. You can lend that $250 in the repo market. You might earn 1 percent at an annual rate, but you would only earn it for a few turns, so the total amount would be less than a penny.

Or suppose that during one turn you end up paying $35 rent to the owner of Park Place. That is the only transaction for that turn, and you have net receipts of (-) $35. So you borrow in the repo market. You put up an asset as collateral. It might be a 6-month $50 CD from a bank that pays an annual interest rate of 5 percent. It might be a fractional share of your house. It might be a fraction of your next week’s pay. On some future turn when your net receipts are positive, you will repay the loan and get your collateral back. Meanwhile, you pay 1 percent annualized interest on your $35 loan. Again, this amounts to a fraction of a penny in interest.

In order to buy groceries in this economy, you do need some assets or income. If you do not have anything that can serve as collateral for a repo loan, then you cannot support yourself. Someone else has to give you assets to help you. The government could use tax receipts to transfer assets to you. Or it could just give you assets that are backed in some vague way by future taxes. That is called deficit spending.

The Fed intervenes in this economy by intervening in the repo market. When it wants to be expansionary, it lends in the repo market. Increased supply of lending lowers the interest rate on repos. When it wants to be contractionary, it reduces its repo lending or even becomes a repo borrower. This causes the interest rate on repos to go up. This is actually how the Fed operated prior to 2008, so it would not be novel today.

But there is no way to influence the economy by changing the supply of money, because there is no money. Currency does not exist. Checking accounts do not exist.

There is bank debt, which might take the form of CDs. And there are regulations that can constrain banks in terms of how much they can lend and what kinds of loans they can make.

As I said in my previous post, this requires economists to take a different approach to monetary theory.

This essay is part of a series on human interdependence.