"Do Collateral Chains Create Real Value?"

From Asynptosis:

Some of the keenest monetary thinkers out there, over at FT Alphaville — Izabella Kaminska, Cardiff Garcia, etc. (I’ll even throw in Tyler Durden at Zero Hedge, with qualifications) — have been pointing us for years towards the work of IMF Senior Economist Manmohan Singh on collateral chains in financial markets. He provides wonderfully cogent explanation of the shadow-banking system and how it creates “money” for the financial system.

Start here:

The other deleveraging: What economists need to know about the modern money creation process

In brief, banks create debt securities collateralized by other debt securities, which in turn are used to collateralize yet more debt securities. This creates an upside-down pyramid of debt securities, all balanced upon a very small amount of real collateral (ultimately, the real economy’s future ability to produce human-valuable surplus through real effort, skill, and knowledge, hence their future ability to pay off their loans plus interest to the financial system from that surplus).

Singh speaks in terms of the “velocity of collateral” when referring to the lengths of these collateral chains, and equates it to the “velocity of money” in the real economy. During the financial crisis these collateral chains shortened (and in individual cases evaporated), resulting in a huge decline in the financial system’s “money supply.”

Emphasis mine:

When market tensions rise – especially when the health of banks comes under a shadow – holders of pledged collateral may not want to onward pledge to other banks.

With fewer trusted counterparties in the market owing to elevated counterparty risk, this leads to stranded liquidity pools, incomplete markets, idle collateral and shorter collateral chains, missed trades and deleveraging.

In practical terms, the ratio of pledged-collateral (which is a measure of the credit thus created) to underlying assets falls as this onward pledging, or interconnectedness, of the banking system shrinks.

While acknowledging the excellence of Singh’s shadow-banking-mechanics explanation, I have to question his economic conclusions as embodied in the first bullet point, and the enthusiasm of the aforementioned monetary sages for those conclusions.

“Incomplete markets.” “Missed trades.” He’s claiming that shorter collateral chains result in inefficient allocation of financial capital.

I’ve got to ask (as Durden does, in a somewhat self-contradictory manner): Do those pyramids of collateralized debt securities actually result in more (and more sensible) lending to real-economy ventures? Absent such a massive pyramid, would real-economy borrowers be unable to get loans for promising projects? Is he suggesting that “savers’” money would never find its way to borrowers absent that labyrinthine pyramid?

Is Singh simply invoking the tired old money-multiplier/loanable-funds/savers-fund-borrowers silliness (but here on steroids) that has been so resoundingly discredited by so many over so many decades?...MUCH MORE