The Speculative Spread: Some Notes

Sara Hsu

I’m obsessed about this idea that I call the “speculative spread.” A bit more about it and some precisions.

This idea, which I referred to in a previous blog post (and a working paper, and an article), says that if the shadow banking system (non-traditional financing) rises far above the level of financial deepening (measured by M3), financial instability will arise. For the US and Europe, I believe that if the shadow banking system is greater than M3 the financial system is in peril—for the United States, this was the case until 2012, while for Europe, this was not really a problem except, tellingly, in the pre-global crisis period. For China and other less developed countries, I believe that if the size of the financial system (measured in China’s case by total social financing, or bank loans plus non-traditional financing) is greater than M3, instability will arise.

What has happened in the United States leads me to believe that this concept has some force behind it. Regulators are in the process of beefing up the financial system such that M3 will be expanded to provide liquidity for the large cash pools constantly in search of placement in the shadow banking industry. This means that M3 will likely fall above or remain equal to the shadow banking sector for some time, providing financial stability. Europe, which has less of a financial instability issue and more of an ongoing debt problem, has not been in need of such additions to M3. Exactly my point for developed countries.

So why does China not fall into the same category in terms of stability? Why do I compare not just shadow banking itself (trust and entrusted loans primarily) and M3?

The reason is because when you think about it, China lacks the institutions that would allow developed countries like the United States to deal with a considerable level of financial instability. There are few good credit rating institutions (although one might also make this case for the United States), no deposit insurance (although a scheme is in the works), widely available and accurate accounting and auditing results, freely functioning (but well regulated) asset markets, and liberalized interest rates that accurately reflect the cost of borrowing and lending. While developed countries have financial “shock absorbers,” China doesn’t really have any, with the exception of the lender of last resort, the central government. So if non-traditional financing gets out of the range of the traditional liquidity categories in M3, an external shock can bring an enormous burden to bear on the central government.

At first, I didn’t make a distinction between developed and developing countries, but I think this distinction has some validity. This may not be a theory can be proven per se, and I lack sufficient data to do so. The concept is useful, however, because before this time, all financial innovation was considered useful and labeled “financial deepening.”  In the wake of the global financial crisis, that doesn’t really make sense any longer. One should differentiate between true deepening—or enhancing the financial capacity of the economy—and risky finance or even speculation, which, at least in some cases, not only does not enhance the financial capacity of the economy but cripples it.

It’s too bad that the U.S. Federal Reserve discontinued tracking M3, but one can calculate it. It is an indicator to keep an eye on for the purposes of financial stability.

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