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What Is Par Clearing?

Professor Perry Mehrling discussing the price of "par." This refers to the fact that the money in your bank account (which is really just a bank IOU for cash) trades 1-for-1 with actual cash, even though they are different financial assets. Think about it this way: Depositing money in your bank account is really like using cash to buy bank deposits. So let's say that the public had more cash than they wanted, and used this cash to buy more bank deposits. If the amount of bank deposits were fixed, this would put upward pressure on the price of that trade, and would break "par," but fortunately they are not fixed and so new deposits can be created at the same price. Alternatively, suppose the public had less cash than they wanted and tried withdraw the cash from their bank accounts ('sell the bank deposits for cash'). This would put downward pressure on the price of bank deposits, except that the quantity of bank deposits changes to adjust instead. But also in this case, there's an additional danger: what if the banks don't have the cash to meet the demand? This would put upward pressure on the price of cash in terms of bank deposits: each $1 in your bank account might be only worth $.90 cash instead of $1. Since depositors don't like this, this will tend to cause a run on the bank, as customers do everything they can to get the cash, which pushes down the price even further in a positive feedback loop. The way to create par is to have the issuer of cash (the government) stand behind the price. The government does this in 2 ways: 1) through the FDIC, it ensures that even if a bank is insolvent (it owes more to its depositors and other creditors than it owns in assets) depositors will still be able to redeem their deposits 1-for-1, and 2) through the Federal Reserve it ensures that the banks are always liquid enough to be able to meet demands for cash withdrawals. This is why banks need to be regulated: they have a government backstop. Conventional commercial banks are in a position where the government is standing behind their promises, which incentivizes them to take crazy risks and make promises they can't keep. If we want to have par clearing then we need the government backstop, and if we have the government backstop then we need prudential regulation. See this lecture here: https://www.coursera.org/learn/money-... Take the whole online course here: https://www.coursera.org/learn/money-... Follow Deficit Owls on Facebook and Twitter:   / deficitowls     / deficitowls