Wednesday, August 31, 2011

Should we bring back reserve requirements for banks?

This post grew from a back and forth discussion with a commenter at Seeking Alpha. The commenter's position was that taking away the reserve requirement was an mistake, and in substituting quantitative control of bank reserves with control of interest rates instead, central banks ended up with a less useful control lever for money supply.

I believe that central banks cannot fully control the money supply, because private loan demand and government spending is what directly increases it. Central banks can indirectly control it by increasing the cost of credit, so that private loan demand plummets, or by decreasing cost, so private loan demand increases. But at this point in time, when people are already over-indebted and the cost of credit is already at zero, there’s not much more it can do to increase loan demand, and hence to increase money supply.


But just because the Fed controls the cost of credit doesn’t mean they should use it to mismanage the economy. Trying to stimulate more economic activity or bank lending by increasing reserves does not lead to more lending, and only results in fund misallocation, as investors who cannot earn positive income from investing in bonds allocate it to commodities instead (in the belief that inflation is just around the corner).

Now that rates are at the zero bound, monetarists insist that Fed stimulate more activity by quantitative easing, or swapping government bonds held by banks with more reserves. At least when the Fed was controlling the rate of credit, they were able to encourage more lending or they were able to decrease it. Now that it is manipulating reserves, what has that done to increase lending? And if you disagree with Fed control of rates (a position I confess to identify with), why would you advocate Fed control of reserves? Why should the Fed limit all reserves, when their real constraint to lending is their capital?

Bank capital

Taking away restraint on reserves in no way affects the restraint of banks to lend, so bringing it back will not fully constrain it when conditions are right for more lending, and they have adequate capital reserves. In this scenario, all a high reserve requirement will lead to is an increase in interest rates as banks vie to borrow the reserves they need to make the loans they want to give.

With a return to contra of reserve requirements, do you think banks will lend every reserve because they can? Wouldn't it be better and cleaner just to securitize a loan, so no heavy capital requirement is necessary? Whether or not the banks have legal reserve management mandates does not constrain banks anymore. What constrains them more is complying with Basel capital standards. If they are unable to comply with Basel, having no required reserves will do nothing in this world to enable banks to lend.

The real use of bank reserves

Increasing levels of vault cash, ATM networks, retail deposit program have have made unprecedented demands on banks to have the necessary reserves when needed. Hence, there has been a pragmatic shift by central banks away from most reserve, & reserve ratio, restrictions. So why bring back a constraint on reserves? Why limit reserves when banks are just facilitating the various transaction needs of their customers? The level of reserves has no effect on a bank’s lending. It's completely separate and different field of activity from reserve gathering and management.

Thursday, August 25, 2011

Banks don’t lend reserves, it’s bank loans that create deposits

So many people seem to miss this basic concept of Chartalism, and you can see it evident in many people’s comments and attempts to refute MMT posts. Many people find it hard to accept this concept because it defies the basic teachings of mainstream theory, as they learned it in school.
But take a step back, and look at loans and deposits, and how they come about. You want to borrow money from a bank so you can buy a truck from me. Your bank does not have to have the funds to lend you when it funds your loan. All it has to do is go and borrow from the central bank’s deposit window, or otherwise borrow from the interbank market.
Your bank (which lends you the money) credits your account with the amount. You then take the money, go and buy the house from me, and I deposit the amount in my bank. My bank now has money to lend to your bank, so it can pay off its loan from the central bank.
Same thing if I want to buy a house from you. My bank simply credits me the funds, then I go and pay you with the amount, you deposit it into your bank. My bank now has a loan, and it can borrow the funds it lent me from your bank, which now has additional deposits, which has now circuited from me to you then to them, when my bank lent me the loan.
If no bank lent anyone any money, where would any of us get the additional deposit to put in the bank? And without new deposits, which the mainstream claims funds bank loans, how do banks manage to keep loans growing? This is beyond fractional reserve banking, which as a concept means the bank takes a fraction of its deposits and lends out. If banks were contrained by fractional reserve banking, bank lending growth would have slowed to a crawl (or standstill) long ago.
Banks do not need deposits at all to fund loans. The presence of the central bank discount window which bridges any unfunded loans enables them to simply fund any creditworthy client with the funds, knowing that they will always be able to fund it. All they need is to make sure they charge you higher than their cost to borrow, and that they have the (usually Basel-recommended) capital ratio to back the loan.
What is true for a two-bank economy is true for an economy that has several banks, many borrowers, and many depositors. Loans have to be made by some bank first before anyone else can get any money to deposit. Neither you nor I are allowed to print counterfeit money just because we want to increase our deposits. We need to borrow it, or sell a good or service to someone who does. Banks do the rest.
Now go and read this, and see if you understand now.
P.S. And as Mike Sproul's example in the comments shows, a purely 'electronic debit and credit' debt transaction by a commercial bank doesn't even need Fed discount borrowing. No payment of reserves are necessary.

Friday, August 19, 2011

Are Savings Pools really looking to dis-intermediate themselves from investment?

Here's a paper by Zoltan Poszar I found of interest because it puts the recent financial crisis in a new light. Specifically, it explains why institutional cash pools are not invested directly in deposits of traditional banks but in deposit alternatives. By implication, many cash pools seek to dis-intermediate themselves from the savings to investment transformation process by opting out of the banking system. The reason is to ensure principal safety beyond what the FDIC deposit guarantee covers. The paper argues that not all savings are actually looking for a real investment outlet, but are only looking for placements that could function both as source of quick liquidity and as collateral.

Of course, these pools still ended up funding some risky investments, as they ended up with the shadow banking system. The paper argues it was because there weren't enough safe government securities. Zoltan focuses on the US financial system, which by virtue of its having the global reserve currency, suffers from the Trifflin Dilemma.

Zoltan suggests issuing more government securities so that 'AAA' structured bonds securitized by shadow banks do not have to fill the deficit supply of 'safe' assets demanded by asset pools. My take on their conclusion is either the US government must borrow more, people must save less, AAA companies must issue more commercial paper.... or people have to consider the possibility of losing some principal when they save, because if none of the first 3 musts happen, shadow banks will come back to fill the void left by the market.

With the government in austerity mode, a large demographic saving up for retirement, big companies awash in cash while small businesses are losing their customers, the chances of structured products making a comeback looks high.

Wednesday, August 17, 2011

What hobbles the economy today

Regime uncertainty is a term coined by Robert Higgs to describe and ascribe what he believes to be the reason for the lacklustre US economy for the entire 30's and 40's. We now seem to be entering a similar period of uncertainty, and regardless of your opinion of what caused the Great Depression to remain that long, I would credit TODAY's regime uncertainty to a flawed understanding of the economic system by the leaders who shape the policies of the world. All around we see evidence of this flawed framework being put to test, with disastrous results. We need to advance discussion on a better understanding of the financial system, so governments do not enforce cures that only exacerbate the economic malaise, stimulate with measures that kill demand, or moderate bubbles with measures that feed it.

Income creation

I strongly believe the most urgent problem is lack of aggregate demand. What is the necessary cure? Income creation, which should come as a consequence of creating jobs that produce sellable goods. It is income which creates the demand for the goods being produced by the jobs created. So income should not come by itself as a handout. It should come as a byproduct of a labour force able to find joss when they are truly looking. Neither should jobs created provide insufficient income, or demand will not be sufficiently restored. Of course, each job created must also be productive to society, because income created without the commensurate increase in productivity only leads to a supply shock.

The question to ask is how does income keep on generating itself? All of us want to save in order to create wealth. Who then funds the saving? There should be a default spender of last resort, otherwise, when we all do this saving simultaneously, we all stop earning income from one another. And there should be aggregate confidence in the stability of markets, in the currency, and in the belief that income will continue. What makes this confidence possible? When the economy is backed by an employer of last resort able to issue its own currency. Now that national governments are out of the gold standard, they can print money as necessary to spend. Furthermore, taxation should not be the primary, or even the necessary, funding vehicle of this spending, as taxing people actually takes demand away from the private sector. When government takes money from the people, the people are again out of money.

The cure for the current problem is not austerity. The proper stimulus is not more debt at the household/business level, or a deliberate increase in price level via monetary easing. And asset bubbles are neither properly moderated with austerity measures or monetary easing.

Income creator of last resort

Before the age of industrialization and globalization, a great majority of people still lived off the land. Nobody really died of hunger if he didn't have a regular paying job. Just plant a potato in your backyard, and eat it. Now it's not the case anymore. Nobody has land large enough to cultivate the basic food he needs to feed his family, so he needs a job to earn the money to buy it. There are no more cases of homestead, everybody has to buy his abode, or otherwise rent it. To be able to do so, he needs to earn income.

There's no way for us to get back to the idyllic past of Lincoln's time, when losing income merely means people go back to bartering what they make, eating what they sow, and living on what they build. Now you have to buy everything! If a sufficiently large proportion of people loses their job during a market correction, they will stop buying goods not immediately needed for basic survival. This causes a cascade of further job losses as companies lay off their employees to cover the lost sales.

Nowadays, you need someone all powerful to provide everyone with the job and income to live a basic life - either an all powerful feudal lord, one who has monopoly control of all major factors of production, such that he has no fear of people withdrawing money/income from the system….

…..or a government that knows how to strike the right balance between creating income for the people via spending, and ensuring that the money has value enough to purchase an adequate supply of goods.

There are people who want more government, and those who want less. I think MMT, as a proponent of a way to understand monetary/income transmission throughout the economy, has no particular leaning as it is a purely technical description of how the monetary system currently works.

But I believe there's a time and place for more government, but you have to know what the purpose of expansion is. A valid purpose is helping restore full employment and aggregate demand when private sector initiative is lacking. For sure, we should also develop indicators to know when government should start scaling back, like when interest rates are already going through the roof or inflation is rising. The goal is to make it easier for private sector to start employing again, not to compete with them.

Monday, August 15, 2011

Large government per se should not be the political or economic goal

Paul Krugman lays out a hypothetical scenario, mainly to refute the MMT position that money-financed deficits are not much different from bond-financed deficits. He tries to point out that money-financed deficits will eventually lead to inflation.

Let’s have a more or less concrete example. Suppose that at some future date — a date at which private demand for funds has revived, so that there are lending opportunities — the US government has committed itself to spending equal to 27 percent of GDP, while the tax laws only lead to 17 percent of GDP in revenues. And consider what happens in that case under two scenarios. In the first, investors believe that the government will eventually raise revenue and/or cut spending, and are willing to lend enough to cover the deficit. In the second, for whatever reason, investors refuse to buy US bonds.

Let's question the assumptions here one by one. In this hypothetical scenario where private demand has already revived, why does the government still feel the need to commit to spend equal to 27 percent of GDP? What kind of government spending is so necessary that the government will risk possible hyperinflation or mass aversion to its bonds by insisting on spending 27% of GDP?

Since we're on the realm of FICTION anyway, let's assume that in this full employment scenario (let's dream and pretend this is next year), US GDP goes from 15 trillion to 30 trillion. This means the government commits to spend 8.1 trillion. What's with the 27%?

The point of insisting on government expansion right now is because the private sector is in retreat. But when the private sector gets back in full bloom, we should all be insisting on government scaling back. I don't think anybody's goal, MMT or not, is for government to become permanently big. Large government by itself is not a virtue, but a necessary countervailing mechanism, for when both private demand for funds, and its supply, are anemic. When this has reversed, people should insist that private sector lead the way. If enough new funds are being created and demanded by the private sector, we can have a string of balanced government budgets, and believe it or not, even budget surpluses.

Whether money-financed or bond-financed, adding excess government demand to an already strong private demand will lead to inflation. Why advocate big government spending in such a scenario?

Monday, August 1, 2011

Will countries stop investing their trillion dollar reserves in US treasuries?

Felix Salmon writes:
“All those foreign sovereigns, for instance, who love to invest trillions of dollars of their reserves in Treasuries — it’s easy to see how they might be rather less in love with that idea at the moment, and how they might start wondering if they shouldn’t just take that money and invest it domestically, instead, or in some other country’s debt or equities.”
But who are these countries that seem to have trillions of dollars of reserves to begin with? Nobody else issues US dollar but the US. Oh yes, these are the countries that incur trillions of dollars of surpluses with the US. And if they continue to incur trillions of dollars of surpluses with the US, they will always have trillions of dollars to invest. Will they invest it domestically in their economies instead? Not unless their people start accepting and circulating US dollars as alternative domestic currency. Have you ever seen an economy that is circulating trillions of US currency in their domestic economy? No. But if they start doing so, then that actually increases the value of US treasuries because if China, for example, starts circulating US dollars domestically, then their citizens will start saving in US treasuries.

Will they invest the US dollar reserves in other countries' debt or equities? What country is going to sell their bonds for US dollars? Where will these 'other countries' put the additional US dollar reserves? US treasuries? And not unless these other countries start circulating trillions of US currency in their domestic economy, who's going to sell their equities for additional US reserves? Again, have you seen a country circulating trillions of US currency in their domestic economy?

No. But if they start doing so, let’s say in Africa where China seems to invest a lot, then that actually increases the value of US treasuries because if Africa, for example, starts circulating US dollars domestically, then their citizens will start saving in US treasuries.

Mind you, I believe this debt ceiling charade will increase the cost of borrowing for the US and for others borrowing in US dollar. But if you were a country with so much dollar reserves, where are you going to put it? In US assets. And if you as that country were to buy some other country’s assets instead, that’s some other country now with excess US reserves. Where will they put it? In US assets. The fact that the manufactured crisis increases the rate for US Treasuries is icing on the cake.

And the answer to the question: What country is going to sell their bonds for US dollars? A country that needs to buy US stuff. The lucky US recipients of this foreign largesse will have to put their proceeds somewhere. Eventually the chain ends when it reaches someone who just wants to save the money. Guess where he puts it.

Additional points:

Ironically, all it takes for the unstoppable increase in US borrowings to be arrested is for China to accept that the hoard it has accumulated all these years is essentially worthless (because the US can just print more of it to pay them), unless it decides to spend it all back in the US. And if China decides to spend their dollars domestically in China, then that ends their peg, and the yuan will then rise vis-a-vis the US dollar.

If ending the peg results in US trade surpluses with China, then there will be less Chinese demand for US treasuries. But the lost demand from China will just be a wash with the less need for borrowings that are due to the deficits from China. But China seems to want to hedge the fall of its dollar holdings by pushing for everyone to shift to the global SDR reserve instead.

I think the Euro is being dragged, German fear of inflation notwithstanding, into the same printing binge as the US dollar. Just look how the EFSF is supposed to prop up the PIIGS. But for how long before the Germans blink and stop the Euro printing (which so far has kept their currency peg with PIIGS) .