Ask Cullen
Since the Q&A’s are so popular I figured I’d add a permanent page on the navigation bar so readers can ask questions any time they want. Feel free to ask anything about anything. And if it’s a great question I’ll make it a post. Please bear in mind that I don’t know everything about everything so reader help in answering questions is encouraged, but please only answer if you’re “in the MR paradigm”! Also, it might take me days to respond some times depending on my time constraints and availability. And remember, this is all about education so if you think I have something wrong then let’s push the discussion in the right direction towards a better answer. I don’t give specific investment advice at the website so please avoid specific investment questions. Lastly, as always, let’s keep it cordial. This is all in the pursuit of better understanding so let’s be constructive even in our criticism. Thanks as always.
Cullen Roche
Mr. Roche is the Founder of Orcam Financial Group, LLC. Orcam is a financial services firm offering research, private advisory, institutional consulting and educational services.
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There is widespread agreement that European economies are in recession, or worse, but a glance at the stock markets of the better-off, northern-tier countries indicates that they’re well above their June lows. Could that be signalling that their economies are bottoming, or close to that?
The stock market is not the economy so I’d be careful reading too much into the performance of the equity market with regards to precisely where the business cycle is.
No, it means that the money outflow in those countries is smaller than in Southern Europe. And that’s confirmed by the fact that interest rates in those countries are (much) lower.
Cullen: I wish you or someone would write a piece on the inner workings of internet banks. Do they have a capital requirement. I have not found a good source to explain how these cyber banks work. Who regulates them? they have n deposits, right? Are they chartered just like a brick & mortar bank?
Same rules and regs as a brick and mortar. FDIC insured and all that. They just don’t have the expenses of the brick and mortar.
This comment was prompted by your article on rising interest rates and the Japanese bond market.
Cullen,
How does the currency value factor into your analysis of an investors willingness/unwillingness to hold YEN denominated assets?
From the standpoint of a domestic holder, I guess it wouldn’t matter that much, however any nominal coupon value would be wiped out with even a pretty small depreciation in the YEN for a foreign holder of the assets.
Doesn’t the deficit and debt they are running suggest a weaker YEN at some point?
I am not exactly sure what the mechanism for a currency devaluation (a general change in perception?) would be in the Japanese case but that would be my fear as a holder of the bonds.
Thank you.
Depends. Are you referring to purchasing power or FX? FX is relative. So you need to understand the Yen’s relationship compared to other currencies. Purchasing power is a function of inflation among other things.
Cullen,
Yes I was referring to FX. I see the issue as being the willingness of foreign bondholders to continue to accept the currency risk in return for such a modest coupon.
So in theory if the Japanese domestic market becomes the only source of purchasing what will that do to interest rates?
If the domestic market can’t support it (is that a reasonable assumption?) then how high must interest rates rise to attract foreign buyers?
Which is weird because in theory although an interest rate rise should strengthen the currency it would also weaken the fiscal state of the government and exports.
Makes your head spin.
Thought this might be of interest: Economic Policy Uncertainty Index created by researchers from Stanford and the University of Chicago.
http://www.policyuncertainty.com/index.html
Thanks Vincent.
Cullen, its been a while since you have updated your “must read list”. Also its purely focused on Analysts rather than Internet resources.
Would really do your readers a great service if you can have a list of all your sources be they free or paid e.g. Opalesque.tv, MarketFolly.com, ZeroHedge.com, etc.
Good thing to update. Thanks Exertia.
What is the danger threshold for debt:gdp? I understand inflation is the main concern and that hyperinflation according to history requires extreme situations. At some point though, debt:gdp in the USA becomes unsustainable if kept at that level for repeated periods. I’m asking this because I am trying to explain to a friend that debt/gdp is high right now because of the balance sheet recession and that when the private sector balance sheet returns to normal the debt/gdp levels should return to normal levels. Thank You
Also, could you explain how the trade deficit affects the deficit and total debt. Thanks again!!1
A growing debt to GDP ratio is dangerous because it signals that an increasing amount of debt needs to be serviced (interest payments). And those interest payments can’t be used for consumption/economic growth.As long as an economy can service those debts then the debt/GDP ratio is meaningless (see Japan with a debt/GDP ratio of 200%). It depends on how high/low interest rates are. Interest rates going lower make serviceing the debt more affordable. But it’s also a matter of “kicking the can down the road”.The larger the trade deficit the more money (Euro, Yen, USD, etc.) flows out of the country. If foreigners buy US Mortgage Backed Securities with those USDs then they support the US housing market. If they buy T-bonds then they support the federal government. This means that US investors don’t need to buy those T-bonds and can use their money for something else.But when the Trade Deficit shrinks or disappears then all those US debts need to be sold domestically.
Incorrect answers get crossed out. Sorry BV, but this is an educational forum. Please keep these kinds of comments in the regular comments. Thanks.
A persistent current account deficit is a demand leakage which will require an ever increasing budget deficit to offset the demand leakage. So it can potentially exacerbate structural issues if a persistent CAD leads to policy that exacerbates the CAD and the underlying structural problems that lead to these imbalances.
like a football score keeper, they can’t run out of points (dollars) so there is no debt/gdp that can’t be sustained
since the Fed controls interest rates, they won’t rise until the economy is improving
an improving economy results in lower gov spending as the need for UE benefits, food stamps and welfare dry up. plus tax receipts rise thus lowering the debt
lastly, “if” the gov understood MR they’d know they could tax and/or regulate imbalances and would have no problem recognizing imbalances and bubbles
Lastly, if the gov were to dramatically add to the debp, gdp would grow. so these idiotic projections showing debt going to the moon and gdp going no where are just fear mongering. Yes, we haven’t had big gdp growth after the last $5T in debt, but that’s due to the private sector paying down private debt.
“an improving economy results in lower gov spending as the need for UE benefits, food stamps and welfare dry up. plus tax receipts rise thus lowering the debt”
Since when did the gov’t reduce spending ?
Since 1970 (except for the timeframe 1996-2000) the US gov’t NEVER ran budget surplusses, in spite of an improving economy, like e.g. in the 1980s. You’re overlooking that an ageing population like in the US depends more and more on welfare. Never heard of the words “Social Security” ?
When the government talks about reducing spending they mean that the increase of spending will be reduced. Not that they reduce spending.
ever hear of “automatic stabilizers”. they go up in recessions, and down in growing economies… and they are “automatic”.
meanwhile, SPENDING hasn’t grown much at all in the past 3 years. Deficits/Debt have grown in large part due to lower tax receipts. You didn’t bother to take on that part of my argument – an improving economy lowers deficits via tax receipts as well.
believe whatever you want BV. You have shown that they only opinion that matters is yours time and again and facts are inconvenient
A part of gov’t spending occurs “off budget”. Like “Emergency programs”, the wars in Iraq & Afghanistan. And then the picture changes.
E.g. in 2009 the official budget deficit was $ 1.7 trillion but the increase in debt was $ 1.9 trillion.
Agree, my opinion certainly is different from a lot of that has been said on this blog. But thanks to this blog I have changed a number of my opinions, as well. Perhaps I need to change a lot more, as time passes by.
Hard to put a number on it Ely. It’s sort of like saying, what is the size of the deficit that will cause living standards to erode? That’s impossible to know as there are so many moving parts. I don’t think there is a precise number that says a nation is going to experience a reduction in living standards based on outstanding debt. There are many more factors in play than just a single figure like debt:gdp. For instance, if we spend a gazillion dollars into the economy next year and no one spends it then did the new debt really hurt the economy? Of course not. It’s more complex than just putting a figure on debt:gdp.
I found this chart online at
http://illusionofprosperity.blogspot.ca/2012/07/interest-rate-epiphany-must-see-charts.html The chart plots (Money Stock (MZM) divided by wage and salary disbursements) vs the inverse of the 10-year Treasury yield and show a very high 0.85 Rsquared correlation. This suggests that as money stock rises and wages stagnate, interest rates will continue to fall much to the chagrin of hyperinflationist. The author also suggest that bonds are not in a bubble being that the 10 Yr Treasury is only 1% off the trend line.
It appears, that interest rates (and thereby the inflation rate) fall or are inversely correlated to an increase in the Money Stock divided Wages. And so interest rates fall as the Money Stock increases. And so interest rates falls as wages fall.I thought it was interesting relationship. Do you have any comments on the validity or mechanism behind this relationship. http://4.bp.blogspot.com/-iLmkbfRGxmo/UACMfblwBkI/AAAAAAAAFx8/Br-j8Hb2mSA/s400/Interest%2BRate%2BEpiphany.jpg
I found this chart online at
http://illusionofprosperity.blogspot.ca/2012/07/interest-rate-epiphany-must-see-charts.html The chart plots (Money Stock (MZM) divided by wage and salary disbursements) vs the inverse of the 10-year Treasury yield and show a very high 0.85 Rsquared correlation. This suggests that as money stock rises and wages stagnate, interest rates will continue to fall much to the chagrin of hyperinflationist. The author also suggest that bonds are not in a bubble being that the 10 Yr Treasury is only 1% off the trend line.
It appears, that interest rates (and thereby the inflation rate) fall or are inversely correlated to an increase in the Money Stock divided Wages. And so interest rates fall as the Money Stock increases. And so interest rates falls as wages fall.I thought it was interesting relationship. Do you have any comments on the validity or mechanism behind this relationship. http://4.bp.blogspot.com/-iLmkbfRGxmo/UACMfblwBkI/AAAAAAAAFx8/Br-j8Hb2mSA/s400/Interest%2BRate%2BEpiphany.jpg
Cullen,
I came across the chart http://4.bp.blogspot.com/-iLmkbfRGxmo/UACMfblwBkI/AAAAAAAAFx8/Br-j8Hb2mSA/s400/Interest%2BRate%2BEpiphany.jpg which plots MZM/Wages vs Interest rates and shows a very high 0.85 correlation.
This suggest that interest rates (and thereby inflation) falls or is inversely correlation to an increase in Money Stock (MZM) divided by Wages. And taken separately, interest rates fall as Money stock rises much to the chagrin of hyperinflationist. Or interest rates fall as wages fall.
Any comments on the validity and mechanism behind this relationship?
This is the blog entry if you want to read in more detail
http://illusionofprosperity.blogspot.ca/2012/07/interest-rate-epiphany-must-see-charts.html
There’s clearly some correlation between the money supply and inflation and rates, but I’d say the relationship is more complex than just this one data point. Without putting it into more context it’s not entirely useful. For instance, interest rates can certainly rise as the money supply rises due to other factors. I wouldn’t entirely discount this data, but I’d take it with a grain of salt. Interestingly, I largely agree with the authors conclusions at the end of the post though.
Has there been a Target2 article posted here? Is there a simple way to understand it all without writing a BOOK ? IFO economists,Zero Hedge & George Soros seem to think Target2 threatens Germany (or at least inflation/Zero Hedge). Felix Salmon at Reuters & Karl Whelan and FT alphaville seem to think Target2 threat is mostly a misunderstanding of accounting definitions. The comments debate at Felix’s Reuter article is stubborn & intense! Links
http://blogs.reuters.com/felix-salmon/2012/06/14/dont-worry-about-target2/#comment-41763
‘Karl Whelan, expert on all matters Target2 and arch nemesis of Hans-Werner Sinn, has encapsulated his views on Target2 a.k.a “why Hans-Werner Sinn is so very wrong about everything” in a 37-page powerpoint presentation on Wednesday. http://www.karlwhelan.com/Presentations/Whelan-BoE.pdf
http://www.zerohedge.com/news/why-germanys-target2-eurozone-preservation-mechanism-merely-ticking-inflationary-timebomb
JKH is actually working on a big Target 2 piece. I would wait for it at MR. It will be the most comprehensive piece on the subject that you’ll likely see around.
Hi Cullen,
You said in MMS#2:
“It’s important to understand that the Federal Reserve and private banks can always be relied on to provide financing for the Treasury with the mechanics working via borrowing operations.”
I know it’s a general statement, but it isn’t necessarily true.
A popular president who took actions against the banking cartel, or its aligned interests, could be squeezed by the the banks and Fed if congress and the press were also against the president.
The Federal reserve and banks can be relied upon only if their interests aren’t threatened by a government acting in the public interest.
It’s not merely a technicality that the Treasury depends on the banking system and the Fed.
Just for instance, if an independent president attempted to formalize the supposedly de facto consolidation of the Fed by absorbing its powers under the Treasury, all hell would break loose. The Fed, the banks, the congress and the press would all be lined up against it.
It’s not just a technicality it represents real distribution of power and if challenged would be defended.
It would require a political conflict to make the Treasury independent of the Fed and banks, and it is a conflict the President would probably lose.
And this is probably why the fiction of a budget constraint is maintained, which seems to puzzle MM economists. It all comes down to politics with MMT. It challenges the present distribution of power to suggest that the Treasury should be self funded. That it ‘could’ be self funded is a fact, that it is not is also a fact.
Just because under present circumstances all the institutions cooperate does not mean that they don’t have separate interests, wills, and can’t be at odds with each other in the future. I don’t think abstract equations can capture the politics of the situation.
Yes, I say it’s like understanding that the USA can drop nukes anywhere on the planet any time they want. BUT, there are international laws and treaties prohibiting this. These restrictions, exist by design. They serve a purpose. So yeah, it’s possible that the USA can just spend to its hearts content, but the institutional design is specific in NOT allowing that. And that’s a construct of politics logically as you said. To tear down these constraints is a lot like removing the checks on power between Congress and the Executive branch. We could mix all three branches of govt. The fact that we don’t is quite logical. The fact that the Tsy is a USER of the currency is also quite logical. It’s all about power dispersement and creating checks and balances. It’s not perfect and I have my gripes with the design, but I don’t shrug it off as “self imposed constraint” without detailing why that self imposed constraint exists.
MR is more and more becoming all about the institutional undertsandings of the current system. JKH’s brilliant contingent institutional approach is the meat of this understanding. I think we do a better job of explaining WHAT IS than just about anyone else. But I am probably biased.
My only problem with this is that, in the case of spending, both Treasury and Fed are extensions of Congress.
The Treasury acts as the agent responsible for spending the funding Congress decrees; while the Fed and its powers were created by Act of Congress.
The Constitutional checks are between the three branches of government, and, due to the limitation of powers, those left to state and local governments and individuals.
This extra-Constitutional check could be described as Congress tying itself to the mast and stopping the ears of everyone else to save itself from the Siren song: in effect, “Stop me, before I spend again.”
Not only does it allow Congress (particularly the House, charged with ‘the power of the purse’ and designed to be most accountable to the People) to shirk its responsibilities, but also fail (or pretend not) to understand what its powers and responsibilities are, opening the door to demagoguery and hypocrisy, and confusing everyone else (Beowulf being a rare exception) about how the system really works.
I would go so far as to say Congress is, under the Cobstitutiob, the unitary ‘currency issuer’ and needs to acknowledge, enact, and be held accountable for that role.
I see it a bit differently. Let’s take the case of a hyperinflation again. In this case, the Congress will still pass spending. But what will happen? The private sector will reject the currency. They’ll stop paying taxes and stop buying bonds. So the Fed has to step in and buy. It doesn’t really matter that Congress changes the tax code or spending bills at this point. The hyperinflation has already set-in. So the fact that Congress sets spending limits doesn’t mean the private sector can’t still reject the currency. I think this is super important to understand as it highlights the fact that the Tsy is always an operational user and that the pvt sector always has the ability to reject the currency. ESPECIALLY if Congress is acting in a manner that appears corrupted or against the public’s best interests (even if they are supposedly acting as our elected reps).
I agree that the people can always reject the currency – in a variety of ways. From your account, hyperinflation would be one of those ways, but at that point it sounds like the gig is up, regardless of what the Fed, Treasury, or Congress does; as the government, along with its currency, will have lost its legitimacy and the people are in revolt, passively, if not actively.
Right, but this example proves how the currency is a social construct. So saying that Congress merely imposes spending or is the currency issuer doesn’t tell the full story. You’ve got to break down the institutional relationships. Saying Congress is the currency issuer is like saying the 3 branches of govt determine the laws. Well, yes, they do, but without going into the details about how that process occurs will lead to a misunderstanding of how the system works and where the power lies.
You’re right. Here’s what I like to say about that. Most of the time the monetary system is stable enough for the Tsy to be able to use the banks as funding conduits. So funding is never an issue. But there’s a 1% time when something else becomes a problem – hyperinflation. And in that case the PD’s would boycott auctions (due to profitability and survival) and the Fed would be used to fund Tsy directly. It would have to. And they’d find a way to make it happen (again, because they’d be forced to). As you said, all hell would be breaking loose. So I totally agree there. But even in this case, the govt doesn’t “run out of money”. The Fed’s implicit guarantee has become explicit. But it’s just lost the public’s interest in its money (MR would say quantity value has collapsed), which I believe is the key understanding in this. So yeah, it’s kind of a semantic point to say the Fed can be used as a funding source, but it’s an important detail in my opinion because that implicit guarantee helps (to a certain degree) keep things together 99% of the time.
Above you cited this chart. The USA’s govt debt is perpetually rolled over. See this chart. http://research.stlouisfed.org/fred2/series/GFDEBTN
Since (1) the Fed now has $5 trillion of Uncle Sam’s debt on it’s books, and (2) since the interest earned on that $5 trillion goes back to Uncle Sam, further (3) since when the bonds mature Uncle Sam has to pay these off back to the Fed, and thus back to itself, then why isn’t the national debt about $11 trillion instead of $15,582,079? Of course this concept assumes that the Fed will keep this $5 trillion to maturity, which looks more likely every day.
The debt doesn’t roll off the books until it retires. Which most of it doesn’t. So whether the Fed holds it or not doesn’t really matter. It still hasn’t matured so for accounting purposes it’s still very much out there.
Boxers or briefs?
Boxer briefs. Best of both worlds.
Cullen,
Are those who insist that Social Security and Medicare could be funded without payroll taxes correct? For that matter, are any Federal taxes actually necessary to fund Federal spending? Aren’t Federal taxes simply a mechanism for enforcing various political agendas, constricting the private money supply, and ensuring demand for the US dollar? I’m pretty sure you and others have answered this but i can’t quite put my finger on it through all the operational details. Many thanks.
The thing is, if SS was ever in need of funding because the trust fund was short of funds, we’d just transfer funds from elsewhere in essence. So there’s no such thing as SS “running out of money”. It can’t happen. It’s like saying the US govt can run out of money. That’s nonsense.
Taxes are certainly necessary to procure funding and stabilizing the currency. The govt cannot just spend money without taxing or the budget deficit would grow uncontrollably and likely cause hyperinflation at some point. So from a purely accounting perspective, since Tsy is a currency user whose account must be funded by taxes or bond sales, taxes are most certainly very necessary.
Thanks Cullen. The way I read that is that payroll taxes are unnecessary and could be dispensed with, but that some (income and other) taxes are required to dampen the money supply. Yes?
Well, there would be lots of problems if taxes didn’t exist. The most important is that a major source of what MR calls “acceptance value” would be eliminated. Ie, a major source of demand for money would be eliminated. In other words, all sorts of competing moneys would likely pop up without taxes and the state enforcing use of dollars. MR doesn’t say taxes drive money, but they are a crucial piece of the demand puzzle. The key piece to your question is that the govt isn’t going to run out of money to fund social security.
Thanks, I see your point. But one last question: do you think, as Rodger Malcolm Mitchell suggests, that the various state and local taxes should be adequate to ensure continued dollar demand, even if all Federal taxes were eliminated?
The elimination of payroll taxes (both employer and employee) received much support in discussions a while back, including from ‘Beowulf’, one of the MR heavy weights.
My suggestion was to ‘replace’ them with a tax on consumption such as a ‘VAT’ tax, which would basically ensure that citizens contribute to their retirement/medical costs, as well as to encourage saving/investment and reduce the US CAD (trade deficit),
In general, it seems fairer and more efficient for the federal government to do most of the taxing (perhaps excepting property taxes), but combine this with fiscal transfers to states and localities, as well as individuals.
Yeowww. Isn’t there some way to get out from under Federal taxes? Needed or not they are annoying. Are we absolutely sure that a modest increase in money supply over a number of years must inevitably lead to hyperinflation? And that people will reject the dollar if no Federal taxes are levied? If Federal tax is actually required, I lean toward the Fair Tax concept over income-based taxes – maybe with a larger prebate than advertised – if only because it is less labor intensive to comply with.
In dealing with concerns over public debt brought up by other schools of economic thought, what should the primary metrics be? I would think debt service/GDP might be helpful, but given that public debt is rolled over, maybe it isn’t.
I believe the majority of US debt is held directly or indirectly by U.S. citizens, so an increase in debt service cost adds to private coffers. For example, if private citizens own 50% of federal debt, and federal debt doubles from $10 trillion to $20 trillion in a single day while remaining at an average interest rate of 5%, doesn’t that mean an extra $250 billion is transferred to citizens for that year? Is this already something that is tracked/accounted for, and in the real world, does it matter?
You can track interest payments at the St Louis Fed by typing in FYOINT into Fred. The impact here on the budget is about $200B per year or about 1.3% of GDP. Not huge, but not nothing.
Since debt and solvency is the wrong metric to look at regarding the nation’s health, I prefer to look at things like capacity utilization, CPI, unemployment, the output gap, etc. These are better metrics of the true constraint – inflation.
I understand that the level of debt by itself may not matter so much, but a high enough debt service cost would at least theoretically cause inflation, right?
Maybe it would be accurate for me to think about it as a component of money supply? You didn’t list money supply as a preferred metric, but it is the supply side of the equation vs the demand side (unemployment, output gap, etc.), isn’t it?
Thank you enormously for this site and for the work you are doing!
Question: your finding, if provable, that the multiplier effect does not now exist because of the way our banking system really works should really stir the pot in academia. I’m aware of Kuhn and cognitive hegemonies, but still …
Any encouraging signs on this front?
The recent debates between Steve Keen and Paul Krugman were somewhat encouraging. But there hasn’t been much progress to be honest. The neoclassicals are still set in their old ways. To admit that their models are wrong is to admit that many people’s life work has been wrong. That’s not going to happen for any number of reasons. We might literally have to wait for a whole new generation of economist to replace the old before we begin see real change.
Hey Cullen I have a couple quesitons:
1) If the eurozone falls apart and people start to float their own currencies (return of the dragma and deutschemark etc.) how would that effect the price of gold in $US? I.e. would it only effect gold in terms of new currencies or would fear push up gold? Long term I think gold will revert to the cost of production (maybe even over-correct as baby boomer retirees cash out of their holdings) but gold producers are still so cheap as compared to gold prices…. so tempting
2) What’s your outlook on peer-to-peer lending? The last couple years the returns have been pretty nice ~12% in aggregate according to prosper and lending tree. I know you’re long term bull on bonds (but hesitant at current yields) does your thesis include these? Obviously each borrower has a different risk/reward profile and likelihood of default but in the aggregate and with adequate diversification, if we muddle through for a couple years it seems like it might be a good place to park some IRA.
3) If I’m making 6 figures, never-been-married and live with my parents at the age of 28 is there something wrong with me? My parents say no, but sometimes I wonder. (: Anyways thanks for the awesome website, RSS feed and free unlicensed therapy!
Hi Daveynels,
1) A EMU break-up would likely be very positive for gold as it would cause massive turmoil in the global economy and also dent faith in fiat currencies.
2) I don’t engage in peer to peer lending so I can’t claim any sort of real understanding to begin with. Sorry.
3) I guess I’d just ask why you’re living with your parents if you make 6 figures? Is your mom’s cooking that good? It’s certainly not imprudent to be saving the money I guess, but at some point you’ve gotta leave the nest, right? There’s no lesson about growing up like living on your own and realizing all the trials and tribulations of survival without any help from your folks. Plus, if you ever plan on getting married or anything like that this is a great way to kill a relationship. To a potential wife, this just screams – “I am not ready to support myself”. And in the end, that’s what a marriage is largely about. Finding someone to lean on and grow with. Most women don’t want to lean on or rely on your parents or they’d marry them instead.
And if you plan on being a bachelor for the rest of your life then you have the same problem unless you have sound proof walls (you know, for the deep talks you’ll be having with the women you “date”).
haha so true, as of week two I am understanding the wisdom behind your dating advice. I know most people have to cut the cord some day…. or crawl back into the womb. But for me I feel like it’s different I think I can kick the can down the road for a while– it seems like it’s working for the eurozone
I have another question for you: How much of a role does demographics play in your forecasting? Do you look at the age-breakdown of populations when you consider investments? Do you think it is a major driver in economies (i.e. the lost decade in Japan)? Do you think the demographic headwind in the US is going to have major recessionary or depressionary consequences in for the next 10 years as boomers retire and move from consumers to savers?
Hey Cullen,
I know you/we’ve been through this topic before, but I have thought myself into a state of confusion again. The topic is IOR: interest on reserves paid by the Fed. It’s currently 25bps, right?
Now, correct me if/when I go astray:
1) the amount of reserves in the system is altered by Fed operations – buying and selling of monetary instruments. The banks cannot alter the total sum of reserves in the system, they can only move them around amongst each other.
2) But total reserves is not quite the same as “Excess” reserves, right? In other words, if JP Morgan were to go out and make a trillion dollars in new home loans, what would happen to their reserve requirement at the Fed? something? nothing?
3) I assume that JP Morgan’s reserve requirement would increase – and that even though the total “Reserves” in the system wouldn’t change as a result, they would now be required to hold more reserves at the Fed – which is to say that if they already had excess reserves, then now they would just have fewer excess reserves. By making loans (increasing its reserve requirement?), a bank can eliminate “excess” reserves… right? wrong?
4) but that doesn’t really matter, because the Fed pays 25 bps on both required and excess reserves.
5) so if the Fed were to cut this IOR payment down to zero, it would incentivize the banks to not want to hold reserves – certainly not want to hold any more reserves than they had to (minimize excess reserves)… So the banks would offer overnight money to each other at a lower rate than currently… but that shouldn’t really “do” anything in terms of net lending resulting, because there are already plenty of reserves in the system, right?
6) but wait – why, then, is the current FF rate lower than the IOR rate? I thought that IOR was supposed to put a floor on the FF rate? (makes sense – who wants to lent do another bank at less than 25 bps when they can lend to the Fed at 25bps?!?!?!) Why doesn’t Bank X borrow as much money as possible from Bank Y at less than 25bps and then “lend” it to the Fed at 25bps?
several questions embedded in there above… thanks in advance!
When a bank makes a new loan they essentially force new reserves to be created. This occurs by necessity as the central bank must make the reserves available when needed.
The FFR is a target rate in the range of 0-.25. The Fed doesn’t so much care if the rate falls below 25 bps. They just care if it’s in their target range. Paying IOR helps them keep the rate from falling despite the fact that all the extra reserves are putting continual pressure on rates. It’s not a perfect exercise in setting rates. But it’s damn close.
wait – so are you saying that my very first premise is wrong? that banks CAN in fact alter the total amount of reserves in the system??? Holy cow – now i’m really confused. Or perhaps you’re saying that when a bank makes new loans, the Fed makes more reserves available – creates more reserves? Can you elaborate? Why would the Fed make more reserves available when there are already plenty of excess reserves?
also, regarding the FFR: my question was from an arbitrageur’s perspective: if the FFR is 18bps, why wouldn’t a bank borrow as much as possible from the other banks at 18bps and then “lend” that money back to the Fed for 25bps (keep it at the Fed as excess reserves)? Why isn’t that happening, even for small spreads?
When a bank makes a new loan it generates an overdraft at the Fed if the reserves are not available. There’s not choice in the matter. The Fed doesn’t say “well, there’s not enough reserves, here you go”. The new loan essentially creates them by necessity. So you could kind of think of this as banks creating their own reserves (or steering the ship), but the Fed still supplies the overdraft. It’s kind of a convoluted process there.
Banks are borrowing at 18 and lending at 25. This is mostly from the GSE’s who aren’t eligible for the IOR. See the discussion on page 160 for more on this. http://www.richmondfed.org/publications/research/economic_quarterly/2010/q2/pdf/hornstein.pdf
but you said “if reserves are not available”… aren’t there ample EXCESS reserves right now? that’s what I was getting at, and why I didn’t understand “When a bank makes a new loan they essentially force new reserves to be created.”
Studies, by neoclassical economists no less, show that changes in M2 precede changes in base money and M0. This is diametrically opposed to what we learned in econ 102 but consistent with monetary realism’s view that banks can create money by making loans for the FED accommodates the financial sector’s need for reserves. If the FED were to not supply the demand for reserves then it would loose its ability to manipulate interest rates to achieve policy objectives; financial stability, inflation, employment, ect.
If you are interested here is a link (http://www.minneapolisfed.org/publications_papers/pub_display.cfm?id=225) to the study.
but I’m not talking about how the Fed supplies demand for reserves. I’m talking about how there are already PLENTY of reserves. We don’t need any more reserves. There are plenty of excess reserves already.
right?
so why would the Fed provide MORE reserves when banks make a loan?
There are plenty of reserves.
Bill McBride has a really good overall understanding about the economy as a whole. Someone might even say that he has never been wrong. Do you read regularly his blog Calculated Risk? IMO it’s one of the best financial blogs there are (along with your site and FT Alphaville).
I do read CR. It’s very good. I would say my favorite blog is the FT Alpha blog. They’re so superb in their analysis.
Cullen, what do you think of this SocGen opinion :
http://finance.yahoo.com/news/p-500-nears-ultimate-death-091645033.html
S&P 500 Nears ‘Ultimate’ Death Cross: SocGen
The S&P 500 index is on the verge of hitting an “ultimate” death cross, where the market’s 50-month moving average falls below the 200-month average, according to a research note by Societe Generale.
A death cross is the shape made on a chart when a market’s long-term moving average breaks above its short-term moving average or support level. It is seen as a sign of a looming bear market, or a cue to sell.
In the Societe Generale note, published on Monday, strategist Albert Edwards said the last time the S&P 500 (^GSPC) came close to a monthly death cross was in 1978, “towards the end of the 1965-82 secular bear market.”
Edwards added that Japan suffered a monthly death cross in 1988, “and 14 years later we are still in the firm embrace of the bear.”
I think that lines crossing one another on a chart mean nothing. This type of charting or technical analysis is a rear view mirror approach. Without putting the future into some context it tells you very little about where prices are headed. TA and charting are supplements to good fundamental analysis. They do not replace it.
Is it just me or are financial crises (and rallys for that matter) one tremendous bullwhip type distorition effect based on inaccurate demand forecasting and visiblity, as often described in supply chain inventory management. But on a larger scale. For sake of discussion I am excluding exogenous shocks such as a large natural disaster.
For example cheap credit >housing bubble> oversupply/speculation> balance sheet recession> housing inventory reduction > employment shock
If this is true then crises and rallys would be unavoidable as long as humans are involved, when rather than if. And bullwhip fluctuations in value and demand for all things (credit,housing,etc.) simply disguise an underlying valuation for the world economy. One that simply gains true value slowly over time from real gains in efficiency and productivity which in turn grants us time, as you’ve written about as the one true constraint.
This would imply that a truly efficient market would require 100% visiblity in real time for all demand across all providers of goods and services including credit, currency and the like.
Clearly I am speaking of a “perfect world” type scenario but I would just like to get your opinion on the logic chain.
P.S. Also I love your site and I am interested to hear more about your new firm! I am in the military(Army Natl Guard part time) and I spend a lot of time giving presentations busting myths about finance(many soldiers are dreadfully in the dark).
Hi VC. Thanks for the comment. I think you have it just about right in my opinion. I phrase it slightly differently though. Economies and markets are non-linear dynamical systems. They’re complex, impossible to digest and too dynamic for most participants to predict with any consistency. Throw in the fact that humans are irrational, biased and inefficient and you have a perfect recipe for a totally inefficient market. The market and economy is simply the summation of the irrational decisions preparing for this dynamic system’s potential output. So it shouldn’t surprise anyone that the whole thing seems like a big mess a lot of time. It’s our own doing! And yes, it’s likely impossible to “fix” since the flaw (us) is the most crucial piece of the equation.
Break the positive feedback loop that debt creates and you might be able to break the pronounced boom bust cycles that plague our economy. For example consider the housing bubble: mortgage lending > increased home prices >increased perceived credit worthiness of borrowers >which led to more lending >higher housing prices with the loop reinforcing itself until some exogenous shock hits the system. Or you have Latin America in the early 90′s: lending >increased GDP >increased a countries perceived credit worthiness >increasing more lending> increasing GDP until the endogenous shock struck, which was the creditors realizing the loans they made to governments were going to become uncollectible.
I’ve come to the conclusion that my grand parent’s generation eschewed debt for they grew up during the great depression whereas my parents generation grew up with the go-go mentality and easy credit provided the means to get them their. I’ve noticed at school my peers take a very skeptical view of debt as a result of the great financial crisis and the astronomical rise cost of tuition, both of which were/are fueled by cheap and easy credit.
What do foreign countries/businesses do with the dollars they have? You have talked about foreign holders of Treasuries looking for a return on their cash, but do the funds flow around much with business conditions or economic expectations (i.e. do they move into and affect the prices of other asset classes like commodities or equities)?
Most of the dollars are just in electronic accounts around the world. And they’re used to buy things denominated in USDs. That can be commodities, assets or just about anything. One reason why USD’s are in high demand is because they are accepted most everywhere and very liquid or fungible.
You recently tweeted that risk/money management was the hardest part of investing. Do you have any book recommendations on the subject?
P.s. I have recently started reading a book by Ralph Vince.
Off the top of my head – Howard Marks is a great risk manager. Some of his insights from “The Most Important Thing” are excellent.
Besides this site, the voice that I find speaks most clearly about world and national economics, putting today’s into historical and intellectual context, is Michael Hudson at UMKC. I know that his approach is diagnostic and prescriptive: neoliberal economics is the big problem, pushing taxation onto labor and capital by rewarding rent-seekers, for one thing. Taxing increasing land values and reducing the FIRE sector’s influence in the economy are parts of the answer, according to his school of thought.
While MR aims to accurately describe what is, not what should be, being able to read MR and Hudsonian thinkers in the same, integrated if possible, context would be a delight.
Could you point me there, or to something along that line? Or comment about MH & company?
I don’t read much of Hudson’s work because he tends to write very long pieces. I just don’t have the time. I don’t think anyone at UMKC is too happy with me following the MR/MMT split. I think a lot of MMTers think my split was something personal, but it was purely because I didn’t believe that what they’re teaching is entirely accurate. MR is an attempt to get at what IS, not what can be. Unfortunately, I don’t think anyone really does describe the two all that well. MMT is very close, but even they have an “inherently progressive” twist to everything they do. Personally, I’d love to start writing about how the system should be changed, but my intent with MR is to purely describe what is. So I try not to confuse people with a policy focus.
Cullen, I share your enthusiasm for the entrepreneur and all and I think they play an important part in driving growth and living standards. The question is how big is this role? Is their any proof of this very significant role (“the backbone of the economy”) you and MR are advocating? Are not a majority of innovations today coming from big corporations and gov funded fundamental research?
You often critize people for not understanding the monetary system etc. and basing their views of what the economy needs on ideologies/politics. I do however feel that you might be doing the same mistake with putting the entrepreneur on a piedestal like this.
Would love to see you debunk this with an article about the role of the entrepreneur based on pure hard facts and numbers instead of “american dream” ideological arguments!
Love the site and the new design is great!
The big corporations are private sector entities in the USA. Maybe that’s not the case in Sweden or in some other nations. But I know that the overwhelming number of goods and services that are produced in the USA are coming from the private sector and not the public sector. This doesn’t mean the public sector can’t have an extremely positive impact on the economy, but in the USA it’s very clear that private entities are the ones driving the general direction in terms of innovation and production. What makes you think otherwise?
I did not mean private vs. public but the actual role of the entrepreneur/small business. You have been describing the entrepreneur as “the backbone of the economy”, driving growth with innovation. Are you actually reffering to the private sector more generally (i.e. large corporations as well) when you talk of the entrepreneur? In that case no quarrel
I do not have the numbers to back this up but I have a feeling technical innovations today is becoming increasingly complex and requiring ever larger capital inputs (examples are healthcare, computer hardware, nanotechnology etc.), making larger corporations and goverment with less capital constraints the natural ‘innovators’ (and maybe not the entrepreneur/small business). I.e. Edison just needed some glass and a piece of metal wire to invent the light bulb, try building a quantum computer with that in your garage..
No question though entrepreneurs drive innovation in the internet/media-sector today (e.g. google, facebook).
So my question is really is the entrepreneur defined (narrowly) as new and small business really that important to innovation and hence growth and jobs?? I believe so intuitively but do not have the numbers to back this up, would be awesome to see a post on this!
I see what you’re saying. The way I’ve experienced this, larger companies are generally incubators for start-ups. Do you know how many start-ups have spun-off of firms like GE, IBM, Google, Apple? Thousands. That doesn’t mean there isn’t a lot of innovation at these big companies, but their impact is broader than just the products they make. Regardless, I’d argue that even these big companies are innovation engines. You don’t have to be a start-up to be innovative, though it helps….
The important thing is striking the right balance between understanding that the govt isn’t necessarily bad and understanding that its primarily the pvt sector that sparks this growth in innovation. Govt is a tool used by us to facilitate pvt sector prosperity. We need to better understand that.
Completely agree.
And to add, I think MR opens up amazing possibilities for innovation and fundamental research in particular (for the capital constraints reasons I mentioned). What if the politicans realized that there is no limit (except inflation) to fund research? We could build a working fusion-reactor and have a man on mars in no time. Makes you wish this stuff was mainstream already! You guys are getting traction though, all the way up here in Sweden I hear people mentioning your blog every now and then.
Keep up the good work!
Cullen, what do you make of the following issue, that there is a quality collateral constraint when it comes to QE? thanks a lot!
“Why is the Fed doing this instead of simply engaging in more QE? The answer is because QE removes Treasuries from the banking system. We are facing a solvency Crisis and Treasuries are the senior most asset on US bank balance sheets.
When the Fed buys a Treasury from a US bank, it is providing liquidity (cash) to the bank to meet the bank’s short term funding needs.
However, by removing the Treasury from the bank’s balance sheet, the Fed is removing one of the banks senior most assets: the very asset against which the bank has leant or traded hundreds of billions and possibly even trillions of Dollars’ worth of loans and trades.
Put another way, the Fed, by buying Treasuries is making insolvent banks even more insolvent. It is a short-term gain (liquidity) for a long-term disaster: banks need as much collateral as they can get their hands on right now. And with Treasuries rallying (raising the value of the banks’ assets) any aggressive Fed program to take Treasuries out of the system would be a MAJOR step towards another solvency Crisis a la 2008.
The same pattern is playing out in Europe right now though on a much grander scale
…
This in turn only increases the solvency issues in the EU banking system. And remember, bank runs are already underway in Spain, Italy, France, and Greece. So banks are desperate for capital and collateral.
…
So the Fed and the ECB WILL NOT be stepping in unless the entire system starts to go.”
(source is gainscapital.com a doomsday contributor to ZH)
I’d say there’s just generally a shortage of safe assets. This is one of the things we learn from MR. The addition of net financial assets through deficit spending can really help make balance sheets better off. The Fed isn’t having a real positive or negative impact here in my opinion since QE is just an asset swap.
First, there is no economic constraints as to what the central banks can accept as collateral, however there are rules as to what can be accepted but both the FED and ECB have bent the rules when liquidity drys up. Second, what is more senior, or liquid, than cash? Simply swapping cash (non-interest bearing USD) for Treasuries (interest bearing USD).
I think the Eurozone crisis could be solved tomorrow if the ECB comes out and says it will buy any government bond above 4% and engages in a permanent LTRO. This will do two things: 1st it will repair the bank’s balance sheet by raising the value of the bonds on their books and second it will eliminate the threat of a sovereign default because roll over risk would have been eliminated.
Sorry this was meant to be a reply to GreenAB.
Cullen I have two questions: first, how do you construct a macro portfolio and second, are there any articles, books, or papers on economic modeling you would recommend?
Thanks
I was actually about to ask a similar question. I was wondering if there were any books you recommend on how to build a portfolio based on the macro environment or, more general, what to look for and how to interpret it. Thanks.
I’m writing the book. But you might have to wait a few years.
Cullen, how likely do you think it is that the fed’s next move would be to purchase mortgage backed instruments? Where would the trade be- big banks, regionals, homebuilders? Timing wise, I’m thinking the fed will try to keep things smooth at election time- and assuming anything they do won’t have a great impact- any move will come after August. Your thoughts? Thanks again for a great site.
I can’t offer specific investing advice here, but I would say that the odds of MBS purchases in QE3 are extremely high. Assets most impacted would be the banks since the market will see it as likely to help bank balance sheets. MBS itself is already rich so I don’t see much to “price in” on the upside there. Banks more generally, have been crushed.
In view of the chorus of calls for reducing or eliminating the so-called “national debt” it would be greatly appreciated if you would comment on this article:
“Dept Overhangs: Past and Present” by Carmen Reinhart Vincent Reinhart and Kenneth Rogoff, published by the National Bureau of Economic Research (2012)
a link to which can be found at:
http://ideas.repec.org/p/nbr/nberwo/18015.html
Thanks
Bernard Super
Bernard, the Reinhart and Rogoff perspective has been wrong for years. They compare an autonomous currency issuer like the USA to any other nation. But the fact is, a nation like the USA has its own bank and harnesses banks as funding agents. There is no such thing as “running out of money”. Further, “paying back the national debt” would simply involve eliminating a form of private sector saving (tsy bonds). Since inflation is always the true constraint for a nation like the USA (not solvency) then what sense does it make to remove tsy bonds if pvt balance sheets prefer to hold those assets? As I’ve said before, the question we should be asking ourselves is not “does the govt need to obtain funds to spend (which it always can)”, but “does the private sector need more funds to spend”. Obviously right now, the private sector needs more funds. And the govt can help there. But we worry about mythical solvency crises instead so our economy stinks.
What is the role of collateral in managing bank reserves?
I think interbank loans are uncollateralized. What about loans from the Fed’s ‘Discount Window’?
How about for European banks and the EZ NB/ECB system?
What are the standards for collateral, if required?
2. Possibly related question. It seems like the Fed can directly set two rates: the ‘Discount’ rate, and the interest rate it pays on reserves, that would tend to set a ceiling and a floor for the Federal Funds Rate (for loans between banks). Is this generally the case?
All discount window borrowing requires collateral. Not sure on Europe, but I assume it’s the same. See here for more.
http://www.frbdiscountwindow.org/pledging.cfm?genid=13&desc=Pledging%20Collateral&url=pledging.cfm
Yes, the Fed sets the discount rate and the FFR.
“Yes, the Fed sets the discount rate and the FFR.”
For FFR, did you mean the interest on reserves? My understanding was that the Fed sets a ‘target’ for the FFR, and then uses its powers to keep the actual FFR within an acceptable range.
Does the requirement for collateral mean that the ‘Discount Rate’ is generally lower than the FFR?
(Perhaps in Part 4. of your piece on MR, you might add clear explanations of the FFR, the ‘Discount Rate’, and the interest rate on reserves, as the terminology and abbreviations used have led to great confusion between these for me in the past: eg the name ‘Federal Funds’ suggests a rate for funds supplied directly by the Fed, but in fact refers to the rate for lending between banks, the name ‘Discount’ seems to imply a discount from the FFR, and the abbreviation ‘IOR’ for interest on reserves is easily confused with ‘interbank offering (or overnight) rate’ by analogy with LIBOR.)
Right, it sets a target rate. Sorry. IOR helps the NY Fed more precisely keep the target rate in range. It’s become a de facto FFR.
(Last Q and I’ll quit bugging you for now.)
Is the Discount Rate typically lower or higher than the FFR?
Thanks for answering all these questions.
I’m glad to help Colin so there’s no such thing as too many questions or bugging me here.
The discount rate is intended to be a penalty rate so it’s higher than the FFR.