Author Archive for Cullen Roche

About this “Excess Supply of Money” View

Nick Rowe didn’t love David Andolfatto’s post on excess reserves and inflation.  Of course, being a Market Monetarist, his view is a bit different.  He doesn’t like the idea that banks don’t “lend reserves” and instead argues that banks do indeed lend reserves for practical purposes.  He says:

“We define “excess money” as the actual stock of money that people hold minus the stock of money they desire to hold (given prices, income, interest rates etc.).

If an individual person has excess money, he can and will get rid of it, by spending it or by lending it. (And “lending” means “buying an IOU from someone”, so it’s the same as spending.) But that just means another individual person now holds it.

Let’s cut to the goddamn chase: banks lend reserves.

And the fact that banks cannot in aggregate get rid of the excess reserves is a central part of the standard textbook story of why excess reserves raise the stock of money, which creates an excess supply of money, which raises the demand for goods and the prices of goods. If banks in aggregate could get rid of reserves by lending them, the excess reserves would have at most only a temporary effect.”

Monetarists like focusing on “money”.  The problem is, they don’t define money all that well in their models and their focus on “money” leaves them missing the fact that there are many “money like” assets in a monetary economy.  Defining one or even a few items as “money” and then building a model around these particular financial assets is a very narrow way of understanding the monetary system.  And that appears to be what happens in the Market Monetarist model.  And while there’s much to like in the Market Monetarist view I think this narrow perspective often leaves us missing important parts of the bigger picture.

In this case Nick is arguing that banks have “excess reserves” representing “excess money”.  So they lend them to one another, which, in the aggregate accomplishes nothing since the banking system as a whole cannot get rid of their reserves.  That’s a fine view and an accurate description as far as it pertains to banks.  But it doesn’t really apply to the aggregate economy in the sense that Nick would like us to think.

When QE is implemented, the Fed buys financial assets and credits banks with reserves.  If the transaction doesn’t involve a non-bank then this is a clean swap of a safe asset for a safe asset (for instance, a T-bond for  reserves).  The private sector’s net financial assets haven’t changed.  So it’s a lot like having swapped a savings account for a checking account.  Now, some people might say that once you lose the saving account and have a checking account then you have “excess money”.  But who cares?  No on in the real world thinks that way.  They look at their financial assets and savings relative to their income and decide whether they can spend a certain amount of money.  You don’t say “aww shucks, my CD just matured and now I have all this ‘excess money’ to spend.”

Nick is right that banks can end up with “excess money”.  But the way I view it the entire reserve system is an excess to private competitive banks as it’s really the result of a regulatory overhaul that impedes their true desire to monopolize the entire system (in which case there would be no reserves at all as there would only be one bank in which to settle all payments).   So talking about reserves as “excess” is misleading in the first place.  And then applying it to some practical economic sense outside the banking system simply leads to the misguided view that the Fed can determine the amount of spending in the economy simply by changing the portfolio of assets held by the private sector.  And it all ends up with a lot of confused views about “money”, banking and the economy.


Thoughts on QE, the US Economy & the Markets

I did a segment on Boom Bust this afternoon talking about the US economy, the markets and QE.  Here are some bullet points, but you can watch the full interview below or click this link.  I’ll have to apologize in advance for my attire.  I was wearing a suit, but Ed Harrison who produces the show, said that it would be too douchy if I wore a suit at the beach AND the woods.  Just kidding, he didn’t really say that (Ed’s too nice to call me a douche to my face even though I am one), but I did think it before the segment….

Here is the short, short version:

  • The US economy is still operating well below capacity.  The gradual improvement in the economy over the last few years is a sign that we’re filling that capacity shortage slowly, but surely.
  • It’s a mistake to get too bearish about Q1 data.  This truly was a seasonal anomaly and the data in recent months has proven that we’re seeing a big comeback in the data after the Q1 lull.  PMI at 57.5, recovery lows in jobless claims, double digit rail gains and recent housing data are all signs that the economy has thawed after the brief winter slowdown.
  • The markets are forward looking.  Focusing too much on the weak Q1 data at this point is leading people astray.
  • The economy is improving, but the substantial amount of slack means the economy is probably still too weak for a sustained inflation to occur.
  • It would be a mistake for the Fed to tighten sharply at this point as the economy remains fragile enough that a shock could tip us back into a deflationary or recessionary environment.

Or you can watch the interview here:


David Andolfatto Gets Excess Reserves and Inflation Risk Right

This is a very good piece by David Andolfatto on excess reserves and the risk of inflation.  I highly recommend having a read.  He’s explaining his views relative to this piece by Paul Sheard which I discussed last year.  Anyone who’s read my paper on the monetary system will know all of this already, but I did want to reiterate the points Sheard highlights:

• Banks do need to hold reserves (as a liquidity buffer) against their deposits, and banks create deposits when they lend. But normally banks are not reserve constrained, so excess reserves do not loosen a reserve constraint.

• Banks in aggregate can reduce their reserves only to the extent that they initiate new lending and the bank deposits created as a result flow into the economy as new banknotes as the public demands more of them.

• QE does aim to ease financial conditions and spur more bank lending than otherwise would have occurred, but the mechanisms by which this happens are much more subtle and indirect than commonly implied.

• If the excess reserves created by QE were to be associated with too much credit creation, central banks could readily extinguish them.

The part I really like in the Andolfatto post was this explanation of bank notes and their existence relative to how we think of “money”:

“Now, individuals regularly make deposits and withdrawals of cash into and out of their bank accounts. The net flow of withdrawals minus deposits determines by how currency in circulation grows over time. Banks do not lend out their cash. When a bank makes a loan, it issues a deposit liability that is redeemable for cash on demand. The demand deposit liabilities can be used as a payment instrument (they constitute money, and are counted as part of a broader measure of money supply, e.g., M1). The key observation here is that the way currency enters the economy is through the net withdrawal activity of bank customers–it has nothing to dow with banks lending out their reserves.

Alright, so why is understanding all this important? Well, for one thing, it is an accurate description of the way money and banking actually works (as opposed to the traditional “money multiplier” story that is commonly told in undergraduate textbooks). It is the right place to start when thinking of policy questions.”

That’s perfect.  And it’s why I like to think of the monetary system in terms of “inside money” (bank created money like bank deposits) and outside money (notes, coins and reserves).  It helps to emphasize the fact that outside money is really a facilitating form of money that exists primarily to aid the existence of inside money in various ways.  In the case of cash it is simply something that exists to allow users of inside money to convert their deposits into cash for the purpose of transactions.   We get to the reality of the system where the “money” that exists starts primarily with the banking system and not with the government or the Fed through some “government money printing” process or a “money multiplier” process.  Instead, we throw the mainstream descriptions on their head and view the system through the banking system first and then understand how the government supports the private sector banking system in various ways.  Understanding the monetary system through this view has proven crucial for understanding many of the economic and policy outcomes from the last 5 years and also explained why so many of the high inflation or hyperinflation predictions were wrong.

David wraps up his post with a hypothetical situation where the Fed incurs capital losses as interest rates rise and depositors convert their holdings to cash and higher interest rates lead to a self fulfilling inflation:

“Now, higher inflation expectations on the part of the public may induce people to want to hold more currency (in nominal terms–the demand for real money balances may decline). This may be what could trigger a mass wave of redemptions. As people start withdrawing cash from their bank accounts, the banks start redeeming their reserves for cash to meet their customers’ demands. The spike in interest rates unplugs the Fed’s vacuum cleaner — people know that the Fed does not have the tools to buy back all of its reserve liabilities. The wave of redemptions proceeds unchecked, with the flood of currency generating an inflation that becomes a self-fulfilling prophesy.

Well, that’s just a story. I’m not sure if it hangs together logically…”

Yeah, I am not sure I love that part, but he’s obviously just toying around with the idea.  First, I don’t see any reason for the Fed to incur losses in the portfolio since they can hold their portfolio to maturity without having to worry about solvency.  Second, I don’t know why people would convert to cash in a rising interest rate environment (for instance, currency in circulation didn’t increase rapidly in the 1970′s).  And lastly, there’s no reason to assume that the Fed would lose control of the policy rate during a high inflation since it can now target the Fed Funds Rate by changing the interest rate it pays on reserves.  So I don’t think that this story hangs together.  In fact, I don’t know if there’s any real logical story about how high levels of reserves can lead to higher inflation.  It seems to be something that is based on misunderstanding the monetary system and little more….

Go have a read of David’s post.  It’s very good.  He’s great at explaining complex concepts so if you don’t read him and you’re trying to become nerdier than you are (ie, smarter), then add him to your reading list.


Chart o’ the day: Dividends and Buybacks Jump to new All-time High

We’ve officially round tripped it now.  Not only is the VIX at pre-crisis lows, but corporations are now issuing dividends and buying back shares like the crisis never happened (via Fact Set):

“Dividends per share (“DPS”) for the S&P 500 grew 12.5% in the trailing-twelve month (“TTM”) period ending in April. This also marks the thirteenth consecutive quarter in which DPS has grown at double-digit rates. Long-term, significant dividend growth—coupled with growth in share repurchases (which grew over 50%)—has helped quarterly shareholder distributions to reach record levels since at least 2005. In total, $249.1 billion was distributed to shareholders in Q1, which modestly surpasses the $242.1 billion distributed in Q3 2007.”



Let’s Worry About Inflation When Employment Starts to Inflate

There has been a pretty substantial amount of good news over the last few years.  In fact, I’ve argued that this recovery doesn’t get as much credit as it deserves.  But we have to maintain some perspective in these discussions and remember just how deep the hole we’re coming out of really was.

It’s tempting to compare the current recovery to past recoveries.  And in doing so we are inclined to assume that we might approach a policy response with similar concerns and actions.  But this economic environment is nothing like the recoveries over the last 30 or 40 years.  And we need to look back at those recoveries to see just how unusual this environment really is.

To see just how deep the hole was we need look no further than the state of the US workforce.  And the devastation there was tremendous.  For instance, the U-6 unemployment rate is still above any point during the last 20 years:


And the median duration of unemployment is still substantially higher than it was during the last 45 years:



These are numbers that signify a devastating situation in the US labor market and NOT one where we should be overly concerned about an economic boom.  Although there have been many positive economic signs in recent years I think it’s a mistake for policy makers to jump the gun tightening policy too quickly.  The inflation boogeyman isn’t going to resemble anything like we’re used to.  In fact, if the past is any guide then the state of the labor market means that inflation is unlikely to surge any time soon.

I Say Wisdomy Things….

Tadas Viskanta ran a great series this week on blogger wisdom (which might be an oxymoron).  You should check out all the answers as he put together a great group, but here’s my collection of answers:

On Robo Advisors:

As I showed in my recent review of this segment, the so-called Robo Advisors don’t do much (if anything) that an automated buy and hold portfolio doesn’t already do (a well informed Vanguard client, for instance, gets just about everything these firms offer without the extra fees).  In fact, due to failures in risk profiling and a lack of true financial planning, I have a hard time seeing why anyone would pay to have a buy and hold portfolio managed on their behalf through such an oversimplified process.  I think the Robo Advisor phenomenon is a positive industry disruption that will ultimately push down fees, push out weak advisors and create a necessary convergence between human advisors and automation, but will not replace the human element.

On Smart Beta trends:

Like the Robo Advisor phenomenon, “smart beta” looks like a lot like an attempt to take a so-called “passive” approach and sell it as something superior than buying the aggregates (all in the process of charging higher fees for a supposedly passive portfolio).  I have a hard time seeing the real value add here.  There’s value in some active management approaches, but I am not convinced that minor alterations in broad indices is the way this is best achieved.

On the future impact of demographics and equity market returns:

Understanding demographics is largely a function of geography in today’s world.  The new macro world requires an understanding of how the developed world is changing relative to the emerging world.  And while it’s true that there is population stagnation in much of the developed world, there remains a population boom in much of the emerging world.  A new middle class is developing and these consumers want the lifestyle they see in the developed world.  There is a powerful convergence between the accessibility of technologies made in the developed world and the demand from the emerging markets that is transforming the world into a new macro environment.  Investors and businesses need to position themselves accordingly.

On private vs public markets:

The private markets are where I always like to say “real investment” occurs.  That said, real investment is incredibly risky and studies show that 50% of start-ups fail in their first 5 years.  It’s probably a good thing that most people are not able to access the primary markets.

Advice to novice investors:

My advice to novice investors is to know what it means to invest in yourself.  That means taking the time to accumulate knowledge, staying open-minded, learning from mistakes and remembering not to confuse building wealth with building a life.




Bank of America: 4 Reasons Inflation will Remain Low

Here’s the flip side of the Sober Look article I posted earlier.  Bank of America brings us 4 reasons why inflation is likely to remain low (via Calculated Risk):

Reserved money growth
Since the beginning of the economic recovery, monetarists have argued that with the Fed’s massive balance sheet strong inflation could be just around the corner. Our response has always been: reserves are not money, and unless those reserves stimulate a surge in bank lending and spending, they are not inflationary. … even with the recent pick up in business lending, overall bank lending is still growing at half the normal pace of a business expansion. …

Medical mal-pricing?
Another key inflation concern is that special factors have temporarily held inflation in check and are now reversing. There seems to be an element of this in medical inflation. Inflation dipped last year as government payment rates were reduced and as key drugs became generic. Thus the medical PCE price index fell 0.45% in April 2013 and then rose 0.20% this April. That swing alone added more than a tenth to year-over-year core PCE inflation. However, we are reluctant to extrapolate the recent strength going forward. …

It’s a small world after all
In our view, one of the most underrated factors in recent inflation movements is the impact of global markets. … In recent months, there have been some signs of a bottoming out of consumer import prices. However, a significant acceleration seems unlikely. The conditions that created the low inflation are still in place: emerging market growth remains low, there is abundant spare capacity in the global economy, the dollar is trending higher and Europe is at risk of sliding into deflation. The main upside risk comes from commodity prices, but usually that takes some time to develop.

Weak wages
While there is a lot of talk about higher wage growth, there is very little evidence. …. In our view, there is still some slack in the labor market; when slack disappears, the rise in wage growth will be very slow, and as Yellen made clear at the press conference, the Fed will welcome the initial rise in wage inflation as a sign of normalization rather than inflation.

Chart O’ the Day: Round Trippin’ it

Not much to say here.  Just a chart of the volatility index.  Right back to where we were before the crisis occurred and fast approaching the all-time lows (via Bloomberg):


5 Investment Lessons we Can Learn From Futbol (err, Soccer)

With the World Cup on every day for the next month I’ve had to get up to snuff on my soccer, errr futbol.  And as I watch the games unfold I realize just how many parallels there are between futbol and investing.  For instance:

  • You can be a total fraud and get away with it.  Just like on Wall Street, you can be a perennial underperformer, sell products that don’t deliver or even blow up funds time and time again and people will still think you have something legitimate going on.  Likewise, in the World Cup you can apparently just fall over if you’re close to an opponent and the referee will keep rewarding your fraudulent performance with free kicks.  The lesson of course is to be aware of frauds.  They’re out there and they can be avoided if you’re careful.
  • You don’t have to win to advance.  You can tie in soccer.  That’s weird for Americans, but it’s an important lesson in the world of investing.  You don’t have to beat everyone else to succeed.  We’re continually told that we have to “beat the market”, but that’s totally false.  We all have unique financial goals and needs and “beating the market” isn’t necessarily one of them.  Most of us just need to generate positive risk adjusted returns while beating inflation and reducing our risk of permanent loss.  And you don’t have to beat everyone in the world to achieve those goals.
  • The game is a series of sprints inside of a marathon.  We’re often told that investing is a marathon.  You know, you follow the green line to your number or you “buy and hold” “stocks for the long run”.  But the reality is that our lives are a series of events and our financial lives need to be prepared for not only the finish line, but also the events inbetween.  Soccer might be one 90 minute match, but it’s actually a series of sprints inside of that longer match.  Much like investing is a prepared around a series of personal financial events within one longer time frame.
  • Diversification is the only free lunch.  We’ve already seen some of the biggest stars get injured or simply fail to produce in this year’s World Cup matches.  But that hasn’t necessarily spelled doom for those teams.  Soccer is a great team sport in this regard.  One man doesn’t win matches.  You need a diverse team with diverse skills with players who can offset one another and pick each other up when someone else is down.  Investing is no different.  You don’t bet on one asset.  You spread your portfolio out, create non-correlation, and protect the portfolio in ways that ensure that when your trusted assets fail, they don’t torpedo the sum of the parts.
  • It’s a macro world and we’re just living in it.  The World Cup is not only reminding me how bad my geography is, but it’s reminding me that we live in a macro world.   The biggest nations aren’t necessarily the most dominant.  And the nations who are often expected to dominate end up flopping.  In this increasingly interconnected macro world the playing field is not only becoming larger, but it’s becoming increasingly even.  And if you want to succeed in this new macro world you have to understand how its components all come together.

The Pragcap Ad Hominem Hall of Fame

It would be a crime if I kept these recent insults all to myself:

“Cullen Roche – what a blowhard.”

I’ve never actually understood what a blowhard is.  I guess I could figure it out if I really wanted to, but I think maybe I don’t.

“This guy is a delusional dictator wannabe.”

I’ve actually never wanted that kind of power or spotlight.  Too much pressure.

“Cullen’s obviously ignorant. “

This guy could be on to something there….

“This guy has his head up his butt. “

Okay, I understand the meaning there, but can anyone confirm if this is even possible?  I seriously doubt it.

“The author is a homophobic racist and an abject bore….”

I like how being an “abject bore” seems to be on par with being homophobic and racist in this guy’s book.   And yes, while I’m almost certainly an abject bore I am definitely not racist or homophobic.

“I suspect that Cullen Roche is a pen name that Krugman uses because everyone recognizes that he is a fool.”

Yes, all those back and forths we’ve had over the years about IS-LM and endogenous money – we couldn’t fool them Paul, I mean, Cullen, I mean, Paul…..Who am I?

None of those compare to my all-time favorite insult from just after I changed my profile picture to the suit at the beach picture:

“what kind of douche wears a suit to the beach?”

A tremendously good question.  To which I could only respond:

“Technically, I wasn’t at the beach. I was on a cliff overlooking the beach. So your question should be: “what kind of douche wears a suit to a cliff overlooking the beach”. To that, I do not have a great answer. :-) Sorry.”

Food Stamp Usage is Cratering and that Might be a Bad Sign

One of the more common refrains from the permabear crowd over the last 5 years has been the unstoppable rise in food stamps in the USA.  It’s true.  There has been an unbelievable increase during the great recession from 28 million Americans to over 46 million Americans on Food Stamps.  That’s pretty bearish, right?

Then again, this shouldn’t come as a big surprise since the recession was particularly deep and the long-term unemployment situation has been practically unheard of.  But the trend has started to shift in a big way.  The rate of participation in the food stamps program has now declined on a year over year basis for six straight months.  And the cost of benefits has declined at a near double digit pace for each of the last 5 months.  After reaching peak participation of 47.6 million last August the number of participants has declined to 46.1 million.


This might seem like good news, but it’s more likely a sign of a late cycle recovery trend.  You see, food stamps are a countercyclical event.  They’re part of what economists refer to as “automatic stabilizers”.  That is, when corporations fire employees they often sign up for government benefits so they can try to make ends meet while they look for work.  And those benefits are most in demand when the economy is at its worst.  So programs like food stamps “automatically” kick into high gear when the economy goes into recession.  You can see this clearly in the following chart:


The fact that this trend is now sharply improving means that the economy is on the mend.  But it also means that the economy is late in the cycle of expansion.  And so what looks like a positive trend could actually be a sign of something negative developing.  So the time to be most fearful of trends in food stamps is not when they’re soaring thru the roof, but when this trend turns negative.  And we’re getting very close to that point in the cycle.

The Most Hated Economic Recovery Ever

I am going to do something very unpopular in this post – I am going to declare that the economy is healthier than it commonly gets credit for.   I’ve noticed that it’s common in the mainstream media to speak about the US economy as if we’re in some sort of permanent malaise where we’re not really improving.  In fact, from the way some media outlets talk about the economy you’d think that we’re in a recession.  But the data actually says that this hated recovery is doing better than it often gets credit for.  Here are some higlights:

The Misery Index, the sum of the unemployment rate and the rate of inflation, is at 8.1%.  That’s low by historical standards with an average of 9.5% since 1948.


Yesterday’s report on industrial production showed an all-time high in US manufacturing.  Yes, it’s struggled back, but at 3.2% year over year growth we’re almost 1% above the 40 year average of 2.4%.  


Real GDP hit an all-time high in Q1 of 2014 and if Q2 estimates hold up we should see the strongest quarter of growth since the recovery began.


Perhaps most importantly, private sector balance sheets have improved tremendously.  The net worth of the private sector reached an all-time high in Q1 2014.



I know this is an unpopular narrative.  And I know the recovery has been sluggish and uneven.  But there’s been a lot to like about this recovery as well.  And I think we’re so busy focusing on the recent financial crisis that we’ve completely missed a lot of the good stuff that’s gone on over the last 5 years.