Failing the Great Recession Test

Sorry, but I have to snipe at Paul Krugman again.  He’s once again (rightfully) berating the many economists who said QE would cause high inflation and wreck the world (the list is a veritable financial all-star team which is pretty interesting).  At the same time, he’s claiming that his model and his 1998 paper from Japan got the crisis right.  But were they right because they actually explained the dynamics at work?  Or were they partially just luck?  Well, gauging from the way the 1998 paper explains QE and bank lending, it’s 100% clear that he didn’t have the model or explanation correct at all:

“Banks, however, need hold only a fraction ar of their deposits in reserves and will hold no more than necessary; they lend the rest out (which is how consumers get the money for the deposits). So bank deposits will be a multiple 1/’rr of the monetary base”

For the millionth time, that’s just not how banks work.  Banks don’t lend their reserves out so expanding the monetary base was NEVER going to result in consumers getting “the money for deposits”.  Anyhow, I am a nobody even if I’ve been saying all of this for years.  So instead of listening to me, listen to S&P’s Chief Economist who explained this yesterday:

“Banks Cannot And Do Not “Lend Out” Reserves”

Dr. Krugman’s model was right. But was it right because it’s good or was it right because it was less bad than the one’s some other economists use?  I say it was only less bad.  Luckily, some economists on Wall Street are starting to use better models.  Models that are based on actual banking operations and not the fictional loanable funds based IS/LM models that resulted in some good predictions largely by sheer chance.

Cullen Roche

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. He is also the author of Pragmatic Capitalism: What Every Investor Needs to Understand About Money and Finance and Understanding the Modern Monetary System.

More Posts - Website

Follow Me:
TwitterLinkedIn

  • http://brown-blog-5.blogspot.com/ Tom Brown

    I wonder if Krugman learned something from that “Banking Mysticism” debate he had w/ Steve Keen et al? It kind of seemed like he did for a while. I wonder if he’d go back and correct some of those models? … or if he now even has an inkling of the problem.

    Sumner does seem to have learned something. It’s not clear what, but in his post today he was talking about how “base money” is “endogenous” in an “ideal world.”

    That’s REALLY a change from three years ago!

    I wonder if some of this stuff is slowly starting to sink in… you probably have to disguise it so it doesn’t look like accounting, banking or finance… economists can’t have those barbaric endeavors corrupting their pure profession! … but if it’s disguised well enough, some of this might slip through the gates.

  • LVG

    How can base money be “endogenous”? It comes from the Fed. It comes from outside the private sector. The key aspect of endogenous money is that it’s created inside the private sector. Base money can’t come from inside the private sector. It can’t be endogenous. Sumner is as confused as ever.

  • http://brown-blog-5.blogspot.com/ Tom Brown

    LVG, I agree that word is misleading, but this is how I think he means it:

    “In economics, endogenous money refers to the theory that money comes into existence driven by the requirements of the real economy and that banking system reserves expand or contract as needed to accommodate loan demand at prevailing interest rates.”

    http://www.encyclo.co.uk/define/Endogenous%20money

    Here’s an old example from Scott:

    “In the long run banks are constrained, as the Fed will adjust the monetary base to prevent economic overheating. The endogenous money folks, who are right about the period between Fed meetings, overlook this longer run problem with their theory. Six weeks is not a long enough period to have major macroeconomic consequences. But in the very short run the banks are not constrained by a lack of reserves, if the Fed is targeting the short term interest rate. The base is endogenous during that period.”

    http://www.themoneyillusion.com/?p=21786

    There are examples similar to this from many MMists (Glasner, Rowe, Beckworth). Here’s Glasner, for example:

    “So while I think that bank money is endogenous, I don’t believe that the quantity of base money or currency is endogenous in the sense that the central bank is powerless to control the price level.”

    http://uneasymoney.com/2012/04/11/endogenous-money/

    or here from David Beckworth:

    “I suspect you view all changes in the monetary base as endogenous. I only view short-run changes for a given interest rate target as endogenous. Over longer horizons the Fed is changing interest rates according to something like a Taylor Rule. These policy changes in target interest rates mean exogenous changes in the monetary base”

    http://macromarketmusings.blogspot.com/2013/08/a-permanent-expansion-of-monetary-base.html?showComment=1375901514604#c7523207141783165074

    or from Nick Rowe:

    “So drawing a perfectly interest-elastic money supply curve is a reasonable approximation to reality for 6 week periods. For any longer period of time, it’s totally wrong.”

    http://worthwhile.typepad.com/worthwhile_canadian_initi/2012/04/the-supply-of-money-is-demand-determined.html

    So when Scott wrote this today, it was surprising to me:

    “In a sensible system the base money is endogenous. You set the NGDP target, and the public tells you how much base money they want to hold. I’m all for that. But we don’t have a sensible system, the Fed uses QE to signal its target. That’s why it’s such a mess.”

    http://www.themoneyillusion.com/?p=22948&cpage=2#comment-267116

  • http://orcamgroup.com Cullen Roche

    I think the idea of reserves being endogenous is problematic. With IOR the CB does not provide reserves to meet an interest rate. It simply sets the rate and pays the interest.

    I prefer to say the entire reserve system is exogenous. It is a system forced upon capitalist entities who would prefer not to have it so they could compete for monopoly power of the entire banking system. So the whole reserve system is exogenous.

    Sumner is still confused about what money really is. He has it all backwards. The public doesn’t demand base money primarily. It wants inside money. Inside money precedes base money. He doesnt get that.

  • Fed Up

    “The public doesn’t demand base money primarily.”

    I’d say the public demands both currency and demand deposits because they are both medium of account (MOA) and medium of exchange (MOE).

    “Sumner is still confused about what money really is.”

    Exactly. See here where I talk about buying a $700 notebook.

    http://www.themoneyillusion.com/?p=21463

    Sumner says: “If you are going to buy that $700 notebook, ultimately it must be paid for by moving $700 of base money from your account to the store’s account. The check is not payment, just a promise to pay. The store wants cash transfered into its bank account.”

    I’m saying the check is payment.

  • Fed Up

    Have them assume a 0% reserve requirement.

    Have them assume the monetary base (all demand deposit economy) is 0(zero) along with a 0% reserve requirement.

  • http://orcamgroup.com Cullen Roche

    Well, you can’t get cash unless someone has drawn down an acct in inside money. Cash exists to allow people with bank accts to take out physical money. So yeah, I think we all really want the deposits because someone needs the deposits to withdraw cash from an ATM if someone wants cash. That’s how almost all cash gets around.

    I would use a bank deposit instead of the check. Its cleaner. People want bank deposits because that’s what we actually buy things with. Deposits are definitely money. After all, they’re the moe that influences wages, prices, etc at the point of sale. Reserves just facilitate interbank settlement. Banks don’t actually buy the notebook for you. So Sumner has it all backwards. He’s basically using a MMT view here which is exogenously centered around reserves. I think its totally backwards.

  • InvestorX

    Actually Krugman is wrong about the all star list. They are not inflationists. They say the Fed risks high inflation but focus more on the QE distortions and the need fot fiscal stimulus, just like Cullen or Hussman.

  • http://orcamgroup.com Cullen Roche

    “The planned asset purchases risk currency debasement and inflation”

  • http://brown-blog-5.blogspot.com/ Tom Brown

    Cullen, I agree that with ER > 0, the reserves are exogenous (i.e. not set by market needs).

    However, with ER = 0, then the reserves are set by market needs (and thus in that sense “endogenous”) according to that definition I found above. I see what you mean by the system being forced on the banks and thus in that sense “exogenous” but that is a slightly different way to interpret it. I just mean that given the system we have, what determines the reserve levels? The market’s lending (endogenous) or the Fed doing QE so that ER > 0 (exogenous).

    I really can’t say what Sumner is saying here because he seems to contradict himself (my two quotes above), but I was hopeful that the 2nd quote meant that he NOW thinks it’s better that we have ER = 0, and thus let the reserve level be determined by market lending. That’s how I interpreted it anyway. He certainly seems to imply that QE has made a mess of things, which also surprised me!

    I say “hopeful” because of the many seeming contradictions I’ve seen from Scott, so it’s tough to say. That 1st quote (which seems in direct contradiction) wasn’t that long ago!

    Strangely, if we take that 2nd quote from Scott the way I interpreted it, he also seems to contradict some of his fellow MMists, who claim that endogeneity is only over 6-week periods, and that the Taylor rule makes it exogenous over longer periods (they are all assuming ER = 0 with that statement I think). Glasner, Beckworth, and Rowe all argue for this longer term exogeneity… and so has Sumner (in quote #1)! Given that ER = 0, then the inside money level WILL determine the reserve level, and thus if inside money is endogenous, that implies reserves are too: the Fed follows along behind to make sure ER = 0 so they can control the FFR with (small) OMOs (rather than IOR).

  • Fed Up

    “See here where I talk about buying a $700 notebook.”

    add “with a $700 check” there.

    Sumner does not get the idea that entities will swap a demand deposit for real goods/services and/or financial assets. I’ll give up $700 in demand deposits for the $700 notebook. The store will accept $700 in demand deposits for the $700 notebook. No central bank reserves or currency need to be involved in the transaction.

    I could do the transaction this way too. I go to the bank and get $700 currency. I buy the $700 notebook for $700 in currency. The store redeposits the $700 in currency at the same bank. I am pretty sure the transaction ends up being the same (swap $700 in demand deposits for the $700 notebook).

  • Jared

    I agree with Tom. But if we make the assumptions Fed Up suggests, then we’re looking at a very different financial system. One in which bank deposits would not be guaranteed to trade at par. Given that, I think many vendors would be reluctant to accept deposits.

    Given our current system, vendors accept deposits because their banks know they’ll get an equal amount of reserves. If the banks don’t get the reserves, then your $700 check would bounce. From the bank’s perspective, a deposit is a liability that offsets a corresponding asset. If the bank doesn’t see an increase in assets (reserves), they’re not issuing a liability (deposit).

  • http://brown-blog-5.blogspot.com Tom Brown

    Ahhh! Now I remember Fed Up. He and I had a long back and forth there on Sumner’s site (on his link). The more I read the more confused I got here… I wasn’t sure I understood what Fed Up was getting at. If he’s getting at:

    1. Set RR = 0% (reserves not needed *much*)
    2. Get rid of cash (since MB = reserves + cash)

    … AND (following the link)

    3. There’s only a single commercial bank (?)

    I kind of get it now. As I recall though our conversation went off into capital requirements, and does a bank hold it’s own deposits [shudder!] as assets too (somehow). I think I will satisfy myself with knowing that I USED to know what he was talking about … a little bit anyway ;^)

    I was not a fan of his accounting scheme…. though it may hold together… I thought it was confusing w/o offering any advantages. Perhaps it was an attempt by him to better keep track of banks’ buying stuff for the purposes of using or calculating M*V = P*y. Something like that? So maybe it had some hidden charm that I never fully appreciated.

    BTW, Jared, did you ever get any further clarification from Beckworth?

  • Jared

    Nope

  • http://brown-blog-5.blogspot.com Tom Brown

    Just when I think I’ve figured out Scott Sumner… it’s two steps forward, two steps back: does this:

    http://www.themoneyillusion.com/?p=22948#comment-267435

    make any sense to anyone? I thought we’d just arrived at “the HPE is very weak when rates are 0″ and “ideally base money is endogenous: we can do what we did prior to 2008 (no QE, and with ER = 0) we just have to make sure that NGDPLT is KNOWN to be the policy: expectations channel is everything! QE make a “mess” of it all!”

    I was kind of warming up to what I thought was the “new” Sumner. That expectations thing… a little shaky on it’s own, (don’t you think?), but in general (what seemed like) an improvement. But now, it seems we’re back to HPE and “base money” needs to be elevated, and it “doesn’t matter” what the asset purchases are (!?!?). What?

  • Geoff

    TB, it was my understanding that the expectations thing depended on “rational” participants. If so, I agree with your shaky assessment!

  • http://highgreely.com John Daschbach

    There are still many in the inflation must come from the increase in the monetary base. Diana Furchtgott-Roth is but one example. It’s a view that has a great deal of support even though it’s wrong. It’s clear from the open letter linked at the very top that a large subset of economists hold this view.

    While simple, I find that the zero-order model of a single commercial bank to be important. Excluding overseas flows, with a single bank every loan creates a matching deposit, so base money doesn’t even enter into the equation and the money multiplier is easily seen as wrong as well.

    One of the things you learn in science is the importance of zero-order models. A more complex model can always build upon this, but it doesn’t change that in the limit it has to reduce to the zero-order model.

    Nothing in the zero-order view would lead one to conclude that “The planned asset purchases risk currency debasement and inflation”.

    What I find disturbing about the whole QE hysteria (I know people who claim the Fed is completely rigging the bond market and artificially suppressing interest rates) is that Fed holdings of Tsy’s (all maturities) are now around 12.5%, up from an average over the early 2000’s of 10%. Sure, maturities are longer, but it’s not as if the Fed dominates the Tsy market if it’s holdings are only 12.5%. The other interesting thing to note is that yields rose dramatically all during QE1, and the first half of QE2 (ending higher than the start also) and have risen during a significant part of QE3, and they fell significantly between QE periods.

    So the data mostly show that QE, if it has an effect, raises yields (the opposite of the prevailing view). Of course, it could be that the other 87.5% of Tsy holders actually set the prices in a highly liquid market which is why it’s impossible to find any meaningful correlation between Tsy yields and QE.

  • Tim

    Krugman wrote that for simplicit reasons. He explains it in his blog today.

    http://krugman.blogs.nytimes.com/

  • http://brown-blog-5.blogspot.com Tom Brown

    Tim, Ah, OK, you pointed this out earlier. I didn’t even bother looking earlier. Great news!!… some of this stuff will get the exposure it deserves.

  • Fed Up

    “One in which bank deposits would not be guaranteed to trade at par.”

    I’m still assuming 1 to 1 convertibility.

  • http://brown-blog-5.blogspot.com Tom Brown

    Hey Fed Up, do you recall our old discussion over at Sumner’s? (your link above). My conclusion was that the way you did the accounting was equivalent perhaps, but not typical (or at least confusing to me). You might be interested in this:

    http://ask-cullen.com/when-a-bank-earns-interest-on-loan-repayments-where-does-it-show-up-on-their-balance-sheet/

    Joe is an accountant. Tell you the truth, I didn’t read his whole description there, but my simplified way he approved of (at the bottom). That’s what I use in my examples.

  • Max

    The terminological confusion that grates on me is when people say that reserves fund banks. Funding, by definition, is a liability. Who’s liability are reserves? The Fed’s. So reserves fund the Fed. The Fed doesn’t fund (lend to) banks, except in emergencies.

  • http://brown-blog-5.blogspot.com Tom Brown

    Partially agree… I’m just not sure about the “emergencies” bit. What do you call repo (or reverse repos) (I get them confused) then? For example say all BSs are blank. Now the Tsy puts up a bond for sale and the bank creates a TT&L account to buy it. Now Tsy transfers the TT&L balance to the TGA and the bank has to acquire reserves. Can’t the bank repo the bond to the Fed to get the funds to transfer? Isn’t that a non-emergency loan of sorts? The reserves will return to the bank once Tsy spends from TGA.

  • http://brown-blog-5.blogspot.com Tom Brown

    … and thus the bank can repay the Fed and get it’s bond back.

  • Fed Up

    Let’s say I save $100,000 in demand deposits. Someone else wants to start a new bank. They sell me $100,000 in bank stock (bank capital) and then buy $100,000 in treasuries. The reserve requirement is 0%, and the total capital requirement is 10%. I believe that means the capital requirement is 5% for mortgages and is 10% for ordinary loans. This example will be all mortgages.

    Assets = Liabilities plus Equity

    Assets new bank = $100,000 in treasuries
    Liabilities new bank = $0
    Equity new bank = $100,000 of bank stock

    The bank now makes 20 mortgages for $100,000 each. The 20 people use the demand deposits to buy 20 homes for $100,000 each from 1 home builder.

    Assets new bank = $100,000 in tresuries plus $2,000,000 in loans
    Liabilities new bank = $2,000,000 in demand deposits
    Equity new bank = $100,000 of bank stock

    $100,000 / ($2,000,000 * .5) = .10

    The home builder sets up a checking account at the new bank. So 20 checking accounts at the new bank were marked up and then marked down by $100,000 each, while the home builder’s checking account was marked up by the $2,000,000.

    The home builder allocates as follows:

    $1,500,000 in a savings account and $500,000 in a 7 year CD. Bank is funded for now, and the reserve requirement for savings accounts and CD’s is zero so that takes care of a positive reserve requirement.

    Overall, I saved $100,000 in demand deposits, and the 20 borrowers dissaved $2,000,000 in demand deposits. Demand deposits are both medium of account (MOA) and medium of exchange (MOE). $1,900,000 of MOA and MOE were created. No monetary base was involved. Banks and bank-like entities are not just financial intermediaries.

    Is all that correct? Thanks!

  • http://brown-blog-5.blogspot.com Tom Brown

    In my never ending quest to understand the mind of Scott Sumner, I have had many twists and turns. I don’t even really care too much at this point how plausible his argument is, I’m just trying to figure out what it is! It seems to change on a daily basis.

    Sometimes I get the feeling there are at least two Scott Sumners… perhaps a multiple personality thing. Just like sometimes I get the feeling that a few notable commentators here have something like this:

    http://en.wikipedia.org/wiki/Anterograde_amnesia

    Maybe Scott has that too to some degree. Either that or he’s some sort of Zen master hitting people with statements like “It is the sound of one hand clapping grasshopper!” and through our frustration with this kind of nonsense we’re supposed to arrive at enlightenment.

    Perhaps it just seems like all of the above due to my own very limited formal education in econ and my limited ability to grasp what he’s saying.

    So yes, I think expectations is weak on its own, but I was happy that he seemed to be coming around to the rest of it.

    My new theory is this (I’m trying desperately to reconcile his many seeming contradictory statements):

    He thinks that in an “ideal world” in an NGDP slump like we’re in (i.e. weak aggregate demand (AD)), that the Fed should simply be able to promise to provide “base money” (reserves + cash) … however much the market “demands” … that and an NGDPLT should be fine! The hot potato effect (HPE) is “very weak” when “rates are 0″ (i.e. there’s ER > 0 do to QE) and thus “QE has made a mess of things.” HOWEVER, when NGDP starts to recover, and interest rates rise (further out on the yield curve, since they’re pegged to IOR w/ ER > 0: i.e. the ZLB), THEN the HPE will become stronger and will cause a large rise in NGDP.

    So in other words, we’re kind of stuck… there are tools, but they work best after things start working. But isn’t that basically Krugman’s “liquidity trap” idea? The one Scott hates?

    That’s why I think he and Glasner think reducing the IOR to 0 is so important: it’s actually a weak “channel” but becomes strong in comparison at the ZLB. Maybe?

    In the mean time, even though QE has made a mess of things, it’s best not to reverse it, lest it send the wrong signal.

    Scott is a LONG TERM classic monetarist: if you increase the base (reserves, primarily, but he hates to discount cash), then EVENTUALLY “money is neutral” and all that base has to result in an expanded money supply. It’s always this mix of looking way into the future vs what’s happening right now that makes it so confusing to follow because I don’t think he always makes it clear.

    BTW, the arguments here by “Franky” and “Jared” are fascinating: they essentially both are accusing Scott of being hardly any different than new-Keynesians (an idea he doesn’t like, but one which he has a hard time refuting):

    http://www.themoneyillusion.com/?p=22964#comment-267113

    (look above and below the link above)

    Sorry for the long post, but that got me thinking! I hardly addressed your comment at all.. :(

  • http://brown-blog-5.blogspot.com Tom Brown

    BTW, that’d be a helluva thing, wouldn’t it? To type your fingers to the bone explaining some concept, and it turns out that you were explaining it to a person with anterograde amnesia the whole time! Hahaha :D

    Or maybe it’s me! Maybe I’m the Leonard Shelby character:

    http://en.wikipedia.org/wiki/Memento_%28film%29

    … and I just can’t remember repeating the same mistake over and over again.

  • Rick

    “For the millionth time, that’s just not how banks work. Banks don’t lend their reserves out so expanding the monetary base was NEVER going to result in consumers getting “the money for deposits”.

    But this is not what PK said. He said that they keep a fraction as reserves and lend the rest. So you started with a straw man.

  • http://orcamgroup.com Cullen Roche

    They don’t “lend the rest”…..That was my main point….

  • http://brown-blog-5.blogspot.com/ Tom Brown

    Rick, Paul said:

    “Banks, however, need hold only a fraction ar of their deposits in reserves and will hold no more than necessary; they lend the rest out (which is how consumers get the money for the deposits). So bank deposits will be a multiple 1/’rr of the monetary base”

    Even the 1st part of the 1st sentence is confused sounding:

    “Banks, however, need hold only a fraction ar of their deposits in reserves”

    What does he mean here by “their deposits?” Does he mean their Fed deposits (assets to the bank, and all of which are reserves), or does he mean their customer deposits (liabilities to the bank, none of which are reserves)? If the former, he’s wrong by definition. If the latter, he’s confusing bank assets with bank liabilities. As to the former point, there’s this from wikipedia:

    “Bank reserves are banks’ holdings of deposits in accounts with their central bank (for instance the European Central Bank or the Federal Reserve, in the latter case including federal funds), plus currency that is physically held in the bank’s vault (vault cash).”

    http://en.wikipedia.org/wiki/Bank_reserves

    Paul is also CLEARLY using the concept of the “money multiplier” with the following statement:

    “So bank deposits will be a multiple 1/’rr of the monetary base””

    The money multiplier concept is LONG dead and buried with our adoption (long ago) of fiat money and overnight interest rate (FFR) targeting by the Fed. This is a concept that has been known now for decades and it’s embarrassing that PK get’s it so wrong. When presented with the facts, adherents of all schools of economic thought come to this conclusion: Austrians, neo-Keynesians, new Keynesians, Monetarists, Market Monetarists, and PKEers:

    http://econospeak.blogspot.com.au/2013/02/the-myth-of-money-multiplier.html

    And what’s worse, PK doesn’t even get the money multiplier concept correct (even though it is out of date)! 1/rr doesn’t multiply up the “monetary base” … if you think about that for a minute it can’t! For example, that base can be all in the form of circulating cash. If that’s the case, nothing get’s “multiplied” in the classic sense of the word. The only thing that can get multiplied in this sense is bank reserves (vault cash or bank held Fed deposits)… definitely not circulating cash, which is most definitely a component of the monetary base:

    “MB: The total of all physical currency plus Federal Reserve Deposits (special deposits that only banks can have at the Fed). MB = Coins + US Notes + Federal Reserve Notes + Federal Reserve Deposits”

    http://en.wikipedia.org/wiki/Money_supply#United_States

  • http://brown-blog-5.blogspot.com/ Tom Brown

    I think it’s basically all correct. There’s a couple of things I’m not that familiar with like “dissaving” so I can’t evaluate that for you. Since the deposits end up as a savings account and a CD, your reserve requirements don’t have to be 0% to make this work (they could be the usual 10%). I’m also less familiar with the MOA concept (I’ll have to go look that up again), but certainly you’re correct about MOE here. I suspect you’re correct about MOA too. And you’re correct that no monetary base was used.

    To say that the capital requirement is 5% for mortgages and 10% for ordinary loans is a little misleading but I can see how you could look at it that way. If an “ordinary loan” was considered to be safe, it could get a low weighting in the denominator of the capital adequacy ratio (CAR) which is supposed to be a sum of risk weighted assets. I *think* that each asset is either evaluated separately or there’s some means of dividing them into classes. I don’t think there’s a class called “ordinary loans” which automatically gets a risk weighting of 1 (corresponding to your 10%), nor a catch-all “mortgages” class with a weighting of 0.5 (which would correspond to your 5%). I think it’s more clear just to stick with the typical definitions here, and say that the CAR must be greater than or equal to 10%:

    http://en.wikipedia.org/wiki/Capital_adequacy_ratio

    Risk weights on each asset can range from 0 (risk free: like reserves or T-bonds) to 1 (very risky). I think the 0.5 for mortgages is just an example.

    I think I originally “helped” you develop this example months ago in a discussion thread on Sumner’s site, correct? Do you also go by “Had Enough?”

  • http://brown-blog-5.blogspot.com/ Tom Brown

    I suppose you could claim that all circulating cash could be re-deposited, and thus if that happened it could get multiplied up by 1/rr… given an infinite number of loans (again, this is all wrong, but I’m working w/in the assumptions of the old money multiplier concept: which requires a fixed amount of “reserves” for it to work)

  • Rick

    So what do you think they do with the “rest”?

  • Tom Brown

    They leave it on their balance sheets. There’s no place else it can really go until Tsy starts accumulating a surplus (unlikely) or until the Fed starts to sell assets (only real possibility)… oh, unless you count cash advances… $2T of cash advances would do it too.

  • http://orcamgroup.com Cullen Roche

    They’re in the interbank market. Right here: http://research.stlouisfed.org/fred2/series/WRESBAL/

  • Rick

    Interbank market is another form of lending to other institutions that have a funding gap. Listen guys, when PK says they “lend the rest” he means that they can lend the rest. But they may decide not to. I think you are involved in a game of words to set up straw man arguments. Banks get deposits, they keep a fraction for reserves and they lend the rest, retail, wholesale, overnoght, whatever or deposit it with central banks, they buy bonds, which is another form of lending money, or whatever they think it can make them money. Howver, your point is nto clear at all. What is your point? That PK is wrong? That banks do not lend money, what is your point?

    Your statement

    “For the millionth time, that’s just not how banks work. Banks don’t lend their reserves out so expanding the monetary base was NEVER going to result in consumers getting “the money for deposits”. ”

    is a non-sequitur from PK’s statement below:

    “Banks, however, need hold only a fraction ar of their deposits in reserves and will hold no more than necessary; they lend the rest out (which is how consumers get the money for the deposits). So bank deposits will be a multiple 1/’rr of the monetary base””

    At no point PK said that banks lend their reserves out. Actually he said the opposite that they do not. Probably you have a different idea of what reserves mean.

  • http://brown-blog-5.blogspot.com/ Tom Brown

    Rick, you write:

    “Banks get deposits, they keep a fraction for reserves and they lend the rest,”

    That’s the part that doesn’t make sense at all. First of all a deposit (a bank liability) is not a bank reserve (bank reserves are bank assets and they are simultaneously liabilities to the Fed). Let’s start with that simple fact. He’s already wrong there. He’s getting the two sides of the balance sheet mixed up. Do you dispute this?

  • http://brown-blog-5.blogspot.com/ Tom Brown

    Here’s a simple example to demonstrate that bank reserves are most definitely not that same thing as bank deposits:

    http://brown-blog-5.blogspot.com/2013/02/banking-example-1.html

    Do you dispute this example? If so where does it go wrong? Please explain.

  • Rick

    Nobody said that bank reserves are the same thing as bank deposits. PK did not say that. You say that to make up a straw man. You essentially dispute the trivial fact that banks get deposits from clients and loan part of them to other clients. At the same time they keep part of the deposits as reserves to have adequate liquidity. What you do not understand from this trivial fact? You do not have to write a blog and point to a reference to yourself to clarify this. All you have to do is ask a real banker. Writing a blog and putting a link to yourself does not in any way make your claims sound.

    Again, what do you dispute from the above. If you cannot expalin what you dispute and why in just one line then forget about it.

  • http://brown-blog-5.blogspot.com/ Tom Brown

    Rick, I dispute the implied meanings of the words you use, you write:

    “You essentially dispute the trivial fact that banks get deposits from clients and loan part of them to other clients. At the same time they keep part of the deposits as reserves to have adequate liquidity.”

    There are essentially two ways banks “get deposits from clients.”

    A deposit is a BANK LIABILITY. Keep that in mind! It’s what the bank OWES the depositor. If all the depositors walked in the bank tomorrow and said “you know those deposits you owe us.. forget it, we don’t need the money” the bank would be overjoyed because they would no longer have those LIABILITIES on the balance sheets. Their capital would shoot through the roof, extra big bonuses would be in the mail, and shareholder dividents would skyrocket. Deposits are essentially IOUs from the bank to the depositors.

    Now when a bank accepts a transfer deposit: either somebody brings cash in or they bring in a check or they do an electronic transfer… then what happens? Here’s the happy & sad parts for the bank:

    1. Happy: They get reserves which is an asset to the bank. (that’s either the cash itself… which becomes reserves once the bank ownes it… or it’s an electronic transfer of reserves from the depositor’s previous bank. Essentially the bank gets an IOU from the Fed. :D

    2. Sad: The bank is forced to take on another deposit, which is the unhappy part for the bank. It means they have to write out an IOU to the depositor. :(

    OK, that’s a transfer deposit… but what’s the other way a bank “gets” a deposit? The other way happens when they literally LOAN money into existence. What money? The bank deposit: which is “inside” money to the depositor, but is NOT money … and in fact is a liability, to the bank. No transfer depositor had to walk in the bank first so they had those deposits to “loan out.” The deposit in this case (the loan case) is just the same as the deposit in the previous case (transfer deposit case): it’s an IOU from the bank to the depositor. However, the LOAN here is the asset (rather than the reserves which come with a transfer deposit). The loan is an IOU from the depositor to the bank. Essentially money is created when the bank and depositor exchange IOUs. Money that didn’t EXIST prior to this!

    So your language is backwards! Banks CREATE deposits… because they HAVE to! They don’t “get” them… it’s what they are selling. The thing they “get” is the reserves or the loan… those are the assets that the bank wants to “get.” You make it sound like there’s a fixed amount of deposits that the banks just pass around between themselves!… cutting off a slice to “save” as reserves. That’s all very confused! That’s mixing unlike things.

    Reserves are money created OUTSIDE the banking system (that’s why it’s called “outside money.”). Bank created money (bank deposits) is created INSIDE the banking system and is thus “inside money.” I’m not making this up! Look them up on the Fed’s website and publications.

    ALL MONEY (except coins) in our system is money to one party and an obligation to another. There’s no fixed amount of it that we just all have to share: it can be created as needed. Inside money (bank deposits) are money to depositors (the public) and obligations to the bank. Outside money (electronic reserves and paper money) are money to banks. The public can also hold one of these forms of outside money (Fed obligations) and that one is cash (paper notes).

    http://www.nakedcapitalism.com/2012/04/scott-fullwiler-krugmans-flashing-neon-sign.html

    He covers it pretty well. Or read this:

    http://www.cnbc.com/id/100497710

  • Johnny Evers

    Isn’t it fair to say that banks create deposits (through loans) and that those deposits wind up in the reserve system?
    Excess reserves are a result of deposits created when the Fed buys MBS and Treasuries.)? These deposits are just sitting there in reserves.

    You might consider a post sometime explaining why a bank would even bother with deposits, if they are, at best, a neutral event.

  • http://brown-blog-5.blogspot.com Tom Brown

    Johnny, you write:

    “You might consider a post sometime explaining why a bank would even bother with deposits”

    I believe that if IOR were lowered to 0 or less and we still have excess reserves (ER) >> 0 (much greater than 0) … OR … if ER = 0 but the FFR is set by the Fed to 0… then the need (by the banks) for demand depositors (anyway) really does diminish to nothing. Why “borrow” from depositors when the Fed/inter-bank-market offers you the same thing for free and w/o the hassle of having to cart truckloads of $ to ATM machines and manage bank cards, vaults of cash, and hire tellers and phone bank operators to interact with them. The Fed/inter-bank-market can give you the same thing for a lot less trouble and no more expense! Notice I said “demand depositors” … there’d still be an advantage to selling time deposits for the banks.

    “Isn’t it fair to say that banks create deposits (through loans) and that those deposits wind up in the reserve system?”

    No, I wouldn’t say that. Those are entirely different things. Think about it this way: How can IOUs that banks write out to you and me (bank deposits) end up in the reserve system as IOUs the Fed has written out to the banks? How can something the bank owes to party A become something party B owes to the banks??

    “Excess reserves are a result of deposits created when the Fed buys MBS and Treasuries.)?”

    Yes, excess reserves are that. But this part doesn’t make sense (I’m filling in the details based on your prior sentence):

    “These [bank] deposits [which are money to non-banks] are just sitting there in reserves.”

    The non-bank held bank deposits, are money to the non-banks, and they can do as they please with them: they are money in every sense and they are NOT “just sitting there in reserves.” The thing that’s sitting there in reserves are the excess reserve deposits held by the banks, which are money for the banks and liabilities to the Fed. The reserves (Fed deposits) and the “deposits” (bank deposits you mention here are totally different things arising from the same process: “Fed buys MBS.”

    Make sense? See Case 2 here:

    http://brown-blog-5.blogspot.com/2013/08/banking-example-41-quantitative-easing.html

  • Johnny Evers

    Tom, I find it interesting that when a bond owns a T-bond, the bond is part of the general economy. The bank can sell it to you and me, for example.
    However, once the bank sells the bond to the Fed, it becomes a reserve, and you are insisting that money in reserves can’t get out into the general public (with a few limited exceptions.
    As a matter of definition, how often do we define something by *where* it is?

  • http://brown-blog-5.blogspot.com Tom Brown

    Johnny, you write:

    “Tom, I find it interesting that when a bond owns a T-bond, the bond is part of the general economy.”

    That 1st “bond” is supposed to be “bank” I think. Ok.

    As to the rest: by “bond becomes a reserve” … you really mean “bond is exchanged for reserves” … the bond still exists after the exchange (but the reserves didn’t exist prior to the exchange).

    “As a matter of definition, how often do we define something by *where* it is?”

    Well, I don’t know. Certainly it’s true of reserves which by definition are assets of the bank. Once some form of reserves (say a paper dollar bill) leaves the bank, it loses its “reserve” status (look up “bank reserves” on wikipedia).

    So I’m not just making that stuff up!

  • Fed Up

    Yes. I’m working on my “equivalent accounting”.

    Joe Franzone said at the link: “Let me try to answer by boiling it down to the simplest scenario. Let’s establish bank A with $10 of equity. The owner’s bank account (at another bank) would reduce his deposit by $10 and wire $10 of reserves to our new bank’s (Bank A) deposit account at the Fed. For proper record keeping purposes Bank A establishes a ledger account called “Operating Account” which it records the $10 received in equity. So Bank A’s balance sheet is Assets: $10 in Operating Account, Liabilities: $0 and Equity: $10.”

    I’m not an accountant, but that seems a little incomplete. Shouldn’t the central bank reserves be an asset of bank A?

    Assets: $10 of DD (demand deposits) in the Operating Account plus $10 in central bank reserves
    Liabilities: $10 in DD
    Equity: $10

    Also, at the “at another bank”, shouldn’t its liabilities be marked down by $10 in DD?

    Now buy treasuries (see my 08/16/2013 at 3:41 PM comment) from an outside entity. Mark down bank A’s assets by $10 of DD (demand deposits) in the Operating Account and mark down bank A’s liabilities by $10 of DD (demand deposits). Also, mark down its account at the fed by $10 of central bank reserves. Lastly, mark up bank A’s assets by $10 of treasuries.

    Assets: $10 treasuries
    Liabilities: $0
    Equity: $10

  • http://brown-blog-5.blogspot.com/ Tom Brown

    Fed Up,

    I wrote out a longer reply, but it was just as the pragcap server went down for maintenance :(

    so I don’t know if it’ll show up… but the gist was that I think Joe’s example was complete: You add in that bit about the bank holding it’s own DD as both asset and liability: but you don’t really need that. Joe’s “Operational Account” IS reserves… he just slapped another name on it.

  • Rick

    “Reserves are money created OUTSIDE the banking system (that’s why it’s called “outside money.”). Bank created money (bank deposits) is created INSIDE the banking system and is thus “inside money.” I’m not making this up! Look them up on the Fed’s website and publications”

    Nothing of what you wrote contradicts what PK or I have said. Nothing of that you wrote contradicts the fact that when a bank receives a deposit it can create loans. Honestly, you make a lot of noise for no reason. But you have missed an essential part of the process which is the funding of the bank gap between assets and liabilities.

    “A deposit is a BANK LIABILITY. Keep that in mind!”

    It is good that you know that but it has nothing to do with what PK or I have said.

    “If all the depositors walked in the bank tomorrow and said “you know those deposits you owe us.. forget it, we don’t need the money” the bank would be overjoyed because they would no longer have those LIABILITIES on the balance sheets. ”

    Why do you want to set up another straw man. It is very strange that you have this tendency, Again, this has nothing to do with what PK or I have said. If you disagree with the fact that when a bank receives a deposit it can loan out money say it clearly. The rest you wrote, besides being an incomplete picture of the banking system in some serious ways, is not related to what PK or I have said.

  • http://orcamgroup.com Cullen Roche

    Rick,

    I highly doubt that Tom has missed the idea that banks are spread businesses. After all, that’s one of the core pieces of understanding MR! But the thing you seem to be implying is that banks necessarily need deposits to make loans. No they don’t. They prefer deposits for various reasons, but they don’t need them to make loans.

    Banks can match their assets and liabilities in many many ways. Deposits are just one of those ways so the idea that loan creation necessarily starts with deposit then loan is not the right way to look at this.

    Cullen

  • http://brown-blog-5.blogspot.com/ Tom Brown

    Rick, yes when a bank receives a deposit it can loan out money. Also when a dog barks a bank can loan out money. There’s nothing preventing the bank from loaning out money in either case. There’s also nothing about receiving a deposit which ENABLES a bank to loan out money. The implication of “when a bank receives a deposit it can loan out money” is that the bank NEEDS to receive the deposit (and by the word “receive” you imply a TRANSFER deposit) PRIOR to loaning out money, because it can always borrow any matching reserves needed (if they are needed) on the inter-bank market or from the Fed itself.

  • Fed Up

    Let’s start here:

    Assets: $10 treasuries
    Liabilities: $0
    Equity: $10

    Now I decide to move my $5 checking account to the new bank from another bank.

    Assets: $10 in treasuries plus $5 in central bank reserves
    Liabilities: $5 in DD (which is my asset)
    Equity: $10

    Now have the bank sell a new $5 bond for bank capital (asset swap DD for bond).

    Assets: $10 in treasuries plus $5 in central bank reserves plus $5 in DD
    Liabilities: $5 in DD (no longer my asset)
    Equity: $10 in stock plus $5 in a bond (now my asset)

    Notice the demand deposit(s) move.

  • Fed Up

    Rick said: “Banks get deposits, they keep a fraction for reserves and they lend the rest, retail, wholesale, overnoght, whatever or deposit it with central banks, they buy bonds, which is another form of lending money, or whatever they think it can make them money.”

    Let me try an example. The reserve requirement is 10%. A bank takes in $100 in demand deposits (DD). It puts $10 of the DD at the fed. It now has $90 of DD to “lend”. Is that what you are trying to say?

  • http://brown-blog-5.blogspot.com/ Tom Brown

    Fed Up,

    You almost lost me by leaving “me” out of the following:

    “Now have the bank sell a new $5 bond for bank capital (asset swap DD for bond).”

    OK, but nevermind that… let’s see how I’d do the accounting:

    Let’s start here:

    [Bank]
    Assets: $10 treasuries
    Liabilities: $0
    Equity: $10 [shareholder's equity (stock)? -- that pops up later, so I'm moving it up here too]

    Now I decide to move my $5 checking account to the new bank from another bank.

    Assets: $10 in treasuries plus $5 in central bank reserves
    Liabilities: $5 in DD (which is my asset)
    Equity: $10 [shareholder's]

    Now have the bank sell [me] a new $5 bond for bank capital (asset swap DD for bond). [ok, you lost me here a bit... "for bank capital?" I don't get what you mean there... is this a special kind of bond... "convertable" or whatever they call that? I'm going to assume "no."]

    Assets: $10 in treasuries plus $5 in central bank reserves.
    Liabilities: $5 bond held by me
    Equity: $10 in shareholder’s equity.

    All the way through I’ve assumed an unchanging $10 of shareholder’s equity… meaning it’s just plain equity (i.e. assets – liabilities), but that there are shareholders… so it belongs to them.

    That’s how I’d do it. Did I make the correct assumptions about the things which were unclear to me?

  • http://brown-blog-5.blogspot.com/ Tom Brown

    Fed Up… I think part of the confusion w/ Rick was the words he was using. Allow me to rephrase what you just wrote:

    “Let me try an example. The reserve requirement is 10%. A bank takes in $100 in transfer demand deposits (DD) (which of course come along with reserves in the form of $100 of electronic Fed deposits or physical cash). It hold $10 at the fed (in their Fed deposit, which is where those electronic reserves were, or in their vault, if in the form of cash). It now has $90 to “lend” in the form of DDs… [or $900 or $9000 ... it doesn't matter, because banks aren't reserve constrained in their lending.]

    The part in the [ ] at the end is what should be added so as to not give the wrong implication (i.e. the wrong implication that banks are somehow reserve constrained or deposit constrained in their lending, when of course they are not)… but I understand that you were just trying to clarify what Rick was saying… and he probably wouldn’t have said that last bit!

  • Fed Up

    “Assets: $10 in treasuries plus $5 in central bank reserves.
    Liabilities: $5 bond held by me
    Equity: $10 in shareholder’s equity.”

    1) Certain bonds can be bank capital/equity. Move the bond from liabilities to equity.

    2) The DD as a liability and asset got cancelled. Don’t do that. Think about this by adding a next step. Have the bank pay someone $5 who has a checking account at the new bank.

  • Rick

    “it doesn’t matter, because banks aren’t reserve constrained in their lending.]”

    What does this mean? This is another straw man and twisting of words,

    All loans must be eventually backed by real, hard cash deposits, at least at a fraction. Your problem is that you create examples that fit your straw man arguments exactly. See this example:

    Bank creates $100 loan to Joe. Joe gets the money and pays Tom for a new mouse trap. Tom deposits the money in the same bank and then orders a wire it to his girlfriend in Antarctica.

    Now, Bank has a $100 funding gap. It must find $100 to cover the loan it created. Bank must borrow $100 in hard cash. There is nobody else to create a loan for. But there is only one Bank. This means that Bank must find a depositor for $100, an investor or someone to finance the gap otherwise it defaults.

    Trust me, it all boils down to “cash is King” and “money talks, BS walks”.

    If you consider the banking system in its totality, then at the end of the day it is hard cash that finances it. Otherwise, there would not be any banking crisis. Banks would loan to each other to create enough deposits to cover their losses. This is ludicrus that you even think that way.

  • http://brown-blog-5.blogspot.com Tom Brown

    Fed Up, you write:

    “1) Certain bonds can be bank capital/equity. Move the bond from liabilities to equity.”

    I’m absolutely no expert on that… there are “convertible” bonds, like I said… and there’s “subordinated debt”… I know that sub-ordinated debt can be used to count for Tier 2 capital in the Basel II accords:

    http://brown-blog-5.blogspot.com/2013/03/banking-example-7-calculating-capital.html

    Is that what you’re getting at? Are convertible bonds a kind of sub-ordinated debt? Either case, it definitely falls in the right hand column of the spreadsheet under “Cr” (credits)… just like normal liabilities and equity.

    You also write:

    “2) The DD as a liability and asset got cancelled. Don’t do that. Think about this by adding a next step. Have the bank pay someone $5 who has a checking account at the new bank.”

    OK — I know that’s how you like to do it. But I was demonstrating how **I’d** do it! So far you haven’t convinced me that your system is better or more “mainstream.” ;)

  • Fed Up

    Tier 2 capital. Yes, I think so.

    What happens when the bank pays $5 to someone with a checking account at the new bank? The DD should move so that person’s checking account gets marked up by the $5 and the new bank’s assets get marked down by $5 of DD.

  • http://brown-blog-5.blogspot.com Tom Brown

    Rick you write:

    “All loans must be eventually backed by real, hard cash deposits, at least at a fraction.”

    Again, your mixing up what a deposit is: A deposit is an abstraction: it’s a legal obligation the bank holds to the depositor. It makes no difference what this obligation is recorded on (paper, computer, clay tables, the memories of the bankers), or how many copies there are of it. It most definitely is NOT “real, hard cash”

    What you should have said here is:

    “All *demand* deposits (in the US: because of the reserve requirement rule) must be backed by electronic Fed deposit holdings or real hard cash (paper reserve notes) in the amount of 10% of the deposit. This applies to deposits resulting from loans and kept at the same lending institution, or to deposits transferred in by the depositor.”

    Now it turns out that in Canada (where RR = 0%) or for savings deposits in the US, there is no such requirement. No “backing” is required.

    On to your example:

    “Now, Bank has a $100 funding gap. It must find $100 to cover the loan it created. Bank must borrow $100 in hard cash. ”

    Actually “hard cash” isn’t required: only an electronic Fed deposit is. Assuming that bank in Antarctica has a Fed deposit itself (which it probably does… many foreign banks have Fed deposits).

    The thing you’re forgetting here is that there’s literally an infinite supply of “hard cash” or Fed deposits! Both serve as “outside money” (again, look it up in the Fed docs):

    All the Fed has to do to create that $100 is to literally type a credit into the Fed deposit of that Antarctic bank and at the same time receive a loan agreement from the originating bank saying they agree to pay those back. That’s it! Now what if it’s “hard cash” (i.e. paper reserve notes)? They simply call up the BEP, buy that paper notes for production costs (a few pennies) and send them out the door recording the liability on their balance sheet:

    Fed BS:
    Liabilities: +$100 in reserve notes in circulation

    the assets side of the Fed’s balance sheet would be modified in exactly the same manner as for the electronic Fed deposit:

    Fed BS:
    Assets: +$100 loan of reserves to US Bank.

    I suggest you read Cullen, Fullwiler, Carney, Tobin or any number of other sources on this because we are all “ludicrus” in this manner. Here’s another from the Fed itself:

    http://citeseerx.ist.psu.edu/viewdoc/download?doi=10.1.1.148.158&rep=rep1&type=pdf

    If you don’t believe me, take a look at the other sources!

    BTW, Krugman has another post up today, and he’s sounding MUCH more conciliatory towards Cullen:

    http://krugman.blogs.nytimes.com/2013/08/23/the-monetary-base-is-lm-and-all-that-very-nerdy/?_r=0

  • http://brown-blog-5.blogspot.com Tom Brown

    Fed Up, you write:

    “What happens when the bank pays $5 to someone with a checking account at the new bank? ”

    All that HAS to happen is that the bank types a credit into their deposit. That’s it!

    I demonstrate that here with Person x:

    http://brown-blog-5.blogspot.com/2013/03/banking-example-5-bank-spends-excess.html

  • http://brown-blog-5.blogspot.com Tom Brown

    Fed Up,

    Just thought I’d leave you with an idea: This is just my own thing, but it’s the way I like to think about things from a macro point of view:

    Imagine all the commercial banks are really just highly competitive branches of the same single commercial bank. This is not unusual… this is a common macro perspective. Here’s what I add to that to help me think these things through:

    Now our one big bank (call it “BB”) has exactly two ways to financially interact with the non-bank private sector:

    1. The use cash

    2. They credit and debit bank deposits.

    That’s for EVERYTHING: paying salaries, their electric bill, shareholder dividends, interest to depositors, interest received from borrowers, fees, fines, and charges of all sorts: … if it’s not cash, then it’s crediting and debiting bank deposits. That’s it!

    They use their reserves to transact with entities having Fed deposits (foreign central banks, Tsy, GSEs) or with the Fed itself.

  • Fed Up

    Example 5, Bank A needs $100 of DD as an asset and a liability to start so that the DD(s) move.

  • http://brown-blog-5.blogspot.com/ Tom Brown

    Fed Up, … from **your** point of view I guess…. but you did read that post by Joe… the accountant right?

    As far as I’m concerned you can keep doing it your way… it all works out in the end, but I see no reason why I or anyone else should adopt that system! … so carry on, have fun with it. :D

  • Fed Up

    Tom Brown, check at the end. I moved my response to there.

  • Fed Up

    Tom Brown, I read Joe’s response. I don’t see what exactly an opreating account is.

    “After such an easy profit, Bank A pays its employee $1 for great work. Employee does not bank at Bank A. Bank A cuts a check from its Operating Account for $1 and employee deposits it at his bank. $1 in reserves is wired from Bank A’s Fed account to the employee bank’s Fed account. Bank A’s balance sheet is now:
    Assets: Operating Account $11 Loan to Customer 1 $0
    Liabilities: Customer 1 Deposit $0
    Equity: $11″

    I need to see what happens here if Employee does bank at Bank A instead of Employee does not bank at Bank A.

    The point would be about your example 5. It gives the impression that the bank creates a DD (what I would call leverage) for payment. I don’t think that is correct.

  • http://brown-blog-5.blogspot.com/ Tom Brown

    Fed Up, Joe Franzone (an accountant) used exactly the same language there that “Joe in Accounting” (another pragcap commenter, and a bank auditor by profession) did many months ago when I asked him the same question: an “Operating Account.” Unfortunately those old “Ask Cullen” links are dead now (back when Ask Cullen was part of pragcap). Joe in Accounting described an operation account as a partition of the bank’s Fed deposit (i.e. it’s just a name applied to part of the bank’s reserve balance).

    Regarding what happens if employee banks at the same bank he’s employed at: I’m 97% certain that’s exactly what happens: The bank credit’s his deposit. That’s the only way the banking system as a hole has to pay for anything from the non-bank private sector aside from using physical cash.

    Read the whole set of responses carefully. My example #5 was checked by Joe in Accounting (the bank auditor) and he said it was correct. It was also checked by Joe Franzone (the accountant and he too specifically said that it was correct). Read it all again carefully:

    http://ask-cullen.com/when-a-bank-earns-interest-on-loan-repayments-where-does-it-show-up-on-their-balance-sheet/

    I specifically posted this is response to the question asker “DismalEconomist.”

    Tom Brown (after writing out some word answers, I wrote this long before Joe Franzone ever got to the question):

    ““Can a bank hold its own inside money on the asset side of the balance sheet?” I’m going to go with “No”

    Here’s my examples, BTW:

    http://brown-blog-5.blogspot.com/2013/03/banking-example-5-bank-spends-excess.html

    http://brown-blog-5.blogspot.com/2013/08/banking-example-10-principal-interest.html

    So the banking system in aggregate pays their employees by crediting their bank deposits. (Like person x get’s paid in example #5) but an individual bank may have to pay some employees like person y get’s paid. That’s my take and I’m sticking with it until somebody can talk me out of it! ;^)”

    Notice I included two examples, including Example #5.

    Then Joe answered the questions without reading my responses. I asked Joe the following:

    Tom Brown:
    “Joe… I’m feeling lazy here… you wrote a lot. Did I basically get it right (above)? Keep in mind I’m not trying to teach people accounting (which would be preposterous, since I’m not one!), I just want them to get a feel for the double-entry thing so far as it helps to understand our monetary system. Thanks!”

    Joe Franzone responded here:
    “Tom, I apologize, I just answered without looking at your examples. Your examples are correct. When it comes to banks paying expenses or receiving income from interest and/or fees, equity is always affected. The corresponding debit or credit is ultimately dependent on where the payment is going/coming from, ie paying/receiving from a bank customer or from someone at a different bank.”

    So Joe checked my “examples” and found that they were “correct.”

    I don’t know what else I can do to convince you of this! Think about it this way: if there was just one commercial bank in the system, how would it pay any non-bank private sector entity except with physical paper reserve notes, coins, or by crediting their bank deposit. There’s NO OTHER WAY!

    So when it comes down to it, even w/ multiple banks, some electronic Fed deposits move around behind the scenes, but in the end a bank somewhere must credit a deposit to pay… either that or use physical cash. There are really no other choices. When the banking system pays the private non-banks, deposits are created/credited (same thing) or cash is used, that’s it.

  • Fed Up

    Let’s start here:

    Assets: $10 treasuries
    Liabilities: $0
    Equity: $10

    Let’s say a construction company opens a checking account at the new bank.

    Can the new bank spend $100 on a new branch (including regulations)?

  • http://brown-blog-5.blogspot.com/ Tom Brown

    I’m not sure. If it can include the new branch as an asset on its balance sheet, and they have it independently assessed as being that valuable ($100), I suppose so. It might be a Tier 2 asset though, which might not help it with Tier 1 requirements. I think just Tier 1 on it’s own has to have a CAR > 6%. I think there’s also a 5% threshold of some kind. I’m CERTAINLY not expert though!… I’m trying to understand this stuff just like you, but I’ve already been down some of these roads and encountered people that seemed to know the answers (the two “Joes” I already mentioned, for example). Check this out:

    http://en.wikipedia.org/wiki/Capital_requirement#Common_capital_ratios

    Actually, I’m probably wrong about the Tier 2 thing above. It seems there’s a “reevaluation capital” in which land and buildings purchased long ago can be “reevaluated” to the bank’s benefit:

    http://en.wikipedia.org/wiki/Tier_2_capital#Revaluation_Reserves

    I did a quick search in here for buildings, land and real estate and didn’t see anything, but that doesn’t mean that stuff can’t count for Tier 1 or for capital in some other meaningful way:

    http://en.wikipedia.org/wiki/Tier_1_capital

    But let’s suppose that it’s allowed, as in your example. You could even call the building “risky” but it still works with the 10% CAR (Tier 1 + Tier 2 in numerator).

    All is fine until the builder want’s to spend, withdraw or move the $100… now the bank needs to come up w/ reserves, but it does have collateral (the real estate + treasuries), etc. It should be able to borrow those somewhere.

    That’s my take!

  • http://brown-blog-5.blogspot.com/ Tom Brown

    “spend” in the last paragraph should really be “spend on somebody w/ a deposit not at the bank.”

  • Fed Up

    My intuition (only) is that between regulation(s) and a poor spread, the new bank can only spend $10 on a new branch. There would not be any leverage.

  • Fed Up

    “I don’t know what else I can do to convince you of this! Think about it this way: if there was just one commercial bank in the system, how would it pay any non-bank private sector entity except with physical paper reserve notes, coins, or by crediting their bank deposit. There’s NO OTHER WAY!”

    Let’s take that even further. Assume $0 currency, $0 central bank reserves, 0% reserve requirement, and one commercial bank. Run an all commercial bank demand deposit (DD) economy.

  • http://brown-blog-5.blogspot.com/ Tom Brown

    A new branch is a tough example. How about two other examples: What if the bank wanted to buy donuts from the donut shop w/ an account at the bank. I think $10 is going to be the limit, like you say.

    However, let’s say they want to buy a loan agreement from a borrower … say taking a home equity loan, and the borrower has a deposit at the bank. Then they may well be able to do the full $100.

    The HELOC is going to be a money maker for them (not like a new branch, which isn’t so clear.. certainly the building itself with decline in value.. and cost money for upkeep and to keep the power on… but perhaps the new business it brings in will compensate).

    The main “purchases” banks have traditionally made to make money with are loan agreements… and the system is specifically set up to let them expand their balance sheets buying these.

  • http://brown-blog-5.blogspot.com/ Tom Brown

    OK, I do like to think about it that way sometimes! It sure makes the analysis simpler! … you really don’t need reserves in such a system, …except for paying taxes with (to Tsy) or payments from Tsy (to gov contractors) or for any other transactions with non-bank Fed deposit holders or the Fed itself (e.g. the Fed, when it buys and sells assets).

    That’s kind of the basis of this post of mine:

    http://brown-blog-5.blogspot.com/2013/08/banking-example-11-all-possible-balance.html

    The very last BS in that post is for what the private non-banks (I call them the “public”) aggregate BS would look like given those assumptions + the assumption that Tsy spends every dollar it gets.

    That’s where I come up with public’s bank deposits = L + B + F

    In the BS above that one (in the post) I assume cash exists, but it’s not a huge change. The public’s total money stock still follows this formula.

    I’m just assuming four entities: Tsy, Fed, Banks & public. The more complex BSs are above (for all 4). To derive the bottom two just set Ut and D to zero (Ut = unspent funds at Tsy, D = bank equity).

    I’ve been thinking about how to fold in intra-gov Tsy debt holders like social security and foreign exchange.. and I think I have a solution. I think there’s an error in my 11.2 post, which I’m going to go fix right now!