ON BEING RIGHT FOR THE WRONG REASONS

There are some in the economic and investment world who claim that it doesn’t matter how you’re right, it only matters that you’re right.  And this is quite common in the financial world.  Your thesis might be 100% off-base, but the markets or economy might still respond in a manner that validate your original thesis even if things didn’t play out exactly as you expected.  This is not surprising given the complexity of the financial markets. In a way, they are the most complex non-linear dynamical systems we deal with on a daily basis.  With so many moving parts it’s easy to see how we can make broad prognostications about one facet of this system and misinterpret its impacts on the system as a whole.

This general misinterpretation is nowhere more apparent than it is in the mainstream economic communities where myths run rampant due to the propagation of convertible currency system beliefs.  Combine this misunderstanding with the even broader misunderstandings that are based on equilibrium theory (people are rational, markets are efficient, information is quickly and accurately disseminated, etc) and you have an environment that is essentially the equivalent of blind people throwing darts at a Wall Street Journal quote page and congratulating themselves for being great stock pickers.

A real-time example of this is Dr. Krugman’s latest blog post.  He says:

“I’m glad to see some people noticing that those of us who have taken the basic theory of the liquidity trap seriously have done very well at calling the economy these past three years. This was big stuff: predicting that a tripling of the monetary base would not be inflationary, that deficits exceeding a trillion dollars a year wouldn’t drive up interest rates. In a rational world, the way things have panned out would add a lot of credibility.”

It’s true.  Dr. Krugman has called this economic environment far better than most.  And his understanding of this dynamical system is better than most.  But that doesn’t mean it is entirely accurate and worthy of “praise”.  For instance, the liquidity trap is based on an incomplete understanding of the monetary system.  So, while it appears to explain the many unusual economic reactions in recent years it is misleading to imply that it has been some sort of crystal ball.  For instance, in early 2009 Dr. Krugman said interest rates would remain low unless the economy recovered.  He said the economy wouldn’t recover as the stimulus was too small so do the math.   And he had all the charts and math to back up his argument.  He broke out the old IS-LM curve (which its founder rejected), the loanable funds theory (which is a myth) and went on to explain how zero interest rate policy resulted in inept monetary policy during a liquidity trap.  The only problem is that the dots are not exactly connected here and it is because Dr. Krugman is working from this defunct model (also on display in his 2009 post where he compared the USA to Ireland – a big no no as we all know by now).

When one understands the actual operations of the modern monetary system, it’s quite easy to decipher why interest rates behave in a particular manner (though more difficult to predict how they’ll behave).  In a non-convertible fiat currency system where the currency issuer has endless supply of that currency within a floating exchange rate regime, deficits always put pressure on interest rates.  This is because deficits result in reserves in the banking system.  Reserves, which left untouched, will result in lower rates as banks bid down rates in the overnight market as they try to rid themselves of these reserves.  If the central bank and Treasury do not actively manage these reserves they will lose control of the overnight interest rate.  Of course, they don’t let that happen (interest on reserves make this easier given the Fed’s asset purchases).  And as the supplier of reserves to the banking system they always have the firepower to control the interest rate on their “debt”.  So, in order to understand why interest rates are low we merely have to listen to the bond market’s master – Ben Bernanke.  His interpretation of the environment (recovery or not) could be entirely wrong and it matters not what the market thinks.  If Ben wants to set the long bond at 0% for the rest of eternity he merely has to deem it so.

Perhaps more importantly though, there is no loanable funds market.  The loanable funds theory implies that there is some enormous market of savings just waiting for borrowers to tap into (the government included).  This makes several mistakes though.  First it implies that a sovereign currency issuer must borrow back the currency it can freely create.  That’s as illogical as a Broadway Theater company borrowing back its tickets so it can issue more of them the next night.  Of course it would never do such a thing.  It would merely print up fresh new tickets as opposed to reaching into the bin of ripped up tickets at the end of each night and reissuing them.

Additionally, this implies an inaccurate functioning of the modern banking system.  Banks aren’t sitting around trying to compile savings so they can then meet borrowers at this loanable funds market where they lend them money.  Instead, banks lend money when creditworthy customers enter their establishments.  The loans actually create new deposits.  The bank doesn’t check their reserve balance before lending money, so the reserve position of the bank matters little at the time of lending.  If they need reserves they’ll go into the overnight market where they’ll obtain the reserves from another bank or the bond market’s master (the Fed) will supply them as the supplier.  You didn’t need to understand the loanable funds theory to know that more reserves in the banking system wouldn’t result in more loans or hyperinflation.  You merely needed to understand how modern banking actually works.

The point is, you don’t have to understand the liquidity trap to understand the current economic environment (in fact, it might hurt you as it’s based on several misconceptions).  You merely need to understand how a modern monetary system actually works.   More importantly though, being right doesn’t always justify one’s original thesis.  In fact, it can potentially harm us all by leading others to believe that this original thesis was accurate and is therefore worthy of praise.  Being right matters.  But being right for the right reasons matters a hell of a lot more.

 

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Got a comment or question about this post? Feel free to use the Ask Cullen section, leave a comment in the forum or send me a message on Twitter.

Cullen Roche

Mr. Roche is the Founder of Orcam Financial Group, LLC. Orcam is a financial services firm offering research, private advisory, institutional consulting and educational services.

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  • http://pragmaticcapitalism Michael Schofield

    I’m trying hard to learn, Cullen. That would make things a lot easier. I guess that’s why they invented trend following and hedges, so dunces like me can find a way to function. I actually thought QE2 would boost inflation so I bought into the commods trend a year ago. I was making money and thought I was real smart. Not the first time I made mistake like that sometimes the greater fool theory trumps everything. Got out in March at least I did that right. Anymore, I focus on risk management because I can’t afford not to. Thanks for your posts,Cullen I think some of it is starting to sink in!

  • LVG

    Is it just me or has PK changed his tune on Europe? His statement about Ireland is different from his recent comments where he says that being a currency issuer matters.

    “Now, there are real problems with large-scale government borrowing — mainly, the effect on the government debt burden. I don’t want to minimize those problems; some countries, such as Ireland, are being forced into fiscal contraction even in the face of severe recession.”

    Is he stealing this from MMTers? Maybe there’s hope after all.

  • Peter D

    Sorry, LGV, couldn’t parse your comment. Are you saying that PK did not use to say that “being a currency issuer matters” but now does or is it the other way around.
    From what I know, he’s being saying that being a currency issuer matters for quite a while and in that respect he has been pretty close to MMTers. He always brings Iceland’s example as the positive one: Iceland was able to depreciate its currency.

  • LVG

    He says government borrowing can be problematic and then cites Ireland. Sounds like he’s hedging his bet. Why would he use Ireland as an example if he understood that the EMU was different than the USA? I think he’s changed his tune.

  • Peter D

    1) He never said govt borrowing could never be a problem, even for the US – hence his biggest disagreement with MMT.
    2) He always said Ireland and other Euro members have harder time than countries with their own currency (such as Iceland), but his explanation is only partially along the lines of MMT – it is not the ability to always serve debt denominated in your own currency, but rather possibility to devalue your currency. Or something like that
    3) I wouldn’t read too much into his choosing of Ireland as an example of when govt borrowing could be problematic. If you imply that he could have chosen US, then he clearly doesn’t think that our current borrowing is problematic.

  • MMTer

    It’s funny how MMTers get no such praise even though they’ve predicted all the same things Krugman did. Where are all the people pointing out how MMTers predicted no hyperinflation, no recovery, no collapsing interest rates, failed QE, etc?

    Our track record is better than just about anyone’s in the last 3 years. Where is the praise?

  • MMTer

    oops. no *surging* interest rates.

  • Colin, S.Toe

    My favorite illustration is Ptolemaic astronomy, which, with all its epicycles, could predict the apparent motions of celestial bodies, eclipses, etc.

    But try basing a voyage to the moon or Mars on it.

    (Markets also support self-fulfilling prophecies based on widely shared, if mistaken, beliefs, etc.)

  • RN

    Krugmans credibility is at least two orders of magnitude greater than yours. So I cast my ballot with him until shown otherwise.

  • Peter D

    >>Krugmans credibility is at least two orders of magnitude greater than yours.

    Is there a FRED chart to show that?

  • http://www.pragcap.com Cullen Roche

    99% of mainstream neoclassical economists have more “credibility” than I do. All they have to do is flash their PhD card and that would solve it for most people. But that doesn’t mean they understand everything. For instance, the no hyperinflation call was easy (and yes, I also predicted that in real-time). All you had to do was understand how modern banking works and understand that banks are never reserve constrained. But Dr. Krugman doesn’t understand modern banking so he has to explain this away in some other long winded format. For instance, in 2009 he wrote:

    Now, it’s true that the Fed has taken unprecedented actions lately. More specifically, it has been buying lots of debt both from the government and from the private sector, and paying for these purchases by crediting banks with extra reserves. And in ordinary times, this would be highly inflationary: banks, flush with reserves, would increase loans, which would drive up demand, which would push up prices.

    But these aren’t ordinary times. Banks aren’t lending out their extra reserves. They’re just sitting on them — in effect, they’re sending the money right back to the Fed. So the Fed isn’t really printing money after all.

    http://www.nytimes.com/2009/05/29/opinion/29krugman.html?em

    This is categorically false. Banks are never reserve constrained. There is no such thing as banks lending their reserves. They’re not just sitting on them as Dr. Krugman says. He has the whole thing wrong. So yeah, he got it right, but not because he understood it.

    So yes, if I go get my PhD I’ll have instant credibility. Problem is, I’ll have to read out of a Mankiw textbook about loanable funds and money multipliers and other fun myths that mislead young economists. Credibility in the economics business is a mangled term.

  • http://deltafinancials.com Delta Financials

    So, if the Fed hasn’t started paying interest on deposits, there would have been an opportunity cost to holding onto cash and there would have been greater credit creation than there has been. Do you agree with that, Cullen?

    To be honest, I’m a little confused on here. I appreciate MMT as a descriptive representation of how the financial system works, and I have no problems with that. Many economic identities help illustrate where the imbalances are. But, often you make claims that go beyond anything I’ve picked up from MMT, that seem to tread into the realm of how the economy as a whole works.

    For example, the claim that fiscal deficits put downward pressure on interest rates? That one, I must confess, has me stumped. From my understanding of this stuff, interest rates aren’t covered by MMT, itself. MMT outlines theoretical possibilities of how the FOMC can alter the yield curve to fit its FFR – and that’s fine, but in the real world, the bernank can never produce 0% on the 10-year, without letting out an inflation genie that would lead to hyperinflation in no time. So, the actual bid in the bond market is consequential. MMT outlines theoretical possibilities in some sense, but there’s this whole issue of faith in currency which renders most of the theoretical possibilities either invalid or inconsequential.

    So I enjoy the descriptive MMT stuff – but often the claims, appear to me to go far beyond that. On the other hand, there are ways in which MMT explains the world that can’t be matched by neo classical nonsense – eg. why Japan can still borrow at low rates, while Spain, Ireland and Greece can’t. That, to my mind is MMTs key contribution. But with stuff like fiscal deficits leading to downward pressure, you lose me.

  • Gordon

    “it’s better to be lucky than good!”

  • http://www.pragcap.com Cullen Roche

    Banks aren’t holding reserves because they don’t want to lend them. Do you think the banks wanted to hold the USTs that the Fed bought from them? Would they rather own the higher risk free int bearing asset or the low int bearing asset? So, this idea that QE and reserves is putting pressure on banks to hold reserves makes no sense. If they were coveting the bond before QE then they’d be MORE inclined to make loans after swapping for reserves, right? But they’re not. They weren’t clamoring to sell their USTs so they could make loans before QE.

    The problem all along is that there is a low demand for debt. Granted, some element of this is that the banks have tightened lending standards, but the bigger issue is that there is just not a lot of demand for debt. And no, banks don’t check reserve balances before making loans.

    As for interest rates and the deficit – I don’t understand your point. Why would a 0% 10 year cause hyperinflation?

  • Adam1

    Without the issuance of bonds to absorb excess reserves, by operational definition of a fiat currency, deficit spending adds reserves to the banking system. Bank reserves make up the Federal Funds Market. If deficit spending is increasing the quantity of reserves the price of those reserves (the interest rate) must be falling unless some other action is taken to prevent/counteract that from happening (i.e. OMO, pay interest on reserves, issues bonds to soak up the reserves).

    “So, if the Fed hasn’t started paying interest on deposits, there would have been an opportunity cost to holding onto cash and there would have been greater credit creation than there has been.”

    Banks do not lend out reserves or deposits as loans. Banks don’t lend out money. They underwrite loans which create an asset for the bank and a deposit in the banking system.

  • Peter D

    >>there would have been an opportunity cost to holding onto cash and there would have been greater credit creation than there has been.

    If there is no demand for loans there would be no credit creating. Banks cannot force loans on people. And there are stronger determinants of such demand than just low rates. Because the short term rate is low because the Fed is afraid to “tighten” and tries to revive the economy, while the long term rates are low because people expect economy to suck in the future. With generally pessimistic outlook there is little demand for loans.

  • Peter D

    >>but in the real world, the bernank can never produce 0% on the 10-year, without letting out an inflation genie that would lead to hyperinflation in no time.

    No, that’s the standard economic thinking and it is wrong. People were saying the same thing about QE2. You cannot get inflation, much less hyperinflation, just by scaring people of inflation. Inflation expectations theory is just wrong. When people expect their savings to evaporate, they don’t go on consumption binges – they either hunker down, like deer caught in the headlights, or buy assets like gold, real estate, forex… Those things might cause some Cantillion effects but not across the board inflation.

  • rhp

    So Gordon. Would you rather have a medieval doctor who got “lucky” doing the operation for your appendicitis, or a modern trained surgeon who understood his anatomy and physiology before he undertook an intervention?

    And would you refer your valued friend to a practitioner who got lucky with you for the wrong reason, or would you refer your valued friend to someone who could replicate the result in a consistent manner because they actually undertood how the system worked??

    I’ve used Colin s. toe’s ptolemaic analogy myself and i think it is a good one to keep in mind……..

  • The Missing Link

    It baffles me that PK hasn’t been more open to MMT. As I recall, he dabbled in it a few months back, only to walk away drawing the conclusion “deficits don’t matter”. Which couldn’t be any further from the truth if one reads MMT introductory material without having that kind of bias in place to begin with. It does nothing but lessen his credibility, he should know better.

  • Pocket Rocket

    Men and their egos. I mean it’s great and all, just don’t expect the rest of the world to orbit around it. That’s the disconnect here and more evidence of why women need to run the entire joint.

  • perpetual neophyte

    Sometimes it’s better to be lucky than to be good, but it’s always better to be both.

  • http://deltafinancials.com Delta Financials

    Because the fed pays interest on reserves there’s less of an incentive for banks to loosen their lending standards and get rid of excess reserves than there would have been if there was a 0-rate, right? That’s my only point. The Fed’s just borrowed tools that other central banks have been using for years. They’re quite transparent about the process. Here’s the New York Fed’s QE101: http://www.newyorkfed.org/research/staff_reports/sr380.pdf

    As for 0% on a 10-year. The fed becoming the monopoly owner of bonds, while simultaneously being the monopoly issuer of currency would, in effect lead to a situation where there would be no perceived checks and balances on the growth of money supply and consequently no rational reason for anyone to have any faith in pieces of paper anymore. So, why wouldn’t there be hyperinflation?

  • http://deltafinancials.com Delta Financials

    It’s not inflation expectations alone that would cause inflation its the death of lending standards. If you had a 0-rate, there would be demand for credit. I’d certainly like some 0% money – I don’t currently want any. There would also be far less incentive for prudent lending standards. A combination of the two would lead to a credit led bubble, and without higher rates to check it, it would lead to a loss of faith in the ability of a dollar as a store of value. The hyperinflation argument isn’t one that rests on some form of instant hyperinflation – it rests on rising inflation levels over time, before an eventual loss of faith in currency as a store of value. A 10-12-15 year process, I imagine.

  • Peter D

    So, Delta, you think that FFR being 0.09% is what separates us from the scenario that you outline? Really? Banks would not lend at 0% even if FFR were 0%. And they still need creditworthy customers.

    >>The hyperinflation argument isn’t one that rests on some form of instant hyperinflation – it rests on rising inflation levels over time, before an eventual loss of faith in currency as a store of value. A 10-12-15 year process, I imagine.

    How many times in history did hyperinflation arise after 10-12-15 years of “rising inflation levels over time, before an eventual loss of faith in currency as a store of value”? My money is on “never”.

  • Adam1

    “Because the fed pays interest on reserves there’s less of an incentive for banks to loosen their lending standards and get rid of excess reserves than there would have been if there was a 0-rate, right?”

    Wrong. First, banks don’t lend reserves. Second, overall, they can’t get rid of them either. Reserves can only be used for buying cash/coin, clearing a tax payment, buying bond issuances and settling payments between banks. They have no other use.

  • http://deltafinancials.com Delta Financials

    Right, but deficit spending by definition entails the creation of fresh assets. If you run on the assumption that government usage of financial assets is less efficient than that of the private sector, at some point in the future, you arrive at money supply growth in excess of actual productive gains. So, goods measured in dollar terms will become more expensive. i.e. there will be inflation.

    If inflation runs higher than growth, deficits feed on themselves – increasing debt and requiring the creation of fresh assets at an increasing pace.

    Now, if the reserves so created within the banking system offer no interest – banks will lend more, more recklessly and lower rates will attract greater demand for credit.

    Now, if you could have a wonderful, efficient government that treats every dollar with respect and creates productivity consistent with overall productivity, there would be no problem. But, as far as I know, that’s quite beyond the scope of MMT. Where do I have this wrong?

  • http://deltafinancials.com Delta Financials

    The rate at which the Fed pays interest to banks on excess reserves is .25%, not .09. And that is actually quite significant. There’s no opportunity cost on holding reserves – so no reason for banks to loosen lending standards. It’s free money, for them. http://www.federalreserve.gov/monetarypolicy/reqresbalances.htm

    As for the stuff on hyperinflation – isn’t that how it always pans out?! Without rising inflation and negative real rates, why would anyone lose faith in currency? Just to be clear – I’m not making any hyper inflation argument for the US based on current circumstances, at all.

  • Adam1

    “There’s no opportunity cost on holding reserves – so no reason for banks to loosen lending standards. It’s free money, for them.”

    Banks don’t lend out reserves and even if they did the “borrowed ” portion of the reserves would be a liability on the balance sheet and would still be owed to the FED. If a loan went bad because of bad underwriting (lower standards) then they bank still writes down CAPITAL to pay back the FED. The cost of funds SHOULD have no correlation to underwriting standards.

  • Gordon

    i’m an indexer. and investing is not medicine. and fund managers and advisers are most certainly not doctors. witch doctors, charlatans, liars, thieves, and con artists maybe. but not medical doctors.

  • Pierce Inverarity

    Banks don’t lend reserves, for one.

    Even if your assumption were correct (and it’s not), banks only lend if there is a demand for profitable loans that fall within their legal and risk guidelines–assuming there are any. In the end, it’s all about net interest margin for the banks. It doesn’t matter what the absolute level for interest rates is, it’s the spread between asset and liability that banks care about.

  • http://deltafinancials.com Delta Financials

    @ Adam1 – banks are required to keep a percentage of their assets liquid – that’s what required reserves are! All their excess reserves is stuff they’re keeping in cash or with the Fed, rather than lending it out! They’re doing that almost exclusively because of the interest paid by the Fed. Of course, if they believed there were outstanding lending opportunities out there, they would lend out more despite the .25 that the Fed is paying them for doing nothing. But to argue that banks don’t lend out “excess reserves” is an argument too far for me. Excess reserves are, by definition what banks could lend out but have chosen not to. Opportunity cost of funds is fundamentally correlated with lending standards – how can it not be?

  • Pierce Inverarity

    It’s an operational reality of banking, that’s all. Canada does not have reserve requirements for its banks, yet, they are arguably one of the strongest banking systems out there (until the real estate market blows up there too).

  • http://deltafinancials.com Delta Financials

    My argument isn’t that there’s some sort of insatiable demand for loans out there. It’s simply that banks have an incentive to tighten their lending standards since they get paid on excess reserves! It’s sort of like having a risk-free NIM! Banks will rationally tighten their lending standards with a risk-free NIM relative to a condition where there was no risk-free NIM. That is the extent of my argument.

    As for the argument that banks don’t lend reserves – that would be to say that banks don’t lend out deposits! Of course they do. I’m assuming there’s a technical explanation for why all of you insist that they don’t lend their “excess” reserves. So let’s hear it. Keep in mind, they obviously CANNOT lend their “required” reserves. The NY Fed link attached earlier shows you a graphic representation of excess reserves and required reserves.

  • Different Chris

    ” Besides, I actually think him becoming a MMT proponent could possibly give it a political bent that MMT doesn’t need.”

    It would definitely do this. And being that one of the key steps in understanding MMT is removing the household financial model of thinking from application to we the federal government ie no revenue constrain, someone so vocally and ardently liberal supporting MMT would automatically prevent 99% of those with differing political views from ever taking MMT seriously.

    MMT gaining more suport hopefully will continue to be politically agnostic. If not, it would actually be of greater benefit to have converts from the mainstream right side of the political spectrum, something I will obviously note is unlikely at this point.

  • Pierce Inverarity

    You are correct, banks do not lend out deposits. Please read Scott Fullwiler’s primer on the operational realities of the monetary system: http://moslereconomics.com/2010/08/30/mmt-and-fedtreasury-operations/

  • Pierce Inverarity
  • http://www.pragcap.com Cullen Roche

    Take away our egos and we’ve got nothing left. Slowly but surely you women are stealing our thunder so let us keep our egos and call it even, okay?

  • Pocket Rocket

    You can still lift the heavy things, yes? And me not having to work through that whole righty-tighty-lefty-loosey logic helps too.

  • http://www.pragcap.com Cullen Roche

    And we can kill things. We are good at that also. Don’t forget that or we’ll remind you with our next big war!

  • http://deltafinancials.com Delta Financials

    From the article you referred me to
    “Regarding (a), for example, it is recognized that under a monetary regime other than gold standards or currency boards, the central bank is able to expand its balance sheet to enable smooth functioning of the retail and wholesale payments systems. Even in this case, though, the operational logic of interbank markets means that for the central bank to achieve its target rate in the absence of interest on reserves at the target rate, it must offset any changes occurring to its own balance sheet (i.e., an increase in currency that by accounting identity drains bank reserve accounts) that are inconsistent with banks’ desired reserve holdings at the central bank’s target rate. ”

    and.. “For the former, as noted above, loans create deposits and the creation of more bank liabilities does not require that banks hold more reserve balances; banks do use reserve balances to settle payments and meet reserve requirements, but the quantity of reserve balances held for these purposes is mostly unrelated to growth in monetary aggregates. For the latter, absent interest on reserves at the target rate, a central bank would not be able to achieve its target rate if it employed the money multiplier model and tried to directly target reserves (and, by extension, the monetary base, as again according to tactical logic of the monetary system the currency component of the monetary base is set by the public’s portfolio preferences). Instead of the money multiplier, a proper understanding of the operational realities of the monetary system demonstrates that central banks—as monopoly suppliers of reserve balances to the banking system—must set an interest rate target (or, in the case of the Fed during 1979-1982, an operating range for the target rate) but can only directly target the quantity of reserves if the target rate is set equal to the central bank’s remuneration rate on reserves.”

    So, in a case where the fed IS paying interest on reserves, it’s directly targeting interest rates. I’m not using the multiplier effect argument in a normative sense. I’m simply saying that in the absence of interest on reserves, there would be an inflationary effect.

    The New York Fed describes this process perfectly. I quote
    “The idea that banks will hold a large quantity of excess reserves conflicts with the traditional view of the money multiplier. According to this view, an increase in bank reserves should be “multiplied” into a much larger increase in the broad money supply as banks expand their deposits and lending activities. The expansion of deposits, in turn, should raise reserve
    requirements until there are little or no excess reserves in the banking system. This process has clearly not occurred following the increase in reserves depicted in Figure 1. Why has the money
    multiplier “failed” here?
    The textbook presentation of the money multiplier assumes that banks do not earn interest on their reserves. As described above, a bank holding excess reserves in such an environment will seek to lend out those reserves at any positive interest rate, and this additional lending will decrease the short-term interest rate. This lending also creates additional deposits in the banking system and thus leads to a small increase in reserve requirements, as described in the previous section. Because the increase in required reserves is small, however, the supply of excess reserves remains large. The process then repeats itself, with banks making more new loans and the short-term interest rate falling further.
    This multiplier process continues until one of two things happens. It could continue until there are no more excess reserves, that is, until the increase in lending and deposits has raised required reserves all the way up to the level of total reserves. In this case, the money multiplier is fully
    operational. However, the process will stop before this happens if the short-term interest rate reaches zero. When the market interest rate is zero, banks no longer face an opportunity cost of holding reserves and, hence, no longer have an incentive to lend out their excess reserves. At this point, the multiplier process halts.
    As discussed above, however, most central banks now pay interest on reserves. When reserves earn interest, the multiplier process described above stops sooner. Instead of continuing to the point where the market interest rate is zero, the process will now stop when the market interest rate reaches the rate paid by the central bank on reserves. If the central bank pays interest on
    reserves at its target interest rate, as we assumed in our example above, the money multiplier completely disappears. In this case, banks never face an opportunity cost of holding reserves and, therefore, the multiplier process described above does not even start. It is important to keep in mind that the excess reserves in our example were not created with the goal of lowering interest rates or increasing bank lending significantly relative to pre-crisis
    levels. Rather, these reserves were created as a byproduct of lending policies designed to mitigate the effects of a disruption in financial markets. In fact, the central bank paid interest on reserves to prevent the increase in reserves from driving market interest rates below the level it
    deemed appropriate given macroeconomic conditions. In such a situation, the absence of a money-multiplier effect should be neither surprising nor troubling.”

    So this just describes the absence of a transmission mechanism between an expansion of the base and no great expansion in lending. In the absence of interest on reserves, banks would have lent more relative to what they’ve done.

  • Adam1

    Banks do not accept deposits in order to make loans! That is a mischaracterization of how a bank operates. Banks accept deposits in order to make investments. How do they get you to deposit money with them? They offer to pay you interest on large deposits AND they operate a payment system which you can utilize. You deposit money into a checking account; the bank gives you checks (or other PAYMENT instruments) and promises to settle these payments from your account as they come due. Now when you deposit money into your checking account the bank doesn’t put it into the vault and wait for the payment requests to come in, it uses those deposits to make investments and keeps only enough liquidity to clear those payments as they are needed. Deposits are just cheap ways of funding payment requests. If a bank needs additional liquidity there are other ways of obtaining it (sell bonds, borrow from Federal Funds market, etc…)

    Loans… Loans only require deposits (or other forms of liquidity) to fund payment
    requests generated by the loans. When you receive a loan from a bank you do not
    receive money! It is better to think about what you need and what the bank is really promising. When you need a “loan” what you really need is to make a payment (or series of payments) that exceed your current ability to finance. So when you go to the bank you are really asking the bank to make one BIG payment (or a series of payments) for you in exchange a series of smaller payments plus interest. The bank is really only promising you to make a payment. This is why you typically get a loan check when you leave the bank – it’s a payment instrument – the bank is promising to make good on this payment.

    Think of the billions of dollars in Lines of Credit or Credit Cards or even overdraft payments that are never used. The bank is not sitting on deposits (costing them money) waiting for these lending vehicles to be used.

    Operationally when you get a loan you get a check – a payment promise. The check
    is going to get deposited in an account. If the check gets deposited at the same bank the bank just credits the account – the deposit comes out of thin air. The bank doesn’t take money out of the vault to make the payment it just creates the deposit. Funds or liquidity is only needed when a payment request is made.

    Alternatively that loan check could have been deposited at another institution that is
    now going to make a payment request to the originating institution. When that payment request comes in the originating bank only needs funds to settle that payment request. If the bank does not have sufficient liquidity at the time it will have to source the funds elsewhere. Most likely it will borrow from the overnight Federal Funds Market.

    The reason it can borrow from the Federal Funds Market is because when the deposit hit the books at the other bank the deposit became “money”. That bank took a deposit and wants to make income off that deposit. It is ready for investment and if another bank needs liquidity it’s willing to pay interest to borrow from another bank with excess deposits. (note: a bank can invest money from a deposit the moment the teller hits enter on the key board. Yes the bank is taking a risk that the payment is rejected, but the bank is in the business of taking risks to make money).

    All said and done, banks use deposits as an inexpensive way to fund their payment system and while loans do generate payment needs they also generate their own deposits so they are self funding. (note: it is possible a loan does not generate a deposit. Example: a car dealer goes to his bank and CASHES a loan check he received from a customer. No deposit (at this time) is made. If there are no excess deposits in the banking system such as in this example then the FED will always make sure there is sufficient liquidity in the system. The FED’s primary role is to insure the payment system does not fail (hence the
    FED discount window). Reserve requirements are suppose to help protect the payment system and have nothing to do with the creation of loans.

    Side note – even if a bank did lend reserves it will come right back to it as a deposit. The banking system can not get rid of reserves!

  • http://neweconomicperspectives.blogspot.com Scott Fullwiler

    You have no idea what you are talking about, Delta.

    1. Banks are required to hold reserves against deposits, not assets, and those have become essentially voluntary anyway over the years with retail sweep accounts.

    2. Excess reserves are NOT by definition the reserves bank could lend out. As others have explained, banks don’t lend reserves except to other banks in interbank markets–but this is of no consequence since the Fed always supplies the qty banks desire at its target rate; that’s what it means to hit an interest rate target.

    3. IOR doesn’t constrain lending. A bank loan always has to exceed the risk-free return, with or without IOR. And without IOR, there are these things called Treasuries that banks could hold instead of lending, yet somehow they still make loans.

    4. Bank cannot get rid of the reserves in the aggregate unless the Fed drains them. Reserves are a liaiblity on the Fed’s balance sheet, and only other changes to the Fed’s balance sheet can change the aggregate quantity. That’s accounting 101.

    5. The current rate in the fed funds market is of no real consequence. Interbank lending has slowed to a trickle given all the excess reserves. The interbank trading is at a slightly lower rate than the target because of a quirk in how the Fed pays IOR–it doesn’t pay the GSEs and a few other instititutions, which must find a bank to deposit their balances in to earn any interest. Given that banks are flush with reserves, they won’t take them at 0.25%. The fact that banks won’t take the only balances out there that an instiuttion is actively trying to shop at 0.25% basically proves that banks DON’T want to hold reserve balances at 0.25%–they are NOT happy to hold reserves at 0.25% besides lending, that is. The two are unrelated.

    6. The fact that BoA and Citibank have increased their fees for depositors further shows that banks are having difficulty keeping interest margins holding all the reserves at 0.25%.

    7. As if this should need to be said, but it clearly does–loans create deposits. Reserves NEVER fund loans. Banks can make all the loans they want and still hold the excess reserves at 0.25%, particularly since the latter have no capital charge.

    8. The Fed CANNOT hit a positive interest rate target without either draining all undesired excess reserves or paying IOR. That is, you, Krugman, etc., don’t understand monetary operations to understand that the “liquidity trap” where reserves and Tbills are perfect subsitutes is operationally necessary to carry out QE and the other non-conventional practices the Fed has engaged in. The two cannot be operatoinally separated, but somehow there is this view that the IOR is keeping the unconventional operations from “working.”

  • Lenny

    Banks currently get 0.25% on their *excess* reserves.

    We all understand that banks don’t lend reserves they will lend to any credit worthy borrower.

    The definition of a credit worthy borrower must include some balance between risk and return. In other words if it were possible to make a little more on the loan then the assessment of who is the marginal borrower would change. A guy may not be “credit worthy” at 10% but maybe credit worthy at 20% (to take extreme numbers).

    So I would put it to you guys that a rejecting Delta’s points that lowering the excess reserve rate could marginally increase the number of people deemed credit worthy by increasing the spread between their excess reserves and whatever they are charging the marginal borrower.

  • http://neweconomicperspectives.blogspot.com Scott Fullwiler

    The problem, Lenny, is that even without IOR banks can always choose to hold the risk-free asset, Treasuries. Any loan, with or without IOR, has to be preferable to the risk-free asset. Substituting IOR for Treasuries into the decision makes absolutely no difference.

  • http://neweconomicperspectives.blogspot.com Scott Fullwiler

    That article by the Fed gets several things wrong, as do you, thanks to decades of incorrect teachings on banking and monetary operations.

    “I’m not using the multiplier effect argument in a normative sense. I’m simply saying that in the absence of interest on reserves, there would be an inflationary effect. ”

    And that’s 100% wrong. Not to mention that it’s operationally impossible to do unconventional operations and not set the target rate equal to IOR. If you don’t understand what that means, then you don’t understand monetary operations.

  • http://neweconomicperspectives.blogspot.com Scott Fullwiler

    btw, your article on MMT was pretty good. :)

  • +2 Overdrafter

    Adam1, sounds like you spent some time working at a Fed Funds Desk at a bank. I did, and while it’s been 15 years, your operational description is exactly right. You sit at a desk all day watching payments move in and out of bank balances, net your ending balances at the end of the day, move some balances around between banks as needed, and finally settle your net position in the overnight market. Fill out some blue and pink pieces of paper (debits/credits) to reflect the day’s activities, send them over to operations for processing, and come to work the next day hoping you didn’t overdraw an account somewhere in the banking system (or leave any funds sitting idly by). Rinse and repeat every single day thereafter. It always works.

  • Needs a jar opened.

    Ok, I demand to know comment filter rules! Spill!

  • http://deltafinancials.com Delta Financials

    False. The rate on comparable treasuries can and in fact has dropped to zero. Care to check what the yield on a 3 month currently is? Yea, 0.01%. Which is better than it was yesterday! Keep in mind, the holding period on reserves held with the fed is 7-days (or is it 14?).

    So, my very very basic point remains. Interest on reserves alters the decision making metrics of banks. I still haven’t seen a rational argument to address my very limited point.

    QE was designed to eliminate counter-party risk, not to increasing lending. If it was designed to increase lending – there would have been a 0 rate on reserves, inducing banks to double up on their already terrible lending, and in that event, likely inducing mal-investment. Interest rates are sort of important things. Every heard of a highly leveraged banking system with 15% interest rates? That’s the stuff that actually kills demand for loans. So again, if you want to say banks are holding onto their reserves because there are no borrowers – I have to say, give me some of that free money. I want it.

    Like I said, the prescriptive quotient requires a lot more than MMT.

    Enjoyable debate, but can we have it without questioning each others knowledge? Surely, we don’t need a new set of fundamentalists in economic thought.

  • Pierce Inverarity

    Delta,

    Scott is one of the leading academics on bank operations, you’d do well to listen to him. I’ll let him ably tackle your objections. That said, you are still operating under the false assumption that banks lend reserves. They do not. That is the *factual* argument that is dealing with your limited point, because your point is moot.

  • http://deltafinancials.com Delta Financials

    Pierce,
    I’m sure Scott’s a smart guy, but from everything I’ve read so far – there’s nothing to suggest that IOR doesn’t alter bank behavior. The fed says it does, the evidence suggests it does – so the onus is on any of you to establish that banks CAN’T lend excess reserves. So let’s hear a logical argument for why that’s the case. Simple. I’m only too happy to change my mind – but the data is certainly consistent with the NY Fed’s paper.

  • http://neweconomicperspectives.blogspot.com Scott Fullwiler

    You completely missed my point. The point isn’t that the IOR stops them from holding a Tbill. The point is that neither the Tbill or the IOR stop the bank from lending. Does holding a Tbill stop a bank from lending? Do banks not make loans without IOR because they instead buy a bunch of Tbills? Where’s your evidence to support they do?

  • http://neweconomicperspectives.blogspot.com Scott Fullwiler

    “So let’s hear a logical argument for why that’s the case. Simple. I’m only too happy to change my mind – but the data is certainly consistent with the NY Fed’s paper.”

    I’ve provided several arguments already. Appeals to authority just mean you actually don’t know yourself. My explanation can fit both with and without IOR. Yours can’t. Without IOR, tbills arbitrage with the Fed Funds rate and would be nearly perfect substitutes for earning the funds rate on reserve balances, but banks don’t stop lending to hold tbills. Lots of data to support that. Where’s your evidence to the contrary?

  • http://neweconomicperspectives.blogspot.com Scott Fullwiler

    “So the onus is on any of you to establish that banks CAN’T lend excess reserves.”

    It’s just accounting. The creation of a loan is a bookkeeping entry that also creates a deposit. The reserves are used in settlement of withdrawals of deposits, if necessary, but under normal circumstances without so many excess reserves they are always forthcoming from the Fed in desired quantities at the target rate–that’s what it means to set an interest rate target. And there’s tons of research supporting this, too. I really don’t care what the Fed says–they’ve gotten this wrong for decades, though they’ve gotten a bit better the past few years given the necessity to understand why nothing works as they thought it would.

    Also, reserves in the aggregate are on the Fed’s balance sheet. By accounting identity, the only way to change them in the aggregate is to change something else on the Fed’s balance sheet. Banks can lend reserves to/from each other in the interbank markets, but this doesn’t change the aggregate quantity. Again, accounting 101.

  • JWG

    Delta, banks do not lend reserves. That isn’t how the system works. Take Scott Fullwiler’s word for it, despite what the grossly overrated hacks in the mass media say. Banks were jammed full with a trillion dollars worth of reserves by the Fed in 2009 to address systemic solvency concerns, not to support loans.

    Here is what a research paper from the BIS says about bank reserves:

    “In fact, the level of reserves hardly figures in banks’ lending decisions. The amount of credit outstanding is determined by banks’ willingness to supply loans, based on perceived risk-return trade-offs, and by the demand for those loans. The aggregate availability of bank reserves does not constrain the expansion directly.”

    BIS Working Papers, No 292: Unconventional monetary policies: an appraisal
    by Claudio Borio and Piti Disyatat, Monetary and Economic Department November 2009.

  • http://www.pragcap.com Cullen Roche

    Delta,

    The whole point is illogical. As I said in my first comment, why would a bank be more inclined to stop lending AFTER it has traded bonds for a lower interest bearing asset? If you are a bank and you’re earning 5% on your bonds and the Fed comes and takes your bond in exchange for a 0.25% interest bearing asset, why would you suddenly be more inclined not to lend? That makes ZERO sense. You don’t even need factual proof that IOR would not impact lending (even though anyone who understands banking ops knows it to be true). All you need is a little common sense.

  • http://deltafinancials.com Delta Financials

    lets try a diluted argument: if reserves paid nothing and treasury bills paid nothing – the benchmark that would govern bank lending would be anything that pays more than nothing. If reserves pay something, the benchmark that determines bank lending is risk-adjusted returns greater than that something. The greater the perceived ‘risk’, particularly considering they borrow short and lend long, the less likely they are to make loans. the lower their alternate return on excess reserves, the more likely they are to make that same loan on a risk-adjusted basis.

    In the current scenario, in the absence of IOR, excess reserves would lead banks to park their reserves in t-bills, driving rates lower and lower and eventually to zero. So, their benchmark for lending activity would be anything that pays more than zero. Instead, it’s anything that pays more than .25% – that’s my limited (diluted) point. So, please illustrate how this notion is flawed. I’m diluting this argument to get to the basic logic.

    One allied question. What, in your opinion happens when reserve requirements are changed? So, if I raise reserve requirements from say 4% to say 12% – what happens?

  • Pumpkin Knuckles

    Riiiight. Because ‘Needs Jar Opened’ sounds SO credible. Or? OR? ‘Pocket Rocket’. Like I don’t have enough battles going on right now, I need to fight your spam filter…I’ll take that bet, that you’re gonna regret, ’cause I’m the best there’s ever been.

    Stop encouraging me. Bring it ON.

  • Pumpkin Knuckles

    I WIN!

  • Pumpkin Knuckles

    “One allied question. What, in your opinion happens when reserve requirements are changed? So, if I raise reserve requirements from say 4% to say 12% – what happens?”

    Nothing, absolutely nothing changes. Banks just lend. And they find reserves after-the-fact, which are always made available. In fact, banks manage themselves entirely around lenders. Lenders have zero constraints outside of lending strategies/standards and capital ratios. No bank spends its time pouring over reserve requirements as a prerequisite to lending. Just doesn’t happen.

  • Ken

    Hi. Thanks a lot for the introduction to MMT. I have a few questions.

    1) Based on MMT, government deficit will lower interest rates (via higher reserves). Does interest rates refer only to the short term Fed Fund rate only?
    What about the longer term rates, which I presume should increase due to fears of inflation?

    2) If banks are not lending due to higher credit requirements and lower demand for debt. Does it mean that the central banks (ECB and Fed) should do more QE, replacing the government debt with more reserves, since they will not be lent anyway (Just a swap from interest-bearing government debt to reserves)
    There will be no inflation, if the governments starts austerity at this very moment and have 0% deficit.

    3) So what if MMT is true? Does it mean we shouldnt fear deficits?

  • Adam1

    Reserves can only be used to settle tax payments, buy government treasuries, buy currency/coin and to settle payments between banks. Reserves requirements are a vestige of the pre-computer era when actually reserve notes were trucked around the country to finalize reserve settlements between banks – that’s why there are 12 regional FED banks to make the settlement process simpler when geography mattered. In the pre-computer days if a bank did not hold a minimum of reserves they (or a whole region) could run out and then the payment system freezes up and a banking panic sets in. In the computer era reserves just appear as needed by key strokes – Canada has a 0% reserve requirement because it knows that banks don’t need to hold a minimum level because they can be instantly created when the bank(s) need them.

    As for 100% reserve banking, it stops credit creation not because the bank doesn’t have deposits to lend but because it stops the bank from operating a payment system which is what is leveraged to create loans.

  • Adam1

    Actually I manage an analytical team at the bank, but a good friend/co-worker runs the payments department so I get to ask lots of good questions when I think of them. Bill Mitchel, Warren, Scott, Randal and Cullen have really help me understand the big picture, but Joan has help me on the intricate operational details.

  • Andrew P

    I don’t think those of us on the Right are resistant to MMT as you might think, since it is the most accurate description of the financial and monetary system that I have seen. (Although banking operations are still very hard to understand in their entirety.) We just don’t like the policies that the Krugman types would want to implement. Policies like socialized medicine, which has been the greatest dream of The Progressives for at least 125 years. Issues that have more to do with the proper role of government than with how much is spent. And yes, we do want to constrain Obama’s credit card because we don’t like him spending the money on his political supporters.

    And on a side note, did you see the declaration by the Pope yesterday calling for a World Central Bank to be the sole monopoly supplier of currency to the whole earth? Declarations like that by world leaders make me cringe, because there is some possibility that such ideas could be implemented.

  • Andrew P

    Banks must pay a FDIC fee on 0.13% on deposits, so maybe IOR is the Fed’s way of covering the banks and ensuring that they are willing to take deposits far in excess of what they can prudently lend?

  • Andrew P

    Banks must pay a 0.13% fee to the FDIC on deposits. Perhaps the IOR is done to prevent interest rates from generally falling below zero.

  • Why are you sensoring posts?

    CR: “This is categorically false. Banks are never reserve constrained.”

    I disagree. This is what happened during the crisis, i.e. banks became reserve constrained before the FED intervened. Even though banks had good customers they could lend money to, they couldn’t borrow the money overnight because other banks did not trust due to toxic assets they had. This is why the FED came in.

    By that time though, the good customers were scared away by the economic conditions and they didn’t want to borrow money and as a result the banks were stuck with the funds. Your MMT math model is static and just an average result. It is like saying that if you participate in a coin tossing game where you get paid $1 for heads and lose $1 for tails, you will never lose. Of course you will lose everything if you have only $3 in your pocket and you toss three tails in a row. The model says you never lose, but in reality you get destroyed. Think about it.

    Why do you think currently banks are trying to lure each other’s customers by offering instant transfer of deposits and an iphone as a present? This is because banks have reserve requirements. During the crisis loans went bad and these reserves felt.

    That banks are NEVER reserve constrained is a huge fallacy. Often they are not, particularly during good times, but during bad times they are.

    You also said: ” Reserves, which left untouched, will result in lower rates as banks bid down rates in the overnight market as they try to rid themselves of these reserves.”

    For the same reasons in explained above, banks cannot always bid down rates, because they may not have trustworthy counterparties. This is what happened during the crisis. Thus, your premises are false and although your argument may be sound logically, the conclusion is false.

  • Ron

    Why are you sensoring posts from people who have countearguments and are still polite?

    Explain that before you explain MMT. Why are you sensoring posts that you cannot answer?

  • http://deltafinancials.com Delta Financials

    Cullen,

    Let’s get a clarification here – WHAT DOES INFLUENCE credit growth, in your view? And… presumably banks are holding on to $1.6 trillion or whatever the number is these days – because? There isn’t enough demand and that’s it?

    And.. your argument seems to suggest that IORs make no difference. So, why is the Fed paying interest on reserves? Do interest rates themselves matter? Would you accept that negative real rates lead to greater likelihood of excesses, all else equal? All else constant, do higher rates encourage savings? Do lower rates encourage borrowing? I’m just curious to see how far this divergent view of the fundamentals of banking extends to.

    Just to be clear – there are big chunks of stuff posted by others that are evidently accurate and I readily accept. But, the assertion that the Fed can go to a zero rate on the 10-year without that leading to hyperinflation and the notion that IORs don’t matter are places where I can’t follow the logic.

  • Different Chris

    Andrew P,

    I lean to the right myself, dear friend. Maybe I’m wrong but I’m just speaking based on my own experiences- having conversations with friends and family members it seems to be more difficult to ‘get through’ to people who lean right.

    Regardless, it has definitely been more difficult to have these conversations with people who are more polarized either way compared to those closer to center.

    Just what I’ve noticed.

    Best,

  • LRM

    Adam1,
    I am a bit late to this discussion and you have been “crystal clear” in you past posts.
    I wondered if you could explain more on this leverage business. How does the bank track its leverage and has it been in decline lately due to less loans or has the assets backing the leverage been internally marked down to reflect deterioration in asset values and so even though less loans, leverage is increasing
    You mentioned in a previous post that a bank can create a loan out of thin air if the payment ends up in house but when the payment is made by competitor bank, it then needs to cover this with a loan. What portion is thin air stuff for typical loan book

  • perpetual neophyte

    See this article from Cullen:
    http://pragcap.com/i-want-to-come-back-as-the-federal-reserve-you-can-intimidate-everybody

    I ran my own numbers before I saw he had, using the FFR, 2-year Treasury yield and 10-year Treasury yield. From 1971-08 through 2011-08, I found a 97% correlation between the FFR and 2-year yield and an 88% with the 10-year yield over that time period.

    The correlation has not been as high in the recent “ZIRP.”

  • Nephric

    Adam1:

    When you say that banks can only use Reserves to buy cash/coin, etc could that be expanded to allow the banks to buy gold and silver? Could the run up in gold and silver prices during QE have been at least partly attributed to the commercial banks buying those precious metals with their newfound excess reserves forced upon them by the Federal Reserve?

  • Peter D

    >>But, the assertion that the Fed can go to a zero rate on the 10-year without that leading to hyperinflation and the notion that IORs don’t matter are places where I can’t follow the logic.

    Look, there is something to your concern because hyperinflation is not just a monetary phenomenon – it has to have a psychological component to it. If people are scared enough – even for the wrong reasons – there could be a self-perpetuating panic, a self-fulfilling prophecy. It could happen tomorrow if a large chunk of population all of a sudden decided that all dollars were worthless, started a campaign of civil disobedience and not pay taxes etc. You have to have a serious social breakage for hyperinflation to ensue – this is the point of Cullen’s essay on hyperinflation – look it up.
    But this is very unlikely under normal circumstances. What happens when he Fed monetizes the entire debt of the US govt? The system is flushed with reserves, but these are just asset swaps: reserves for bonds. And those that held the bonds did so not because they were “bribed” not to spend, but because they wanted to save – in fact, for the non-govt sector in aggregate the only way to save is in HPM or bonds – all other assets are liabilities of some other entity in the non-govt sector at the same time and thus cannot serve as saving vehicles for the aggregate non-govt sector. The people that needed the bonds to save would have to find other assets to invest into. This will be self-defeating, as per above and would lead to higher asset prices=>lower yields=>new indifference levels where at the margin people will just be more willing to hold cash. Yes, there would be price adjustments (Cantillion effects) due to asset appreciation and the dynamics could be unstable, which is why most MMTers don’t advocate retiring the debt in too short timeframe, but doing so gradually while keeping a short term option (such as 3-months T-bills) available to satisfy non-govt sector’s savings desires.
    By the way, another point to keep in mind is that to hit a target rate on any point on the yiled curve the Fed does not even need to do open market operations – it can do “open mouth operations” – just announce the target rate. The market, knowing that the Fed can always hit it, gravitates there on its own. It happens all the time with the overnight rate, see this paper by Marc Lavoie:
    http://www.economia.unam.mx/amhe/pdfs/conferencia_marc_lavoie_01.pdf

  • jt26

    Occam’s razor … choose the simplest explanation ….
    Savings rate goes from >10% pre-1990s to -1% in 2005 back now to 5%. That’s all you really need to know.
    Anyone, who has ever had a relative who lived through depression or anyone who had a son/daughter in college in 2005 where they were practically giving 3-4 credit cards away and actually used them to buy ipods, knows there is a vast range of human behaviour.
    That’s all you really need to know.
    A 20-decimal-place model with 17 fitting parameters does not prove a liquidity trap … or pretty much any other model.

  • Peter D

    Uh, Cullen, I replied to this Delta’s comment, but apparently my comment got caught in the spam filter or something – can you check? It wouldn’t let me post it twice…

  • http://www.pragcap.com Cullen Roche

    I don’t censor posts. The spam filter is an external plug-in for the website. If your post gets hung-up in it it’s most likely because you’re using funny formatting, too many links, an odd email, etc.

  • http://www.pragcap.com Cullen Roche

    The credit markets did freeze in 2008/2009, but not because banks were reserve constrained. This chart pretty much blows that theory out of the water. Why did lending continue to crater if banks were reserve constrained and the Fed was dumping billions in reserves onto bank balance sheets?

  • http://www.pragcap.com Cullen Roche

    Got it. Not sure why that happened…..I check it a few times each day so don’t worry if it happens. I always clear it.

  • Wasl

    Cullen how do you think this all plays out for MReits as it seems some of the big boys are almost an extension of the FED as far as money cost?

  • Peter D

    Agree with Scott! Delta’s MMT article is pretty damn good:
    http://deltafinancials.com/2011/09/26/modern-monetary-theory-mmt-and-quantitative-easing/
    Except I think you’re putting the horse before the cart in the IOR part, as per our discussion here :)

  • Rick

    Why does the chart blow the theory away? The money came to the banks in the form of QE for events that happened BEFORE the start of that chart. The problem was before that. Then, despite the QE banks didn’t lend but put the placed the money with the FED.

    “Why did lending continue to crater if banks were reserve constrained and the Fed was dumping billions in reserves onto bank balance sheets?”

    Two different things here. Lending continued to crater because people didn’t want to borrow being afraid of the future. Any talk about reserves is irrelevant.

    Banks can ideed create deposits from loans but only until they cannot do that any more and they need actual cash to create loans. It is a complicated system with many variables at play. Banks need cash deposits to meet reserve requirements. Ultimately, reserve requirements and the ability to create more deposits from loans are related with what is called a “Bank Rating”.

    Banks and the financial system do not operate based on any economic model. They have their own rules. Please do not try to explain to anyone how banking works through a simplified aggregate model like the MMT. It ain’t that simple.

  • plain jane

    I think it’s because we know “value” has to come from the people, and since people’s ideas of value and money are all tangled up it’s hard to separate it out and say, “OK, yes, value and productivity come (largely) from the private sector, but “money” comes from the government.”

    Pretty much everyone I know is military, or ex-military. I live in a military town. To me it is a little model of how it all works– the federal gov puts money into the bank accounts of the soldiers, and into the pockets of contractors to work on infrastructure, healthcare workers, etc.

    Then they all go out and spend, and private businesses spring up to serve all those workers. The state/local levels of government rely (largely) on the resulting taxes to fund things like schools and road maintenance off-post… and it would ALL blow away in the wind without Uncle Sam’s spending, for better or for worse!

    (So then it’s super-weird to see these same people, either directly or indirectly employed by the US Government, going on about Ron Paul, gold-standard, taxation-as-theft, etc. My “liberal” friends are sometimes even weirder, though. lol. Listening to my local Paulbot and her German democratic-socialist interlocuter rave at each other about how *the US is turning into Greece!* and merely disagreeing about how much to cut/tax/sacrifice to the gods to avoid that, is slightly surreal now. When in doubt, nod and smile!

    Anyway: money! Not the same thing as wealth, or virtue, or even usefulness. I guess I think that is easy to forget.

  • http://www.pragcap.com Cullen Roche

    Banks are capital constrained. They are not reserve constrained. You don’t seem to be understanding that distinction. You said:

    “Lending continued to crater because people didn’t want to borrow being afraid of the future. Any talk about reserves is irrelevant.”

    I don’t disagree. In fact, that was my point from the very beginning….Banks lend when they have credit worthy customers. Not based on their reserve position.

  • Rick

    “Banks are capital constrained. They are not reserve constrained. You don’t seem to be understanding that distinction.”

    Could you explain the distinction? Isn’t reserves a form of capital?

    Your point was that banks create deposits from loans and they are not reserved contrained. You point is false empirically. Remove deposits from a bank and it defaults immediately no matter how many loans it can make.

    My point was that while your statement is true under normal conditions it is NOT generally and actually fails a crisis. This means your theory failed completely during the crisis.

  • http://www.pragcap.com Cullen Roche

    Reserves are an asset. Capital is equity.

    I said that loans create deposits. Maybe read these links. I recommend the comments by Scott Fullwiler:

    http://pragcap.com/discussion-forum?mingleforumaction=viewtopic&t=138

    http://pragcap.com/discussion-forum?mingleforumaction=viewtopic&t=120

    http://pragcap.com/discussion-forum?mingleforumaction=viewtopic&t=25

    Banks didn’t stop lending because they didn’t have enough reserves. They stopped lending because they were scared of doing business with another bank that might have deficient capital.

  • Adam1

    In some of my post I say that a bank “leverages” its payment system to make loans. When I say that I am using leverage in a more generic term; banks utilize the capability to clear and settle payments to provide customers with a product that is called a loan. However the “loan” that is provided is really just a promise to clear and settle a payment. You walk into the bank, the bank uses underwriting guidelines to asses your creditworthiness and if it deems you good it will provide you with a loan check (a payment instrument). It then uses its payment system to ensure that the loan check is depositable (somewhere in the banking system). The process of depositing the loan check creates a deposit.

    “You mentioned in a previous post that a bank can create a loan out of thin air if the payment ends up in house but when the payment is made by competitor bank, it then needs to cover this with a loan.”

    If a loan check is deposited at the originating bank or at a competitor bank a deposit comes out of thin air. The process of pressing enter by the teller creates it. However, if the deposit occurs at the competitor bank the actual check still needs to be cleared and settled… enter payment system stage right… the competitor bank will make a request of the originating bank to clear the check. The originating check will then say yep we wrote the check and it’s good. When all checks between the institutions are cleared they then determine the differences owed and exchange reserves. If the bank that originated the loan is also the one who net owes a balance (during the settlement process) and is short funds, they can always source additional funds in the Federal Funds Market (remember the accepting bank has a new deposit to loan out if it chooses) or at the FED discount window.

    This whole process is what MMT refers to as horizontal or bank or credit money creation. While I have used the term “out of thin air” many times, any healthy bank should be capable of converting assets into reserves and then into currency to meet depositors needs.

    As for bank leverage… from a generic accounting perspective it’s the ratio of total assets (loans, treasuries, investments, etc…) to bank capital (equity). When a loan goes bad it is bank capital that takes the hit on the non-asset side of the balance sheet.

    The bank I work for had somewhat higher loan losses last year then expected but this year we have had less than planned for (planned for… banks set aside operating capital and retained earnings to build “capital reserves” in anticipation of loan losses). Overall we’re a very healthy institution and since we’re in Upstate NY we were spared the housing bubble and its collapse.

  • Adam1

    “(Cullen) Banks are capital constrained. They are not reserve constrained. You don’t seem to be understanding that distinction.”
    (Rick) Could you explain the distinction? Isn’t reserves a form of capital?”

    You may find “loan loss reserves” as a category on a bank balance sheet that is equity/capital; but this is just capital that is set aside for EXPECTED losses. If loan losses are larger than expected than the bank just has to write down other capital and hope that they don’t write down so much that the FDIC doesn’t shut them down.

    On the asset side of the balance sheet there are the types of “reserves” that you hear talked about a lot on Cullen’s site (or by other MMT’ers). These reserves are the heart of the bank payment system. This is the money that is used to clear and settle payments and what makes horizontal banking possible. I’ve given a pretty detailed operation description in a few earlier comments to this blog post.

    As for what happened in 2008/09 there are two very key items that occurred to cause the crash. 1) Investment banks (at the time) and shadow banks did not have access to the FED discount window so their liquidity could be shut off (and was). 2) Many of the shadow banks and investment banks had relied on cheap short term lending to fund their assets (via a bank payment system) and were relying on rolling over their liabilities.

    So what happened to say Bear Sterns or Leahman Bros was that they got shut out of the overnight banking market (because they were perceived as an extreme lending risk) and at the same time they needed funds to meet their short term liabilities which were rolling over every day. When they couldn’t get funds via lending markets they were forced to sell assets and a fire sale it was. When a bank is forced to fire sale its assets to stay open it’s only a matter of time before they become insolvent as asset values plummet. And the rest is history.

    The crisis didn’t start because they were reserve constrained, but because their balance sheets were a mess and once they were locked out of the market they didn’t have access to the FED discount window to ensure liquidity while they properly wound down their assets. Why do you think all of the remaining investment banks went out and bought or got bought by banks? To ensure access to the FED discount window!

  • Gerald P

    Andrew, does it matter that countries with “socialized medicine’ all have longer life averages than the USA? Germany has had it longest and, for example, their recruits were better than the English. A healthier country is, I believe, a better country. True,it needs to be smarter to cost less, but Medicare with all its faults is much cheaper than private insurance.

  • Rick

    CR: “Reserves are an asset.”

    AFAIK the assets of a bank are its loans and its liabilities are its deposits.

    It appears you and ADAM1 have redefined banking terms to fit your theory.

  • Pumpkin Knuckles

    Reserves are assets. When a bank purchases USTs, where would you place that on its balance sheet?

  • Sideshow Bob

    re: differences between reserves and capital

    Might be worth pointing out here that in Australia there is no reserve requirement placed on banks by the central bank but there are capital requirements placed on banks by the banking regulator.

    AFAIK Canada operates similarly.

    The upshot is that by definition the banks there are not reserve constrained but they are however capital constrained.

  • Pierce Inverarity

    I tried pointing that out earlier re: Canada. Doesn’t seem to be sticking for those who believe banks lend deposits and are reserve constrained.

  • http://www.pragcap.com Cullen Roche

    Yep. Thanks guys.

  • http://neweconomicperspectives.blogspot.com Scott Fullwiler

    “Lets try a diluted argument: if reserves paid nothing and treasury bills paid nothing – the benchmark that would govern bank lending would be anything that pays more than nothing.”

    If reserves and tbills pay nothing, then the target rate is at or near nothing, too (otherwise tbills wouldn’t pay nothing–there’s an arbitrage). And that’s your benchmark. The prime rate will be 3% above that. T-notes will arbitrage mostly with 0 and expected future target rates, and will set a benchmark for other rates like mortgages.

    “If reserves pay something, the benchmark that determines bank lending is risk-adjusted returns greater than that something.”

    No. In Canada, reserves pay “something” always, but this “something” is always 0.25% below the target rate. It’s the target rate that matters. Only when IOR is set equal to the target rate does IOR matter, and IOR must be set equal to the target rate if you run “unconventional monetary policy” like QE. You can’t separate them operationally.

    “The greater the perceived ‘risk’, particularly considering they borrow short and lend long, the less likely they are to make loans. the lower their alternate return on excess reserves, the more likely they are to make that same loan on a risk-adjusted basis.”

    As above, this is wrong. The benchmark is the fed funds rate, wherever it is. That’s the one rate that cannot be arbitraged up or down if the Fed doesn’t want it to be.

    “In the current scenario, in the absence of IOR, excess reserves would lead banks to park their reserves in t-bills, driving rates lower and lower and eventually to zero. So, their benchmark for lending activity would be anything that pays more than zero. Instead, it’s anything that pays more than .25% – that’s my limited (diluted) point. So, please illustrate how this notion is flawed. I’m diluting this argument to get to the basic logic.”

    No. The benchmark would be zero. It would be the equivalent of the Fed cutting the target rate to zero.

    “One allied question. What, in your opinion happens when reserve requirements are changed? So, if I raise reserve requirements from say 4% to say 12% – what happens?”

    Nothing aside from an extra cost to banks. In the current environment, not even that since there are so many ER already. In the pre-Lehman environment, almost nothing since banks will use retail sweep accounts to avoid RR–research already showed that since the late 1990s RR were essentially voluntary.

  • http://neweconomicperspectives.blogspot.com Scott Fullwiler

    Let me say this a different way. Essentially, all you are arguing is that if IOR went away, the fed funds rate would be zero, and this would reduce rates overall. Sure, since IOR at 0.25% is essentially the same thing as a target rate of 0.25% in the current environment (aside from some issues related to the GSEs not receiving IOR that keep the rate in the fed funds market–which is quite inactive now compared to normal, so that rate matters little at the moment–below IOR). This is correct in as far as it goes–cutting the fed funds rate target by 0.25% reduces other rates, usually. But that has nothing to do with IOR; all IOR do right now is set an effective target at 0.25% (again, the rate in the fed funds market–0.09% or whatever–is economically insignificant).

  • http://neweconomicperspectives.blogspot.com Scott Fullwiler

    “It appears you and ADAM1 have redefined banking terms to fit your theory.”

    See any bank management textbook and you will see it the same way CR and Adam1 are explaining it. I know this because I happen to teach bank management.

  • http://neweconomicperspectives.blogspot.com Scott Fullwiler

    “Could you explain the distinction? Isn’t reserves a form of capital? ”

    Rick, that’s all we need to see to know that you don’t know what you are talking about. Next time you criticize MMT, you might want to familiarize yourself with what a bank’s balance sheet actually looks like first.

  • Adam1

    “When you say that banks can only use Reserves to buy cash/coin, etc could that be expanded to allow the banks to buy gold and silver?”

    No, because these are items denominated in dollars. If you write a check for a pound of gold you will get a pound of gold. The seller of the gold will get a check which will be deposited at a bank and then the banks will clear and settle that payment with reserves.

    There is a hierarchy of money within the monetary/banking system and some of that money is nothing more than accounting entry on a balance sheet (though it usually can over time be converted into a reserve/unit of currency) and then there is the “real” money – reserves. Reserves are at the heart of the banking/monetary system and they have few uses for a bank – buying currency and coin, settle tax payments and buying bonds (because the treasury’s accounts are at the FED and “bank created money” can’t be passed up the hierarchy) and settle payments between banks.

  • jrbarch

    Hmmm .. Patanjali, maybe over 5 thousand years ago described ego as a “modification of the vritti” (mindstuff). In other words – vapour. To match the strutting stuff of the male of the species we have a trillion dollar industry massaging the vanity of the female – still vapour!

    What we need ‘running the individual (by which means the joint would take care of itself)’ is the application of human intelligence elevated way above ego and ruled by compassion. To paraphrase an old yogi from long ago: ‘Without the heart, the worldly mind is born in darkness, lives in darkness and dies in darkness’.
    It’s always been that simple!
    Human 101 …

  • Pumpkin Knuckles

    I have no idea what any of that means, but I am confident I’m on board with it. Call it woman’s intuition.

    Problem is that the more civilized humanity becomes or attempts to become, the more miserable men get. We can’t afford health care, but we can pour trillions of dollars into wars. And as one winds down, prepare for the next. Everyone cheers.

    It’s as though, in a nearby galaxy, we are some kid’s science project gone awry. And HE can’t stop laughing. But if I can get my hands on him, I fully intend to stuff him into the giant sea monkey tank he’s created. And then make him wear an over-sized snowmobile suit. Until he cries.

  • Rick

    I never claimed to be an expert. You did. Soon you will make a mistake and be exposed like all self-proclaimed experts. I asked a question. You attack me right away. Maybe you think you know. You play with words and you are ignorant of the fact that banks around the word use different definitions. For example in Australia there are no reserves.

    Stop your red herrings and your play with words. Banks are reserve constrained. Why would they care to raise cash deposits if they were not? Ask yourself this question Mr. Expert. Do you know of any bank that has no cash deposits? If banks could create deposits from loans without reserve constraints then why should they have private banking departments? Do you know that in all banks the most important department is the one that raises cash from people to who they never going to loan anything?

    and you appear as an expert…lol

    Just think why is Ms. Merkel is asking for bank recapitalization through raising private capital? If banks could create deposits from making loans why that would be the issue? Ask yourself.

    Simply because when times are tough Mr. Expert, banks become reserve constrained. They cannot fund an open gap from the open market and they must find actual cash to lend.

    It is only a fantasy that banks create deposits from loans. Even a high school kid can understand that this leads to a blow up unless there is a reserve constrain in the form of real cash in the whole system, something that acts as a firewall to a blowup.

  • http://www.pragcap.com Cullen Roche

    Rick, you’re still misunderstanding the basic difference between reserves and capital. This conversation has clearly run its course so lets avoid getting personal. I suggest you read the links I posted and let it sink in.

    Cullen

  • http://neweconomicperspectives.blogspot.com Scott Fullwiler

    Rick,

    1. You have no idea what you’re talking about, and the fact that you resort to name calling, etc., only shows you have no arguments. It makes you look really smart, too, by the way, so keep doing it. Impressive.

    2. Regarding “cash” deposits, whatever that is–now who’s making up terms? If you don’t know what I mean by this, that’s just another sign you’re in way over your head; I’ll just assume you mean deposits since “cash” deposits is a meaningless term–people can make a deposit with cash, but that doesn’t leave a cash deposit, it leaves a deposit. At any rate, banks desire deposits because they are the cheapest liabilities and thus give banks the largest profit margin on lending, and the bank regulators give them a higher CAMELS rating if deposits make up a larger % of their liaiblities.

    3. As I said before, the terms being used here are straight out of the textbooks. Go look before you criticize again and try and show me where terms have been changed here. The fact is, as in 1 above, you don’t know what you are talking about so you are getting confused on some basic definitions.

    4. Banks are not reserve constrained. Again, you don’t understand the actual terms at issue here. If you still think I’m wrong, show with balance sheets how a bank cannot make a loan without reserves–if you want to say “I never claimed to be an expert so I shouldn’t be expected to do that” then fine, but if you can’t prove your own point you shouldn’t be putting forth an argument in the first place.